The Debt Supercycle is a description of the long-term decline in U.S. balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity.
Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.
Periodic “cyclical” corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows.
These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance sheet excesses become, the more painful the corrective process would be. So, the stakes have become higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means are available. The Supercycle process is driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation.
The Supercycle reached an important inflection point in the recent economic and financial meltdown with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead. Once fiscal policy is pushed to the limits of sustainability, the Debt Supercycle could come to a violent end.
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