Deleveraging and adjustment

The global economic crisis and the euro area sovereign debt crisis have highlighted the aggravating influence of excessive leverage and related internal and external macroeconomic imbalances on the exposure of Member States to common shocks when financial markets are not fully integrated. This chapter reviews different mechanisms implied by the presence of high levels of indebtedness which were not sufficiently considered in the pre-crisis view. The reduction of high levels of indebtedness, both internal and external, private and public, tends to be very slow and the adjustment in flows (credit flows, current account) takes time to translate into a significant reduction in vulnerabilities and risks. The adjustment process implies constrained domestic demand and growth for a protracted period of time, which makes deleveraging more difficult and exacerbates vulnerabilities, especially in a context where creditor countries continue to record large current account balances on the back of weak domestic demand. In addition, the necessary reallocation from non-tradable to tradable activities is hampered by rigidities in the capital allocation process, especially when high levels of non-viable debt are not addressed efficiently. The set-up of adequate insolvency frameworks turns out to be of major importance to foster the adjustment in the euro area.