Home > political-economy > I. Understanding the difference between depression and recession…

I. Understanding the difference between depression and recession…

The saying goes, “When your neighbor is unemployed, that is a recession; when you are unemployed that is a depression.”

There is some good old down home wisdom in this aphorism. We tend to measure the severity of an event by its impact on us personally. This is also probably behind a recent observation by some media personality (we forget who) who observed last week that the only way to get the media interested in an African war crimes trial was to force the testimony of a fashion supermodel.

To avoid falling into the trap of subjectivity on things like recessions and depressions we would like to introduce our new and improved definition of recessions and depressions.

We promise, this will only hurt a little bit, and there is a point to be made by making a distinction between the two by proving they are very different creatures: only by making this distinction will we be able to show how dangerously ominous the present economic environment is for you and your family.

The most common definition of a depression is provided by the Wiki as follows:

In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen by economists as part of a normal business cycle.

Considered a rare and extreme form of recession, a depression is characterized by its length, and by abnormally large increases in unemployment, falls in the availability of credit— quite often due to some kind of banking/financial crisis, shrinking output and investment, numerous bankruptcies— including sovereign debt defaults, significantly reduced amounts of trade and commerce— especially international, as well as highly volatile relative currency value fluctuations— most often due to devaluations. Price deflation, financial crises and bank failures are also common elements of a depression.

Definition

There is no widely agreed definition for a depression, though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions. Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output). Another proposed definition of depression includes two general rules: 1) a decline in real GDP exceeding 10%, or 2) a recession lasting 2 or more years.

This, of course, is not the definition of a depression; it is a description of the Great Depression. In this description a depression is defined as a recession on crack – a sort of super-recession. It includes such terms as “substantial”, “sustained”, “long-termed”, and “severe”. Its markers are those of a typical recession: a collapse of employment, a credit crunch, banking failures, shrinking output and investment, sovereign debt defaults, price deflation, and a collapse of international trade.

Finally, the wiki gives us some potentially definitive indicators: a contraction of real GDP in excess of ten percent, and a duration of greater than two years.

Many of these economic symptoms can be applied to the current situation, but several do not fit the bill – our current economic disaster, therefore, would fall quite short of this definition. Yet, we are in a depression. And, moreover, we are sitting on the cusp of the second recession in three years.

If a depression is merely a recession on steroids, how is it possible for us to be in a depression, but emerging from one recession only to enter a second?

The simple answer is that depression and recession refer to two different creatures. We can have a recession during a depression, and we can have a recession during an expansion. Moreover, it is possible to have several recessions within a single depression, or an expansion with several recessions.

It is possible to have a recession without a depression, or a depression with many different recessions events. In fact, at least theoretically, you can have an entire depression without ever experiencing any of the economic symptoms of contraction listed above.

The key to understanding why this is true is to be found in the definition of “real GDP”. What are we to take as “real”? In economist-speak, “real” refers to the gross domestic product of an economy after you adjust for inflation. But inflation is simply the depreciation of the purchasing power of the dollar. “Real GDP”, then, would be a contraction of the economy after accounting for the loss of purchasing power of the dollar.

Which raises the question: against what are we measuring the loss of dollar purchasing power? Economists employ any number of government and privately generated measures of the loss of dollar purchasing power, but the most commonly employed measure is the GDP Deflator. All of them suffer the shortcoming that purchasing power of dollars are compared to dollars – it is a little like measuring temperature by comparing how hot it feels today to how hot it felt yesterday.

To really measure a thing – the temperature or the purchasing power of a dollar – it helps to have an objective standard. In our case, we prefer to use gold as that standard. Since we have a clear benchmark in the 1929 dollar-ounce of gold peg of $20.67, the fact that today that ratio is $1200, means that the dollar has lost more than 98 percent of its 1929 purchasing power against gold.

A single dollar in 1929 had more purchasing power than $50 today.

Using our ounce of gold as a standard of measure for real GDP we can now identify three periods where economic contraction met the wiki definition of a depression – a greater than ten percent contraction of real GDP, lasting two or more years. These periods are evident in the now familiar chart below.

Chart 1: GDP 1929-2009 (Gold)

But, we can also do something else: we can show on the above chart all the recessions (highlighted in red) as defined by the National Bureau of Economic Research (NBER) since 1929 – the gold standard, so to speak, for telling economists when we are or are not in a recession.

Chart 2: Recessions in the US economy 1920-2010 (NBER)

(Not coincidentally,the NBER provides no definition of a depression.)

As you can see, recessions are very different from depressions at least since 1933. A recession can occur in the middle of a depression, or the middle of an expansion. While the above three depressions each begin with a recession the duration of the depression can extend far longer than the initial recession, and the depression can include multiple recessions within it.

We think the above facts indicate something about the distinction to be made between depressions and recessions: depression are real economic events, while recessions are monetary events. This is not to say a real event is not monetary, but to emphasize that a real event is something more than a mere monetary event.

If we go back to the wiki definition of a depression, however, we see a rather lop-sided emphasis on the monetary component of economic contractions (highlighted in red):

  • abnormally large increases in unemployment
  • falls in the availability of credit
  • banking/financial crisis
  • shrinking output and investment
  • bankruptcies
  • sovereign debt defaults
  • reduced amounts of trade and commerce— especially international
  • highly volatile relative currency value fluctuations— most often due to devaluations.
  • Price deflation

While we don’t argue with this list, it is only fair to point out that, for instance, employment grew through the entire depression of the 1970s, and for most of the present depression. Credit expanded in both, and international trade grew during the 1970s and for most of the most recent depression. Deflation never occurred during the depression of the 1970s — indeed, it was a period a rampant inflation. And, in this depression, prices, though more subdued than during the Great Stagflation, have so far not veered into outright deflation.

Usually, when trying to define or diagnose a thing, we begin by excluding from that thing, circumstances which are not exclusively associated with it. In medicine, this process is called ruling out. We begin with a broad list of symptoms, and narrow that list down until we come to some particlar synptom that decisively excludes all other diagnoses.

On this basis, we can see the above wiki list does not allow us to rule out anything. The only thing that the depressions of 1929-1933, 1970-1980 and 2001-2010 have in common is that they show up on a chart which takes into account the price of an ounce of gold. On the other hand, the numerous recessionary contractions indicated on chart 2 tend to show up reliably only when economic activity is denominated in dollars. But, when, as in the period from 1929 to 1933, the dollar is fixed to some definite quantity of gold (in that case, $20.67 to an ounce) we can see that the depression and the recession are identical – the economic contraction is evident and identical in both gold and dollar terms.

For the sake of simplicity, therefore, we can assume that a depression is a contraction of economic activity measured in gold, while a recession is a contraction of economic activity measured in dollars. The two can occur together, but they are not the same because the things by which they are measured – dollars and gold – are no longer fixed to each other.

Once we have made this distinction between a depression and a recession it becomes surprisingly easy to define a depression, despite NBER’s silence on the subject. A depression is simply the contraction of economic activity as measured by the price of an ounce (or some other definite unit) of gold. All of the above list of symptoms from the wiki can be exclusively used to further define the severity of a recession.

If we now turn to the implications of our definition, you will be able to see why the NBER is silent on the subject, and why this silence has such profound implications for you and your family.

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