What Causes a Recession?

The National Bureau of Economic Research (NBER) defines a recession as a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.

A recession is caused by a chain of events in the economy, such as disruptions to the supply chain, a financial crisis, or a world event. A recession can also be triggered after an inflationary period. When inflation increases, the probability of a recession does as well, leading to layoffs, fewer jobs, and higher interest rates.

As companies and consumers become anxious about the economy, they hold on to their money and cut spending. Businesses are forced to reallocate resources, scale back production, limit losses, and lay off employees as the economic downturn intensifies. Trends during a recession include a rise in the unemployment rate and a decrease in the GDP for two consecutive quarters.

Key Takeaways

  • A recession is a trend of simultaneous failures of businesses and investment plans. 
  • Several competing theories exist for the causes of a recession.
  • Financial, psychological, and real economic factors affect recessions.
  • The recession in 2020 was impacted by COVID-19 and the preceding decade of extreme monetary stimulus that left the economy vulnerable to economic shocks. 

Signs of a Recession

The standard macroeconomic definition of a recession is two consecutive quarters of negative GDP growth. When this occurs, private businesses often scale back production and tries to limit exposure to systematic risk. Measurable levels of spending and investment are likely to drop, and a natural downward pressure on prices may occur as aggregate demand slumps. GDP declines, and unemployment rates rise because companies lay off workers to reduce costs.

At the microeconomic level, firms experience declining margins during a recession. When revenue, whether from sales or investment, declines, firms look to cut their least-efficient activities. For example, a firm might stop producing low-margin products or reduce employee compensation. It might also renegotiate with creditors to obtain temporary interest relief. Unfortunately, declining margins may force businesses to fire less productive employees.

A range of financial, psychological, and real economic factors are at play in any given recession.

What Causes a Recession?

The significant economic theories of recession focus on financial, psychological, and fundamental economic factors that can lead to the cascade of business failures that constitute a recession. Some theories look at long-term economic trends that lay the groundwork for a recession in the years leading up to it. Some look only at the immediately visible factors that appear at the onset of a recession. Many or all of these various factors may be at play in any given recession. 

Financial factors can contribute to an economy's fall into a recession during the 2007–2008 U.S. financial crisis. The overextension of credit and debt on risky loans and marginal borrowers can lead to an enormous build-up of risk in the financial sector. The expansion of the supply of money and credit in the economy by the Federal Reserve and the banking sector can drive this process to extremes, stimulating risky asset price bubbles.

Artificially suppressed interest rates during the boom times leading up to a recession can distort the structure of relationships among businesses and consumers. It happens by making business projects, investments, and consumption decisions that are interest rate-sensitive, such as the decision to buy a bigger house or launch a risky long-term business expansion, appear to be much more appealing than they ought to be. The failure of these decisions when rates rise to reflect reality constitutes a major component of the rash of business failures that make up a recession.

Psychological Factors of a Recession

Psychological factors are frequently cited by economists for their contribution to recessions also. The excessive exuberance of investors during the boom years brings the economy to its peak. The reciprocal doom-and-gloom pessimism that sets in after a market crash at a minimum amplifies the effects of real economic and financial factors as the market swings.

Moreover, because all economic actions and decisions are always to some degree forward-looking, the subjective expectations of investors, businesses, and consumers are often involved in the inception and spread of an economic downturn.

Interest Rates

Interest rates are a key linkage between the purely financial sector and the real economic preferences and decisions of businesses and consumers.

Economic Factors of a Recession

Real changes in economic fundamentals, beyond financial accounts and investor psychology, also make critical contributions to a recession. Some economists explain recessions solely due to fundamental economic shocks, such as disruptions in supply chains, and the damage they can cause to a wide range of businesses.

Shocks that impact vital industries such as energy or transportation can have such widespread effects that they cause many companies across the economy to retrench and cancel investment and hiring plans simultaneously, with ripple effects on workers, consumers, and the stock market.

There are economic factors that can also be tied back into financial markets. Market interest rates represent the cost of financial liquidity for businesses and the time preferences of consumers, savers, and investors for present versus future consumption. In addition, a central bank's artificial suppression of interest rates during the boom years before a recession distorts financial markets and business and consumption decisions. All of these factors may cause a recession over time.

In turn, the preferences of consumers, savers, and investors place limits on how far such an artificially stimulated boom can proceed. These manifest as economic constraints on continued growth in labor market shortages, supply chain bottlenecks, and spikes in commodity prices (which lead to inflation). When not enough resources can be made available to support all the business investment plans, a rash of business failures may occur due to increased production costs. This situation may be enough to tip the economy into a recession.

Impact of Covid-19 Pandemic on the Economy

In February 2020, the National Bureau of Economic Research (NBER) announced that according to their data, the U.S. was in a recession due to the economic shock of the widespread disruption of global and domestic supply chains and direct damage to businesses across all industries. These events were caused by the COVID-19 epidemic and the public health response.

Some of the underlying causes of the two-month recession (and economic hardship) in 2020 were the overextension of supply chains, razor-thin inventories, and fragile business models.

The pandemic-related recession, according to NBER, ended in April 2020, but the financial hardship caused by the pandemic is still impacting Americans.

Article Sources
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  1. The National Bureau of Economic Research. "What's a Recession?," Page 6.

  2. The New York Times. "The Changing Business Cycle."

  3. The Brookings Institution. "The Origins of the Financial Crisis," Pages 7-9.

  4. Wharton School of the University of Pennsylvania. "Hope, Greed and Fear: The Psychology Behind the Financial Crisis."

  5. Congressional Service Reports. "What Causes a Recession?"

  6. National Bureau of Economic Research. "Business Cycle Dating Committee Announcement July 19, 2021."

  7. National Bureau of Economic Research. "Business Cycle Dating Committee Announcement July 19, 2021."

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