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What Is an Economic Depression?

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economic depression

The Great Depression of 1929 is the best example of an economic depression.

Photo: Dorothea Lange/Library of Congress,FSA-OWI Collection
Question: What Is an Economic Depression?
Many people worry that the world could experience another economic depression. However, once you understand the severity of a real depression, you will see we have come nowhere near that in recent years.
Answer: An economic depression is a severe downturn that lasts several years. Fortunately, the U.S. economy has not experienced an economic depression since The Great Depression of 1929, which lasted ten years. The decline in the GDP growth rates were of a magnitude not seen since:
  • 1930 -8.6%
  • 1931 -6.5%
  • 1932 -13.1%
  • 1933 -1.3%.
  • 1938 -3.4%
During the Depression, the unemployment rate was 25% and wages (for those who still had jobs) fell 42%. Total U.S. economic output fell from $103 billion to $55 billion and world trade plummeted 65% as measured in dollars.

How does that compare to other recessions since then? During the financial crisis of 2008, economic growth plummeted, but nowhere nearly as bad as during 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. In 2008, the economy contracted .3%, and in 2009 it shrank 3.5%. (For details, see GDP Statistics.)

The 2001 recession had some bad quarters, but no years that were negative. In 1991, the economy contracted .2%. The 1980-1982 recession saw two negative years: 1980 was down .3%, and 1982 was down 1.2%. During the 1973-1975 recession, the economy contracted .6% in 1974, and .2% in 1975.

In fact, the closest the country has come to a depression was right after World War II, when economic engines readjusted poorly to peace-time production:

  • 1945 -1.1%
  • 1946 -10.9%
  • 1947 - .9%
  • 1949 -.5%

What Creates an Economic Depression?

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. However, 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%. This created massive deflation, where prices dropped 10% each year. As people expected lower prices, they delayed purchases. Real estate prices plummeted 25%, and people lost their homes.

Once the downward spiral of an economic depression takes hold, it is extremely difficult 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, so rebuilding for the war effort meant jobs because new capacity had to be built.

Why a Depression Won't Happen Again

An economic depression on the scale of that in 1929 could not happen exactly the way it did before. Many laws and government agencies were put in place because of The Great Depression with the express purpose of preventing that type of cataclysmic economic pain. Central banks around the world, including the Federal Reserve, are so much more aware of the importance of expansive monetary policy in stimulating the economy. 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 global financial system. This also restored confidence among panicked bankers, who were unwilling to lend to each other for fear of taking on each others' subprime mortgages as collateral.

To prevent the deflation associated with a global depression, the Fed has adopted a policy of inflation rate targeting. In fact, the Fed will continue expansive monetary policy to keep the core inflation rate at 2%.

However, there is only so much monetary policy can do without fiscal policy. In 2009, the economic stimulus bill helped prevent an economic depression by stimulating the economy. However, the incredible size of the national debt limits further government spending to stimulate the economy. Working together, monetary and fiscal policy can prevent another global depression. Article Updated March 7, 2012

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