What Is an Economic Depression?

What Causes It, Why It Won't Happen Again.

Depression soup
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Definition: An economic depression is a severe downturn that lasts several years. 

Fortunately, the U.S. economy has only experienced one economic depression. That's the Great Depression of 1929. It lasted ten years. The decline in the GDP growth rates were of a magnitude not seen since:

  • 1930   -8.6 percent
  • 1931   -6.5 percent
  • 1932 -13.1 percent
  • 1933   -1.3 percent
  • 1938   -3.4 percent

During the Depression, the unemployment rate was 25 percent.

Wages fell 42 percent. Total U.S. economic output fell from $103 billion to $55 billion. World trade plummeted 65 percent as measured in dollars. For more, see Effects of the Great Depression

How does that compare to recessions since then? During the financial crisis of 2008, economic growth plummeted. But it never came close to the severity of the Great Depression. Although there were some steep downturns during a few quarters, the were no years where the economy contracted as severely as in the Great Depression. In 2008, the economy contracted 0.3 percent. In 2009 it shrank 3.5 percent. (For details, see GDP Statistics.)

The 2001 recession had some bad quarters, but no years that were negative. In 1991, the economy contracted 0.2 percent. The 1980-82 recession saw two negative years: 1980 was down 0.3 percent, and 1982 was down 1.2 percent. During the 1973-75 recession, the economy contracted 0.6 percent in 1974 and 0.2 percent in 1975.

In fact, the closest the country has come to a depression was right after World War II, when economic engines struggled to readjust to peacetime production:

  • 1945   -1.1 percent
  • 1946 -10.9 percent
  • 1947   -0.9 percent
  • 1949   -0.5 percent

Causes

An economic depression is so cataclysmic, it almost takes a perfect storm of events to create one.

In fact, many experts say that the Depression was aggravated by contractionary monetary policy. 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 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 30 percent. This created massive deflation, where prices dropped 10 percent each year. As people expected lower prices, they delayed purchases. Real estate prices plummeted 25 percent. People lost their homes. For more, see Great Depression Timeline.

Once the downward spiral of an economic depression takes hold, it is hard to stop. The "New Deal" created many government programs to end the Depression, but government programs alone couldn't do the trick. Unemployment remained in the double-digits until 1941, when the U.S. entry into World War II created defense-related jobs. Production capacity had declined during the Depression decade. Rebuilding for the war effort meant lots of job creation. That's because new capacity had to be built. 

Prevention

Many people worry that the world could experience another economic depression.

As long as you understand the severity of a real depression, you will see we have come nowhere close in recent years.

First, a depression on the scale of 1929 could not happen exactly the way it did before. Many 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.

Second, 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. In fact, central banks did act in a coordinated fashion to prevent a depression in October 2008 by bailing out banks. They lowered interest rates, pumping credit and liquidity into the global financial system. This 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.

Third, the Fed has 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 to keep the core inflation rate at 2 percent.

There is only so much monetary policy can do without fiscal policy. In 2009, the economic stimulus bill helped prevent a depression by stimulating the economy. But the incredible size of the national debt limits further government spending. Working together, monetary and fiscal policy can prevent another global depression. For more, see Could the Great Depression Happen Again?

 

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