The virtuous cycle continues until the system collapses under its own weight. Bad loans are made to bad borrowers; defaults pick up and the cycle finally turns. The Fed, in its normal response to weakening growth, predictably lowers interest rates to stimulate more borrowing. This time it does not work. More borrowing is not possible simply because the borrowers are no longer creditworthy and the lenders, after recently being burned with massive defaults, have stopped lending. Rates fall to zero and the business cycle unexpectedly does not revert this time. The market is stunned and the economic machine literally stalls. Since total spending must come from money plus credit, and credit growth has reversed, total spending falls precipitously. This surprise creates fear, and those with money significantly cut their spending, which further exacerbates the problem. The cycle reverses after decades of going in one direction and the deleveraging process begins. It's akin to a speeding car on a crowded freeway suddenly shifting into reverse. Horrific accidents are inevitable. This is exactly what happened to the U.S. economic machine in 2008, and it is the exact same experience that captured the nation in 1929 at the onset of the Great Depression. These periods are normal responses, but they just don't repeat frequently enough for people to fully recognize and understand them.
The deleveraging process is just that: a process. It is inescapable and will repeat over and over again. The process is a largely unavoidable part of the economic machine because it is fundamental to how the machine is built. A credit-based economic system like ours is dependent on increased borrowing to finance spending, and there is great incentive to keep the cycle going as long as possible. It works well for a long time until the debt cycle reverses. When the cycle changes course, the process is self-reinforcing, just as it was during the upswing. In contrast, the normal business cycle is self-correcting. When the economy is too strong, tight policy causes it to slow, and when it is too weak, loose policy promotes an improvement. The long-term debt cycle feeds off of itself, however. I have already covered how this is the case on the way up. The opposite set of conditions drives the self-reinforcing process on the way down. I can't borrow any more so I spend less than I spent before. My reduced spending brings down your income so you spend less and that in turn negatively impacts someone else's income. The reduced overall spending and selling of assets to pay down debt also drives down asset prices, which hurts the value of borrowers' collateral, further degrading their ability to borrow. I spend less because I am earning less but also because I recognize that I have too much debt and want to take some of my income and pay down debt to gradually repair my balance sheet. This self-feeding dynamic causes a severe economic contraction in the beginning stages of the deleveraging process. The weak economic climate exacerbates conditions and confidence and can quickly lead to an economic depression. This is why a depression is not simply another variant of the normal business cycle recession. It is caused by a reversal of the debt cycle, not by the Fed tightening interest rates too much, which is precisely what causes normal recessions. Most people fail to appreciate this critical distinction because of a general misunderstanding of the mechanics of the economic machine and a lack of appreciation of the difference between the short-term business cycle and the long-term debt cycle.
How does all this relate to where we are in the cycle currently? The simplest way to measure the total debt to income ratio of a country is by taking all the debt in the economy and dividing it by the country's income, called the gross domestic product (GDP). This is a very basic measure of how indebted a nation is. You would follow the same logic to assess whether you personally have too much debt relative to your income. The country as a whole is merely a sum of its parts and is no different.
Figure 1.4 illustrates the debt level of the United States over the past century. The last deleveraging process in the United States took about 20 years to run its course. The country reached its debt ceiling in 1929 (after the Roaring Twenties) and deleveraged until around 1950. It subsequently enjoyed the tailwinds of the leveraging cycle from the early 1950s until 2008 and is likely now once again saddled with the headwinds of the deleveraging process, and will likely be for a decade or two. The ratio of debt to GDP in 1929 was about 175 percent (it jumped to 250 percent during the Great Depression because GDP fell faster than total debt). In 2008 the ratio hit 350 percent, twice the level that caused the Great Depression! It took about 60 years of leveraging to achieve such a high ratio. Last time it took 20 years to bring the debt-to-GDP ratio back to a normal level; how long will it take this time, given the more extreme starting point? It certainly will not happen in a few years.
Figure 1.4 U.S. Total Debt as a Percentage of GDP (1900–2013)
Source: Bridgewater Associates.
In most cases throughout history, economies live through a painful depression during the deleveraging process as the self-reinforcing negative feedback plays out. This process produced Japan's so-called lost decade, which began in the early 1990s. Europe is suffering through the same fate today, and even countries like Australia and Canada remain vulnerable to that critical inflection point, given their high debt levels.
Given this discouraging backdrop, why has the U.S. economy not fallen into a depression during the present deleveraging process? What makes the current period seem not as bad as the Great Depression or other similar depressionary environments? Deleveraging produces a persistent headwind for the economic machine and prevents it from functioning in its normal fashion. This force is exceptionally powerful and if left alone to run its course, extreme economic and social hardship is a near certainty. Fortunately the central bank has the tools to manufacture a smooth deleveraging, one in which the debt ratio gradually declines over time, but with positive growth through the process. Recall that the Fed's main policy tool is having control of short-term interest rates. Thus, their first step is to lower rates to zero. Normally during the deleveraging process this does not work because high debt levels prevent the normal leveraging response to lower rates. People can't borrow more, even though rates are extremely low, because they already have too much debt and are no longer creditworthy.
Recall that spending must be financed by money or credit. The credit pipelines have been impaired so the Fed is not able to increase spending by stimulating borrowing. Therefore, it must create money to make up for the spending falloff from declining credit. If spending must be financed by money or credit, and credit is constrained, then the only tool left to stimulate more spending is to manufacture more money as shown in Figure 1.5.
Figure 1.5 The Source of Spending
The Fed has the unique ability to print money and buy assets. It can essentially create more money and inject it into the economic machine. Normally the Fed prints money to buy government bonds, which has the dual effect of lowering long-term interest rates and pushing money into the economy. Lower long-term rates along with already low short-term rates help reduce debt service and leaves more money to be spent.
Many argue that printing money is irresponsible and will ultimately create more problems than it solves (including hyperinflation). Proponents of this perspective may not recognize that nearly every deleveraging in history has ended with printing of currency. The reason is straightforward within the context of the economic machine: The negative feedback loop of the deleveraging process will continue until the cycle is broken with the printing of more money. Spending will continue to decline as credit contracts (remember that spending = money + credit). The debt-to-GDP ratio will get worse because the debt is falling slower than asset values and incomes. This is exactly what happened during the first few years of the Great Depression and in the United States in 2008, and is what Japan has been living through since the early 1990s. In all three cases conditions degraded until the printing of currency ensued. The same process has been repeated across countries over time.
Along the same lines, a common question is why the printing of trillions of dollars does not automatically result in high inflation. The answer is that the printing of more money replaces the decline in credit to the degree that total spending does not increase enough to