Paradox of Deleveraging

Readers Question: What is the paradox of deleveraging?

It isn’t as difficult as it sounds.

Basically, it refers to a situation where everyone is trying to reduce debts and improve their balance sheets all at once; and this process of paying off debts creates problems for the economy.

From a personal point of view it is good to reduce your debts, and improve your financial position. However, if everyone does it at the same time it can lead to a financial crisis.

Why?

To reduce debts people sell off assets to gain liquidity. Selling assets causes fall in the price of shares and house prices. Falling house prices cause lower consumer spending, negative equity and more losses for banks.

To reduce debt, people cut back on spending to save  costs. This leads to lower aggregate demand in the economy.

You can see this in the fact people are repaying mortgages and housing equity withdrawal has become negative

The paradox of deleveraging is similar to the paradox of thrift.

The paradox of thrift says if individuals have higher levels of saving that is good. But, if everyone saves more at the same time it can lead to a big fall in consumer spending in the economy.