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Economic crisis disrupts the smooth functioning of an economy, causing widespread hardship. Understanding economic crises – what causes them, how they impact economies, and how to navigate them – is crucial in staying informed about major economic trends. This comprehensive guide will equip you with the knowledge to decipher the causes, impacts, and strategies for weathering economic storms.
What is an economic crisis?
An economic crisis is a condition in which the economy is shaken unexpectedly and rapidly spreading. The trigger can take various forms, such as a debt crisis, a banking crisis, an asset bubble burst, or a balance-of-payments crisis.
For example, a debt crisis occurs when the risk of default soars. The government’s ability to repay debts falls. Government debt increases dramatically, higher than the increase in tax revenue. The government cannot borrow any more money because investors have lost faith in the government’s ability to pay.
Some economists argue that most economic recessions or depressions originate from financial crises. One notable example is the Great Depression, which started with a bank run and a stock market crash.
The 2008-2009 subprime mortgage crisis also triggered a severe recession in the United States and spread worldwide. The cause was the bursting of the real estate bubble. Real estate prices rose so much that they exceeded fair value. And suddenly, the price fell. That sparked panic in the economy because large sums of money were being invested in real estate.
The crisis has an impact on economic activity and raises some socio-political problems. GDP growth slumped, the unemployment rate shot up, and many people lost their money. Poverty and hunger increased, giving rise to problems of crime and riots. In some countries, the crisis led to the removal of the incumbent government.
Why economic crisis matters
Economic crises aren’t just theoretical concepts in textbooks. They have real-world consequences that ripple through individuals, businesses, and entire nations. Here’s why understanding economic crises is important:
- Severe economic disruption: Economic crises cause a sharp decline in economic activity. Businesses struggle, leading to job losses, bankruptcies, and a decline in the overall production of goods and services.
- Financial strain: During an economic crisis, access to credit can tighten, making it harder for businesses and individuals to borrow money. This can lead to defaults on loans, foreclosures on homes, and overall financial hardship.
- Social impact: The human cost of economic crises can be significant. Job losses lead to decreased income, which can strain families and increase poverty. The stress of financial hardship can also have negative impacts on mental and physical health.
- Investor losses: Stock markets typically decline significantly during economic crises, leading to substantial losses for investors. Understanding these cycles can help investors make informed decisions about their portfolios during periods of economic downturn.
- Policy Responses: Governments often implement various policies to mitigate the effects of economic crises. These policies can have a major impact on businesses and individuals, so understanding the potential responses is crucial.
By understanding economic crises, we can better prepare for their impact, both individually and collectively. This knowledge can help us make informed financial decisions, navigate challenging economic times, and support effective policy responses.
Types of economic crisis
Many economists offer theories about how economic crisis arise, develop, and spread in the economy. They also propose several options to prevent worse effects. However, there is no right consensus or formula, and the crisis continues from time to time.
In general, economic crises can take many forms. We will try to discuss the following:
- Recessions and Depressions
- Currency crisis
- Banking crisis
- Asset bubbles
- Balance of payments crisis
- Debt crisis
Recessions and Depressions
Economic crises come in various flavors, but two of the most common terms you’ll encounter are recessions and depressions. While both represent periods of economic decline, they differ significantly in severity and duration:
- Recessions are considered milder economic downturns. The National Bureau of Economic Research (NBER), the authority on business cycle dating in the US, typically defines a recession as a period of decline in economic activity that lasts for at least six months, often measured by two consecutive quarters of negative Gross Domestic Product (GDP) growth. Recessions are characterized by a slowdown in economic activity, rising unemployment, and a decrease in business investment. However, they are usually temporary, and the economy eventually recovers.
- Depressions are far more severe and prolonged economic downturns than recessions. They involve a much sharper decline in GDP, often lasting for several years. Unemployment rates soar, reaching double digits in many cases. Businesses fail at an alarming rate and consumer confidence plummets. Depressions can have a devastating impact on a nation’s economy and social fabric, taking a much longer time to recover from compared to recessions.
The Great Depression of the 1930s serves as a prime example of a depression. In contrast, the economic downturn of 2008-2009 is considered a recession, even though it was a significant economic shock.
Currency crisis
The currency crisis is considered part of the financial crisis. Currency crises occur when the exchange rate of one currency against another falls. In other words, it’s currency depreciation, it’s just going badly.
The currency crisis may be the result of hyperinflation, in which the purchasing power of the domestic currency over goods and services declines. People don’t believe in domestic currency anymore. They sell domestic currency and exchange it for a more stable currency, such as the US dollar. As a result, the domestic currency exchange rate against the US dollar falls.
Currency crises may also occur due to speculative activity. Speculators attack weak currencies, especially countries with weak economic fundamentals. Typical targets are countries that:
- Adopting a fixed exchange rate system
- Running double deficit (fiscal deficit and current account deficit)
- Having insufficient foreign exchange reserves
Those countries are vulnerable to small attacks on exchange rate markets. Foreign exchange reserves are insufficient to intervene and reduce the effects of speculators’ attacks, so the exchange rate depreciates.
Depreciation increases debt denominated in foreign currency, say US dollars. Governments and businesses must raise more money to pay back the debt.
Businesses try to avoid increasing debt burdens by buying dollars. That move might save them from default, but it has other consequences. The purchase of dollars exacerbates the fall in the exchange rate.
Banking crisis
A crisis usually starts with a bank run, when savers suddenly withdraw their deposits from the bank. Such panic may occur because they lost confidence in the purchasing power of the domestic currency, as during hyperinflation. Or, they no longer trust the bank because of insolvency problems.
During hyperinflation, the currency’s purchasing power falls. People prefer to hold cash because they can use it at any time, which triggers massive withdrawals of deposits from banks.
Banks have difficulty paying back deposits. They usually only set aside a small portion of the savings as a reserve. The rest, they lend to households or businesses. Banks, of course, cannot suddenly withdraw their loans.
Withdrawal of deposits suddenly makes the bank bankrupt. That sparked panic, not only among savers but other banks as well. The banks are usually linked to each other, for example, through interbank loans. Such a situation then led to a banking panic and a systemic crisis.
Asset bubbles
A crisis usually occurs when an asset bubble bursts suddenly. Assets can take many forms, such as stocks or real estate. The significance of the effect depends on how much money is invested in these assets. The more money invested, the worse the effect.
Asset bubbles occur when the asset price continues to surge rapidly, far exceeding its fundamentals. Prices are no longer reasonable and far exceed their fair values. One cause is speculative activity.
Speculators try to take advantage of price increases in the short term. They buy assets only in the hope that they can later sell them back at a higher price, and their purchases make prices skyrocket even more.
Having exceeded its fundamentals, it suddenly fell. That sparked panic, not only among speculators but also among other long-term investors. Households lost some of their wealth, and so did businesses.
Balance of payments crisis
This crisis occurs when a country is unable to pay for imports or service its foreign debt payments. A fall in exchange rates usually accompanies a crisis.
One cause of the balance-of-payments crisis is short-term capital flows (or what we call hot money). Foreign investment flows into the domestic economy to take advantage of fast economic growth, and foreigners hunt for assets such as stocks and bonds.
Others are more long-term oriented. They invest directly in building production facilities or acquiring domestic companies.
If economic conditions weaken (e.g., contraction), it pushes short-term foreign investment out of the domestic market. Capital outflows result in sharp currency depreciation.
The government tries to intervene in the exchange rate by using foreign reserves. But, it may not work because of the massive capital outflow.
The government then took other options, such as raising interest rates. The expectation of a rate hike prevents further declines in the currency’s value. However, a sharp increase in interest rates only further hurt the domestic economy and reduced investor confidence.
Debt crisis
A debt crisis arises when the risk of default increases. Debt soared because the government ran a budget deficit that increased year over year. At the same time, the ability to increase tax revenue was limited. High debt reduces the government’s ability to pay interest and principal, slumping investors’ confidence in the domestic economy.
The European debt crisis since 2010 is an example. Several eurozone member countries, such as Greece and Spain, were unable to pay back their debts. They were then forced to ask for help from third parties, such as the European Central Bank (ECB) and the International Monetary Fund (IMF).
These creditors forced the government to implement austerity policies and fiscal discipline. They must reduce the level of their budget deficit through tax increases and decreases in government spending.
Impacts of economic crisis
The economic crisis has had a broad impact on the economy and even the social conditions of society. I’ll break down some of the adverse effects:
- Unemployment spiked. Economic crises can lead to a recession or even depression, forcing businesses to cut output due to weak demand. They began rationalizing production costs by firing some of their workers.
- Household wealth falls. People’s incomes drop because of the higher unemployment rate. Those who are still working may also have to receive lower salaries as the business measures efficiency and rationalizes operating costs. Falling assets worsen the situation and reduce household wealth. They incurred capital losses and no longer received regular payments, such as dividends.
- Deteriorated business profits. Demand for goods and services falls as household income and wealth fall. Falling demand left most production facilities unemployed. Businesses cannot operate at economies of scale, increasing the unit cost of the product.
- Social crisis. Poverty levels soar as household income and wealth fall, triggering an increase in social problems such as crime and hunger.
Preparing for and responding to economic crisis
Economic crises are inevitable features of the economic cycle. While they can be disruptive, there are steps governments, individuals, and investors can take to prepare and respond effectively. This guide explores these strategies to help you navigate economic downturns and emerge stronger on the other side.
Government policies
Governments have a significant role to play in mitigating the effects of economic crisis. They can deploy various policy tools to stimulate economic activity and support those most affected. Here’s a closer look at two key approaches:
Fiscal Stimulus: During economic downturns, governments can increase spending on infrastructure projects, social programs, and tax cuts. This increased spending injects money into the economy, boosting demand for goods and services.
Additionally, tax cuts can leave more money in people’s pockets, encouraging them to spend and invest. The ultimate goal of fiscal stimulus is to create jobs and encourage economic growth.
Monetary Policy: Central banks, which are the institutions responsible for a country’s monetary policy, also have tools to address economic downturns. One key tool is lowering interest rates. Lower interest rates make borrowing cheaper, encouraging businesses to invest and consumers to spend on big-ticket items like homes and cars.
Additionally, central banks can purchase government bonds, which inject money directly into the financial system. This increased liquidity can help stimulate lending and economic activity.
Individual and household strategies
Individuals and households can also take proactive steps to prepare for and weather economic crisis. Here are two key strategies to consider:
Savings: Building a healthy emergency fund is critical for navigating economic downturns. Having a financial cushion helps cover unexpected expenses or income loss during periods of economic hardship. Aim to save enough to cover several months of living expenses to provide a buffer against job losses or other financial disruptions.
Diversification: Don’t put all your eggs in one basket. Diversifying your income streams and investments across different asset classes can help mitigate risk and protect your financial well-being during downturns. Consider spreading your investments across stocks, bonds, real estate, and other asset classes. This way, if one asset class experiences losses, the others can help offset those losses and provide stability to your portfolio.
By adopting sound saving and diversification practices, individuals and households can build resilience and navigate economic downturns with greater financial security.
Investing during downturns
Economic downturns can present unique opportunities for investors with a long-term perspective. Stock prices and other asset values may decline during economic downturns. This can present buying opportunities for investors who are willing to take a long-term view. By investing during a downturn, you can potentially acquire assets at lower prices, which can lead to higher returns when the economy recovers.
However, it’s important to remember that economic crises can be volatile and unpredictable. Investing during these periods requires careful analysis and a risk-tolerant strategy. Don’t blindly invest during downturns. Be sure to thoroughly research any potential investment and ensure it aligns with your financial goals and risk tolerance.
