For all the pain, fear, and uncertainty they bring, recessions are a recurring feature of the economic landscape. Below we'll explain what they are and what causes them, discussing their costs as well as the reputed consolations.
- Recessions are significant, widespread and prolonged economic downturns.
- The frequency and length of recessions has diminished in recent decades.
- Recessions can impose heavy costs on the newly unemployed, limit the economy's long-term growth potential and strain public budgets.
- Governments and central banks around the world use countercyclical monetary and fiscal policies to limit the severity and length of recessions.
- Recessions may also end the misallocation of investment capital and provide opportunities for bargain hunters.
What Is an Economic Depression?
What Is a Recession?
A recession is commonly defined as two or more consecutive quarters of negative economic growth, which is most commonly measured using real gross domestic product (GDP). Recessions can cause high unemployment, business failures, and bankruptcies as a result of diminished demand from consumers and businesses.
The National Bureau of Economic Research (NBER), which marks U.S. recessions, defines one as a significant and widespread decline in economic activity lasting more than a few months, though it can be flexible in making such assessments.
In 2020, the NBER called the economic decline caused by the onset of the COVID-19 pandemic a recession based on its depth and pervasiveness, which offset its unusually short duration of two months.
The NBER gauges economic expansions and contractions based on indicators including employment levels, real incomes, retail sales, and industrial output.
A recession is a substantial, broad-based decline reflected in numerous indicators of economic performance and typically lasting longer than a few months.
A recession may be caused by an imbalance within the economy, such as a pullback in consumer spending financed by excessive debt or a slump in housing prices. It can also stem from an external shock such as a global pandemic or a spike in energy prices caused by a supply issue.
The U.S. has experienced 34 recessions since 1857 according to the NBER, varying in length from two months (February to April 2020) to more than five years (October 1873 to March 1879). The average recession has lasted 17 months, while the six recessions since 1980 have lasted less than 10 months on average.
The concept of an economic cycle grants recessions equal billing with economic expansions. In fact, recessions have grown increasingly rare. The nine recessions since 1960 have taken up not quite 8 years in total; that means economic growth has prevailed about 86% of the time over the past 62 years.
Despite their growing infrequency, recessions remain costly. A typical downturn will cause economic output to shrink by 2%, while a severe one can set an economy back 5%, according to the International Monetary Fund (IMF). The 2007-2009 recession caused by the global financial crisis caused U.S. output to contract by 3.7%, while the Great Depression downsized the U.S. economy by 30% over a four-year period. Real U.S. GDP fell 10% during the recession of 1937-1938.
The fact that recessions happen from time to time doesn't make them desirable, nor does it discredit policies aimed at reducing the length and severity of the downturns.
The U.S. central bank, the Federal Reserve, conducts monetary policy under a congressional mandate to promote stable prices and maximum employment. Just as the Fed is likely to raise interest rates when high inflation threatens stable prices, it's likely to cut them (if there's room to cut) when a recession causes employment to plummet. Other developed countries also use countercyclical monetary and fiscal policy.
A shallow recession cooling off an overheated economy is unlikely to do lasting damage, and policymakers have learned the hard way they can do little to prevent one. Nor can they end one: that depends on the decisions of every business and individual.
Policymakers do use monetary and fiscal policy to support the economy as needed and promote favorable long-term outcomes. They are unlikely to remain idle while a deep downturn throws millions out of work and homes, because the economic and personal damage caused can slow growth long after the NBER has deemed the recession over. The U.S. economy grew at rates well below its potential for years following the 2007-2009 recession, slowed by a lower labor force participation rate as some laid off workers never returned.
Here's why recessions can be so costly.
Rising unemployment is a recession staple. As demand declines and orders drop, companies respond by cutting costs, and labor is by far the biggest expense for many. Those layoffs, in turn, further sap demand, extending a downward spiral in economic sentiment and output. This dynamic ensures that employment declines rapidly in a recession, then gradually recovers during the subsequent expansion.
People who lose jobs during recessions, especially deep ones, are more likely to become long-term unemployed, and find it more difficult to re-enter the labor market later. Among workers displaced during the Great Recession, only 35% to 40% were employed full-time by January 2010. Re-employment rates remained unusually low for workers who lost their jobs as late as 2013.
Another study found men lose an average of 1.4 years of earnings if laid off with the unemployment rate below 6% but twice as much if the unemployment rate is above 8%.
Recessions are bad for capital as well as labor. Corporate profits drop as sagging demand and severance drive up unit costs. Overly indebted companies may default on their debt, driving up borrowing costs or causing credit to evaporate entirely for others in similar straits.
Publicly listed companies are not immune, and stock market prices tend to decline well in advance of the recession as investors price in the increased risk. The decline in financial asset prices can, in turn, reverse the wealth effect, further undermining consumer spending and balance sheets.
During a recession, labor and capital go idle and unemployed. Economic output falls as a result.
Falling Living Standards
Rising unemployment and diminished economic output often cause real per capita income to fall during a recession. Many people are not able to maintain their standard of living as a result. Birth rates may fall and divorce rates increase as families feel the stress of economic hardship. The newly unemployed and their dependents often lose health insurance tied to former employment. For the worst off, malnutrition and homelessness increase.
Strained Public Finances
Government budgets depend on tax revenue that ebbs and flows with the pace of economic activity. When incomes and profits decline so do tax collections, even as recessionary layoffs translate into increased demand and outlays for unemployment insurance and food assistance.
The resulting increases in budget deficits can limit public spending aimed at counteracting the downturn, even when such spending might pay for itself in the long run by generating additional economic growth and tax revenue.
Recession Silver Linings
A recession resulting from an economic imbalance may rectify it, clearing the way for a return to growth. For example, the 1981-1982 recession, which was triggered by Federal Reserve interest rate increases in response to high inflation, helped to lower the inflation rate from 11% in June 1979 to 5% by October 1982, and the U.S. economy grew for the next eight years.
Similarly, a recession can end the misallocation of investment capital, whether fueled by a housing bubble or a dot-com one.
By driving down asset prices, recessions can also provide opportunities for attractive returns for investors willing to take the long view.
The Bottom Line
Recessions are a natural, unavoidable stage of the economic cycle that invariably bring hardship to individuals who lose their jobs or businesses. Even if they do pop bubbles and offer some investors attractive buying opportunities, their silver linings aren't so nice that you would want to stand under that storm cloud and get soaked for any longer than is absolutely necessary.