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6 Deleveraging, What Deleveraging
level (below which debt levels are safe enough that this feedback loop is not
operative).
There is considerable evidence that a high stock of debt increases vulnerability
to the risk of a financial crisis. 4 The three main types of crisis are banking crises,
sovereign debt crises and external crises (where an economy is unable to rollover
its external debt and/or obtain external funding to cover a current account
deficit). These crises can occur in isolation or in various combinations (Reinhart
and Rogoff, 2009). Moreover, a crisis along one dimension can trigger crises
along the other dimensions. For instance, a sudden stop in external funding may
induce a wave of bankruptcies that threaten the banking sector, while the (direct
and indirect) costs of a banking crisis may generate a sovereign debt crisis. In the
other direction, of course, a sovereign debt crisis can undermine the health of the
banking system and also lead to non-repayment of foreign liabilities.
Excessive debt levels also can give rise to moral hazard problems and
distributional conflicts across sectors. For instance, a government may choose to
take over private liabilities, either for efficiency reasons or in response to political
pressure. In turn, the anticipation of such fiscal bailouts may lead to lower
repayment discipline among private-sector creditors, especially if debt problems
are sufficiently widespread in the population to render punishment threats noncredible
(Arellano and Kocherlakota, 2014). A similar logic applies if banks are
taken into public ownership and private-sector debtors believe that governmentowned
banks will take a softer line in enforcing repayment. Finally, from a
national perspective, the aggregate net international investment position fixes
an aggregate resource constraint for the economy: if the aggregate economy is
highly indebted vis-à-vis the rest of the world, there is a limit to the effectiveness
of domestic policies in shifting debt obligations across sectors. In contrast, a
sectoral debt problem in a creditor economy poses fewer risks, since those sectors
that have positive levels of net financial assets provide a counterweight to those
sectors with stocks of net financial liabilities. This basic consideration illustrates
the different implications of high stocks of sovereign debt in creditor countries
(such as Japan) versus debtor countries (such as the euro periphery).
Moreover, the 2007-onwards global financial crisis has provided fresh
evidence that the resolution of severe crises is extremely costly. 5 At a global level,
the advanced economies suffered a severe recession during 2008-10, while the
second wave of the crisis in Europe from 2011 onwards further prolonged subpar
macroeconomic performance across large parts of the Eurozone. Looking across
countries, the severity of the crisis in terms of the decline in consumption and
investment was most severe in those countries that had accumulated the largest
debt imbalances during the pre-crisis credit boom of 2003-07 (Giannone et al.,
2011; Lane and Milesi-Ferretti, 2011, 2012, 2014). Finally, the international
nature of the crisis also highlights the interdependence across modern financial
systems – a crisis that is triggered by an isolated event in one country can quickly
4 See, amongst many others, Reinhart and Rogoff (2009), Jorda et al. (2011), Gourinchas and Obstfeld
(2012) and Catão and Milesi-Ferretti (2013).
5 McKinsey Global Institute (2010) provides extensive evidence that macroeconomic recovery in the
aftermath of financial crises tends to be extremely slow; see also Reinhart and Rogoff (2009).