What Is a Recession? – What You Need to Know
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In the U.S., the stock market downdraft continues unabated, inflation is creeping higher, forcing the Federal Reserve to raise borrowing costs, and weekly jobless claims reached a four-month peak. However, there's a glimmer of hope: the job market and spending remain robust.
Still, questions have begun to swirl if the U.S. is headed toward a recession. Wells Fargo CEO Charles W. Scharf said there was "no question" the country was barreling towards a recession. Former Federal Reserve Chairman Ben Bernanke warned of "stagflation" — a high unemployment rate and high inflation. And former Goldman Sachs CEO Lloyd Blankfein said recession risks were "very, very high."
A recession is a natural component of the business cycle, even though it is highly unwelcome. But throw in the Coronavirus and its effects on real estate, shipping, and jobs and the wild ride of the past two years has been a mess on consumer confidence. Companies going out of business, a collapse of the financial system, stagnant or declining industrial production, and rising unemployment are the hallmarks of a recession and experts agree the next recession is closer than the politicians want you to think. Even while the economic suffering brought on by recessions is only brief, it may significantly impact an economy in the long term.
In this article
What is a recession?
Every country prioritizes economic growth, financial stability, and employment. Yet, short-term economic activity swings creep in before losing steam and resuming their long-term growth trajectory alongside these growth aspirations. These fluctuations are known as recessions. In other words, a significant pause in the economic activity is called a recession.
In the U.S., the National Bureau of Economic Research is responsible for declaring a recession. Two consecutive quarters of decline in the GDP is how a recession is generally defined. The definition of a recession, according to the bureau, is a sustained decline in economic activity characterized by a fall in not only gross domestic product (GDP) but other economic indicators such as income, industrial production, employment, and wholesale-retail sales over a few months, instead of just two. Just as the National Bureau of Economic Research decides the start of a recession, it also has the final say when the U.S. economy is out of a recession.
The U.S. has had multiple bouts with recessions, the most infamous being the Great Depression of 1929, which reverberated across the globe. The severe downturn is also known as Black Tuesday, the day of the stock market crash that would usher in the worldwide economic depression. The Great Depression is widely considered to be the longest and the most severe depression of the 20th century.
The only good thing about recessions is that they're generally short-lived. These numbers aren't set in stone, but the average duration of a recession is between eight and 18 months. Short as that may be, it can feel like an eternity to anyone directly affected by it.
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Recession vs. depression
A recession reduces economic activity that lasts for months, while a depression is a loss in economic activity that stays for years. The duration of each event might vary from case to case. A protracted period of economic contraction characterizes depression. When compared to a recession, it is substantially more detrimental to an economy, and it manifests itself as a steep and severe decline in GDP.
Depressions are characterized by several factors, including high rates of unemployment and a standstill in domestic, commercial activity, and foreign commerce. The effects of the economic slump are felt on a national and international scale. After suffering severe losses during the Great Depression, the stock market in the U.S. did not begin to make a comeback until the 1950s.
Causes of a recession
Recessions are hard to predict. Economic expansion generally gives way to a recession, as evidenced by the pandemic-induced downturn, which followed the most prolonged economic growth in American history. That said, there are several factors that can result in an economic downturn.
Economic shock
Recessions are characterized by a confluence of concurrently occurring macroeconomic factors largely stemming from high inflation or an economic shock. Because the U.S. has trade relationships with many other countries, an economic downturn at home mostly coincides with recessions elsewhere in the world.
Too much debt
In a healthy economy, borrowing money is made easy thanks to low interest rates. This encourages businesses and people to pile on debt. In most cases, as was evident in the Great Recession of 2007, people bit more than they could chew and loaded up on so much debt that they couldn't repay. As reality sets in, the bubble bursts, the stock market crashes, businesses close, people get laid off, and the economy begins to contract — all telltale signs of a lingering recession.
High inflation or deflation
A sustained increase in the price of goods and services is called inflation. And while it isn't a bad thing in itself, as inflation begins to rise, central banks are tasked with setting the monetary policy to raise interest rates to cool the economy. This discourages consumer spending and incentives saving. As a result, the economy begins to lose steam. If central banks take an aggressive approach to inflation, recession can set in.
Conversely, too much deflation can also herald the beginning of a recession. Deflation is defined as a sustained decrease in the price of goods and services. While it may sound economically viable on paper, deflation can spell disaster if left unchecked. As prices begin to fall, people delay their purchasing decision in the hopes of further price cuts. With no money pouring in, the economy starts to slow down.
Corporate greed
One of the most significant factors that perpetuated the Great Recession was corporate greed. Lax controls by financial institutions led them to lend money to people who couldn't repay the money. Soon to turn sour, these loans were packaged into complex financial instruments that would eventually lose significant value. One might argue that all the warning signs were there, yet corporate greed forced them to look the other way.
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Notable recessions of the past
COVID-19 Recession
This global economic recession began in February 2020 amid the pandemic's stagnant economic growth and consumer activity. Even though the downturn's reach was far and wide, the tourism and hospitality industries were particularly hit hard. The situation was aggravated by the Russia–Saudi Arabia oil tussle that led to a significant decline in oil prices. Lasting two months, the COVID-19 recession may be the shortest in American history. Still, it was accompanied by high unemployment (10 million unemployment cases were filed in the U.S. by October 2020) and a stock market crash that resulted in a short-lived bear market.
The Great Recession
For many people, myself included, the Great Recession was their first introduction to a downturn. As a 20-something just starting in financial journalism in 2008, I had a window seat to the meltdown happening everywhere. The Great Recession was a significant economic downturn that occurred concurrently with a catastrophic financial crisis in the U.S. Although the official duration of the recession was from December 2007 through June 2009, it took the economy a significant amount of time to return to its employment and production levels from before the crisis. This sluggish recovery was partly caused by people and financial institutions paying debts off in the years leading up to the crisis.
The fall of investment bank Lehman Brothers is thought to have contributed significantly to the financial crisis and one that sent shockwaves around the world. Bad mortgage investments brought down the 160-year-old bank. Videos and pictures of boxes being carried by bankers out of the building were played on loop on news channels. Two other large investment banks, Bear Stearns and Merrill Lynch, were sold at fire sale prices to other banks.
The U.S. Department of Labor estimates that approximately 8.7 million Americans lost jobs between February 2008 and February 2010. Real GDP decreased by 4.2% between the fourth quarter of 2007 and the second quarter of 2009, making the Great Recession the worst economic downturn since the Great Depression. The unemployment rate increased from 4.7% in November 2007 to 10% in October 2009.
The Great Depression
The crash that occurred on Wall Street in October 1929 marked the start of the Great Depression in the U.S. This collapse of stock market prices heralded the beginning of a decade distinguished by high unemployment, poverty, poor profits, deflation, and collapsing agricultural incomes. The standard explanations include several variables, the most important being the elevated level of consumer debt and the poorly regulated markets that allowed overoptimistic lending by banks (sounds familiar?). These factors led to a downward spiral in economic activity, spurred by decreased spending, declining confidence, and low output.
Economists haven't agreed on the causes of the Great Depression. Some attribute it to reducing the money supply and insufficient demand from the private sector and consumer spending. Other economists, however, lay the blame squarely on the banking crisis that shuttered one-third of all banks at the time and the Federal Reserve's inaction that made a bad situation worse.
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How to protect yourself from a recession
Build an emergency fund
Periods of economic downturn bring uncertain times. You could be forced to take a pay cut or lose your job. An emergency fund ensures you don't have to dip into savings to sustain yourself until the recession blows over. Experts recommend contributing to this rainy-day fund each month until it accumulates enough money to last for six months. To separate your emergency savings from your other savings, open a high-yield savings account dedicated to emergencies.
Related: How to Start an Emergency Fund
Invest for the long term
Long-term investment generates wealth; that's a well-known fact. If you have a long investment horizon, you may be able to ride market volatility better than others. Markets have an upward bias. So while indexes may be flashing red now, they'll always increase in value in the long run. Depending on your risk tolerance, you can choose where you'd like to put money to work — stocks, ETFs, or mutual funds. Stock prices nosedive during a recession, so you have to be able to stomach volatility. If you don't panic sell, you'll do fine. ETFs and mutual funds are better options if you're risk-averse and want to build a nest egg.
Have another income steam
This should be a no-brainer, but having another income stream to add on funds to your regular 9-5 job isn't a bad idea. This is especially true during recessionary times. If you're suddenly out of a job, you'll have a side gig already in place generating money. This secondary source of income could be anything — whether you're renting a property on Airbnb to create passive income or something more hands-on, making and selling items online on sites like Etsy.
Related: How to Recession-Proof Your Savings
The bottom line
Economic crises are inevitable. Recessions are fairly common throughout the world and are part of the economic cycle. Poor decisions and ever-increasing inflation mainly cause them. Unemployment begins to accelerate rapidly, and even once-thriving businesses are forced to shut down. Recessions lead to soul searching as economists and policymakers look to identify factors that led to the economic slump. Still, there's no way to reverse a recession or stop one. The onslaught must be patiently dealt with and monitored closely. If you play your cards right, you may be able to withstand a recession.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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