Disasters of Macroeconomic Proportions

Begin with one of the more dramatic aspects of macroeconomics – financial crises – and see why macroeconomics matters.

What should a country do to ensure that it meets as much of its population’s infinite needs as possible, given its finite resources? Macroeconomics focuses on an economy’s productivity to answer this.

Begin with one of the more dramatic aspects of macroeconomics – financial crises – and see why macroeconomics matters.

Macroeconomics and its mandates

What should a country do to ensure that it meets as much of its population’s infinite needs as possible, given its finite resources? Macroeconomics focuses on an economy’s productivity to answer this.

Macroeconomics has 3 main goals. The first is to promote economic growth, as measured by GDP: countries aim to operate at full production in order to achieve maximum income. Additionally, they strive to sustainably expand capacity so they can grow. It’s similar to how a professional wants to earn as much as they can given their skill set and work experience. Why settle for earning less than $100,000 if you know you’re worth that much? Furthermore, if you’re already being paid your worth, you would try to up-skill yourself to grow your earnings potential.

The second goal of macroeconomics is to limit unemployment: high unemployment indicates that an economy is not using all its human resources efficiently. The third goal is to keep price levels stable: both deflation and uncontrolled inflation wreak havoc on an economy, thus requiring  a delicate balance to keep the system chugging along.

Why macroeconomics matters

Understanding macroeconomics greatly helps individuals and businesses make better decisions. On a personal level, an appreciation for macroeconomics paves the way for informed choices. Depending on where the economy stands, the feasibility of certain life choices – switching jobs, asking for a raise, or taking out a loan for big-ticket purchases – ebbs and flows. For instance, should you attempt a career shift during uncertain times, or should you wait until the economy is stable?

When the economy is on a downturn, a basic knowledge of macroeconomics keeps us clear-headed and calm. Understanding where the government’s role in macroeconomic issues starts and stops, and accepting that recovery can take time, saves us from disillusionment and despair.

On a professional level, managers with a grasp of macroeconomics are better-equipped to analyze current circumstances to decide whether they should expand the business, lay off workers, or keep inventory levels low. Timing is a vital element of good business decisions and helps firms weather economic storms, potentially signifying the difference between survival and bankruptcy in the worst of times.

The worst economic downturn in modern history

To those familiar with it, the Great Depression conjures up images of lines of men, sometimes so long they rounded the street corner, hungrily waiting for food at the soup kitchen or bread line. Unemployment reached an all-time high during this period, peaking in May 1933, when roughly 1 in 4 workers was unemployed[1]

This stands in stark contrast to the growth and prosperity many enjoyed in the Roaring Twenties, when it seemed everyone could afford the new Ford Model T or to hedge their bets in the stock market. 

This prosperity came to a screeching halt on Black Thursday, marking the Wall Street Crash of 1929. Panicked investors pulled out funds, signifying a sharp turnaround from optimism-fueled speculation to uncertainty and wariness. By day’s end, 12.9 million shares had been traded in Wall Street, 3 times its then normal trading volume, indicating how frantic the market was as stock prices went into free fall. 

The devastation experienced by investors is best reflected in the picture of the investor Walter Thornton, newly bankrupt, trying to sell his 1929 Chrysler 75 for $100 cash. Prior to the crash, it would’ve sold for $1,555 brand new.

Image: Walter Thompson’s Chysler Image: Walter Thompson’s Chysler

The ripple effects of the Great Depression

Speculation and excessive optimism drove Wall Street to unprecedented heights, only to have it crash in 1929, when this optimism proved unsustainable. This then resulted in the Great Depression, replacing people’s confidence with tightfisted wariness. Having suffered great losses, businesses scaled back on spending.

This created an unfortunate feedback loop. Businesses were producing less and required a smaller workforce, leaving many jobless. The average Joe hardly had cash to spend, so business slowed further. From a macroeconomic lens, the US economy halved in 5 years. On an individual level, many had to make do with wage cuts and laid-off workers took on low-paying jobs for which they were overqualified.

Desperate to protect American workers, Congress passed the Smoot-Hawley Tariff Act in 1930, imposing taxes on foreign goods. European countries retaliated by imposing their own taxes on American goods, ultimately leaving the US economy worse off and initiating a global trade war. This, together with the American Midwest’s Dust Bowl drought, exacerbated the situation. In the end, the depression lasted for 10 years.

The 2008 global financial crisis and the US housing market

You might remember that, in 2008, the US experienced another financial crisis. This time, it was tied to the US housing market crash. Investors had placed funds in financial instruments backed by mortgages – and not just their own funds. Enticed by the promise of high returns, they took out debt to further invest in these financial instruments. As demand for these instruments soared, financial institutions eager to meet the demand grew lax with their screening processes. The average American could easily take a mortgage, whether they could afford it or not. 

Once homeowners defaulted on their mortgages, their homes were repossessed. Trouble was coming. Repossessed homes re-entered the market, driving housing prices down. Homeowners’ debts were magnified as their homes dropped in value, which resulted in a domino effect when financial institutions woke up to the reality that they were holding on to financial assets that were way too risky and, essentially, overvalued. Ultimately, this led to the Great Recession, which occurred from 2007 to 2009.

Irrational exuberance

Although the Great Recession and the Great Depression stem from 2 different crashes – the housing and the stock market – they share some similarities. Both recessions were preceded by an extended period of optimism. Investors behaved irrationally, as if placing their money on sure bets. 

With the 2008 crisis, we can also point to corporate greed and misguided incentives. Banks that issued more loans earned more revenue, which meant bigger bonuses. So, caution was swept out the door. Unfortunately, checks and balances were lacking. Since financial institutions created increasingly sophisticated financial instruments to take advantage of the housing wave, some of them skipped financial regulators’ radars. The system became less transparent.

Luckily, the US government learned from the Great Depression. Instead of allowing the market to correct itself, as before, the government intervened immediately, propping up institutions that would have otherwise gasped their last breath. Though many people suffered from the Great Recession, it lasted only 18 months, and unemployment peaked at 10%[2]. Has the market finally learned its lessons, and can we spare ourselves from another disaster of this magnitude? Only time will tell.

East Asia in the ‘90s, a boom-bust cycle

Rapid growth marked the years leading up to 1997 in East Asia. Export boomed and a surplus of foreign investment poured in. However, trouble started brewing when other markets like the US started offering higher interest rates, diverting foreign investors away from East Asia and into more attractive markets. 

Suddenly, investment dried up and the economy slowed down. It became apparent that much of the debt issued years prior was unsustainable – it was invested in projects that rode the wave of optimism but had no hope of profitability. But, clouded by visions of prosperity, financial institutions had turned a blind eye and allowed debt to roll over until they could no longer afford to do so. 

Under the weight of foreign debt, the Thai government was forced to abandon the Thai Baht’s peg to the US dollar. As a result, the currency’s value dropped, setting off a chain reaction throughout the Thai equity and property markets.

1997’s Asian Contagion

The bubble burst, first in Thailand, then in its neighboring countries. A devalued Thai Baht meant importing from Thailand was now cheaper, fueling its export market but simultaneously hurting competing export industries in other East Asian countries. This played into investors’ doubt. If the Thai economy was this precarious, what’s to say its neighboring countries wouldn’t be the same? 

The crisis rippled through East Asian countries that had close ties through trade links and financial channels. The South Korean Won lost 50% of its value within a single month. Indonesia saw widespread rioting and ousted its incumbent president. Businesses collapsed across the board. 

Most affected countries started showing signs of recovery in 1999. But, until then, the average East Asian endured severe cost cutting, a sharp increase in school dropout rates, and high barriers to gainful employment[3].

The 1970s stagflation

Let’s shift our attention to a financial crisis that didn’t involve excessive optimism. In the 1970s, the US economy experienced something unprecedented – stagflation. This involved a combination of rapidly increasing prices, or high inflation, and slow economic growth, or stagnation. The economy was flat as the post-war boom petered out. Increased competition from international players limited production. Unemployment was growing, but interestingly, price levels continued to rise as the government expanded its social programs. 

To top it off, the Organization of the Petroleum Exporting Countries (OPEC) announced in late 1973 that it would stop exporting oil to the US. Oil prices skyrocketed. As oil prices quadrupled, families and businesses alike struggled with further instability and uncertainty. 

Until then, stagnation and inflation occurred mutually exclusively. The government knew how to address inflation, by cutting back on spending or increasing taxes, and it could address a stagnant economy by boosting government spending or decreasing taxes. But these 2 solutions were in direct conflict with each other, and novel solutions were required for the situation. In the end, the US had to wait out a recession in order for inflation to cool off.

Who wants to be a Zimbabwean trillionaire?

What if, with a single banknote, you could be a trillionaire? Sounds implausible, but somewhere some time ago, that was indeed the case. In 2008-2009, the Zimbabwean Reserve Bank, faced with disastrous hyperinflation, issued $100 trillion banknotes – Zimbabwean dollars, that is. 

But holding on to that bill would not have meant much, either then or now. Inflation in Zimbabwe peaked at a 98% daily rate. If you received $100 trillion then but chose to hold on to it another day, you would’ve been able to buy half as much stuff the next day. Nowadays, that same banknote has essentially zero value, except perhaps for its novelty and historic significance. 

How did this $100 trillion banknote come about? And how did Zimbabwe become economists’ poster child for hyperinflation? Zimbabwe’s economy had been struggling for some time before hyperinflation hit. The Government had enacted land reform policies, taking land away from commercial farmers and transferring ownership to small-scale production. Inevitably, production dropped. With mounting debt and collapsing output, the government desperately needed cash. And so, because they could, they printed more money, sending the currency’s value into free fall.

Venezuela, a riches to rags story

In 2012, oil accounted for 95% of Venezuela’s exports. Yet, in 2020, the average citizen rejoiced if they only had to queue overnight to gas up their car. Once the richest country in Latin America, Venezuela paints a dire riches to rags story. From a prosperous oil-rich nation where basic goods and services were widely accessible, it now sees a population hungry and poor, having lost, on average, 11 kg of body weight between 2015 and 2016[4].

What went wrong? Venezuela flourished when oil prices were high. As oil money pumped into the economy, then-president Hugo Chávez enacted numerous social programs. Unfortunately, during prosperous times, we often fail to plan for the long term. The Venezuelan leader failed to diversify the economy, which drew strength from its oil exports alone. So, when oil prices dropped, the economy caved. 

Although Chávez’s successor, Nicolás Maduro, merely inherited the flailing economy, it was under his rule in 2014 that the economy finally collapsed. Since then, the situation has worsened, resulting in a humanitarian crisis in the once-affluent nation.

China’s Great Leap Forward

In the late 1950s, Chairman Mao’s Great Leap Forward led to widespread famine and death. In its bid to accelerate industrialization within its borders, the Chinese government introduced backyard steel furnaces in farms and cities. Warm bodies were needed for steel making, so they diverted farmworkers away from agriculture. But of course, people still had to eat. So, to sustain agricultural output, private farmlands were converted into collectives that the Communist Party controlled centrally, on which toiled the remaining farmworkers and their wives.

Take a step back and identify what’s wrong with this picture. Why are farmworkers working with steel when their expertise lies in agriculture? And why, in their stead, were laborers tending to farms? Unfortunately, output decreased sharply and across the board due to several factors – failed experiments, local politics, unequal food distribution, and natural disasters. So, although a massive amount of input was redirected toward agricultural and industrial production, the program did not achieve the corresponding output expected – a disaster in economic terms.

Long-lasting effects of economic crises

Carefully planned, thoughtful policy responses are often enough to put the brakes on financial crises. With the right people calling the shots and some luck, economies rebound from disasters, even in the direst situations. But though economies appear resilient, long-lasting effects may remain.

In theory, poor countries recover from a global crisis faster because each extra level of investment generates a higher level of output compared to more developed countries. Historically, this has not been the case. They are likely to hit another snag, negating any advances they make in the short termp[5].

Economic crises also highlight and magnify inequalities between the rich and the poor, and show how vulnerable the middle class is[6]. With unemployment and inflation imposing a heavy burden on families, certain pockets of the population may suffer from mental health problems. Alcohol consumption and suicide stemming from economic hardship, in particular, pose significant challenges[7]. Studies also find that economic uncertainty causes women to postpone childbearing[8], ultimately reducing fertility rates.

[1] https://www.fdrlibrary.org/great-depression-facts

[2] https://www.federalreservehistory.org/essays/great-recession-of-200709

[3] Knowles, James C.; Pernia, Ernesto M.; Racelis, Mary. 1999. Social Consequences of the Financial Crisis in Asia: The Deeper Crisis. © Asian Development Bank. http://hdl.handle.net/11540/2615. License: CC BY 3.0 IGO.

[4] https://www.reuters.com/article/us-venezuela-food-idUSKCN1G52HA

[5] https://blogs.imf.org/2018/03/21/the-economic-scars-of-crises-and-recessions/

[6] https://openknowledge.worldbank.org/bitstream/handle/10986/10206/537450BRI0EP70Box345626B01PUBLIC1.pdf?sequence=1&isAllowed=y

[7] https://www.euro.who.int/__data/assets/pdf_file/0008/134999/e94837.pdf

[8] https://scholars.unh.edu/cgi/viewcontent.cgi?article=1230&context=carsey

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