We are all impacted by the virus pandemic one way or another. I like to convince myself that things are not too bad. If we look from a bright side, at least more than 80% of people are still employed. However, many people are still not confident about the future. As a result, we hold on to our saving money. And, when consumers don’t spend their money, economic growth is slow. Would we end up in a lost decade like what happened in Japan in the 1990s?
Inflation, deflation and stagflation
Let start with some basic economic terms to lead to the answer to the above question. We all hear about these terms, but they are more important to understand than ever.
Inflation is a situation that overall prices of goods and services in an economy increase for a period of time. It results in a reduction of consumer’s purchasing power. In other words, inflation results in a loss of value of money. Inflation sounds bad, but there are situations that an economy needs to inject inflation to boost growth as well.
Deflation is the opposite of inflation. It is a situation when overall prices decline or when an economy has a negative inflation rate.
Stagflation is a situation when an economy experiences inflation (overall prices increase) and stagnation (low economic growth) at the same time. Under stagnation, we normally see a very high unemployment rate as a result.
There is another term called ‘disinflation’. It is a situation that the rate of inflation reduces. An economy still has inflation, but inflation increases at a decreasing rate. Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation.
What would happen after the virus crisis? It looks like we will experience the situation that oil price drops (lower cost, prices drop), lower purchasing power (due to unemployment), and slow economic growth. We could end up with stagnation as some goods, e.g. food still have high prices with stagnant economic growth. There are also some concerns now that the world’s economies could fall into long periods of deflation. If you remember a lost decade in Japan, it would be something like that. Due to uncertainties in the near future, consumers (myself included) save money rather than spending it. As a result, aggregate demand declines, prices decline.
The difference between recession and depression
There are more talks about the potential economic crisis followed the Covid-19 crisis. The fear is that we could end up with the second depression. I personally don’t believe (or hope we wouldn’t) reach that point. The worst case would hopefully be another recession.
What is the difference between recession and depression?
Recession is an economic situation that country’s gross domestic product (GDP) contracts for two or more consecutive quarters. There are other economic indicators, but this is a quick way to measure for recession. The major cause of a recession is a decline in consumer purchasing power. It could be because consumers lose confidence in economic prospect or because demand is sluggish.
Depression is something that is much more severe than a recession. It is an extended recession that an economy experiences years of economic contraction. In depression, you would see something like an unemployment rate reaches 25% or more, housing prices plummet 30%, and prices fall 10%.
We only experienced depression once in 1929. But, we had multiple recessions. The global financial crisis in 2008 was the worst recession we’d ever had until the Covid-19 pandemic arrived in March this year. I really hope we don’t go into the second depression after the virus crisis as all governments are very diligent with different economic measures. Let’s hope we could go through this challenging time and come out well.
We need inflation now!
When the economy is not running at capacity, meaning there is unused labour or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.
If price levels continue to drop, it is not good for the overall economy. What would happen is consumers tend to hold off their purchase to get the lowest prices possible. This situation could lead to reducing aggregate demand, leading to less production, layoffs, and a faltering economy.
An appropriate degree of inflation is also good for people who have to pay debts (which is most of us). Because the money is less valuable than when we borrowed, inflation encourages more leading transactions. As a result, there is more money floating in the economies, which lead to more production and more employment.
The lost decade in Japan
Many economists are now concerned that the world’s economies would experience a long period of economy sluggish like what happened to Japan between 1991 and 2001. GDP shrank, wages fell, and asset prices dropped or went sideways at best. These conditions are similar to what many economies in the world are about to experience now. If it happens, the good news is it will spread slowly. The bad news is it will end slowly, too.
Japanese lost decade had monetary root. The 1985 Plaza Accord drove the yen higher and inflated the asset bubble. The Bank of Japan tried to pop the bubble with a series of rate hikes beginning in 1989. Upon reaching 6% in 1992, the Bank of Japan (BOJ) began cutting rates and eventually reached zero a few years later. It reached the point that BOJ had to just give money away to boost the economy. Unfortunately, those activities had minimal effect. All the money went to businesses not because they had innovative, profit-generating ideas, but simply because they existed. That’s how you get zombie companies.
The result had been neither boom nor depression. Japan had its problems, but people didn’t have to stay in line to get help from the government. It’s a zombie-liked situation.
Will we enter the zombie-liked economy?
The Japanese lost decade is very well-known by policy-makers around the world. There are tons of analysis and ways to prevent the situation to happen. The US’s Fed chairman recently gave many signals that he wants to see inflation rate increases in the US. Many countries, such as Australia prepared fiscal budgets to drive growth in the months to come.
One of the key success factors to drive the inflation rate up is to ensure that consumers do spend money. It means consumers must feel confident about the future. If they don’t, they will hold on to their money which would drive saving up, and we may end up in the lost decade.