What is Economic Collapse?
Economic collapse refers to a period of national or regional economic breakdown where the economy is in distress for a long period, which can range from a few years to several decades. During periods of economic distress, a country is characterized by social chaos, social unrest, bankruptcies, reduced trade volumes, currency volatility, and breakdown of law and order.
Due to the magnitude of the economic distress, government interventions for economic recovery can be slow to bring the economy back on track, and the delay causes even greater disorganization of the economy.
Causes of Economic Collapse
The following are some of the causes of economic collapse:
Hyperinflation occurs when the government allows inflationary pressure to build up in the economy by printing excessive money, which leads to a gradual rise in the prices of commodities and services. Governments resort to creating excess money and credit with the goal of managing the economic slowdown and financing its activities. Hyperinflation occurs when the government loses control of the price increases and raises the interest rates as a way of managing the accelerating inflation.
Stagflation refers to a situation in which the economy is growing at a slow rate while simultaneously experiencing high rates of inflation. Such an economic situation causes a dilemma among policymakers since the measures implemented to reduce the rise in inflation may increase unemployment levels to abnormally high levels. Stagflations and its effects on the economy may last for several years or decades.
For example, the United States experienced stagflation from the 1960s to the 1970s. During said period, economic growth was stagnant, and the inflation peaked at 13% per annum while the inflation rate in the United Kingdom was at 20% per annum. Once stagflation occurs, it is usually difficult to manage, and governments must incur huge costs to bring balance to the economy.
3. Stock market crash
A stock market crash occurs when there is a loss of investor confidence in the market, and there is a dramatic decline in stock prices across different stocks trading in the stock market. When a stock market crash occurs, it creates a bear market (when prices drop 20% or more from their highs to hit new lows), and it drains capital out of businesses.
Crashes occur when there is a prolonged period of rising stock prices, price earning ratios exceed long-term averages, and there is excessive use of margin debt by market participants.
Scenarios that Define an Economic Collapse
The following are some of the things that characterize an economic collapse:
1. Rising interest rates
During periods of economic collapse, interest rates peak to abnormally high levels, and it limits the amount of money that is available for investors to invest. High interest rates hinder economic growth since investors, corporations, and government find it costly to service existing debt obligations and take out new loans due to the high cost of capital.
When a major company declares its inability to finance its debt obligations and resorts to disposing of its assets to pay creditors, investors lose confidence in the company and will be hesitant to trade their money during periods of financial distress.
2. Sovereign debt crisis
Sovereign debts are debts taken up by a government to finance capital-intensive infrastructural projects. However, when the government takes too many debts and is unable to pay principal and interest obligations when they fall due, it increases the risk of defaulting on its existing debt obligations and becoming bankrupt.
A sovereign debt crisis occurs during periods of slow economic growth, wars, political instability, drought, and when investors lose confidence in the government. Due to the large size of sovereign debts, a default by the government is likely to affect the global economy and cause spill-over effects on other jurisdictions.
3. Local currency crisis
Local currency crisis occurs when the currency depreciates in value due to a loss of investor confidence. It occurs when foreign investors who have invested in a country and advanced credit to the government lose confidence in the government’s ability to meet debt obligations or generate the agreed upon returns.
In such situations, the foreign investors withdraw their investments in the country. The move increases the selling of the borrowing country’s currency in the international market, resulting in currency devaluation. In return, the currency devaluation increases the country’s international debts, resulting in the loss of the country’s purchasing power.
4. Global currency crisis
Glocal currency crisis involves the loss of value of a major currency that is used in cross-border trade transactions between individuals, corporations, and governments. For example, the US dollar is used as the world reserve currency in the Bretton Woods institutions, which means that if the US dollar depreciates in value, it may trigger a global economic crisis.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: