Monday, February 8, 2010

Debt Hangover

Definition of Debt Hangover - A situation where agents (firms, governments, individuals) hold too much debt holding back normal economic activity.

Definition of Debt Overhang - a similar situation. Debt overhang occurs when the interest burden of existing debt is greater than the profit the firm can generate from its core business. Debt overhang was a situation faced by many banks during credit crisis.

Debt imposes the cost of debt interest repayments. A high level of debt increases the cost of servicing debt. If this cost of paying debt interest payments is too high then firms may be reluctant to invest and individuals reluctant to spend - governments may have to increase tax. Thus debt can be a constraint to economic recovery.

A further problem is when debt interest payments are so high, firms or individuals lose hope of ever getting on top of their debts so are encouraged to default on debt.

At the moment the cost of our debt hangover has been diminished by the record low interest rates. However, as interest rates rise back to normal levels the cost of servicing debt will come as an unwelcome shock.

The Culture of Debt in UK

Among households, debt-to-income ratios have risen significantly over the past twenty
years. In the UK, household debt-to-income ratios rose from around 100% in 1988 to
a peak of around 170% in 2008. (1) see also: Personal debt in UK

The Great recession has also led to a significant rise in public sector (government debt). The UK's rise in public sector debt is well documented. The IMF forecast that the public sector debt ratios of the G7 will rise from 80% (2007) to 125% in 2014 (1)

Gross Debt.

Gross Debt it the total debt of the economy - combining government, private and corporation debt. Th is is important because it shows the combined debt of an economy. For example, one justification for deficit spending in Keynesian economics is that the government needs to borrow to offset a rise in private sector saving during a recession. However, if the government is borrowing more - but also, the private sector still have high debts, this is more of a problem.

According to the McKinsey Global Institute gross debt has risen 60% by $40 trillion in ten leading developed economies. This is roughly split between the three main sectors.

(1) The Debt Hangover at B of E Andrew Haldane

(2) McKinsey’s Global Institute (2010), “Debt and Deleveraging: the Global Credit Bubble and its
Economic Consequences”.

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