Deleveraging

One of the factors that makes this "recession with adjectives" so different is the extreme degree of financial leveraging that is pervasive in the economy. Businesses with excessive debt loads. Consumers with huge mortgages and tons of credit card debt. Banks with insufficient and illiquid capital. Heavily leveraged hedge funds. Investors heavily into commodities (which are typically leveraged). Not to mention government debt. Part of the reason for the sharp pullback in economic activity is that there was an excess of activity due to the extra capital "created" by all of the leveraging and now that leveraging is being removed in a rather disorderly manner. This painful deleveraging process will continue for some indeterminate period. Bankruptcy hastens the process. Renegotiation of interest and maybe even principle moves the process along, but at only a slightly faster than a natural paydown of debt. Bailouts and "stimulus" helps as well. And, unfortunately, even as deleveraging proceeds, some businesses and consumers are going even deeper into debt due to lost income, revenue and jobs.

The big question is whether the necessary deleveraging of the excess leveraging of the past five years will be completed promptly and reasonably orderly to end the recession within the next year or so, or whether the process stalls out and we slip into Japan-style "lost decade" or even a true depression.

It looks as if the likely scenario will be a partial deleveraging over the next two years, sufficient to enable the economy to be semi-healthy again. This being America, a disturbing degree of leveraging will persist, but not sufficient to push the economy into a "lost decade" or depression.

The most important factor is getting the banking and the rest of the financial system solvent again. The Federal Reserve has been stepping in to substitute its own solvency and liquidity, and that will continue and be sufficient to hold the financial system together over the next two years, but eventually we need to see the private sector once again be able to pick up the slack.

In short, leveraging made the economy look stronger than it was over the past five years and now the deleveraging is making the economy look a lot worse. Fed action, fiscal stimulus, bailouts, bankruptcies, and restructuring will gradually repair the economy and most likely assure that the economy does not slip into a lost decade or outright depression.

Still, deleveraging is one of the key factors to keep an eye on. For example, in the case of GM, they must figure out how to reduce their debt load by at least a factor of three if not four or even five to assure not just that they can survive, but to enable them to thrive as well. Bankruptcy can do that, but they may be able to convince bondholders that they would get an even worse deal in an outright bankruptcy. That is just one example.

-- Jack Krupansky