One of the new economic terms coined to describe some of the situations caused by recent recessionary activity is "circular debt," which is meant to illustrate a scenario of inescapable debt due to interwoven credit or loans among multiple parties. If left to expand without being controlled, circular debt can even provoke a shutdown of public utilities if it causes a nation's wealth to stagnate. A situation of circular debt is best addressed by correcting the underlying reasons for the inability to pay, whether that means stricter accounting practices or a realignment of product value and cost to consumers.
How It Starts
For a system of circular debt to be established, three different parties need to owe each other money in succession. For example, Person 1 owes Person 2 money, and Person 2 in turn owes money to Person 3; Person 3 also owes a sum of money to Person 1. Each party owes money to one other party, but cannot pay off that debt until they receive their payment from the party that owes money to each. A state of circular debt means that the accrued debt between all of these parties will continue to grow because nobody is capable of paying off their own debt.
How to Resolve
In microeconomic situations, such as small loans among members of a household, situations of circular debt can be resolved by forgiving the lowest common amount of money from each debt; Person 1 owes $20 to Person 2, Person 2 owes $35 to Person 3 and Person 3 owes $28 to Person 1. If $20 is forgiven from each, Person 1 owes nothing, Person 2 still owes $15 to Person 3 and Person 3 owes $8 to Person 1.
In larger contexts where governments and corporations are involved, resolving circular debt becomes trickier, because of larger money amounts and more complicated contributing factors. Identifying the root cause of the circular debt and minimizing the waste leading to debt requires expert insight; simply forgiving debts may leave the mechanisms causing the circular debt in place.
Pakistan
The term circular debt began to be used to describe economic problems in Pakistan's energy sector arising in 2008. Poor accounting practices and inefficient power generation led to losses among oil refineries, power generation companies and oil marketing companies. For a time, each sector was able to pass losses on to the next company, but Pakistani power outages began to spike in 2010, because utilities companies could no longer pay to keep electricity flowing to all consumers. Increases in petroleum prices and government inability to answer the root causes of circular debt caused Pakistan's oil refineries to be operating at only 45 percent at the end of 2010, according to an article in "The Express Tribune."
Dangers of Circular Debt
If a situation of circular debt occurs in the larger economy, it can lead to a shutdown of important private or public sectors, as the case in Pakistan shows. These problems continued even though the Pakistani government invested billions of rupees into the energy sector. This direct infusion of funds did not end up solving the root problem of waste. The Pakistani online newspaper, "Dawn.com," reported in April 2010 that energy sector inefficiencies were contributing to a generated electricity waste of about 40 percent. Recent economic problems in Europe, and the close economic ties between European Union nations, have caused some economic forecasters to warn of possible situations of circular debt between these countries.
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