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A deleveraging can be beautiful
Four ways debt falls
Debt burdens come down in four ways: people, businesses, and governments cut spending; debts are reduced through defaults and restructurings; wealth is redistributed from the haves to the have nots; and the central bank prints new money. All four have appeared in every deleveraging in modern history. The first three are deflationary, and printing money is inflationary and stimulative.
Balancing the levers
Stability depends on balancing the deflationary ways against the inflationary ones, which takes a certain mix of cutting spending, reducing debt, transferring wealth, and printing money. Handling a difficult situation in the best possible way is more beautiful than the debt-fueled, unbalanced excesses of the leveraging phase.
Recovery and the lost decade
When the mix is right, growth is slow but debt burdens go down. Incomes begin to rise, borrowers look more creditworthy, and lenders start lending again. Eventually the economy begins to grow, which is the reflation phase of the long term debt cycle. It takes roughly a decade or more for debt burdens to fall and activity to return to normal, hence the term lost decade.
How did the US shrink its debt after 1945?
US federal debt peaked at roughly 106 percent of GDP in 1946. It fell to about 23 percent by 1974, mostly because the economy grew quickly while inflation ran above the interest rates paid on government bonds.
Carmen Reinhart and Belen Sbrancia estimated in a 2011 paper that this kind of negative real interest rate removed an amount of debt equal to a few percent of GDP each year.
Why do economists speak of lost decades?
The phrase became common for Latin America in the 1980s, after Mexico announced in August 1982 that it could not service its foreign debt and a wave of sovereign debt crises followed. The region's economies largely stalled while borrowers worked through the debts.
The label was later applied to Japan's 1990s, after its stock and property bubble burst.
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