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Economic collapse – a sudden and dramatic downturn in a nation’s economy – can be a frightening prospect. While economic downturns are a normal part of the business cycle, an economic collapse goes far beyond a typical recession. It’s a severe and prolonged period of economic hardship, often triggered by a major crisis. Whether you’re a student of economics, an investor, or simply someone interested in economic trends, understanding the warning signs and potential causes of economic collapse can be valuable knowledge.
Understanding economic collapse
An economic collapse is a shock to a country’s economy, usually when a crisis is widespread. The decline may have been preceded by a debt crisis, currency crisis, war, and supply shocks. The economy then enters a period of market recession or depression.
Economic collapse can last for several years, depending on the severity of the situation. For example, in the United States, the Great Depression occurred in 1929 and began to recover in 1933. Indonesia also experienced it in 1997 due to the deadly effects of the Asian financial crisis and recovered in late 1999.
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Economic collapse triggers a decline in economic and, often, social life. Production, consumption, investment, and exchange rates all fall, usually followed by social crises. The 1997 crisis in Indonesia, for example, caused Indonesia’s real GDP to contract by 13.1% in 1998. Inflation soared to 72%, and the rupiah exchange rate fell from IDR 2,600/USD to IDR11,000/USD in 1998. This also forced the Soeharto regime to resign and sparked social unrest.
Warning signs of economic collapse
Through the concept of the business cycle, economists outline several phases through which the economy goes. A typical economic cycle includes a movement from a trough to expansion, towards a peak, and then to a contraction, leading back to the trough. These stages are repeated.
Meanwhile, an economic collapse is an extraordinary event. It doesn’t have to be part of the general economic cycle. The collapse can happen drastically and can lead to depression.
There are several signs of an economic collapse, including:
- Debt crisis
- Currency crisis
- Increase in interest rates
Debt crisis
Governments often take on debt, called sovereign debt, to cover budget shortfalls (fiscal deficits). This debt financing can be used to stimulate economic growth through increased government spending on infrastructure or other projects that boost aggregate demand.
However, there’s a fine line to tread. If a government accumulates too much debt, its ability to repay both principal and interest becomes strained. This raises concerns among investors, leading to a potential debt crisis. Debt crises are more likely during recessions, wars, or periods of political instability, as these events erode investor confidence in the government’s ability to manage its finances.
A prime example is the Greek debt crisis, where excessive government borrowing triggered economic turmoil. Debt crises can have a domino effect, spreading to other countries and impacting the global economy, especially if they occur in major developed economies.
Currency crisis
Currency crises occur when confidence in a country’s currency falls. It may take the form of severe hyperinflation or depreciation. Hyperinflation means that the purchasing power of the currency for goods and services falls. Meanwhile, depreciation occurs when a currency’s value against another currency (for example, the US dollar) falls.
The currency crisis caused investor confidence to drop. Investors became doubtful about the government’s ability to meet debt obligations. This situation triggered a capital flight, where foreign investors pulled their money out of the country. This mass exodus further weakened the currency, creating a vicious cycle of depreciation.
High-interest rates
Central banks play a critical role in managing the economy, and one of their key tools is setting interest rates. This policy aims to achieve a delicate balance: curbing inflation while preventing a deeper economic slump. Here’s how interest rates can act as a double-edged sword:
- Stifled growth: Borrowing becomes more expensive for businesses and households. Companies may postpone investments or expansion plans, hesitant to take on new debt at a higher cost. This translates to a slowdown in economic activity as businesses hold back on hiring and consumers tighten their belts.
- Debt burden: Existing debt becomes a heavier weight to bear. Businesses and individuals who already have loans see their interest payments rise, squeezing their budgets. This can force companies to sell assets or default on loans, further straining the financial system. In the worst-case scenario, a wave of defaults can trigger a financial crisis.
- Investment chill: High interest rates can discourage investment, a crucial driver of economic growth. Businesses become less likely to invest in new projects or equipment when borrowing costs are high. This can hinder innovation and productivity gains, further hampering economic recovery.
While high interest rates can be a necessary tool to combat inflation, they can also significantly negatively impact economic growth. Central banks must carefully navigate this tightrope walk, aiming to bring down inflation without triggering a recession.
Asset bubbles
Asset bubbles occur when the prices of stocks, real estate, or other assets become inflated far beyond their intrinsic value, often fueled by speculation and excessive optimism. These bubbles can create a false sense of prosperity, encouraging risky investments and fueling further price increases. However, the illusion can’t last forever. Eventually, the bubble bursts, triggering a sharp decline in asset prices.
The bubble burst and its aftermath:
Panic selling: As confidence wanes, investors rush to sell their overvalued assets, leading to a downward spiral in prices. This can trigger widespread losses and erode wealth, impacting consumer spending and business investment.
Credit crunch: When asset values plummet, banks become wary of lending, especially if those assets were used as collateral for loans. This credit crunch can stifle economic activity and exacerbate the downturn.
Domino effect: The collapse of one asset bubble can have ripple effects across the financial system, as interconnected markets and institutions can all be affected. A classic example is the bursting of the housing bubble in 2008, which triggered the global financial crisis.
By understanding the dynamics of asset bubbles, we can be more cautious during periods of rapid price increases and anticipate potential economic downturns.
Other warning signs: beyond the obvious
Economic collapse doesn’t always announce its arrival with a single, dramatic event. Often, a confluence of factors paints a worrying picture. Here are some additional signs that can indicate a brewing economic storm:
- High unemployment: When a significant portion of the workforce is jobless, it indicates a decline in demand for goods and services. This can lead to falling wages, reduced consumer spending, and a vicious cycle of economic stagnation.
- Stagnant economic growth: A prolonged period of slow or no economic growth is a cause for concern. This can be measured by Gross Domestic Product (GDP), which reflects the total value of goods and services produced in an economy. Stagnant growth indicates limited job creation, decreasing investment, and a potential recession on the horizon.
- Social unrest: Growing economic hardship can lead to social unrest, including protests and strikes. This instability can further damage investor confidence and disrupt economic activity, fueling a downward spiral.
By monitoring these warning signs and understanding their implications, policymakers and individuals can take steps to mitigate the risks and prepare for potential economic challenges.
Causes of the economic collapse
Economic collapse is usually caused by extraordinary circumstances. And it may occur when the economy enters a period of contraction or recession, which can end in an economic depression.
Economic collapse can trigger panic in the economy. Economic output falls. Unemployment has risen sharply. Household income and consumption fall. Hunger and poverty soared. In fact, it can spread to socio-political aspects such as riots, crime, and the overthrow of the government in power.
Some of the factors leading to the economic collapse were:
- Hyperinflation
- Stagflation
- Stock market crash
- War
Hyperinflation
Hyperinflation is a period when inflation is soaring and out of control. For example, in Venezuela, inflation reached 1,698,488% in 2018. During this period, the currency’s value fell, and its purchasing power for goods and services immediately evaporated. In this situation, money becomes worthless.
The pressure on inflation arises partly due to the increase in the amount of money in circulation. The government may have high debt levels. To pay it off, it might print money. That drives inflation up sharply as more money chases after fewer goods.
The government may not be able to collect higher taxes to pay debts. It usually occurs during a fall in aggregate supply, war, socio-political upheaval, or other crises.
Stagflation
Stagflation is a situation when economic growth is stagnant but inflation is soaring. This phenomenon is less common. Usually, the inflation rate moves in tandem with economic growth. When economic growth is high, it pushes the prices of goods in the economy up along with the increase in aggregate demand.
But, stagflation is different. That’s because the source of the problem is on the supply side. The best-known cause is an increase in the price of oil.
Petroleum is used in most industries, so when the price goes up, it increases the production cost. Producers pass the increase in production costs on to the selling price, and as a result, inflation rises. Meanwhile, rising oil prices forced some industries to become more efficient and cut output.
The result is stagnant economic growth, and at the same time, inflation soars. Specifically, we call this type of inflation cost-push inflation, which is caused by higher production costs.
Stagflation is a dilemma for the government. Contractionary economic policies will deepen the fall in economic output and increase unemployment, even though inflation may fall. On the other hand, an expansionary economic policy, although it may stimulate economic growth, will only result in higher inflation due to accelerated aggregate demand.
For example, to reduce inflation, the central bank implements a contractionary monetary policy by raising interest rates. This move makes borrowing more expensive, and the real sector usually takes a hit. As a result, business activity decreases, and employment shrinks.
In general, once stagflation occurs, it is usually challenging to manage. The government must spend a lot of effort to balance the economy.
Stock market crash
Various crises, including the Great Depression, started with the bursting of stock market bubbles. Usually, before the breakdown, the speculative activity caused the stock price to continue to soar and no longer be at its fair value fundamental.
When the bubble burst, investor confidence fell. As a result, prices for the same fall dramatically and drain capital from businesses. It also resulted in the loss of a large portion of household wealth, including their pension. It then creates pessimism and causes aggregate demand to fall (via the wealth effect).
Apart from going through the stock market, bubbles can occur in other financial assets, such as real estate. How significant the impact is on the economy depends on how much money in the economy revolves around the asset. The bursting of the stock and real state bubbles had a significant impact as a portion of households and businesses’ wealth was invested in both.
War
War triggers the destruction of a country’s economy. For example, the Iraqi economy collapsed due to the desert war and saw nominal GDP fall to -47% in the 1990s. It previously grew by 213% in the 1960s and 1325% in the 1970s. Likewise, the invasion of the United States in the 2000s saw the country’s economic collapse.
Examples of an economic collapse in the world
Economic collapse can be long or short, depending on its severity. The US Great Depression of the 1930s is a longstanding example. It lasted three and a half years, wiping out more than a quarter of the US GDP. Also, the unemployment rate during the Depression rose to 23%.
The financial crisis of 2007-2009 is another example of an economic collapse, although it lasted much shorter than the Great Depression. One of the triggering factors is speculative activity in the housing sector in the United States. The bubble burst and resulted in the bankruptcy of large financial institutions such as Lehman Brothers.
The collapse also occurred in several other countries, such as the Soviet Union, Greece, and Argentina. In the cases of Greece and Argentina, the collapse started as a debt crisis. The crisis then forced the country to devalue its currency, win international bailout support, and reform the government.
In Indonesia, the economic collapse also took place in 1997. It started from the economic crisis, which then spread to the economy, causing social unrest, and forcing Soeharto to resign.
The effects of the crisis were severe. In November 1997, the currency depreciation caused public debt to soar to USD60 billion, which put enormous pressure on the government budget. As a result, in 1998, Indonesia’s real GDP contracted by 13.1%. Inflation soared to 72%. Meanwhile, the rupiah, which was in the range of IDR2,600 per USD in early August 1997, depreciated to IDR11,000 per USD in January 1998.