Contents
Economic depression, a severe and prolonged downturn in economic activity, stands as one of the most disruptive forces impacting nations and individuals alike. Far exceeding a typical recession, depressions trigger widespread unemployment, plunging stock markets, and a significant decline in overall production. Understanding the causes, effects, and potential solutions surrounding economic depression empowers students of economics, investors, and anyone interested in economic trends to navigate these challenging periods.
Understanding economic depression
An economic depression is a prolonged period of decline in economic activity. It isn’t just a more intense version of a recession; it’s a whole different beast. While a recession signifies a temporary downturn in economic activity, typically lasting up to three quarters and marked by a decline in Gross Domestic Product (GDP), a depression is far more severe and prolonged.
Here’s what separates the two:
- Depth of decline: During a depression, real GDP, which measures the value of goods and services produced in a country after adjusting for inflation, plunges by more than 10%. This stands in stark contrast to a recession, where GDP decline is usually milder.
- Duration: Depressions drag on for years, often exceeding three years. Recessions, on the other hand, are generally shorter, lasting up to three-quarters.
The Great Depression of the 1930s is a prime example. It lasted for a decade and witnessed a real GDP decline exceeding 25%. This prolonged economic downturn had devastating consequences, causing widespread unemployment, poverty, and social unrest.
Historical examples
While economic depressions are thankfully rare occurrences, their impact can be devastating. Though some economists theorize they might follow long cycles of around 50 years, the reality is depressions can erupt at various points in history.
The most infamous example is undoubtedly the Great Depression of the 1930s, a decade-long economic catastrophe that began with the Wall Street crash of 1929 and rippled across the globe. Previous depressions occurred in the periods 1873-96, 1844–51, and 1810–17. Previous depressions occurred in the periods 1873-96, 1844–51, and 1810–17.
- The Great Depression (1930s): This defining moment in economic history witnessed a real GDP decline exceeding 25% and lasted for a decade. Triggered by the Wall Street crash of 1929, the depression’s effects rippled across the globe, causing widespread unemployment, poverty, and social unrest.
- The Great Recession (2007-2009): More recent memory offers the Great Recession, a severe economic downturn that began with the collapse of the housing market in the United States. While not as prolonged or severe as the Great Depression, it still caused significant economic hardship, with unemployment rates reaching nearly 10%.
Causes of economic depression
Economic depressions erupt from a complex interplay of factors. Let’s explore two prominent theories and additional contributors:
The Keynesian perspective: A demand downturn
John Maynard Keynes, a prominent economist, argued that a sharp decline in aggregate demand, the total amount of goods and services consumers, businesses, and governments purchase, can trigger a depression. This decline can stem from several sources:
- Reduced household spending: Consumers, worried about job security or facing declining wages, may tighten their belts and spend less. This decrease in spending ripples through the economy, impacting businesses.
- Shrinking business investment: When economic prospects appear bleak, businesses become hesitant to invest in new equipment or expand operations. This translates to lower production and fewer jobs.
- Net exports slump: If global economic conditions deteriorate, a country might see a decline in its exports while imports remain steady. This widens the trade deficit and weakens the overall economy.
These factors can create a vicious economic cycle. Falling demand leads to production cuts and layoffs, further reducing consumer spending and deepening the economic downturn.
The Monetarism perspective: A money squeeze
Milton Friedman and other monetarists believed that a significant decrease in the money supply can play a crucial role in causing depression. Here’s the chain reaction:
- Higher interest rates: When the money supply shrinks, banks have less money to lend. This drives interest rates up, making borrowing more expensive.
- Loan defaults and credit crunch: Businesses and individuals struggling to repay existing loans due to higher interest rates may default. This discourages banks from lending further, hindering access to credit and stifling investment.
- Business investment decline: With limited access to credit and a cautious economic outlook, businesses are less likely to invest in expansion, further dampening economic activity.
Other contributing factors: the perfect storm
While the Keynesian and Monetarism perspectives offer valuable insights, other factors can contribute to economic depressions:
Falling prices and real estate sales
The real estate market crash started the major recession of 2008-2009, although it did not lead to depression.
When speculative activity increases the market price of real estate, construction activity increases, as do construction costs. Investors also experience euphoria.
The price bubble continues to the point where prices are well above their fair value. The price cannot go up again because it is no longer reasonable, and demand is more limited.
Finally, the bubbles burst. Prices suddenly fell. Real estate developers’ cash flow deteriorated, and they took on surging construction costs. As a result, the default increased.
The increase in default also occurred among real estate investors. Because they are expensive, they usually apply for loans to buy real estate. Previously, when the price went up, they still profited from the difference between the selling price and the borrowing cost, so there was no problem paying for the loan. But, when prices fall, they cannot sell at a profit, increasing their failure to repay the loan.
Stock market crash
Speculation in the stock market also creates price bubbles, as during the dot-com bubble in the late 1990s or the Great Depression in the 1930s. Share prices skyrocketed due to speculation and excessive euphoria. Then, suddenly, the price fell, causing panic.
The panic spread because most of the people’s savings went to the stock market. A drop in share prices means their money is evaporating instantly. They spend less on goods and services because they have less money (wealth effect). That ended up causing many businesses to cut their output.
The weakening demand further squeezed the company’s cash flow. Businesses fail to pay off debts.
Credit tightening
A depreciation in the money supply makes cheap money scarce. Financial market liquidity is tightening, pushing interest rates up. The central bank didn’t immediately inject money into the economy, making the situation even worse.
In the Great Depression, for example, the Federal Reserve could not stop the depreciation of the money supply because loans had to be backed up with gold. The Federal Reserve Act requires 40% gold support from the Federal Reserve Notes issued. That kept the Federal Reserve from responding immediately to a decline in the money supply.
Drought liquidity and sluggish demand due to the stock market crash exacerbated the economic situation. The default rate increased. The case created panic in the financial system and quickly spread to the economy.
Effects of economic depression
Economic depression casts a long shadow, impacting not just the economy itself but also the lives of everyday people. Its effects ripple outwards, creating a global crisis. Let’s delve deeper into the specific consequences:
Cratering economic activity
Real GDP decline: The overall production of goods and services (GDP) plummets, often exceeding 10% as witnessed during the Great Depression. This decline can drag on for years, hindering economic growth and causing a ripple effect throughout the economy, impacting businesses of all sizes and industries.
Industrial downturn: Businesses face sluggish demand, forcing them to cut back on production and investment. This decline in industrial output weakens the entire economy, leading to factory closures, idle machinery, and a decrease in tax revenue for governments.
B. Mass unemployment and declining wages
Job losses: Businesses struggling to stay afloat resort to layoffs, leading to a surge in unemployment. Workers face financial insecurity, anxiety, and a loss of sense of purpose.
Wage stagnation: With a surplus of labor, wages fall as companies have more leverage in negotiations. This puts further strain on household finances, reducing disposable income and limiting consumer spending.
Eroded consumer confidence and purchasing power
Consumer pessimism: Unemployment and economic instability breed pessimism among consumers, leading them to cut back on spending. This further weakens aggregate demand, creating a vicious cycle as businesses see declining sales and are forced to make even deeper cuts.
Reduced purchasing power: Job losses and stagnant wages erode individuals’ purchasing power, limiting their ability to buy goods and services. This can lead to delayed major purchases like homes or cars, and a shift towards buying only essential items.
Deflation and Reduced investment
Falling prices: Deflation sets in as demand weakens, pushing prices down across the economy. While it may seem beneficial at first, deflation discourages spending as consumers wait for prices to drop further, hindering economic recovery.
Investment slump: Businesses hesitant to invest due to bleak economic prospects further dampen demand for capital goods. This stagnation in investment stifles innovation and slows down long-term economic growth.
Financial crisis and debt burden
Shrinking credit availability: Banks become wary of lending due to the high risk of defaults, making it harder for businesses and individuals to access credit. This restricts the flow of money within the economy, hindering business expansion and limiting opportunities for individuals to buy homes or start businesses.
Bank failures and panic: Public fear of bank insolvency leads to bank runs, where customers withdraw their deposits en masse. This can cripple banks and exacerbate the financial crisis, causing a loss of trust in the financial system.
Soaring default rates: The economic downturn leads to increased defaults on loans by households, businesses, and governments as their ability to repay shrinks. This creates a domino effect, as defaults by some borrowers make banks even more reluctant to lend, further restricting credit availability.
Debt deflation: Deflation makes existing debt burdens heavier as the real value of debt increases. This discourages borrowing and investment, hindering economic recovery.
Weakened international trade
Global downturn: As the depression spreads worldwide, international trade suffers due to declining consumer demand, business failures, and reduced investment. This can lead to trade wars and protectionist policies as countries struggle to shield their domestic economies.
Devastating social impact
Poverty and hunger: Job losses and declining income push many people into poverty, leading to hunger and social hardship. This can increase crime rates, strain social safety nets, and create long-term social problems.
Mitigating economic depression
There has always been a constant fear of another Great Depression. That’s why economists suggest the following policies.
Government policy responses
Expansive monetary policy involves cutting interest rates to encourage consumption and investment (aggregate demand). When interest rates are lower, borrowing costs go down. Consumers and businesses can apply for new loans cheaper, encouraging them to increase spending and investment.
Expansive fiscal policy means increasing government spending, reducing taxes, or a combination of both. A tax reduction increases disposable income, which in turn, boosts spending. Likewise, government spending through transfer payments (such as unemployment benefits) helps the purchasing power not fall deeper.
Fiscal multipliers for dealing with depression
Government investment is a sensible option for bringing the economy out of a depression. During the depression, the private sector was reluctant to invest. Their weak financial profile and cash flow prevented them from doing so.
The outlook for private investment is also bleak as demand is falling. If businesses invest, the market will not necessarily absorb the output from their new capacity. Therefore, if they invest, it will only burden their financial profile.
In this condition, government investment and spending are possible options. The government is not profit-oriented, and therefore, investment policy is at the discretion of the government.
As with Keynesian theory, government investment works through a multiplier effect. Each dollar of investment can create multiple jobs and income, help the government eliminate unemployment, and drive up household sector demand.
When demand increases, businesses’ expectations of profits increase, encouraging them to restore production. If the recovery is strong, the demand for goods and services increases, encouraging firms to invest.
Financial market stabilization
Financial stability involves the government guaranteeing bank deposits, which promotes banks and the financial system’s credibility.
For example, after Franklin D. Roosevelt took office in 1932, the United States founded the Federal Deposit Insurance Corporation (FDIC) to protect depositors’ accounts and formed the Securities and Exchange Commission (SEC) to regulate the stock market.
