The debt deleveraging process has only just begun

In January 2010 the McKinsey Global Institute (MGI) published a study entitled “Debt and deleveraging: The global credit bubble and its economic consequences”. The study examined the global credit bubble and looked at 32 episodes in which countries had significantly reduced their debt (or deleveraged) after a financial crisis.

The study found that episodes of deleveraging have historically been rather painful, and reducing the ratio of debt to GDP by 25% took on average six to seven years. It found that for the first several years of debt deleveraging GDP tends to contract, before recovering during the final few years.

With this in mind, the question is: How far down this road of debt repayment have we come since the bursting of the global credit bubble in 2008?

In January this year McKinsey published a new report entitled “Debt and deleveraging: Uneven progress on the path to growth” which provides the answer.

The new study reveals that only three of the ten largest developed economies have begun the process of debt repayment, while the rest have actually increased their debt burden, three of them quite significantly.

The three nations that have begun to reduce their debts, are, South Korea, the United States and Australia, while the three that have significantly increased their levels of household, corporate and government debt since 2008, are, Japan, Spain and France.

Notes: This chart shows the total debt as a percentage of GDP (1990 – Q2 2011) of the ten largest developed economies. The debt figures include: all loans and fixed-income securities of households, corporations, financial institutions, and government. Chart taken from “Debt and deleveraging: Uneven progress on the path to growth” published by McKinsey January 2012.

The best case scenario is that we begin a new cycle of prosperity in about 6 or 7 years

Before we can draw any conclusions we need to make some assumptions. First, let’s assume that all ten of the largest developed economies immediately stop increasing their debt burdens and begins the process of debt deleveraging. Second, let’s assume that a 25% reduction in nominal debt to GDP is sufficient to take these economies out of the danger zone. I’m not sure these first two assumptions are very likely, but let’s go with them. Finally, let’s assume that high levels of inflation take care of another 25% of our debt. I think this is a pretty safe assumption.

So with these assumptions in mind, our best case scenario is that on a global basis we are in a position to begin a new cycle of prosperity in about six or seven years. In the meantime we can expect short periods of feeble growth, punctuated by recession.

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