What Is Deleveraging?

Key Takeaways

1. 1Leverage is debt measured against income or assets - high leverage means owing too much relative to your earning power
2. 2Deleveraging is mandatory when leverage gets unsustainably high - either by choice (gradual repayment) or by force (default, fire sale, collapse)
3. 3There are four deleveraging mechanisms: pay down with income, sell assets to repay, default, or use inflation to erode the real debt burden
4. 4Deleveraging is inherently deflationary - when borrowers redirect spending into debt repayment, aggregate demand falls and unemployment can rise
5. 5The paradox of thrift: cutting spending to save is rational for one household but disastrous when everyone does it at once - demand collapses
6. 6Nominal and real deleveraging differ - dollar amounts can fall while the debt-to-income ratio stays high if incomes are falling too
7. 7The 2008 crisis showed how punishing forced deleveraging is - even with massive stimulus, it took over seven years for household leverage to normalize
8. 8Policymakers fight deleveraging because the alternative is a self-reinforcing demand collapse - easing rates, fiscal deficits, and QE all aim to soften the unwind