Deleveraging: The question that never gets answered

Britmouse over at uneconomical has this golden quote:

Those who assert that households “need” to deleverage (which is really an argument about expected future income) must address the question of the desired level of leverage.  Is 144% too high or too low; how should we decide where to draw the line?  Should we let central plannersbankers decide by plucking numbers out of the air?

And because debt is just (ah ha) money we owe to ourselves… let’s not forget household assets, which continue to dwarf liabilities; household net worth was up from £6tn in 2008 to £7tn in 2011 in the last Blue Book estimate, mind-boggling numbers.

“Deleveraging is good” is one of the group of poorly hidden value judgments that come from the broad “rebalancing view” that gets thrown around.

If we, as a society, see high leverage levels in the economy we need to ask “why the hell do I care”?  If the individuals borrowing, and the individuals lending to them, are doing so without coercion, and the risks they face only impact upon them, then who cares.

But we may get concerned about the stability of the banking system, we may believe that the taxpayer is implicitly subsidising risk, or as a society have a special concern around Veblen goods (think of it in terms of “keeping up with the Johnes”), we might come up with reasons why leverage can be excessive.  Armed with a cause we can design policy.

The problem is that we see something like high leverage, decide we want to do something about it, and then post hoc justifying policy on the basis of whatever economic explanation we can tie together.  As we noted in from this Friedman quote, there are an infinite number of hypotheses that “fit” the data – and as a result, this is easy.  We need to limit the number of hypotheses by actually asking “what are the trade-offs involved”, and the best way to do this is not to assume our policy conclusion as a starting point 😉

  • boristhefrog

    The measure of leverage can never me answered by LVR alone (which is in effect what this is) – it has to take into account serviceability – so the measure of debt has to link between the asset backing of the debt and the ability to service and repay.

    What are the incomes to support debt servicing – if these are high enough and other commitments can be met then is there really a problem?

    Clearly there is no right answer as every case is different – all you can do is set out some principles or common sense ideas… prescribing a level that is ‘bad’ makes about as much sense as prescribing a level that is ‘good’.

    • I find even the idea of focusing on a broad level of leverage “over and economy” to be a bit strange – we need to ask who is holding it, and what the risks are given that.

      I think things like “deleveraging” are about measurable outputs for people – in truth our interest is in insuring against systemic risk, which provides and externality. However, none of this is observable, and involves fighting “unobserved counterfactuals”. People want visible progress etc etc, and so these other things get more play than they really should …

  • Two Otherguys

    Deleveraging is an interesting subject that can never be answered.

    There are too many players with differing agendas. Often, it can only be observed at the margin.

    As a general rule
    It is “human behaviour” for all players not to want to sell anything at a loss, they will hang on until the achievable or market price returns to either a break even or a minor loss.
    The visible action occurs when a participant is forced to sell because their “note holder” forces their hand and they become a distressed seller, or the position holder is required to offer up additional margin cover and is either unable or unwilling to do so and “capitulates” which is known in the trade as “puking” their assets. Highly visible.

    The invisible sector will hang on if they can and will only unwind if they are tired of the discomfort, or can exit at breakeven, to live another day.
    That we havent seen widespread capitulation is testament to the activities of the banks and central bankers to assist the leveraged by inflating assets back to a point that will enabled them the exit gracefully.

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