Question

Since the end of the financial crisis and Great Recession of 2007-2009, many households have been “deleveraging” by reducing their debts, consuming less, and saving more. Essentially, there has been a shift in preferences towards more saving and less consuming. What is the effect of this change in preferences on the interest rate and the level of investment in the economy? What are the implications for long-run growth?

Answer 1

The levels of debt and leverage grew steadily in the world's developed economies for more than a decade before the global financial crisis, and this growth accelerated after 2000. Today, with asset prices falling and credit loses mounting, it appears we may be entering a period of debt reduction, or deleveraging, both of the overall economy and within those sectors that experienced the highest buildup of debt before the crisis.

The Great Depression was the most severe financial crisis in modern times, resulting in a deleveraging process that stretched over more than a decade and fit three different archetypes - a phase of defaults, followed by belt tightening, and eventually a wartime economic boom that caused the economy to grow out of debt.

Economists have drawn many different lessons from the experience of the depression in the US. We arrive at two important lessons for deleveraging.

First, govt policy makers must be careful not to cut back on monetary or fiscal stimulus measures too soonest they snuff out a nascent recovery, as occurred in 1938.

Second, the right govt policies are also critical to maintaining public confidence so that deflation will not occur. If households and businesses think deflation is a real possibility, they will hold off on spending and investment, possibly causing deflation to take hold and economic activity to fall off, which causes debt to GDP ratios to soar. The policy mistakes that caused deflation in the early 1930s and recession in 1938 prolonged the depression and made the deleveraging process that much more painful.

Household deleveraging in the US has acted as a significant headwind to consumption and activity in recent years, holding back the recovery. Although substantial balance sheet adjustment has taken place, household debt in the US remains at high levels.