The leveraged economy refers to an economy that relies heavily on debt to finance growth and investment. Over the past few decades, many advanced economies like the US have become increasingly leveraged, meaning debt levels have risen sharply relative to GDP and incomes. This trend raises important questions about financial stability and economic growth.
What Is a Leveraged Economy?
A leveraged economy can be defined as one where:
- Debt levels are high relative to GDP, income, and assets
- Both households and businesses take on significant debt
- Credit growth outpaces income growth over prolonged periods
- Financial institutions lend aggressively to marginal borrowers
- Asset prices inflate due to debt-fueled demand
In a leveraged economy, debt to GDP, known as the debt-to-GDP ratio, tends to rise over time. This indicates that economic activity is fueled more by borrowing than organic growth.
Key Drivers of the Leveraged Economy
Several factors have contributed to the growth of leveraged economies in advanced nations:
- Starting in the 1980s, financial markets were deregulated, increasing access to credit
- Lending standards were loosened, allowing more marginal borrowers to access loans
Globalization and Trade Imbalances
- Globalization allowed deficit nations like the US to borrow easily from abroad
- Persistent trade imbalances generated capital inflows into deficit nations
Asset Price Appreciation
- Rising asset prices, especially in housing and stocks, increased household wealth
- This “wealth effect” encouraged greater borrowing against inflating assets
- Securitization and derivatives facilitated rapid credit growth by allowing lenders to pass the risk to investors
- Shadow banking expanded, increasing lightly regulated credit outside the traditional banking system
Interest Rate Policy
- Prolonged low-interest rates made the cost of credit very cheap, fueling borrowing.
Characteristics of a Highly Leveraged Economy
Some key signs that an economy has become excessively leveraged include:
- Household debt over 90% of GDP
- Corporate debt over 75% of GDP
- Total debt over 300% of GDP
- Credit is growing faster than incomes year after year
- Consumers heavily dependent on credit to finance lifestyles
- Speculative investment funded by cheap debt rather than savings
- GDP growth dependent on rapid credit expansion
The Downsides of Leverage
While borrowing can help individuals and businesses invest for the future, excessive leverage has significant risks, including:
- As debt mounts, borrowers become vulnerable to defaults, triggering crises
- Banking systems are put at risk due to over-exposure to bad debts
Balance Sheet Recessions
- Highly indebted households are forced to pay down debt rather than spend freely
- This creates prolonged recessions as demand weakens
- Cheap credit often flows into speculation rather than productive investments
- This can fuel bubbles and lead to a misallocation of resources
- As debts grow, more income goes towards servicing debt rather than consumption
- This can cause stagnant incomes and increased inequality
Deleveraging After a Credit Boom
After a debt-fueled credit boom, deleveraging almost always occurs:
- Lenders tighten credit standards, reducing new lending
- Consumers and businesses focus on paying down debt rather than taking on more
- Defaults and write-downs reduce outstanding debt
- Asset prices often fall as demand weakens
- Growth slows or reverses as credit stops expanding
This deleveraging phase can last many years as the economy works off excess leverage. Typically, the financial sector leads the way, followed by households, corporations, and governments.
Can High Leverage Continue Indefinitely?
Some economists argue that advanced economies have reached a “new normal” state where high leverage can be maintained almost permanently due to globalization and low interest rates.
However, history suggests prolonged credit booms always sow the seeds of their demise. Leverage cannot keep rising faster than income indefinitely. At some point, new lending dries up; borrowers reach saturation, or interest costs rise.
While the timing is difficult to predict, today’s highly leveraged economies face risks if indebtedness continues rising from high levels. More deleveraging episodes are likely in the future.
The leveraged economy model that has emerged in recent decades has clear downsides. Excessive leverage leaves households, businesses, banks, and governments vulnerable to sudden corrections. When the music stops, and liquidity dries up, many overstretched borrowers get hurt.
As we advance, policymakers should pay close attention to debt levels and credit growth, not just aggregate GDP figures. Slowing economies need deleveraging from time to time rather than more stimulus. Otherwise, the consequences of too much leverage could be severe when the next downturn inevitably arrives.
Q: What is meant by deleveraging?
A: Deleveraging refers to reducing the debt level relative to GDP, assets, and incomes. It happens after a credit boom when lenders and borrowers start paying down debt.
Q: Which sectors typically have the most leverage?
A: The financial sector and households usually have the highest leverage. Corporations and governments also take on significant debt.
Q: What role did securitization play in the leveraged economy?
A: Securitization allowed lenders to package loans into securities and sell them to investors. This generated fresh capital to issue new loans, fueling rapid credit growth.
Q: How can policymakers address high leverage?
A: Options include countercyclical buffers for banks, maximum debt-to-income limits, higher capital requirements, and macroprudential policies to slow credit growth during booms.
Q: What is the risk of relying on debt rather than income growth?
A: An economy overly dependent on credit growth becomes vulnerable to financial crises and balance sheet recessions when lending contracts. Sustainable development needs rising incomes.