— By every measure — lost jobs, plunging stock prices, scarce credit and a profound loss of confidence in the banking system — the economy is in awful shape.
The nation's 11th recession of the postwar era began in December 2007 and easily could become the longest since the Great Depression, although most forecasters expect a weak recovery to begin in the second half of this year.
But what are the odds that we’re in the early stages of what will eventually become a depression rather than just a recession?
The answer starts with definitions. While the term "depression" is reserved for the most extreme economic collapses, there is no technical definition, say economists.
“The difference between a recession and depression is primarily a matter of degree,” said Victor Zarnowitz, a University of Chicago economist and a member of the business cycle dating committee at the National Bureau of Economic Research. “A depression is much more severe and usually longer than a recession.”
With no set milestones, the term doesn’t really apply until after it’s clear a downturn is one of the worst in history.
As bad as things are today, conditions are nowhere near as bad as they were during the Great Depression. At least not yet.
The differences are stark. From 1929 and 1933, inflation-adjusted gross domestic product plunged 27 percent, some 10 times worse than any recession since. Today, even the worst forecasts don’t expect GDP to shrink by more than a few percent this year before recovering in 2010.
Unemployment in the 1930s peaked at 25 percent in 1933; most forecasters don't expect unemployment this time around to rise much above 10 percent, compared with the current 7.2 percent.
Other comparisons don’t measure up either. Since the current crisis began unfolding, the number of banks that have failed or been forced to find merger partners can be measured in the dozens; in the 1930s, roughly a third of all banks failed. Even last year's sickening 38 percent drop in stock prices was fairly tame compared to the 90 percent drop during the Great Depression.
“There is no comparison — an order of magnitude difference in what we're seeing — in the slowdown and the financial stress we're seeing in this economy and what happened in the 1930s,” Federal Reserve Chairman Ben Bernanke, a scholar of the Great Depression, said last month in a speech in Austin, Texas. “So let's put that out of our minds.”
That’s easier said than done. For one thing, until the data begin to show signs of improvement, there’s no way to know how long it will take for this economy to hit bottom. During the Great Depression, the steepest drop in output and employment occurred in the fourth year of the downturn.
“They didn’t know it was the Great Depression in the first year,” said Neil Soss, chief economist at Credit Suisse. “It’s sort of like sort of reading 2008 day-by-day in the newspapers. Why didn’t we know this was about to happen? The reason is you’re living in the fog of unfolding events.”
Those unfolding events are certainly cause for concern, especially given the similarities between today’s headlines and the 1930s. The Great Depression followed a major expansion of consumer credit and home buying; the unwinding of that boom sent consumer spending plummeting. After a period of rapidly rising stock prices, the crash of 1929 destroyed billions of dollars of wealth; stock prices didn’t recover for decades.
Deflation — a persistent drop in prices that prompts consumers and businesses to delay spending and investing — took hold in the 1930s; today, a collapse in housing and energy prices could spark another deflationary cycle.
The current downturn, like the depression of the 1930s, follows a period of rising income inequality as wealth became concentrated in the hands of relatively few people. Much of that wealth was created by an explosion in credit.
During the 1920s boom that preceded the Great Depression, investors relied heavily on borrowed money to buy stocks; today, the financial markets are unwinding losses from a huge buildup of investments based on mortgages that turned out to be worthless. The downturn early in the 1930s accelerated as the banking system collapsed; despite massive government investments, today's banking system is still badly damaged. And much the way global trade flows are slowing today, the 1930s downturn was intensified by a sharp pullback in trade.
Beneath those broad similarities, though, there are some significant differences between now and the 1930s. Most bank deposits today are insured, preventing panicked depositors from cleaning out their savings and hoarding cash under their mattresses. Two-income families have somewhat softened the blow of rising unemployment. Social Security and Medicare help offset the threat of widespread financial destitution among the elderly that accompanied the Great Depression.
Perhaps most importantly, the modern Fed has responded aggressively to the current crisis as the “lender of last resort.” Economists generally agree that the 1930s Fed, along with the central banks of major U.S. trading partners, made a bad economy worse by adhering too long to a rigid gold standard, which kept the supply of money tight when those bankers should have been working to make loans easier to get.
Still, some economists believe that we may be at greater risk for another depression today than at any time since the last one ended more than 60 years ago. The period since then has come to be described by some as the Great Moderation — a period when economic contractions were shorter and milder than at any time in history. The notion that business cycles have been tamed is backed by the statistics. Between 1945 and 2001, the average recession lasted just 10 months; between 1854 and 1945, recessions lasted 21 months on average.
The 1930s collapse — which was actually two back-to-back recessions — was not the first American depression. Back-to-back recessions in the 1870s (one of which, at more than five years, is still the longest continuous contraction on record) were described as a Great Depression in the years that followed. Economists have a tougher time comparing the depth and severity of earlier economic contractions because they have less data to work with.
While economic data confirm the presence of a Great Moderation, there is less agreement about what brought it about. That makes it more difficult to assess how much risk we now face.
Some economists speculate that with more accurate and timely economic data, central bankers have been able to better manage inflation and interest rates, letting them head off recessions before they get started and curtail them once they do. Others suggest that the dramatic expansion of service industries in the modern economy, together with better inventory controls by manufacturers and retailers, have helped minimize the big inventory buildups that triggered past recessions.
Soss believes the huge expansion of credit throughout the period since the 1930s played a big part in the Great Moderation by smoothing ups and downs in consumer spending.
“You don’t have to wait until after you’ve got a job, and after you’ve got a paycheck, and after you’ve got some savings in order to buy a TV or a car or a house or whatever,” he said. “So you get a smoother flow of saving through the cycle; you get less volatility in economic activity, and your recessions, when they come, are rare and brief and mild.”
The length and severity of the current downturn may be dampened by the government’s massive efforts to fight it, from the $700 billion banking industry bailout to the proposed $825 billion stimulus spending package. But Soss and other economists caution that government intervention — as it was in the 1930s — is a double-edged sword.
“The government experimented so much (in the 1930s) that business sector uncertainty was elevated,” he said. “And that actually inhibited the economy, and I think we have experienced some of that last year.”
That may be one reason banks have been hoarding cash from the bailout, especially if they’re not sure which banks the government will decide are worth saving and which ones it will let fail. The plunge in bank stocks this week has been blamed, in part, on investor uncertainty about whether the government's next move to fix the banking system could involve some form of nationalization that could wipe out private investors' holdings.
More troubling, perhaps, is this recession’s stubborn resistance to the Fed’s multipronged efforts to get the economy moving again. The Fed has let a key short-term interest rate fall to near zero and pumped more than $1 trillion of fresh cash into the global economy through an alphabet soup of programs. But economists say those moves could take six months or longer to have their full impact.
There are signs the government's massive efforts are having an effect. Though banks are still posting huge losses and have slowed lending to a trickle, the broader credit markets are beginning to show signs of thawing. The volume of company-issued debt, for example, recently has begun rising, and the higher interest rates investors had been demanding at the height of the fall panic have begun to ease.
But after flooding the economy with cash, the Fed will face an ever tougher dilemma: How will it drain all that money out of the system before it sparks a new round of inflation, without cutting short any nascent recovery?
“It’s risky, because it’s definitely very inflationary at the end,” said Zarnowitz. “The recent deflation will be replaced by large inflation because there is a tremendous increase in money and credit that is being enacted. So yes, it’s worrisome, but we can’t avoid it. Because without it, we would have a large and continuing recession.”