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Lessons in Recessions and Depressions

Introduction

Recession and depressions have occurred many times throughout history. To many they bring fear and uncertainty. In economics, they are a natural part of the economic cycles that occur. To understand them we must look beyond all the myths. In this article we will examine what they are, how they work and what the negative as well as positive consequences are.

Recessions

Since the Mid 1850's the U.S. has had 32 recession according to the National Bureau Of Economic Research (NBER ). To gain a full understanding we must start with the actual definition in order to do an apples to apples comparisons

What are they?

There are two definitions of recessions. One, defines them as two consecutive quarters of negative economic growth. The second, according to the NBER, defines them as a significant decline in economic activity nationwide that last more than just a few months.

How they work

According to the NBER the average recession from the 1940's to today has lasted an average of 10 months. The way our economy works is we have someone producing goods or services and someone consuming them. As we are growing and expanding the economy will continue to grow, incomes rise and consumers are spending money. At some point, the economy has to slow. This slow down can be caused by over supply where, producers produce to many goods. When this happens the demand for those goods will drop. This causes earnings to slow, incomes drop and the equity markets fall. Consumers, start to become less optimistic about things slowing their spending and the economy slows even further.

Historical Examples

Since the end of World War II recessions have varied in length the shortest one was six months from January 1980 to July 1980. Two of the longest ones lasted for 16 months. These were the recessions of November 1973 to March 1975 and July 1981 to November 1982.

Depressions

Depressions are much more severe than recessions. To understand them we must define what they are, how they work, and what are some good examples

What Are They

A depression is a severe economic catastrophe where GDP growth falls at least 10%. Its effects can last for years. It is known to cause calamities in finance, commerce, industry, falling prices, very tight credit, low investment, record bankruptcies, and extremely high levels of unemployment.

How they work

Depressions occur when a number of factors come together at one time. These factors start off with overproduction and decreasing demand. Followed by a brief period of that fear takes place as businesses and investors panic this causes business spending and investments to drop. As the economy starts to slow, unemployment rises and wages drop. These falling wages causes consumers to cut back even more. As the cutbacks take place unemployment rises more and wages continue fall. This begins a cycle where the purchasing power of consumers is eroded severely causing, them not be able to make their mortgage payments, forcing banks to become tight on their lending standards, and eventually leading to bankruptcies.

Historical Examples

Throughout history there are several examples of depressions the most well known is the great depression of the 1930's. However, this event was actually two depressions that took place during that time. The first one occurred from August 1929 to March 1933 where GDP growth declined by 33 percent. The next one occurred from May 1937 to June 1938 where GDP growth declined by 18.2 percent. Further back another economic depression occurred for 1893 to 1898.

What can we learn from recessions and depressions?

Recessions and depressions provide us with both negatives and positives that we can learn from to gain a greater understanding of how they work and how to not be surprised by them.

Negatives of recessions and depressions

There are many negative consequences of recessions and depressions. Some of these negative consequences include one, rising unemployment. Generally, rising unemployment is a classic sign of both. As consumers cut their spending businesses cut payrolls to be able to cope with falling earnings. The difference between the two is that the unemployment rate in a recession is less severe than a depression. As basic rule of thumb the unemployment rate for a recession is in the area of 5 to 11 percent. While in contrast the unemployment during the period from 1929 to 1933 went from 3 percent in 1929 to 25 percent by 1933. Second, recessions create a massive unwinding in the economy. During times of growth businesses keep increasing supplies to meet the demand of the consumers at some point there will be to much supply in the economy. When this happens and the economy slows as demand drops. Recessions and depressions allow us to clear out the excesses of the economy. However, the process can be painful as many suffer during this time. Third, they create high amounts of fear. As the economy slows and unemployment rises many consumers become fearful that things will not improve anytime soon. This fear causes them to cut back on spending causing the economy to slow even more. Fourth, sinking asset values, as the economy slows so does earnings. This causes stock prices to fall because of the slowing earnings and negative outlook from companies. These falling prices causes new investments for expansion to slow and can affect the asset values for many people.

Positives of recessions and depressions

There are many positives that take place as a result of recessions and depressions. These positives include, one, it allows the economy to clean out the excesses. As stated in the negatives the unwinding in the economy while painful is also necessary. During this process inventories drop to more normal levels so the economy can experience long term growth as demand for products picks back up. Two, they help keep economic growth balanced, if the economy grew at an expansionist rate for many years unchecked we could have the potential for inflation that is out of control as consumers are willing to pay any price for their goods and services. By having recessions and depressions it forces consumers to cut back as they have falling wages. These falling wages forces prices to drop as demand has dropped over the long run creating a situation where the economy can grow at normal levels without having prices run away. Three, it creates massive buying opportunities in huge asset classes, as the economy runs its course the markets will readjust to an expanding economy. When this happens many investors who invest can make money as these low asset prices move back to normal. Four, it creates a change in the mindset of consumers. As consumers stop trying to live above their means they are forced to live within the income they have. This causes the national savings rate to rise and allows investments in the economy to increase once again.

Conclusion

Clearly, both recessions and depressions have many effects on the overall economy. To be able to survive and thrive in these environments requires you to understand what causes them and how those causes creates positive and negative effects on the overall economy.

About the Author

Chris Seabury has over 12 years experience following and writing about financial markets. Over the years he has educated and helped a great deal of investors get their portfolio in order. He currently has a financial blog that is dedicated to helping investors understand how the markets work and what they can do to benefit from them. http://davidsonreports.blogspot.com
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