EFA (44): Deleveraging

Economics has quite a few ugly terms, but among the best (that is, worst) at the moment is the concept of "deleveraging".

The Economist described it recently as "an ugly word for a painful process". But what exactly is deleveraging? This is the subject of the 44th item in our Economics for Amateurs (EFA) series.

To understand the concept, we can go back to the meaning of the term "leverage", which we discussed in detail here. Traditionally, this has been the US English term for the ratio of a company's loan capital (debt) to its ordinary shares (equity).  A highly-leveraged company is one that is financed by a lot of borrowing.

More recently, "leverage" has been used to refer generally to the financing of investments via borrowed money, such as a leveraged takeover bid.

Deleveraging, in contrast, is the process of reducing the total amount of debt. As The Economist wrote in a fascinating recent article: "History suggests that severe financial crises are usually followed by long periods of debt reduction – in which credit falls relative to the size of the economy."

Two points are important here. First, various agents in the economy can incur debts. We can distinguish between the public sector (central and local government) and the private sector. Then, within the private sector there are different agents: financial companies (banks, etc.), non-financial companies, private individuals.

Second, it makes sense to assess debt only relative to the size of the economy or the incomes of individual firms or individuals. To know whether or not a debt of €100,000 or €100 billion is large, we have to know the income level of the person, company or country that has to pay it back.

For countries, the debt level is usually measured as a percentage of gross domestic product (GDP). Britain is estimated to have a total debt level — across all sectors, not just the government — of over 450 per cent of GDP.

After financial crises, people try to reduce their levels of outstanding debts. The problem is that this is difficult for all sectors to do simultaneously.

What we have seen recently is that, as the private sector — banks, non-financial companies and individuals — has tried to cut its borrowing, demand and output have fallen. This has led to a significant (and almost inevitable) increase in government borrowing, as tax receipts fall and payments for unemployment benefits rise.

This helps to stabilize demand and output, but at some point (now), governments try to reduce their borrowing as concern grows about whether they can finance it or not. But if this is done too quickly — via spending cuts and tax rises — this can push the economy back into recession.

Deleveraging, like giving up drugs, is a very painful process and requires careful management. In most countries, the pain has only just begun.