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Deleveraging

Cutting debt: Great for you, bad for the economy Add to ...

Canadians with ready access to credit cards have created an economy based on high and expanding consumer debt. But what happens when John and Mary Smith and millions of other Canadian families decide to get out of debt or to reduce their debts? Can Canadians be weaned off this burgeoning debt cycle without affecting economic growth, jobs and stability?

Deleveraging - reducing debt rapidly, often by shedding assets - is an ugly term. Its economic consequences can be even uglier.

When an economy slows or a recession begins, it becomes clear that companies and individuals with too much debt must "delever" as quickly as possible. One way for a company to do this is to immediately pay down any debts on the balance sheet. If the company can't do this and the debts come due, it might default on its obligations. Any sign that a company needs to delever is usually taken as a warning to creditors and investors to keep watch on the solvency of the business.



There is a consumer counterpart to deleveraging that may be even more important. During recent boom times, households in most advanced countries sharply leveraged their finances, taking on more debt to pay for housing and consumer goods. When consumers delever, they stop buying on credit and try to pay down their debts, just as businesses do. When assets such as housing and stocks fall in value, as they have in the recent past, the debt burden is even more likely to cause problems.



It's only logical that businesses and individuals want to stabilize their financial situations and erase the red ink. But there is a dark side to the ledger: Corporate and consumer deleveraging shrinks economic activity. Indeed, massive deleveraging usually causes, or certainly exacerbates, recessions.



At the corporate level, cutting back on borrowing often means reducing capital spending and laying off staff, or freezing new hires. When consumers reduce their borrowing, it usually results in fewer housing sales, fewer purchases of cars and major appliances, less spending on travel and entertainment, and so on. In turn, the corresponding sectors slow or come to a halt.



The term deleveraging became common parlance during the U.S. credit crisis, in which banks and financial firms were forced to sell their mortgage-related securities and other risky assets to repair weakened balance sheets. All that deleveraging exacerbated the housing crisis by drying up credit availability and forcing further asset sales. So until deleveraging runs its full course in the United States, it will continue to depress housing activity and other financial sectors of that economy.



At the household level, leveraging occurs when consumer spending grows faster than disposable income. Deleveraging reverses this process and results in an increase in the personal savings rate - and a prolonged slowdown in consumer spending growth. Another way for household deleveraging to occur is through some form of debt default, such as foreclosure on real estate or non-payment of credit card bills - a painful, scary venture.



During the recent boom phase of the global business cycle, there was too little saving and too much spending. In both the boom and the bust phases, the essential balance between saving and spending was out of step for a fully employed and growing economy. Now the recession is demanding difficult belt-tightening for both companies and consumers as they try to spend less and conserve more.



But deleveraging at the consumer end has unintended and perverse economic consequences. The "paradox of thrift" mechanism, often attributed to John Maynard Keynes, suggests that if all households are more careful with their money and save more, this will lower aggregate demand, which in turn will lead to a decline in economic activity. Because the economy and the number of jobs shrink below where they would otherwise have been, total savings also declines.



Thus the paradox: Increased savings for the individual, which may be prudent and sensible, can be collectively bad for the economy. In other words, unless increased saving is matched by an increase in investment by business or governments, the economy will stay in recession.



The paradox of thrift is clearly at work now. Personal incomes and consumer spending are still declining, and precautionary savings are soaring. But business investment is lagging. The only way to bring about recovery from the slump is for governments to fill the gap with increased investment and other stimulus spending. Government infrastructure programs - such as investments in roads, schools, hospitals - take time to get going, but once they are under way, they have strong multiplier effects on job creation and economic growth.



Canadian and American consumers are sharply increasing the amount they are saving relative to their disposable income. In 2006, for example, the per capita savings rate was 1.6 per cent in Canada and 0.7 per cent in the United States, according to Statistics Canada and the U.S. Bureau of Economic Analysis. In 2008, the amounts rose to 3.7 per cent in Canada and 1.8 per cent in the United States.



Make no mistake: The increased emphasis on consumer saving will make the recession worse and will retard economic recovery. Indeed, this major shift toward frugality is expected to be one of the lasting legacies of this recession.



In sum, despite the unprecedented amount of monetary and fiscal stimulus being injected into the U.S. and Canadian economies, deleveraging by households and businesses alike limits the prospects for a quick recovery.



As well, households in both countries are facing the weakest labour market in decades, making consumers even more cautious about borrowing and spending. The U.S. unemployment rate, now at 9.7 per cent, will likely top out at above 10 per cent before the recession eases. Canada's unemployment rate, 8.6 per cent last month, will likely rise above 9 per cent before turning down. High personal savings rates in both countries will keep a lid on consumer spending and will limit the scope of the economic recovery next year.



Therefore, the need for an expanding government sector to keep Canada's economy on a growth path will be an essential component of a full economic recovery for some time to come.



Bear in mind an important lesson from Japan's lost decade of economic growth: Fiscal stimulus half-measures lead to years of subpar economic activity and make fiscal deficits even larger. Canada's job losses have been brutal in this recession, and a painful and difficult restructuring of our economy has already begun. In this unsettled environment, the federal government will need to sustain its infrastructure stimulus programs to ensure that Canada does not permanently have near-double-digit unemployment rates.



Arthur Donner is a Toronto economic consultant. Doug Peters is former chief economist of Toronto-Dominion Bank.

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