Are we heading into an economic depression?

During this time of uncertainty, when businesses are failing and people are losing jobs, it is not hard to imagine that the economic damage caused by this crisis could lead to more losses in the future.

Such losses, which might send the economy to a dee­per crisis, can be caused by overborrowing and deflation.

In the early 1930s, an American economist by the name of Irving Fisher suggested that an economy can fall into depression, when overleveraged companies and consumers try to liquidate their debts by selling their assets.

Fisher, who developed the theory of debt deflation, after losing a fortune in the stock market during the Great Depression, explained that, in tough economic times, when borrowers sell their assets in distress, prices in general also tend to fall.

This happens because, when bank loans are paid off, there is also a contraction in deposit currency, which slows down the velocity of money in circulation.

A slowing economy intensified by lower velocity of money means lower sales for businesses. Excess inventories resulting from this contraction will prompt businesses to cut their prices.

When prices fall, as we see in deflation, the market value of assets also falls. At this point, borrowers that try to liquidate their assets to pay off remaining debts will not be able to keep up.

This is because the value of debt will remain fixed in amount, amid declining value of assets. The more the debtors pay, the lower the value of their assets becomes and the more debt they owe in real value.

Falling prices will also mean lower profits, if not losses, for many companies who will be forced to either close or downsize and lay off workers.

The rise in bankruptcies and unemployment will result in loss of confidence and heightened anxiety that will encourage people to hoard cash and delay spending.

When that happens, aggregate demand will collapse and more businesses will fold up, leading to even more layoffs.

While liquidation of debt will only make depression worse, Fisher suggested that deflation can be prevented through government stimulus spending, which is already happening now.

By increasing money supply and lowering interest rates along with infrastructure spending, government hopes to promote consumption in the private sector and increase investment.

This view is consistent with the Quantity Theory of Money, which states that when money supply is multiplied by the number of times money changed hands, which is velocity, one can derive the nominal GDP (gross domestic product).

By following this theory, an increase in money supply should translate to an increase in spen­ding, but given the ongoing coronavirus crisis, such an increase in money supply may not necessa­rily increase demand.

Because people are encouraged to stay home and most retail outlets are closed, the rate at which money is exchanged will slow down.

With rising uncertainties in the economy, consumers would rather save than spend, while businesses would use their income to pay off their debts than invest.

Using the same equation, an increase in money supply multiplied by lower velocity may not achieve the desired increase in economic output.

For example, the money supply under M2 increased by 12.7 percent for the first three months of the year compared to last year, but because velocity fell by 5.6 percent from outbreak of the virus, GDP in constant terms fell by 0.7 percent.

In the second quarter, money supply again increased by 14.3 percent, but mandatory lockdowns decreased velocity by 10.7 percent, causing real GDP to fall by 16.5 percent.

In the past, we also had similar situations where velocity also slowed down while money supply increased, but real GDP has always managed to grow because consumer confidence was high, and businesses were optimistic about growth.

But today, the situation is different where pessimism, fear and frustrations dominate our social mood.

Perhaps, reflating the economy by expanding money supply will be more effective if the current pandemic is already over, but for now, with the economy falling, we should prepare for the inevitable risk of deflation. INQ

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 85th batch of RFP Program this September 2020. To register, e-mail [email protected] or text at 09176248110