A depression is a period of sustained downturn in the economy. It is considered worse than a recession in both depth and duration.
During this period, economic contraction takes place. Unemployment rises as companies seek to offset the decline in revenues. Investment tends to dry up as investors with resources take a conservative approach. Safe assets are in demand. We also see the demand for consumer goods falling.
The worst period was the Great Depression of the 1930s. This was triggered by the excess of the 1920s, resulting in a turn in the business cycle.
Firms suffer from an excess of capacity since demand wanes. It is a situation that filters through the economy affecting many markets. Real estate prices are high as people are unable to pay their mortgages. The result is an increase in foreclosures, bringing more supply to market.
Equity markets also suffer. Since capital becomes tight, the amount of money heading into markets drops greatly. Eradication of wealth is commonplace during these times. Those who are utilizing leverage by buying on margin is wiped out.
The overall sentiment is pessimistic. Unlike a bear market, which affects investors, a depression affect the most of the population. Workers either lose their jobs or are in fear of it. This further reduces spending as people turn to savings as much as they can.
Governments often respond with stimulus packages. The impact of these are greatly debated. Many feel they help to soften the blow while others maintain the actions only make things worse. Governments are known to set forth the next crisis through their decisions during the previous ones.
Depressions are deflationary periods. This is due to the fact that commercial banks stop lending during these periods. Without the inflating of the money supply, prices cannot help but to keep dropping. Central Banks such as the Fed will obviously try to entice lending, a move the banks will reject. It becomes a matter of self preservation.
In the past, governments would offset this by engaging in deficit spending. This was something they felt justified considering the economic circumstances. Unfortunately, the past 40 years reveal governments are addicted to spending, leaving the situation unclear if we suffer another major economic collapse.
