Arnold Kling  

What's Wrong with Deleveraging?

If You Want Peace, Prepare for... Lectures on Macroeconomics, No...

In a previous post, a commenter asked a good question about what bothers me about deleveraging.

Deleveraging in the nonfinancial sector means that consumers buy less on credit and firms use less debt financing. That is obviously necessary, because we had excess leverage before.

Deleveraging in the financial sector means that banks and bank-like institutions try to hold fewer risky long-term assets and issue more risky long-term liabilities. That is a bad thing, in my view. Within the financial sector, rapid deleveraging is a beggar-thy-neighbor situation, in which firms destroy one another's liquidity. The demands for collateral to back credit default swaps are a prime example.

However, the financial sector became excessively leveraged in recent years. So what is the solution? I believe that the solution is to aggressively shut down insolvent institutions. In the case of banks, you pay off the depositors and try to make the best deal you can for other creditors (usually, that means selling the bank and writing down some its debt).

The strategy of shutting down institutions is not perfect. It scares the bleep out of people who have bonds or preferred stock in similar institutions. It makes it hard for banks to raise capital. So you have to give them some capital forebearance--let their capital ratios get low, as long as you think they are not hiding some really big losses somewhere.

There is no perfect way to get rid of excess leverage in the financial sector. But I think that getting rid of weak institutions works better than propping them up. When you prop them up, they continue to participate in the beggar-thy-neighbor process that is the ugly side of financial sector deleveraging.

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COMMENTS (6 to date)
Maniel writes:


First look at deleveraging from the debtor side. If I have taken on too much debt, it is time to cut up the credit cards and start paying it down. This is a necessary step, because once my debt service costs are using too much of my income, I will have little money to spend now and none to spend later.

Then look at it from the lender side. If I have taken on too much debt already, a lender should consider whether any new money lent will ever be repaid. A possible scenario is that I will default and that the lender will be stuck with a worthless "asset."

Will the economy suffer in all this? Yes, but an economy based on an unrealistic (debt-driven) level of spending by me (the consumer) was bound to slow. We would do well to allow the markets to work this out. We would do better to move towards an equity-based economy.

TA writes:

Two points:

First, "deleveraging" is a word that covers too much ground. When it's used, it's impossible to know what's meant until examples are cited, and then only so far as the examples go.

Second, if credit is constrained, it seems to me that the problem isn't so much that the intermediaries are trying to gather cash and sitting on it, but that the "savers" -- essentially what the Fed quaintly calls "Rest of the World" and households and their frontline repositories for their savings (mutual funds, pension funds, life ins. reserves) -- are in aggregate fleeing to Treasuries and cash and out of everything else.

Or maybe credit isn't constrained so much as households and businesses don't want to borrow. That would be deleveraging.

Philo writes:

How do you know that “we had excess leverage before”? What is the formula for determining the right amount of leverage in an economy, and what is the right amount for the U.S., and for the world, now?

While endorsing deleveraging (though, oddly, you say that within the financial sector it is a "bad thing"!), you worry about rapid deleveraging. But how fast is “rapid”; supposing that deleveraging is desirably, what is the proper pace, and how does that compare with the actual pace in the U.S. and elsewhere?

I doubt that you can satisfactorily answer these questions (perhaps no one can), and so I regard your remarks as, at best, impressionistic.

Phillip Huggan writes:

I don't mind that solution Arnold. Certinaly bailing out the good banks is better than a non-transparent process of rewarding the worst bankers in the land. I've seen a similiar idea posited I don't like where you pay bad banks to go away. This is silly.

Philo, the BIS reported derivatives contracts outstanding jumped to around $300T in 2007, from a double digit $T figure a few years before. Probably you index an acceptable leverage rate to global R+D intensity increases or something, until GDP accounts debt increases and environmental capital depreciation. Certainly 7 years of the world's GDP is too much for dumb/corrupt but powerful bankers to play with.
What people don't realize is business is usual is itself a choice. The people managing growing derivatives positions don't have the education or incentives to use their power for good and not waste. People running hospitals and Universities and civil defense institutions, and farms and utilities will eventually see their resources crowded out by bankers under business as usual, at some point in the decades ahead.

Niccolo writes:


So, are you saying that banks are now borrowing more when you say they're holding more risky liabilities?

Is that true? From what I hear in the news - not the most reliable source, I know, haha - borrowing isn't exactly at the highest level.

If so, how does it drain capital?

My questions are not really here so much about the general policy advice, but about the specifics themselves. I'd like to know all this ahead of everyone else in my grade level when I enter the business world.

Thank you for your answers.

Nicholas writes:

Hmm, this whole post about deleveraging has me a bit concerned.
Quite clearly, the appropriate level of credit/leverage in the economy is at equilibrium, where the supply of credit is equal to the demand for credit at the market-determined, risk-adjusted price. While this may sound abstract, it's important to understand that deleveraging is an appropriate market response to an environment where credit markets are way above equilibrium. Which is to say that credit providers are simply realizing that they weren't pricing credit in line with risk, and now as those investments fail to provide return (b/c credit defaults are generating losses), credit providers (financial institutions) are either vastly increasing prices on credit instruments, or they are not providing the credit at all. Thus, deleveraging is simply a market mechanism for re-pricing risk, which demonstrates that most firms could not really afford the risk-adjusted credit at the true, equilibrium price. It's really all about pricing credit - which is nearly impossible to do when you have a central bank that is constantly, artificially changing the perceived market price for credit (interest rates).

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