Inflation has been affecting the economy globally since the beginning of 2022, mainly caused by the global supply chain disruption in China due to Covid. The rise in oil prices because of Russia’s invasion of Ukraine also contributed to this situation. The US reported an annual inflation rate of 8.3% in April, which has been unseen since the 1980s. Correspondingly, the UK economy shows a higher inflation rate at 9%. Meanwhile, 6% and 6.9% for Australia and New Zealand, respectively.
On 19th May 2022, the New Zealand government released its $6.0 billion budget plan for 2022, which includes a 1.0 billion package for the cost of living in the country. So, what the NZ government can do about this inflation crisis? Unfortunately, the answer is not so much.
When we talk about inflation, we always assume that the cause is from the demand side, that the supply cannot meet the increasing demand. Usually, in a demand-pull inflation scenario, the inflation would happen gradually because people’s confidence in the market and their willingness and power to consume more goods do not happen overnight. However, the inflation caused by supply happened so fast and has caught New Zealanders off-guard. New Zealand was just ready to open its border to welcome international travellers. People and businesses were thrilled to welcome the pre-COVID prosperity in NZ’s economy. So now, what kind of situation are we facing?
The NZ government's first thing to mitigate inflation was an interest rate increase. Today, the 1-year fixed-rate goes up to 4.8% compared to the interest rate of 3% in 2020. What does it mean? Increasing interest rate is a typical counteract to inflation. This method encourages saving and reduces household spending. In the meantime, because the cost of capital also increases along with the interest rise from the reserve bank, investments become less attractive to investors.
Consequently, companies become less profitable due to the decrease in customer demand. Another effective way to mitigate inflation is to increase taxes. But this tool remains untouched because the cost of living in New Zealand is already high.
So, what's the impact on us? And what should we do? For high-income households, inflation is just a fraction of their everyday spending. There will be some impact, but nothing critical. But for low and mid-income families, they have to live on the edge, cutting down their weekly expenditure or even looking for additional income sources. The current tax-cut policy on petrol and half-priced public transportation could lift some pressure on most households, but low and mid-income families have to rely on their own. The cost of living package is more like a psychological placebo because government need to be conscious that this package does not worsen the inflation practically.
Most likely, large organisations won't be as profitable as they did before. But thanks to strong financial capability and network effect, large organisations will still be doing just okay to capture their market share. The downside is that those investment projects that look profitable before won't be that attractive. In other words, businesses tend to postpone their innovation or investment projects when facing a volatile economy.
Inflation hits the hardest for small businesses. According to Stats NZ, defined as those with fewer than 20 employees, there are approximately 530,000 small businesses in New Zealand, representing 97% of all firms. Facing the decrease in consumer demands, small businesses cannot compete with more dominant competitors. In the meantime, fixed-cost makes up a significant portion of the total cost, which means that they are less flexible in cost-saving in a volatile economy. Most importantly, under the current situation, small businesses are more likely to be risk-seeking to survive. Consider these two problems:
Problem 1: Which do you choose?
Get $900 for sure OR 90% chance to get $1,000
Problem 2: Which do you choose?
Lose $900 for sure OR 90% chance to lose $1,000
In problem 1, most individuals choose to take the $900 for sure. In problem 2, most people choose the gamble in this question. Based on the prospect theory introduced by Daniel and Amos (1979), in mixed gambles, where both a gain and a loss are possible, loss-aversion causes extremely risk-averse choices. However, in bad choices, where a sure loss is compared to a larger loss that is merely probable, diminishing sensitivity causes risk-seeking.
Therefore, most households and large businesses are facing the problem 1. But for small businesses in this economic stage, they face the problem 2. The two problems sound a bit extreme, but I hope you can understand the underlined psychological message. That’s also why the gambling industry becomes more robust in a volatile economy. So, what would you do if you were a small business owner? Would you cut down the cost as much as possible, although a negative net profit will still happen? Or would you spend even more money on sales and marketing to find a slim chance of survival?
There are no right or wrong answers. But certainly, it is a challenging decision for small business owners to make. I am sure that some small businesses will survive this inflation crisis. Each crisis is an opportunity for creative disruption. This brutal environment will oust less sustainable businesses, and businesses with more sustainability will become stronger after the crisis. We will find out.
Kun
Book to read: "Thinking, Fast and Slow" ------ Daniel Kahneman