Debt Crisis Recovery: Bell Curves and Balance Sheets

Debt Crisis Recovery: Bell Curves and Balance Sheets

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

Debt Curves 2013

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.

John Greenwood

Chief Economist

Invesco Ltd

Based in London, John is Chief Economist of Invesco Ltd. with responsibility for providing economic analysis and forecasts to Invesco portfolio managers and clients.

John started his career in 1970 as a visiting research fellow at the Bank of Japan. He joined our company four years later in 1974 as Chief Economist, based initially in Hong Kong and later in San Francisco. As editor of Asian Monetary Monitor in 1983, he proposed a currency board scheme for stabilising the Hong Kong dollar. John was a director of the Hong Kong Futures Exchange Clearing Corporation for four years until 1991, and in 1992 became a council member of the Stock Exchange of Hong Kong, a position he held for twelve months. In that same year, he was an economic adviser to the Hong Kong Government. He has been a member of the Committee on Currency Board Operations of the Hong Kong Monetary Authority since 1998. He is also a member of the Shadow Monetary Policy Committee in England, and he serves on the board of the Hong Kong Association in London.

John holds an MA from the University of Edinburgh, and an Honorary PhD, also from the University of Edinburgh.


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