What is a Recession?
A recession is an economic downturn that causes significant and widespread economic activity to slow down. Recessions can last up to six months. One rule of thumb is that a country’s Gross Domestic Product (GDP ) will be considered a recession if it has two consecutive quarters.
According to economists at the National Bureau of Economic Research, a recession is an economic contraction that begins at the height of the expansion and ends at the lowest point of the subsequent downturn.
Recessions are known to cause declines in consumer demand, economic output, and employment. In determining the beginning and end of U.S. economic recessions, the NBER uses indicators such as nonfarm employment, industrial output, and retail sale. These indicators are often months after the peak or trough of a business cycle.
The Key Takeaways
- A recession is an economic downturn that causes a substantial, persistent, and widespread decline in economic activity.
- Economists use the previous expansion’s peak as a measure of the length of a recession.
- While a recession may only last a few months or years, the recovery process to the peak of the economy can take many years.
- A negative yield curve predicted 10 of the most recent recessions. There were also a few that did not materialize.
- Many people feel that the initial stages of economic recovery can feel like a prolonged recession because unemployment is often high even after an economic recovery.
- To limit the risk of a recession, countries around the globe use monetary and fiscal policies.
To qualify as a “recession” according to NBER, a downturn must be severe, persistent, and long-lasting. However, these are retrospective judgments made by academics and not a mathematical formula that can flag a recession right away.
The NBER designated it a recession because of its widespread impact and depth, despite the fact that it only lasted two months.
The NBER stated that the U.S.’s economic expansion had reached its peak in February 2020 and then fell into recession due to the COVID-19 epidemic the following month. The 128-month period of economic expansion that began in June 2009 was longer than the 120-month period of expansion between 1991 and 2001, which is the longest uninterrupted stretch of growth in American history. The NBER declared that the following recession lasted just two months and economic activity bottomed in April 2020.
Economic growth has been the norm in most countries since the Industrial Revolution. However, contractions are a frequent exception to this rule. Recessions are a short corrective phase in the economic cycle. They often address the economic imbalances that were created by previous expansions, allowing for growth to resume.
Recessions are an inevitable part of the economic landscape. However, their frequency and duration have decreased in modern times. According to the International Monetary Fund, 122 recessions that affected 21 advanced economies occurred between 1960 and 2007.
Reckonings are an abrupt reversal of the generally dominant growth trend. The declines in employment and economic output that they cause can spiral into self-perpetuating problems. The result of a recession is a sudden reversal in the trend towards growth. Layoffs can further reduce the income and spending of newly unemployed people, which can lead to even more decline. The bear market in stocks that often accompany recessions may reverse the wealth effect by reducing consumption based on higher asset values and greater net worth. Small businesses may find it hard to grow if lenders stop lending. Some may even go bankrupt.
To ensure that recessions do not become more severe than they are now, governments all over the world have implemented counter-cyclical fiscal policies. These stabilizers can be automatic like higher spending on unemployment Insurance which makes up a fraction of the lost income of laid-off workers. Other stabilizers, such as interest rate cuts to support investment and employment, must be decided by a central banking, such as the Federal Reserve.
An investment in companies that have strong balance sheets, low debt, and good cash flows is a great strategy for investors. Avoid shares in companies that are high-leverage, cyclical, or speculative until the recession ends. Then, the survivors of the recession often outperform the rest.
It is difficult to determine the timing of these economic turning points without looking back. It is difficult to see the timing of such economic turning points from a retrospect perspective because economists, investors, and workers can all define it differently. Workers may not consider it a recession until after the economic recovery has taken place for several months, or even years. Investors may believe that a recession is beginning when capital losses mount and corporate earnings drop, even though consumer spending and employment are healthy.
Recession Indicators and Predictors
Although there is not one reliable indicator of recession, the inverted yield curve has predicted every U.S. recession since 2005 (while also triggering a few false alarms).
Longer-term debt usually yields higher than shorter-term obligations due to the greater duration risk. A 10-year bond is more likely to yield than a 2-year note, as there is more chance that inflation and/or higher interest rate will lower its market value prior to redemption.
Inverting the yield curve means that the yields on longer-dated bonds fall, pushing prices higher as traders expect economic weakness and interest rate reductions in the future. The federal funds rate and near-term expectations regarding monetary policy are important factors in determining the short-term yield curve. Expectations that the Federal Reserve will continue raising the federal fund’s rates will lead to 2-year yields rising more than 10-year yields.
To anticipate economic turning points, investors also use leading indicators. These indicators include the ISM Purchasing Managements Index, Conference Board Leading Economic Index, and the OECD Composite Leading Indicator.
What causes recessions?
Many economic theories try to explain why the economy may fall from its long-term growth trend into recession. These theories can broadly be classified as being based on psychological, economic, and financial factors with some bridging between them.
Economists often focus on the economic aspects of changes. This includes structural shifts in industries. A sudden, sustained rise in oil prices as a result of a geopolitical crisis might increase economic costs. However, new technology could quickly make entire industries obsolete. A recession is possible in both cases.
Another example of an economic surprise that can trigger a recession is the 2020 COVID-19 outbreak and the restrictions on public health that were imposed to stop its spread are the COVID-19 epidemics. Sometimes, an economic shock can only accelerate the onset of a recession that would otherwise have occurred due to other economic factors or imbalances.
There are many theories that explain why recessions occur. Many theories focus on the effects of financial factors on recessions. These include credit growth, accumulation of financial risk during good times, the contraction in credit and money supply at the recession’s onset or both. Monetarism is an example of this theory. It associates recessions with insufficient growth of the money supply.
Psychological theories of recession focus on the exuberance of economic booms, and the deep pessimism that is common during downturns. This helps to explain why recessions can happen and continue to occur. Keynesian Economics focuses on economic and psychological factors that can prolong and reinforce recessions. The Minsky Moment concept, named after economist Hyman Minsky, integrates financial and psychological frameworks. It emphasizes how bull market euphoria may distort economic incentives and encourage unsustainable speculation.
Depressions and Recessions
According to NBER, there have been 34 recessions in the United States since 1854. Since 1980, only five recessions have been recorded. The 2008 global financial crisis, the 1980 double-dip slumps, and the Great Depression were the worst since the Great Depression and the 1937-38 recession.
According to the IMF, a routine recession can result in a GDP decline of 2% while severe ones could cause an economy to fall by 5%. Depression is a severe and prolonged recession that is not easily defined by any common numerical formula.
The Great Depression saw the U.S. economy drop by 33%, stocks plummet by 80%, and unemployment reaches 25%. Real GDP fell 10% during the 1937-1938 recession, while unemployment rose to 20%.
What happens in a Recession
In a recession, economic output, employment, and consumer spending all drop. The Federal Reserve, the U.S. central bank, will reduce its benchmark rate to help the economy. Interest rates are likely to fall as well. Due to a fall in tax revenues, the government’s budget deficit increases. However, spending on unemployment insurance and other social services rises with more people claiming these benefits.
What was the last recession?
The U.S.’s last recession occurred in 2020, shortly after the COVID-19 pandemic. NBER reports that the two-month recession ended in April 2020. This qualifies as a recession, despite the fact that it was so severe and widespread.
How long do recessions last?
Since 1857, the average U.S. recession lasted 17 months. The six previous recessions have lasted less than 10 months.