The great de-leveraging | FT Alphaville

The great de-leveraging

Or as Matt King at Citi put it in his latest presentation, “Payback Time: The Coming Decade of Deleveraging”. In short, we’ve borrowed much too much, and the public sector can’t substantially reduce its debt without a corresponding increase in borrowing in the private sector, or growth will suffer. All of this being particularly painful for countries that can’t unilaterally weaken their currencies.

The charts the Citi strategist uses to make these point are enthralling… but then FT Alphaville does have a tendency to go weak at the knees at the sight of a graph that perfectly encapsulates a story.

First up, the last few decades of households, corporates, and governments levering up in Europe, North America, and Japan:

Of note: Belgium saw the greatest percentage increase in 1980-1990. Portugal and Germany(!!) looked to be the worst in the decade after, and most recently everyone got in on the game. The red bars are the most relevant, being the ones that saw the introduction of the euro, hence the start of when Greece could borrow at a subsidised rate indirectly provided by Germany.

Anyone below the weighted average red bar may naturally feel a bit miffed at the prospect of having to bailout any country above it. Although this is something of a simplification given that these figures include the borrowings of all sectors.

Stepping away from Europe for a moment, here’s debt to GDP broken out by sector, for the US alone:

In summary, this time is not different, just a maybe a bit more gradual. And good of Fannie and Freddie to join us this time around in order to help fulfil the American dream of owning one’s second third home for however brief a time.

About those mortgages, and other types of leverage, and the effect on economic growth, Citi has done a bit of simplifying for us:

Pyramid scheme, you say? We feel Minsky at the very mention of it. From Wiki, which is using this paper as a source:

Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

The “hedge borrower” can make debt payments (covering interest and principal) from current cash flows from investments. For the “speculative borrower”, the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The “Ponzi borrower” (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. Because of the unlikelihood of most investments’ capital gains being enough to pay interest and principal, much of this type of finance is fraudulent.

If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.

Which brings us to the rather unfortunate fact that when governments have sought to decrease borrowing, success may in part hinge on private debt expanding their debt burden to feel the breach. Something they are rather unlikely to be able to do if even the hedge borrowers have gotten slammed.

And if not the private sector, than who is left to buy up assets? The central banks, perhaps?

The ECB, however, is just not in the mood. It’s notable just how big the holdings of the Bank of Japan are. We wonder how that’s been working out for them…

Well, that’s interesting. Someone want to show this to Angie?

Related links:
On misunderstanding QE and UK inflation – FT Alphaville
Another look back at housing and deleveraging – FT Alphaville
Ray Dalio on the D-Process in Europe – Credit Writedowns
Two Charts That Everyone Must See On Debt And Deleveraging – Business Insider