What Is a Recession and What Causes It?

Among the multitude of market and  economic event that can take place, a recession is arguably one of the most devastating and moving. 

In this article, we cover what a recession is, why it happens, and how to tell if it’s coming. Let’s dive deeper:

TL;DR

• A recession refers to two consecutive quarters of negative GDP growth, which is the common indicator of a recession.

• During a recession, economic output, employment, and consumer spending decline; interest rates typically fall, and government spending increases.

• Structural shifts, financial risks, psychological factors, or a combination can cause a recession.

• High interest rates, increasing bankruptcies, stock market weakness, inverted yield curve, declining manufacturing, housing, and consumer confidence can signal a possible recession.

Recession Defined: What Is a Recession?

There is no widely accepted, precise definition of recession. But the most commonly accepted indicator of a recession is when we get two back-to-back quarters of negative growth in the Gross Domestic Product (GDP). That is understood as the total value of all the goods and services produced within the economy has diminished for six months straight.

In the case of the United States, however, the National Bureau of Economic Research (NBER) uses a broader definition of recession. It includes employment and industrial production data, among others, to conclude whether a recession is happening as they track the start and finish dates for the said recession. NBER points out that the beginning of a recession can commence when economic activity advances to a peak point, and it can end with economic activity contracting to a low. In other words, they define a recession as a period of a downward trend. (Source: Investing.com)

What Happens During a Recession?

Economic output, employment, and consumer spending all decline during a recession. Interest rates are likely to decline as the central bank cuts the reference rate to support the economy. The government will see a widening deficit due to a loss of tax revenue while spending on social programs increases.

A recession brings about a major decline in economic activity that usually lasts for at least half a year and is accompanied by a decline in the stock market, an increase in unemployment, and a decrease in housing prices.

What Causes a Recession?

Many economic theories try to explain how and why an economy falls into recession. The causes can be broadly categorized into economic, financial, psychological, or a combination of all three.

Some focus on structural shifts in industries that have an important impact on the economy. Others point to financial factors, such as growth and accumulation of financial risks during the growth period preceding the recession. Those arguing that psychological aspects are the most crucial focus on the over-exuberance during economic booms, followed by pessimism when the downturn happens. An example of combining several factors could be the "Minsky Moment," named after the economist Hyman Minsky, which describes how an economic bubble grows and bursts based on financial and psychological factors encouraging unsustainable.

How to Tell If a Recession Is Coming

There are early signs of an economic recession, such as high interest rates, an increasing number of bankruptcies, and weakness in the stock market, just to name a few. Among those is also the inverted yield curve, which is considered a vital signal of a potentially up-and-coming recession. Notably, the yield curve has inverted in the past without leading to a recession. Usually, the yield curve is sloped upward, as longer-term debt has higher interest rates than shorter-term debt. 

Accordingly, an inversion occurs when short-term debt has higher interest rates than long-term debt. In turn, this reflects expectations for a possible onset of a recession.

Other indicators include declining manufacturing orders, weaker housing markets, and lower consumer confidence and spending.

Conclusion

Recessions are a natural part of the economic cycle, but they can have far-reaching consequences. Understanding the causes and early warning signs of a recession can help individuals, businesses, and governments prepare for and navigate these challenging periods. While there’s no surefire way to prevent a recession, being aware of the factors that contribute to them can provide insight into how to weather the storm and potentially emerge stronger when the economy recovers.

FAQs:

What is a recession? 

A recession is a period of economic decline where there is a decrease in GDP for two consecutive quarters, typically accompanied by reduced consumer spending, rising unemployment, and lower industrial output.

What causes a recession?

Recessions can be caused by a variety of factors, including structural shifts in industries, financial instability, or psychological factors like over-exuberance during booms followed by pessimism. The "Minsky Moment" explains how these factors can create and burst economic bubbles.

How can we tell if a recession is coming?

Early signs of a recession include high interest rates, increasing bankruptcies, stock market weakness, and an inverted yield curve. Other indicators are declining manufacturing orders, weaker housing markets, and reduced consumer confidence and spending.

How long does a recession last?

A recession typically lasts at least six months, though it can be longer depending on the severity of the economic downturn.

Can the government prevent a recession?

While governments can't prevent recessions entirely, they can take steps to mitigate their impact, such as lowering interest rates, increasing government spending, and introducing fiscal stimulus packages.