What is Recession? Meaning, Examples, Causes and Effects

A recession is an economic downturn where the economy experiences negative growth over two consecutive quarters. There are many effects of a recession in an economy; the meaning, causes, and some examples of economic recessions would be discussed.

Recession Meaning

A recession in economics refers to a downward trend in an economy’s business cycle that is characterized by a decline in production and employment which in turn brings about a decline in the incomes and spending of households. In other words, it means a microeconomic term referring to a significant fall in general economic activities in a given region or nation. Although it is not all households and businesses that experience actual declines in their incomes, they have fewer expectations about the future during a recession which brings about a delay in making large purchases or investments.

In recessions, one can trace a decline in purchases of durable household goods by consumers and the purchases of machinery and equipment by businesses, and a decline in the additions of goods to stocks or inventories. Probably, the greatest effect of recession is on inventory as businesses stop adding to their inventories and become more willing to draw on them to fill orders on production. Thus, a decline in inventory has a double impact on the volume of production.

Whether a recession would develop into a severe and prolonged depression is dependent upon a number of circumstances. These circumstances include the extent and quality of credit extended during the previous prosperity period, the amount of speculation that is allowed, the ability of monetary and fiscal policies to reverse the downward trend, and the amount of excess production capacity that exists.

Recesssion in economy

A recession is an economic downturn where the economy experiences negative growth over two consecutive quarters. There are various economic indicators that can help business investors and government officials in the prediction or confirmation of the onset of recessions which is usually declared by the National Bureau of Economic Research (NBER). This can include production, employment, real income, wholesale-retail trade. When we talk about the working definition of a recession, it is two consecutive quarters of negative growth in income as it is measured by the gross domestic product of a country. However, it is not necessary for the NBER to see this in order to call a recession. It makes use of monthly data that is more frequently reported to make their decision. Therefore, there is usually no alignment between quarterly declines in GDP and the decisions to declare a recession.

As it is known, a recession is an unpleasant part of the business cycle and it is characterized by business and bank failures, negative production growth, and a high unemployment rate. Although recessions are temporary, they can have major effects that can alter the economy. This can occur as a result of structural shifts in the economy as firms, industries, and technologies that are vulnerable or obsolete are being swept away. It can be as a result of dramatic policy responses by the government and monetary authorities as they can literally rewrite rules for businesses or social and political disruption which results from economic distress and widespread unemployment.

For investors, one of the favorable strategies to adopt during a recession is to invest in companies that have low debt, good cash flow, and strong balance sheets. On the other hand, investors should avoid companies that are highly cyclical, leveraged, or speculative.

Economic theories of recession

The economic theories of a recession focus basically on financial, psychological, and economic factors that can bring about a sequence of business failures that constitute a recession. Some theories have an overview of the long-term economic trends that lay a foundation for a recession in the years thereby leading up to it. On the other hand, some theories only look at the factors that are immediately visible, that appear at the beginning or onset of a recession. These factors can manifest in any given recession.

Financial factors of a recession

Financial factors can contribute to the fall of an economy into a recession. these factors include the overextension of credit and debt on loans that are risky and marginal borrowers can bring about a build-up of risks in the financial sector. When the Federal Reserve and the banking sector expand the supply of money and credit in the economy, this can drive this process to the extreme thereby stimulating risky asset price bubbles.

Psychological factors of a recession

When interest rates are artificially suppressed during an economic boom and it brings about a recession, it can distort the existing relationship structure among businesses and consumers. It happens by making business projects, investments, and interest-rate-sensitive consumption decisions more appealing than they ought to be. If these decisions fail to reflect when interest rates rise, there will be a rash of business failures which in turn will bring about a recession.

Economists frequently cite psychological factors for their contributions to recessions as well. When investors are excessively exuberant during an economic boom, the economy will be brought to its peak. The reciprocal doom-and-gloom pessimism that sets in after the crash of a market at a minimum magnifies the effects of real economic and financial factors as the market swings.

As a result of the fact that every economic action and decision is usually forward-looking to some extent, the subjective expectations of investors, businesses, and consumers are usually in the inception and spread of an economic recession or downturn.

Interest rates are a basic key linking factor between the purely financial sector and the actual economic preferences and decisions of businesses and consumers.

Economic factors of a recession

Beyond financial accounts and the psychology of investors, real changes in economic fundamentals also contribute critically to a recession. Some economists give an explanation to recession solely as a result of fundamental economic shocks that include disruptions in supply chains, and the damage they can bring about in a wide range of businesses.

Shocks that have an impact on vital industries such as transportation and energy possess such widespread effects that they cause many companies across the economy in order to retrench and cancel investment and plans with regard to hiring simultaneously. This in turn has ripple effects on workers, consumers, and the stock market.

Some economic factors can as well be tied back into financial markets. Market interest rates are a representation of financial liquidity for businesses and consumer time preferences, savers, and investors for present versus future consumption. Additionally, if the central bank of a nation artificially suppresses interest rates during the economic boom before a recession brings about a distortion in financial markets and decisions with regard to business and consumption.

In turn, consumer preferences, investor preferences, and savers preferences place limits on the level at which an artificially stimulated boom can proceed. These factors act as economic constraints on the continued growth in labor market shortages, bottlenecks in supply chains, and upward shifts in the prices of commodities that lead to inflation. When there are not enough resources available to support all business investments plans, a sequence of failures in business can occur as a result of an increase in production costs. This situation is enough to bring an economy to a recession.

Causes of a recession

1. Economic shocks
2. Loss of consumer confidence
3. High-interest rates
4. Deflation
5. Increased inflation
6. Reduced real wages

It is not possible for economic growth and expansion to last forever. A combination of factors can trigger a significant decline in economic activities, some of which are being stated above. Having looked at the economic theories of recession, we looked at three basic factors which are financial factors, psychological factors, and economic factors. The aforementioned factors can fall within any of the categories. They are explained below, thus;

Economic shocks

This refers to an unpredictable event that brings about an economic disruption that spreads widely. This includes natural disasters and terrorist attacks. These factors bring about economic recession. In these instances, economic activities decrease drastically thereby affecting the growth of the economy. Oftentimes, it takes a longer period for an economy to recover from economic shocks because they were unpredictable.

Loss of consumer confidence

This is a psychological factor whereby consumers begin to worry about an economic state. In turn, this causes them to reduce their spending and save more. It is certain that about 70% of an economy’s GDP is dependent upon consumer spending. So when consumers begin to slow down their spending, the economy slows down drastically.

High interest rates

When interest rates are high in an economy, it becomes expensive for consumers to purchase houses, cars, and other large purchases. This causes companies to reduce their rate of spending and growth plans as the cost of financing becomes too high. In turn, the economy begins to shrink. In other words, high-interest rates limit the liquidity of companies and the amount of money invested.

Deflation

Deflation refers to an economic situation in which the prices of goods and services fall as a result of a large decrease in demand, leading to a rise in the value of money. Sellers drop the prices of their goods and services as demand falls in an attempt to attract buyers. People do away with making purchases as they wait for lower prices. This brings about an ongoing downward spiral or a slowing down of economic activities and a greater level of unemployment.

Increased inflation

Inflation is the opposite of deflation, where there is a general rise in the prices of goods and services over a period of time. Increased inflation can bring about an economic recession because it decreases the purchasing power of individuals and businesses. The number of goods that one can purchase with the same amount of money decreases thereby reducing consumer spending and economic activities.

Reduced real wages

Real wages are wages that have been adjusted for inflation, their reduction can bring about economic recession. When real wages fall, it implies that the paycheck of workers is not keeping up with inflation. Here, it is possible that the individual is making the same amount of money but there is a decrease in his purchasing power.

Macroeconomic and microeconomic indicators of a recession

Macroeconomic indicators

As earlier stated, the macroeconomic definition of a recession is when there are two consecutive quarters of negative growth in GDP. When this happens, private entities usually reduce their production activities and try to reduce the rate at which they are being exposed to systematic risk. Levels of spending that are measurable are likely to decline and at aggregate demand slumps, levels of spending that are measurable are likely to decline. When workers are being laid off by companies, GDP declines, and the rate of unemployment rises.

Microeconomic indicators

At this level, business firms begin to experience a decline in their margins during a recession. Whether from sales or investments, when revenue declines, firms look for ways to cut down the activities that are least-efficient. For instance, the production of low-margin products is being stopped by the firm and employee compensation is being reduced as well. Also, a firm might engage its creditors in negotiation with regard to obtaining temporary interest relief. It is unfortunate that when margins decline, business firms may be forced to lay off less productive employees. As earlier pointed out, a range of financial, psychological, and economic factors play a role in any given recession.

Recession examples

1. The impact of COVID-19 pandemic on the economy
2. The great recession December 2007 – June 2009
3. Recession 2001
4. Recession 1937 – 1938

The examples of recession listed above are being explained further, thus;

Impact of Covid-19 Pandemic on the economy

The National Bureau of Economic Research (NBER) in February 2020, announced that based on their data, the United States was in a recession as a result of the economic shock of the widespread disruption of the global and domestic supply chains as well as direct damage that occurred on all businesses across all industries. These events took place as a result of the COVID-19 Pandemic as well as the public health response. Globally, nations experienced a series of lockdowns as the pandemic came in different phases which hampered economic activities. This brought about an economic downturn

The Great Recession (December 2007 – June 2009)

The great recession was the worst economic downturn in the United State’s history. It came about as a result of real estate bubbles and complex investments known as derivatives. Although it lasted between 2007 and 2009, it had a great impact on the economy as well as the following years because the path of economic recovery could take a lot of years to be attained. Although the housing market was recovered, currently, a large number of Americans have not been able /to recover everything that they have lost.

Recession 2001

The 2001 recession is also known as the Dot-Com Recession. This came about as a result of a bubble in technology stocks as there was a rapid expansion in the commercial use of the internet. Also, the Y2K problem brought about the fear that computers and software would break down because it made use of two-digit numbers to signify years. This brought about massive amounts of one-time purchasing. This downturn could not last because of the tax cuts and the reductions in the Federal Reserve interest rates during the administration of George Bush.

Recession 1937-1938

The1937–1938 recession occurred in the United States during the Great Depression. In 1937, wages, production, and profits had regained their early 1929 levels. Unemployment was still high but was lower than 25% in 1933. There was a sharp economic downturn in the mid-1937 which lasted for 13 months through most of 1938. Also, there was a decline in industrial production by almost 30% and there was a faster fall in the production of durable goods.

In 1937, the rate of unemployment moved from 14.3% to 19.0% in June 1938. Production output fell by 37% from the 1937 peak and was back to the levels of 1934. The levels of expenditure of durable goods by producers reduced and there was a decline in inventories. However, personal income was 15% lower than it was at the peak of 1937. Throughout the recession, hourly earnings kept on rising which was partly compensating for the decrease in the number of hours worked. While unemployment rose, the expenditures of consumers declined which brought about a further decrease in the level of production.

Effects of recession

1. Unemployment/job loss
2. Changes in lifestyles
3. Reduction in investments
4. Reduced business oportunities
5. A decline in real estate value
6. Reduction in education level
7. Credit and debt

Unemployment/job loss

Massive unemployment affects the stability of individuals, families, and the economy at large. When jobs are being lost, it affects economic activities as purchasing power decreases. This may bring about social vices which will further ruin the economy.

Changes in lifestyles

During a recession, individuals and families in the economy reduce extra activities. Fewer travels by buyers and sellers due to a lack of funds can lead to missed opportunities.

Reduction in investments

As a result of the recession, investments reduce as private budgets may no longer be able to accommodate short-term and long-term non-residential investments. During this period, investment accounts are usually on hold, hoping to catch up later. Investments are usually not feasible during a recession. In later times, there may be devastating effects on the retirement and saving accounts of individuals as there is usually a need to tap into investments and retirement funds.

Reduced business opportunities

During a recession, entrepreneurs may not have access to loan facilities to start new companies. It is usually from a small business segment that innovation comes. When the economy is in a recession, lack of funding and a decline in spending will cause entrepreneurs to become unwilling to take large risks. For entrepreneurs that are unemployed, it is easier for lack of funding to distort their chances of success.

A decline in real estate value

During a recession, there is a drastic fall in the values of real estate. Therefore, it is not a safe investment when the economy is in a downturn.

Reduction in education level

It becomes difficult for families to afford education during a recession. This is a result of decreased economic activities and fund deficiencies.

Credit and debt

Financial obligations do not cease at any point in time even when the economy is in a downturn. Because of the need to meet these financial obligations, individuals and families resort to debt which keeps accumulating. This may extend to the nation where the economy will have to borrow in order to increase government spending which will help expand the economy (expansionary fiscal policy).

Recession and inflation relationship

It is usual to expect a fall in the rate of inflation because of a fall in demand and economic activities. In great recessions such as 1929-1932, 1981, 1991, and 2020, the inflation rate fell. However, it is not a guarantee that inflation will fall during every recession. For instance, there could be a period of stagflation where inflation is rising and output is falling such as the rise in the price of oil in 1974band 2008. If economies decide to respond to a decline in output by printing more money, this can result in hyperinflation like that of Zimbabwe in 2008.

In macroeconomics, a recession is two consecutive quarters of negative economic growth. As economic output falls with the presence of rising spare capacity, prices may either fall or at least rise at a slower rate. This is because of the fact that there are unsold goods by firms, lower growth of wages, lower prices of commodities, lower expectations of consumers, and falling asset prices. As earlier stated, lower demand brings about lower prices thereby leading to lower wealth and less spending.

Recession vs depression

While a recession is a downward trend in an economy’s business cycle, depression is a major downswing that is far more severe than a recession.

A recession reduces or lowers the income and spending of households thereby bringing about a delay in investment and purchase decisions. On the other hand, depression has a serious decline of growth in construction as well as a great decrease in international trade and capital movements.

While a recession can be limited to a geographical area like in a country, depression can have a global reach.

FAQs on recession