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Mar. 27, 2020 Commentary

What’s the Difference Between a Recession and Depression?

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“Buddy, Do You Have a Dime?”

We can all think back to the time when the stock market was rising and the mentality was that while something may occur that may disrupt business activity for a short period, the U.S. economy was going to continue to chug along. It’s hard to contemplate, but that period was just four short weeks ago. 

The stock market has since sold off by approximately 30% (I can’t give an accurate number, because the amount of loss depends on what hour you measure) over the last four weeks. Long-term interest rates declined to an eye-popping .5% over that period of time as well. The financial market activity has been stunning, as the percentage losses in the stock market eclipse what many – including myself – had been expecting. It appears margin calls are ongoing, with selling begetting selling.  I can go on, but you get the picture.

I’m hearing the word “depression” being kicked around Wall Street.  Some fear that the world’s economy has entered a new depression and not a recession. I don’t buy it. 

Chart from Dow Jones showing impact of the great depression

What is the difference between a recession and a depression? It is generally agreed that a recession is period where “real” gross domestic product (GDP) declines for at least two quarters in a row.  Normally, unemployment doesn’t rise above 10% or so in recessions. The stock market, on average, declines by 30 - 35% during a recession. A depression is, like a recession, a period of GDP contraction, but it can last years, not quarters. Unemployment reached a high of 24% during the last depression. The stock market dropped by 80%+ (see chart above from Dow Jones).

Most of us read books. I’m assuming the majority of you read fiction for enjoyment. I read so much I really don’t have the time, or the inclination, to read fiction. I have read nonfiction books all of my adult life. As an economist, I am obviously interested in business cycles - what drives them and what ends them. The business cycle of the 1920s, of course, ended as the Great Depression unfolded. Perhaps the best book I have read, which covers the economic period of the Great Depression, is The Forgotten Man by Amity Shlaes. It is a great read and easy for folks who don’t have formal training in the “dismal science” to understand. Ms. Shlaes’s work is centered on the economic impact imparted by Washington policies. By the way, I am currently reading her newer book “Great Society:  A New History.” So far, it is also a good read.

The core cause of the Great Depression was, in my opinion, the reaction of businesses and consumers to the stock market crash of 1929. A loss of confidence took place by both consumers and businesses.  Consumption activity slowed dramatically, as did consumer discretionary spending. These slowdowns were persistent, and history has proven that Washington’s policy actions following the stock market crash were, by and large, counterproductive.  

That being said, I think it important to understand the policy changes (mistakes) that ultimately led to the creation and maintenance of the Great Depression, according to work done by Amity Shlaes. 

  • Federal Reserve: During the beginning of the Great Depression, the Fed’s actions were counterproductive. In an environment where prices were collapsing (general prices fell by 25% from 1929 to 1933), GDP growth was severely negative (nominal GDP contracted by a whopping 46% from 1929 – 1933), and unemployment soared (from 4% in 1929 to 25% in 1933) the Fed allowed “real” interest rates to rise from 3% in 1927 to 14% in 1930 and money supply (M2) to contract by 35% from 1929 – 1933, leading the banking system from a liquidity problem to a solvency problem, as banks closed their doors. Both of these developments deeply worsened the contraction in overall final demand levels from the economy.  Chart source1.

  • Chart Showing Money Supply During the Great Depression Era

  • Recently the Fed has been lowering interest rates (now effectively at 0% on short-term Fed borrowings). They have also been injecting massive levels of liquidity in the financial system, giving the financial and banking systems the ability to transact and staving off solvency concerns. Importantly, M2 (calculation of money supply) is now growing at a 14% annualized rate, compared to 5% at the beginning of this year, and by 3% a year ago. This is a huge upward push in money supply growth.
  • From a fiscal policy standpoint, the Smoot-Hawley act, which led to a major contraction in global trade, was probably as much to blame for the intensifying of the initial global economic downturn. In addition to that, because of rising deficits, the federal government decided to raise taxes in 1932, which led to the intensification of the demand-driven downturn. Throughout the beginning of the Great Depression, the government continued to focus on attempts to balance the budget. This desire, while honorable, proved to be wrong-footed. 
  • Today, certainly the federal government isn’t worried about balancing the budget. Perhaps they should have been over the last few years when the economy was growing. But that is rear-view mirror gazing. Deficits are going to be measured in the trillions of dollars, rather than in billions. 

I understand why some are concerned that the current economic downturn may turn into a depression. Some of the factors that led the economy into the Great Depression are present in today’s environment. The stock market has crashed, as was the case in 1929. Trade activity has declined, as was the case following the passing of the Smoot-Hawley act. Consumers are running scared, with their fears of the unknown. Unemployment is rising rapidly, as was the case in 1930-1932. 

But there are significant differences between now and 1929, as highlighted above. 

Another factor that I need to point out is that the cause, the catalyst of the problem, is health in nature. This isn’t a financial problem the world is facing, which was the case in the early 1930s. We aren’t facing a military conflict issue, which of course was the case in the late 1930s. The economic system isn’t in a financial-driven meltdown.

I believe that, as long as the coronavirus pandemic is forcefully addressed, consumer and businesses confidence levels should start to push upward.

I don’t buy the idea that our current problem is going to morph the economy into a depression. Prior to the Great Depression, economic contractions, which we now call recessions, were called panics. I like the descriptive nature of the word panic. It is descriptive of many investors’ attitudes.

And panic is what I’m seeing in the stock market. High-quality stocks are being sold wholesale, regardless of the underlying value of these companies. Now, don’t get me wrong, there are some real problems. Some smaller, more levered oil patch companies are in trouble. Some small airlines will probably not make it to the other side of the pandemic. A number of restaurants and retailers won’t make it through this mess. 

Additionally, we all need to brace ourselves for ongoing bad news about infection rates, which will continue to unfold over the next few weeks. Sentiment levels are going to fall, both for businesses and consumers. Anticipate this activity, as it is coming.

Stay Calm and Carry On

The market in general has been in “waterfall” mode. The current waterfall stock market move is similar to the two previous rapidly declining market experiences. These previous panics lasted between two to three months. The current bear market is well along the path that was blazed by the two previous declines.

Bottom line: Resist the urge to panic. While the financial system may continue to swoon with stock prices declining further, the market has already declined dramatically. Very good values are available in high quality companies' shares. We need to remember that this is America—our country and our people have been through a lot before. We will make it through this. And finally, this isn’t, in my opinion, the start of an economic depression.  

Sources

1Wikipedia: Causes of the Great Depression

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