In this study, the author examines the hypothesis of private-sector debt overhang, which suggests that households and businesses may on occasion find themselves holding too much debt and so decide to reduce it by cutting back expenditures. His aim is to determine whether this hypothesis can help explain the weakness of credit growth and the sluggishness of the recent economic recovery in Canada.

The author examines the debt overhang hypothesis using three approaches. The first attempts to establish whether there is a cointegration relationship between the effective debt ratios of households and businesses and the macroeconomic (and demographic) variables that determine long-term debt ratios. The two other approaches examine whether the differences between the effective debt and the long-run debt ratios of households and businesses significantly affect their credit demands and their expenditures.

Overall, while the cointegration tests based on estimation errors of long-term equations are inconclusive, the results of the other two approaches generally support the debt overhang hypothesis. Coefficients estimated with indicator models suggest that the household and business debt overhang may have significantly constrained the growth of consumer spending and investment in 1991 and 1992. Thus the private-sector debt overhang hypothesis may offer a partial explanation for the sluggish economic recovery.