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What is a Recession?

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What is a Recession?

Recession is part of an economic life cycle when things are not going well, opposite to economic expansion.

While this extended period of economic decline can be unavoidable, understanding what it is and how it works is critical to prepare to plan for the next one.

Understanding Recession

In a nutshell, a recession refers to a prolonged, significant, and widespread downturn in economic activity. There would be a recession if two consecutive quarters of negative GDP (gross domestic product) occurred. However, more complex formulas are used as well.

In the US, the National Bureau of Economics Research (NBER) declares a recession. Economists at NBER measure a recession by looking at retail sales, industrial production, non-farm payrolls, etc., going beyond the simpler negative GDP two quarters.

On the other hand, NBER also notes that no fixed rules can measure what contributes to the process or is weighted in their decisions. The NBER defines recession to have a deep, lasting, and pervasive downturn to qualify as one. But still, no clear formula is used to determine it as soon as one starts.

A recession is part of the natural economic or business cycle of contraction and expansion. After reaching the highest point (peak), an economy begins to expand at its weakest point (trough) and begins to recede.

As a deep recession lasts for an extended period, it translates into a depression. The Great Depression lasted for a few years and resulted in a 10% GDP decline with a 25% unemployment rate in the early 1900s.

What are the Indicators of a Recession?

Below are different recession indicators:

Gross Domestic Product

Real Gross Domestic Product can indicate the total value an economy generates through services and goods produced based on a timeframe adjusted for inflation. Meanwhile, negative real GDP is an indication of productivity’s sharp drop.

Real Income

To calculate real income, personal income is measured and adjusted for inflation, and social security is discounted. If there is a decline in real income, purchasing power reduces.

Employment

The high unemployment rate is a lagging indicator. Generally, it confirms the pivot of the economy into a recession stage instead of a recession prediction in the future. An unemployment rate close to 6% of the total workforce is often considered problematic.

Wholesale/Retail

Retail and wholesale sales are both measured to gauge the goods’ market performance, adjusted for inflation.

Manufacturing

The manufacturing sector’s health signifies an economy’s self-sufficiency and strength, taking into account overall imports/exports and a trade surplus or trade deficits with other countries.

What Causes a Recession

Different economic theories, such as psychological, financial, economic, or a combination of these factors, attempt to explain how and why an economy goes into recession.

Many economists concentrate on structural shifts in industries and other economic industries. A sharp and sustained oil price surge, for example, can raise costs throughout the economy. This leads to a recession.

On the other hand, some theories state that financial factors cause recessions. When a recession starts, these theories pay attention on the

  • financial risks accumulation and credit growth during good economic times
  • money supply
  • credit contraction

To explain why a recession persists and occurs, other theories concentrate mainly on psychological aspects, like deep pessimism during downturns and over-exuberance thru economic booms.

For a bigger picture and further explanations, check out the following:

Real Factors

Structural shifts and external conditions sudden change can trigger recessions. The Real Business Cycle Theory says that a recession is a way a rational market participant responds to negative or unanticipated shocks.

For example, a revolutionary tech that causes automation in many factories can impact the economies disproportionately with a significant pool of unskilled labor.

Nominal/Financial Factors

Monetarism, a school of economics, defines a recession as a direct consequence of credit over-expansion during expansion periods. Insufficient credit availability and money supply can exacerbate a recession during the initial slowdown stages.

There is a significant correlation between real and monetary factors, including relationships and interest rates between particular goods. Please note that the relationship is not explicit since interest rates and other monetary policy instruments encompass institutional responses to the predicted slowdowns as well.

An upcoming recession’s financial indicators are usually associated with benchmark interest rates. The Treasury yield curve, for example, inverted in 18 months, which preceded the US’s last seven financial crises. A sustained fall in equity values also displays lower expectations.

Psychological Factors

Overexposure to risky capital and excessive euphoria during an economic expansion period are some of these psychological factors. In 2008, the Global Financial Crisis was caused by irresponsible speculation. This led to a bubble formation in the housing market in the US.

Also, these factors can be manifested as curtailed investment, which can result from widespread market pessimism, lacking grounds in the real economy.

What are the Effects of Recessions?

A recession causes standard fiscal and monetary effects, where short-term interest rates fall, and credit availability tightens. When businesses cut costs, there will be an increase in unemployment rates. As a result, consumption rates are reduced, causing inflation rates to reduce.

As corporate profits go down due to lower prices, more job cuts are triggered, and an economic slowdown vicious cycle is created.

Typically, national governments intervene. For example, they bail out large banks and other structurally important financial institutions or businesses that face possible failure.

A larger unemployment workers pool allows employers to find and recruit more qualified candidates. Some businesses with foresight and understanding of the implicit opportunities that capital’s lower cost has created as prices and interest rates fall took advantage of the recessionary period.

Recession Vs. Depression

The NBER stated that the US had experienced only five recessions since 1980 but more than 30 since 1854. The downturn after the global financial crisis in 2008 and the double-dip slumps in the early 1980s were considered the worst since the Great Depression, as well as the 1937-1938 recession.

The GDP declined by 2% because of routine recessions, while severe recessions are predicted to set the economy back by 5%. Particularly, depression is a deep, long-lasting recession. However, there is still no accepted formula to define depression.

The US economic output fell as low as 33% during the Great Depression. Also, the unemployment rate hit 25%, and stocks declined by 80%. During the 1937-1938 recession, real GDP plunged by 10%, and the unemployment rate jumped to 20%.

What are the Recent Recessions?

The public health restrictions and the COVID-19 pandemic in 2022 are an epitome of an economic shock that could result in a recession. The widespread and depth nature of the economic downturn because of the 2022 pandemic made the NBER consider it a recession even if it was only relatively two-month long.

There’s a debate among economic analysts whether or not the US economy suffered a recession in 2022, especially since some economic factors indicate a recession.

Analysts from Raymond James, an investment advisory firm, argued in a report in October 2022 that the US economy wasn’t in recession. There was an argument that the economy met the recession’s technical definition after the two consecutive negative growth quarters. Still, other positive economic indicators display that the economy was not in recession.

Is Recession Predictable?

Predicting recessions in the future is far from easy, given that there is always uncertainty in economic forecasting.

COVID-19, for example, appeared out of nowhere in early 2020. And the US economy had been closed down, and many workers had lost their jobs within a few months. Then, the NBER officially declared recession in the US because of COVID. In February 2020, the economic contraction started.

Meanwhile, several things indicate the looming trouble. Below are some warning signs that provide more time to determine how someone can prepare for a recession before happening:

Rising Unemployment Rate

Obviously, an increase in the unemployment rate is a negative sign for the economy. A few months of severe job losses is a significant warning of a forthcoming recession.

Sudden Stock Market Declines

Another hint that a recession is coming is a sudden stock market decline. Investors are usually forced to sell off parts or all of their holdings as they anticipate an economic slowdown.

Leading Economic Index Drop

The Leading Economic Index is having a hard time predicting future economic trends. Please note that it looks at different factors, including stock market performance, new orders for manufacturing, and unemployment insurance applications. A declining LEU causes trouble in the economy.

Consumer Confidence Declines

What the consumers spend primarily drives the US economy. As surveys show a sustained consumer confidence drop, it can be a warning of impending trouble for an economy. If there is a decline in consumer confidence, people say they do not feel confident spending money. When fears overrule people’s buying decisions, this results in lower spending, slowing down the economy.

Inverted Yield Curve

If there is an inverted yield curve, people can make predictions of potential recessions. The yield curve refers to the graph plotting the yield or the market value of a range of US bonds. It involves a term of 4 months to 30 years bonds.

The yields must be higher on longer-term bonds if the economy functions normally. However, the longer terms are lower compared to the short-term yields; investors usually become worried about the recession.

How does Recession Affect You?

During a recession, you might lose your job as the unemployment rate rises. Besides that, finding a job replacement can be challenging since more people are also out on a job hunt. Meanwhile, if you have successfully kept your job, you might notice cuts to benefits and pay. Also, you might struggle to negotiate pay raises in the future.

Investments in real estate, bonds, stocks, and other assets might lose money during a recession. This reduces your savings and hinders your retirement plans. Plus, if you cannot pay the bills because of job loss, there is a big chance that you will lose your home and other properties.

A recession can also result in fewer sales among business owners. Some businesses might also be forced into bankruptcy. While the government will try to support these businesses, keeping everyone afloat can be hard during a severe downturn.

Since people cannot pay their bills, more lenders will tighten their standards for car loans, mortgages, and other financing types. You will need a larger down payment or a better credit score to qualify for a loan.

Despite planning ahead to prepare for recessions, it is still a frightening experience for everyone. But the silver lining is that it will not last forever. Remember, the Great Depression ended, and the strongest period of US economic growth followed in US history.

Conclusion

Recessions are a significant decline in economic activity, lasting for a few months or years. Experts will declare a recession if the economy of a country experiences negative GDP, increasing unemployment levels, retail sale decline, and contracting measures of manufacturing and income for an extended period. They are an unavoidable part of the economic or business cycle, but some factors can help predict them in the future

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