On a recent radio call-in show, an economist used the terms ‘recession’ and ‘financial crisis.’ A caller asked, ‘Well, just what is the difference?’
There is a difference, but confusion is understandable, especially when economists and others switch between terms that are not well understood by the general public.
Here are some brief explanations of terms commonly used in discussing our predicament:
Recession. “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.” The National Bureau of Economic Research, a nongovernment research organization with a special committee devoted to dating the onsets and ends of recessions, uses that definition.
In this definition, GDP, or Gross Domestic Product, means the total dollar value of all the goods and services produced in our economy in a year. And whenever economists use the word real, they mean “adjusted for inflation.” Declines in employment refer to decreases in the total number of jobs. This usually is accompanied by an increase in the unemployment rate, the proportion of the labor force that does not have a job but is trying to get one.
The NBER committee officially dates recessions after the fact. A common simple definition is that a recession occurs whenever GDP, the value of all output, drops in two successive three-month periods.
Depression. There is no official definition of what constitutes a depression. Prior to the 1930s, people used the word “depression” as we use “recession” today. Wags opine that when a neighbor loses her job, it is a recession; when you lose yours, it is a depression. More seriously, depression generally means a very deep and prolonged recession. Some economists talk of a 20 percent decline in GDP or 20 percent unemployment lasting several years. At the depth of the Great Depression, GDP had fallen 25 percent and unemployment exceeded 25 percent.
Financial crisis. A financial crisis occurs when there is a widespread loss of confidence in banks and other financial institutions, usually caused by one or more important financial companies going bankrupt so spectacularly that many of their creditors suffer large losses. These creditors in turn may go broke or may be so financially impaired that they are unable to carry out business as usual or meet their contractual obligations for an extended period. If limited to depository institutions, it is called a banking crisis.
Bear market. This is a deep drop in the prices of many corporate stocks, usually followed by a slow recovery of value. There is no official definition, but the common understanding is a 20 percent decline in major stock price indices like the Dow Jones Industrial Average or SP 500 rings in a bear market.
Bubble. A dramatic and ultimately unsustainable increase in the price of a whole class of asset — usually corporate stocks or real estate — that ultimately must reverse itself is a bubble. The joke, containing much truth, is that the best indicator of a bubble is when everyone says, “This time is different.”
Foreign exchange crisis. This occurs when a country cannot readily get the currencies of other nations that it needs to pay for imports and service foreign debts. It often is manifest in a dramatic drop in the value of the country’s domestic currency compared to major currencies used internationally.
Such crises are common in developing countries, especially in Latin America, but also hit France and the United Kingdom in the 1950s and 1960s. The United States has never had a serious one because other nations have been so foolish as to lend us enormous amounts in our own currency. I predict one before the current debacle is over, however.
Not all these symptoms occur in every period of economic difficulty. We often have had bear markets and recessions without a prior financial crisis. Not every financial crisis is due to the collapse of a bubble. A recession need not accompany a bear market or vice versa. And even large trading nations can have most of these problems without having a foreign exchange crisis. Japan after 1989 is a good example.
But in major downturns like 1907, 1929 or right now, virtually all of these symptoms appeared eventually — or will before it’s all over.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.