Leverage and deleverage

Total debt-to-GDP levels in the 18 core countries of the OECD rose from 160 percent in 1980 to 321 percent in 2010.
Disaggregated and adjusted for inflation, these numbers mean that the debt of nonfinancial corporations increased by 300 percent,
the debt of governments increased by 425 percent, and the debt of private households increased by 600 percent.
David Rhodes and Daniel Stelter, via John Mauldin, January 2012

But the costs of the West's aging populations are hidden in the official reporting.
If we included the mounting costs of providing for the elderly, the debt level of most governments would be significantly higher. (See Exhibit 1.)

It's the classic pyramid, or snowball scheme, practiced by thousands of con artists after Ponzi. The most spectacular case was that of New York financier Bernard Madoff, who was responsible for losses of about $20 billion by 2008. Snowballs are set into motion, becoming bigger and bigger as they roll along. In the worst case, they end in an avalanche that takes everything else with it.

Ponzi
Western economies have not acted much differently than the fraudster Madoff.
Almost everyone - in Europe and in the United States - has been living beyond their means, from consumers to politicians to entire countries
Alexander Jung, Der Spiegel, 5 January 2012

Some aspects of the economic system in the industrialized countries resemble a gigantic Ponzi scheme. The difference is that this version is completely legal.

The fact that nations are continually spending more than they take in cannot turn out well in the long run. The word "credit" comes from the Latin "credere," which means "to believe." The system will only function as long as lenders believe in borrowers. Once the belief in the creditworthiness of borrowers is destroyed, hardly anyone will be willing to buy their securities.
When that happens, the system is finished.

Nästa gång Du möter en sån där som ojar sig över något lands dåliga statsfinanser så fråga honom om han, eller hon, anser att underskotten bör skäras ner.
Njaa, inte nu precis blir nog svaret, för var och en som inte heter Lucas, eller givit Lucas Nobelpriset, förstår att det vore jätte-jättedumt.
Det måste ske på sikt, brukar det heta.
Rolf Englund blog 2010-02-02

The banks are under massive pressure to raise their core Tier 1 capital ratios to 9pc by next June.
This requires a €2.5 trillion adjustment according to the BIS’s Global Stability Board.
Most of that is going to be done by slashing loan books – deleveraging in the jargon –
since they cannot raise fresh capital at a viable cost and don’t wish to be nationalised.
Ambrose Evans-Pritchard, December 21st, 2011

There are clear-cut things that you do if you’re in a liquidity trap.
A liquidity trap is simply defined as when the private sector is in a deleveraging mode, or a de-risking mode,
or an increasing savings mode — all of which you can also call deleveraging phenomena —
because of enduring negative animal spirits caused by legacy issues associated with bubbles.
Paul McCulley, at John Mauldin, 3 October 2011
Highly Recommended

In that scenario, the animal spirits of the private sector are not going to be revived by a reduction in interest rates because there is no demand.
It’s not the price of credit driving the deleveraging. It’s "I took on too much debt during the bubble. I have negative equity in my home. I don’t care what the price of credit is, I already have too much outstanding. I am paying down credit!"

That can be entirely rational for an individual household. It can be rational for an individual firm. It can be rational for an individual country.
However, in the aggregate, it begets the paradox of thrift. What is rational at the microlevel is irrational for the community, or at the macro level, and
I’m amazed that this is not assumed as a given description of what we’ve got going on right now.

The paradox of thrift and the liquidity trap are fellow travelers that are functionally intertwined.

Could it be that people are confused because of all the attention paid to the liquidity the Fed has pumped into the system via quantitative easing — even though most of that only flowed into the most speculative and unproductive pockets in Wall Street?

That could very well be the case. But that diversion of attention is unfortunate because it clouds people’s vision of the larger picture, which is pretty straightforward. It’s really textbook sort of stuff. My friend, [Nobel Laureate, Princeton Economics professor and New York Times columnist] Paul Krugman, has been writing a great deal about it recently. If the private sector is delevering and derisking and you’re caught in the paradox of thrift, the public sector is supposed to go in the exact opposite direction. The exact opposite direction.

You mean that cutting federal spending in a liquidity trap, like we’re in, is absolutely counterproductive?

Yes, it’s ludicrous and I don’t use that word too often. There’s a large range of opinions about most issues, and rightfully so. But if you are in a liquidity trap and you are advocating frontloaded austerity—

/Ludicrous
ludicrous (comparative more ludicrous, superlative most ludicrous)
Idiotic or unthinkable, often to the point of being funny.
Synonyms: (idiotic or unthinkable): laughable, ridiculous
http://en.wiktionary.org/wiki/ludicrous/

Again, it’s absolutely ludicrous. And if we need an example, we can just look across the pond and see what’s going on in Euroland. Putting somebody who is suffering from anorexia on a diet doesn’t make a lot of sense to me.

I mean, the historical parallel that a lot of us point to would be 1931, when Andrew Mellon said, essentially, liquidate, liquidate, liquidate and assets will be transferred to moral hands, and we’ll live a more moral life.

That was in 1931. Then in 1937, when it looked like the economy might have been having "a decent" economic recovery, we decided to slap it in the face with monetary and fiscal policy tightening.

And it only took World War II to lift us out of that extension of the Depression.

Why can't the economy grow? It's the debt, stupid.
Added up, household, business and government debt now amounts to some $36.5 trillion, a new nominal record.
And that figure excludes the government's unfunded liabilities for Medicare and Social Security.

Wall Street Journal, Rolfe Winkler, 17 Sept 2011

The Relationship Between Peak Oil and Peak Debt - Part 1 Gail Tverberg Tuesday, 12 July 201

Stephen Cecchetti and his team at BIS have written the definitive paper
Debt becomes poisonous once it reaches 80pc to 100pc of GDP for governments, 90pc of GDP for companies, and 85pc of GDP for households.
“The debt problems facing advanced economies are even worse than we thought.”
Ambrose Evans-Pritchard, 31 August 2011

“Deleveraging” will dominate the rich world’s economies for years.
Done badly, it could wreck them
The process of deleveraging has barely begun
The Economist print July 7th 2011

The general view is now that in this, the next round of the Great Recession,
there is a high risk of things getting worse, with no effective instruments at governments’ disposal.
The first point is correct but the second is not quite right.
Throughout the crisis – and before it – Keynesian economists provided a coherent interpretation of events
Joseph Stiglitz, August 9, 2011

According to an index that Comeback America developed, the US is in worse shape from a fiscal standpoint than debt-plagued nations such as Italy or Spain
Comeback America is a conservative think tank funded mostly through a grant from the Peter G. Peterson Foundation, named for the founder the Blackstone Group private equity firm.
CNBC 23 May 2011

Kenneth Rogoff, former chief economist of the International Monetary Fund and now a professor at Harvard University,
Given the low growth, he says, inflation above central banks’ targets could be helpful:
“A bit of inflation is by far the lesser evil compared with even lower growth.
Five per cent inflation for 2 to 3 years is not the end of the world. There are even some benefits.”
Financial Times 13 may 2011

UK is the most indebted advanced economy in the world
At every level – public, corporate, household and financial – the UK is attempting to pay off its debts.
As long as this continues, there's unlikely to be much growth in real terms.
Jeremy Warner, Daily Telegraph, 19 July 2011

As we now know, much of the above trend growth of the pre-crisis decade was the result of mounting leverage.

Now that the credit bubble has been removed, the natural rate of growth is bound to be quite a bit lower, whatever the situation in Europe and the rest of the outside world. Economies cannot both pay down debt and have fast growth. By the same token, if you don't pay down debt, you will be stuck in slow growth for years to come.

The adjustment is proving long and painful. Policy has so far concentrated on attempting to put off the moment of truth, to spread and smooth it. Yet events are conspiring to bring matters to a head.

What makes Britain particularly vulnerable to the sort of fiscal and financial market contagion now sweeping Europe is the magnitude of its banking sector, with liabilities several times the size of GDP. Taking all debt together - public, private, household and financial - the UK is the most indebted advanced economy in the world.

“Deleveraging” will dominate the rich world’s economies for years.
Done badly, it could wreck them
The process of deleveraging has barely begun
The Economist print July 7th 2011

Debt reduction, or deleveraging as it is known in the inelegant argot of economists, is a painful process. Growth suffers as consumers and firms, let alone governments, try to reduce their debts. Countries which experienced the biggest asset busts, such as America, Britain and Spain, have had the most disappointing recoveries. And the pain will continue: a careful look at the numbers suggests that the process of deleveraging has barely begun.

It can be paid off with the help of higher thrift
(though not everyone can spend less than they earn at the same time).

In practice, rich countries seem to be using different combinations of these approaches.

Vanliga medeklassmänniskor i Sverige har gjort mångmiljonaffärer på bostadsmarknaden med en belåning på 90 procent eller mer,
en nivå som skulle få vilken solbränd riskkapitalist som helst att skrika rätt ut av ångest.
Andreas Cervenka, svD Näringsliv 2 okt 2011

– I Sverige amorterar vi till exempel inte längre, lånen ses ofta som eviga, en status som bara staters lån hade tidigare. Förtroendet för återbetalningsförmågan har blivit extremt stort, det har skett på bara en generation, säger Daniel Waldenström, professor i nationalekonomi vid Uppsala universitet och forskare i ekonomisk historia.

Vårt finansiella system bygger på ömsesidig skuldsättning där nya värden skapas genom skuldsättning.
Få är idag helt utan skuld. I själva verket ser vi det som en självklarhet att
varje form av tillgång ska balanseras mot en viss grad av skuldsättning
Nils Fagerberg och Ulf Jakobsson, SvD Brännpunkt 24 aept 2011

Få är idag helt utan skuld. I själva verket ser vi det som en självklarhet att varje form av tillgång ska balanseras mot en viss grad av skuldsättning, det är så varje företagare upprättar sin balansräkning.

Skulden är numera ett självklart inslag i ekonomin. Den som är satt i skuld, är visserligen inte fri, men har i alla fall gjort en stor samhällsinsats genom att se till att nya pengar kommit i omlopp. Om det inte fanns några som var villiga att acceptera skuldbörda och räntebetalningar för att få tillgång till nytt kapital, skulle samhällsekonomin snabbt sluta fungera.

De svenska hushållen fortsätter att låna.
Under 2010 ökade lånen med 188 miljarder.
e24 24/3 2011

The trouble with this latest US recovery
it is built on monetary and fiscal policies which are wildly expansionary,
wholly unsustainable and will surely soon come to an end
Liam Halligan, Daily Telegraph 2 Apr 2011

During the final three months of 2010, while consumer credit fell by a net $20bn, this was more than offset by a $99bn rise in net corporate borrowing.

For Wall Street’s commission-based optimists, many of them with a mountain of stocks to sell, and their own home loans and credit card bills to service, such credit growth is Exhibit A when it comes to making the case that America is now out of the economic woods.

If only it were so. The trouble with this latest US recovery is that it amounts to little more than an economic “sugar-rush”. The recent growth-burst is built on monetary and fiscal policies which are wildly expansionary, wholly unsustainable and will surely soon come to an end. When the sugar-rush is over, and it won’t be long, the US will end up with a serious economic headache. Investors should keep that in mind.

Recessions are supposed to teach thrift. So when the amount Americans owe on their houses, cars and credit cards,
which more than doubled in the years between the tech and housing busts,
fell $550 billion in 2009, commentators said U.S. consumers had reformed.
But nearly 2½ years after the financial crisis, we still owe $6 trillion more than we did a decade ago.
Worse, figures released by the Federal Reserve in late February revealed that 65% of the recent drop in consumer debt stems not from our paying overdue bills but from write-offs--banks' foreclosing on homes, canceling credit cards and otherwise...
Time, March 14 2011

Why austerity alone risks a disaster
Martin Wolf, Financial Times June 28, 2011

A number of economies are in what the Jerome Levy Forecasting Center calls a “contained depression” – a period of sustained private sector deleveraging.

Implicitly, the BIS report rejects such a view. It argues for monetary and fiscal tightening across the globe.
“addressing overindebtedness, private as well as public, is the key to building a solid foundation for high, balanced real growth and a stable financial system. This means both driving up private savings and taking substantial action now to reduce deficits in the countries that were at the core of the crisis.”

The question I have is this: does the BIS know that every sector cannot run financial surpluses at the same time?

Repayment means spending less than one’s income. That is what is happening in the US private sector.

Households ran a financial deficit (an excess of spending over income) of 3.5 per cent of gross domestic product in the third quarter of 2005. This had shifted to a surplus of 3.3 per cent in the first quarter of 2011.

Since the US has a current account deficit, the rest of the world is also, by definition, spending less than its income.

This is what a controlled depression means:
every sector, other than the government, is seeking to strengthen its balance sheet at the same time.

The BIS boldly calls for simultaneous private and public deleveraging. But what are to be the offsets?

Why economic recovery has been so long in coming
Some economists expected a rapid bounce-back once we were past the acute phase of the financial crisis
— what I think of as the oh-God-we’re-all-gonna-die period —
which lasted roughly from September 2008 to March 2009.
Paul Krugman, New York Times March 3, 2011

But that was never in the cards. The bubble economy of the Bush years left many Americans with too much debt; once the bubble burst, consumers were forced to cut back, and it was inevitably going to take them time to repair their finances.

And business investment was bound to be depressed, too. Why add to capacity when consumer demand is weak and you aren’t using the factories and office buildings you have?

According to the NBER, the “Great Recession” is now two years behind us,
but the recovery that normally follows a recession has not occurred.
While growth did rise for a while, it has been anaemic compared to the norm after a recession, and it is already trending down. Growth needs to exceed 3 per cent per annum to reduce unemployment—the rule of thumb known as Okun’s Law—and it needs to be substantially higher than this to make serious inroads into it. Instead, growth barely peeped its head above Okun’s level.
It is now below it again, and trending down.
Steve Keen June 11th, 2011

In Debunking Economics, Steve let the general public in on a little-known secret: that many widely believed economic models have been shown by economists to be wrong—hence the subtitle to his book, “the naked emperor of the social sciences”.
This is emphatically the case with the so-called “Efficient Markets Hypothesis”, which still dominates academic thinking about finance today—even after the Global Financial Crisis. Since 1995, Steve’s main research focus has been the development an alternative, empirically grounded theory, known as the “Financial Instability Hypothesis”, which argues that finance markets are inherently unstable. Steve’s forthcoming book on this topic, Finance and Economic Breakdown, will be published by Edward Elgar (UK) in 2012.
From November 2006 till March 2010, he published Debtwatch, a monthly report which explains the dangers of excessive private debt. In March 2007, he started the blog Steve Keen’s Debtwatch, which now has over 5,000 members and more than 50,000 unique readers each month.

Deleveraging, Deceleration and the Double Dip
For a long time I’ve focused on the contribution that the change in debt makes to aggregate demand,
in the relation that “aggregate demand equals the sum of GDP plus the change in debt”.
Posted on October 19, 2010 by Steve Keen

An obvious extension of that was that “change in aggregate demand equals change in GDP plus acceleration in the level of debt”—which would imply that change in unemployment is driven by changes in the rate of growth of debt.

The deleveraging process in the US and, to a lesser extent the UK, appears to have stalled
before it has even started to gather impetus.
John Plender, FT, February 8 2011

When central banks start tightening again, the potential for default in residential property is huge, especially in the UK and Spain where much mortgage lending is at floating rates.

Household sector debt in the UK and Spain amounted to 101 per cent and 85 per cent of GDP respectively in 2008. These inflated levels are unprecedented.

The best interpretation of our current difficulties is that we’re suffering from a deleveraging shock,
and that the economy will need support until over-leveraged players have had time to work down their debt.
Paul Krugman 9 december 2010

That logic implies that you need a tow, not a jump-start; the economy is going to need help for an extended period of time.

In a new book “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation”*, Gary Shilling, an economist, argues for the deflationary outcome.
He expects American GDP growth to average only 2% over the next decade as the economy struggles to deal with the debt burden.
Buttonwood, The Economist print Jan 6, 2011

The baby boomers will be forced to increase their savings as they approach retirement, he argues.

In The Age of Deleveraging, Gary Shilling notes that with deleveraging comes slow economic growth,
and he details nine reasons why real GDP will rise only about 2% annually in the years ahead
— far below the 3.3% growth it takes just to keep the unemployment rate stable.
John Mauldin 15/11 2010

This new age of deleveraging was sired by the back-to-back collapses of the housing and financial bubbles in 2007 and 2008, both of which he had been forecasting since early in the 2000s. He begins his new book with a look at how both of those bubbles were created, how they grew and how he was lucky enough to have spotted them in their infancies. Gary loves to be among the few to spot them and predict their demises

The crisis has not proved a great turning point, so far.
The ratio of private gross debt to US gross domestic product rose from 123 per cent in 1981 to 293 per cent in 2009.
By the third quarter of last year, the ratio had fallen to 263 per cent.
Martin Wolf, February 1 2011

The crisis revealed the vulnerability of the eurozone to excessive accumulations of private and public sector leverage, caused by floods of surplus savings into bad investments via undercapitalised financial institutions.
Managing the deleveraging will be very hard, particularly without internal exchange rate flexibility.

How the private sector deleveraging is to occur, without mishap, is far from clear. The chance of renewed economic weakness is large. So is that of financial shocks, perhaps in response to fiscal concerns.

Again, the mood about the eurozone is now more optimistic. But how the zone is to exit from its difficulties remains obscure.
European leaders have willed the end: survival of the eurozone. Whether and how they can will the means is still unknown.
Martin Wolf, February 1 2011

The UK and a number of other economies, including the US, are both excessively leveraged and have weak financial sectors. The low interest rate policy is designed to prevent an uncontrolled collapse of this mountain of leverage into mass bankruptcy and, instead, allow debt to be paid down and the financial system to return to health more gradually.

Thus, we have to choose between low interest rates on current assets or better returns on what would soon be shrunken assets: with higher rates, house prices would fall further, unemployment would rise, more loans would default and banks would fall back into difficulties. Ms Altmann argues that the bubble economy was partly an illusion. So, then, must be a big part of the financial claims on which savers now depend.

“You can’t cut debt by borrowing.” How often have you read or heard this comment from “austerians” (a nice variant on “Austrians”),
who complain about the huge fiscal deficits that have followed the financial crisis?
The obvious response is: so what?
Martin Wolf, September 26, 2010

The problem is that, even after more than two years of near-zero official rates and huge amounts of stimulus spending, economies such as the US have failed to grow as strongly as hoped.
The hangover effect of the debt-fuelled house-buying and consumption binge that started to unravel three years ago.
People are no longer able to borrow unless they have a good credit history. In any event, many people do not want to borrow.
They are focused instead on reducing the debts they have taken on – a process called deleveraging – either by choice or because they cannot roll over debts with new loans.
FT October 31 2010

As the International Monetary Fund and World Bank meetings start in Washington,
the word “deleveraging” is haunting policymakers and investors.
It is now crystal clear to everybody that debt levels were absurdly high during the credit boom.
Gillian Tett, FT October 7 2010

What is not evident, however, is how much further that debt now needs to decline to produce any sense of normality.

We do not know, in other words, how far along we are into this “deleveraging” process, nor what this might mean for growth or asset prices.

Total liabilities of the shadow banks have dropped from almost $22,000bn two years ago, to nearer $17,000bn, or where it was five years ago.

The forces that will stop the imbalances are already very evident
Fiscal consolidation cannot properly occur in advanced economies until there is a strengthening in private demand.
For well rehearsed reasons, this is proving difficult to achieve.
The handover from fiscal stimulus to private demand growth isn’t happening as quickly as hoped.
Unfortunately, the private sector is still in a strongly deleveraging frame of mind.
Jeremy Warner, Daily Telegraph 7 Oct 2010

Deleveraging/The Chances of a Double Dip
The good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s and in the early 1980s among U.S. consumers.
That leverage propelled the dot com stock bubble in the late 1990s and then the housing bubble.
But now those two sectors are being forced to delever and in the process are transferring their debts to governments and central banks.
Gary Shilling at John Mauldin 17/9 2010

The deleveragings of the global financial sector and U.S. consumer arena are substantial and ongoing. Household debt is down $374 billion since the second quarter of 2008. The credit card and other revolving components as well as the non-revolving piece that includes auto and student loans are both declining. Total business debt is down, as witnessed by falling commercial and industrial loans.

This deleveraging will probably take a decade or more - and that's the good news. The ground to cover is so great that if it were traversed in a year or two, major economies would experience depressions worse than in the 1930s. This deleveraging and other forces will result in slow economic growth and probably deflation for many years. And as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies.

Meanwhile, federal debt has exploded from $5.8 trillion on Sept. 30, 2008 to $8.8 trillion in late August. Many worry about the inflationary implications of this surge, but the reality is that public debt has simply replaced private debt.

Leverage was at the root of the crisis
The writer was chairman of the Council of Economic Advisers under President George W. Bush, and is dean of Columbia Business School.
He is co-author with Peter Navarro of ‘Seeds of Destruction: Why the Path to Economic Ruin Runs Through Washington,
and How to Reclaim American Prosperity’
Glenn Hubbard, September 13 2010

How did the pressures build before the blow-up? Imbalances in global saving coupled with investment growing for more than a decade led to low real interest rates around the world for many years, putting pressure on prices of assets and reducing risk premiums in financial markets

Bernanke’s recent Jackson Hole speech didn’t contain one reference to the key force driving the American economy right now:
private sector deleveraging
(here’s the previous year’s speech for comparison’s sake
By Steve Keen at John Mauldin 2010-09-06

Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt.

The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt.
So when debt is rising demand exceeds what it could be on the basis of earned incomes alone,
and when debt is falling the opposite happens.

I’ve been banging the drum on this for years now, but it’s a hard idea to communicate because it’s so alien to the way most economists (and many people) think. For a start, it involves a redefinition of aggregate demand. Most economists are conditioned to think of commodity markets and asset markets as two separate spheres, but my definition lumps them together: aggregate demand is the sum of expenditure on goods and services, PLUS the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) PLUS the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.

Households and companies will continue to reduce debt built up before the financial crisis,
according to a report by the Bank for International Settlements.
Bloomberg 6/9 2010

A study of 20 systemic banking crises that were preceded by surges in credit showed that in 17 cases, debt relative to gross domestic product returned to levels seen before the crisis, economists Garry Tang and Christian Upper wrote in the Basel, Switzerland-based BIS’s latest quarterly review.

“If history is any guide, we should expect to see a much more significant reduction in private-sector debt, particularly of households, than has so far taken place after the recent crisis,” they wrote. “Lower house prices may induce households to reduce their desired level of debt. Similarly, a lower level of output and tighter financial conditions could put firms under pressure to reduce their leverage.”

Paradoxes Of Deleveraging And Releveraging
From 1929 to 1933, everyone was trying to pay down debt — and the debt/GDP ratio skyrocketed thanks to contraction and deflation.
During and immediately after WWII, there was massive borrowing — but GDP grew faster than debt, and the debt burden ended up falling.
Paul Krugman, New York Times, September 3, 2010

When, however, the economy suffers from Post Bubble Disorder,
characterised by private sector deleveraging and a fat-tail risk of deflation
In such a liquidity trap, private sector demand for credit is, axiomatically, very inelastic to low interest rates,
as evidenced by contracting private sector debt footings, even when the central bank’s policy rate is pinned against zero.
In such circumstances, the central bank has a profound duty to act unconventionally
Paul McCulley August 2010

ballooning its balance sheet by monetising assets, either government or private, or both. Put differently, the central bank has a profound duty to meld itself with the fiscal authority, until the fat-tail risk of deflation is cut off (and then killed, in the famous words of General Colin Powell).

Indeed, this very idea is what gave Chairman Bernanke his nickname of Helicopter Ben back in November 2002, when discussing possible remedies to deflation in the United States were it to unfold.
Here’s what he said:

To generate increased growth in aggregate demand, some sector of the economy must be willing to proactively lever its balance sheet. And that must be the fiscal authority, if the private sector is intent on delevering.

Yes, I know all about the perils of long-term fiscal unsustainability. But I also know that in the long run, we are all dead. I see no reason to die young from fiscal-orthodoxy-imposed anorexia.

Aggregate consumer debt continued to decline in the second quarter,
continuing its trend of the previous six quarters.
As of June 30, 2010, total consumer indebtedness was $11.7 trillion,
a reduction of $812 billion (6.5%) from its peak level at the close of 2008Q3
Calculated Risk with nice chart 17/8 2010

Whatever you think about fractional reserve banking the truth is that we no longer have it.
Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
Washingtons blog 21/3 2010

With the repeal of Glass-Steagall, deposits have been used to speculate in every type of investment under the sun, using insane amounts of leverage. Instead of the traditional 10-to-1 ratio, the giant banks and hedge funds were using much higher levels of leverage.

For example, Congresswoman Kaptur told Bill Moyers that while - on paper - there are 10-to-1 reserve requirements, banks like JP Morgan were using 100 to 1 leverage. She said that, with derivatives, leverage might be much higher.

And remember that most of the credit in our economy is actually through the shadow banking system, not through traditional depository banking.

This U.S. debt to GDP started accelerating in the 1960s (with the Vietnam War, Space Race and continuation of the Cold War) when it took $1.53 to generate an additional $1 of GDP.

Then during the 1970s, with the continuation of the Vietnam War, it took $1.68 to generate $1 of GDP.

In the 1990s (with the internet bubble) the debt it took to generate $1 of GDP climbed to $3.12.

However, the most incredible of all was the first decade of this century when it took over $6 to generate an additional $1 of GDP.
That decade included the war on terror, two wars, private equity firms (new name for leveraged buyouts) and housing and another stock market bubble, as well as promises of entitlements that we have no possibility of being able to keep.

Eurozone credit contraction accelerates
Bank loans and the M3 money supply in the eurozone contracted at an accelerating pace in November, raising the risk that a lending squeeze will choke the region's fragile recovery next year.
Ambrose Evans-Pritchard, 30 Dec 2009

Banks have chosen to restrict lending as they struggle to meet tougher capital rules rather than dilute shares by raising fresh equity or accepting the onerous terms of state support schemes. This has prompted harsh criticism from finance ministers, but Professor Tim Congdon from International Monetary Research said the authorities themselves are to blame.
"This is becoming ridiculous. How can banks raise capital asset ratios and lend more at the same time? These people are barmy," he said, comparing the new rules with policy mistakes in the early 1930s.

Barmy
1. stupid, bizarre, foolish, silly, daft (informal), irresponsible, irrational, senseless, preposterous, impractical, idiotic, inane, fatuous, dumb-ass (slang) This policy is absolutely barmy.
2. insane, odd, crazy, stupid, silly, nuts (slang), loony (slang), nutty (slang), goofy (informal), idiotic, loopy (informal), crackpot (informal), out to lunch (informal), dippy, out of your mind, gonzo (slang), doolally (slang), off your trolley (slang), round the twist (Brit. slang), up the pole (informal), off your rocker (slang), wacko or whacko (informal), a sausage short of a fry-up (slang) He used to say I was barmy, and that really got to me. insane reasonable, sensible, rational, all there (informal), sane, of sound mind, in your right mind
www.thefreedictionary.com

The Age of Deleveraging
Total consumer debt is shrinking for the first time on 60 years.
And the decline shows no sign of abating.
John Mauldin 19/12 2009

This recession was caused not by too much inventory but by too much credit and leverage in the system. And now we are in the process of deleveraging.
And this is true in Europe as well, and maybe more so; but today we will look at some data in the US.

Credit card companies have reduced available credit by $1.6 trillion dollars. And for good reason.

Past post-recession expansions have been built on growing credit and leverage. That will not be the case this time. We are going to see reduced lending and borrowing. Even though the federal government is running massive deficits, the stimulus portion of the debt will be running down in the latter half of 2010. There will be little political will to continue with massive stimulus and deficits.
While this is good in the long run, in the short run it will reduce GDP.

We know that the current driving force behind this downturn is “deleveraging”.
Overindebted households and undercapitalised banks are adjusting their balance sheets, building up savings in the first case and restricting lending in the latter.
There is no chance of a sustained economic recovery until that process is almost complete.
Wolfgang Münchau, Financial Times, December 28 2008

We are still some way from that point. For example, on my calculations it will take a total peak-to-trough decline in real US house prices of some 40-50 per cent to get back towards long-term price trends and for price-rent ratios to return to more sustainable levels. We are about half-way through this process.

I arrive at three policy priorities for 2009. The first is for central banks to avoid deflation.
If ever there has been a need for a central bank to target price stability, it is now.
I mean this in the European sense of the term, meaning a small but distinctly positive rate of inflation, say 2 or 3 per cent annually.

I worry, though, that the US will try to raise inflation afterwards, which would reduce the real level of US debt but create massive distortions in exchange rates and financial flows and produce another global financial and economic crisis.

The second priority is to shrink the financial sector. A disorderly collapse would be catastrophic, but it is neither desirable, nor possible, to maintain the financial sector at its current excessive size. Take the market for credit default swaps, an unregulated $50,000-$60,000bn casino that serves no economic purpose except to enrich its participants at massive risk to global financial stability.

We are living through the painful end of an age of leverage which saw total private and public debt in the US rise from about 155 per cent of gross domestic product in the early 1980s to something like 342 per cent by the middle of this year
Once, monetarism and Keynesianism were considered mutually exclusive economic theories. So severe is this crisis that governments all over the world are trying both simultaneously.
Niall Ferguson,Financial Times, December 18 2008

Every tumultuous period of financial boom and bust comes to be defined by a word or catchphrase.
Tulipmania. The Great Depression. The dotcom bubble.
The word that could define the financial times we are now living through — and the economic pain that has begun — is leverage.
Bill Powell, Time Magazine, October 23 2008

Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain (or fill in your own four-letter words).

As I have written for a very long time, there are two aspects to the current recession and financial crisis.

The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.

The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages, and especially commercial property mortgages all suffer during a recession.

Leverage was the mother's milk of Wall Street — and of Main Street — for the past 20 years. Leverage meant debt, specifically the number of dollars you could borrow for every dollar of wealth you had.

On Wall Street, debt funded investments in pretty much everything a financial firm could bet on, including the toxic mortgage-backed securities that led the way into this crisis.

On Main Street, it meant borrowing to buy a house or a condo — maybe two — then perhaps borrowing again off the increasing value of that property to pay for something else: a flat-screen TV, a new set of golf clubs, your daughter's braces.

The debt binge was fueled by easy money and the belief that prices of assets — those of houses in particular — never went down; only interest rates did.

That era is over.

It will be replaced by what will be one of the more painful, and consequential, economic chapters in our history:
the great deleveraging of America.

Leverage and Deleveraging