Deleveraging

Deleveraging is the process by which either economic units (taken individually) or the economy as a whole get rid of their debts. The most obvious way of carrying this out is by repaying existing debt, which should result in the aggregate stock of debt decreasing. However, while debt may fall in nominal terms, the attempt to deleverage - that is, to repay debts accumulated in the past - can increase the burden of debt in real terms.

According to Fisher (1933), repaying the debt implies a decrease in the means of payment in circulation and therefore a fall in the price level. This logic is based on the quantity theory of money. As a result, this fall would increase the debt in real terms; during a crisis, therefore, the attempt to repay debt would result in a larger debt. This means that if all units simultaneously try to deleverage, a debt deflation could occur, resulting in a self-defeating exercise.

This is what happened during the 1929 financial crisis. In other episodes of banking crises, the deleveraging by the private sector was offset by an increase in public debt, which avoided debt deflation. For instance, this occurred in the United States during the 2008-09 global financial crisis. However, this was not the case in the euro area. Rather, as households and firms were trying to get rid of previously accumulated debt, some coun- tries, especially those in the periphery of the euro area, were constrained by fiscal rules, which were agreed upon at the European Union level, but also by pressure by financial markets to cut government deficits in order to reduce debt. Hence, both the public and private sectors were trying to increase their savings at the same time. This uncoordinated effort resulted in a fall in income, which in turn caused a further round of cuts in govern- ment expenditures and increases in taxes as the objectives of a falling public debt as a ratio to GDP had not been achieved. Note, however, that the attempt to repay the debt did not directly cause a fall in credit and in the price level, but a fall in nominal income and in the price of assets.

While the rate of change in the price level has not become negative on average, it has nonetheless slowed down. Prices of financial assets and real estate have declined, because the private sector was selling assets to a greater extent than before the crisis, in order to repay old debts and, above all, to be able pay the new higher taxes, particularly those on real estate.

Further, owing to the discrepancies between euro-area countries' interbank and finan- cial markets, long-term interest rates (measured in a way that allows comparisons - the so-called harmonized long-term interest rates for convergence assessment purposes) have increased between 4 and 10 per cent for those countries that have experienced large cuts in government deficits as well as increases in government debts (see European Central Bank, 2014, p. 51). In these countries, the rate of growth of credit to the private sector has been negative throughout the 2011-13 period (ibid., p. 49). If the higher interest rate is used to discount future income flows, then the present value of these assets will decline. Because of the low rate of increase in prices, the real value of debt and real interest rates are rising.

Under these policies, a debt deflation process as described by Fisher in the 1930s, which affects not only the general price level but also the price of assets in a Minskyan way, has begun (see Minsky, 1986; Tropeano and Vercelli, 2014). The fall in income out of which debt is repaid means in the end that debt cannot be repaid and that the deleverag- ing attempt has failed.

See also:

Asset price inflation; Debt deflation; Euro-area crisis; Financial crisis; Minsky, Hyman Philip; Quantity theory of money.