What's the difference between a recession and a depression?

There's no firm rule distinguishing the two. But as Ronald Reagan put it, "A recession is when your neighbor loses his job. A depression is when you lose yours."

After recessions, the economy heals and people are quickly put back to work. In depressions, output may heal, but the jobs machine breaks down. That's the main difference.

"In a recession, you have growth, and then the economy runs too hot, and then it has got to cool down for a while. And when it's cooling down people get laid off. And then when it warms up again, they get hired back at the same jobs and things go on," said Agora Financial's Bill Bonner in 2008. "But that's not what's happening now. People are not getting laid off. They're getting fired. And they're fired permanently because the jobs are not just cooling off; those jobs are disappearing."

What's interesting is that this trend hasn't been unique to the most recent downturn. After the recessions of 1990-91 and 2001, the jobs machine sputtered. Post-WW II, unemployment regained its prerecession level an average of eight months after recessions bottomed. After the 1990-91 recession, it was 23 months before jobs came back. It took 38 months to regain full employment levels after the 2001 recession. "At the rate we're going," Fed chairman Ben Bernanke told 60 Minutes earlier this month, "it could be four, five years before we are back to a more normal unemployment rate." Call it 72 months from the 2009 lows.           

Why has the jobs machine, so reliable in the past, been so defective over the past two decades? Why have we, in a sense, faced more depressions than recessions over the past 20 years?

There could be many reasons, and there's almost no consensus. But Raghuram Rajan, a University of Chicago economist who called the financial crisis years before it happened, gives three compelling ideas in his latest book, Fault Lines.

1. The world is changing
As Rajan writes:

unlike in past recessions, in which factories laid off workers temporarily when demand was low and rehired them when demand recovered, the economy at these times [1991, 2001] was undergoing deep structural change. Resources were moving from mature old industries to new young ones -- form steel to software, so to speak. As a result, laid-off workers had to search much harder and also retrain themselves for the available jobs -- hence the jobless recovery.

This has jammed up the jobs machine over the past two years as well. From 2003-2006, nearly one-quarter of all new jobs were related to the housing industry -- everyone from carpenters to mortgage brokers to Realtors. Many of these jobs are gone for good. Most never should have been created in the first place; it was a bubble.

People who once held these positions not only need to find a new job, but a new job in a new industry. They need to be retrained and re-experienced. That takes time.

2. We had it too good for too long
Here's Rajan again:

In the same way regular small fires rid forests of undergrowth that could contribute to a greater and more devastating conflagration, recessions force firms to think hard about their resources and compel them to reallocate resources ruthlessly in a way that would not occur in more normal times. In the process they help the economy avoid deeper long-term damage ...

Firms therefore use recessions to clean house effectively.

What was different about the 1990-91 and 2001 recession is that each came after nearly a decade of growth ... [F]irms had acquired far more "undergrowth" during the long expansion: thus more cleansing was necessary and its effects more prolonged. Put differently, the longer the years of plenty, the longer the famine.

Exacerbating this phenomenon, much of the growth of the late '90s and especially during the last decade was the result of runaway monetary policy and speculation. Bubbles bubbles bubbles. So not only did the "undergrowth" have a particularly long time to grow, but much of it shouldn't have been growing at all to begin with.

3. Attack of the Internet
Rajan again:

In earlier recoveries, firms would put out advertisements for positions, people would reply by mail, be screened, and then be called for interviews, all of which took time. Long lead times in hiring meant that firms had to worry that they might not have enough employees to meet the growing demand and could lose sales if they did not start hiring early enough. With the advent of the Internet, it is easier for firms with positions and candidates with the right qualifications to find a match. The Internet also makes it easier for firms to wait and watch their order books, hiring just in time to meet demand.

One piece of evidence in support of the "just-in-time" hiring theory is the greater dependence of firms on temporary workers in two most recent recoveries, which suggest a reluctance on the part of firms to create permanent jobs.

This is a boon for online employment directories like Craigslist and Monster Worldwide (Nasdaq: MWW). Here's that "greater dependence" he talks about:


Source: Bureau of Labor Statistics, author's calculations.

Note that most of the surge occurred during the mid- to late '90s, when the unemployment rate was incredibly low and economic confidence was about as high as it gets. The increase in temp help, then, doesn't seem to be caused by firms too timid to hire permanent workers, as some insist. It's a product of the Internet.

We're moving in the right direction down the road toward job gains. But it's going to be slow. Agonizingly slow. That's the nature of our new economy -- the nature of depressions.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

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