Economic Depression, Its Causes, and How to Prevent It

Understanding a Depression's Causes Helped the U.S. Avoid One in 2008

economic depression
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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 10 years. According to the Bureau of Economic Analysis, the decline in the gross domestic product growth rates were of a magnitude not seen since:

  • 1930 -8.6 percent
  • 1931 -6.4 percent
  • 1932 -12.9 percent
  • 1933 -1.2 percent
  • 1938 -3.3 percent

During the Depression, the unemployment rate dropped to 24.9 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. That was partly because of deflation. The Consumer Price Index fell 27 percent between November 1929 to March 1933, according to the Bureau of Labor Statistics. The effects of the Great Depression may still be felt today. 

How does that compare to past recessions? 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, there were no years where the economy contracted as severely as in the Great Depression. According to GDP annual statistics, the economy contracted 0.1 percent in 2008. In 2009, it shrank 2.5 percent. The lengths and severity of economic contractions differentiate a recession from a depression.

The 2001 recession had some bad quarters, but no years that were negative. In 1991, the economy contracted 0.1 percent. The 1980 to 1982 recession saw two negative years: 1980 was down 0.3 percent, and 1982 was down 1.8 percent. During the 1973 to 1975 recession, the economy contracted 0.5 percent in 1974 and 0.2 percent in 1975.

In fact, the closest the country came to a depression was right after World War II. Economic engines struggled to readjust to peacetime production. The economy contracted four years in a row.

  • 1945 -1.0 percent
  • 1946 -11.6 percent
  • 1947 -1.1 percent
  • 1949 -0.6 percent

Causes

An economic depression is so cataclysmic, it almost takes a perfect storm of negative events to create one. In fact, 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 30 percent.

The Fed's actions 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. The Great Depression timeline began in August 1929 and didn't end until June 1938.

Once the downward spiral of an economic depression takes hold, it's hard to stop. The 1933 "New Deal" created many government programs that briefly ended the Depression. But in 1936 Congress forced President Roosevelt to balance the budget and raise 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. 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 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 that 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. It is highly unlikely that the Great Depression could happen again.