Deleveraging - Macro-Economic Consequences

Macro-Economic Consequences

Massive deleveraging in corporate and financial sectors can have serious macro-economic consequences, such as triggering Fisherian debt deflation and slowing GDP growth. In the financial market, the need to deleverage causes financial intermediaries to shed assets and stop lending, resulting in a credit crunch and tighter borrowing constraint for business, especially the small to medium sized enterprises. Many times, this process is accompanied by a flight to quality by the lenders and investors as they seek less risky investment. However, many otherwise sound firms could go out of business due to the denied access to credit necessary for operation. Moreover, firms in distress are forced to sell assets quickly to raise cash, causing asset prices to collapse. The pressure of deflation increases the real burden of debt and spreads loss further in the economy.

In addition to causing deflation pressure, firms and households deleveraging their balance sheet often increase net savings by cutting expenditures sharply. Households lower consumption, and firms fire employees and halt investment in new projects, causing unemployment rate to rise and even lower demand of assets. Empirically, consumption and GDP often contracts during the first several years of deleveraging and then recovers, which in some cases cause a fall in total savings in the economy, despite the individuals' higher propensity to save. This is known as the paradox of thrift.