Sunday, November 22, 2009

“Deleveraging”? Does it mean giving up our lifestyle?

Adapted from Investor, “deleveraging” is:

The pay down of debt, whether public or private. Individuals, companies or nations use leveraging (i.e. borrowing) to accelerate their consumption, growth or return.

But when an entity is concerned about defaulting on its obligations, about to be forced into bankruptcy, or concerned about rampant losses, it can use deleveraging to lower its risk of default and mitigate its losses. By deleveraging its balance sheet, a company sells off debt to lower its overall risk profile. Deleveraging can have serious financial consequences when a company, individual or nation tries to dispose of assets that are illiquid.

In this case, deleveraging may mean selling assets at relatively steep discounts. When an individual does this, he sells his widescreen TV he paid $2,000 for last year for $500 and whatever else he can unload for 5 cents on the dollar at a garage sale. As a result, deleveraging may lead to downward pressure on security and asset prices as more and more companies, individuals, or nations tighten their belts during the deleveraging process.

What happens when a nation deleverages because of rampant debt that no other nation wants to hold anymore?

One investment company in Europe tells clients how to prepare for potential 'global collapse'. Here’s another description of what US deleveraging might involve.

The preferred method of national deleveraging is inflation of the currency. For example, in the next five years, the United States might need to make the dollar worth 50 cents. A $2.29 half gallon of milk will cost close to $5.00. Inflating the currency to achieve deleveraging requires incomes to remain the same as they are today while prices of everything increase substantially.

Will our lifestyles be affected? Absolutely. Is that necessarily a bad thing? No. Such action would bring us back to a sustainable level of consumption – a place we strayed from several decades ago.

Is this what will happen? Probably not. We are so clever that we will figure out a way to prolong our over-consumption until the only recourse is a total collapse of our economy. That will most certainly affect our lifestyle, with unpredictable and extremely unpleasant consequences.

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