In the public sector, profligate governments ran amok in deficit spending that pushed them toward sovereign default. In an earlier column (“Lessons from leveraging and pains of deleveraging,” March 10, 2008), before the global financial crisis had reached its nadir, the credit markets freezing abruptly in the fall of 2008, I discussed the expected costs of deleveraging, which is the unwinding of unsustainable global debt burdens, as the ultimate collateral damage from the crisis. Since then deleveraging, slow and painful, has become a serious drag on economic growth.
Since late 2009, the escalating eurozone sovereign debt crisis has been the epicenter of involuntary deleveraging that is likely to cause economic stagnation, even contraction, for years to come. The US, whose subprime mortgage mess triggered the global financial crisis of 2008-09, has achieved remarkable deleveraging in its private sector, comprising the household, financial and corporate sectors. Two-thirds of the household debt reduction resulted from defaults on home mortgages and other consumer loans. But its public sector, especially the federal government with rapidly rising leverage that reached a post-World War II high last year, has not yet found a secure path to lasting fiscal stability due to political gridlock. That cost the US its first sovereign credit downgrade last August, when Standard & Poor's removed the top AAA rating the US had for 70 years. One of the reasons why emerging market economies will continue to grow faster than advanced economies is that they have been relatively less leveraged, partly due to their less developed financial systems.
In the last two years, the McKinsey Global Institute (MGI), the research division of international consulting firm McKinsey & Company, has conducted a major international study on the growth of debt and leverage before global financial crisis, the consequences of deleveraging and the implications for government and business leaders. Its first report “Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences,” issued in January 2010, focused on defining leverage and measuring deleveraging costs. (See my columns “Deleveraging revisited” (1) and (2) Jan. 18 and 19, 2010.) In the report, “debt” referred to outstanding debt (all credit market borrowing, including loans and fixed-income securities), measured across countries by the debt-to-GDP [gross domestic product] ratio; “leverage” referred to the debt-to-asset or debt-to-income ratios, measured differently across different sectors.
The main argument of the 94-page report was that the total debt-to-GDP ratio by itself is an inadequate leverage indicator. Leverage had to be viewed from multiple lenses, measured at different levels using different metrics, distinguishing among the household, financial, corporate and government sectors. The likelihood of deleveraging across the four sectors depended on their absolute leverage levels, debt and leverage growth rates and debt service capacities as well as vulnerabilities to income, funding and interest rate shocks. The report offered country and sector-specific analyses of the past, current and expected deleveraging trends in the global economy. It contained an in-depth analysis of 45 significant deleveraging episodes during which the total debt-to-GDP ratio declined for at least three consecutive years and fell by 10 percent or more, 32 of them following a financial crisis, since the 1930s. Turkey's single episode, during 1987-2003, qualified as one of the seven cases of the “massive default” archetype, each of which followed a financial, mostly a currency, crisis. Turkey's debt-to-GDP ratio started at an incredible 25,371 percent, by far the highest among all the cases, and ended at 92 percent. The report concluded that although the global financial crisis of 2008-09 was over, we faced prolonged and painful deleveraging, especially in developed countries, for years to come, which would be a serious drag on global economic growth.
The MGI has issued two updates of this report. Its first, brief and preliminary, update issued last July, found that the debt ratios in most major economies stabilized and in some cases had started to decrease only slightly. But in many countries the decline in private sector debt was offset by a significant rise in public sector debt due to the Great Recession that resulted in higher government expenditures and lower tax revenues. It concluded that deleveraging had just begun, with the speed and pattern varying across the major economies. Last month the MGI issued its second and full 64-page update, “Debt and Deleveraging: Uneven Progress on the Path to Growth.” I will review its major findings and implications next week.
