Economic Depression: Causes, Examples, Effects, Possible Solutions

What it is: An economic depression is a prolonged period of decline in economic activity, worse than a recession. A recession occurs when economic growth falls for two consecutive quarters and can last up to three years, such as in the 2007-2009 recession. In periods of depreciation, real GDP falls by more than 10% and lasts for 3 years or more.

What are examples of an economic depression

Depression is rare. Some economists believe they occur in long cycles, around 50 years. In the United States, the last Great Depression happened in the 1930s. Previous depression occurred in the periods 1873-96, 1844–51, and 1810–17.

The 1930s Great Depression affected the economy of the United States and the world. It started with the collapse of Wall Street in 1929, and the crisis quickly spread to many other economies in the world.

How to differ an economic depression from an economic recession

Depression is a more severe recession. Real GDP falls during an economic depression, such as during a recession. However, the decline occurred significantly and lasted for years, not just for a few quarters.

The effects of depression are much more severe than that of a recession. Unemployment was widespread, poverty soared, hunger was rampant, many businesses went bankrupt and defaulted, and economic activity shrank.

Severe depression is called the Great Depression, which has occurred in the United States and lasts for a decade. During the Great Depression, unemployment was 25%, and wages fell 42%.

What causes economic depression

Two main theories explain the causes of depression: Keynesian and Monetarism.

Sluggish aggregate demand

Keynesians believe that aggregate demand shocks can bring the economy down. The reasons for this may come from shocks in household demand, business investment, a slump in net exports. Household demand shocks are often the main motor, given their significant contribution to gross domestic product (GDP).

Falling demand is forcing businesses to cut production. They also rationalize the workforce to control operating costs and maintain profitability. As a result, the unemployment rate goes up.

The increase in unemployment exacerbates demand further. Consumers have less money to spend on goods and services. That then brings economic output back down and creates negative expectations on the economy, business conditions, job prospects, and income.

A sharp decline in the money supply

Monetarists believe a shrinkage in the money supply explains periods of depression. Interest rates soared as liquidity in the economy dried up.

Higher interest rates make new loans more expensive. It worsens the economic situation, leads to falling demand, and gives rise to increased defaults.

Default is higher, forcing banks to be more careful in extending credit. As a result, credit availability shrinks. Businesses cannot get new loans. In fact, it was hard for them to renew their old loans, forcing many to stop investing in capital goods.

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. It also increases construction costs. There is also euphoria among investors.

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 is deteriorating, and they are taking on surging construction costs. As a result, default increased.

The increase in default also occurred in real estate investors. Because they are expensive, they usually apply for loans to buy real estate. Previously, when the price went up, they still profit from the difference between the selling price and the borrowing cost. So, there is 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 dotcom bubble in the late 1990s or during the Great Depression in the 1930s. Share prices skyrocketed due to speculation and excessive euphoria. And, suddenly, the price fell and caused 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.

How depreciation affects the economy and business

The economic depression had a significant impact on the economy. It also exposes people’s lives. The effect immediately spread to various countries, creating a global dark period.

The economic activity falls. Real GDP can shrink by more than 10% as it did during the Great Depression. And, the decline can last a long time, up to more than three years.

Industrial output and investment shrank sharply. Sluggish demand means businesses are unable to maintain production and finance operations as sales shrink. They began to reduce labor to rationalize costs and sustain profitability.

The unemployment rate has jumped dramatically. Many businesses go bankrupt. Dismissals are everywhere. That results in high instantaneous unemployment and downward pressure on wages.

Wages go down. Unemployment and shrinking job opportunities create excess supply in the labor market. It pushes wages down to a lower equilibrium point. Companies also cannot maintain normal wages, forcing them to lower wages.

Consumer confidence fell. Many people no longer have income due to unemployment. Businesses go bankrupt and the economy crashes. This has led to increased consumer pessimism over job prospects and income by households.

Purchasing power evaporates. High unemployment makes many people lose their purchasing power. They do not have sufficient savings. And, they will have to spend less, anticipating the possibility of a further economic downturn.

Finally, that pessimism lowers demand and leads to further economic downturns. Aggregate demand is not strong enough to sustain economic growth.

Deflation emerged. Weak demand drives down prices in the economy.

The decrease in manufacturing orders. Sales pressure and profitability force businesses to cancel purchases of capital goods. That exacerbates the decline in aggregate demand because investment in capital goods is one of the drivers of demand in the economy.

Business profits fell. The company is unable to sell the product due to a further drop in demand. At the same time, they still bear operating expenses, push down profitability and cash flow, and increase the default risk.

Credit availability is shrinking. Banks are reluctant to provide loans because of the increased risk of default. Also, depression gave rise to failed banks and triggered a banking crisis.

Panic banks spread. Under these conditions, a large number of customers fear the solvency of the bank. They simultaneously seek to withdraw their deposits in cash.

Panic can spread to the financial system. Even financially sound banks were also devastated by such great fear. Ultimately, it gave rise to the failure of the financial system.

The default rate skyrocketed. The outlook for household income and business profits is deteriorating. As a result, tax revenues also shrank. This situation ultimately increased defaults in three macroeconomic sectors: households, businesses, and government.

Deflation exacerbates default. The real value of debt increases as the purchasing power of money falls (known as debt deflation).

Export-import activity is shrinking. As the depression spread worldwide, a sharp decline also occurred in international trade, the effects of weak consumer demand, business bankruptcies, and a sharp drop in investment.

Poverty and hunger hit. During the depression, many people lose all their money and cannot find jobs. Because of that, they couldn’t buy food. It gave rise to acute poverty and hunger.

What are the possible solutions to overcoming economic depression

There has always been a constant fear of another Great Depression. That’s why economists suggest the following policies.

Through expansionary monetary and fiscal policies

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 getting the economy out of a period of depression. During the depression, the private sector was reluctant to invest. Weak financial profile and cash flow did not allow them to do 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 and help the government eliminate unemployment and drive up the household sector demand.

When demand increases, businesses’ expectations of profits increase and encourage them to restore production. If the recovery is strong, the demand for goods and services increases, encouraging firms to invest.

Launched financial market stabilization policy

Financial stability involves the government to guarantee 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.

Economic Depression: Causes, Examples, Effects, Possible Solutions

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