We're a nation of debtors. A survey released by BMO in June showed that the average Canadian household is more than $100,000 in debt, and most have ramped up borrowing over the past five years. With interest rates rising, many are scrambling for a way out.
The same thing happens on a macroeconomic scale in national and global economies. In fact, it's going on right now in much of the world. It's called deleveraging, and it happens when people, companies and governments hit a dead end in terms of borrowing and have to switch to paying it all back. So what does that mean for investors? As with all things economic, it's a matter of some debate.
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Let's take a look...
What's deleveraging, anyway?
We're seeing the term deleveraging in the news a lot these days, and while the economic predictions that surround it may be complicated, defining it is simple. Leverage is essentially a geeky way of saying debt. The term derives from the fact that in business, debt is often about more than racking up a credit card balance on shoes and shiny baubles; in business, debt means opportunity, and companies often use it as a launching pad. So if leveraging involves taking on debt, deleveraging is the opposite. Whether you're an individual, a company or an economy, there comes a point when our debts must be repaid.
Why does the buck stop here?
Why deleveraging is occurring now is a result of a complicated web of economic factors. For decades, many Western countries have been taking on debt like it's going out of style, growing cities, economies and business. In the U.S., low interest rates combined with economic strength drove up borrowing of all kinds, including (most infamously) on mortgages. As a result, more people bought homes, the housing market thrived and home prices shot through the roof.
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Unfortunately, building a world based on debt can be likened to a pyramid scheme: a lot of people are jumping in, but there's very little real money being added to the system. Eventually, the whole mess collapses. So, while the tenuous situation in the U.S. took years to develop, it all came apart rather quickly in 2008, when the housing market imploded, sending the U.S. economy — and other economies around the world — into a tailspin.
So we're paying down debt...that's good, right?
Back to that household debt. Think about what happens when it finally comes time to face the music. It means no morning latte, no summer vacation and much less shopping for anything but the essentials. In short, it means less spending. We tend to feel that pretty viscerally on a personal level, but what about the coffee shop that sells your latte, or the person who owns the lake cottage you rent for a couple weeks over the summer? They miss you, too. Well, maybe not you personally, but when a lot of people are forced to cut their spending all at once, retailers and other businesses feel the pinch.
The same thing happens in an economy: when borrowing contracts, so does everything else. There's less investment, less expansion, less employment and, overall, less prosperity. It's what economists call a "vicious cycle". In this kind of cycle, holding a lot of debt is just too risky, and everyone scrambles to put their balance sheets back in balance.
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So how does deleveraging happen?
We know that the global economic system is carrying a massive amount of debt, but the notion of deleveraging starts with a bit of a disturbing assumption. That is, that the debt — both public and private — is far too big to reasonably believe it can ever be paid back. It's a lot like racking up your credit card and landing yourself on the 100-year repayment plan. So how then, is all this debt dealt with?
The first and most damaging option happens all on its own: default. The problem is that if too many companies and individuals cry broke at once, the economic contraction can be so swift and intense, it can cause bank failures and a major recession, or even a depression. Fortunately, you don't have to get ready to stand in a bread line just yet. Nowadays, countries have fiscal and monetary policy in place to avoid this scenario.
Exactly what that policy consists of varies widely, and it's something you're likely to hear politicians and economists arguing about for years to come. Lately, stimulus spending has been a popular choice among governments. In the U.S., fiscal stimulus packages in 2008 were passed to provide tax rebates and increase government spending in ways designed to help stimulate the economy, such as on employment insurance, housing and public works projects. Whether this stimulus works — or only digs a government deeper into debt — is a matter of great public debate, but most governments will do anything that might prevent a severe economic contraction (and keep voters happy).
Another monetary solution we've seen recently is lower interest rates. If you've done any borrowing, you can imagine how this works; lower interest rates boost borrowing, and this money can stimulate spending and investing. Of course, lower interest rates also tend to lead to more debt, which makes this a tricky issue in a struggling economy. Raise interest rates and some borrowers will be crushed; leave them too low and debt may continue to accumulate, which could also pose a risk down the road.
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Quantitative easing is another option that governments attempt, usually as a last resort, to inject more money into an ailing system. Governments tend to use this method when interest rates are already near zero. It involves buying government bonds and other financial securities in an effort to flood the financial market with capital. The idea here is that more money in the system will boost lending and investment. Of course, because this option also causes the value of the currency to decrease, lenders are still getting less than they bargained for, but economists these days generally accept this as the least-bad option. Stimulating an economy through its worst period drags the economic contraction out in an attempt to make it less painful.
So what about me? How do I fit into this?
There isn't much an individual can do about the economy (besides suffer through its ups and downs). Fortunately, Canada's strong banking system and more conservative approach to debt has made us somewhat less vulnerable to the deleveraging process that is making economic waves in the United States and the European Union. Even so, globalization has made economic crises increasingly pervasive, no matter where they originate. What we, as individuals, can control is how we invest in this type of economic climate.
According to Rob Clarfield, a CPA, CFP and columnist for Forbes.com, deleveraging presents a conundrum for investors. On the one hand, debt deleveraging puts a damper on economic growth and, as a result, investment income. This suggests that investments such as bonds should be the focus, as growth-oriented stocks are likely to struggle. On the other hand, central banks' attempts to increase the money supply essentially cause inflation, in which case investments that hedge against it are a strong bet.
So what's the right answer? For investors, it tends to be the same no matter what the economic climate: a well-diversified portfolio that helps to protect against risks (whether inflationary or deflationary) and provides the best growth possible given the economic climate. It's a tricky balance, so professional advice is recommended.
It starts at home
And while you might not be able to change the global economy, a balanced economy begins at home. If you stay out of debt, spend what you can afford and save for the future, you'll have everything you need to survive any economic atrocity. It starts with you.
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