2020 will go into the history books as the year that the world turned upside down. From a global pandemic to an economic crisis, racial reckoning, and a nail-biter election, most of us were eager for 2020 to be over. However, economically, the world is still in turmoil. Many countries still face a financial crisis resulting from the global coronavirus pandemic. While some economies already went through a recession, others are still going through one right now.
On June 8th, 2020, the National Bureau of Economic Research (NBER) announced that the longest economic expansion in US history officially ended in February 2020, and a recession started.
But what exactly is a recession? This article will explain what it is, its causes, indicators, and how to survive one.
What Is a Recession?
In the U.S., the National Bureau of Economic Research, a non-profit research organization, is generally recognized as the authority that officially defines the beginning and ending dates of a recession. It defines a recession as a significant decline in economic activity spread across the economy that lasts more than a few months.
It views real GDP (Gross Domestic Product) as the best measure of aggregate economic activity. It also uses 2 other macroeconomic indicators: real income (real GDI) and payroll employment measured by the Bureau of Labor Statistics (BLS). When necessary, it will also consider economic indicators such as industrial production, wholesale-retail sales, and claims for unemployment insurance.
The NBER used to define a recession as 2 consecutive quarters of an economic downturn. However, in light of the most recent U.S. downturn due to the Covid-19 pandemic, the drop in activity had been so great and so widely spread throughout the economy that, even though the duration was shorter than 2 quarters, NBER’s Business Cycle Dating Committee decided that the downturn that started in February 2020 should be classified as a recession. In the past, it often took the dating committee over a year to officially declare a recession.
A recession is an unavoidable part of the business cycle. The business cycle (also known as the economic cycle or trade cycle) describes how an economy alternates between periods of economic expansion and economic contraction (recession). Each business cycle has 4 phases: expansion, peak, contraction, and trough. A recession is the period between the peak in economic activity and its subsequent trough or lowest point. An expansion (recovery) is the period between a trough and a peak.
A recession is often characterized by an economy’s negative GDP, declining sales, rising unemployment levels, a decline in manufacturing output, and a decline in real income.
Globally, the International Monetary Fund (IMF) monitors economic developments to identify risks and recommend policies for financial and economic stability and growth. Furthermore, it conducts regular economic health checks of its 190 member countries.
Recession Predictors and Indicators
Predicting the future is difficult and predicting future recessions is no different. Unfortunately, some downturns seem to come out of nowhere, just like the 2020 recession that was caused by the Covid-19 pandemic.
Some indicators might point to a possible recession. A decline of real GDP for several months is the most widely used indicator for a recession. In the USA, real GDP comprises everything produced by businesses and individuals adjusted for inflation. However, besides GDP, economists assess other economic metrics to determine whether an economy is already in a recession or whether one is about to occur.
If the following group of monthly indicators shows a decline, it is an indication that GDP will decline, and an economic downturn is likely. Therefore, these indicators are watched closely by economists, investors, and politicians to determine if and when the economy will go into recession.
Employment – A rise in the unemployment rate is a lagging indicator. This means that it is used to confirm that an economy is already in a recession. If the unemployment rate has been rising for the last few months, it is clear that the overall economy has started a downturn and is likely to continue its decline. Businesses are shutting down, people are losing their jobs, and as a result, consumer spending is declining as well.
Real personal income – This is a coincident indicator of economic health. Lower real personal income often results in a struggling economy because consumers have less money to spend.
Manufacturing – The status of the manufacturing sector is an indicator of the economy’s health and can point to a possible recession. Industrial production is considered a leading indicator of GDP growth and economic performance. A continued decline in manufacturing indicates that a recession might be looming.
Monthly GDP Estimates – Monthly estimates of GDP are also considered a leading indicator of recession. If the estimated GDP numbers go down for several months in a row, a downturn is expected.
Wholesale and Retail Sales – This is also a leading indicator. If wholesale and retail sales decline for a few months in a row, it is a good indicator that GDP will decline as well, and a downturn is imminent.
Please note that the stock market is not a recession indicator because it is significantly more volatile than the economy. However, a stock market crash can trigger a recession because too many investors lose confidence in the economy when their portfolios take a nosedive.
What Causes Recessions?
There are many reasons for economic downturns. Here are some of the main ones:
A sudden economic shock – The recent spread of the COVID-19 pandemic and the lockdowns resulting from it are a perfect example of how an economic shock can lead to a recession. Other examples of past economic “shocks” are sudden spikes in oil prices that raised costs across industries or new technology that made whole industries obsolete.
Excessive debt – Recessions can also be caused by turmoil in financial markets. When businesses or people take on too much debt and fail to pay off their debts, it can cause bankruptcies and eventually collapse financial markets. An example of a recession triggered by debt is the Great Recession (2007-2009), led by the bursting of the housing bubble and subprime mortgage rates.
High inflation – Although the word inflation often invokes a negative feeling, inflation actually is a good thing and denotes a steady upward rise in prices. Inflation of around 2% is desirable. However, when the inflation growth rate is too high, it becomes dangerous. Central banks, such as the Federal Reserve generally control rising inflation rates by raising interest rates to slow down economic growth.
Too much deflation – While excessive inflation can lead to a downturn, deflation can also be bad at times. Deflation denotes declining prices over time. This causes wages to decrease, which further depresses prices. When such a cycle gets out of control, people lose confidence, stop spending, and the economy suffers. For example, deflation caused a devastating recession in Japan in the 90s.
Asset bubbles – Emotion-driven investment decisions often harm the economy. When the economy is strong, investors become optimistic. As a result, stock prices keep going up, fueling the increased demand. Then, new investors jump on the bandwagon, and due diligence goes out the door. The Fear Of Missing Out (FIMO) is real. Such tendencies inflate the stock market, and eventually, the bubble bursts, and investors panic. They sell their stocks, and the market crashes. This can then lead to a recession.
Revolutionary technological change – New technological inventions can boost productivity and improve the economy over time. However, there are short-term adjustment periods for technological breakthroughs that can turn out to be harmful.
An example is the Industrial Revolution of the 19th century that made an entire group of professionals obsolete and triggered a recession. Likewise, today, experts are concerned that robots and AI (Artificial Intelligence) could eliminate entire job profiles and trigger an economic downturn.
What Happens During a Recession?
A recession becomes powerful when more and more indicators get affected. Here is what happens during a significant downturn.
During a recession, the unemployment rate typically rises as businesses start shutting down. As consumer confidence declines, demand for products and services drops, and companies produce fewer products. As a result, they need fewer workers, and companies lay off people resulting in unemployment rising. Some companies even go out of business which causes the unemployment number to rise even further.
For example, many people working in the finance industry lost their jobs after the financial market collapse of 2008 and 2009. Likewise, when the demand for cars declined, car companies laid off most of their workers.
Saving ratio increases
People who lose their jobs naturally spend less. In addition, those who have their jobs spend less because they worry about getting unemployed themselves. Lack of confidence means increased savings.
This type of paradox of thrift makes the recession worse as people save more and consume less. Individually, they are doing the right thing in these uncertain times. However, when too many people save more and spend less, the economy gets knocked down even further.
Rate of inflation declines
With declining economic growth and a fall in demand, there is downward pressure on prices. As a result, you are likely to see discounted prices as businesses try to sell their unsold goods.
This results in a low rate of inflation or even deflation. Deflation occurs when the inflation rate is below zero. For example, the U.S. economy saw a notable deflation during the Great Depression of the 1930s.
Interest rates decline
Interest rates tend to fall during an economic downturn because a nation’s central bank, such as the Federal Reserve in the U.S., will implement monetary policy to increase the money supply to stimulate the economy. It can do this in various ways. One of the most effective ways is to decrease the federal fund’s target rate and reduce the discount rate. This will make credit cheaper, stimulate demand, and boost the economy.
Government borrowing rises
As unemployment rises during a downturn, the government will spend more on benefits such as unemployment payments and receive fewer income taxes. In addition, business profits will decline, resulting in further reduction of incoming taxes for the government. This increase in spending and decrease in income means that the government has to borrow more money to fund its budget.
Furthermore, the government will implement fiscal policy by increasing its spending and cutting taxes to stimulate the economy. Examples of expansionary fiscal policy are the various Covid stimulus packages the government approved, including the Cares Act that helped shorten the recession.
Stock market falls
When demand is down, businesses are less profitable. As a result, revenue and profit forecasts are lower, and investors are less inclined to pay high prices for stocks. So, typically, stock prices will decline, and the stock market suffers.
However, if the stock market predicted the recession, share prices may not fall. In contrast, if the downturn were unexpected, Wallstreet most certainly would take a hit as profit forecasts would get downgraded and stock prices would fall. This was the case with the Covid-19 recession. Luckily, stocks rebounded pretty quickly after the short downturn.
Real estate prices decrease
During a recession, unemployment rises and this often results in many people defaulting on their mortgages. This leads to home repossessions, lower demand for homes, and eventually a decrease in real estate prices. During the 2008 recession, housing prices in the U.S. fell drastically. However, for many years preceding this downturn, housing prices boomed due to low interest rates and new subprime mortgage products.
As companies avoid taking risks and fear uncertainty during a recession, investments will typically decrease. In addition, banks’ liquidity goes down, and it becomes harder to borrow money.
How Long Do Recessions Last?
According to NBER reports, the average length of a recession in the United States was a little over 10 months between 1945 and 2021. This means that the average length of a recession has decreased significantly as it was a little over 20 months between 1854 and 1945.
The U.S. has had 4 recessions in the last 31 years:
The Gulf War Recession – This downturn hit in July 1990 when the nation went through an 8-month decline partly triggered by a spike in oil prices during the First Gulf War.
The Dot Com Recession – In 2001, the U.S. faced multiple economic challenges emerging from the 9/11 terrorist attack, the tech bubble crash, and various financial scandals. The combination of these problems resulted in a short recession from which the economy bounced back quickly in about 8 months.
The Great Recession – This historic economic downturn was triggered by a real estate bubble in December 2007 and lasted for 18 months, more than double the duration of other recent recessions. Though it was not as drastic as the Great Depression, the effects were quite severe, and the nation had six quarters of economic decline.
The Covid-19 Recession – The Covid recession was the deepest and shortest recession in U.S. history. According to the NBER, the contraction started in February 2020 and lasted only 2 short months until April 2020. GDP dropped by a staggering 31.4% in the second quarter of 2020, followed by an enormous GDP jump of 33.4% in the following quarter, mostly due to various government stimulus packages.
What Is the Difference Between a Recession and a Depression?
The difference between a recession and a depression is that a depression is more severe. It lasts for years instead of months, and it typically has significantly higher unemployment rates and a larger drop in GDP. According to the NBER, a recession involves a significant decline in economic activity spread across the economy and lasts more than a few months. On the other hand, a depression is an extended period of economic slowdown (years) during which you can see a significant decline in many major economic indicators.
Similar causes trigger both recessions and depressions. However, the impact and severity of depressions are much higher. It takes years for the economy to start recovering again after a depression. While there are no specific metrics or criteria to recognize that a recession has turned into a depression, its impact is long-lasting and deep.
According to the National Bureau of Economic Research, the United States has experienced 34 recessions since 1854. The longest one was 65 months long and started in October 1873 and ended in March 1879. The shortest one was the Covid-19 recession that only lasted 2 months. According to the Bureau of Labor Statistics, it resulted in an unemployment rate of 14.7%, the highest since data collection started in 1948.
We have only experienced one depression in modern times – The Great Depression that lasted from 1929 to 1933. This Depression originated in the U.S. and caused a drastic decline in GDP, severe unemployment, acute deflation, and had a long-lasting impact on global economies. As a result, the U.S. unemployment rate rose to an estimated 25%, while GDP fell by about 30 percent.
When the economy declines during a recession, it is natural for many investors to want to stop investing and wait and see what happens. However, some investors are eager to invest and take advantage of the lower-priced stocks. In reality, you do not need to change your investment strategy at all when you are a long-term investor. It is best to keep allocating the same amount of money to your investment account and not make any rash decisions during this time of turmoil.
If you are a short-term investor, you have more to worry about, and you most likely will feel uncomfortable with the bear market. However, DO NOT PANIC and refrain from selling all your stocks at huge losses. The dollar-cost-averaging strategy works and will boost returns in the long run. The most important thing is to keep a long-term perspective during a recession and not worry about short-term fluctuations in the stock market.
Those who want to benefit from the recession and invest more should not buy more than they can afford.
The Covid-19 Recession
A recession is a normal part of the economic cycle. Many economists believed that the global economy was due for one even before the pandemic hit. However, the pandemic led to economic declines never seen before. Over 38 million Americans lost their jobs during the nine-week period starting in March 2020. The 2997-point drop in the Dow Jones Industrial Average was the biggest in its 123-year-old history. Furthermore, consumer confidence took a nosedive.
This lack of confidence triggered reduced spending and further worsened the economic condition. However, as quickly as the recession started, it ended only 2 months later. A rebound started in May 2020 and was mainly due to the government’s massive relief packages to keep households and businesses afloat.
However, as of today, August 30th, 2020, the recovery is far from complete.
However, as of today, August 30th, 2020, the recovery is far from complete. According to the U.S. Bureau of Economic Analysis (BEA), GDP got back to pre-pandemic levels in the first quarter of 2021, which is a great accomplishment. However, economic output is still below where it should have been had there been no pandemic, and there are still several million jobs less than before the pandemic. The quick recovery has increased demand and increased prices. Therefore, the threat of inflation is real. Furthermore, the more contagious Delta variant is definitely putting a damper on the recovery and is decreasing consumer confidence. What happens in the next few months will be critical to a full recovery.
A recession is one of those events in life that we can plan for in advance as it is part of the normal economic business cycle. Although a recession brings many challenges and difficulties, it is possible to ride it out with the right plan. Having a good-sized emergency fund available is the first step of a successful strategy. Then, consider cutting unnecessary expenses, remaining debt-free if possible, and diversifying your income. Another part of the strategy is to keep calm and not panic. Finally, if you have investments, keep a long-term view and hold on to those investments. Once the economy recovers, your portfolio will most likely grow again and benefit you in the long run.