The economist: What’s the definition of a depression?
“What’s the probability that the U.S. economy will never recover?” the reporter asked.
There aren’t many questions about the likelihood of an economic event occurring that I can answer with a great deal of confidence, but that one was easy. “It’s zero!” I replied. The U.S. economy has been through dozens of business cycles — 33 according to the National Bureau of Economic Research, which has dated them back to 1857. In every instance, after a period of contraction, the economy recovered.
Although the reporter was my most pessimistic questioner, for the first time in a 30-plus-year career I’m getting questions about the possibility of a depression. They usually begin with, “What’s the difference between a recession and a depression?”
The short answer is that while this is an official definition of a recession…
… a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible
in real GDP, real income, employment, industrial production, and wholesale-retail sales (NBER)…
… there is no official definition of a depression. One man told me with great certainty that a recession became a depression when the economy contracted by 10 percent or more. If he were correct, the U.S. economy has gone through four depressions since World War II: two in the 1950s, one in the mid-1970s and a fourth in the early 1980s. Another told me, “No, it’s when the economy contracts by 25 percent.” If that were right, then there hasn’t been a depression since the Great Depression of 1929-33. It lasted 43 months, during which output declined by 27 percent. Economic activity did not return to its previous peak until 1941. There have been two other economic contractions lasting more than three years – the 65-month decline in the 1870s and the 38-month decline in the 1880s.
When I was in graduate school, depression wasn’t a topic of discussion. Of course, we read Milton Friedman’s “A Monetary History of the United States,” which lays much of the blame on the 30 percent contraction in the money supply. We learned about the Smoot-Hawley tariff, which many economists believe turned a cyclical contraction into the worst economic slump in our history.
We read John Maynard Keynes’ “General Theory,” which argued that government intervention with appropriate spending and taxing policies could stop a potential depression in its tracks. But the major concern in the 1970s and for many years afterward had to do with inflation, which was at double-digit levels in 1979-1981. Depression wasn’t a problem; we were confident good monetary and fiscal policy could avert another major downturn.
Economist Saul Eslake argues that it is important to determine whether we are in a recession or a depression because each calls for a different response from the federal government. If it is a recession, it resulted from tight monetary policy and can be cured by lowering interest rates. Fiscal policy — government spending and/or tax cuts — won’t be very effective. That would bode poorly for our $800 billion stimulus package.
But, if it is a depression, it resulted from the bursting of an asset bubble, a contraction in credit and a decline in the general price level. It may be mild or severe, but it calls for different economic policy. (There’s a longer discussion in the Jan. 3 issue of The Economist.)
We’ve pulled out all the stops to fight this contraction, whether it is a recession or a depression, whether it lasts 18 months or three years. Trillions of dollars have been poured into the economy since the fall of 2007, yet still the situation worsens.
I don’t know what the answer is. But I do know that it is important not to confuse proper long-run policy with proper short-term policy. In the long run we need a smaller government, appropriate but not excessive regulation and the opportunity for the market to function freely. But, in the short run, emergency measures are necessary. I hope the ones we are taking work!