One of the themes we have focused on over the last three years is the deleveraging of the developed economies. But what does deleveraging mean and why does it matter in terms of economic growth?

The first question to answer is what does it mean to be leveraged? And why are we at a stage where that has to change? Simply speaking, leverage refers to the amount of debt you have relative to your ability to pay for that debt. To show the growth of leverage for the U.S. consumer, the chart below shows the ratio of household debt to household income over the 1980-2010 period in real dollars.

Source: U.S. Census and St. Louis Federal Reserve Economic Data

Interest rates declined over that period so the cost of servicing debt got cheaper but it still shows a significant rise in overall debt levels.There is nothing inherently wrong with debt - if it is put into a productive investment. A real estate investment can be highly leveraged. But if the cash flows are positive and the payments maintained, by the end of the mortgage period the payments usually constitute a much smaller real dollar amount than it had at the outset and the investor owns the equity in the building. The danger is leveraging yourself to a point where you cannot make the payments on the debt or where a small decline in the value of your assets wipes out a large portion of your equity. The productivity of household debt can, in part, be measured by the growth in income produced by that debt. the chart below shows the amount of additional household income "bought" by each dollar of debt in from 1980-200 and then 2000-2010.

Source: U.S. Census and St. Louis Federal Reserve Economic Data

Measuring the growth of household net worth  or GDP growth per dollar of household debt would produce similar results. What this shows is that American households were getting less in return for raising their overall leverage. With the death of easy credit over the last few years, American households have started reducing their leverage, sometimes by defaulting on the debt but also by reduced spending.

That reduced spending has been particularly noticeable in new housing starts and auto sales, not coincidentally two of the more leveraged purchases households make. This chart shows the number of new housing starts as a percentage of existing households since 1980:

Source: U.S. Census Bureau

and new auto purchases as a percentage of households:

Source: U.S. Census and WardsAuto InfoBank

We feel this shows households (and their lenders) have been actively pursuing a deleveraging strategy. There are two real questions going forward. The first is whether these reduced level of sales are a floor. If that is the case, it implies that at the very least, equities are fairly valued at current prices with regard to consumer activity. The second question is about the non-deleveraging entity in this equation, government. Just as too much household borrowing can result in slower economic activity when the point of deleveraging occurs, the same is true of government borrowing. The question becomes the time horizon at which that happens. While the U.S. government has massively increased its debt load over the last three years, there are no indications that its lenders are yet ready to reduce their support. But as the events in Europe have shown, this lack of lender confidence can be a rapid event with little time for participants to react.

We feel that in many ways we have seen the floor as regards to consumer purchases such as housing and autos. Deleveraging will continue but that does not imply that growth has to decline to happen, it just makes rapid growth a less likely outcome. Over the next couple of years though, governments will have to make plans for their own deleveraging. The interplay and timing of household and government deleveraging will lead to more bouts of high volatility and generally lower growth rates than historical norms in these deleveraging nations.

 Back to Top 

5 Steps to Lowering the Interest Rate on Your Credit Card