Economic Scenario 3: Depression
This third and last economic scenario is the one of an economic depression. Contrary to a recession, the timeline for a depression is at least several years. It takes this much time of continuous economic contraction until the lowest point is reached and the situation starts to get better. Furthermore a depression is characterized by high unemployment that can be as high as 25% and the passing of many new political programs. For example during the last depression in the US, Franklin D. Roosevelt passed a series of programs, summed up under the term New Deal.
How could a depression play out?
During a Deflation prices are falling. In a deflationary environment consumers and businesses alike, anticipating prices falling further, bring their spending to a minimum. They prefer holding on to cash, because the same amount can buy more later on. The reason why Deflation is so dangerous is that it can quickly lead to a vicious cycle. Whereas the first decline in prices can be caused by an exogenous shock, consumers and businesses holding on to their cash cause further declining prices even though the shock is already absorbed. Now that prices declined further consumers and businesses will hold on to cash even more and so the vicious cycle ensues. Ultimately this behavior can bring the entire economy to a halt and it will be very difficult to get going again. The Great Depression of the 1930s is an example of an economic depression that was caused by deflation. During this crisis deflation was caused by a collapsing financial sector and bank failures, which ultimately resulted in a depression.
There are many examples in history, where economic depression goes hand in hand with (hyper-)inflation. Countries experiencing hyperinflation in present times that come to mind are Zimbabwe and Venezuela. The example I want to discuss further is Germany (Weimarer Republik) in 1923. After the end of World War 1 Germany had to pay massive reparations. Because the entire economy was destroyed and the state was completely broke, the central bank (Reichsbank) had to print large amounts of money. This increase in the supply of money, while at the same time the amount of goods produced was very low, caused one of the biggest hyperinflations ever recorded in a western nation. On June 9th 1923 1$ was equal to 100.000 Reichsmark. Six months later on December 2nd 1$ equaled 4.21 Trillion Reichsmark.¹ Finally there was a monetary reform and a new stabilized currency. The consequence was, that anything people owned in cash or cash equivalents became worthless.
3. Deflation then Inflation
A further possibility is a depression, that is caused by a combination of deflation and inflation. In such a scenario an exogenous shock would lead to deflation and a collapsing economy. States intervening by printing money in order to stop deflation could then lead to massive inflation in the end.