The debt ratchet explained

The predicament that the so-called "advanced" economies now find themselves in — i.e., terminal debt strangulation — can be easily understood by two considerations.

The first is generally referred to as "Parkinson's Second Law": expenditure rises to meet income.

The second comes from asking, what happens if part of that consumption is financed by debt? Say our income doubles one year because we get a new job, and each subsequent year we finance a little extra consumption by taking out loans, rather than by simply spending the cash on goods.

Initially, this seems to work quite well, we can afford a lot more goods each year, much more than if we simply paid extra cash for them. But over time the debt rises, and it rises until we can just afford to pay the interest on it, in addition to our other involuntary expenses. At that point, further non-obligatory consumption stops.

Now let's suppose, the applicable interest rate declines by one percent. Suddenly we have a little more money available at the end of the year. Plugging that into our earlier loop, we buy some more goods using more debt finance, until we again can only just pay the interest.

This is exactly what happened in the last few years, as interest rates declined over a couple of decades right across the world, and governments responded by taking out fresh debt. I don't know how many times, in this period, that I read articles in the financial press talking about the national debt and concluding that it wasn't the absolute size of the debt that mattered, but the size of the interest payments, and making the observation that as interest rates seemed to be continuously declining, things looked OK, at least for a while

The problem is, if each new interest rate decline encourages you to take out even more debt, what happens when interest rates finally start to creep up again, as they inevitably must? In my lifetime, the UK bank rate has varied from 2% up to 17%, and is now back down at 0.5%. With interest rates so low, even a tiny increase will double or triple your payments. And if you've already allowed your repayments to rise until you can only just afford them, then you are bankrupted by the first rise.

That's where Europe is now, with rates being artificially held down by a quantitative easing that is temporarily sterilised by the deflationary environment. It won't last.