Since the financial crisis all major advanced economies have been in a debt trap where low growth deepens the burden of debt, prompting the private sector to cut spending further. Persistent economic weakness damages the extent to which economies can recover. Skills and capital atrophy. Workers become discouraged and leave the labour force. Prospects decline and the noose tightens. 1  At market prices. In PPP terms it is third largest after China and the US. BIS central bankers’ speeches  1  As difficult as it has been, some countries, including the US and the UK, are now escaping this trap. Others in the euro area are sinking deeper. This relative performance underscores the importance of policy and institutions, particularly those that share and transfer risks. Building institutions at a time of reform fatigue may not be easy, but it is essential. Before I draw out this crucial point, I would like to quickly review how we got here. 2. Setting the debt trap  Building the debt that now weighs on our economies was the work of a generation. In the decade before the crisis, private financial balances became unsustainable. UK households borrowed 4% of GDP year after year; Irish households at more than twice that rate. Household debt peaked close to 100% of GDP in the UK, and 120% in Ireland. 2 This borrowing was largely for consumption and real estate investment rather than businesses and projects that would generate the earnings necessary to service those obligations.
This all suggests that investors may be attaching some probability to very bad outcomes, possibly the tail risk of economies becoming stranded in a debt trap. This market view is mirrored in elevated corporate caution. Investment remains subdued and businesses continue to build cash in many advanced economies. 6 This is one reason why the so-called “equilibrium” real interest rate is negative in many advanced economies, though it has risen and is possibly now positive in others like the UK. 7 Reflecting these real dynamics, central bank interest rates have had to be set at extraordinarily low levels and supplemented by large scale asset purchases simply for monetary policy to remain neutral. 8 Escaping a debt trap requires a suite of measures including structural reforms to boost productivity. But above all an economy needs to be able to channel all available savings – household, corporate and foreign – to those sectors willing and able to spend. In many respects, recent progress in the UK shows how. 3. How the UK is escaping its debt trap  In recent years, the UK economy has shown increasing signs of normalisation. Non-financial private debt has fallen by around 30% of GDP since its peak, the economy has grown consistently above trend, and unemployment has fallen from a peak of 8.5% to less than 6% today. This performance underscores several structural features necessary to escape a debt trap. The first is an integrated financial system which channels savings from one part of the economy to investment in others.