What is a Recession?

A recession is a macroeconomic term that refers to a significant decline in general economic activity in a designated region. It had been typically recognized as two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment. However, the National Bureau of Economic Research (NBER), which officially declares recessions, says the two consecutive quarters of decline in real GDP are not how it is defined anymore. The NBER defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Key Takeaways

  • A recession is a period of declining economic performance across an entire economy that lasts for several months.
  • Businesses, investors, and government officials track various economic indicators that can help predict or confirm the onset of recessions, but they're officially declared by the NBER.
  • A variety of economic theories have been developed to explain how and why recessions occur.

Recessions are visible in industrial production, employment, real income, and wholesale-retail trade. The working definition of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP), although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession, and uses more frequently reported monthly data to make its decision, so quarterly declines in GDP do not always align with the decision to declare a recession.

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.

Understanding Recessions

Since the Industrial Revolution, the long-term macroeconomic trend in most countries has been economic growth. Along with this long-term growth, however, have been short-term fluctuations when major macroeconomic indicators have shown slowdowns or even outright declining performance, over time frames of six months up to several years, before returning to their long-term growth trend. These short-term declines are known as recessions.

Recession is a normal, albeit unpleasant, part of the business cycle. Recessions are characterized by a rash of business failures and often bank failures, slow or negative growth in production, and elevated unemployment. The economic pain caused by recessions, though temporary, can have major effects that alter an economy. This can occur due to structural shifts in the economy as vulnerable or obsolete firms, industries, or technologies fail and are swept away; dramatic policy responses by government and monetary authorities, which can literally rewrite the rules for businesses; or social and political upheaval resulting from widespread unemployment and economic distress.

For investors, one of the best strategies to have during a recession is to invest in companies with low debt, good cash flow, and strong balance sheets. Conversely, avoid companies that are highly leveraged, cyclical, or speculative.

Recession Predictors and Indicators

There is no single way to predict how and when a recession will occur. Aside from two consecutive quarters of GDP decline, economists assess several metrics to determine whether a recession is imminent or already taking place. According to many economists, there are some generally accepted predictors that when they occur together may point to a possible recession.

First, are leading indicators that historically show changes in their trends and growth rates before corresponding shifts in macroeconomic trends. These include the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, the OECD Composite Leading Indicator, and the Treasury yield curve. These are critically important to investors and business decision makers because they can give advance warning of a recession. Second, are officially published data series from various government agencies that represent key sectors of the economy, such as housing starts and capital goods new orders data published by the U.S. Census. Changes in these data may slightly lead or move simultaneously with the onset of recession, in part because they are used to calculate the components of GDP, which will ultimately be used to to define when a recession begins. Last are lagging indicators that can be used to confirm an economy’s shift into recession after it has begun, such as a rise in unemployment rates.

What Causes Recessions?

Numerous economic theories attempt to explain why and how the economy might fall off of its long-term growth trend and into a period of temporary recession. These theories can be broadly categorized as based on real economic factors, financial factors, or psychological factors, with some theories that bridge the gaps between these.

Some economists believe that real changes and structural shifts in industries best explain when and how economic recessions occur. For example, a sudden, sustained spike in oil prices due to a geopolitical crisis might simultaneously raise costs across many industries or a revolutionary new technology might rapidly make entire industries obsolete, in either case triggering a widespread recession.

The spread of the COVID-19 epidemic and the resulting public health lock-downs in the economy in 2020 are an example of the type of economic shock that can precipitate a recession according to Real Business Cycle Theory. It may also be the case that other underling economic trends are at work leading toward a recession, and an economic shock just triggers the tipping point into a downturn.

Some theories explain recessions as dependent on financial factors. These usually focus on either the overexpansion of credit and financial risk during the good economic times preceding the recession, or the contraction of money and credit at the onset of recessions, or both. Monetarism, which blames recessions on insufficient growth in money supply, is a good example of this type of theory. Austrian Business Cycle Theory bridges the gap between real and monetary factors by exploring the links between credit, interest rates, the time horizon of market participants’ production and consumption plans, and the structure of relationships between specific kinds of productive capital goods.

Psychology-based theories of recession tend to look at the excessive exuberance of the preceding boom time or the deep pessimism of the recessionary environment as explaining why recessions can occur and even persist. Keynesian economics falls squarely in this category, as it points out that once a recession begins, for whatever reason, the gloomy “animal spirits” of investors can become a self-fulfilling prophecy of curtailed investment spending based on market pessimism, which then leads to decreased incomes that decrease consumption spending. Minskyite theories look for the cause of recessions in the speculative euphoria of financial markets and the formation of financial bubbles based on debt which inevitably burst, combining psychological and financial factors.

Recessions and Depressions

Economists say there have been 33 recessions in the United States since 1854 through to now in total. Since 1980, there have been four such periods of negative economic growth that were considered recessions. Well known examples of recessions include the global recession in the wake of the 2008 financial crisis and the Great Depression of the 1930s.

A depression is a deep and long-lasting recession. While no specific criteria exist to declare a depression, unique features of the Great Depression included a GDP decline in excess of 10% and an unemployment rate that briefly touched 25%. Simply, a depression is a severe decline that lasts for many years.