Economic Recessions: History, Causes and Characteristics

An economic recession is the term used to describe a significant decline in economic activity in a particular region, which can last a few months to even years. This is indicated by the area’s declining gross domestic product (GDP), increasing level of unemployment and shrinking production and consumption, among other factors. For the average individual, a recession could mean having a promotion delayed, losing a job or needing to cut back on expenses and luxuries.

An economic recession occurs when economic activity declines for two consecutive quarters. This is typically characterized by a downward trend in the area’s GDP.

However, a decline in GDP for two consecutive quarters does not automatically mean a region is in recession. In the U.S., the National Bureau of Economic Research (NBER), a private, nonprofit and non-partisan organization, is the recognized authority when it comes to declaring a recession. Aside from looking at the GDP, the NBER also analyzes monthly reports for at least 6–18 months on all related components such as income, employment, retail sale and manufacturing to determine if an economy is in recession.

There can be several contributors to a recession. This can include sudden economic shocks, an economy taking on too much debt, loss of consumer confidence, high-interest rates, too much inflation or deflation or asset bubbles. For instance, the COVID-19 virus is an example of an economic shock, as the NBER declared a recession in February 2020. The Dot Com era, on the other hand, is an example of an asset bubble, where prices of investments rose rapidly due to artificially-inflated demand until it “popped” or dissipated and confidence collapsed.

The announcement of an economic recession affects businesses and the average consumer alike. Individuals are more likely to lose their job during a recession, resulting in reduced consumer spending and the inability to pay for expenses. This can lead to business owners struggling to make sales and lenders tightening loan requirements.

An economic recession is a normal part of a business cycle, a term used to describe an economy's natural expansion and recession over time. An expansion is a sustained period of rising real GDP, while a recession is a sustained period of declining real GDP.

Business cycles have four phases: expansion, peak, contraction and trough.

• Expansion: An expansion is a period of healthy and sustainable economic growth. This is where employment rates increase, and lenders make it easier to borrow money by giving favorable interest rates. This results in higher spending and demand, leading to increased manufacturing or production rates.
• Peak: A peak is the highest point of a business cycle, where growth hits its maximum rate. This is where economic imbalances, such as asset values rising more rapidly or consumers taking on too much debt.
• Contraction: A contraction, otherwise known as an economic recession, is where growth slows, unemployment increases and retail sales decrease. On average, the contraction or recession phase lasts 11 months.
• Trough: A trough signals an economy’s lowest point, where it will begin to recover. This is then followed by an expansion, and the cycle repeats.

One of the most popular recessions is the Dot Com Bubble, where the economy expanded thanks to the rise of technology and the internet. However, this growth happened too rapidly, leading to fad-based investing, excess venture capital funding for start-ups and the failure of these tech companies to turn a profit. Eventually, the bubble of investments ultimately burst, leaving investors and business owners facing steep losses.

Initially, an economic recession was determined based on the GDP of an economy alone. Now, to determine whether an economy is in recession, the NBER looks at various indicators, such as the real GDP, unemployment rates, consumer confidence, manufacturing rates and inflation rates. Together, these factors paint a clear picture of the economy’s state.

Decline in Real GDP - The real GDP, or real gross domestic product, is the total value of all goods and services produced within a particular period, adjusted for price changes. A decline in real GDP is often accompanied by other shifts, such as a decline in employment or similar.

Rise in Unemployment - A rise in unemployment often occurs during or right before a recession is declared. It indicates that output and demand fall enough to make businesses cut back on labor or reduce their job vacancies. Case in point, the unemployment rate during the Great Depression soared to 25% in 1933 from 3.2% in 1929, while during the Great Recession, unemployment peaked at 9% in June 2009. Even worse, a rise in unemployment can fuel a recession by the snowball effect. More unemployed individuals mean less consumer spending.

Lower Consumer Confidence - Consumer confidence can grant insight into potential retail spending and, in turn, production rates, impacting the declaration of a recession. This can be tracked using the U.S. Index of Consumer Sentiment (ICS). Generally, it can determine a consumer’s pessimism during recessionary periods and confidence during expansionary periods.

Stagnation in Manufacturing and Sales - The manufacturing rate of goods is an essential indicator of an economy’s health and often ties in with consumer confidence. When an economy is expanding healthily and sustainably, consumers are confident and want to make big-ticket purchases. It also leads to businesses feeling good about investing in durable goods. However, during a recession, stagnation or even decline in manufacturing happens when companies and consumers are no longer interested in purchasing durable goods.

The manufacturing and service sectors also have an index indicating whether those sectors are going through an expansion or a contraction, called the Purchase Manager Index (PMI). This shows the view of purchasing managers in the sector, which can provide business owners with a look into current and future business conditions. Generally, the PMI is measured on a scale of 0 to 100, with the higher end of the spectrum indicating an expanding market.

High Inflation - Inflation is the rate of change in the prices of products and services. Moderate inflation can be good for economic progress, as it signals a healthy economy with rising demand for items. However, too much inflation can reduce the purchasing power of consumers, which can reduce retail sales and manufacturing altogether.

Inflation is measured using the consumer price index (CPI), which is the average price of basket goods and services that the average consumer purchases. This takes data from thousands of different products and services from various industries each year, letting you take into account the price change of certain commodities.

For instance, the price index for food items rose to 1.2% in May 2022, a 0.3% increase from April. Similarly, the energy index rose 34.6% between May 2021 and May 2022, with natural gas increasing by 30.2% in the same period — the highest increase since July 2008.

While recessions are a natural part of a business cycle, some events can help push it along. These are unpredictable events such as global economic shocks, financial market problems or a combination of economic factors that create the perfect scenario for a recession.

Overheating

An overheating economy is when supply cannot keep up with demand or the economy is expanding too rapidly, characterized by rising inflation or deflation rates and an unemployment rate below the normal standard for the economy. The Great Recession in 2008 is an example of an overheated economy.

Asset Bubbles

An asset bubble is somewhat similar to an overheating economy in that it features rapid growth — but it is not caused by rising inflation or deflation. Instead, an asset bubble occurs when the price of an asset increases rapidly without justification, such as herd mentality or short-term thinking. Think of the Great Recession of 2008, where the housing market was booming, and more and more individuals took out low-interest loans to purchase a home. Eventually, this asset bubble popped, causing one of the worst economic recessions.

Economic Shocks

An economic shock, or macroeconomic shock, is an unpredictable event that causes large-scale impacts on the economy. These are similar to Black Swan events, which are rare and have severe consequences on an economy, potentially even on a global scale.

Economic shocks can originate from supply and demand issues, particular industries, natural calamities or even shocks from an international market. For instance, the COVID-19 pandemic is an example of an economic shock.

Since 1854, the U.S. has had a total of 34 recessions, which underscores how recessions are a natural part of any modern economy’s business cycle. While a decline in economic factors often accompanies recessions, it also indicates a new expansion that is different and perhaps more prosperous than the last. Case in point, since the Great Depression in 1929, industries have had many evolutionary changes.

Below are a few examples of the most popular recessions in U.S. history.

The Great Depression of 1929 is one of the most severe economic recessions in history, severely impacting the U.S. and global markets.

Several events influenced the recession and its duration. Aside from the U.S. stock market crashing, it was also spurred on by banking panics in the U.S., where banking clients simultaneously attempted to withdraw their cash, leading to a fall in the money supply. International lending also decreased thanks to the Hawley-Smoot Tariff and U.S. banks holding relatively high-interest rates.

Combined, the Great Depression crippled the economy. Between 1929 and 1933, the country’s GDP fell by 50%, nearly one in five banks failed, 25% of the workforce lost their jobs and stocks lost almost 90% of their value. It took a decade for the country’s economic indicators to recover and two decades for the stock market to return to pre-recession levels.

The Great Depression caused the U.S. unemployment rate to rise to a high of 25.6% in May 1933, equating to 15 million unemployed individuals. The stock market crash played a role as those who lost money spent less, lowering demand and impacting manufacturing and sales.

The economy started to recover in 1933, which is also when President Franklin D. Roosevelt took his place in office. To respond to banking panics, Roosevelt declared a four-day “banking holiday,” where he gave banks the time to figure out whether they could stay in business or otherwise be solvent. Roosevelt also launched the New Deal, where the government implemented many relief and recovery programs to employ individuals and stimulate the economy. Additionally, gold inflow from Europe helped spur recovery as, at the time, Europe was in worse economic shape.

The effects of the Great Depression demonstrated the importance of price stability for monetary policies, as fluctuations can cause financial stability and hinder economic growth. Further, banks should have ample reserves to meet withdrawal demands.

The Dot Com Bubble occurred in the late 1990s and early 2000s due to speculation in dot-com or internet-based firms. This was characterized by the NASDAQ Composite index, which rose exponentially in the early 2000s. It increased from 1,468.86 to 8,083 between January 1995 to February 2000.

Indeed, the formation of internet and tech-based start-up enterprises, combined with the introduction of the World Wide Web, contributed to the Dot Com Bubble's growth as the 1990s ended.

Due to the exhilaration of the new digital age, internet company share values rose faster and higher than their competitors — eventually, the bubble burst. As a result of internet companies being overpriced compared to their fundamental value, many online and technological businesses filed for bankruptcy and faced liquidation.

The 2008 Financial Crisis, or the Great Recession, is one of the worst recessions next to the Great Depression. Before the Great Recession, the U.S. market experienced an expansion in the housing market. This came with an upsurge in home mortgage borrowing, where lenders offered low-interest rates and high-risk mortgages repackaged into securities.

In turn, the demand for homes increased. U.S. households' mortgage debt increased from 61% of GDP in 1998 to 97% in 2006. This also caused prices to surge nationwide. Eventually, expansion peaked, and the “bubble” burst, leading to an economic recession.

The housing sector was at the center of both the financial crisis and the slowdown in overall economic activity. The U.S. GDP declined by 4.3% from peak to trough, which lasted 18 months — making this the deepest recession since World War II and the longest in history. During the same period, the unemployment rate increased from less than 5% to 10%.

In response, the Federal Reserve provided monetary accommodation and a range of programs to ensure the gradual pace of recovery. For instance, traditional banks required a larger capital and regular stress testing was conducted to help banks and regulators understand market risks.

Since COVID-19 was picked up in late 2019 in Wuhan, China, countries around the globe turned to lockdowns to prevent the spread. This resulted in major disruptions in all facets of the economy, creating a demand shock, a supply shock and a financial shock. It also heavily impacted industries like travel, hospitality, manufacturing and logistics, causing millions to lose their jobs.

In the U.S. alone, 9.6 million lost their jobs due to business closure during the pandemic. On the other hand, the U.S. GDP fell by 8.9% in the second quarter of 2020, which is the largest single-quarter contraction in 70 years.

Merchandise trade volume from the WTO also paints a picture of how restrictions for COVID-19 wrecked the supply chain and impacted global economies. Case in point, the index was steadily increasing from the first quarter of 2015 but took a steep downturn by 15% in the second quarter of 2020 as lockdowns were implemented.

The U.S. government provided stimulus checks or economic impact payments to stimulate the economy, boosting household incomes and supporting consumer spending. Additionally, lockdowns were eased in the second half of 2020 thanks to infection rates decreasing and economic growth picking up again.

A recession generally brings about a sense of foreboding in terms of finances, but understanding the finer details can help you prepare. Review MoneyGeek’s answers to some of the most commonly asked questions about recessions below.

When a recession hits, it can be tricky for the average consumer’s finances. Below are a few more resources to help you better understand your financial state and the economy.

• 5 Factors That Could Signal Economic Recovery: Learn how to tell if the economy is improving.
• 5 Best Ways to Build an Emergency Fund: Having cash on hand for unexpected emergencies is essential for financial security. Learn how to build your safety net.
• Understanding Supply: Understand what supply means in the greater context of the economy.
• Understanding Demand: Learn how demand can play a role in the economy’s well-being.
• The Ultimate Guide to Budgeting: Creating a budget is a crucial step in your financial plan. Explore how to create one and why it’s important.