Wednesday, September 8, 2010

Does Reduction in Outstanding Debt Equal "Deleveraging"?

Karl Denninger takes a look at today's consumer credit report and rightly observes that the American consumer isn't deleveraging.  As this chart from FRED shows, total outstanding credit is down only $162 billion from is peak, or 6.2% from the July 2008 peak of $2.58 trillion:

But, as Steve Keen has pointed out, somebody seems to be deleveraging (he's just wrong in assuming it is the American consumer).  According to his data, the amount of debt outstanding debt in the private sector (households, non-financial businesses and the financial sectors) reduced by $1.85 trillion from the end of 2008 through the end of 2009.

So, who is the cause of this debt reduction? 

Answer: the financial institutions account for more than 75% of that $1.85 trillion reduction in outstanding debt.

There are a few observations here. 

First, the vast majority of the reduction in outstanding debt has resulted not from consumer deleveraging or write-offs of consumer debt but from the reduction of financial sector debt. 

Second, given the precipitous drop in financial sector debt, most if not all of that drop-off comes from write-offs of debt incurred in purchasing derivatives. 

Third, instability caused by excessive leverage on risky loans caused the financial crisis, not the risky loans themselves.  Even if one could successfully argue that banks were forced to lend to unworthy borrowers (something that has been debunked time and again), nobody made the banks create completely unregulated derivatives based on loans made to unworthy borrowers.