What is the paradox of deleveraging?

Readers Question: What is the paradox of deleveraging?

It refers to a situation where everyone is trying to reduce debts and improve their balance sheets all at once; but this process of paying off debts creates problems for the economy – such as a shortage of liquidity and fall in consumer spending..

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

Why can paying off debts cause an economic problem?

To reduce debts people sell off assets to gain liquidity. Selling assets causes a fall in the price of shares and house prices. Falling house prices cause a negative wealth effect and a fall in consumer confidence. This leads to lower consumer spending, lower economic growth 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. An individual choice to save more might make perfect sense, but if everyone in the economy increases saving by 20% (and reduces spending by 20%), then it will cause a significant fall in aggregate demand in the economy and can cause a recession.

saving-ratio-since-1963-recession-growth

This shows how the periods of a rapid rise in saving are associated with recessions. This was particularly noticeable in the 2008/09 recession and credit crunch. Banks and individuals were highly leveraged (high debts). When the banking system struggled, there was a rush to pay off debt and improve financial position, this led to a sharp fall in bank lending and fall in economic growth.

housing-equity-withdrawalHousing equity withdrawal is another example of the deleveraging paradox. Before the crash people were remortgaging. After the crash, people were trying to pay more off their mortgage.

Similar concepts

  • 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.

Impact of the paradox of deleveraging

  • A Central Bank may need to provide liquidity to the banking sector to avoid banks running out of cash.
  • Some economists suggest the government may need to intervene and provide a stimulus to aggregate demand to deal with the shortfall.
  • Banks may offer higher interest rates to attract savings and discourage borrowing.

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