Friday, September 9, 2011

The Painful Process of Deleveraging

People, companies and governments take on excessive levels of debt in order to either spend money they don't have on things they want in the here and now, or in order to invest in projects which are intended to initiate growth. This debt assumption is called leverage.

Using leverage is always a risky process, and if economic or income growth does not result as planned, the risk assumed by borrowing can become too much to bear. When this happens, all the individual, company or country can do is delever by paying off or defaulting on the debt. Continuously reducing debt levels is known as the process of deleveraging.

In the current environment, it may be helpful to think of the deleveraging process underway as analogous to a football game consisting of four quarters. Different players in our worldwide economy are in different phases or quarters of completing the game.

Unfortunately, we have far too many players still in the beginning quarters of the game. As such, too many of us have a very long way to go before becoming healthy and "normal" again, if ever.

The Long Slog of Paring Debt summarizes the current debt level and its meaning for economic growth this way: "Add it up: U.S. bank deleveraging is in the fourth quarter, but European banks are in the first. Overall U.S. consumer deleveraging is at halftime with housing still in the first quarter. Government deleveraging has barely begun. This will hold back economic growth for a long time."

And that's why we need to study both the causes of deleveraging and its effects as well.

The article describes the end-to-end process as follows: "In finance, leverage allows the bold or the foolish to borrow to make bets today that are supposed to pay off later. But leverage magnifies losses when things go bad. Borrowing binges are followed by spells of deleveraging in which lenders, investors and consumers borrow less, save more and take fewer risks.

The U.S. went on a borrowing binge in the 2000s and is now in the deleveraging phase. To borrow a metaphor from Federal Reserve Chairman Ben Bernanke, this is creating "formidable headwinds" that are blowing against the economy's natural momentum and fiscal and monetary policies aimed at propelling it."

My view is that we have mindlessly and needlessly stumbled onto the biggest long term societal issue of our lifetime. Its successful resolution will take many years, regardless of which future course we choose.

Because what path we opt to follow will matter so much to future generations, it's imperative that we take the time to better understand the significance of what we've done to ourselves. We must avoid, albeit unintentionally, making matters worse for our descendants. In other words, let's not compound the formidable deleveraging problems we now have, the resolution of which will take many years and hard work.

In future writings, we'll try to teach ourselves how otherwise reasonable people could have acted so foolishly. As we come to a better understanding of all this, we'll know what Pogo meant when he said that "We have met the enemy and he is us."

More importantly, we'll know what advice to try to pass on to younger generations so that they don't needlessly repeat our mistakes. Sadly, for far too many of us, it's too late to do anything about it except to warn others of our folly. But that's a warning well worth giving for the sake of future Americans, even though it will be a painful admission to make for many of us.

In any event, it's a life lesson worth both learning and teaching. Accordingly, we'll take some considerable time to deal with the issue fully and thereby enhance our American "institutional" knowledge.

Thanks. Bob.

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