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Economic Cycle
An economy normally goes through four cyclic phases. These are expansion, peak, recession and recovery. Typically, on an average, the cycle repeats itself every five to seven years. A recovery happens when output starts to increase. Commonly, it is said that 'green shoots' are visible. Things look up, and businessmen start reporting improved sales. New investments are made in factories and greater production is achieved. This leads to the expansion phase. At this point the people are very optimistic about the future and commit to further new investments. In a modern economy there is a natural lag between perceived demand and the means to produce to satisfy those wants. That is investments must be made now to satisfy identified future demand. Thus as a peak nears, demand outstrips actual production, while credit also grows, leading to inflation. Usually at this point the Central Bank steps in to 'cool' the economy by raising interest rates. The theory is that as demand comes down it will match the available supply of goods. As interest rates rise and demand for goods and services fall, businessmen feel constrained to reduce production; leading to a fresh recession. Alternatively, if producers created excess capacity in their enthusiastic expectations of increasing demand, you have higher supply and lower demand, leading to fall in prices, which then further constrains production, and thus causes a contraction or recession.
Depression
A deep economic downturn is referred to as a depression. This is when the GDP or output plummets continuously. A corollary is that, in an environment of falling production, unemployment soars. A downturn needs to persist for at least two years before it can be classed as a depression. "A depression is characterized by economic factors such as substantial increases in unemployment, a drop in available credit, diminishing output, bankruptcies and sovereign debt defaults, reduced trade and commerce, and sustained volatility in currency values. In times of depression, consumer confidence and investments decrease, causing the economy to shut down."(Investopedia)
The Great Depression
Though it is seventy years and more now, the Great Depression of the Thirties of the last century still gives the world the jitters. The Great Depression began shortly after the Oct. 24, 1929, U.S. stock market crash known as Black Thursday. The stock market bubble had burst and a huge sell-off began, with a record 12.9 million shares traded. The United States was already in a recession, and the following Tuesday, on Oct. 29, 1929, the Dow Jones Index fell 12% in another mass sell-off, triggering the start of the Great Depression. Many investors' portfolios became completely worthless. Although the Great Depression began in the United States, the economic impact was felt worldwide for more than a decade. (Investopedia).
Another disturbing factor of the Great Depression was that the prices declined 10% every year during the contraction. This led to widespread business and bank failures and unemployment would continue in double digits for nearly a decade.
Clearly this is not a scenario that anyone wants. Since that cataclysmic event, economists have battled even recessions with the tools that were developed to fight the Great Depression. The principal ones are monetary easing and increasing government spending to keep demand high. This became known as 'demand management' in economic parlance.
What is a Recession?
A recession is a downturn that lasts for a few quarters only. The down turn while very real in terms of declining output is much shallower that that of a Depression and also lasts for a much lesser period. In fact economists class this a part of the economic cycle. In the U.S., in the seventies, in the recession following the first Oil Crisis, output shrank 3.4%, while the jobless rate surged to 9%.
A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades. (Federal Reserve Bank of San Fransisco).
Technically, two consecutive quarters of decline in GDP classify as a recession. During the last few years, Japan, Europe and the US have experienced recessions, with monetary easing (QE) being resorted to in order to lift growth and get out of recessions.
When is a Recession a Depression?
According to economists, a recession becomes a depression when the GDP falls more than 10% in real terms from peak to trough or if the downturn lasts for a period of more than two years. Thus the decline in the Japanese economy by 3.4% for two years up to 1999 is not considered as a depression.
But a recent analysis by Saul Eslake, chief economist at ANZ bank, concludes that the difference between a recession and a depression is more than simply one of size or duration. The cause of the downturn also matters. A standard recession usually follows a period of tight monetary policy, but a depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level. (30th December, 2008, Economist)
Still recovering from the Financial Crisis of 2008, the world economy continues to be fragile. Most countries are struggling with structural adjustments, while Central Banks have opened the monetary taps for easy credit. Yet there are no signs of a sustained recovery in sight. What is really worrying is that even after several rounds of monetary easing, there is little inflation in the developed economies; a sign that demand continues to be weak.
The worry for experts like Dr. Rajan is that in such a fragile environment, deflation caused by asset bubbles finally bursting, can shrink demand further, to levels where it no longer resembles a short and sharp recession, but a more prolonged depression. Whether asset bubbles will burst to cause such extensive damage is what experts are keenly watching out for.
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