Leveraging and deleveraging explained
Brad Robideau of American Public Media says:
Leveraging—or borrowing—has been cited as one of the contributors to the financial crisis. In this Marketplace Whiteboard, Marketplace Senior Editor Paddy Hirsch explains how the move to deleverage—or reduce debt—is prompting wild market swings and concerns about deflation.All of “The Marketplace Whiteboard” videos can be accessed at www.marketplace.org and are part of "Fallout: America's Financial Crisis," Marketplace's comprehensive coverage of the current financial crisis.
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A good little clip and a sad reminder that the typical American, left or right or center, doesn't really know much about finance.
He lost me when he said (ca. 6:30) that, "instead of increasing earnings or capital, which they can't do because people aren't buying or investing, they try to lower their debt by selling things." My confusion goes like this:
If you sell things for money that you use to pay down your debt, don't you decrease your capital as well as your debt? E.G. If I own two $1 houses (or bonds or factories) and owe $50, and I sell one of them to pay down my debt, don't I *increase* my ratio from 25:1 to 49:1?
If anyone could help me out I would like that.
@2
I'm no expert on the subject, but I think you're mixing up capital with assets.
Assets are anything you own, including cash, factories, machinery, offices, etc.
Capital is basically cash in hand. You could also call that liquid assets. Liquid assets are handy because you can spend them, but having too much liquidity isn't great, because it's better to reinvest the money into your business (e.g. buying a new factory). That's why it's OK, when things are good, to have relatively low levels of capital compared to debt.
Selling assets for cash (liquidating) means you can pay off your debts. Ideally, you want to sell enough assets to pay off some debt, without decreasing your earnings too much.
So you have a ratio of debt:capital:assets of, say, 10:1:11.
Then you sell 1 assets and get 1 capital, changing the ratio to 5:1:5.
@3 Thanks! That's neat.
Hey boingboing, did you see what the video makers did? They managed to put up a little clip of video without inserting irritating and pointless ads every couple of minutes?
Just a thought....
Turgid!
without trying to rely TOO much on the metaphor to explicate the issue, can someone clarify where the air or in this case, the metaphorical assets get dumped when they are sold? They don't just dissapear. Who picks up the goods at the firesale? And what are the consequences of this? Also, debt, if i am not mistaken, can also be sold off as a means of deleveraging?
#7: Part of the problem with the current situation is that a large amount of the assets that people were trying to liquidate were houses, and there were too many and they were overvalued. You can't sell a percentage of your house -- it's all or nothing. Best case scenario, you can sell it and buy a less expensive one, but once things started to fall apart, there were no buyers.
Another example are large cars. Suddenly the car companies had an excess inventory and no one bought them because the price of gas increased. They had to reduce the prices, probably below cost, just to maintain liquidity. (Cash flow being more important in the short term than profit.)
There aren't enough buyers at the firesale and they aren't willing to pay as much anymore. Like he said, letting the air out slowly (deleveraging slowly, scaling back bit by bit) is good. But if everyone suddenly tries to sell their assets, or demand drops, prices drop and they can't get as much capital for them, so their debt:capital ratio can't improve as much.
I am not an economist. But #7: I would guess that it is the inflated value of things that disappears. There is no law of conservation of value. Economics is a confidence game. If we all believe, then things (stocks, bonds, tulip bulbs, houses) are worth a ton of money. If we stop believing we see the man behind the curtain and the value just disappears. Why our economy has to function like this is a mystery to me. Many things have intrinsic value - you can chop a tree with an axe, eat a chicken, and rock ut on a Stratocaster. Why build a system based on wishes and illusion? In other news, unicorn futures are up!
No one explains financial issues and the economy better than Brad!!
He really makes you understand how the money moves around.
It makes so much sense - I even make my teenage kid watch it!
Overall, a good explanation. He didn't go into how deleveraging applies to our specific situation (e.g. all our leveraging went into consumption - upgrading the kitchen, buying plamsa tvs, buying new ipods, etc.) That's why the capital side can't go up. Not because of the recession. Once confidence in the assets fall, that's when the recession begins but only months later is it really acknowledged. The concept of the Fed trying to keep the balloon maxed out is completely true. The real problem with the balloon is the air in the balloon represents the money supply and as deleveraging is going on, the Fed is propping up the economy by printing more money. What you're not seeing from the balloon is more printed money from the Fed. Right now the deleveraging is happening faster than the Fed can inflate so this selling off of assets is being mis-interpreted as deflation - a contraction in the money supply, but that's obviously not the case. The selling of assets increases the supply which also affects price. Plus, the inflationary effects of the Fed printing money won't be felt until much later. What do you think would happen once the deleveraging period ends? The dollar will collapse and lose all value.
This ties into Jetset's question. The reason why value can disappear into thin air is because that's where the whole monetary system is created from. We used to have a gold standard which puts confidence in the economy but a fiat currency, which is what we have had since 1971, is backed by an IOU from the governent...maybe you've heard of it...it's called a governmment bond.