How The Economic Machine Works: Part 4

Deleveraging in a deleveraging: people cut spending, incomes fall, credit disappears, asset 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 at the same time as spending falls.

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 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. 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? I don't know. The problem is debt burdens are too high, and they must come down. There are four ways this can happen: one, people, businesses, and governments cut their spending; two, debts are reduced through defaults and restructurings; three, wealth is redistributed from the haves to the have-nots; and finally, four, the central bank prints new money.

These four ways have happened in every deleveraging in modern history. Usually, spending is cut first, as we just saw. People, businesses, and even governments tighten their belts and cut their spending so that they can pay down their debt. 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. 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 a borrower doesn'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. 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 than was first agreed. 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 get worse. Like cutting spending, debt reduction is also painful and deflationary.