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8 Deleveraging, What Deleveraging
incentive for a government to deliver growth-friendly policies is weakened if
domestic residents enjoy only a limited gain from extra output. In addition, a
high outstanding level of debt increases fragility in funding markets: the higher
level of rollover risk that is associated with a large outstanding stock of debt means
that new lenders may be unwilling to provide funds due to the risk of market
disruptions. Empirical studies indicate that high external debt is associated with
poorer macroeconomic outcomes and greater vulnerability to external crises
(Cordella et al., 2005; Imbs and Ranciere, 2008; Reinhart and Rogoff, 2010; Catao
and Milesi-Ferretti, 2013).
In addition to the acute and chronic impact of high debt levels, leverage also
alters the macroeconomic dynamics in response to various cyclical shocks. In
general, the procyclical characteristics of the leverage cycle (rising incomes and
asset prices boosting borrowing capacity; declining incomes and asset prices
squeezing borrowing capacity) imply that the amplitude and duration of the
business cycle are larger compared to those expected in economies without
financial frictions. Moreover, leverage also increases the vulnerability of the
real economy to financial shocks by affecting the responses of spending levels
and productive capacity to shifts in financial conditions. These features have
been studied in a range of recent macroeconomic models that study leverage at
the household, firm, bank and sovereign levels and at the aggregate level (see,
amongst others, Bernanke and Gertler, 1989; Devereux et al., 2006; Mendoza,
2010; Eggertsson and Krugman, 2012; Midrigan and Philippon, 2012; Corsetti
et al., 2013; Martin and Philippon, 2014). In Section 3, we provide a stylised
framework linking leverage to output dynamics.
Finally, it is important to appreciate how financial globalisation means that
cross-border dimensions of leverage are increasingly important. At one level,
cross-border funding is an important driver of domestic credit dynamics (Lane
and McQuade, 2014). Moreover, the aggregate level of credit in an economy is
also determined by direct cross-border lending and bond issuance that bypasses
the domestic financial system (Borio et al., 2011). In Section 4, we highlight that
the external dimension of debt is especially important for the euro periphery and
deficit-running emerging markets.
1.3 Guide to the report
The rest of the report is structured as follows. In Chapter 2, we set the scene by
describing the evolution of debt levels around the world; this empirical review
is comprehensive in examining sector-level developments as well as aggregate
leverage patterns.
Chapter 3 provides some conceptual frameworks that can help guide the
interpretation of debt dynamics and the ongoing poisonous interaction between
financial crisis and output dynamics. First, we outline the nature of the leverage
cycle, a pattern repeated across economies and over time in which a reasonable
enthusiasm about economic growth becomes overblown, fostering the belief that
there is a greater capacity to take on debt than is actually the case. A financial