Deleveraging out of the debt mire will be an unsavoury task
Comment of the Day

January 15 2010

Commentary by David Fuller

Deleveraging out of the debt mire will be an unsavoury task

My thanks to a subscriber for this topical column by Gillian Tett for the Financial Times. Here is the conclusion
Contrary to popular perception, for example, McKinsey points out that, by historical standards, most of the financial world was not crazily leveraged in the past decade. Instead, the crazy debt increase was focused on a small group of brokers, and global banks.

Moreover, alongside the (limited) rise in broker borrowing in the past decade, there was also a far more startling increase in "real economy" debt, particularly in the household and real estate sector. Since the crisis started, this "real economy" debt has declined a tiny bit, while financial sector leverage has fallen considerably. But since public debt has spiralled, gross leverage levels for most large nations have not fallen. And that, in turn, has a crucial implication: namely that, insofar as deleveraging is inevitable, much of it is still to come. From a historical perspective, this challenge is not entirely unprecedented. The UK and US have, after all, slashed vast debt burdens before during the last two centuries, and McKinsey has identified four dozen smaller deleveraging episodes around the world since 1950.

But while governments have sometimes softened this task before by creating rapid growth, often due to exports (via devaluation), or a peace dividend (after a war), those routes do not offer an easy escape this time. Growth, in other words, could be tough to achieve. So that leaves three unpalatable options, McKinsey suggests: outright default, inflation or belt-tightening.

McKinsey's best guess - or hope - is that belt-tightening will predominate, and it consequently forecasts a grim climate of austerity for the next decade. It may be right. But to my mind, at least, it remains a very open bet whether western voters will accept austerity without a backlash; personally, I would thus put a higher emphasis on the other options too.

Either way, the real moral is that the task now facing the western governments is monumental. It is a pity that groups such as McKinsey were not producing these leverage charts three years ago. If so, the politicians might now not be in quite such a pickle, even - or especially - in the UK.

David Fuller's view he key paragraph for investors is the penultimate one above. My guess is that we are most likely to see belt tightening in the EU, with Ireland's recent budget leading the way. We have also seen some competitive currency devaluation by the UK and USA. Euroland and Japan may be next. In a leapfrog race to the bottom, the purchasing power of our fiat currencies is being devalued.

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