Economic Instability
Why we have booms and busts
This article is useful to read for those who are unsure about why we have economic stability.
Economic cycle -> there are natural fluctuations around the trend which is to be expected. But large or frequent fluctuations are not good for an economy. It is better for the economy’s short-run growth to mimic the trend rate.
Economic Cycle - A Boom and Bust Economy
Demand and Supply-Side shocks
Demand-side shocks -> anything that causes AD to significantly change e.g. housing market boom, world recession
Supply-side shock -> anything that causes AS to significantly change e.g. war, poor harvest, natural disaster, discovery of new resources
Economic cycle -> there are natural fluctuations around the trend which is to be expected. But large or frequent fluctuations are not good for an economy. It is better for the economy’s short-run growth to mimic the trend rate.
Animal Spirits
Keynes coined the term ‘animal spirits’ to reflect the actions of human beings. People seem to act irrationally in real life which is why the economy can fluctuate so much. It explains why there are periods of economic instability, which seems to be guided by peoples' instincts and emotions, causing them to act irrationally.
Example from recent times: Bank run on Northern Rock -> some bad news caused account holders to rush to the banks and close their accounts. This by experts as being irrational behaviour as Northern Rock were not in as much trouble as was made out. The irrational actions by human beings was actually the cause of the bank failing.
Speculative Bubbles
People buy assets in the hope that they can sell them at a later stage for a profit e.g. buy a house today and in 10 years’ time it could be worth double. This is called speculative buying.
Speculative bubbles are sometimes the cause of economic instability. There is a ‘herding effect’ which describes the actions of people who all want a piece of the action (why so many people invest their money in housing). They think that because everybody is doing it, it must be a safe bet. An example is the housing market bubble leading up to 2008 and the stock market bubble which was responsible for the Great Depression in 1929.
The reason for a speculative bubble bursting -> people believe their assets will continue to rise in value forever (forever as long as they own them). But the problem is there is a true value of everything and if the market price exceeds the true value of the asset, then the market price will have to return to its true value eventually.
Example: People buy houses expecting them to increase at a faster rate than inflation, therefore it must be a good thing to buy. More and more people adopt this financial strategy (herding) causing a bubble. It causes the price of houses to increase due to the increased demand. There comes a point where demand is growing too fast and prices increase beyond the point of their asset’s true value. Eventually, the bubble bursts – the price of housing may start to fall and it triggers off ‘panic selling’ which is an example of animal spirits taking control again.
The economy is pretty much bipolar! - and it's just because of the people within it and their mindsets.
Accumulation of Debt
When credit is cheap people can acquire too much and they start to buy everything on credit. “Oh let’s just book that fancy holiday. The interest rate is 0%, it’s fine – we’ll just pay it back!”
However, there comes a point where the debt has to be paid back and the more debt people accumulate, the harder it is to pay back. Because credit becomes cheap it doesn’t mean you must over-borrow.
[It’s kind of like buying bargains in the store. Just because there is a sale on, doesn’t mean you have to buy the whole shop. Chances are you spent more than what you would have on things you don’t really like and end up regretting it.]
Secondly, the more debt accumulated causes inflationary pressure to rise due to the increased demand. It places pressure on the Central Bank to increase interest rates, which raises the cost of loans. This causes people to panic and stop ANY spending in the fear they won’t be able to pay their loans back. This causes damage to the economy as spending suddenly falls.
Sustainable Growth
This is the ultimate objective as far as economic growth is concerned. Sustainable growth means the economy continues to grow in the future without causing problems for the future generations. To achieve this, countries must:
1) Ensure output increases each year
2) Ensure a continuous supply of raw materials, so production can continue
3) Ensure a continuously growing demand for the products the country is selling
4) Ensure externalities are being internalised
If a country achieves all of the above, then they have achieved sustainable growth. If not, then growth will fall in the future and damage to the environment may cause welfare problems that we need to deal with. One of the biggest economic issues of the future is how the world will deal with global warming. To deal with global warming, we must act now in a pre-emptive way. Things like switching from non-renewable energy to renewable, carbon neutral energy will solve many environmental problems (environmental degradation) and also more greatly ensure the economy’s continued supply of resources to allow future growth.
What have we learned?
How economic instability occurs
Animal spirits
Sustainable growth and how it is achieved
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