Economic Collapse: Signs, Causes, and Examples

What’s it: 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 since 1933. Indonesia also experienced it in 1997 due to the deadly effects of the Asian financial crisis and recovered in late 1999.

Indonesia real GDP growth and real GDP per capita Growth

Economic collapse triggers a decline in economic life and often social life. Production, consumption, investment, exchange rates all fall and are 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.

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

Sovereign debt is debt taken by the government, usually to cover a fiscal deficit.

If the government increases the fiscal deficit, it will increase financing through debt. A higher deficit is usually to stimulate economic growth. The government increases capital spending, such as infrastructure projects, to increase aggregate demand.

However, if the government takes on too much debt, the risk of default increases. The ability to pay the principal and interest on debt decreases. That increases pressure in the economy due to falling confidence in a country’s economy. The debt crisis came to the fore.

The odds of a sovereign debt crisis are usually higher during periods of recession, war, political instability, and when investors lose confidence in the government.

Due to the high amount of state debt, the government’s failure can disrupt economic stability, as happened in Greece. It might spread to other countries and affect the global economy, mainly if it occurs in developed countries.

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 a loss of investor confidence. They become doubtful about the government’s ability to meet debt obligations.

Foreign investors withdraw their investment in the country. The flight of capital out of the country results in a depreciation that is getting worse.

High-interest rates

During periods of economic downturn, interest rates peaked at abnormally high levels. That stifles economic growth as loans become more expensive, discouraging households and businesses from taking out loans.

Also, paying off debts is more expensive. Many businesses start selling their assets just to pay creditors. Likewise, defaults by the household sector have also increased.

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 fell. Hunger and poverty soared. In fact, it can spread to the socio-political aspects such as riots and 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. And, to pay it off, they 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 at the same time, inflation is soaring. This phenomenon is less common. Usually, the inflation rate will move in tandem with economic growth. When economic growth is high, it will push 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 will increase the production cost. Producers will pass the increase in production costs to the selling price. As a result, inflation rose.

Meanwhile, in some industries, rising oil prices forced them to be more efficient. They then cut output.

The result is stagnant economic growth. And at the same time, inflation soars. Specifically, we call this type as 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 decrease, 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 bubbles in the stock market. Usually, before the breakdown, the speculative activity causes the stock price to continue to soar and is no longer 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 falling to -47% in the 1990s. It previously grew by 213% in the 1960s and1325% 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 and short, depending on its severity. US Great Depression of the 1930s is a longstanding example. The Great Depression of the 1930s lasted three and a half years, wiping out more than a quarter of 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 a 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 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 depreciation of the currency caused public debt to soar to USD60 billion. That puts enormous pressure on the government budget. And, as a result, in 1998, Indonesia’s real GDP contracted by 13.1%. Inflation soared to the level of 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.

Economic Collapse: Signs, Causes, and Examples