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4 Deleveraging, What Deleveraging
Still, the legacy of the past crisis remains severe in developed markets, especially
in the peripheral countries of the Eurozone, which remain vulnerable due to the
complexity of their crisis and the partial inadequacies of the mix and sequence
of the policies adopted. Anglo-Saxon economies – namely, the US and the UK –
seem to have managed the trade-off between deleveraging policies and output
costs better so far, by avoiding a credit crunch while achieving a meaningful
reduction of debt exposure of the private sector and the financial system. This
result, however, was achieved at the cost of a substantial re-leveraging of the
public sector, including the central banks, whose deleveraging is a primary policy
challenge for the years to come.
1.2 Leverage: What we mean by it and why it matters
The concept of leverage has many applications in economics. 2 At the sectoral
level, the levels of household debt and corporate debt are much studied in terms
of their implications for consumption and investment behaviour. The leverage
of financial-sector entities (banks and other types of financial intermediaries)
also gives rise to a range of concerns in relation to the incentives facing financial
firms and vulnerability to funding shocks. At the sovereign level, the stock of
public debt has implications for projected levels of spending and taxation, in
addition to determining exposure to financial shocks. Finally, the aggregate
level of external debt matters for national macroeconomic performance, with
the stock of external debt also an important factor in determining exposure to
international funding crises and sudden stops in capital flows.
Of course, the stock of debt has to be assessed in the context of the overall
balance sheet. On the liability side, debt gives rise to more concerns if there is
only a thin layer of equity liabilities to provide a buffer against losses. On the
asset side, debt that is backed by liquid assets with stable returns is less likely to
generate repayment problems than debt that is used to fund illiquid assets with
volatile returns.
At the same time, a snapshot of a balance sheet is insufficient to conduct
a debt sustainability exercise. In particular, the stock of financial assets does
not provide a good guide to repayment capacity, since much debt is serviced
through future income streams that are not typically capitalised in the balance
sheet. For example, household debt may be primarily serviced through wage
earnings, while the main asset for most households is non-financial (the family
home). Similarly, early-stage firms may have few assets but healthy streams of
projected future earnings. For banks, the quality of loan assets is determined
by the underlying income streams of their customers. As for the government, it
typically has limited financial assets, holds very illiquid non-financial assets and
funds debt servicing from future revenue streams.
While taking note of the wide range of other relevant factors, the debt-toincome
ratio remains a key metric in assessing debt sustainability. In truth, this
2 See also the review of different types of debt overhang provided by Brown and Lane (2011).