Depression in the Economy: Definition and Example

What Is a Depression?

A depression is a severe and prolonged downturn in economic activity. A depression may be defined as an extreme recession that lasts three or more years or which leads to a decline in real gross domestic product (GDP) of at least 10% in a given year.

Depressions are far less common than milder recessions. Both tend to be accompanied by relatively high unemployment and relatively low inflation.

The U.S. has experienced at least 34 recessions since 1850 including, in recent years, the Great Recession of 2008-2009 and the covid recession of 2020. But it has had only one depression, which lasted from 1929 until 1941 and is known as the Great Depression.

Understanding Depressions

Two major factors characterize a depression. Consumer confidence falls dramatically as people begin to worry about their job security and pull back on spending. And, investments decrease as businesses and individuals stop investing, whether that means building a new factory, developing a new product, or buying stocks.

Economic factors that characterize a depression include:

• A substantial increase in unemployment
• A drop in available credit from banks
• Diminishing output and productivity
• Consistent negative GDP growth
• Bankruptcies
• Sovereign debt defaults
• Reduced trade and global commerce
• A bear market in stocks
• Falling currency values
• Low to no inflation, or even deflation
• An increased savings rate (among those who still have money to save)

Economists disagree on the duration of a depression. Some argue that a depression encompasses only the period that is plagued by declining economic activity. Other economists argue that the depression continues up until the point that most economic activity has returned to normal.

Depression vs. Recession

A recession is considered a normal part of the boom-and-bust business cycle. It is generally defined as a decline in GDP for at least two consecutive quarters. Given the lag in collecting data on economic activity, a brief recession may be over before it is confirmed to have happened.

A depression lasts for years, and its consequences are far graver. Almost 25% of the U.S. population was unemployed during the depths of the Great Depression, and that figure does not include the farmers who lost their homes and their land due to cratering prices for their produce.

Recessions are much more common: Between 1854 and 2008, there were 32 recessions in the U.S. and just one depression. Since then, we've had the Great Recession of 2008-2009 and the briefer and less disruptive covid recession of 2020.

As noted, a recession is defined as at least two consecutive quarters of negative GDP growth, even if that decline is slight. A depression is defined by a drop in annual GDP of 10% or more.

The Great Depression lasted for a decade.

Example of a Depression 

The Great Depression is to this day the worst economic downturn in modern world history. Lasting roughly a decade, many historians trace its origins to October 24, 1929, when the stock market crashed in an event afterward known as Black Thursday. After years of reckless investing and speculation, the stock market bubble burst and a huge sell-off began, with a then-record 12.9 million shares traded.

On that day, the United States was already in a recession. The following Tuesday, Oct. 29, 1929, the Dow Jones Industrial Average fell 12% more in another mass sell-off, triggering the start of the Great Depression.

The Great Depression began in the United States but soon took hold throughout the industrialized world. Its economic impact was felt for more than a decade. The era was characterized by catastrophic levels of unemployment, poverty, hunger, and political unrest. Consumer spending and business investment dried up. U.S. unemployment reached a level of just under 25% in 1933 and remained in the double digits until 1941 when it finally fell to 9.66%.

Shortly after Franklin D. Roosevelt was elected president in 1932, the Federal Deposit Insurance Corporation (FDIC) was created to protect depositors' bank accounts in the event of bank failure. In addition, the Securities and Exchange Commission (SEC) was formed to regulate the U.S. stock markets.

Why a Repeat of the Great Depression Is Unlikely

Government policymakers appear to have learned their lesson from the Great Depression. New laws and regulations were introduced to protect consumers and investors. Central banks developed tools designed to keep the economy steady.

Nowadays, central banks are quick to react to inflation before it gets out of control. They are equally willing to use expansionary monetary policy to lift the economy during difficult times. These tools are widely credited for helping to stop the Great Recession of 2008-2009 from becoming a full-blown depression.

A series of factors can cause an economy and production to contract severely. In the case of the Great Depression, questionable monetary policy took the blame.

What Causes a Depression?

An economic depression is a rolling disaster that begins with a decline in consumer confidence. There is, of course, a triggering event or events behind this loss of confidence. The subprime mortgage crisis of 2006 is seen as the first major event leading to the Great Recession of 2007-2009. As home prices fell, many Americans watched their personal wealth and that of their neighbors evaporate. They grew cautious about spending money.

When consumers spend less, businesses produce less and rethink investments in new enterprises. They need fewer workers to produce fewer goods, so they begin laying off people. With more people unemployed, wages for the few remaining jobs fall. With fewer people spending money, the prices of many goods fall.

The wheel keeps turning as the economy sinks farther into negative territory.

What Signals an Upcoming Depression?

If it all starts with the consumer, the number to keep an eye on is the Consumer Confidence Index published by the Confidence Board. One of the numbers considered to be a key economic indicator of the health of the U.S. economy, the latest updates to the index are published on the last Tuesday of every month.

For example, on the last day of January 2023, we learned that U.S. consumer confidence declined in December 2022. The index stood at 107.1, down from 109.0 the previous month.

The survey used to compile the index delves into the reasons behind consumer confidence, or lack of it. Its "Present Situation Index," which assesses views on current business and labor market conditions, increased slightly. Its "Expectations Index," based on consumers' short-term outlook, fell a bit.

In fact, the Expectations Index fell to 77.8, below the key level of 80, which is seen as a possible signal that there will be a recession in 2023.

Note, that's a potential for a recession, not a depression. The number would have to indicate a catastrophic loss in consumer confidence to cause anyone to use the "d" word. And even then, monetary policymakers and fiscal policymakers would be scrambling to use the tools at their disposal to prop up those numbers.

How to Prevent a Depression

In modern times, a deep recession or an outright depression is most often fended off by the use of two weapons wielded by separate branches of government, expansionary fiscal policy and expansionary monetary policy.

There is another course, fiscal austerity, that has been controversial, to say the least.

Fiscal Policy

Fiscal policy is the job of the U.S. Congress and the president. In warding off an economic downturn, fiscal policymakers spend taxpayer money. They may approve massive public works projects such as the Works Progress Administration (WPA), which was created in 1935 to create jobs to replace those lost. They may put money directly into the hands of the public, through such measures as the expanded child tax credit that increased the spending power of families during the Covid-related recession.

Monetary Policy

Monetary policy is the job of the central bank. In the U.S., that's the Federal Reserve, The Fed can goose the economy simply by lowering the interest rates it charges banks for the short-term loans that keep the banking system running.

These rates influence all other rates that are charged for consumer and business loans. Cheap money encourages more borrowing and more business investment, leading to the creation of more jobs. When it works, the rolling disaster of a looming depression comes to a halt and begins to reverse course.

If still more firepower is needed, the Fed may adopt a policy of quantitative easing. The Fed uses its own reserves to buy massive amounts of the government's debts, such as bonds. This has the effect of adding more cash to the economy. That cash becomes available for new investments.

Fiscal Austerity

Fiscal austerity stands in direct opposition to expansionary policy as a strategy for fending off an economic downturn.

In times of recession, government revenues decline. Fewer people are working, fewer projects are getting off the ground, and consumer spending is reduced. All of the taxable events that keep a government humming are in decline.

A commitment to a balanced budget could logically be met with cuts in government spending. That course was followed during the Great Recession by some nations in the European Union as well as by some U.S. states which were hamstrung by balanced budget rules or had a pronounced aversion to increasing government debt.

Whether this strategy cures a recession or feeds it continues to be a matter of debate. Most recently, U.K. Prime Minister Liz Truss was ousted from her job after a record-short tenure for recommending fiscal austerity in response to the nation's economic problems.

How to Protect Your Money in a Depression

If history is any guide, you shouldn't spend your time worrying about a depression but you should prepare for the next recession. It's really about maintaining your awareness that the economy moves in a boom-and-bust cycle, and if it's boom time, get ready for the bust.

As an investor, that means keeping your portfolio diversified to include safe haven picks that do well even in a downturn. As a responsible adult, it means saving regularly, paying your debt down, and maintaining an emergency fund.

And, as a participant in the modern American economy, it can mean looking around you and considering alternative sources of income that you can exploit when things turn dicey.

The Bottom Line

Recessions are common enough events to be considered a normal part of the economic cycle. A period of expansion is followed by a period of contraction. They are unpredictable, although plenty of people try to predict them.

Economists couldn't anticipate, for example, that a worldwide pandemic would cause a near shutdown of the global pipeline of goods and services, leading to a recession that began in the first quarter of 2020. They also could not predict that the recession would be over by the third quarter of 2020, after a huge infusion of government cash not only propped up the economy but kept it going until more normal economic activity could resume.

A depression is a recession of catastrophic proportions. The U.S. economy has not been in an economic depression since 1939. That may in part be because the nation's policymakers have developed tools to alleviate the effects of a recession before it morphs into something worse.