How Do Doom Loops Work?
 

A "doom loop" is a situation in which one unfavorable action or circumstance sets off another, which in turn worsens the original unfavorable action or factor and repeats the cycle. It is analogous to a vicious cycle when a downward trend reinforces itself. The management text Good to Great by Jim Collins from 2001 is credited with popularising the phrase.

A doom loop is a situation in economics when one unfavorable economic state leads to a second unfavorable circumstance, which in turn leads to a third unfavorable condition or strengthens the first, creating a downward spiral.
 

KEY LESSONS
 

• The term "doom loop" refers to a situation in which one unfavorable circumstance leads to another unfavorable element, which worsens the first or results in a third, much like a vicious cycle.
  An economic death spiral can be started by excessive government debt, as was the case in Greece in 2010.
  
   
• A doom cycle can also be set off by a weak banking system (or one that is overexposed to risk), as it was in the case of the global financial crisis of 2008.
   
• To escape a death spiral, intervention in the form of a bailout is frequently required.
  Example of a Doom Loop
   
• An effective illustration of a doom loop is the Greek debt crisis. A new Greek government revealed in 2009 that earlier administrations had been inflating data on the country's finances. In 2010, the administration unveiled a budget deficit that was significantly larger than anticipated. It exceeded 12% of GDP and was more than double earlier projections (GDP). Later, this was increased to 15.4%. As the country's government debt was downgraded to junk status by credit rating agencies, Greece's borrowing prices skyrocketed.
   

Investor confidence was damaged by the discovery of higher-than-expected deficits, and concerns about the fiscal health and debt burdens of other eurozone nations swiftly spread. Lenders demanded higher interest rates on sovereign debt from any European Union (EU) country with shaky economic fundamentals as worries over the eurozone's sovereign debt expanded, making it harder for those nations to raise money to pay their budget deficits. Some nations had to increase taxes and curtail spending, which slowed the domestic economy. This reduced government tax collection further weakened those nations' financial situations.
 

International credit rating agencies downgraded the sovereign debt of several nations, including Greece, Ireland, and Portugal, to junk status, which heightened investor concerns.

Investors were driven to sell their bonds—which local banks also owned—as a result of these downgrades. Local banks experienced significant losses when the value of bonds fell. The possibility of a bank bailout put further strain on government budgets, increasing the risk of their debt, driving rates up, and causing more losses for banks.
 

The European System of Financial Supervision (ESFS), tasked with guaranteeing consistent and appropriate financial supervision throughout the EU, was approved by the European Parliament in late 2010 in an effort to break the doom loop that had already expanded and caused a European sovereign debt crisis.

In return for austerity measures that reduced public spending and raised taxes, Greece also got repeated bailouts from the European Central Bank (ECB) and the International Monetary Fund (IMF) throughout the ensuing years.
 

Doom Loop vs. Flywheel

 

A flywheel is a mechanical device that stores energy by using momentum. Once the heavy wheel starts rotating, it does so almost effortlessly thanks to its weight and momentum. It resembles a doom loop's opposite in certain ways.

The aforementioned book Good to Great is where the phrase "flywheel effect" first gained notoriety. Collins' book advanced the idea that corporate turnarounds and startup success stories seldom occur as a consequence of a single act, regardless of how dramatic the outcome, but rather as a result of a continuous process of gradual but steady growth that eventually yields amazing outcomes. It is comparable to a flywheel gaining enough momentum to continue spinning on its own or with little effort as its speed slowly but steadily increases.

A doom loop is the antithesis of the flywheel effect. A doom loop, as used in the context of corporate management and leadership, is a cycle of unfavorable management behavior that drives a company in the wrong direction. Examples of this kind of behavior include recurrent shake-ups intended to quickly turn a company around rather than slow but steady improvements over time, as described by the flywheel effect.

Doom Loop Effects
 

A country's sovereign debt (government bonds) may lose value if it goes through a debt crisis. Since domestic banks typically own government bonds, the value of their portfolios will also decrease, maybe to the point where they require financial assistance from the government to remain solvent. The significant amount of money spent by the government to save the banks lowers its credit rating, even more, forcing it to increase interest rates to draw in investors for its sovereign debt.

In addition to slowing the economy, higher interest rates also result in lower tax receipts, which the government needs to fund, among other things, the bank rescue. If the government borrowed more money to make up for the lost tax revenue, this will damage its creditworthiness and slow down the economy even more, which would further reduce tax revenue.
 

Brexit.

The GDP level will NEVER bounce back to 2019 levels not in this decade at least.

Stop blaming Brexit for damage we BEGGED you not to create by overblowing the Pandemic.

Can't Blame the EU for mistakes made here like usual.

Remainers and the lock-downers created this : pic.twitter.com/MYAlAq0mg0

— Doom-Loop (@Doom_Loop) December 4, 2022

By having less liquidity and being unable to lend as much money, the banks' dropping bond portfolio values may also be dampening the economy. Many investors, particularly banks whose policies frequently state they cannot buy non-investment grade bonds, may be forced to sell a government's bonds if its credit rating drops below investment grade.

The cycle continues as the already stretched government faces further borrowing pressure, which further devalues the bonds it issues.

Can an increase in interest rates start a doomsday cycle?
 

A vivid illustration of how interest rate increases might set off a death spiral is the eurozone debt crisis. The crisis was initially brought on by Greece's weak economic fundamentals (such as massive budget deficits and excessive government spending), but it grew out of control when investors started demanding higher interest rates on the country's debt.

The wave of U.S. interest rate increases scheduled for 2022 provides a more current illustration of how interest rate increases might harm banks.

The yields on the Treasury bills that the U.S. Federal Reserve Bank sells increased significantly as rates were hiked. The measures did affect U.S. banks, even if the market's assumption of ongoing interest rate increases was more likely to be the cause than worries about the country's ability to pay its obligations. This is due to the fact that bond values often decline and vice versa when borrowing costs (interest rates) increase.

JPMorgan Chase & Co. (JPM) announced losses on its portfolio of $313 billion in U.S. Treasuries and other bonds in the first quarter (Q1) 2022 of around $7.4 billion.

The bank's capital ratio decreased from 13.1% to 11.9% during the quarter.

Since of the reduced capital ratio, JPMorgan had to postpone a planned stock repurchase because it had less money to lend and spend. In addition, Wells Fargo & Co. (WFC) disclosed a $5.1 billion loss on its bond holdings, which it blamed on rising interest rates.
 

Even if it doesn't seem like American banks will need to be bailed out (as happened during the global financial crisis of 2008), the ripple effect of rising rates causing bank losses illustrates how interest rate increases could trigger a doomsday cycle.

How Could Government Debt Set Off a Death Cycle?
 

The Asian financial crisis is a good illustration of how a doom loop can be set off by high levels of public debt. As the market became aware of the rising levels of public debt in 1997, economies throughout Asia were severely impacted. This led to a currency and financial crisis that affected the entire region but was particularly severe in nations with high levels of public debt.
 

Investors start to demand greater returns on government bonds when governments borrow more money than the market feels they can afford to repay in order to offset the increased risk. In order to keep issuing bonds to fuel their economies, central banks are forced to hike interest rates.

First, as a result of the increased interest rates, the value of banks' frequently sizable holdings of sovereign debt declines, lowering their capital ratio and reducing their ability to extend loans. The banks' credit rating may be impacted if they hold sizable quantities of sovereign debt that the market suddenly views as more hazardous.

Banks are forced to pay more for the reduced quantity of money they can lend as a result of rising costs and lower capital ratios. As bank borrowing costs rise as a result of a fall to the banks' own credit rating, the economy may experience a credit crisis as a result. Government finances are negatively impacted by the slower economic development as a result of less tax collection, which keeps the bank-sovereign doomsday cycle going.

How Can a Doom Loop Be Started by a Falling Stock Market?
 

Institutions that hold investments on margin may be subject to margin calls, which force them to provide additional cash as security if the stock market declines. As a result of these requests for more collateral, cash may be consumed or selling may be sparked, which widens the downward pressure. When people find it difficult to borrow the money they require to fulfill the margin call, which may result in further falls, the financial stress is exacerbated.

One instance of how a declining stock market might set off a doomsday cycle and cause the Great Depression is the stock market crash of 1929. U.S. businesses had a boom in exports to Europe in the first half of the 1920s as that continent recovered from World War I. Low unemployment and the widespread use of autos led to the creation of jobs and economic efficiency. Stock values had nearly doubled by the time they reached their peak in 1929. Anyone who had the means to do so began to consider investing in the stock market to be a national sport. Even those who were unable to participate by borrowing funds to finance investments.

Many others also used margin, putting down a smaller portion of the asset's value while borrowing the remainder. Investors occasionally contribute as little as one-third of the capital. When you buy on margin, you increase your potential for profit but also increase your potential for loss. The investor loses everything if the stock's value drops by a third but they only put down a third to purchase it. A full-payment investor would suffer only a one-third loss. The investor could lose everything and still owe the bank money if the value drops by more than one-third and only one-third of the cost was paid in advance.

Banks initiated margin calls after the 1929 stock market crisis. Many investors were unable to pay their margin calls since there were so many shares purchased on margin and so little cash was available. If the investor cannot provide more funds and the lender continues to demand more money as the stock's value drops, the lender will often sell the portfolio.

The stock market began to decline as the cycle of margin calls and forced sales accelerated. It finally lost about 89% of its value, making it the largest bear market in Wall Street history.
 

What results in a death loop?
 

A doom loop may result from a variety of circumstances. A doom loop may occur, for instance, when a government engages in high levels of expenditure that the market deems unsustainable. Doom loops can also be caused by issues like insolvency in the banking industry or abrupt drops in the stock market. These factors frequently come together and build upon one another, as in the case of a sovereign debt crisis endangering the viability of a nation's banks.

Is the American economy doomed to fail in 2022?
 

Some investors and market watchers may be afraid that the U.S. economy would enter a death spiral in 2022 due to the probable spillover effects of interest rate hikes. Indeed, rising interest rates affect the cost of borrowing money typically results in falling bond values, which has resulted in losses for major banks on their bond portfolios. The impact of rate hikes on banks serves as a reminder of the potential for monetary policy to set off a death spiral, but for the time being, the market seems more worried about ongoing rate hikes than it does about the prospect that the United States won't be able to pay its debts.

Doom loops finish in what way?
 

As the example of the eurozone debt crisis demonstrates, the only option to escape a vicious cycle is typically by outside funding intervention, which is frequently accompanied by additional steps to reestablish financial stability.

The conclusion
 

A doom loop is a circumstance in which one unfavorable development leads to another unfavorable development, which exacerbates the initial issue. The end outcome is a vicious cycle-like loop of negative feedback that feeds off itself.

A doom cycle in economics is typically brought on by excessive government expenditure that the market fears the government won't be able to pay for, issues or insolvency in the banking industry, or even sharp drops in equity markets. Only intervention, such as a government bailout of the banking system or an international bailout of the nation's finances, can typically break doomsday cycles.

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