Stock market declines can caused depressions by making it difficult for companies to raise the needed funds to grow. (See Could Stock Market Decline Cause a Recession?)
Lower housing prices and resultant foreclosures have already totaled over $1 trillion in losses to banks, hedge funds and other owners of subprime mortgages on the secondary market. Since the amount of losses is really unknown, the extent of the damage is also unknown, potentially triggering a depression.
Business credit is needed for banks to make loans to businesses so they can continue to run on a daily basis. Without credit, some businesses have been forced to shut down, raising unemployment.
Bank near-failures frightened depositors into taking out their cash. Although the FDIC insures these deposits, many are concerned that this agency will also run out of money. Commercial banks depend on consumer deposits to fund their day-to-day business, as well as make loans.
High oil prices signal to many people the end of cheap oil, which has been the foundation of the fast-growing global economy. Others are concerned that current low prices are signaling a global recession that could lead to depression.
Stock price declines haven't exceeded 11% in one day, and 30% in a year. The kick-off to the Depression was Black Tuesday. By the stock market's close on that day, the Dow had fallen 30% in just one week.
Housing prices and foreclosures panicked banks, which tightened credit, causing the recession. The Federal Reserve has taken extraordinary measures to restore credit to give the housing market a chance to recover. However, housing sales are still glutted with foreclosures.
Business credit has been affected the most. The world's central banks have pumped in much of the liquidity needed. In effect, they have replaced the financial system itself.
Monetary policy caused the Great Depression of 1929. According to Federal Reserve Chairman Ben Bernanke, the Great Depression was actually caused by the contractionary monetary policies of the Fed. During the U.S. recession in the summer of 1929, the Fed decreased the money supply by 30%. It raised the Fed Funds rate to defend the value of the dollar. Without liquidity, banks collapsed, forcing people to remove all funds and stuff them under the mattress, causing economic collapse. Only the advent of World War II got the economy going again.
This time the Fed is keeping needed liquidity in the system through using innovative tools like the Term Auction Facility. In addition, the FDIC insures deposits. Finally, the government is seizing banks before they go bankrupt, and then reselling them to more profitable banks. This often happens on a Friday, so that depositors notice little difference.(Source: Source: The Federal Reserve Board web site, " Remarks by Governor Ben Bernanke at the H. Parket Willis Lecture in Economic Policy", March 2, 2004; Federal Intervention in the Mortgage Crisis)
Oil prices at $85 per barrel translate into gas prices that are still less than half of what Europeans pay, thanks to heavy gas taxes. (See Forecast of Crude Oil Prices - Interview with Gavin Longmuir) Furthermore, OPEC prefers to keep the price of oil under $100 per barrel to keep others from exploring their own oil reserves and developing alternative fuels. Lower demand for oil, and lower oil prices, has removed this summer's inflationary pressure. This allowed the Fed to lower the Fed Funds rate to zero, which helps stimulate the economy and avoid a depression.
Outcome
The U.S. economy has been living on borrowed money for a long time, and the economy is experiencing the unwinding of that excess currently. However, it probably won't be enough to disarm the global economy's growth, so a worldwide depression is unlikely. It could trigger a global recession in 2008 or 2009. Although the U.S. economy may see another quarter of negative GDP growth, the global economy may not even slow that much, thanks to growth in China and other emerging markets. (See Not With A Bang but a Whimper)The best course of action is to cut down on your own credit, rebalance your retirement portfolio to be more defensive, and make sure you are living within a balanced budget.
