A study published by the Bank for International Settlements on Sunday says households and companies will continue to cut debt built up before the financial crisis. However, it does not necessarily follow that economic growth prospects will be seriously impacted.

Economists Garry Tang and Christian Upper at the Basel, Switzerland-based bank, known as the central bank for central banks, say that financial crises tend to be followed by a protracted period of debt reduction in the nonfinancial private sector. They report that a period of debt reduction followed 17 out of 20 systemic banking crises that were preceded by surges in credit. Debt/GDP ratios fell by an average of 38 percentage points, returning to approximately the levels seen before the increase. They say if history is any guide, we should expect to see a much more significant reduction in private sector debt, particularly of households, than has so far taken place after the recent crisis. The costs of this process in forgone output are difficult to pin down, but there are reasons to believe that they need not be high provided that the banking sector problems that led to the crisis are fixed.

The study says US households increased their indebtedness from close to 100% of disposable income in 2000 to more than 130% in 2007. Similarly, over the same period, British and Spanish households raised their debt by approximately 60 percentage points to more than 160% and almost 130%, respectively, of disposable income. Ireland's ratio rose to about 190%. The expansion in debt was not confined to households. Non-financial corporations in several, but not all, of these countries also increased their debt substantially, mainly to finance real estate, and subsequently experienced servicing problems.

The economists say mounting loan delinquencies are a clear indication that this rise in indebtedness was not sustainable. Some of the debt will not be repaid and will have to be written off, if it has not already been. But debt reduction may not stop there. Lower house prices may induce households to reduce their desired levels of debt. Similarly, a lower level of output and tighter financial conditions could put firms under pressure to reduce their leverage.

The smallest amount of debt reduction by private, non- financial borrowers in the study was in Chile, where the ratio of debt to GDP fell by 10 percentage points from 1982-1983. That’s still more than what borrowers have achieved so far after the most recent crisis.

The economists say there are reasons to believe that slides in economic output are not the consequence of the debt reduction process but would have occurred anyway. The first reason to suspect that debt reduction need not be costly is based on the dynamics of output and credit ratios after the crisis. Output often starts to contract before real credit, reaches a trough more quickly, and then at a rapid pace even though debt ratios are still falling.

A second reason for doubting that the reduction in debt ratios is the main cause of output losses after crises is the experience of crises preceded by a credit boom but not followed by a debt reduction. There were three such crises in the sample, of which two were followed by drops in output of a magnitude similar to those associated with the crises followed by debt reduction, although the third one was not

The economists say changes in the flow of credit rather than the stock of credit are the key factor.

They says policymakers have first to fix the problems in the banking system that led to the financial crisis. The experience of Japan, but also that of other crises, indicates that this requires essentially two things: to (i) recognise losses, and (ii) rebuild bank capital.

Recovery following an individual crisis case has often happened in recent decades against a positive international backdrop.

The current crisis has severely hit several advanced countries and has been the severest peacetime contraction since the Great Depression. So the past pattern may not be exactly replicated.

Last week, the IMF published 3 staff papers on public debt and defaults.