What is a Recession?
A recession refers to a significant decline in economic activity that lasts for months or even years. It is a normal part of the business cycle that typically features contracting output, rising unemployment, falling incomes, and shrinking retail sales.
Recessions disrupt financial markets and often precipitate wider crises across businesses, households, and even governments.
Identifying a Recession
There is no single definition or fixed criteria for what constitutes a recession. However, these key elements might help identify one:
A sustained decline in a nation’s gross domestic product (GDP), which measures the value of all goods and services produced, is a telltale sign of a contracting economy.
As consumer, business, and government spending declines, companies lay off workers. This leads to spiking unemployment rates.
Reduced Incomes and Retail Sales
With rising job losses come falling wages, shrinking incomes, and decreasing spending by consumers and businesses.
Lasting Months or Quarters
A recession sees declines across various sectors of the economy over a sustained period, not just one or two quarters.
Timing in the Business Cycle
Recessions occur after the peak of economic expansion and continue until activity reaches its trough.
The National Bureau of Economic Research (NBER) is considered the authority for dating U.S. recessions. It uses monthly data on employment, personal income, retail sales, and other indicators to determine when a recession starts and ends.
The NBER does not rely on the common definition of two consecutive quarters of falling GDP for identifying and categorizing recessions as such.
Causes of Recessions
There are several potential triggers for an economy entering a recession, including:
- Asset Bubbles: Speculative frenzies can drive overvalued asset prices that eventually crash and significantly impact wealth.
- Financial Crises: A banking or financial crisis disrupts lending, credit flows, and financial markets.
- Deflation: Falling prices lead to lower corporate profits and wages, which result in lower consumer and business spending.
- High Inflation: Central banks raise interest rates to control inflation, cooling economic growth.
- High Government Debt Levels: Excessive fiscal debt drags on spending as the cost of financing increases and budget cuts are needed for federal governments to stay afloat.
- Oil Price Shocks: Sudden spikes in oil prices increase costs throughout the economy.
- Pandemics: Widespread outbreaks halt travel, trade, and normal economic activity.
- Policy Actions: Government policy mistakes or changes can inadvertently dampen economic growth.
Recessions also often spread between countries through trade and financial links, becoming global recessions.
Characteristics of Recessions
Recessions share some common traits, including:
- Declining Consumer Confidence: Households cut back on spending and big purchases.
- Falling Business Investments: Firms reduce capital expenditures and hiring as sales outlooks worsen.
- Tightening Credit: Lenders tighten their standards to extend loans in response to uncertainty and rising defaults.
- Stock Market Declines: The market capitalization of publicly traded companies falls as investors become more risk-averse.
- Lower Interest Rates: Central banks cut rates to stimulate the economy.
- Higher Insolvencies: Bankruptcies and defaults rise across households, companies, and even governments.
- Rising International Trade Falls: Global trade shrinks as demand contracts across major economies.
What are the Most Common Consequences of a Recession?
Recessions can have severe consequences on people, businesses, and governments, including the following:
- Job losses or wage cuts.
- Difficulty finding work.
- Declines in savings and wealth.
- Financial hardship and struggles to meet financial obligations.
- Reduced consumption and quality of life.
- Lower purchasing power if inflation spikes.
- Lower sales and revenue.
- Excess inventory and capacity.
- Smaller profits or losses.
- Reduced investment and expansion.
- Bankruptcies and closures.
- Falling tax revenue.
- Higher spending on social safety-net programs.
- Increased budget deficits.
- Higher borrowing costs.
- Difficulty funding essential services.
Recessions vary in their severity and duration based on their underlying causes and the policy response. However, they invariably impose short-term pain on most actors across the economy.
Recession vs. Depression
Recessions are distinct from the more extreme economic crises known as depressions.
The criteria to define a depression is often different among analysts, but they often entail the following circumstances:
- Much larger economic declines: GDP shrinks dramatically.
- Lasting years, not months: Extended periods of economic contraction.
- Extremely high unemployment: The percentage of jobless individuals increases beyond 10%.
- Severe deflation: Steep declines in the price of goods.
- Heavy debt burdens: Widespread defaults and insolvencies.
- Protracted recoveries: Growth resumes slowly.
Depressions are exceptionally rare events that have been seen only a handful of times in modern history, while recessions have occurred every 5 to 10 years, give or take.
The most recent depression in the United States was the Great Depression of the 1930s, during which America’s GDP fell by around 25% amid mass unemployment.
Predicting the exact timing and severity of recessions remains difficult. They arrive unexpectedly due to sudden shocks or financial crises. Quantitative econometric models are generally not reliable enough to predict them.
Economists often look for various indicators to gauge the likelihood of an impending recession, including:
Equity Bear Markets
Equity valuations falling by more than 20% are a signal to investors that weaker growth is coming.
Yield Curve Inversions
When short-term interest rates exceed long-term rates, this is considered a negative factor for economic outlooks.
Falling Leading Indicators
Declines in employment and manufacturing metrics across the economy.
Tightening Credit Conditions
Banks restricting business and consumer lending.
Rising Corporate Defaults
Businesses are unable to service their financial commitments.