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The economic and financial crisis is primarily due to the inordinate accumulation of debt by the developed economies, especially between 2000 and 2009. Beginning in 2008, the private sector –households, businesses and financial institutions – began the deleveraging process. This contributed to the 2008-2009 recession and also had the effect of further increasing the debt and the risk borne by governments.

It is hard to assess the remaining adjustments to be made, but the deleveraging process seems far from complete, especially for sovereigns, and is likely to put a damper on growth for the foreseeable future. This dampening effect is stronger than the deleveraging effort that is simultaneously taking place in all developed countries. Furthermore, recovery is undermined by the daunting process of adjustment in some countries, notably in the peripheral euro area.

The private sector has considerably deleveraged since the crisis began...

Total debt (private and public sector combined) has sharply increased as a percentage of GDP since the beginning of the 2000s. The generalised reduction in interest rates and innovations in finance have contributed to ballooning debt. Since the collapse of Lehman Brothers, the non-financial private sector has been engaged in a major deleveraging effort. The greatest strides have been made in the United States, where the debt ratio of non-financial players has been falling since early 2009. In the space of two years, US households reduced their debt burden by nearly $500 billion (from 99% to 89% of GDP between early 2009 and early 2011). Simultaneously, non-financial corporations decreased their debt by seven percentage points, to 73% of GDP.

In the United Kingdom, non-financial corporations, which were relatively more indebted before the crisis, began this process late in the game. However, barely more than a year later, they have reduced their debt by 13% of GDP. In the euro area, the deleveraging process is more recent and is taking place on a smaller scale. However, the aggregate figures hide wide national disparities.

For example, although Germany's private sector did not engage in the same excessive leveraging as did the peripheral countries, it significantly lowered its debt ratio. Conversely, non-financial private debt was exaggerated in Spain, Ireland and Portugal and efforts at lowering debt ratios appeared to be either half-hearted or non-existent: indeed, the denominator (nominal GDP) is falling just as fast as the numerator (debt). The financial sector also had to make some balance sheet adjustments. International comparisons of debt levels are especially tricky but the trend is the same overall. Leveraging had strongly accelerated prior to the crisis and the sector began a substantial debt reduction effort that that could be seen in the United States, the United Kingdom and in the euro area.

...placing constraints on growth but also on government debt

Deleveraging can occur in several different ways: increase in savings relative to investment, balance sheet restructuring and transfers of debt to other actors. Since the beginning of the crisis, savings increased significantly in all countries as investment declined, which accounts for the scale of the 2008/2009 recession. In the United States for example, the rate of household saving grew from approximately 2% of disposable income in 2007 to nearly 6% in 2009, representing an increase of nearly $300 billion. Furthermore, balance sheets were restructured by writing down some loans (such as mortgages in the United States), and selling assets.

A portion of the debt shed by private sector was implicitly passed on to government debt. This process proceeded via a reduction in tax revenue, an increase in spending (automatic stabilisers and individual aid measures) and official support to the financial sector (via recapitalisation and government guarantees). Hence, the crisis resulted in a sharp increase in government debt in all countries. Excluding the financial sector, the increase in government debt offset more than two-thirds of the debt shed by the private sector (and even up to 90% in the United States). If you include the financial sector, the increase in government debt offset approximately one-third of the debt shed by the private sector. In the euro area, strong divergences appeared between member states. Peripheral countries experienced a sharp increase in government debt despite only minor adjustments by the private sector. In Ireland for example, government debt had grown to 25% of GDP prior to the crisis to nearly 115% by 2011 while in Greece government debt grew from 105% of GDP to 150% during the same period. This implicit transfer of private sector debt to governments slowed the adjustment process, which would have been more violent otherwise. However, government debt has now reached levels that are difficult to bear and which now require adjustment.

The road ahead of us is long and filled with challenges

What will be deemed to be a sustainable debt level? The IMF suggests a government debt to GDP ratio of 80% for developed countries. However, economic theory provides no answer as to a desirable level of sustainable debt. In any event, with respect to historical data and the problems with access to market funding that some countries are having, debt levels still seem to be too high today. The stress is highest in countries with excessive external imbalances, such as Greece and Portugal. In fact, these countries have no choice other than reducing their expenditure when they are faced with a sudden withdrawal of foreign investors. On the other hand, in a country like Japan, where government debt is almost entirely held by residents, the stress is lower since there is no domestic impoverishment (but only redistribution between lenders and borrowers). In any event, there is a simultaneous need for adjustment in all developed economies that is going to put a damper on economic growth for the foreseeable future. However, the expected rebalancing within emerging economies could act as a shock absorber mechanism. In fact, in the coming years, all economies, China in particular, are expected to further reduce expenditure and consumption. Against this backdrop, the monetary policy of the main central banks will continue to play a key role during the lengthy balance sheet deleveraging phase. By keeping interest rates low for the foreseeable future, the central banks can ensure the sustainability of the debt burden and allow deleveraging to occur gradually. However, we cannot rely on inflation to lessen the effort that remains to be made. Indeed, in an environment where markets have become more responsive, any increase in inflation would be quickly followed by higher nominal and real interest rates. In fact, as emerging economies showed in the 80s and 90s, inflation is not the answer to the debt problem.