Doom Loop: Definition, Causes, and Examples

What Is a Doom Loop?

In economics, a doom loop describes a situation in which one negative economic condition creates a second negative condition, which in turn creates a third negative condition or reinforces the first, resulting in a downward spiral.

The term draws from the broader concept of doom loops, in which a negative factor triggers another, which then triggers another or exacerbates the original negative factor, creating a vicious cycle. The term "doom loop" was popularized in the 2001 management book "Good to Great" by Jim Collins.

Doom Loop Example

The Greek debt crisis is a good example of a doom loop. In 2009, a new Greek government revealed that prior governments had been misreporting national financial information. In 2010, the government revealed a worse-than-expected budget deficit—more than double previous estimates, and in excess of 12% of gross domestic product (GDP). This was later revised upward to 15.4%. Greece’s borrowing costs soared as credit rating agencies downgraded the country’s government debt to junk status.

The revelation of higher-than-expected deficits eroded investor confidence, and fear quickly spread about the fiscal positions and debt levels of other eurozone countries. As fears over eurozone sovereign debt spread, lenders demanded higher interest rates on sovereign debt from any European Union (EU) country with weak economic fundamentals, which made it even more difficult for those countries to raise money to finance their budget deficits. Some countries had to raise taxes and cut spending, slowing the domestic economy, which in turn trimmed government tax revenue, further weakening their finances.

Several countries—including Greece, Ireland, and Portugal—saw their sovereign debt downgraded to junk status by international credit rating agencies, which worsened investor fears. These downgrades prompted investors to sell their bonds, which local banks also owned. As bond values tumbled, local banks suffered heavy losses. The threat of a possible bank bailout further strained government finances, making their debt even more risky, pushing yields yet higher and creating more losses for banks.

To break the doom loop that had already spread and created an European sovereign debt crisis, in late 2010, the European Parliament voted to create the European System of Financial Supervision (ESFS), tasked with ensuring consistent and appropriate financial supervision throughout the EU. Greece also received several bailouts from both the European Central Bank (ECB) and the International Monetary Fund (IMF) over the following years in exchange for implementing austerity measures that cut public spending and raised taxes.

Flywheel vs. Doom Loop

A flywheel is a mechanical device that uses momentum to store energy. Once the heavy wheel gets moving, its own weight and momentum keep it moving with minimal to no effort. Conceptually, it is the opposite of a doom loop.

The term “flywheel effect” was also popularized in the aforementioned book "Good to Great." According to Collins, corporate turnarounds and startup success stories are the result of an ongoing process of slow and steady progress. Collins likened this to the slow but steady increasing speed of a flywheel as it gains enough momentum to continue spinning on its own or with minimal effort.

Doom Loop Causes

If a country experiences a debt crisis, the value of its sovereign debt, or government bonds, may fall. As domestic banks usually own government bonds, the value of their portfolios will also fall, possibly so much that they need government help to stay solvent. The heavy government spending to bail out banks can hurt the government’s credit rating further, which forces it to raise interest rates to attract more buyers for its sovereign debt.

Higher interest rates also slow the economy, which also means less tax revenue. However, the government relies on tax revenue to pay for, among other things, bank bailouts. The government then may need to borrow more to cover the lost tax revenue, further hurting its creditworthiness and dampening economic growth even more.

The declining value of the banks’ bond portfolios may also mean that they have less liquidity and so can lend less, which also dampens the economy. If a government’s credit rating falls below investment grade, many investors may have to sell its bonds, including banks whose guidelines often say they cannot own non-investment grade bonds.

The loop increases borrowing pressure on the already-stressed government, which further reduces the value of the bonds it issues, and the loop continues.

Can Interest Rate Increases Trigger a Doom Loop?

The eurozone debt crisis is a good example of how interest rate increases can trigger a doom loop. Greece’s poor economic fundamentals—such as high budget deficits and excessive government spending—were the root causes of the crisis. But the crisis became unmanageable as investors began demanding higher interest rates on government debt.

A more recent example of how interest rate hikes can hurt banks can be seen in the 2022 round of U.S. interest rate hikes. As the U.S. Federal Reserve Bank raised rates, yields on the Treasury bills that it sells rose sharply. While the likely cause was market expectation of continued interest rate hikes (as opposed to concerns that the United States could not pay its debts), the moves did hit U.S. banks. This is because when the cost of borrowing money rises when interest rates rise, bond values usually fall, and vice versa.

JPMorgan Chase & Co. (JPM) reported first quarter (Q1) 2022 losses of some $7.4 billion on the $313 billion of U.S. Treasuries and other bonds in its portfolio. The bank’s capital ratio fell from 13.1% in the quarter to 11.9%. The lower capital ratio meant that JPMorgan had less money to lend and to spend, prompting it to cancel a planned stock buyback. Wells Fargo & Co. (WFC) also reported that it lost some $5.1 billion on its bond holdings, which it attributed to higher interest rates.

Although it did not appear that U.S. banks needed bailing out (as was the case during the 2008 global financial crisis), the knock-on effect of higher rates leading to bank losses shows how interest rate hikes could start a doom loop.

How Can Government Debt Start a Doom Loop?

The Asian financial crisis is a good example of how heavy government debt can trigger a doom loop. In 1997, economies across Asia were hammered as the market became aware of rising levels of government debt, triggering a currency and financial crisis that affected the entire region and hit economies with heavy public debt burdens hardest.

When governments borrow more than the market believes they can repay, investors begin demanding higher returns on government bonds to compensate for the increased risk. This causes central banks to raise interest rates so that they can continue issuing bonds to finance their economies.

First, the higher interest rates cause banks’ often-heavy holdings of sovereign debt to fall in value, cutting their capital ratio so they can’t lend as much. If the banks hold substantial amounts of sovereign debt now perceived by the market as more risky, it may affect the banks’ credit rating.

The combination of higher costs and lower capital ratios means that banks have to pay more for the smaller amount of money they are able to lend. If the banks’ own credit rating is downgraded, it can further increase bank borrowing costs, leading to a credit crunch that slows economic growth. The slower economic growth hits government finances as tax revenue falls, which perpetuates the doom loop between banks and their sovereigns.

How Can a Falling Stock Market Trigger a Doom Loop?

If the stock market falls, institutions holding investments on margin face margin calls that require them to deposit more cash as collateral. These calls for increased collateral absorb cash or may trigger selling, which then spreads the downward pressure. The financial stress is even worse if liquidity is tight, meaning people cannot easily borrow the cash they need to meet the margin call, which can cause further declines.

The stock market crash of 1929 is one example of how a falling stock market can trigger a doom loop, in this case leading to the Great Depression. In the first half of the 1920s, U.S. companies saw exports to Europe boom, which was rebuilding from World War I. Unemployment was low, and automobiles spread across the country, creating jobs and efficiencies for the economy. By its peak in 1929, stock prices had climbed nearly tenfold. Investing in the stock market became a national pastime for anyone who could afford it. Even those who could not got in on the action by borrowing money to finance investments.

Many also bought on margin, putting up only a percentage of the asset’s value and borrowing the rest. Investors sometimes put down as little as one-third of the money. Buying on margin means you can earn a lot more from a small investment, but it also means you can lose a lot more. If the value of the stock goes down by one-third and the investor has put down only one-third to buy it, the investor loses everything. An investor who paid the full amount would lose only one-third. Even worse, if the value falls more than one-third and the investor put down only one-third of the cost, the investor could not only lose everything but also end up owing the bank money.

When the market crashed in 1929, banks issued margin calls. With huge volumes of shares bought on margin and little cash available, many investors could not get the cash to meet the margin calls. If the lender asks for more money as the value of the stock declines and the investor cannot put up more cash, the lender usually sells the portfolio.

As the cycle of margin calls and forced sales picked up speed, the stock market spiraled downward, eventually losing some 89% of its value, making it the biggest bear market in Wall Street’s history.

The Bottom Line

A doom loop describes a scenario in which one negative development causes another negative development, which then makes the first problem worse. The result is a self-reinforcing loop of negative feedback.

In economics, a doom loop is usually the result of excess government spending, for which the market believes the government will not be able to pay, insolvency in the banking sector, or sudden declines in equities markets. Doom loops are usually broken only by intervention, such as a government or an international bailout of an affected country’s finances.