The decade of de-leveraging that wasn’t

This was the decade of de-leveraging that wasn’t. A decade ago, as the world began to piece the financial system back together after an epic credit crisis, there was agreement on one thing: Too much debt had caused the crisis, and so there must be a huge de-leveraging. It has not worked out like that.

Everyone knew that leverage was too high. In 2007, as subprime lenders went bankrupt and the crisis took hold, sinister charts circulated around Wall Street. Shooting upwards, on one side, was US household debt as a proportion of total GDP. Shooting downwards, on the other side, was the US savings rate, plunging near zero.

Consumers had grown overleveraged because the financial sector bombarded them with cheap credit, funded on absurdly generous terms by the markets. European banks, often the ultimate lenders (or “suckers” as Wall Streeters tended to call them), suffered terrible losses.

Prolonged and painful deleveraging seemed inevitable. Debt would have to be paid down or written off. Disputes over who should retrieve what from the wreckage would have to be resolved. Economic growth would be difficult if not impossible. Central bankers, trying to minimise the pain, cut interest rates to zero or below.

Behold the result of their labours: Leverage has increased. US consumers and the Western banking system have cut back somewhat, but leverage has just moved elsewhere. Their retrenchment was far outstripped by a rise in borrowing by companies and particularly by governments.

What went wrong? Money is fungible. Companies, particularly in the US, took advantage of the rock-bottom interest rates meant to bail out banks to go on their own borrowing spree.

And the world found a new borrower of last resort. Ten years ago, China had been enjoying phenomenal economic growth for two decades, and largely avoided debt to fund it. No more. China’s debt has ballooned, transforming the geography of global debt in the process. It’s now bipolar, revolving around the US and China.

The global economy suffered a difficult decade — a global Great Recession followed by a persistent slump in western Europe, and slow growth and widening inequality in the US. It might have been far worse without desperate measures from central banks and China’s debt-fuelled spending splurge. But while their intervention averted a painful deleveraging, it created an alarming set of problems.

The changing face of American debt
By 2008, household debt accounted for 98 per cent of US GDP. Americans were spending and borrowing far beyond their means. A decade later, Americans have changed their behaviour and reined in their excesses.

The deleveraging was vitiated by sluggish and unequal economic growth. You need money to clear a debt. Middle-class Americans didn’t have it and soon borrowed anew to acquire such basics of their lifestyle as a college education and a car. They couldn’t pay down debts. Outstanding auto and student loans have doubled since the eve of the crisis, from $1,36 trillion to $2,73 trillion.

Even so, painful lessons were learned from the crisis. Housing debt, even in nominal terms, is lower than it was a decade ago. Home equity lines of credit — the disastrous practice of using your house as an ATM — have declined sharply. Banks, after a brief decline, are offering more credit card debt than ever, yet their clients are staying within their credit limits.

Banks deleveraged in the US, But miles to go in Europe

Banks in the US and western Europe teetered on the edge of failure a decade ago. Only massive government bailouts tided them through. Since then they’ve been re-regulated, and they’ve used low interest rates to put their houses in order. They are unquestionably healthier than they were a decade ago. The debts of the biggest US financial companies are smaller compared with their equity than they were even in the 1970s.

Corporate borrowing soared, but quality fell
Nonbank corporations entered the 2008 crisis far less leveraged than they’d been at the beginning of the decade. But since then new debt has far outstripped the free cash they generate. This is most true of the smaller companies in the Russell 2000 Index. That suggests vulnerability.

China’s debt binge is buying less
None of these debt splurges compare to the borrowing binge that China sanctioned in late 2008 in a bid to ward off an alarming slowdown in its own economic progress. Before the crisis, China had largely managed to finance its growth without recourse to much debt. Huge flows of income from exports had done the job. The population, fast reaching middle-class living standards, still tended to fund itself conservatively. Household debt was equal to only 18.8 percent of China’s GDP. That number has since almost tripled, to 51 percent.

Is this rate of borrowing sustainable?
Chinese officials want to deleverage. But they don’t want to let economic growth drop below 6 percent per year. On several occasions, the country has started to rein in lending by banks and local governments, only to reverse course when growth begins to fall.

Much of China’s debt is ultimately controlled by the government, which has greater powers to enforce debt workouts than Western governments enjoy. But China has replaced the US as the source of greatest anxiety over debt. — Bloomberg.