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Aug 4, 2022

What is a Recession?

By Stash Team
In this article:
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Recessions are a natural part of the economic cycle in which the economy contracts, which means there is significant economic decline across many sectors that lasts more than a few months. The decline usually shows up as reductions in spending, income, employment, and industrial production. The economy is always contracting or expanding, and recessions are typically much shorter than expansions.

In this article, we’ll cover:

Recessions are part of the business cycle

What is a recession’s place in how the economy functions? It can be seen in the four parts of the business cycle: expansion, peak, contraction (recession), and trough. Index funds, which aim to mimic the performance of the stock market overall, often demonstrate this pattern. 

  • During an expansion, company production and profits grow, the stock market rises, and unemployment is low. People have disposable income to buy products, save, and invest. As demand increases, businesses raise prices, causing inflation.
  • The economy peaks when inflation and growth become unsustainable. At the peak, prices are too high, and there is no room for further expansion.
  • The contraction phase, or recession, follows the peak. Economic activity decreases, stock prices fall, and portfolios lose value. Businesses cut back on spending; they shed staff, unemployment rises, and individuals have less to spend.
  • The trough is the cycle’s low point. It’s also the turning point, when growth resumes and recession recovery begins.

Historically, the average contraction is far shorter than the average expansion, although recovery can take time. Recessions are an unavoidable part of the business cycle.

The difference between a recession and depression

A depression is an exceedingly severe recession, and depressions are quite rare. In fact, only one has been recognized in the US: the Great Depression of the 1930s. In general, depressions are much longer than recessions: many years instead of months. Unemployment rates are much higher in depressions,  and they often have a global impact, whereas recessions usually are more localized.

RecessionDepression
DurationLasts for monthsLasts for years
Global impactOften localized to a single economyMay have a global impact
Economic impactEmployment, income, spending, and manufacturing decreaseEmployment, income, spending, and manufacturing plummet
Occurrences in US history34 in the US since 1854One in the US since 1854

Examples of past recessions

On average, modern-day recessions last about 11 months. Expansions, on the other hand, average four to five years, though they’ve been known to last anywhere from 10 months to over a decade. Recent recessions during the twenty-first century include:

  • Dot-Com Recession: Following a 10-year expansion, the market crashed in March 2001 when the dot-com asset bubble burst. Many tech investments became worthless and businesses failed. The 9/11 terrorist attacks and revelations of accounting fraud at major companies like Enron in September 2001 caused further shock waves. The recession lasted eight months, though employment in the high-tech industry did not recover until 2008.
  • The Great Recession: The Great Recession began in December 2007 and was felt around the globe. The housing market collapsed as the subprime mortgage crisis worsened, foreclosures and unemployment skyrocketed, and major financial institutions folded. The recession lasted 18 months, ending shortly after the American Recovery and Reinvestment Act was passed. Recovery took approximately three and a half years.
  • The COVID-19 Recession: Early in the pandemic, a wave of business closures sparked massive increases in unemployment, causing widespread housing and food insecurity. Pandemic-related uncertainty also caused a market crash following a February 2020 peak in viral infections. Ultimately, the recession lasted for just two months, but employment figures did not fully rebound until the end of 2021.

What causes a recession

What are the recession drivers? Well, it’s complicated. Each recession has a complex set of causes and solutions, and economists often disagree on what they are. That said, there is broad agreement on several recession culprits:

Overheated economy

During long periods of economic growth, consumer wealth increases. Businesses attempt to capitalize on that by increasing production, often kicking off a cycle of inflation that becomes unsustainable. For example, the Great Recession occurred after an overheated economy with high inflation and unusually low unemployment. Exceptionally high consumer confidence, asset bubbles, and economic shocks can also cause an economy to overheat.

Excessive inflation

Inflation means rising prices, often driven by increased demand from consumers with money to spend, and too much of it can be harmful. For instance, inflation crested at 13.5% in 1980, and the Federal Reserve responded by raising ithe federal funds rate to 19.3% by 1981, sparking a recession. The unemployment rate topped 10% and tens of thousands of businesses failed. 

Severe deflation

Deflation is a decline in prices. Businesses respond by cutting wages or laying off staff. People have less money to spend, so businesses must reduce prices further. Too much deflation creates a feedback loop, and there is little that the Federal Reserve can do to stop it. Severe deflation can cause recessions; prices and spending drop until a trough is reached and recovery can begin.

Economic shocks

The COVID-19 pandemic is an example of an economic shock: an unexpected problem that results in serious economic problems. When widespread illness and death forced stay-at-home orders, unemployment quickly rose and businesses closed down. Natural disasters, technological disruptions, severe supply chain issues, and major regulatory changes can also trigger recessions.

Asset bubbles

An asset bubble occurs when investor confidence outstrips the value of investments. The dot-com bubble, for instance, was caused by a flood of cash into tech companies that ultimately failed en masse. Similarly, the housing bubble that set off the Great Recession was driven by investment in high-risk mortgage-backed securities. An asset bubble can also be part of an overheating economy. 

Signs of an upcoming recession

Since recessions are challenging to predict, economists track indicators that suggest a recession is approaching. Most experts attempt to measure confidence in the market. Here are some warning signs to watch:

  • Inverted yield curve. Yields are the interest rates on bonds. Usually bonds that take longer to mature command higher interest rates, so the “yield curve” slopes upward. An inverted yield curve, however, slopes downward. It reflects demand for higher interest rates for shorter-duration bonds because investors think the immediate future is riskier than the long-term future.
  • Decline in consumer confidence. When people feel worried about the economy, they spend less: if you know you might be laid off soon, you’re likely to postpone your vacation or hold off on buying a new car. Because fears of a recession can become a self-fulfilling prophecy, an ongoing drop in consumer confidence can herald a recession.
  • Rising unemployment. When businesses are nervous about the economy, they tend to schedule employees for fewer hours, hire less, and rely more on temporary workers. They may also lay people off. Rising unemployment benefit claims can be a sign that businesses are bracing for a recession.
  • Steady stock market drops. All of the indicators above can show up in stock prices. Companies also use the signals to guess at market behavior, which can influence their decisions and increase the risk of a recession. But while market drops are worth watching, they aren’t always good predictors of a recession. Recessions can happen without a preceding drop, and not every price dip becomes a recession.

Industries most impacted by a recession

When people have less money to spend, they cut back wherever they can, so nonessential or “cyclical” industries, like leisure activities and personal care, tend to contract. Particularly vulnerable business types include:

  • Retail stores
  • Restaurants
  • Travel and tourism
  • Leisure/hospitality
  • Hair and nail salons
  • Real estate
  • Manufacturing
  • Warehousing

Of course, there are some things people can’t do without. Defensive sectors, like groceries, healthcare, and utilities, are more likely to hold steady.

How you can prepare for a recession

In addition to asking “What is a recession?” you might be wondering “How do I prepare for one?” First, remember that they’re an unavoidable part of the business cycle. Recessions can make people nervous, but you take action to protect yourself, like creating a diversified portfolio that matches your risk profile, budgeting, paying off debt, and avoiding new financial commitments. Take a deeper dive into preparing for a recession with this guide.

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