Unemployment is often one casualty during a recession -- as economic growth slows, companies generate less revenue and begin to lay off workers in order to cut costs. A domino effect follows, where increased unemployment leads to a drop in consumer spending, slowing growth even further, which forces businesses to lay off more workers. Here, we examine this self-reinforcing cycle of recession and unemployment.

Key Takeaways

  • A recession is a period of economic contraction, where businesses see less demand and begin to lose money.
  • To cut costs and stem losses, companies begin laying off workers, generating higher levels of unemployment.
  • Unemployed people tend to spend far less as their income falls sharply, leading to even less demand and lower corporate profits, sometimes starting a self-reinforcing downward spiral.

Growth and Employment

Before we explore how recessions and unemployment relate to each other, we must first examine the factors that drive growth and employment. Growth in an economy is often measured in terms of the gross domestic product (GDP). GDP is the aggregate total of all the goods and services produced in a country. Two key factors drive growth: consumer spending and business investment.

Consumer Spending

If consumer spending is robust, consumers might increase purchases of clothes, homes, cars, and electronic devices. As a result of all the spending, employment or jobs are created in industries such as the retail or clothing sectors, banks that supply the mortgages and credit cards that consumers use, as well as any business that caters and sells to consumers.

Business Investment

If the economic outlook appears to be favorable, companies tend to invest in their businesses for the medium to long-term by upgrading and expanding their operations. Business spending and investment typically include large purchases of equipment or technology to enhance their production facilities. In doing so, companies hire workers to help with the added production, sales, and marketing staff as well as software engineers to program and run the machinery.

The increase in business investment also helps ancillary businesses, including banks that lend to companies, so they finance their new equipment purchases. Any outside consulting firms that help with the business expansion or the companies that manufacture the equipment and service it.

Recession & Unemployment

A recession occurs when there are two or more consecutive quarters of negative economic growth, meaning GDP growth contracts during a recession. When an economy is facing recession, business sales and revenues decrease, which cause businesses to stop expanding. When demand is not high enough, businesses start to report losses.

Let's take the the case of the Great Recession of 2008 and 2009 as our example, where banks were sharply impacted due to mortgage defaults and a collapse in the sub-prime sector. As a result, banks suffered massive losses, which led to fewer new loans being issued, as shown in the graph on the left below.

Business spending then declined in the same period (right graph) since they could not obtain the credit needed to make large purchases to expand production. Equipment, software, and structure spending or physical assets like plant and equipment all contracted in 2008 and 2009.

Bank Lending & Business Spending 2008
Bank Lending & Business Spending 2008.  Investopedia

As companies struggled with less cash and revenue, they first tried to reduce their costs by lowering wages or ceasing to hire new workers, which can stop employment growth. A recession can lead companies to report financial losses while some companies go bankrupt—leading to companies laying workers off.

When there are layoffs and no new jobs being created, consumers tend to save money or spend less. From the graphs below, we can see that personal consumption declined during 2008 (left graph) while the saving rate, over the same period, jumped to the highest level since the 1990s (right graph).

Consumer Spending & Saving Rate 2008
Consumer Spending & Saving Rate 2008.  Investopedia

With less consumer and business spending, there's less money in the economy. As a result, a decrease in the demand for goods occurs and leads to lower growth rates for companies and the overall economy.

The graph below shows the negative or contracting GDP growth that occurred during the Great Recession in 2008 and 2009 (right graph). Negative economic growth due to lower consumer and business spending, as well as declines in bank lending, resulted in massive layoffs that also increased the unemployment rate (left graph).

Unemployment and GDP Growth 2008
Unemployment and GDP Growth 2008.  Investopedia

The Bottom Line

Recession and unemployment go hand in hand - and a slowing economy makes unemployment worse, and vice-versa, leading to a downward spiral in some cases.

Often times, the central bank needs to step in to stop that vicious cycle. For instance, only after measures by the Federal Reserve Bank to shore up the banking system and nearly a trillion dollars in fiscal or government spending did the U.S. economy recover from the Great Recession. However, the events that occurred during the crisis illustrates the link between unemployment and recessions.