Economic Collapse

A state of the economy that is not always a part of the normal economic cycle.

An economic collapse is a one-of-a-kind occurrence that is not always a part of the normal economic cycle. It can happen at any time during the cycle, resulting in contraction and recession. An economy can go through numerous stages, according to economic theory.

Economic collapse

A complete economic cycle involves a transition from trough to growth, a peak, and finally, a contraction that leads back to the trough. 

Although an economic crisis should be more likely in an organization already shrinking, black swan occurrences or global economic dynamics can trigger a collapse at any stage in the cycle.

Unlike expansions and recessions, there is no global alliance for the collapse. Instead, the phrase "economic collapse" is a designation that economists and government officials might use years or even decades after an event has occurred.

Governments also prefer to speak about economic catastrophe when constructing large-scale stimulus amid market instabilities. The prospect of the collapse is highlighted to build the argument for economic intervention. 

What Is Economic Collapse?

It is a disintegration of a country, region, or territory's economy, usually after a period of turmoil. 

An economic slump happens when a severe form of an economic contraction, depression, or recession begins. It can continue anywhere from a few months to many years, based on the intensity of the conditions. 

It might occur suddenly because of an unforeseen incident, or it can be preceded by events or signals indicating economic fragility. 

It might also happen when a country's economy is thrown into disarray because of a broad catastrophe. 

The drop may have preceded a debt crisis, currency crisis, war, and supply disruptions. After that, the economy enters a period of market contraction or depression.

Economists use the notion of the business cycle to describe the many stages the economy goes through. 

A typical economic cycle comprises transitioning from a trough to expansion, peaking, and then contracting back to the trough. These steps are done again and again.

Meanwhile, it is a once-in-a-lifetime occurrence. It isn't required to follow the broad economic cycle. The breakdown might occur suddenly, resulting in depression.

There are several indicators that an economy is collapsing, including:

  • Debt crunch

  • Currency depreciation

  • Rise of interest rates 

Sovereign debt is borrowed money from the government to offset a budget deficit.

If the government's budget deficit rises, it will have to borrow more money. In most cases, a more significant deficit stimulates economic development. To boost aggregate demand, the government boosts capital investment, such as infrastructure projects.

The danger of default grows if the government takes on too much debt. Therefore, the ability to pay off debt principal and interest diminishes.

As a result of the drop in trust in a country's economy, the economy is put under more strain. The debt situation is then brought to the forefront. 

Currency crises arise when people lose faith in a country's currency, which might lead to severe inflation or devaluation.

Hyperinflation decreases the currency's buying power for goods and services. Meanwhile, depreciation happens when the value of one currency declines against another. For instance, if the EUR-USD exchange rate falls from 1.15 to 1.00, the euro has lost 13% of its value versus the US dollar.

Investor trust was eroded because of the currency crisis: they started doubting the government's capacity to pay its debts. 

Interest rates peaked at extraordinarily high levels during periods of an economic slump. As loans become more costly, it restrains economic growth by preventing consumers and enterprises from taking out loans.

Paying off debts is also more costly. As a result, many firms begin selling their assets to pay off their debts. Similarly, defaults in the home sector have risen. 

Reasons behind the economic collapse

Special conditions are frequently the cause of an economic collapse. It can also happen when the economy enters a period of contraction or recession, which might lead to depression. 

Reasons

It can send the economy into a tailspin. The economy's production is decreasing since unemployment is at an all-time high, and household income and consumption have decreased. 

Hunger and poverty levels have risen dramatically, things that increase socio-political dimensions such as rioting and criminality, as well as the overthrow of the current administration.

Many factors contribute to an economic collapse: 

· Hyperinflation

· Stagflation

· Stock market crash

· War

Hyperinflation

Hyperinflation is a phase in which inflation is extremely high and uncontrollable. In Venezuela, for example, inflation hit 1,698,488 percent in 2018. 

The currency's value decreased throughout this time, and its purchasing power for goods and services vanished. Money loses its value in this circumstance.

Hyperinflation

The increase in the amount of money in circulation contributes to inflationary pressures. This is because the government may be heavily in debt, and they could print money to pay it off. As a result, inflation rises dramatically as more money chases fewer commodities.

The government might be unable to collect greater taxes to pay off its obligations. It frequently happens because of a reduced aggregate supply, war, socio-political instability, or other disasters. 

Stagflation

Stagflation occurs when economic growth is stagnated while inflation rises at the same time. This is a less usual occurrence. 

Stagflation

In most cases, inflation moves in lockstep with economic development when the economy grows rapidly, and the prices of items in the economy rise in tandem with the increase in aggregate demand.

Stagflation, on the other hand, is a unique phenomenon. This is because the problem stems from the supply side. The most well-known factor is an increase in oil prices.

The majority of industries rely on petroleum. As a result, the cost of production rises as the price rises. The increase in manufacturing expenses will be passed on to the consumer in the form of a higher market value, which leads to inflation being at an all-time high. 

Meanwhile, increased energy costs drove certain businesses to become more efficient. After that, they reduced output.

As a result, economic growth has slowed; meanwhile, inflation is rising. This inflation is known as cost-push inflation since rising manufacturing costs trigger it.

For the government, Stagflation is a problem. Even if inflation falls, contractionary economic policies will accelerate the decline in economic production and raise unemployment. 

A stimulative economic strategy, however, stimulating economic growth, would only result in increased inflation as aggregate demand accelerates.

The central bank, for example, pursues a contractionary monetary policy by raising interest rates to lower inflation. This increases the cost of borrowing, which the real sector typically absorbs.

Stock market crash

Several crises, notably the Great Depression, began with breaking stock market bubbles. Before the crash, speculative activity usually leads the stock price to continue to rise and is no longer at its basic fair value.

Market crash

Confidence in the economy plummeted once the recession hit. As a result, prices for the same plummet, causing firms to lose money. It also led to the loss of a significant percentage of the family's assets, particularly their pension. It subsequently breeds pessimism, lowering aggregate demand (via the wealth effect).

Bubbles may arise in other financial assets, such as real estate and the stock market. The size of the economic impact is determined by how much money in the economy rotates around the item. 

Because a significant number of individuals and companies' wealth was involved in both, the bursting of the stock and real estate bubbles had a massive effect.  

War 

The devastation of a country's economy is triggered by war. The Iraqi economy, for example, imploded as a result of the desert war, with nominal GDP plunging to -47 percent in the 1990s. In the 1960s, it expanded by 213 percent, and in the 1970s, it rose by 1325 percent.

Similarly, the invasion of the United States in the 2000s resulted in the country's economic downfall. 

War

Although conflict might temporarily increase domestic demand, it is vital to remember that war comes at a price. The opportunity cost of military spending, the human cost of lost lives, and the cost of reconstructing after a war's damage are all factors to consider.

It also depends on the type of war, how long it has lasted, and where and how it is waged. For instance, the United States fought wars during WWII, the Korean War, and the Vietnam War. These conflicts appeared to increase domestic demand, with certain manufacturing enterprises performing exceptionally well. 

However, it is essential to remember that these conflicts occurred in countries other than the United States. The actual carnage occurred in Asia and Europe.

Examples in History

Depending on the intensity of the economic collapse, it might last for a long time or a short time. The Economic Crisis in the United States in the 1930s is a well-known example. 

The Great Depression of the 1930s lasted three and a half years and cost the United States over a quarter of its GDP. During the Financial Crisis, the unemployment rate reached 23%.

Another example is the financial crisis of 2007-2009, which lasted significantly shorter than the Great Depression. 

The speculative activity in the housing industry in the United States is one of the leading variables. When the bubble broke, huge financial companies like Lehman Brothers filed for bankruptcy. 

Many other countries, like the Soviet Union, Greece, and Argentina, also experienced an economic catastrophe. However, in the situations of Greece and Argentina, the debt crisis was the catalyst for the collapse. 

The country was subsequently obliged to devalue its currency, seek foreign bailout assistance, and change its government because of the crisis.

In 1997, Indonesia experienced a similar economic catastrophe. Again, it began with an economic crisis, which extended throughout the country, sparking social discontent and pushing Soeharto to resign.

The crisis had devastating consequences. The weakening of the currency led the state debt to rise to USD60 billion in November 1997. This puts a lot of strain on the government's finances. As a result, Indonesia's GDP Growth shrank by 13.1 percent in 1998.

Inflation reached a high of 72 percent. In the meantime, the rupiah declined from IDR2,600 per USD in early August 1997 to IDR11,000 per USD in January 1998. 

Acting in the Face of Economic Collapse

Although economies may and do undergo economic collapse, national governments have a significant motivation to use fiscal and monetary policy to try to prevent or mitigate the severity of such a collapse.

Several interventions and fiscal measures are frequently used to combat economic depression.

Banks may shut down to limit withdrawals, new capital restrictions may be implemented, billions of dollars may be injected into the economy via the financial system, and whole currencies may be revalued or replaced. 

Regardless of government attempts, some economic breakdowns result in the removal of the administration responsible for the collapse and the government reacting to it. 

Following a financial crisis, there is virtually always a slew of legislative amendments to prevent a repeat of the scenario. 

A post-collapse analysis is frequently used to guide these reforms, identify the fundamental elements that led to the collapse, and incorporate controls into new laws to prevent future risks. 

As the memory of the economic collapse fades, the desire for these financial regulations may wane, allowing the regulation of hazardous market conduct to loosen.  

Crisis

Fiscal policy is a Weapon Against Recession: the use of government spending and tax policy to alter the economy's trajectory over time is known as fiscal policy. 

Fiscal policy, whether through changes in spending or taxation, drives economic activity outward in monetary expansion and inward in deficit spending, as shown graphically. 

For example, in the late 1990s, private sector investment in physical capital in the US economy soared, going from 14.1 percent of GDP in 1993 to 17.2 percent in 2000 before declining to 15.2 percent in 2002. In contrast, if changes in aggregate demand outpace increases in aggregate supply, inflationary price rises will ensue.

Shifts in aggregate supply and demand cause recession and recovery in business cycles. When this happens, the government can redress the disparity through fiscal policy. 

Monetary Policy and Bank Regulation demonstrates how a central bank might utilize its regulatory authority over the banking sector to take countercyclical (or "against the business cycle") policies. 

When a recession is on the horizon, the central bank employs an expansionary monetary policy to boost the money supply, increase the number of loans available, lower interest rates, and move aggregate demand to the right. 

When inflation looms, the central bank employs a tight fiscal policy, which involves reducing the money supply, reducing the number of loans, raising interest rates, and shifting aggregate demand to the left. 

Fiscal policy, which uses either government spending or taxation to influence economic activity, is another macroeconomic policy instrument.

Consider a recessionary economy as an example of how the government may influence the economy through fiscal policy. For example, the government may give tax stimulus refunds to boost aggregate demand and economic development.

This strategy is based on the idea that when individuals pay reduced taxes, they have more money to spend or invest, stimulating increased demand. 

As a result of this demand, businesses hire more people, lowering unemployment and increasing labor competitiveness. As a result, salaries are rising, and consumers have more money to spend and invest. It's a win-win situation.

Rather than cutting taxes, the government may strive to expand the economy by increasing expenditure (without corresponding tax increases). More motorways, for example, might boost employment, hence boosting demand and GDP.

Fiscal stimulus characterizes expansionary fiscal policy, which occurs when government expenditures exceed revenue from taxes and other sources. In actuality, deficit expenditure usually results from a mix of tax cuts and increased spending.

A government is in charge of fiscal policy. On the other hand, monetary policy is implemented by central banks or other monetary authorities. The US government's executive and legislative branches are in charge of fiscal policy. 

In this regard, the President and the Secretary of the Treasury are the two most powerful posts in the executive branch. However, modern presidents also rely on a council of economic experts. 

Through its "power of the purse," the United States Congress authorizes taxes, makes legislation, and appropriates money for any fiscal policy actions. The House of Representatives and the Senate are involved in this procedure, ensuring interoperability, debate, and approval.

Accounting Foundations Course

Everything You Need To Build Your Accounting Skills

To Help You Thrive in the Most Flexible Job in the World.

Learn More

Researched and authored by Abdelmoussaour Boukhatem | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: