An acquaintance asked what the difference was between a recession and a depression. Just a question of degree?

I thought this was an interesting question. No, it isn’t a question of degree. A recession is a normal, healthy part of the business cycle. Malinvestment and overinvestment are corrected and the stage is set for further growth. While recessions may be accelerated by some external stimulus, like the oil price shock which triggered the 1973-74 recession, they happen anyway. They may not be very comfortable, but they are really a necessary course correction for the economy as leadership changes.

A depression, on the other hand, occurs when the financial system breaks down. For whatever reason, the supply of credit dries up as the banking and financial system can no longer supply the needs of the economy. The most recent example of this is in 1990s Japan. After the stock market and real estate bubble burst, the banks were left holding huge amounts of non-performing loans. They could not realize on their collateral because prices fell dramatically in the post-bubble deflation. With the banks’ capital badly or entirely impaired, lending stopped and the economy ground nearly to a halt. Fortunately, Japan was savings-rich and therefore the level of consumer pain was not nearly that which resulted from the more serious 1930s depression. However, today deflation still plagues the Japanese economy and the stock market is at or near lows last seen more than 20 years ago.

This has been a major wake-up call to central bankers, who thought that, having freed the money supply from gold or other commodity backing, that they could always print enough money to forestall deflation. The Japanese experience falsified this theory.

Alan Greenspan, responding to a question from Congressman Ron Paul: “I’ve stated in the past that I’ve always thought that fiat currencies by their nature are inflationary. I was taken back by observing the fact that from the early 1990s forward Japan demonstrated that fact not to be a broad, universal principle.”

The Fed is aware the US debt levels have long since surpassed anything ever seen before. They fear that any recession which caused default on a portion of this debt could rapidly cause the same kind of bank problems seen in Japan. Therefore, they have been doing all they can to keep inflating the economy in the hope of re-igniting normal growth. Alas, so far all the growth in the economy is being purchased at the cost of increased debt. The waterfall rumbles in the distance.