What Is Economic Depression?

What Is Economic Depression?
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As far as economic events go, true depressions are rare. Over the last century, the Great Depression of the 1930s was the only economic downturn in the U.S. that earned the distinction of being classified as a depression.

Today, rising inflation, contracting gross domestic product (GDP) and stagnant wages have prompted some to question whether the U.S. is heading for another. Luckily, it’s unlikely that our current economic turmoil will get close to the severity required to be termed a depression.

What Is a Depression?

There’s no formal definition of a depression, but economists generally agree that it is a severe and lengthy period of economic decline that impacts several countries simultaneously.

The Great Depression, for example, lasted more than 10 years, from the stock market crash on Oct. 24, 1929, until 1941, when the U.S. entered World War II, when millions of jobs were created to fulfill wartime needs.

During a depression, the unemployment rate spikes into double-digits and demand for consumer goods collapses.

Companies usually slow production or shut down factories to compensate, and investment activity dries up. As a result, GDP and other measures of economic activity experience deep contractions. Recovery from a depression can take years or decades.

Signs of a Depression

It’s been nearly a century since the U.S. experienced depression, yet the impacts of the Great Depression still linger in the minds of policymakers and consumers alike.

Although a recession may be imminent, another depression on the scale of the Great Depression is unlikely. For example, some characteristics of a depression that differentiate it from a regular recession include a combination of the following:

  • Poor stock market performance. The stock market’s decline—usually calculated by broad market indices like the S&P 500—over a prolonged period can signal a declining economy and low confidence in the stock market.
  • High unemployment rates. One hallmark of a depression is skyrocketing unemployment rates. For example, unemployment reached 24.9% during the worst of the Great Depression while wages plummeted. To put that number in perspective, consider that the national unemployment rate was 3.5% in July 2022. When people lose their jobs, they lose the ability to buy things, and demand for products tends to follow.
  • Rising inflation rates: When jobs are solid, rising inflation can signify high demand. When unemployment is high and inflation rates rise, consumers may struggle to afford everyday essentials, curbing the demand for consumer goods and services.
  • Declining home sales: During a depression, consumer spending significantly decreases in all industries. As consumers stop spending their money, home sales decline as people stay where they are or rent, rather than purchase real estate. A cooling housing market also signals an overall loss of confidence in the economy.
  • Increased default rates: When the economy is doing well, default rates on loans and credit cards are relatively low because people work and earn stable incomes to afford their bills. As the economy worsens, people often have trouble affording their monthly payments, leading more consumers to default on their credit cards and loans.

Recession vs. Depression

Recession and depression are both used to describe economic downturns but have different characteristics and long-term impacts.

Although definitions for a recession vary, the National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity that’s evident across different areas of the economy.

Depression shares some characteristics with a recession but is more severe and far-reaching. For example, real output in the U.S. dropped 30% between 1929 and 1933, or during the peak of the Great Depression, and unemployment neared 25%.

By contrast, the recession that lasted between 1973 and 1975—generally regarded as the most severe recession post-World War II—had lower levels of decline. Real output dropped by just 3.4%, and unemployment went from 4% to 9%.

While true depressions are exceedingly rare, recessions are more common. Since World War II, there have been 13.

Protecting Your Finances

No one can predict the future, but preparing for economic downturns helps you protect your finances in any scenario. Here are five tips to help recession-proof your finances.

  • Pay down debt. One of the best things you can do for your finances is to pay down high-interest debt, like credit card debt. Not only will you save money on interest payments, but you’ll also be in a better position if you lose your job or experience a drop in income.
  • Build your emergency fund. An emergency fund can help weather an economic storm. Aim to save enough money to cover at least six months of living expenses. This will help you make ends meet if your company announces layoffs or if you have other financial hardships.
  • Diversify your investments. If you invest in only a few stocks, downturns that affect certain industries or companies can devastate your portfolio. To lower your level of risk, diversify your portfolio by investing in a mix of stocks, bonds and short-term securities. Also, consider investing in a variety of industries, as well as a combination of domestic and international stocks.
  • Adjust your portfolio allocation. While the economy was booming, you may have invested primarily in stocks. Although a stock-heavy portfolio has the potential for high levels of growth, it’s risky in a recession. If you need the money in your investment accounts within the next few years, you may want to adjust your portfolio allocation to be more conservative. Consider meeting with a financial advisor to determine what allocation is best for you based on your current financial situation and future goals.
  • Look for other sources of income. A recession is a good time to reassess your budget and look for additional revenue streams. Another income opportunity can help you make ends meet if your salary gets slashed or you lose your job.

The term depression is scary, but remember that a depression as severe as the Great Depression is unlikely.

A recession as part of the natural ebbs and flows of the market is more common, so protect yourself from any economic downturn by taking steps now to pay down debt, save cash and diversify your investments.

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