The Four Tools of Deleveraging
“The policies that reduce debt burdens fall under four broad categories: 1) austerity, 2) debt defaults/restructurings, 3) debt monetization/money printing, and 4) wealth transfers (i.e., from the haves to the have-nots)” — a-00173
Tool 1: Austerity
Effect: Deflationary — reduces spending, incomes, tax revenue simultaneously.
Works when: Economy still has excess demand; not in full depression.
Fails when: Economy in depression — spending cuts reduce income faster than they reduce debt burden. See austerity-failure.
Historical policy error: Used as the first and dominant tool in virtually every poorly managed crisis (Hoover 1930-32, European austerity 2010-13, IMF programs).
Tool 2: Debt Defaults/Restructurings
Effect: Deflationary — creditors take losses, debtors get relief.
“Ultimately, the process of cleansing existing bad debts is critical for the future flow of money and credit and for a return to prosperity. The best-managed cases are those in which policy makers a) swiftly recognize the magnitude of the credit problems; b) don’t save every institution that is expendable, balancing the benefits of allowing broke institutions to fail against the risks of causing a self-reinforcing panic.” — a-00176
Best practices:
- Swift recognition of full extent of bad debts
- Selective — save systemically important, let expendable fail
- Orderly — coordinated timing to avoid contagion
- Separate good assets from bad (good bank / bad bank)
Bank run triage:
“That puts the central bank and the central government in the position of having to decide which depositors/lenders should be protected from losses and which should be allowed to sustain them, and which institutions are systemically important and should be saved.” — a-00175
The Lehman failure is the canonical policy error: letting a systemically important institution fail uncontrolled.
Tool 3: Monetization / Money Printing
Effect: Inflationary — stimulates spending, reflates asset prices, reduces real debt burden.
Works by: CB creates money → buys debt → keeps rates low → debt service manageable → nominal growth > nominal rate.
Risk: Too much → currency devaluation → hyperinflation (see hyperinflation-spiral-and-exit).
Key constraint: CB independence required. Without it, government can force unlimited monetization. See central-bank-independence-monetization.
Tool 4: Wealth Transfers
Effect: Redistributive — moves purchasing power from high-wealth (low MPC) to low-wealth (high MPC) individuals.
“Wealth gaps increase during bubbles and they become particularly galling for the less privileged during hard times. It is during such times that populism on both the left and the right tends to emerge.” — a-00177
Forms: Progressive taxation, capital levies, inheritance taxes, targeted transfers (stimulus checks).
Political reality: The hardest tool to implement democratically because it explicitly redistributes from powerful to less powerful constituencies.
The Required Balance
All four tools must be used simultaneously, calibrated so:
- Deflationary pressure (tools 1 + 2) ≈ inflationary stimulus (tools 3 + 4)
- Nominal growth rate > nominal interest rate
- Inflation stays within acceptable range
Imbalanced → ugly deleveraging (either depression or hyperinflation).
CB independence is required to maintain this balance against political pressure to either (a) prevent any pain (over-monetize) or (b) avoid inflation at all costs (over-tighten).
Tension Tool 3 (monetization) and Tool 4 (wealth transfer) politically overlap in MP3 — helicopter money is both. The inflationary risk from this combination is the 2020-22 inflation lesson.