Recession
A recession is an income statement event typically caused by a lag in investment cycles (so a kind of real business cycle theory). The economy could see a demand shock or the pace of demand growth outstripping the ability of the fixed asset stock to respond in real time. This could happen for housing or tankers or drillships or other fixed assets with long order-to-delivery cycles. During this time asset prices will move into bubble territory. As orders are delivered, asset prices will start to fall, companies will start to lay off employees, and demand for assets and other goods will fall. Earlier ordered assets continue to hit the market as they are completed. Prices continue to fall and layoffs continue. This process usually lasts 12-18 months until orders in the pipeline start to peter out. Employment and similar indicators regain their prior peaks typically within 24 months or so. Cutting interest rates is helpful is moving inventory of assets hitting the market.
A variation of this includes a supply shock, almost always an oil shock in the modern era. In such an event, supply of a critical enabling commodity — oil — falls, inducing a recession in oil importing countries. Oil consumption falls to a new equilibrium at then begins to grow again from there. This is again a 9-18 month recession with 24 months to prior peak. For a recession, the policy prescription is the garden variety reduction in interest rates and fiscal stimulus essentially through automatic stabilizers.
Source: Calculated Risk
Depression
A depression is a balance sheet event. The hallmark of a depression is the impairment of collateral, most typically housing values. In the Great Depression and the China Recession (the Great Recession), housing values fell by 17%, in other words, a material decline. This meant that a significant portion of homeowners were under water with the equity in their homes and had to pay down debt to restore equity in the homes. If the debt has to be paid down with real money (ie, not inflated away), this is a slow process, figure 2-3% per year, implying the whole process takes seven years or so. If you take a look at the graph below, and look at the 2008-2016/17 stretch, you can see negative equity withdrawals (ie, net paydown of debt). I would argue that is the hallmark of a depression, and you won’t find it in the historical record except during the Great Depression. Because homeowners cannot borrow, the recovery is sluggish, employment growth is sluggish and everyone is kind of unhappy for a long time. These sorts of events are consistent with the rise of fascism, by the way.
https://www.calculatedriskblog.com/2021/09/the-home-atm-aka-mortgage-equity.html#google_vignette
For a depression, the main objective is to repair balance sheets quickly. That implies inflating the economy and debasing the currency, ie, expropriating lenders to benefit mortgage borrowers in order to revive the borrowing capacity of the economy. The prescription is then unsterilized cash injections into the economy, not QE. Interest rates adjustments will be largely ineffective because the collateral is itself compromised and people cannot refinance without a net repayment to the bank (because their house is not worth what they paid for it). Unsterilized cash injections may not cause significant inflation, at least for a while, due to the high propensity of consumers to pay down debt rather than increase consumption. Plus there should be plenty of spare capacity in the economy.
Note that this is not what any of the Fed or other central banks did. Their policy was largely ineffective at reviving the economy (although not in preventing a horrendously deep downturn). My perspective is more niche than even a minority view, but that’s where I think the analysis takes you. People were calling to help Main Street, not Wall Street, and I think that is in fact correct. Direct, unsterilized payments to households are far more important than putting the FFR to zero, which by the way, is another hallmark of a recession, that is, the FFR or equivalent is set to zero without causing either inflation or a robust recovery of the economy. The FFR will sit at zero for, say, seven years without much to show for it. That’s because it is the value of collateral, not interest rate, which is the problem. Again, the Great Depression and the China Depression have this in common, and only these two downturns in the last century have it in common.
I use the phrase ‘China Depression’ neither as a pejorative or to blame. Rather, we need to distinguish this event somehow from the Great Depression, and I believe the Great Recession was not a recession, but a depression. So what to call it? It is clear that the impetus for the China Depression was the rise of China’s economy in the global order. This is a good thing (assuming we don’t go to war) and lifted more people out of poverty faster than at any other time in human history. It would be fair to call it a near miracle. However, the size of China means that it is ‘large’ by comparison with other systems, including the US economy. Thus, China’s integration represented a major challenge to established economic structures and relations, and the process of integration had far reaching consequences for the global economy. From my perspective, the depression was likely unavoidable, but in any event, the proximate cause was the rise of China, hence the ‘China Depression’.
Suppression
In a suppression, there is fundamentally nothing wrong with the economy, no bubbles, excess inventory or unacceptable inflation. Economic fundamentals remain intact. However, a virus sends everyone to their homes. If the virus ended the next day, everyone would come out of their homes and it would be as though nothing has happened at all. So we’re not talking about an ordinary recession at all, but a kind of outage.
Recession dating supports this view. The NBER, the official US score-keeper for recessions, counts the length of the 2020 downturn as two months from peak to trough. This is the shortest recession in US history by a factor of four and does not even qualify as a recession by historical standards, usually defined as two consecutive quarters output decline (that is, 6+ months from peak to trough). We can state that the pandemic downturn was something qualitatively different that a traditional recession.
The outage is caused by 1) fear and 2) the government deliberately shutting down the economy, for example, through a lockdown. The government is actively suppressing the economy for public health reasons. The government is then also distributing massive amounts of cash to help people while the government is preventing them from working. This is going to be unavoidable, but we might expect significant inflation as a result, because purchasing power will be sustained (and then some) while supply falls. We would also expect the trade deficit to blow out as consumers turn to foreign supply, and if the stimulus is too large, it could blow up the logistics systems at its weak points, let’s say, the ports of Los Angeles. Here the issue is not whether you might get inflation, but rather how much. As Larry Summers pointed out, Biden’s fiscal stimulus (maybe some Trump stimulus is in here, too) was nearly 13% of GDP on a GDP output gap of 3%. Clearly, the stimulus was oversized, leading to the inflation problems we have today. Still, I think the model would suggest some inflation and trade balance deterioration is likely even in a more reasonably sized stimulus, just not necessarily this much.
Note that dumping the FFR to zero, as was the case again here, is a bad, bad idea. Because underlying purchasing power is not impaired, because there is no excess housing inventory, and because the ability to supply incremental housing is potentially impaired, tanking interest rates is likely to lead to a rapid and massive bubble in housing values, as well as in the stock market. And that’s what happened: Powell mistook a suppression for a depression and tanked interest rates to depression levels, when this was not warranted. We’ll have to see how this unwinds, but I would note that we could once again see collateral values impaired, and that means a depression, at least on paper.
https://fred.stlouisfed.org/series/FEDFUNDS
So, from my perspective, recessions, depressions and suppressions are different things and require different policy approaches. For that reason, they should have designations that clearly distinguish one from the other.