To fully appreciate what is occurring in the financial markets, I recommend reading two articles: Deleveraging: A Fate Worse than Debt from The Economist and The Question of Our Age by Tony Crescenzi.
The theme of both articles is the same- cheap credit for the past 20 years has fueled economic growth. Now that credit has dried up, can the system deleverage without causing economic contraction? The coordinated effort of the U.S and other governments is meant to prevent (or at least slow) this deleveraging process. So far the governments have added liquidity to credit markets and injected capital to expand lending and revive economic growth.
Like Crescenzi, I hope the deleveraging process can be stopped so that debt can be unwound in an orderly fashion. Current market conditions, however, seem to indicate that many people are simultaneously running for the exits. Although markets will become less volatile, the deleveraging process will require months, if not years, to resolve; just as it took years for the massive amount of debt to be created. However, I do not think it is possible to delever without economic contraction.
I think of economic growth similar to net income on the income statement. In this way, growth can only occur by expanding production (increasing sales) or by decreasing input costs (decreasing expenses). Credit fuels net income growth in two ways- by decreasing borrowing costs and increasing the amount of assets available for production.
It is unlikely production will expand because the U.S. consumer is tapped out. Like businesses, the consumer financed their standard of living with debt for the past decade. Chinese businesses were the primary beneficiaries of our spending and loaned us more money. Currently, debt stands at ~130% of the U.S. consumer’s of disposable income. Therefore, it is unlikely consumption will increase for some time, even if new, unforeseen products or services come to market.
Therefore, the only hope for growth is to decrease input costs or increase efficiency. Fortunately commodity costs have recently decreased, thus providing more capital for the economy. Additionally, the recent spike in energy costs has forced firms to improve efficiency. Although both factors will ease the effects of deleveraging, they are not immediate solutions and will take longer to affect the economy.
In summary, the entire economy needs to deleverage. The consumer is tapped out and can’t buy any more from the Chinese, who in turn financed more of our debt. The fastest way for deleveraging to occur is for the consumer to decrease spending and save. It will be painful as the economy contracts, but we’ll all be better for it in the long term.
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