What is an economic depression?

Depression is a taboo word in the English language. Its mention conjures up images of bread lines, shanty towns an general misery from the 1930’s. Yet, the D-word is making a comeback amidst the backdrop of a weak global economy. In fact, a growing number of pundits are calling this economic malaise a depression. But, what is a depression, really?

If one goes to Wikipedia, the oft-used reference online source, one does not receive much help:

Definition
There is no widely-agreed-upon definition for a depression, though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions.

A proposed definition for depression is a sustained recessionary period in which the population is forced to dispose of tangible assets to fund every day living, as was seen in the US and in Germany in the 1930s.

Often, in Canada and the United States, the word “depression” is used interchangeably with “recession”, often to simply indicate a deeper or more serious recession. Some economists require a fall in GDP of 10 per cent or more before a recession would be referred to as a depression.

Characteristics
Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output).

Though there is no widely accepted definition for an economic depression, according to an article in The Economist, there are two rules of thumb found widely on the internet. One is a decline in real GDP exceeding 10%, and the other is a recession lasting 3 or more years.

The last part of the definition is the most helpful here but it still leaves one wanting greater precision. The economist David Rosenberg does a remarkably good job of getting to the heart of things in a recent research report titled, “Some inconvenient truths.” I have highlighted the parts of his report that are the most important.

Not your father’s recession, but maybe your grandfather’s
In our marketing tour through Europe last week, we brought along our new chart package entitled “Not your father’s recession, but maybe your grandfather’s”. Looking at the youthful demographics that characterize today’s money management industry, we should have probably gone with “great-grandfather’s” instead.

How is a depression defined?
It shouldn’t come as any big surprise that with such a provocative title, we would be saddled with questions as to how an economic depression is even defined. Of course, most portfolio managers still don’t know that a recession is not defined as back-to-back quarters of negative real GDP prints (which we had neither in 2002 nor 2008) but instead the timing of the peaks in real sales activity, employment, industrial production and organic personal income growth.

We are likely enduring a depression today
As for depressions, there is no official definition, except to say that they have
existed in the past. There were no fewer than four in the nineteenth century, one in the twentieth century, and we are very likely enduring another one today. Though this current one is muted by the fact that most countries have an elaborate social safety net (deposit insurance, unemployment benefits, welfare, and socialized health care).

Depressions can last anywhere from three to seven years
Depressions are basically long recessions – they can last anywhere from three to seven years, while historically cyclical recessions last 18 months – and tend to follow years of leveraged prosperity of Gatsby-like proportions. Considering that in this most recent leveraged cycle from 2002-07, we reached a point where a record 40% of corporate profits were derived from financial activities, where household debt relative to income and assets surged to unprecedented levels and the personal savings rate briefly went negative at the height of the housing bubble, it is safe to say the down-cycle we are currently experiencing did indeed follow a classic elongated period of leveraged prosperity. It is now reverting to the mean.

Depressions marked by balance sheet compression
Recessions are typically characterized by inventory cycles – 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper. Unfortunately, as our former investment strategist Bob Farrell’s Rule #3 points out, excesses in one direction lead to excesses in the opposite direction.

The key distinction here comes in the last paragraph. Essentially what Rosenberg is saying is that depressions are the result of disequilibria which are so large that they can only be worked out through credit contraction, deleveraging, balance sheet compression, and asset liquidation in the financial sector.

Having defined depression, the question is: what can be done about it? In my view, the first thing to understand is the nature of deleveraging and attendant credit contraction.

When asset prices are no longer providing artificial support, it is readily apparent that many business models were dependent on increases in those asset prices and the related transaction volume to sustain themselves. These business models become inviable and many of these companies cease to exist. An economy can withstand such a contraction in the ‘real economy.’ It usually means recession. But, when the financial services sector suffers such an overcapacity, followed by contraction and deleveraging, there is little government can do.

Meanwhile, the most important step governments can take, comprehensive banking reform, is usually seen as a last resort. Instead, fiscal and monetary stimulus are seen as the policy course of the day. These methods are not going to be effective.

In today’s politics, notice that the Obama administration is caught up in the politics of the stimulus package while it has delayed announcement of structural banking reforms. I am all for using stimulus to cushion the blow. However, stimulus without structural changes in the banking system is irrelevant as it will not arrest the deleveragaing process now ongoing.

In essence, as in depressions, the financial sector has become too large and suffers massive overcapacity. A liquidation of excess capacity must ensue before the economy can right itself. Whether we get there by good bank/bad bank, nationalization or some other means is secondary.  We need to know that the stimulus debate going on right now is merely a sideshow.  The real work lies ahead — and some tough choices will have to be made as to which banks survive and which do not.

Sources
Depression (economics) – Wikipedia
Some inconvenient truths – David Rosenberg, Merrill Lynch