Part 1: The Making of a Debt Crisis
This three-part series examines the life cycle of a debt crisis and looks at where the US, UK and eurozone are in the recovery process. This first post explains the phases of a debt crisis. Part 2 will look at where the US stands in the deleveraging process, while Part 3 will focus on why the UK and eurozone lag the US in balance-sheet repair.
Investors are inundated with media commotion about the US debt ceiling/default dilemma, the Federal Reserve’s tapering strategy and other issues. But this chatter distracts from what really matters when it comes to economic recovery — repairing balance sheets in the private sector.
Life cycle of a debt crisis
The emergence of a credit bubble and its aftermath — the process of “bubble and burst” — may be visualized as two overlapping bell curves, as shown below. The curves illustrate the typical trajectory of leverage — the ratio of debt to income, measured by gross domestic product (GDP) — in the private and public sectors.
Debt Crisis: Two Curves, Three Phases
Source: Invesco, for illustrative purposes only
A debt crisis occurs over three phases:
- Phase 1: The bubble inflates, financed by rising debt-to-income ratios in the private sector.
- Phase 2: After the bubble has burst, the private sector typically starts to deleverage by reducing spending, repaying debt and repairing balance sheets. These spending cutbacks trigger recession, which, in turn, results in declining government revenues, government budget deficits and a higher ratio of government debt to GDP. As the recession intensifies, the government may also commit to additional fiscal stimulus measures, further expanding the public sector’s deficits and debt ratio. That’s why the government’s debt ratio typically starts to rise steeply at exactly the moment when the private sector begins to deleverage.
- Phase 3: Eventually, private-sector balance sheets are repaired, and normal growth can resume. The recovery of private-sector growth restores government revenues, narrows the fiscal deficit and enables the government debt-to-GDP ratio to start declining.
Part 2 of this series will examine why the US is outpacing both the UK and the eurozone in balance-sheet repair and recovery from the debt crisis.
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