A Guide to Recession: Everything You Need to Know

Updated July 30, 2022 GuidesTrending

The dreaded “r” word – recession – is a normal, though unpleasant, part of the business cycle, which fluctuates between periods of expansion and contraction. In the good times, the economy is growing, and asset values are rising. Unemployment is low and cheap credit can gradually lead to an increase in debt.

But when this becomes too expensive to maintain, defaults occur which cause asset values to drop. In turn, this can lead to failures of businesses, slow or negative production and high unemployment. These short-term declines in general economic activity are known as recession.

What is a recession?

The often-cited rule of thumb in economics is that a recession is two consecutive quarters of negative economic growth, as reflected by gross domestic product (GDP). This may be handy and easy to classify for analysts, journalists, and the general public. But economists think slightly differently about business cycles.

In the US, the National Bureau of Economic Research (NBER) is generally recognised as the authority that defines the beginning and ending of US recessions. This can sometimes come a year or more after the fact. The NBER has its own definition of what constitutes a recession, namely:

“a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

In essence, there are three criteria which need to be met individually to some degree – depth, diffusion, and even duration – although extreme conditions revealed by one criterion may partially offset weaker indications from another.

The NBER will officially declare a recession, but it doesn’t necessarily rely on two straight quarters of negative economic growth using GDP data to call a recession. This is partly because GDP is a very broad measure that can be influenced by several wider factors like international trade or government spending. Instead, the Bureau will also study numerous other higher-frequency indicators such as a rise in the jobless rate, retail sales and other measures of manufacturing, services, and income. This data is released monthly and not quarterly like GDP.

Since 1950, the US has not experienced a two quarters-in-a-row contraction in GDP that was not in the end associated with a recession.

What causes a recession?

There is any number of ways an economy can fall into a recession, from sudden disasters like war to a fallout from uncontrolled inflation, or a combination of several factors. Some of the main drivers are:

  • A sudden economic shock – this type of event can create serious financial damage to businesses and consumers. For example, the energy price shock in the last 18 months has been compared to the 1970s oil shock. The latter saw OPEC cut off the supply of oil to the US with no warning, causing a recession[1].

  • Elevated inflation – the steady, upward trend in prices over time is not a bad thing, all things considered. But excessive inflation often means central banks will raise interest rates quickly which can depress economic activity. Rampant price pressures were an issue in the 1970s which saw the Fed hike rates rapidly[2], which in time, led to an economic decline. Sound familiar?

  • Excess debt – if the cost of debt is too high, businesses and individuals may struggle to repay loans. This can lead to debt defaults and bankruptcies which can ultimately capsize the economy. The housing bubble that led to the 2008 crisis is the obvious example of excessive debt resulting in an economic recession.

  • Asset bubbles – This situation is closely linked to excessive debt. Also driven by emotion, investors can drive up the prices of risky assets which inflate stock market and real estate prices way beyond reasonable valuations. When these bubbles pop, a recession and worse will follow.

Recession indicators

Here are some indicators that could provide some insight into the possibility of a recession:

  • Rising unemployment: Job losses are a big warning sign of an imminent slowdown as this means businesses and companies, and so the economy is not growing. What’s vexing economists at present is the fact that 2022 has seen job growth remain strong with jobs being added in the US by hundreds of thousands monthly, as well as raising wages.

  • Sharp stock market selloffs: Nine of 12 bear markets, or falls of more than 20%, that have occurred since 1948 have been accompanied by recessions. Nervous investors will sell stock holdings in anticipation of a slowdown in economic activity.

  • Leading indicators: There are numerous other monthly data releases which can tell us if the (US) economy is slowing. These include The Conference Board Leading Economic Index and the ISM Purchasing Managers Index. There also lagging indicators and the US Treasury yield curve which can give advance warnings of an economic decline.

Recessions in the past

According to NBER data, there have been 34 recessions in the US since 1854. The average recession which took place between 1945 and 2009 lasted 11 months. Economic downturns in earlier eras tended to last over 20 months[4].

Two recent examples are:

  • The Great Financial Crisis which occurred between December 2007 and June 2009. This economic decline was almost double the length of recent US recessions. It was caused in part by a bubble in the real estate market and defaults in subprime mortgage.

  • The Dot Com recession took place from March 2001 and November 2001. The fallout from the tech bubble stock market crash, plus the 9/11 terrorist attacks and accounting scandals all combined to push the US economy into recession.

Effects of a recession on you

The real impact from economic recessions comes in the form of job losses, falling wages and business closures. Finding another job becomes harder while existing employees may experience cuts to pay. With many people finding it harder to pay their bills, lenders will tighten standards for mortgages and other loans.

Investments in the stock market, real estate and other assets can lose value. Interestingly, the benchmark S&P 500 has fallen as low as 23.6% from its January record high this year, in line with the 24% median decline the index has registered in past recessions[5]. This could be indicating that at least some of the recent challenging environment is reflected in stock prices.


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References

  1. “1973 Energy Crisis” 19 July. 2022, https://www.investopedia.com/1973-energy-crisis-definition-5222090. Accessed 25 July 2022.
  2. “How the Great Inflation of the 1970s Happened”, https://www.investopedia.com/articles/economics/09/1970s-great-inflation.asp. Accessed 25 July 2022.
  3. “US Consumer Spending Cools in Sign of Economy on Weaker Footing”, https://www.bloomberg.com/news/articles/2022-06-30/us-inflation-adjusted-spending-declines-for-first-time-this-year. Accessed 25 July 2022.
  4. “A Review of Past Recessions”, https://www.investopedia.com/articles/economics/08/past-recessions.asp. Accessed 25 July 2022.
  5. “Recession? Soft landing? Stagflation? Investors assess economy’s strength”, https://www.reuters.com/article/usa-stocks-weekahead-idTRNIKBN2OJ1YD. Accessed 25 July 2022.

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