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The modern economy experiences two types of cyclical debt cycles: the short-term business cycle that produces the familiar oscillation between expansion and recession, bull and bear; and the long-term debt cycle that we are experiencing now. During the 75-year period of these cycles, the debt-to-income profile of the entire economy gradually builds up a stock of household, corporate, and government debt that income is insufficient to service. The credit reset from indebtedness to balance is called a deleveraging.

The present American deleveraging started in 2007-2008, as rolling mortgage defaults undermined a system of extraordinary household and financial-sector leverage, triggering a shift in debt from the financial sector to a debt-burdened federal sector, through fiscal and monetary bailouts. Household debt-from both consumer and mortgage sources-remains high at a time of high unemployment (8.6 percent at the time of writing). This, in turn, drives household-level austerity that reinforces a negative cycle of lowered demand, lowered employment, lowered asset values, and lowered government revenue. As this negative cycle grinds on, middle-class expectations are being dramatically lowered, with political implications being seen in the Tea Party and the Occupy Wall Street movements.

Today’s deleveraging cannot be softened or expedited by monetary policy-the use of interest rates and open market purchases to prop up equity markets-if for no other reason than because the Federal Reserve’s target funds rate is already zero and the Federal Reserve cannot politically take any more debt onto its books. This is not the normal business cycle. Deleveraging ends only when widespread demand and creditworthiness are restored. Classically, such conditions are brought about by a combination of six often painful adjustments: debt restructuring (to reduce the cost of servicing existing debt); increased money supply (to reduce the cost of new debt); redistribution of wealth (to convert unproductive liquidity into widespread demand through taxation); businesses cutting costs (e.g., layoffs and cutting capital investment); increases in risk and liquidity premiums (to reduce speculation and redirect investment to the productive economy); and, finally, by nominal interest rates being held under nominal growth rates (to reduce debt burdens).1 While as much as half of the private-sector debt overhang has been alleviated, household debt and government debt are still in dangerous territory. The last deleveraging in the United States took ten years and World War II to unwind, while in Japan the 1990s deleveraging was known as the “lost decade.”