Deleveraging can be understood through a metaphor in which a car symbolises the economy. Borrowing is like stepping on the gas and accelerates economic activity. When borrowing stops, the foot comes off the pedal and the car slows down. However, the car’s trunk is now weighed down by accumulated debt so economic activity slows below its initial level.
With deleveraging, households increase saving and re-pay debt. This is the second step and it is like stepping on the brake, which causes the economy to slow further, in a motion akin to a double dip. Rapid deleveraging, as is happening now, is the equivalent of hitting the brakes hard. The only positive is it reduces debt, which is like removing weight from the trunk. That helps stabilise activity at a new lower level, but it does not speed up the car, as economists claim.
Unfortunately, the car metaphor only partially captures current conditions as it assumes the braking process is smooth. Yet, there has already been a financial crisis and the real economy is now infected by a multiplier process causing lower spending, massive job loss, and business failures. That plus deleveraging creates the possibility of a downward spiral, which would constitute a depression.
Such a spiral is captured by the metaphor of the Titanic, which was thought to be unsinkable owing to its sequentially structured bulkheads. However, those bulkheads had no ceilings, and when the Titanic hit an iceberg that gashed its side, the front bulkheads filled with water and pulled down the bow. Water then rippled into the aft bulkheads, causing the ship to sink.
The US economy has hit a debt iceberg. The resulting gash threatens to flood the economy’s stabilising mechanisms, which the economist Hyman Minsky termed “thwarting institutions”.
So basically, we've lifted our foot off the accelerator, slowed down, then slammed on the breaks, and if that weren't bad enough, we hit an iceberg too. Sounds like we're screwed.
by Joe Weisenthal
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