The Housing Chronicles Blog: Diagnosing (economic) depression

Monday, January 5, 2009

Diagnosing (economic) depression

With all the rhetoric (and blog posts) about a potential economic depression, The Economist offers a means to diagnose the differences between a recession, a depression and a Great Depression. From the story:

THE word “depression” is popping up more often than at any time in the past 60 years, but what exactly does it mean? The popular rule of thumb for a recession is two consecutive quarters of falling GDP. America’s National Bureau of Economic Research has officially declared a recession based on a more rigorous analysis of a range of economic indicators. But there is no widely accepted definition of depression. So how severe does this current slump have to get before it warrants the “D” word?

A search on the internet suggests two principal criteria for distinguishing a depression from a recession: a decline in real GDP that exceeds 10%, or one that lasts more than three years. America’s Great Depression qualifies on both counts, with GDP falling by around 30% between 1929 and 1933. Output also fell by 13% during 1937 and 1938. The Great Depression was America’s deepest economic slump (excluding those related to wars), but at 43 months it was not the longest: that dubious honour goes to the one in 1873-79, which lasted 65 months...

Before the 1930s all economic downturns were commonly called depressions. The term “recession” was coined later to avoid stirring up nasty memories. Even before the Great Depression, downturns were typically much deeper and longer than they are today (see right-hand chart). One reason why recessions have become milder is higher government spending. In recessions governments, unlike firms, do not slash spending and jobs, so they help to stabilise the economy; and income taxes automatically fall and unemployment benefits rise, helping to support incomes. Another reason is that in the late 19th and early 20th centuries, when countries were on the gold standard, the money supply usually shrank during recessions, exacerbating the downturn. Waves of bank failures also often made things worse.

But a recent analysis by Saul Eslake, chief economist at ANZ bank, concludes that the difference between a recession and a depression is more than simply one of size or duration. The cause of the downturn also matters. A standard recession usually follows a period of tight monetary policy, but a depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level. In the Great Depression average prices in America fell by one-quarter, and nominal GDP ended up shrinking by almost half. America’s worst recessions before the second world war were all associated with financial panics and falling prices: in both 1893-94 and 1907-08 real GDP declined by almost 10%; in 1919-21, it fell by 13%...

Where does that leave us today? America’s GDP may have fallen by an annualised 6% in the fourth quarter of 2008, but most economists dismiss the likelihood of a 1930s-style depression or a repeat of Japan in the 1990s, because policymakers are unlikely to repeat the mistakes of the past. In the Great Depression, the Fed let hundreds of banks fail and the money supply shrink by one-third, while the government tried to balance its budget by cutting spending and raising taxes. America’s monetary and fiscal easing this time has been more aggressive than Japan’s in the 1990s.

However, these reassurances come from many of the same economists who said that a nationwide fall in American house prices was impossible and that financial innovation had made the financial system more resilient. Hopefully, they will be right this time. But this crisis was caused by the largest asset-price and credit bubble in history—even bigger than that in Japan in the late 1980s or America in the late 1920s. Policymakers will not make the same mistakes as in the 1930s, but they may make new ones.

Click here for full story.

1 comment:

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