The Great Deleveraging

Currently, we are witnessing a crisis unfold in Greece that threatens the entire Euro zone and even the European Union.

However, Europe does not stand alone in the fiscal problems faced by its component states. Many states in the US face budget crises and funding issues that are prompting questions about whether and/or to what extent the federal government should intervene.

But before these crises, we had problems in Iceland and Dubai, and before them we had the Lehman failure, the collapse of the US government sponsored entities, Fannie Mae and Freddie Mac, AIG go wobbly, Merrill Lynch collapse into the arms of Bank of America and Bear Sterns fall. And prior to all those problems, the situation was viewed in the paradigm of a sub-prime mortgage crisis specific to the US. Finally, overlaid against all these crises has been the notion of a Great Recession.

Many economists, strategists, analysts and commentators speak about the above-mentioned issues in isolation. However, the observer gains greater clarity by connecting the dots between the incidents and recognising a larger pattern. The situation began before the commercial paper market seized up in Aug’07.

Indeed, it began even before the Bear Sterns’ hedge funds blew up earlier in 2007. It actually began back in March 2000, when the Internet Bubble popped. It was at that point that the Great Deleveraging, the first global financial/economic crisis of the 21st century, and the worst since the Great Depression, began.

The Great Deleveraging refers to the sloughing off, or purging, or burning away of all of the leverage and excesses that had been layered gradually into the system since the last “cleansing” episode that began with the 1929 stock market crash, extended through the Great Depression and ended only with the cessation of hostilities at the end of WWII.

Enough leverage and excesses had been built up into the global system by the height of the Internet Bubble to trigger the start of the Great Deleveraging. However, policymakers, particularly in the US, had figured out how to slow the process through a combination of tax cuts and interest rate cuts – exactly the opposite of the policy actions implemented after the Crash of 1929 that precipitated the downward spiral into the Great Depression.

Unfortunately, after staving off a Great Depression in 2001, US policymakers allowed the leveraging process to recommence. This happened partly through an overly stimulative interest rate policy, but also by allowing a core of US banks to become highly leveraged, as well as by failing to regulate and limit the amount of leverage that was eventually plowed into the formal and shadow banking systems.

The laxness was not limited to US policymakers, though. Private actors in the economy, from overleveraged, ill-educated homebuyers to the financial alchemists who created fantastic – and unbelievable – structured products, to supposedly sophisticated credit analysts and portfolio managers who “believed,” all took part. And laxness of the policymakers and private actors did not reside only in the United States.

As the situation unraveled, few countries were spared at least some pain for having engaged in behaviour that after the fact appeared reckless.

Unfortunately, the deleveraging process has not ended. One could argue that it has actually evolved or progressed very little. Rather, what has happened is that governments at all levels – from towns, to states, to countries to economic regions – have taken a large chunk of the leverage off the hands of the private system and put it in the hands of the governments. As a whole, the global system has not managed a de-leveraging so much as a transfer of existing leverage to the public sector.

The toxicity of that leverage was thought to be manageable for the various governments. When smaller governments like those of Iceland and Dubai ran into trouble, the problem was passed off as the inability of the smallest and weakest to withstand the shock of the toxic leverage.

But now we are discovering that the toxicity is so monumental and embedded into the system as to keep rising up into higher, more secure levels of government. Consequently, both the EU and the US federal government have balked at actively standing behind Greece on the one hand and California on the other.

How far the damage extends before the Great Deleveraging has finally cleansed the global system is highly uncertain. The consensus economist call is for US growth to continue at trend speed throughout 2010. Some very optimistic economists believe that the economy, particularly that of the US, will continue to experience a “V” shaped recovery.

At the other end of the spectrum is the apocalyptic crowd, whose members believe that the US “empire” is headed the way of the Roman Empire and that either war or a modern day Dark Age will descend upon the land until a new power equilibrium can be established. We cannot reasonably expect sustained trend speed growth after all the damage to the banking system and real economy, and sanity requires that the notion of major war be discarded.

The truth likely lies somewhere in the middle, with the deleveraging process likely to exact a much higher toll than is currently expected by consensus economists.

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