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The Paradox Of Deleveraging

By Rohit Harlalka

Most of us have studied microeconomics before diving into the huge pool of macroeconomics. This is because the simple concepts of supply and demand are the commencement points of microeconomics, a pre-requisite for all economic analysis. Further, macroeconomics is not only the summation of microeconomic outcomes but also the interaction of its various consequences.

However, sometimes combining the two fields can lead us to various paradoxical situations, with the most prominent being the paradox of aggregation. According to this, what is good or holds true for an individual does not necessarily hold for a group of them. A simple example of the same is the Paradox of Deleveraging.

But before delving into this, let us first understand what we mean by leverage and deleverage and why they matter. Leverage results when a firm or any economic agent uses borrowed capital as a source of funding to expand the asset base or carry out various economic activities. This has many kinds of applications in economics. At the sectoral level, the amount of debt or leverage the households and the corporates have is studied to analyse the investment and consumption behaviour. The leverage of the various financial institutions helps in understanding the incentives facing them and their ability to fund shocks. At the sovereign level, the amount of public debt can help in the determination of the exposure to financial shocks alongside assessing the projected levels of taxation and government spending. Lastly, the aggregate amount of external debt impacts the macroeconomic performance with the same affecting the vulnerability to the international financial crises and capital flows into the country.

Deleveraging, on the other hand, occurs when an economic agent tries to pay back its debt. In other words, it happens when there is a reduction in the agent’s total financial leverage. Households tend to deleverage or write-off debt so that their financial position is restored and they are ready to cope up with the uncertain financial future by providing support for a sustainable and smooth spending pattern. Banks and other financial institutions, at the same time, have to deleverage in order to obtain stable funding sources and secure sufficient amount of capital buffers that would, in turn, help them in improving their financial resistance. Banks can either increase the amount of equity capital they possess or de-lever by reducing assets. However, when they do the latter by reducing their lending activities, credit to the private sector declines, especially for the MSMEs and households, thereby, dampening economic activities.

Given this background, it becomes easy to understand the concept of the Paradox of Deleveraging. Paul McCulley in July 2009 was the first to discuss the same. In 2008, the U.S. stock market witnessed the biggest crash after the Great Depression. Once Lehman Brothers filed for bankruptcy and the double bubble in the housing valuations and debt burst, all levered financial institutions, banks, non-banking financial institutions, and even shadow banks, started writing-off debt from their balance sheets. Although, at the individual level it made complete sense, at the macroeconomic level, it created havoc and defied the sole purpose of deleveraging. 

Therefore, the paradox of deleveraging refers to a situation in which all individuals try to reduce their debts by selling off assets, thereby, causing a fall in the prices of the same. This creates a negative wealth effect and a fall in consumer confidence. Therefore, when many individuals try to de-lever at the same time, they eventually end up doing less of it because of the deflation in the assets from which the leverage is being removed. In other words, it is not possible for all levered lenders to remove the assets and the associated debt simultaneously, without causing the prices to decline. This, in turn, creates a paradoxical situation by increasing the leverage by driving down the net worth of the lender. 

For example, a company that has an equity of Rs. 2,00,000 borrows Rs. 8,00,000 and buys an asset worth Rs. 10,00,000. Therefore, in this situation, the company has a leverage of 5 which depicts the scenario where the equity worth Rs. 2,00,000 is actually one-fifth of the asset value. Now if this asset value falls by 10% to Rs. 9,00,000 with the amount of debt remaining unchanged, it implies a fall in equity or net worth to Rs. 1,00,000, thereby increasing the leverage to 9 (where the equity is one-ninth of the asset value). If, for instance, the company plans to de-lever in order to get back the leverage of 5, it has to sell its assets worth Rs. 4,00,000. This helps the company in reducing its debt to Rs. 4,00,000. Hence, now the company has equity worth Rs. 1,00,000; debt worth Rs. 4,00,000 and a total asset value of Rs. 5,00,000. However, if a similar approach is followed by many firms, it would lead to a situation of excess supply in the asset market, causing its price to fall. For example, the price falls by 10% due to the aforementioned reason, causing the company’s asset value to reach Rs. 4,50,000. With an unchanged debt of Rs. 4,00,000, the total net-worth computes to be Rs. 50,000 causing the leverage of the company to be back at 9.     

Therefore, although at an individual level when the firm decided to write-off debt, it improved its balance sheet, when the same step was implemented by all the firms, it led to deflation causing the deleveraging to be of no value. The process is also sometimes called the negative feedback loop. It is similar to what John Maynard Keynes called the Paradox of Thrift where when all individuals reduce their spending to save more, it leads to a fall in other people’s income and eventually the national income- the fountain from which savings flow. 

Some of the examples of the Paradox of Deleverage can be seen at times when the countries face recessions. This is because, during economic slowdowns, due to the uncertainty, people tend to save more and sell off assets to smooth out their consumption. To reduce debt, individuals cut back on their spending activities in order to save costs. This leads to a reduction in the aggregate demand in an economy, which might lead to a recession. Figure 1 shows the household savings ratio in the United States. Periods of rapid rise in savings mostly coincide with recessions. This can be seen for the years 1979-81, 1990-92, and 2008-09. 

Figure 1: Household Savings Ratio

                         (Source:, ONS NRJS)

Moreover, if we delve deeper into the 2008-09 financial crisis, it can be seen that both banks and individuals had high amounts of debt, i.e., were highly leveraged. However, with the onset of the bubble burst, there was an immediate urgency to pay off debts and improve the balance sheet positions. This eventually led to a sharp fall in housing equity withdrawal, bank lending and thereby, the economic growth, as can be seen in Figure 2 and Figure 3. Further, in the latter, the fall in consumer credit can also be seen in the years 1970, 1980, and 1990, all coinciding with economic slowdowns and recessions in the U.S.

Figure 2: Household Equity Withdrawal in the U.S.

                      (Source:,  ONS NRJS)

Figure 3: Consumer Credit

                (Source: EconompicData)

Similarly, India faced a recession in 1980 and an economic slowdown in 2008-09. Figure 2 shows the country’s total debt service, taken as a percentage of the Gross National Income. It is evident from the chart that during both the aforementioned years, the total debt in the country fell, or in other words, deleveraging took place. 

Figure 4: India's Total Debt Service (% of GNI)

          (Source: World Bank Data)

Therefore, having understood the paradox, the major question that is left to ponder about is what implication does it have on the governments’ policies. Paul McCulley calls on for a combination of fiscal and monetary policies. According to him, the first step to tackle the situation would be monetary easing which would lead to a fall in the interest rates. This would work by pulling down the long-term rates which are also used as discount rates for valuing assets with cash flows dating till the distant future. However, this step would be of limited scope if all levered agents write off debt at once. In order to mitigate it, there is a need for someone to lever up his or her balance sheet by buying the assets shed by those deleveraging. And this is precisely where the fiscal policy would come in place. Therefore, the apt prescription for the public sector would be to act countercyclical by increasing budget deficits and public debt. This would help in reviving the demand in the economy alongside getting rid of the private sector debt burden and removing the financial stress via bank recapitalization. 

However, very high levels of indebtedness in the public sector acts as a constraint and calls for medium-term consolidation for the countries, in order to get back a sound financial system with the potential for future growth. At times where only one or two countries are facing such an issue, with a vibrant global economy, then the external sector demand can still give hopes for economic growth. However, during the Global Financial Crisis, almost all countries found themselves being affected by the consequences of deleveraging and this was exaggerated by the fiscal consolidation and steep fall in the aggregate demand. This conundrum can be dealt with the right pace of consolidation in the near term, credible and effective commitments in the medium- term and the political will to make adjustments as and when needed. Although deleveraging is necessary, it should be done in a manner that does not dampen the growth.


  1. Pettinger, T. (May 6, 2019). What is the Paradox of Deleveraging? Available at SSRN:

  2. McCulley, P. (2008) The Paradox of Deleveraging. PIMCO. Available at SSRN:

  3. Shostak, F. (November 3, 2011). Is Deleveraging Bad for the Economy? Available at SSRN:

  4. Lipton, D. (November 12, 2012). Resolving the Crisis And Restoring Healthy Growth: Why Deleveraging Matters? Available at SSRN:


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