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Peak Debt

Peak debt was briefly explored in a previous blog post: What do the GDP figures mean? In this post, I wish to explore Peak Debt more and offer a proper model for it.

What is Peak Debt

Well, it could be a theory seeing as the basis for it is Peak Oil, which is a theory slowly becoming an observation, but it is an observation with a theory attached to it.

Once the peak of the bell has been crossed, a contraction in consumption will be felt throughout the economy in order to service the debt. The contraction will begin in large structures – in order to balance the books – before it filters down. Once it hits the individual consumer, the contraction is sudden and sends shock-waves up the system, exacerbating the situation and repeating the process until debt is brought back to manageable levels.

Now to the theoretical part. It is cyclical as the rise to peak can take a long time and can collapse within years, this current cycle took almost 30 years to peak and 3-4 years to trough. Things will continue unless a thorough and exhaustive reform of the system and the culture takes place. The problem with this country is that individuals do not consider themselves in debt until they are £15,000 in it. The stark reality is that as soon as one borrows money, one is in debt. End of.

How do you calculate Peak Debt?

Peak debt relies on a debt threshold, which can be calculated using a debt-to-income ratio.

EXAMPLE

A debt-to-income (DTI) ratio consists of two DTIs x and y. x, or the front-end ratio, is the pecentage of income associated with living – rent, food etc. y, or the back-end ratio, is the percentage of income associated with living and any recurring debt payments. If we take a person on £12,000 pa and assume that x is equal to 28% and y is equal to 36% we can begin to calculate their debt threshold per month.

As you can see from the above illustration, the DTI is calculated and the total is subtracted from the income. This leaves the Threshold. With the Threshold, the higher the number the better. A 100% Threshold, though impossible, would mean that they could borrow 100% of their income and be OK. A 0% Threshold would mean they were insolvent. Another way to get to this point is to look at the back-end DTI, if it equals 100% they are insolvent, or nearing to it, as all their income is going on costs and debt repayments.

This can be applied to individuals and businesses. To apply this to a government is a lot more difficult as servicing debt for a government is a lot easier, considering the economic instruments available to them.


 

 

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Categories: Uncategorized
  1. Ust Oldfield
    January 23, 2012 at 10:19

    Reblogged this on The Guerrilla Economist.

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