The Broader Market

by Jordan Eizenga

The most recent publication of the McKinsey Quarterly includes an article discussing the challenges associated with deleveraging, which, in this instance, involves a country reducing its total debt to GDP.  Deleveraging is typically considered to be a drag on growth because consumption is decreased in order to pay down debt obligations.  Recent forecasts, which show the global economy in recovery mode, suggest that any negative effect on growth from deleveraging has been minimal.  The problem, according to the authors of the article, is that deleveraging may not have begun. If correct, economic growth could see slowdowns in the future.

The McKinsey article is based on research of ten mature and four emerging market economies.  Their research indicates that different parts of the economies in Spain, the United Kingdom, the United States, South Korea and Canada will likely experience deleveraging at some point in the future, though each to different extents.  In all five countries, deleveraging will occur at the household level, while in Spain, the United Kingdom and South Korea, deleveraging will also occur in the commercial real estate sector.  Spain is the only country of those listed in the study with a financial sector that will probably undergo a purposeful reduction in debt levels (relative to asset levels). 

Deleveraging will likely manifest itself through a series of austerity measures in which spending is reduced and taxes are increased - this is how deleveraging typically damages economic growth (i.e., less money for households means less household spending).  The study finds that real GDP drops during the first three years following deleveraging, but ultimately rebounds strongly in the four years following (even when deleveraging continues throughout).   

The real challenge for contemporary policymakers (referenced in a recent speech by Larry Summers) is balancing stimulative policies, crucial to mitigating the effects of the financial crisis, with the long term need to deleverage before the cost of borrowing increases substantially.   The real issue, therefore, is not if, but when to deleverage.