Q&A: What is the difference between a depression and a recession?

This is a good question and you wont be surprised to hear that economists have different views on the distinction between the two! My answer is that the difference is a matter of degree both about the duration of an economic downturn and also the severity.

The fashionable definition of a recession is ‘two consecutive quarters of negative GDP growth’. But most economists now favour a broader interpretation. The National Bureau of Economic Research defines a recession “as a significant decline in activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators.”

A depression is a persistent and severe downturn in output and jobs where an economy operates well below its productive potential and where there can be powerful deflationary forces at work. Harvard University economist Robert Barro defines it as a decline in per-person economic output or consumption of more than 10%.

Many economic historians say the line between recession and depression is crossed when unemployment rises above 10% of the labour force and stays there for several years. It can take many years for output to recover to where it was at the peak of the economic cycle and, because unemployment tends to lag the cycle, a depression can leave a legacy of mass unemployment whose consequences can take a generation to resolve.

This Economist article ‘Diagnosing Depression’ provides a useful background to the idea of depression.

The fragility of the financial system and the dangers that come from a severe deflation in the value of assets - especially a prolonged property slump can cause powerful depressionary forces in an economy.

But there are reasonable grounds for believing that the risks of a full-scale depression are relatively low for the UK economy - here are five reasons:

(a) The eye-wateringly large policy stimulus from monetary and fiscal policy - much of which has only recently come about and which will start to take effect as we move through 2009

(b) The 30% depreciation of the sterling exchange rate which has given a sizeable boost to the competitiveness of our export industries

(c) The rapid reaction of businesses to the downturn - many have cut their stock levels very aggressively and started to cut prices - whilst in the short term this makes a cyclical recession worse, it also provides some grounds for optimism that businesses will be better placed to expand production if and when demand starts to rebound

(d) Business and consumer confidence has taken a big hit in recent months - but it has not collapsed completely. The household savings ratio is picking up (currently 5% up from 1.7% in the final months of 2008) and this should help to provide a better platform for a rise in consumer spending in 2010

(e) Cheaper mortgages and energy costs are providing a sizeable boost to the effective disposable income of millions of consumers.