4 Steps of Debt Reduction in the Process of Economic Deleveraging

4 Steps of Debt Reduction in the Process of Economic Deleveraging

Debt repayments continue to rise which makes spending drop even further... ...and the cycle reverses itself. This is the long term debt peak. Debt burdens have simply become too big. For the United States, Europe and much of the rest of the world this happened in 2008. It happened for the same reason it happened in Japan in 1989 and in the United States back in 1929.

Now the economy begins Deleveraging. In a deleveraging; people cut spending, incomes fall, credit disappears, assets prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole thing starts to feed on itself the other way.

As incomes fall and debt repayments rise, borrowers get squeezed. No longer creditworthy, credit dries up and borrowers can no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers are forced to sell assets. The rush to sell assets floods the market This is when the stock market collapses, the real estate market tanks and banks get into trouble.

As asset prices drop, the value of the collateral borrowers can put up drops. This makes borrowers even less creditworthy. People feel poor. Credit rapidly disappears. Less spending › less income › less wealth › less credit › less borrowing and so on.

It's a vicious cycle

This appears similar to a recession but the difference here is that interest rates can't be lowered to save the day. In a recession, lowering interest rates works to stimulate the borrowing. However, in a deleveraging, lowering interest rates doesn't work because interest rates are already low and soon hit 0% - so the stimulation ends.money

Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. The difference between a recession and a deleveraging is that in a deleveraging borrowers' debt burdens have simply gotten too big and can't be relieved by lowering interest rates.

Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt - they don't even want more! Lenders stop lending.

Borrowers stop borrowing. Think of the economy as being not-creditworthy, just like an individual. So what do you do about a deleveraging? The problem is debt burdens are too high and they must come down. There are four ways this can happen.Steps of Debt Reduction

1. people, businesses, and governments cut their spending.

2. debts are reduced through defaults and restructurings.

3. wealth is redistributed from the 'haves' to the 'have nots'. and finally,

4. the central bank prints new money.

These 4 ways have happened in every deleveraging in modern history. Usually, spending is cut first. As we just saw, people, businesses, banks and even governments tighten their belts and cut their spending so that they can pay down their debt.Steps of Debt Reduction

This is often referred to as austerity. When borrowers stop taking on new debts, and start paying down old debts, you might expect the debt burden to decrease. But the opposite happens! Because spending is cut - and one man's spending is another man's income - it causes incomes to fall.

They fall faster than debts are repaid and the debt burden actually gets worse. As we've seen, this cut in spending is deflationary and painful. Businesses are forced to cut costs... which means less jobs and higher unemployment.Steps of Debt Reduction

This leads to the next step: debts must be reduced!

Many borrowers find themselves unable to repay their loans — and a borrower's debts are a lender's assets. When borrowers don't repay the bank, people get nervous that the bank won't be able to repay them so they rush to withdraw their money from the bank.Steps of Debt Reduction

Banks get squeezed and people, businesses and banks default on their debts. This severe economic contraction is a depression. A big part of a depression is people discovering much of what they thought was their wealth isn't really there. Let's go back to the bar.

When you bought a beer and put it on a bar tab, you promised to repay the bartender. Your promise became an asset of the bartender. But if you break your promise - if you don't pay him back and essentially default on your bar tab - then the 'asset' he has isn't really worth anything.

It has basically disappeared. Many lenders don't want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders get paid back less or get paid back over a longer time frame or at a lower interest rate that was first agreed.Steps of Debt Reduction

Somehow a contract is broken in a way that reduces debt. Lenders would rather have a little of something than all of nothing. Even though debt disappears, debt restructuring causes income and asset values to disappear faster, so the debt burden continues to gets worse.

Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower incomes and less employment means the government collects fewer taxes. At the same time it needs to increase its spending because unemployment has risen.

Many of the unemployed have inadequate savings and need financial support from the government. Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy.Steps of Debt Reduction

Governments' budget deficits explode in a deleveraging because they spend more than they earn in taxes. This is what is happening when you hear about the budget deficit on the news. To fund their deficits, governments need to either raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from?

The rich. Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy - from the 'haves' to the 'have nots'.Steps of Debt Reduction

The 'have-nots,' who are suffering, begin to resent the wealthy 'haves.'

The wealthy 'haves,' being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the 'have nots.' If the depression continues social disorder can break out. Not only do tensions rise within countries, they can rise between countries - especially debtor and creditor countries.

This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power, war in Europe, and depression in the United States. Pressure to do something to end the depression increases.Steps of Debt Reduction

Remember, most of what people thought was money was actually credit. So, when credit disappears, people don't have enough money. People are desperate for money and you remember who can print money? The Central Bank can.

Having already lowered its interest rates to nearly 0 - it's forced to print money. Unlike cutting spending, debt reduction, and wealth redistribution, printing money is inflationary and stimulative. Inevitably, the central bank prints new money — out of thin air — and uses it to buy financial assets and government bonds.

It happened in the United States during the Great Depression and again in 2008, when the United States' central bank — the Federal Reserve — printed over two trillion dollars. Other central banks around the world that could, printed a lot of money, too.Steps of Debt Reduction

By buying financial assets with this money, it helps drive up asset prices which makes people more creditworthy. However, this only helps those who own financial assets. You see, the central bank can print money but it can only buy financial assets.

The Central Government, on the other hand, can buy goods and services and put money in the hands of the people but it can't print money. So, in order to stimulate the economy, the two must cooperate. By buying government bonds, the Central Bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits.

This increases people's income as well as the government's debt. However, it will lower the economy's total debt burden. This is a very risky time. Policy makers need to balance the four ways that debt burdens come down.

The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a Beautiful Deleveraging. You see, a deleveraging can be ugly or it can be beautiful. How can a deleveraging be beautiful? Even though a deleveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful.Steps of Debt Reduction

A lot more beautiful than the debt-fueled, unbalanced excesses of the leveraging phase. In a beautiful deleveraging, debts decline relative to income, real economic growth is positive, and inflation isn't a problem. It is achieved by having the right balance.Steps of Debt Reduction

The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth and printing money so that economic and social stability can be maintained. People ask if printing money will raise inflation. It won't if it offsets falling credit.

Remember, spending is what matters. A dollar of spending paid for with money has the same effect on price as a dollar of spending paid for with credit. By printing money, the Central Bank can make up for the disappearance of credit with an increase in the amount of money.Steps of Debt Reduction

In order to turn things around, the Central Bank needs to not only pump up income growth but get the rate of income growth higher than the rate of interest on the accumulated debt. So, what do I mean by that? Basically, income needs to grow faster than debt grows.Steps of Debt Reduction

For example

let's assume that a country going through a deleveraging has a debt-to- income ratio of 100%. That means that the amount of debt it has is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt, let's say it is 2%.

If debt is growing at 2% because of that interest rate and income is only growing at around only 1%, you will never reduce the debt burden. You need to print enough money to get the rate of income growth above the rate of interest.

However, printing money can easily be abused because it's so easy to do and people prefer it to the alternatives. The key is to avoid printing too much money and causing unacceptably high inflation, the way Germany did during its deleveraging in the 1920's.

If policymakers achieve the right balance, a deleveraging isn't so dramatic. Growth is slow but debt burdens go down. That's a beautiful deleveraging. When incomes begin to rise, borrowers begin to appear more creditworthy. And when borrowers appear more creditworthy, lenders begin to lend money again. Debt burdens finally begin to fall.Steps of Debt Reduction

Able to borrow money, people can spend more. Eventually, the economy begins to grow again, leading to the reflation phase of the long term debt cycle. Though the deleveraging process can be horrible if handled badly, if handled well, it will eventually fix the problem. It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal - hence the term 'lost decade.'

Of course, the economy is a little more complicated than this template suggests. However, laying the short term debt cycle on top of the long term debt cycle and then laying both of them on top of the productivity growth line gives a reasonably good template for seeing where we've been, where we are now and where we are probably headed.Steps of Debt Reduction

So in summary, there are three rules of thumb that I'd like you to take away from this: First: Don't have debt rise faster than income, because your debt burdens will eventually crush you. Second: Don't have income rise faster than productivity, because you will eventually become uncompetitive.

And third: Do all that you can to raise your productivity, because, in the long run, that's what matters most. This is simple advice for you and it's simple advice for policy makers. You might be surprised but most people — including most policy makers —Steps of Debt Reduction

don't pay enough attention to this. This template has worked for me and I hope that it'll work for you.you can read more about 4 Steps of Debt Reduction in the Process of Economic Deleveraging here.