Deleveraging with a twist

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The lat­est Flow of Funds release by the US Fed­eral Reserve shows that the pri­vate sec­tor is con­tin­u­ing to delever. How­ever there are nuances in this process that to some extent explain why a recov­ery appeared fea­si­ble for a while.

The aggre­gate data is unam­bigu­ous: the US econ­omy is delev­er­ing in a way that it hasn’t done since the Great Depres­sion, from debt lev­els that are the high­est in its his­tory. The aggre­gate pri­vate debt to GDP ratio is now 267%,  ver­sus the peak level of 298% achieved back in Feb­ru­ary 2009–an absolute fall of 31 points and a per­cent­age fall of 10.3% from the peak.


This dwarfs any pre­vi­ous post-WWII experience–even the steep reces­sion of the mid-1970s.

US Debt Downturns Now 1990s 1970s
Dura­tion in years 1.3 2.3 1.3
Peak Debt 298 169 114
Debt Trough 268 163 106
Fall in Debt 31 7 8
Per­cent Decline 10.3% 4.2% 6.7%
Rate of Decline p.a. 7.9% 1.8% 5.1%

The aggre­gate level of pri­vate debt now tow­ers over the econ­omy, putting into sharp relief the obses­sion that politi­cians of all per­sua­sions have had with the pub­lic debt. Rather like Nero fid­dling as Rome burnt, politi­cians have focused on the lesser prob­lem while the major one grew out of con­trol. Now they are obsess­ing about a rise in the pub­lic debt, when in a very large mea­sure that is occur­ring in response to the pri­vate sector’s deleveraging.

If they had paid atten­tion to the level of pri­vate debt in the first place, then we wouldn’t be fac­ing explod­ing pub­lic debt today.

How­ever, though the decline in pri­vate debt is steep and con­tin­u­ing, the rate of decline has slowed. Because debt inter­acts with demand through its rate of change, this has given a stim­u­lus of sorts to the econ­omy in the midst of its deleveraging.


This is obvi­ous when one con­sid­ers aggre­gate demand as I define it: the sum of GDP plus the change in debt (where this demand is spread across both goods & ser­vices and the asset mar­kets). Though debt lev­els are still falling, because they are falling less rapidly there has actu­ally been a boost to aggre­gate demand from debt from the fact that debt is declin­ing less rapidly in 2010 than in 2009:

This is dou­bly so when the con­tri­bu­tion to demand from the pub­lic sec­tor is included, as this shorter term graph shows more clearly.

How­ever while recent data shows a pos­i­tive con­tri­bu­tion to demand from debt falling more slowly, on an annu­alised basis, the change in debt is still sub­tract­ing from aggre­gate demand–and more so than in the pre­vi­ous year. So total demand (across all markets–commodity and assets) had to fall, even though GDP itself grew. Obvi­ously most of the fall in demand has been absorbed by the asset mar­kets, which have not recov­ered to the same level of turnover as in the boom years–and nor should they.

The next table, which uses the aggre­gate debt fig­ure (pub­lic and pri­vate debt com­bined) from the Flow of Funds, shows that aggre­gate demand fell across July 2008 to June 2009, even though debt was still ris­ing, because the rate of growth of debt fell from $3.7 tril­lion to $1.4 tril­lion. Across July 2009 to June 2010, the decline in aggre­gate demand was less than the pre­vi­ous year (a 9.7% fall ver­sus a 15.2% fall), even though the change in debt had turned negative.

Variable\Year 2006.5 2007.5 2008.5 2009.5 2010.5
GDP 13,347,800 14,008,200 14,471,800 14,034,500 14,575,000
Change in Nom­i­nal GDP % 6.6% 4.9% 3.3% –3.0% 3.9%
Change in Real GDP % 3.0% 1.8% 1.2% –4.1% 3.0%
Infla­tion Rate % 4.1% 2.4% 5.6% –2.1% N/A
Total Debt 43,337,326 47,528,151 51,272,735 52,686,684 52,054,500
Debt Growth Rate % 10.0% 9.7% 7.9% 2.8% –1.2%
Change in Debt 3,934,348 4,190,825 3,744,584 1,413,949 –632,184
GDP + Change in Debt 17,282,148 18,199,025 18,216,384 15,448,449 13,942,816
Change in Aggre­gate Demand % 0.0% 5.3% 0.1% –15.2% –9.7%

The rise in aggre­gate demand sup­ported a recov­ery in employ­ment, but the prospects of this con­tin­u­ing to the point at which eco­nomic activ­ity booms once more are remote: with debt lev­els as high as they are, the poten­tial for fur­ther delever­ag­ing still exceeds the worst that the US expe­ri­enced dur­ing the Great Depression.

I have recently become aware of some other econ­o­mists using a sim­i­lar con­cept to my mea­sure of the debt con­tri­bu­tion to aggre­gate demand, which they call the “credit impulse” (Biggs, Mayer et al., http://ssrn.com/paper=1595980). They define this as the change in the change in debt, divided by GDP.

My def­i­n­i­tion empha­sises aggre­gate demand and cor­re­lates this with the level of employ­ment (or unem­ploy­ment, as above), whereas theirs empha­sises the change in aggre­gate demand and cor­re­lates with changes in the level of employ­ment. The logic is iden­ti­cal, but has the advan­tage of being able to cor­re­late the change in the change in debt with change in employ­ment. It high­lights an appar­ent para­dox: the econ­omy can receive a boost from debt, even though it is falling, if the rate of that decline slows.

The next few charts apply this con­cept using the recent Flow of Funds data, and shows why it is so impor­tant to con­sider the dynam­ics of debt when try­ing to under­stand why this down­turn has been so severe—and why it also seems to have eased. Firstly, change in employ­ment and change in real GDP are obvi­ously cor­re­lated, and on this basis this down­turn is bad, though not sig­nif­i­cantly worse than pre­vi­ous down­turns in 1958, 1975 and 1983.

How­ever when you con­sider the cor­re­la­tion between the “credit impulse” and the change in employ­ment, this cri­sis has no prece­dent in the post-WWII period:

Fur­ther­more, debt is the lead­ing fac­tor is this process. Though the cor­re­la­tion between changes in real GDP and changes in employ­ment are higher than those for the accel­er­a­tion in debt and changes in employ­ment, the “credit impulse” leads changes in employ­ment while GDP slightly lags changes in employ­ment: credit, which is ignored by con­ven­tional “neo­clas­si­cal” eco­nom­ics, is in the dri­ving seat.

This is some­thing that Keynes real­ized after writ­ing the Gen­eral The­ory (Keynes 1936), but which never made its way into the text­book ver­sion of Keynes that con­ven­tional econ­o­mists like Stiglitz and Krug­man learnt as Keynesianism.

Planned investment—i.e. invest­ment ex-ante—may have to secure its “finan­cial pro­vi­sion” before the invest­ment takes place; that is to say, before the cor­re­spond­ing sav­ing has taken place. This ser­vice may be pro­vided either by the new issue mar­ket or by the banks ;—which it is, makes no dif­fer­ence… let us call this advance pro­vi­sion of cash the ‘finance’ required by the cur­rent deci­sions to invest. Invest­ment finance in this sense is, of course, only a spe­cial case of the finance required by any pro­duc­tive process; but since it is sub­ject to spe­cial fluc­tu­a­tions of its own, I should (I now think) have done well to have empha­sised it when I analysed the var­i­ous sources of the demand for money. (Keynes 1937, pp. 246–247)

The good news in the lat­est Flow of Funds data is there­fore that a slow­down in the rate of delever­ag­ing can impart a pos­i­tive impe­tus to employ­ment. How­ever the bad news is that the econ­omy is now hostage to changes in the rate of delever­ag­ing, from lev­els of debt that far exceed any­thing it has ever expe­ri­enced before­hand. Since much of this debt was taken on to finance spec­u­la­tion on asset prices rather than gen­uine invest­ment, it is highly likely that delever­ag­ing will accel­er­ate in the future, as spec­u­la­tors tire—literally as well as metaphorically—of car­ry­ing large debt loads that finance stag­nant or declin­ing asset prices.

Drilling down into the debt data, it’s appar­ent that the sec­tor that caused the crisis—the finance sector—is the one that has delev­ered the most is also the one whose rate of delev­er­ing is slow­ing most rapidly.

This is not a good thing, nor is it likely to last. The finance sec­tor exists to cre­ate debt, and the only way it can do that is by encour­ag­ing the rest of the econ­omy to take it on. If they were fund­ing pro­duc­tive invest­ments with this money, there wouldn’t be a cri­sis in the first place—and debt lev­els would be much lower, com­pared to GDP, than they are today. Instead they have enticed us into debt to spec­u­late on ris­ing asset prices, and the only way they can expand debt again is to re-ignite bub­bles in the share and prop­erty mar­kets once more.

Here’s where the level of debt (when com­pared to income) mat­ters, as opposed to its rate of change: reignit­ing these bub­bles is easy when debt to GDP lev­els are low. But reignit­ing them when debt to income lev­els are astro­nom­i­cal is next to impos­si­ble. Spec­u­la­tors have to be encour­aged to take on a level of debt whose ser­vic­ing con­sumes a dan­ger­ously high pro­por­tion of their income, in the belief that ris­ing asset prices will let them repay that debt with a profit in the near future.

With the debt to GDP lev­els for all non-government sec­tors of the Amer­i­can econ­omy at unprece­dented lev­els, the prospect that any sec­tor can be enticed to take on yet more debt is remote. Delever­ag­ing is America’s future.

Biggs, M., T. Mayer, et al. “Credit and Eco­nomic Recov­ery: Demys­ti­fy­ing Phoenix Mir­a­cles.” SSRN eLi­brary.

Keynes, J. M. (1936). The gen­eral the­ory of employ­ment, inter­est and money. Lon­don, Macmillan.

Keynes, J. M. (1937). “Alter­na­tive the­o­ries of the rate of inter­est.” Eco­nomic Jour­nal
47: 241–252.

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About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
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132 Responses to Deleveraging with a twist

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  3. It would be great if we could find a for­mula to make the pri­vate sec­tor DELEVER and DELIVER at the same time. If the pro­pos­als pre­sented here can be imple­mented in prac­tice this may actu­ally hap­pen. More aus­ter­ity lead­ing to even greater lever­ag­ing will have the oppo­site effect.

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