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30 Deleveraging, What Deleveraging
Much more bracing to economic prospects is a reduction in debt capacity to
below current debt levels. The recognition of excessive optimism triggers the
understanding that the nation has already over-borrowed relative to its capacity
to repay. To live within the limit of this lower level of debt capacity, borrowing
has to contract, representing a more significant headwind to continued economic
expansion.
The different potential outcomes once excessive optimism is recognised
explain why the tree diagram in Figure 3A.1 subsequently branches out. The
shock that current debt levels cannot be supported by future growth in potential
output is more likely to be associated with a crisis, as the level of the debt has
to be paid down or its accumulation slowed down abruptly, either overall or in
some of its key components – private borrowing from banks, public debt, foreign
debt – either explicitly, via defaults, or implicitly, via inflation.
Even a relatively smooth slowing of the pace of additional borrowing, the
middle branch, involving a gradual grind of deleveraging, is harmful to economic
performance because of the growth and debt nexus. However, it is likely to be
more manageable given the appropriate policy response.
The rightmost branch is the aspiration of most politicians. A government
overburdened by debt could, in principle, launch structural reforms to expand
productive potential. This is the historical rationale for the pairing of additional
lines of credit in programmes of the International Monetary Fund with promises
of structural adjustment, such as reducing monopoly concentration, reforming
the tax system, and opening up to foreign trade.
The attributes of debt outstanding and a nation’s ongoing access to borrowing
shape the path of adjustment. There are four important attributes of debt that
influence the form of deleveraging. All else equal, an economy is better positioned
to weather a ratcheting down of its debt capacity when its outstanding obligations
are (i) of long maturity; (ii) denominated in its own currency over which it has
the ability to print; (iii) issued in its own jurisdiction; and (iv) owned by nonresidents
who have little sway over the political process.
The need to readjust to a lower debt capacity is associated with some economic
dislocations. Three alternative scenarios for the path of real GDP over time,
corresponding to the three branches of the tree diagram, are provided in Figure
3A.3.