DELEVERAGING is an ugly word for a painful process. But few things matter more for the world economy than whether, and how fast, the rich world's borrowing is cut back. History suggests that severe financial crises are usually followed by long periods of debt reduction—in which credit falls relative to the size of the economy. This time, too, that process is under way. Banks have been furiously reducing leverage. Consumer credit in America has fallen for ten consecutive months, the largest and longest drop on record. But how much further is there to go?

A new report by the McKinsey Global Institute, a research arm of the consulting firm, tries to offer an answer. It begins by comparing the recent evolution of debt levels in ten big rich economies and four large emerging ones. Ratios of total debt to GDP (including debt owed by households, government, non-financial businesses and the financial industry) vary widely, with America's, at just under 300%, lower than many others. But with a few exceptions, such as Germany and Japan, most rich countries saw a huge rise over the past decade. Britain and Spain were the most extreme, with an increase in their total-debt ratios of more than 150 percentage points apiece, to 465% and 365% respectively.

The debt piled up in different places in different countries. With the exception of Japan, which was dealing with the aftermath of its own earlier asset bust, government debt as a share of GDP was mostly flat or falling. Nor, with the exception of commercial property and leveraged buy-outs, did the rich world's firms go on a debt binge. Corporate leverage, measured as debt to book equity, was stable or falling in most countries before the crisis. Financial-sector debt rose as a share of GDP in most countries, especially Britain and Spain, and some pockets of finance (such as investment banks) saw a huge increase in leverage. But outside Germany and Japan, where it fell, the most striking jump was in household debt. Most rich countries saw a rise of more than 40% in the ratio of household debt to disposable income. Even there, though, the rise was not uniform. In America middle-income households built up most debt. In Spain poorer people did.

The picture McKinsey paints is one of concentrated (albeit large) credit excesses rather than economy-wide debt binges. As a result, the debt-reduction process will differ by sector and by country. Judged by ratios of total debt to GDP, deleveraging has barely started. As of June 2009 these ratios had fallen only in America, Britain and South Korea, and not by much at that. But the composition of debt has shifted sharply, as government borrowing has soared while private debt has fallen. The financial sector has cut back the most. By mid-2009 financial leverage in most countries had fallen to around its average in the 15 years before the crisis.

To pinpoint where more squeezing is likely, the study examined how far the level and growth of debt in different sectors were out of line with other countries and with historical averages. It also looked at measures of borrowers' capacity to service their debts and their vulnerability to income shocks. On this basis it could assess where the chances of more deleveraging over the next couple of years are high, moderate or low (see chart). Half of the ten rich countries in the report's sample have one or more sectors that are “highly” vulnerable to more debt reduction. Not surprisingly, these include households in America, Britain, Spain and, to a lesser degree, Canada and South Korea, as well as commercial property in America, Britain and Spain. With a high risk of more corporate and financial deleveraging as well, Spain has the rockiest road ahead. No country in the sample has much chance of government-debt reduction over the next couple of years.

Changing gear

Assigning the odds of further deleveraging is not the same as gauging its likely economic impact. To do that, the study looks to history. It finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. (Countries which defaulted or inflated their debt away saw bigger recessions at first, but had higher output growth than the belt-tighteners by the end.)

Worse, there are several reasons why today's mess could be more protracted than previous episodes. First, the scale of indebtedness is higher. The highest debt ratio in the report's group of belt-tighteners was 286%, in Britain after the second world war. Today more than half the rich countries in the McKinsey sample have debt totalling more than 300% of GDP. Second, the number of countries afflicted simultaneously means that rapid expansions of exports, which have supported output in the past, are harder to achieve. Third, big increases in public debt, while cushioning demand in the short term, increase the overall debt reduction that will eventually be needed. Once private deleveraging is done, the public sector will need to cut back.

In theory that sounds simple. In practice it will be fiendishly hard to get the balance right. Investors may worry about the sustainability of public debt long before private-debt reduction is over, forcing a lot of belts to be tightened at once. The most painful bits of deleveraging could well lie ahead.