The Decade of Deleveraging Didn’t Quite Turn Out That Way

This was the decade of de-leveraging that wasn’t. A decade ago, as the world began to piece the financial system back together after an epic credit crisis, there was agreement on one thing: Too much debt had caused the crisis, and so there must be a huge de-leveraging. It has not worked out like that.

Everyone knew that leverage was too high. In 2007, as subprime lenders went bankrupt and the crisis took hold, sinister charts circulated around Wall Street. Shooting upwards, on one side, was U.S. household debt as a proportion of total GDP. Shooting downwards, on the other side, was the U.S. savings rate, plunging near zero.

Consumers had grown overleveraged because the financial sector bombarded them with cheap credit, funded on absurdly generous terms by the markets. European banks, often the ultimate lenders (or “suckers” as Wall Streeters tended to call them), suffered terrible losses.

Prolonged and painful deleveraging seemed inevitable. Debt would have to be paid down or written off. Disputes over who should retrieve what from the wreckage would have to be resolved. Economic growth would be difficult if not impossible. Central bankers, trying to minimize the pain, cut interest rates to zero or below.

Behold the result of their labors: Leverage has increased. U.S. consumers and the Western banking system have cut back somewhat, but leverage has just moved elsewhere. Their retrenchment was far outstripped by a rise in borrowing by companies and particularly by governments.

What went wrong? Money is fungible. Companies, particularly in the U.S., took advantage of the rock-bottom interest rates meant to bail out banks to go on their own borrowing spree.

And the world found a new borrower of last resort. Ten years ago, China had been enjoying phenomenal economic growth for two decades, and largely avoided debt to fund it. No more. China’s debt has ballooned, transforming the geography of global debt in the process. It’s now bipolar, revolving around the U.S. and China.

The global economy suffered a difficult decade—a global Great Recession followed by a persistent slump in western Europe, and slow growth and widening inequality in the U.S. It might have been far worse without desperate measures from central banks and China’s debt-fueled spending splurge. But while their intervention averted a painful deleveraging, it created an alarming set of problems.

The Changing Face of American Debt

By 2008, household debt accounted for 98 per cent of U.S. GDP. Americans were spending and borrowing far beyond their means. A decade later, Americans have changed their behavior and reined in their excesses.

The deleveraging was vitiated by sluggish and unequal economic growth. You need money to clear a debt. Middle-class Americans didn’t have it and soon borrowed anew to acquire such basics of their lifestyle as a college education and a car. They couldn’t pay down debts. Outstanding auto and student loans have doubled since the eve of the crisis, from $1.36 trillion to $2.73 trillion.

Even so, painful lessons were learned from the crisis. Housing debt, even in nominal terms, is lower than it was a decade ago. Home equity lines of credit—the disastrous practice of using your house as an ATM—have declined sharply. Banks, after a brief decline, are offering more credit card debt than ever, yet their clients are staying within their credit limits.

Banks Deleveraged in the U.S., But Miles to Go in Europe

Banks in the U.S. and western Europe teetered on the edge of failure a decade ago. Only massive government bailouts tided them through. Since then they’ve been reregulated, and they’ve used low interest rates to put their houses in order. They are unquestionably healthier than they were a decade ago. The debts of the biggest U.S. financial companies are smaller compared with their equity than they were even in the 1970s.

Europe’s banking sector has also deleveraged, but it still has a long way to go. Germany’s banking assets were three times larger than GDP a decade ago; they’re now equivalent to more than 200 percent of GDP. The biggest banks from many of the largest European countries are far too big for their home governments ever to rescue them.

If you want to explain the grinding economy of the euro zone over the past decade, look no further than the banks. They cut back their assets by an amount equivalent to the region’s entire GDP, but the process is barely even halfway through. With profits hard to come by, a long road lies ahead.

Corporate Borrowing Soared, But Quality Fell

Nonbank corporations entered the 2008 crisis far less leveraged than they’d been at the beginning of the decade. But since then new debt has far outstripped the free cash they generate. This is most true of the smaller companies in the Russell 2000 Index. That suggests vulnerability.

Big companies have enjoyed big profits, fattened by widening margins as wages stagnate. That’s allowed them to sustain a huge debt load. But drilling down shows that credit quality, as viewed by ratings companies, has tumbled. According to S&P Global Ratings, the companies rated BBB+, BBB, or BBB- (the three lowest investment grades before they would hit “junk” status and face much higher interest payments) now outnumber all of the companies with some level of A-rated debt. It looks as though companies are “gaming” the ratings companies, borrowing as much as they can get away with.

China’s Debt Binge Is Buying Less

None of these debt splurges compare to the borrowing binge that China sanctioned in late 2008 in a bid to ward off an alarming slowdown in its own economic progress. Before the crisis, China had largely managed to finance its growth without recourse to much debt. Huge flows of income from exports had done the job. The population, fast reaching middle-class living standards, still tended to fund itself conservatively. Household debt was equal to only 18.8 percent of China’s GDP. That number has since almost tripled, to 51 percent.

Overall, China’s total debt has increased sevenfold since the crisis. It accounts for more than half the outstanding debt of the entire emerging world, while its private sector has accounted for 70 percent of all new debt taken on anywhere in the world since the crisis.

This splurge kept China’s economy throbbing and generated demand for Western goods. Without it, Western banks and consumers probably could not have deleveraged as much as they have. But the stimulus from credit in China is weakening—ever-greater doses are leading to dwindling growth in output.

Is this rate of borrowing sustainable? Chinese officials want to deleverage. But they don’t want to let economic growth drop below 6 percent per year. On several occasions, the country has started to rein in lending by banks and local governments, only to reverse course when growth begins to fall.

Much of China’s debt is ultimately controlled by the government, which has greater powers to enforce debt workouts than Western governments enjoy. But China has replaced the U.S. as the source of greatest anxiety over debt.