After a good few hours of reading it became apparent that trying to cover this in a single post would be a bit of a challenge. There are so many factors which would normally determine the fortunes of our economy.
Self-serving, irresponsible, Government policies and a lack of foresight within our Central Banks have led us to where we are today. Throw in a war in Ukraine and a global pandemic and it becomes a really messy picture. These are far from “normal” times.
In this post I’ll try to break the subject down in to its component parts to explain why the current outlook is somewhat gloomy. In addition, in case you were afraid to ask, a full explanation of all the terminology below can be found here.
The Big Picture – Boom & Bust
Our economy is constantly fluctuating between periods of growth and periods of decline. As we’ll explain below there are a number of factors that can affect this swing as well as the speed at which it happens.
Economic Growth (Boom)
If Central Banks want to maintain or boost economic growth, they lower interest rates to make saving less appealing and borrowing more affordable. At the same time they may also create more money through Quantitative Easing which allows businesses to invest, and consumers to borrow and spend more money.
Those who are lucky enough to have surplus cash (such as the commercial banks) may choose to invest. They generally tend to do well because the companies they invest in are also experiencing higher demand for their goods and services.
The result is that GDP and house prices rise, unemployment falls, and everyone feels better off. This continues until the economy “overheats” as we’ll see below.
Economic Contraction (Bust)
As demand for goods exceeds the capacity of businesses to create them, prices rise making those products less affordable. Employees demand higher wages to meet these costs.
Employers can’t avoid these wage rises as there is low unemployment and competition for skilled workers. The upward spiral continues with each driving the other.
At the same time, during times of economic growth and prosperity, households tend to over-borrow. As prices and the cost-of-living rise, they find it increasingly difficult to meet their repayments. As a result lending slows and borrowing becomes more difficult.
Increases in lending, inflation, low unemployment, and stalling growth are all signs that an economy is overheating.
At this point Governments and central banks tend to reverse their policies. Interest rates rise to discourage borrowing. Investment and spending are reduced, saving is encouraged. Debt repayments become much more expensive.
Consumers feel worse off and less optimistic about the future. Some may lose their jobs as businesses scale back their operations and try to streamline. Unemployment rises. Instability and economic decline accelerates.
Other Significant External Factors
Covid-19 was the first of these external factors to hit our economy. During 2020 growth plummeted by 9.7% in the UK as millions of us were told to stay at home. The government borrowed billions to help support those worst off.
Covid-19 continues to disrupt global supply chains, made worse by lockdowns in China which have affected around 370 million people.
In addition, the war in Ukraine has had a significant impact on the global economy. European countries have been hit by massive spending on support for refugees fleeing the conflict as well as an overall increase in defence spending.
The conflict has pushed inflation higher as the supply of commodities such as wheat, oil and gas have been restricted. This is set to get worse as winter draws ever closer due to our reliance on Russian energy.
So Where Does This Leave Us?
Inflation is at a 40 year high. Under normal circumstances the central banks would raise interest rates to slow down overall consumer demand and reduce borrowing and inflation. But as I said at the start, these are not normal times, right now the drivers of inflation are mostly external.
The problem is that the economy is already contracting even with low unemployment – because despite low unemployment we’re not very productive, possibly due to the fact that businesses have been artificially propped up by government handouts.
So central banks are in a bit of a pickle. If they raise interest rates the recession will more than likely be deeper and longer but if they don’t, inflation will more than likely remain high.
Meanwhile our governments are struggling to balance the books. Covid spending on support measures and poor fiscal policies have left them with huge debts, despite higher taxation. As the cost of living continues to rise politicians are facing increasing pressure to act but again, they have nowhere to go.
If they choose to reduce taxes to help alleviate the cost-of-living crisis, the effect would be increased inflation as consumers and households have the ability to spend more. The central bank will then need to increase interest rates to control inflation.
Who knows where this will lead? A global and long-lasting recession has been forecast. One thing is for sure, we are in for some difficult times ahead.
If you’d like to find out how to protect yourself from the effects of a recession check out our related posts on preparing yourself, diversifying your income and saving money. Also, as I mentioned above a full explanation of the above terminology can be found here.
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