Economic Depression, Its Causes, and How to Prevent It
Understanding a Depression's Causes Helped the U.S. Avoid One in 2008
An economic depression is a severe downturn that lasts several years. Fortunately, the world has only experienced one economic depression. That was the Great Depression which lasted for 10 years. The decline in the gross domestic product growth rate was bigger than anything experienced since then:
- 1930: -8.5%
- 1931: -6.4%
- 1932: -12.9%
- 1933: -1.2%
- 1938: -3.3%
U.S. economic output fell from $1.1 trillion in 1929 to $817 billion in 1933, even after removing the effects of deflation. Prices fell 27% between November 1929 and March 1933. World trade plummeted 66%, as measured in dollars, between 1929 and 1934.
By 1933, the unemployment rate had climbed to 24.7%. For those who remained employed, manufacturing wages fell 34% between 1929 and 1932.
- An economic depression is an extremely severe, long-term contraction in economic activity.
- In a depression, GDP annual falls more than 5% and unemployment is in the double digits.
- The 10-year Great Depression was the world's only depression.
How a Depression Compares to Past Recessions
What differentiates a recession from a depression? A depression is longer and it more severe. In a recession, the economy contracts for two or more quarters. In a depression, it contracts severely for two or more years. Here are some comparisons of the Great Depression with recent recessions.
- The Great Depression suffered five years when the economy contracted. Three of them contracted more than 5%.
- During the 2008 recession, the economy contracted 0.1% in 2008. and 2.5% in 2009.
- The 2001 recession had some bad quarters but no years that were negative.
- In the 1980s recession, 1980 was down 0.3% and 1982 was down 1.8%.
- In the 1970s recession, the economy contracted 0.5% in 1974 and 0.2% in 1975.
The closest America came to a second depression was right after World War II.
After the war, the country suffered two recessions. Only one year, 1946, was as bad as a contraction as occurred in the Great Depression. Economic engines struggled to readjust to peacetime production. The economy contracted the following four years out of five:
- 1945: -1.0%
- 1946: -11.6%
- 1947: -1.1%
- 1948: +4.1%
- 1949: -0.6%
An economic depression is so cataclysmic that it takes a perfect storm of negative events to create one. Many experts say that contractionary monetary policy aggravated the Depression.
The Federal Reserve rightly sought to slow down the stock market bubble in the late 1920s. But once the stock market crashed, the Fed kept wrongly raising interest rates to defend the gold standard. Instead of pumping money into the economy and increasing the money supply, the Fed allowed the money supply to fall 33%.
The Fed's actions created massive deflation, where prices dropped 10% each year. As people expected lower prices, they delayed purchases. Real estate prices fell by a third. People lost their homes. The Great Depression began in August 1929 and didn't end until June 1938.
But in 1936, Congress decided it was more important to balance the budget, and began raising taxes. The Depression returned in 1937, sending unemployment into the double digits until 1941. The U.S. entry into World War II created defense-related jobs. Since production capacity had declined during the Depression decade, new capacity had to be built.
Preventing Another Depression
Many people worry that the world could experience another economic depression. There are four reasons why a depression on the scale of 1929 could not happen exactly the way it did before.
The New Deal
Many New Deal laws and government agencies were put in place because of the Great Depression. Their express purpose was to prevent any more of that type of cataclysmic economic pain. For example, the Federal Deposit Insurance Corporation guarantees bank deposits. That restores depositor confidence and prevents future bank runs.
Central Bank System
Central banks around the world, including the Federal Reserve, are so much more aware of the importance of stimulating the economy with expansive monetary policy.
Central banks acted in a coordinated fashion to prevent a depression in October 2008 by bailing out banks. They lowered interest rates, pumping credit into the global financial system. It also restored confidence among panicked bankers, who were unwilling to lend to each other for fear of taking on each other’s subprime mortgages as collateral.
Inflation Rate Targeting
The Fed adopted a policy of inflation rate targeting to prevent the deflation associated with a global depression. As a result, the Fed will continue expansive monetary policy ward off deflation.
Fiscal Policy Working With Monetary Policy
There is only so much that monetary policy can do without fiscal policy. In March 2020, Congress passed the $2 trillion Coronavirus Aid, Relief, and Economic Security Act. In 2009, the economic stimulus bill helped prevent a depression by stimulating the economy. Working together, monetary and fiscal policy can prevent another global depression. It is highly unlikely that the Great Depression could happen again.