Deleveraging theme still a problem

Investors would like to move forward and stop discussing poor economic growth. We would like to see the robust recoveries of business cycles past, but this is not likely given the overhang of deleverage. However, a closer examination of the deleveraging history suggests that debt cannot just be turned off to solve the problem. Like an addition, you cannot deleverage cold turkey. The deleverage extremists are wrong. Growth will not occur through a singular approach to cutting leverage because that means cutting credit lines and credit is still the lifeblood of any economy.

In reality, there has to be an adjustment in the type of debt that is incurred by the economy to ensure that growth can continue. A slowing of growth effects all firms and what is actually needed is for weak firms to restructure and productive firms being given funds to continue on their growth path. Call this a structuralist approach to deleverage. There has to be a process of "creative destruction" in order to move the credit available from those who do not know how to use it to those who do. 

In this structuralist view, the government has a key role. It has to take on more debt to stop the retrenchment of the private sector as it goes through the process of separating good from bad firms. This the role of counter-cyclical policy, soften the impact of the destruction process. The government should be focused on macro-policies and not trying to replace private lending. The tax cuts and spending policies helped with this process. 

The government also needs to protect the banking system to ensure proper financial intermediation. If banks are endangered, there will be an interruption of credit which will prolong any recession. The reason for helping banks is that bank lending requires private information on borrowers. If a bank goes under, this private information is lost and good borrowers may not be able to receive funds when needs because they are unknown by other institutions. The disruption of banking relationships will mean that good companies will be denied funds which worsens the economic distortions from a downturn. The TARP program helped with this process.

There needs to be credible plans for financial sustainability by the government. There has to be a plan that explains how counter-cyclical policy will work. Structural deficits are not part of this plan. Counter-cyclical policies can easily turn into structural deficits if there is no plan to return the government spending to normal. This has been a critical piece that has been missing from the US. If there is not a sustainability program, there credit rating of the government will be in jeopardy which will lead to further debt problems.

There has to be structural reforms to allow for overall investment in plant and equipment as well as exports. The excess leverage means that there has been an imbalance between sectors within the economy so this is a time to allow for structural reforms such as taxes and manufacturing. Finally, there needs to be sustainability in housing and real estate as a means of protecting consumer wealth. Because consumers make up such a large amount of the US economy, there has to be policies which will protect wealth other wise there will be poor expectations for future consumption. 

The solution to excess leverage is not just cutting but pruning with a eye for protection.