How an Economic Depression Works

[Warph]

Recently you have probably heard an ominous sentence that goes something like this, "The United States may be on the verge of another Great Depression." You may have heard it more than once, because a number of people have been throwing this idea around lately.

It is a sentence that strikes fear in the heart of any American. Even though few who actually lived through the Great Depression of the 1930s are still alive today, we have heard so many stories and seen so many photographs that we understand the pain that the Great Depression brought. We know that we don't want to experience anything like that again.

But what exactly is an economic depression? And what makes a depression so painful?

One way to understand a depression is to look at its opposite. What is a "good" economy? When the U.S. economy is behaving normally, one thing we see is an expanding job market. The number of jobs in the economy is growing. This means that unemployment is low. When someone needs a job, or wants to change jobs, an expanding job market makes it easy to find employment.

In a good economy, that expanding pool of jobs combines with increasing wages. Over time, people are making more money for what they do. In addition, inflation is low, so the increasing wages are able to outpace inflation and provide a rising standard of living for everyone.

The rising standard of living and a growing population translates into a growing economy. People are able to start new businesses, and existing businesses are able to sell more stuff. The stock market reflects this growth by rising.

A tool called the GDP, or Gross Domestic Product, measures the size of the economy. If you add up all the money that people, businesses and governments spend on products (like food, clothing, cars and paper) and services (like hospital care, dry cleaning, car insurance, and package delivery), you have the GDP for the country. In a good economy, the GDP is growing at a healthy clip. Three to 4 percent GDP growth per year (after inflation) would be considered a good average for the United States.

So, when jobs are expanding, wages are increasing, inflation is low and the economy as a whole is growing at a nice clip, times are good. People are happy with the economy.

A depression is the exact opposite of this rosy picture. For example, in the Great Depression jobs were scarce. The unemployment rate went as high as 25 percent during the worst of the crisis, compared with the 5 percent unemployment figure that we see today. Instead of growing, wages fall in a depression. So the people who still have jobs are making less money as time goes by.

Because fewer people have jobs, and those who do have jobs are making less money, people have less money to spend. This means that businesses have to close or scale back. Banks also fail and close, meaning that loans dry up (nearly half of the banks closed during the Great Depression). And that means the GDP is shrinking rather than growing. GDP growth turns negative in a depression. The stock market reflects all of this economic discord and plummets.

The effect of high unemployment and lower wages is where the real pain of a depression comes from. Without jobs, people can't make their house payments or their car payments. So they lose their homes and cars. Eventually, for a large segment of the population, there isn't enough money for essentials like food and clothing. In the Great Depression, this led to soup lines in cities and shanty towns in rural areas. It was an economic disaster that lasted for about a decade, although actual negative GDP growth only took place in five of those 10 years.

Several government programs in the 1930s worked toward ending the Great Depression. They included the Works Progress Administration, or WPA, which provided millions of government-backed jobs, the start of Social Security, which helped provide income to the elderly, and the creation of the National Labor Relations Board, which helped increase wages for workers. But it was the massive war-time spending during World War II that finally finished the Great Depression.