What is a Recession? (Are We in One or Close to One?)
For many, the idea of a recession can be extremely unsettling. In fact, it’s been a little more than a decade since Americans faced one of the worst recessions in history: The Great Recession of 2008 that was fueled by the collapse of the housing market. Now, with the coronavirus pandemic upheaving economies across the world, many may be wondering whether we’re experiencing a recession now.
Throughout this post, we’ll dive into the intricacies of important questions, such as “what is a recession?”, “what causes a recession?”, “what happens during a recession?”, and more. For a full scope on recessions, including warning signs and whether they can be predicted, read end-to-end. Or, use the links below to jump to a section that might contain an answer to one of your recession-related questions.
What Is a Recession?
A recession is defined as the period between an economy’s peak of economic activity and its subsequent lowest point (trough), where a significant decline in economic activity spans across the entire economy for more than a few months. On the other hand, expansion is the period between an economy’s lowest point and its subsequent highest point, where there is a gradual increase in economic activity.
The National Bureau of Economic Research is the governing body that officially declares recessions and includes the following three criteria in their recession definition:
- Depth, which measures how many workers are impacted by an economic downturn by looking at unemployment levels.
- Diffusion, which measures how widespread the recession is by looking at how many industries are affected by an economic downturn.
- Duration, which measures how long an economic downturn lasts before experiencing economic expansion.
When it comes to identifying a recession, these criteria can be interchangeable, as long as each criterion is met to some degree. For instance, an extreme event can significantly offset weaker indications, which can be seen today.
Are We in a Recession?
In a recent NBER statement, they claimed that yes, we are currently in a recession. This is due to the unprecedented magnitude in unemployment levels and production (depth) that resulted from the COVID-19 pandemic, paired with its broad reach across the entire economy (diffusion). While the duration is far weaker than depth and diffusion, the magnitude of the depth and diffusion of the current economic downturn classify the economy’s current state as a recession.
NBER’s recession definition focuses closely on diffusion. In order for a recession to be declared, it must influence the economy broadly, not just a single industry. For example, if the auto industry experiences sharp declines in production, but other industries within the economy continue to perform well, a recession can’t be declared.
The recession definition in economics uses real gross domestic product (GDP) as the best measurement of economic activity, which is measured in two ways by the Bureau of Economic Analysis: the product side (GDP) and the income side (gross domestic income (GDI)). NBER considers both product and income equally and uses these indicators to determine the months of peaks and troughs. NBER will also look at additional indicators when determining peaks and troughs, such as:
- Wholesale retail sales adjusted for price changes
- Household unemployment
- Real personal consumption expenditures
- Industrial production
- Initial claims for unemployment insurance
However, these indicators are given less weight than GDP and GDI, but provide NBER with more supplemental information when deciding whether the economy is doing well or poorly.
Recessions vs. Depressions
After the Industrial Revolution during the 1700s and 1800s, a majority of countries across the globe experienced a long-term macroeconomic trend of economic growth. However, when you look at the long-term growth over the past few centuries, you’ll notice a few dips along the way. These drops in economic activity are short-term fluctuations that indicate slowdowns in the economy, which can last anywhere between a few months to a few years before returning to the long-term growth trend.
What are these dips? These dips can be either a recession or, in worst-case scenarios, a depression. So, what’s the difference between a recession and a depression? From our recession meaning in the previous section, recessions are characterized by a significant decline in economic activity that spans across the economy for a few months.
Depressions, on the other hand, are similar to recessions but differ in severity. Depressions are characterized as an extreme recession that lasts three or more years or results in a decline in GDP of at least 10%. While less common than recessions, depressions bring about high unemployment rates and low inflation, which leads to an economic shutdown.
In the history of the United States, there have been roughly 50 economic recessions and one depression, dating back to 1785. Of these periods of economic downturn, some recessions proved to be more drastic than others, and each one had its own set of factors that lead to a drop in economic activity.
What Causes Recessions?
The causes of recessions are both obvious and uncertain. Many economists will disagree on certain causes of recessions and develop their own theories as to why recessions might occur. While no two recessions are the same, there are a few characteristics that most recessions often have in common. Some common causes of recessions include:
- High Inflation: Inflation is the upward trend of prices over time, and while it’s not necessarily bad, a sharp rise in inflation can lead to a recession. This is because, when there is excessive inflation, central banks typically raise interest rates, which limits liquidity, or the amount of money that is available to invest. With little money available to put into the stock market or other assets, a recession can occur. The Federal Reserve’s decision to hike interest rates in the 1970s to combat stagflation led to the 1980 recession.
- High Deflation: High deflation, on the other hand, can be just as detrimental to the economy as high inflation. Deflation is where the price of goods declines, which can lead to wages being lowered. Lowered wages can then lead to an even sharper decrease in prices, resulting in companies having to reduce spending, such as laying employees off. High deflation can also lead to lower demand, which can result in a recession. Trade wars during the 1920s resulted in deflation, which was one of the causes of the Great Depression.
- Sudden Economic Shock: An unexpected shock to an economy can also lead to a recession because legislatures and consumers have little time to react and make a plan. The 1973 Oil Embargo cut off the United States oil supply after they re-supplied the Israeli military to gain the upper hand in post-war peace negotiations. In turn, oil prices skyrocketed (along with gas station lines!), resulting in a recession. A more recent example was the sudden coronavirus pandemic that shut down economies across the globe, forcing businesses to close and workers to lose their jobs unexpectedly.
- Asset Bubbles Bursting: During strong economies, investors often become over-emotional and trade an asset at a price that exceeds its intrinsic value, which inflates an asset bubble, such as real estate or stocks. However, when an asset bubble pops, and demand and prices fall, investors often panic-sell, which can crash the market. The most notable examples of an asset bubble bursting are the 2001 recession where the “dot-com” bubble burst and the Great Recession of 2008, where the housing bubble burst.
- Stock Market Crash: A bear market, which is when a broad market index falls by 20 percent or more over a two-month period or more, can also cause a recession. Stock markets can often crash when there is a loss of confidence by businesses, investors, and consumers, and “bears” will begin selling their assets in fear the price of those assets will drop.
- Excessive Debt: When businesses or consumers take on excessive debt, it can snowball, making it hard to get out of the red, which can result in bankruptcy and debt defaults. When this happens, it can overturn the economy. An example is the Great Recession of 2008, where bankers lent risky mortgages to lenders. When housing prices fell, homebuyers couldn’t keep up with their mortgage payments, resulting in the housing bubble to pop.
- Advances in Technology: Technology is continually changing how we live and navigate through our daily lives. While innovation can be great for moving forward, it can have a serious impact on certain sectors in the economy. For example, Henry Ford’s assembly line made the mass production of automobiles possible but took away the jobs of millions of workers who used to assemble the vehicles themselves. Today, speculation is rising that AI and robots might make entire industries obsolete, which can result in another recession.
- Post-War Slowdowns: WWII was one of the factors that got America out of the Great Depression due to the high demand for military weapons and products that stimulated the economy. However, once wars are over, the economy can slow down, resulting in a recession. This was notable after WWII and the Korean War ended, leading to the 1945 and 1953 recessions.
As you can tell, recessions aren’t all one and the same, which means different causes can set one off. From sudden economic shocks to advances in technology, these are just some of the common causes that can lead to a recession.
What Are Warning Signs of a Recession?
Recessions aren’t always predictable. If they were, governments would work hard to prevent them in the first place. However, there are a few warning signs that can lead to a recession. Knowing these warning signs can even help you understand how to prepare for a recession, so you aren’t left struggling to make ends meet when the economy plummets. Take a look at these top warning signs of a recession below:
- Increase in Unemployment: If there is a sudden rise in unemployment levels, it can mean a recession is underway. This is because when people lose their jobs, businesses might be closing or losing revenue. In turn, unemployed workers will have less money to put into the economy, which can lead to a cycle of declining GDP.
- Inverted Yield Curve: The yield curve measures the relationship between the interest rates of short-term and long-term fixed-income securities issued by the U.S. Treasury. An inverted yield curve occurs when short-term securities’ interest rates exceed the interest rates of long-term securities, which can suggest a pending economic recession.
- Rise in Credit Card Debt and Late Payments: Consumers who spend their money help fuel the economy. However, when using credit cards, they can fall into debt if interest rates are high, making defaults and bankruptcies more likely. When this happens, it can trigger a recession.
- Poor Stock Performance: The stock market is extremely volatile, which means it’s not always a great indicator of a recession because drops are somewhat common. However, if poor stock performance continues for an extended period, a prolonged bear market can lead to a recession.
- Consumers Losing Confidence: Consumers are the backbone of the economy—without them, the economy would plummet. When consumers lose faith in the economy, they may be inclined to spend less due to financial stress. When spending slows down, it can be a sign that a recession is looming in the future.
- Drop in Leading Economic Index (LEI): Every month, the Conference Board publishes the LEI, which looks at factors like unemployment insurance applications and stock market performance to predict future economic trends. If the LEI shows a decline, it can be a warning sign that a recession is on its way.
Knowing what warning signs to be aware of can help you prepare for a recession. While predicting a recession isn’t always possible, you can use these warning signs to make predictions on future trends in the economy.
Can You Predict a Recession?
As you might be able to tell, you can’t always predict a recession. Take today’s current state of affairs, for example. No one could have predicted the COVID-19 pandemic spreading across the globe, shutting down economies from every corner of the world and leaving millions of workers out of a job. However, using the warning signs mentioned in the previous section, such as increasing unemployment rates, an inverted yield curve, and a decline in consumer confidence, you can get a good idea of whether a recession is in the near future.
What Happens During a Recession?
Recessions can be nerve-wracking for everyone, namely because unemployment levels rise across a variety of sectors within the economy, which means millions of people can lose their jobs. This can create a snowball effect where the economy gets worse and worse before getting better. Here’s what you can expect to happen during a recession:
- Unemployment Rises: One of the first things to occur during a recession is an increase in unemployment levels. This is because during recessions, businesses often have to cut spending, and employees are often one of the first expenses to be cut.
- Less Spending: When employees are laid off, their income is obviously affected. With little or no income, consumers are less likely to spend, which puts less money into the economy and hurts businesses and stocks.
- Government Debt Increases: With businesses laying off workers and those workers filing for unemployment, government debt grows as it tries to stabilize the economy with stimulus bills and aid.
- Assets Lose Value: Many assets, especially stocks and homes, can lose their value, which can result in homebuyers and investors to lose money or even become bankrupt.
- Interest Rates Drop: During recessions, the Federal Reserve typically slashes interest rates in an effort to stimulate the economy. This makes it more likely for businesses and consumers to take out loans and put more money into the economy to get it back on track.
- Difficulty Finding Jobs: Widespread unemployment can saturate the job market as more and more people are out looking for jobs. This can be seen with the boomerang generation (25-34 year-olds) who suffered greatly after the Great Recession and are still living at home with their parents in an effort to save money.
Recessions can be troubling for people from all walks of life due to their broad reach across the economy. With that in mind, it’s important for individuals and businesses to understand what happens during a recession in order to figure out solutions to get back on solid ground.
How Long Do Recessions Last?
Recessions can last anywhere between two months and three years. The National Bureau of Economic Research defines a recession as a period of economic downturn that lasts for a few months, and a depression as a period of economic activity lasting three or more years. As long as the economic downturn doesn’t surpass the three-year mark, it will be classified as a recession.
The Great Recession of 2008 lasted about 18 months, marking it as the longest recession in American history. However, the other ten recessions post-WWII only lasted between six and sixteen months, showing you just how different each recession can be, according to NBER data. The Great Depression, on the other hand, was much more severe than any other recession in American history. The Great Depression lasted between 1929 and 1939, with the worst years falling between 1929 and 1933, where unemployment levels rose to 25%, and GDP fell by 30%.
It’s important to remember that recessions are a normal part of the economic cycle. Once a recession occurs, the economy typically rebuilds itself once again—often much stronger than before the recession. However, even short recessions can have lasting effects on the economy, such as policy changes by the government and social and psychological shifts fueled by economic distress.
The Uncertainties of COVID-19 and How It Impacts the Market
In their recent statement, NBER announced we are currently in the midst of a recession. The coronavirus pandemic proved to be a sudden economic shock, causing businesses across the world to shut their doors to prevent the spread of this disease and consumers to shelter in place at home. These measures dealt a massive blow to the economy, with unemployment rising to 16.9 million people in July 2020.
This sudden increase in unemployment and business closures resulted in the recession we’re currently in and will impact the market in more ways than one. What’s different about the current recession we’re facing is its uncertainty. Without a vaccine, and with cases spiking in countries across the globe, there doesn’t seem to be an end in sight. This uncertainty is impacting the market in several ways:
- Stock Market Volatility: The uncertainty of the current global pandemic can result in a volatile stock market, where prices peak and drop depending on new advances in a vaccine or further steps back that keep economies closed.
- Homebody Economy: With stay at home measures in place in countries across the world, more and more consumers are expected to engage less frequently in out-of-home activities, such as going to the movies, restaurants, and so forth, and instead will shift their spending habits to essentials, rather than discretionary categories.
- Lowered Consumer Confidence: High unemployment levels, along with a volatile stock market and vaccine uncertainty, is expected to continue leading to low consumer confidence in the economy, which means less spending. In return, consumers might be pessimistic about the long-term and continue to be wary about discretionary spending.
- Economic Disparities: While the coronavirus pandemic is far-reaching and impacting numerous sectors of the economy, certain groups are experiencing deeper economic disparities, particularly women and people of color. This is resulting in many calling the current recession a “she-cession,” due to women experiencing higher levels of job loss and reduced hours.
COVID-19 is impacting the market in several ways due to its uncertainty and broad scope. While we can’t predict the future or how the pandemic will pan out, we can look at how this global event is affecting different areas of the economy to devise a plan for the future.
Wrapping Up on Recessions
Recessions can lead to tumultuous times filled with uncertainty and fear. With increased levels of unemployment, business closures, and reduced consumer confidence in the market, navigating a recession can be a challenge for consumers and businesses alike. Throughout this post, we discussed various intricacies of recessions, such as how they’re caused, warning signs to look out for, and how the coronavirus is impacting the economy today.
With this information, you can make a plan to ride out this current recession, along with future recessions, to keep your finances in good health. Some tips include cutting unnecessary expenses, such as subscriptions and eating out, growing an emergency fund to help keep you afloat during financial hardships, and diversifying your portfolio by investing in a wide range of assets. At Mint, you can use our free budgeting app to help you organize your finances and create a budget that works for you.