The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in the real gross domestic product (GDP), real income, employment, industrial production, and wholesale-retail sales." A recession is also said to be when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises, and housing prices decline.

Key Takeaways

  • A recession is in essence a rash of simultaneous failures of businesses and investment plans. 
  • Explaining why they happen, and why some many businesses can fail at once, has been a major focus of economic theory and research, with several competing explanations.
  • Financial, psychological, and real economic factors are at play in the causes and effects of recessions.
  • Causes of the incipient recession in 2020 include the impact of Covid-19 and the preceding decade of extreme monetary stimulus that left the economy vulnerable to economic shocks. 

The nature and causes of recessions are simultaneously obvious and uncertain. Recessions are in essence a cluster of business failures being realized simultaneously. Firms are forced to reallocate resources, scale back production, limit losses and, usually, lay off employees. Those are the clear and visible causes of recessions. There are several different ways to explain what causes a general cluster of business failures, why they are suddenly realized at the same time, and how they can be avoided. Economists disagree about the answers to these questions and several different theories have been offered.

The NBER officially declared an end to the economic expansion in February of 2020 as the U.S. fell into a recession amid the coronavirus pandemic.

Macroeconomic and Microeconomic Signs of a Recession

The standard macroeconomic definition of a recession is two consecutive quarters of negative GDP growth. Private business, which had been in expansion prior to the recession, scales 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. 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 often force businesses to fire less productive employees.

General Causes of Recessions

In general, the major economic theories of recession focus on financial, psychological, and real 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 recession in the years leading up to it, and 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. 

What Causes Recessions?

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

Financial factors can definitely contribute to an economy's fall into a recession, as we found out during the U.S. financial crisis. The overextension of credit and debt on risky loans and marginal borrowers can lead to 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. And when the music stops the repercussions can carry over into the real economy. 

Even worse, artificially suppressed interest rates during the boom times leading up to a recession can distort the structure of relationships among businesses and consumer 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 ultimate 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 are frequently cited by economists for their contribution to recessions also. The excessive exuberance of investors during the boom years that bring the economy to its peak, and the reciprocal doom-and-gloom pessimism that sets in after a market crash at a minimum amplify 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 always involved in the inception and spread of an economic downturn.

Real changes in economic fundamentals, beyond financial accounts and investor psychology, also make critical contributions to a recession. Some economists explain recessions solely as a result of real economic shocks, such as disruptions in supply chains, and the damage they can cause to a wide range of businesses. Shocks that impact key industries such as energy or transportation can have such widespread effects that they cause many businesses across the economy to retrench and cancel investment and hiring plans simultaneously, with ripple effects on workers, consumers, and the stock market. 

Some real economic factors can also be tied back into financial markets. Because market interest rates represent not only the cost of financial liquidity for businesses, but also the time preferences of consumers, savers, and investors for present versus future consumption, artificial suppression of interest rates by a central bank during the boom years before a recession distorts not just financial markets but real business and consumption decisions.

Interest Rates

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

In turn, the real preferences of consumers, savers, and investors place limits on how far such an artificially stimulated boom can proceed. These manifest as real economic constraints on continued growth, in the form of labor market shortages, supply chain bottlenecks, and spikes in commodity prices (which lead to inflation) when not enough real resources can be made available to support all the overstimulated business investment plans based on easy-money policies. Once these set in, a rash of business failures begins in the face of increased production costs and the economy tips into recession. 

Some Causes of the Current Recession

Though an official recession has not yet been declared, the economy is clearly heading in that direction. A major cause is obviously evident in the real economic shock of the widespread disruption of global and domestic supply chains and direct damage to businesses across all industries, due to the Covid-19 epidemic and the public health response. Both the impact of the epidemic and the fear and uncertainty surrounding it are important. 

But a major underlying cause is also the overextension of supply chains, the overinvestment in marginal business, and the razor-thin inventories and fragile business models that have all become the norm over the decade of extreme low interest rates and monetary policy by central banks everywhere, and especially the Federal Reserve, since the last recession. The deep distortions in business, investment, and consumer behavior, that by 2020 have all become thoroughly addicted to an endless flow of easy money, laid the groundwork for the economic devastation that is currently underway by leaving the economy with zero margin of resilience to buffer against negative economic shocks. 

Recession Warning Signs

Leading indicators were already flashing warning signs in 2019, long before Covid-19.

This had become clear as early as 2018 and 2019, when widespread shortages of needed employees and generally tight labor market conditions came to a head and spurred the Fed to very slightly slow the expansion of money and credit. The stock market plunged and leading indicators such as the yield curve quickly began flashing warning signs of impending recession. As serious a challenge as Covid-19 and the associated lockdowns represent over recent months, the economic fallout has been years in the making. The economy was sitting on a powder keg, and Covid-19 was a match.