Economic Depressions: History, Characteristics and Impact

An economic depression is a downturn in the economy. It’s a period where economic activity suddenly declines. Unemployment skyrockets and production slows down. Although a depression shares some similarities with a recession, it lasts longer and has more devastating results.

During a depression, we see a drastic and sustained drop in the country’s real Gross Domestic Product (GDP). Real GDP measures goods and services produced by an economy in a year.

MoneyGeek’s guide dives deeper into this economic event, using the Great Depression of 1929 to 1939 as its primary example. We’ll also flesh out typical characteristics of an economic depression and how it differs from a recession.

Several factors could trigger an economic depression. A stock market crash is one — when investors begin to pull out, it could indicate a loss of confidence in the economy. A loss of demand could also trigger it. The lack of economic activity typically leads to a period of deflation, recession and, if not managed, a depression.

The effects of a shrinking economy don’t just remain at a macro level. The impact eventually reaches the average consumer. Unemployment rates skyrocket. In turn, it decreases households’ incomes and can even lead to homelessness.

The U.S. economy has experienced several economic phenomena. We’ve faced periods of inflation and several recessions. However, when it comes to economic depressions, one example stands out in history: the Great Depression of 1929.

A lot of things characterized the 1920s. It was the age of prohibition, flappers and jazz. For most of the decade, the economy thrived. The Real GNP increased by 4.2% annually from 1920 to 1929. Similar to GDP, real GNP measures an economy’s production in a given year. The difference, however, is RNP includes goods domestically and internationally.

The 20s represented a time of great hope. People had a more positive outlook after recovering from World War I (1914–1918) and the Spanish Flu pandemic (1918–1920). It was the golden age for music, art and literature. Innovation was also at its peak, leading to the introduction of several inventions that would later shape the country. These included drive-in restaurants, the convertible, television and the jukebox.

Stock prices were at an all-time high. Investors borrowed heavily from financial institutions to invest in the market. As a result, the value of stocks more than quadrupled during this time. New financial products entered the market, such as unit trust (now known as mutual funds) and savings accounts with compound interest.

But all eras end and all bubbles burst. And for the roaring 20s, the end came on October 29, 1929.

Source: St. Louis FED

When people flourished, the economic boom led to market confidence. Even small investors and average consumers purchased stocks, leading to an asset bubble. By September 1929, stock prices were at $362.35 per share.

The Federal Bank of New York increased interest rates to 6% several weeks before the crash, slowing economic growth. Stock prices began dropping in October, and, on the 29th, historically known as Black Tuesday, investors traded 16,410,030 shares on the New York Stock Exchange, leading to a stock collapse.

After the crash, people believed stock prices would begin climbing. However, the downward trend continued, reaching $46.85 per share in June 1932.

The stock market crash of 1920 could have been a recession. However, banking panics in the 1930s turned it into the Great Depression. People started withdrawing their funds, and banks had to liquidate loans to generate the cash. Thousands of banks closed (659 in 1929 and 5,102 by 1932). Four banking waves of panic occurred in the 1930s, ending with Roosevelt’s bank holiday of 1933.

Source: St. Louis FED

The Great Depression suffered an unemployment rate of over 25% in 1933. Several factors contributed to it. For example, those who lost money when the market collapsed started spending less. It created less demand for goods and services, prompting businesses to let people go to stay afloat.

People withdrew their money after losing their confidence in the banking system. It led to thousands of banks closing, reducing the economy’s money supply. Deflation soon followed, which resulted in businesses shutting down.

Besides the service and manufacturing sectors, an agricultural recession also took place. Farming cost more money than it yielded, so people left their farms and traveled to California to find better opportunities.

Because of the Great Depression, countries implemented strategies to protect local industries. For instance, the Smoot-Hawley Tariff placed taxes on imported goods. Unfortunately, other countries started imposing their tariffs, severely affecting trade.

Lastly, the Federal Reserve’s decision to raise interest rates at the end of the 1920s did not improve conditions. Their objective was to protect the value of the U.S. dollar instead of stimulating the economy. Reducing rates would have been a better move, encouraging people to spend.

Source: Bureau of Economic Analysis

The various causes of the high unemployment rate during the Great Depression also contributed to another economic phenomenon called deflation, defined as the prices of goods and services decreasing over a prolonged period.

In general, households had less income due to the stock market collapse, bank closures and job losses. With less money to spend, the economy began shrinking. Prices dropped by 25% for consumer prices and 32% for wholesale rates. It reached the point that the deflation rate exceeded 10% in 1932.

In turn, deflation affected the country’s GDP. An increasing figure indicates a strong and stable economy. Unfortunately, the real GDP (the GDP that factors in inflation) decreased by 29% between 1929 to 1933.

There is no universally accepted definition of depression in economics, but frequently, it’s connected to drastic and prolonged drops in the GDP. Unemployment rates also generally trade upward significantly. It’s similar to a recession, but the economic downturn lasts longer, resulting in more crushing effects.

MoneyGeek’s guide explores the various elements that characterize an economic depression, some of which can be considered causes since their presence also contributes to the continuous shrinking of the economy.

The Great Depression was a worldwide event. Although significant events played a role, economists are still exploring other factors that may have contributed to it. There is much to learn about economic depression. This information can help inform the evaluation of potential depressions in the future and its triggers.

Anyone who wants to understand what an economic depression is must begin with a recession because they share several similarities. Both involve a reduction in economic activity, ultimately leading to lower GDP and higher unemployment. Regarding the comparison of depressions and recessions, their differences lie in duration, impact and reach.

When we experience an economic downturn, economists first evaluate its duration. The economy enters a recession when the real GDP declines for two successive quarters or six months. An economic depression lasts longer — usually for years. The Great Depression was a decade long, spanning from 1929 to 1939.

Recessions typically lead to lower consumer demand. People put off purchases because of less income. Unemployment rises since businesses may reduce their workforce to lower costs. The same goes for depressions, but unemployment rates skyrocket to more than 20%. Negatively affected areas also include business sectors and international trade.

Recessions are domestic events. It can be limited to a specific country or region. In comparison, economic depressions are experienced worldwide.

Economic depression is a broad topic. It might be challenging to grasp as it is not an event that affects every generation. MoneyGeek included the most commonly asked questions and answers to provide additional information.

Economic depression is only one of several macroeconomic subjects. Many of them impact your finances at a personal level, like unemployment and investing. To gain a better understanding of these macroeconomic matters, take a look at the following resources.

• Supply: A lack of demand for goods and services may lead to a period of deflation, potentially followed by a recession or a depression. Find out more about supply and its relation to economic downturns.
• Inflation in Economics: Types, Causes & Indexes: Consumers are always wary of inflation because it directly impacts their spending power. Learn more about this concept in this guide.
• How to Make Rational Investing Choices During Stressful Times: Investments can help you build your financial portfolio. However, you may wonder whether you should pull them out when the economy becomes unstable. Use this guide as a tool in your investment journey.
• Your Financial Guide to COVID-19: Two years after the start of the COVID-19 pandemic, the world is still reeling from its effects. This guide gives you the necessary resources regarding dealing with unemployment, managing your funds and keeping your business afloat.
• How to Manage Your Money When You’re Unemployed: Losing your job can be devastating and can hit your finances hard. Find out how to maximize what you have while searching for your next employer.
• Understanding the Main Types of Debt and How to Pay Them Off: Recessions and depressions often lead to consumers defaulting on loans. Here’s a crash course on different types of debt and resources for managing it.