GDP, Deleveraging and Economic Growth…

May 28, 2010

The McKinsey Report below sets out guidelines for a successful return to growth while outlining potential mistakes that can be made through the necessary process of debt reduction/deleveraging required in the years ahead. Some of the insights have major ramifications for budgetary strategy, particularly our next budget. Too early a contraction on public spending can have severe negative effects making a path out of recession more prolonged.

It would appear that drastic public spending cuts particularly when it comes to loss of jobs can have a negative impact in the short term on any return to growth and can further impede GDP.

Arguably broad budgetary policy should be to increase taxation on the higher paid, stimulate/increase employment by more public spending on areas such as education and public infrastructural projects of value to the economy such as the building of schools/libraries/clinics/extensions to public infrastructure in health/education to give some examples.

Bearing in mind the  NAMA project is predicated on a return to growth and not a dampening of growth due to debt reduction, deleveraging and debt reduction is bound to have an effect on GDP in the years ahead. This factor is very much disguised in positive outlooks on the future growth of our economy as in the following OECD report.  This OECD report disguises the effects of a contraction of GDP in the years ahead compounded in our case by an across the globe similar contraction in other economies. It also ignores the increasing debt servicing budgetary obligations in the face of the necessary adjustments that require to be made to achieve deleveraging in the short to medium term. Return to growth projections ignore or avoid the effects of the necessary adjustments outlined by McKinsey while also ignoring the dangers of maladjustment to the need to correctly manage deleveraging.

Some notes from McKinsey:

“large amounts of foreign capital. Ireland’s total debt relative to GDP more than doubled from 2001 to 2008, to over 700 percent. Financial sector debt accounted for more than half of the total, at 421 percent of GDP. At the same time, the inflow of foreign capital fueled a property boom.”

“6  The mature economies we examined are Canada, France, Germany, Italy, Japan, South Korea, Spain, Switzerland, the United Kingdom, and the United States. The emerging economies we examined are Brazil, China, India, and Russia.”

“45 episodes since the Great Depression in which the ratio of total debt relative to GDP declined, and 32 of them occurred following a financial crisis………..”

“The historic episodes of deleveraging fit into one of four archetypes: 1) austerity (or “belt-tightening”), in which credit growth lags behind GDP growth for many years; 2) massive defaults; 3) high inflation; or 4) growing out of debt through very rapid real GDP growth caused by a war effort, a “peace dividend” following war, or an oil boom.

The “belt-tightening” archetype was by far the most common of the four, accounting for roughly half of the deleveraging episodes. If today’s economies were to follow this path, they would experience six to seven years of deleveraging, in which the debt-to-GDP ratio declines by around 25 percent. Deleveraging would begin two years after the start of the crisis, and GDP would contract for the first two to three years of deleveraging, and then start growing again (Exhibit 4).”

“Many historic examples, from the United States in the 1930s to Japan in 1997, show the danger of withdrawing support of the economy too soon. ”

“A revised Basel II framework could require banks to adjust their internal risk weights to reflect levels of leverage in the relevant sector of the real economy.”

“Middle-income households have much lower default rates and instead deleverage by saving more and consuming less, a process that avoids credit losses but slows economic growth.”

“Rapid appreciation of commercial real estate prices, like residential real estate prices, has been at the heart of many financial crises. In their definitive study of financial crises, Kenneth Rogoff and Carmen Reinhart find a strong association between real estate booms and banking crises.”

“lending takes place with only limited disclosure available on the businesses of real estate developers, most of which are private companies. Third, long lead times in real estate supply can result in big price shifts when there is a change in demand. Finally, real estate developers have an asymmetric payoff due to limited liability, with large potential profits if the project succeeds while losses in the case of default are borne by banks and other investors.”

“While governments could have done more to reduce debt during the boom years, it is fortunate that most entered the crisis with ample room to expand public spending, as they have since done.”

“This deleveraging has been associated with rapid declines in bank lending as banks have sought to slow the growth of (and in some cases even shrink) their balance sheets and as they have raised capital. Further deleveraging by the financial sector may result from changes in capital requirements, particularly the requirement that banks hold more common equity.”

“This leads us to the conclusion that the simplest and only effective policy tool to address the deterioration in the quality of capital is to mandate minimum levels of core capital (such as Core Tier 1 capital), as regulators in some countries have now done.”

“of the larger Spanish banks compared with the smaller, regional ones.  Going forward, the deflating Spanish real estate bubble is likely to affect most heavily the small and medium-size savings banks (the   cajas  ), which have a larger proportion of their balance sheets exposed to domestic real estate and which have experienced significantly higher rates of nonperforming loans than larger banks. ”

“All of this leads us to a conclusion that the most likely path forward today—particularly in the United States, the United Kingdom, and Spain— is one in which deleveraging is postponed until after the crisis passes and government debt growth is reined in.

Then, these economies’ debt burdens will most likely decline more slowly and over a longer period than the historical average. That is because not only will the private sector need to deleverage, given precrisis growth in debt, but the public sector will also have a large debt to pay down (see sidebar,   Sovereign deleveraging through history  ). These highly leveraged economies may therefore remain vulnerable to economic shocks for some time. While we do not forecast GDP, it is likely that deleveraging will dampen GDP growth compared with what it would have been otherwise, possibly slowing the recovery.”


Our analysis has several implications for policy makers and regulators seeking to ease the deleveraging process and enhance future financial market stability, and for business executives as they navigate through these turbulent times.

History shows that policy makers can enable healthy deleveraging by supporting GDP growth through the process. This will require working through multiple channels, such as spurring increases in net exports, productivity growth, and the labor supply. Additionally, policy makers need to carefully consider the timing of reducing government support of aggregate demand. Many historic examples, from the United States in 1938 to Japan in 1997, show the danger of prematurely withdrawing fiscal and monetary support of the economy. However, faced with rising public debt, many governments face an acutely difficult decision on the precise timing of the necessary public spending cuts. ”

“large amounts of foreign capital. Ireland’s total debt relative to GDP more than doubled from 2001 to 2008, to over 700 percent. Financial sector debt accounted for more than half of the total, at 421 percent of GDP. At the same time, the inflow of foreign capital fueled a property boom.”


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