The Deleveraging Pain Is Just Beginning

Executive Summary

• How much have households, corporations, and the government combined deleveraged since 2008? (Barely at all.)
• Have our national debt-to-income ratios improved since 2008? (No, they've gotten worse.)
• Increasingly, unlevered assets will be sold to maintain the phantom value of levered assets.
• Ultimately, levered losses will need to be taken. Cash and cash equivalents will be in high demand as this happens.

Part I: The Pernicious Dynamics of Debt, Deleveraging, and Deflation

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II: The Deleveraging Pain Is Just Beginning

In Part I, we sought an understanding of the causal linkages between debt, deleveraging, and deflation. In Part II, we analyze the key data and charts to get a better understanding of how far deleveraging has to go.

The basic idea in deleveraging is that debt exceeds the value of the underlying asset—for example, a mortgage exceeds the value of the home. The difference must be made up with savings from income or from the sale of other assets, or the asset must be sold and the loss booked.

In the case of consumer and government debt, the underlying assets are, in effect, future income and future tax revenues. The student has no assets to sell to pay off a student loan; the loan was leveraged off future income. The same is true of government bonds.  Though consumers often maintain that the goods they bought on credit have retained value, in many cases the market value of items bought on credit is far below the debt still to be paid.

The situation is thus dire for loans without underlying assets that can be sold. Cash to service these loans must be raised by selling other assets or by diverting income.

I see the forces of debt, deleveraging, deflation, and inflation (money-printing) as positive (self-reinforcing) and negative (countervailing) feedback loops; the interactions are complex and can oscillate in dynamic equilibrium until a crisis pushes the system firmly into disequilibrium.

Many observers believe the answer to the high levels of debt and leverage being pursued by the Federal Reserve is to print enough money and make credit so abundant that assets will reinflate in value due to higher credit-driven demand. Once assets have inflated enough in value (or the dollar has lost enough value—either form of inflation “works”), then the reflated assets can be sold and the debts paid off.