Here’s a critical question for investors in Europe: Can the European Central Bank orchestrate a beautiful deleveraging? It is clear that bail-ins and haircuts are likely to play a larger role going forward in reducing unsustainable debt burdens. This is not to imply the European Central Bank (ECB) would ever contemplate monetisation, but rather to counter the view monetary policy is exhausted while acknowledging its declining marginal efficacy.

Critically, the extent to which bail-ins and haircuts occur depends on growth and inflation. Without the right mix of both, deleveraging can be an ugly affair. A beautiful deleveraging occurs when ample nominal economic growth reduces a debt overhang to a sustainable level. Real growth supports the value of collateral and generates cash flow to service debt; inflation lowers debt’s real burden. For bond investors, achieving the right amount of inflation is crucial to a beautiful deleveraging. Too much erodes creditors’ purchasing power, too little renders debtors vulnerable to default.

Liquidity trap

Europe’s deleveraging is not looking pretty. The post-Lehman policy response averted deflation but the ensuing period has been scant on both growth and inflation. Real national income, as measured by gross domestic product (GDP), has just returned to 2008’s level while nominal GDP, which includes inflation, has grown by only 8% in aggregate, averaging just 1.1% per annum (see Figure 1). Debt levels remain elevated as a result, having increased in the public and non-financial corporate sectors relative to GDP (see Figure 2).

Aging societies, debt overhangs and lack of productivity growth are common factors holding down economic expansion in many industrialised countries. With an incomplete monetary union, the eurozone has additional idiosyncratic factors hindering its recovery.