The Deleveraging Cycle and Its Implications

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The Deleveraging Cycle and Its Implications

For more than 10 years, the Trends editors have been tracking the evolution of the "Debt Super-Cycle."  Prior to the Great Depression, every economic cycle ended in a crash that cleared out the excesses of that cycle and set the stage for the next cycle. 

However, since the Great Depression, governments have been unwilling to face the consequences of a full-blown crash.  That's formed the basis for interventionist fiscal and monetary policies designed to push the ultimate day of reckoning into the future.

This policy has reduced the short-term pain of economic busts, but it means each new boom cycle starts with a greater amount of debt than the prior one. This repeated ratcheting up caused private-sector debt, as a percentage of GDP, to peak at an unsustainable level in late 2008. 

As highlighted in a November 2010 special report from Bank Credit Analyst,1 so far rapid deleveraging in the private sector has been largely offset by an explosion of public-sector debt over the past two years.  As a result, total debt-to-GDP has remained virtually unchanged.

How did we get here?  U.S. households piled up debt for nearly three decades.  As a result, household debt-to-GDP rose from 68 percent in 1983, to 130 percent in 2007.  Since then, household debt has fallen 11.8 percent as a percentage of income.  Between the first quarter of 2008 and the first quarter of 2010, aggregate household credit card debt fell from $840 billion to $760 billion.  Largely due to defaults, mortgage debt as a percentage of household income is also down substantially, and BCA expects it to fall another 26 percent from current levels. 

Even more than households, the financial services sector has proactively deleveraged.  As a result, the ratio of back capital to assets in the banking system is at its highest since the 1930s.  The money-center banks have been particularly aggressive in raising new capital and reducing their risk exposure.  But small regional banks still have too much exposure to questionable commercial real estate loans.  Delinquencies for industrial and consumer loans are down, and commercial real estate loan delinquency rates have stabilized.  Meanwhile, even though residential mortgage delinquencies are still rising, it appears that banks have adequate reserves to cover likely defaults.

As we've discussed in prior issues, nonfinancial firms were, for the most part, smart enough to avoid the debt mania that engulfed consumers and financial institutions.  Therefore, debt levels are not really a factor limiting capital spending by businesses.  Big firms simply don't have the confidence in future consumer demand that would be necessary to justify an all-out capital spending binge...

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