For all the fear, pain and uncertainty they bring, recessions and depressions are a natural part of the economic cycle. Below we'll explain what they are, what causes them, how they hurt—and how they help.

Key Takeaways

  • People often fear a recession, and even worse an economic depression.
  • During these periods of retraction, the economy slows, unemployment rises, companies go out of business, and governments propose stimulus.
  • However, a recession could also have benefits, clearing out poorly-performing companies and providing rock-bottom sale prices for assets.

What Is a Recession?

Let's start with recessions. Broadly speaking, a recession is defined as two or more consecutive quarters of negative economic growth, which is most commonly measured using real gross domestic product (GDP). The National Bureau of Economic Research's (NBER) criteria are more nuanced and include employment levels, real incomes, retail sales and industrial output.

Recessions can occur for a number of reasons, including exogenous shocks such as wars or sudden declines in the supply of key goods. However, they often arise as a result of the economy's own cyclical nature without inputs from the outside. For example, as the economy grows, firms have an incentive to produce more and increase profits. This tendency can lead to oversupply, which weighs on profits, leading to layoffs, falling equity prices and recession. Alternatively, competition between firms over labor can drive household earnings up, spurring firms to raise prices and causing inflation. If the inflation rate gets out of hand, households will begin to cut back on spending, leading to oversupply. In either case, the economy's own expansion contains the seed of the next recession.

The U.S. has experienced 33 recessions since 1857 according to the NBER, varying in length from six months (January to July 1980) to 65 (October 1873 to March 1879). The average contraction lasts lasts 17.5 months, but since 1945, durations have shortened significantly, averaging 11.1 months.

What Is a Depression?

Depressions are drastic economic downturns in which real GDP falls by 10% or more. They are far more severe than recessions and their effects can be felt for years. Depressions are known to cause calamities in banking, trade and manufacturing, as well as falling prices, extremely tight credit, low investment, rising bankruptcies and high unemployment. As such, getting through a depression can be a challenge for consumers and businesses alike. 

Depressions occur when a number of factors come together at one time. Overproduction and soft demand combine with fear on the part of businesses and investors to produce panic. Investment plummets, unemployment rises and wages drop. Consumers drastically cut back on spending, putting additional pressure on firms and setting off further job cuts. This vicious cycle reduces consumers' purchasing power and firms' revenues to the point that they miss mortgage and business loan payments. Banks must then tighten their lending standards, slowing the economy even further.

In the U.S., the most well-known example is the Great Depression of the 1930s. This term actually refers to two depressions: the first occurred from August 1929 to March 1933, during which GDP declined by 33%. The second ran from May 1937 to June 1938, during which GDP declined by 18%.

Negatives of Recessions and Depressions

Recessions and depressions have both negative and positive effects, and understanding them is one of the best ways to survive a downturn. First the negative effects:

Increasing Unemployment

Rising unemployment is a classic sign of both recessions and depressions. As consumers cut their spending, businesses cut payroll in order to cope with falling earnings. Unemployment is far more severe in a depression than a recession. In general, the unemployment rate peaks at 6% to 11% during a recession. By contrast, the unemployment rate hit 25% in 1933, the end of the first period of the Great Depression. Studies have shown the involuntarily unemployed tend to suffer higher levels of anxiety, stress and depression than the employed, as well as more frequent hospital admissions and premature death.

Causing Fear

Recessions and depressions create high amounts of fear. Many lose their jobs or businesses, but even those who hold onto them are often in a precarious position and anxious about the future. Fear in turn causes consumers to cut back on spending and businesses to scale back investment, slowing the economy even further.

Dragging Down Assets

Asset values sink in recessions and depressions because earnings slow along with the economy. For example, stock prices fall as slowing earnings and negative outlooks from companies repel investors, while home values sink as demand retreats in the face of economic uncertainty. 

Positives of Recessions and Depressions

Getting Rid of Excess

Economic decline allows the economy to clean out the excess. Inventories drop to more reasonable levels. Moribund firms that had limped along during a period of expansion go out of business, allowing capital and labor dedicated to them to be used in more productive ways. This process of creative destruction is most closely associated with the 20th-century Austrian economist Joseph Schumpeter, who saw capitalism as a continuous process of destruction and renewal in which entrepreneurs play a key role in overhauling the system. Most adherents to his ideas see the process as enabling long-term growth, though Schumpeter himself suspected the whole system would eventually collapse as medieval feudalism had.

Balancing Economic Growth

Recessions and depressions help keep economic growth balanced. Unchecked growth over many years would likely lead to overcapacity or high inflation (though Australia has gotten along fine since 1991 without suffering a recession). By sparking layoffs, recessions and depressions prevent competition over labor from pushing wages up to the point that prices rise in response, increasing companies' earnings, leading them to hire more, and so on in an inflationary wage-price spiral

Creating Buying Opportunities

Tough economic times can create huge buying opportunities. As the downturn gives way to recovery, markets often achieve higher highs than before the recession or depression. Contractions therefore present a money-making opportunity to investors with the time to wait out a recovery. The S&P 500 stock market index, for example, shot up 285% from its trough in 2009 to October 20, 2017.

Changing Consumer Attitudes

Economic hardship can create 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 generally causes the national savings rate to rise and allows investments in the economy to increase once again.

The Bottom Line

Surviving recessions and depressions requires you to understand what causes them and what effects they have on the overall economy. Some of the positive effects include taking the excesses out of the economy, balancing economic growth, creating buying opportunities in different asset classes and causing changes in consumer attitudes. The negative effects include rising unemployment, pervasive fear and steep declines in asset values.