What is a Recession?

By Kirsteen Mackay

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A recession constitutes a significant decline in economic activity for a prolonged period. Economic shock, inflation, deflation, debt & bubbles cause recessions.

A recession is a period of economic decline. It can last for months or years. The official metrics used to determine a recession include negative gross domestic product (GDP), increased unemployment, a decline in retail sales, a slowdown in manufacturing, and diminishing income.

When a nation’s economy begins to experience these events simultaneously over an extended period of time, there’s a good chance it’s in a recession.

While recessions are difficult for the nation, businesses, and the public, they are a natural part of the regular business cycle. In the midst of a recession, jobs are lost, and companies lose sales momentum. At the highest level, the country sees its economic output decline and its economy struggles.

A recession is usually triggered by a single event or an accumulation of several events.

How a recession is determined

There are a variety of official definitions for determining a recession.

The National Bureau of Economic Research (NBER) is usually considered the authority determining when US recessions officially start and end.

This organization states:

“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.”

Economist Julius Shiskin created a more straightforward definition of a recession in 1974. He concluded a period of two consecutive quarters of declining GDP constituted a recession. That’s because a healthy economy sees its GDP grow. Therefore, six months of contraction is a reasonable sign that all is not well.

Whether we are in a period of recession is debatable based on varied definitions. The Covid-19 pandemic has created an unprecedented time for global economies and financial markets. There have been periods of decline and growth and decline again. Some people would determine this a recession, but it may not fit Julius Shiskin’s official take.

What causes a recession?

  • Economic shock

  • Rapid inflation

  • Extreme debt

  • Asset bubbles

  • Rapid deflation

  • Technological change

Economic shock

There are a variety of reasons an economy can slip or crash into a period of recession. An unexpected economic shock, such as the Covid-19 pandemic, can create a recession.

Inflation

Unrestrained inflation can also lead to recession. In the 1970s, OPEC (the Organization of the Petroleum Exporting Countries) triggered a recession when it suddenly halted oil supply to the United States without warning.

Wild inflation during this time led the Federal Reserve to raise interest rates, which brought about a recession rapidly.

Too much debt

Low interest rates encourage borrowing, but too much debt can quickly become unmanageable if interest rates rise. This is a problem, whether it be individuals, businesses, or a nation’s economy. Debt defaults and bankruptcies can quickly tip the economy into recession.


The housing bubble of 2007/8 led to the Great Recession, which was effectively caused by excessive debt in the real estate market.


When an economy is strong, and confidence is riding high, it is easy for investors to get carried away with the positive outlook. But too much optimism can cloud judgment and lead bad economic outcomes to crash into view when least expected.

Asset bubbles

An asset bubble occurs when the price of an asset, such as stocks, bonds, real estate, art, or commodities, escalates rapidly without fundamental justification. And when the bubble pops, it can cause a full-blown recession.

Deflation

When prices rise too quickly, it can cause inflation, but when prices decline too quickly, and wages tighten, the opposite effect is deflation. This can be even more devastating than inflation. When people can’t afford to spend, they cut back, and the economy suffers. Japan famously suffered a deflationary environment throughout the 1990s, leading to a long-lasting and deep recession.

Technological changes

Technological changes can transform an economy and improve the standard of living long-term. But in the process can destroy a prior way of life, creating a period of recession as the transition gets underway. The Industrial Revolution led to advancements in the way people live and eventually a higher standard of living. But getting there meant professions were destroyed and recessions par for the course. The latest wave of technological innovation is bringing AI, robotics, machine learning, and genomics to the fore. Many economists worry this will cause intermittent recessions as jobs and industries become obsolete.

Recession vs. Depression

What’s the difference between a recession and a depression? The main difference is how long it lasts. A recession tends to last months, whereas a depression lasts years. The job losses, unemployment levels, and decline in GDP are all much worse in a period of depression. Therefore, it takes much longer for an economy to recover from depression.

There has only been one depression in the United States in the past century. And that is well known as The Great Depression, which lasted from 1929 until 1933 after the First World War. The Great Depression lasted four years, whereas The Great Recession from December 2007 to June 2009 lasted approximately eighteen months.

The NBER states the average recession between 1945 and 2009 lasted 11 months.

Meanwhile, between 1854 and 1919, the average recession lasted 21.6 months.

During the past 30 years, the United States has endured three recessions:

  1. The Gulf War Recession (July 1990 to March 1991)

  2. The Dot Com Recession (March 2001 to November 2001)

  3. The Great Recession (December 2007 to June 2009)

Are we in a recession?

According to the official committee NBER, the US entered a recession from February to April 2020. This was only two months and the shortest on record. Nevertheless, it was a very deep recession and had different characteristics and dynamics than prior recessions.

We are not currently in a recession, but there are signs another may be imminent.

The global economy has never been so indebted. Yet during 2020, the stock markets continued to soar, repeatedly making all-time highs throughout 2021. Meanwhile, rumors of transitory inflation abound, and asset bubbles appear to be forming throughout various parts of the economy, from housing to collectibles and blockchain assets such as non-fungible tokens. All this points to the worrying expectation of a prolonged recession which could lead to depression.

But economists agree to disagree. For there are still many reasons to believe economic strength will prevail. Demand for goods and services is strong, and wages in some areas are increasing.

Recession warning signs

There are a few signs economists look to for advance warning of a recession.

An inverted yield curve

The yield curve tracks US government bonds. Higher yields on long-term bonds indicate a healthy economy. When long-term yields are lower than short-term yields, a recession could be on the cards.

Reduced consumer confidence

Consumer spending drives the economy, so when spending slows, economists get concerned.

A drop in the Leading Economic Index (LEI)

The monthly LEI predicts future economic trends. A falling LEI shows trouble ahead.

Stock market crash or correction

A sudden sell-off in the stock market can indicate a recession is nigh.

Rising unemployment

Job losses are never good news and can often indicate economic trouble for a significant period of time ahead.

While recessions are bad for everyone, including businesses, the stock market, and investing, they are transitory. Better still, a period of recession is often followed by an extended period of strong economic growth.

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Author: Kirsteen Mackay

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

Kirsteen Mackay does not hold any position in the stock(s) and/or financial instrument(s) mentioned in the above article.

Kirsteen Mackay has not been paid to produce this piece by the company or companies mentioned above.