What Is a Recession? Every Factor You Must Consider
Most people get scared whenever they hear the word “recession.” The significant decline in the economy during a recession is something that can affect any person, so it’s important to understand how this “economic slowdown” works in order to avoid significant financial problems.
A recession can range from a nationwide problem all the way to a global financial crisis. Still, there are many factors involved in how a recession affects the global economy, and today, I’ll tell you all about them.
This page will walk you through recessions, what they imply, and how you can go through them in the best way possible. If you’re doing economic research to protect your financial future, then you’re in the right place.
What Will I Learn?
What Is a Recession?
In a general sense, a recession is an event that affects economic activity. It’s seen as a significant and persistent decline or downturn in a nation’s or the world’s economy.
A recession can affect a person’s employment and economic output. Moreover, these events can make the average consumer spending rate drop significantly.
The National Bureau of Economic Research has a shorter and simpler definition for a recession, which states that: “It’s a significant decline in a nation’s economic activity, which is spread across the economy, and can last several months.”
Moreover, the National Bureau of Economic Research always measures four different factors to evaluate if a recession happened or not.
How Do You Know You’re in a Recession?
There are many factors that can tell you that a nationwide or global recession may be around the corner. If you do economic research, you will be able to notice the “signs” faster.
However, financial experts are able to measure how and when an economic recession could happen. Typically, financial experts will officially declare a recession or economic downturn whenever a nation’s general economy goes through a negative gross domestic product (GDP) rate.
This change in economic activity can happen after a prolonged period of economic expansion. While a recession is something nobody wants, experts consider them part of the business cycle, and it’s inevitable.
What’s the Business Cycle?
It’s a name used to describe how an economy goes between recession and expansion periods. When we go through an economic expansion, we will see sustainable growth, employment rates go up, consumer spending rates go higher, etc.
During these times, the value of some assets will increase, and debt amounts will get larger, as lenders make it much more affordable for people to borrow money, which can cause an “asset bubble.” When this bubble pops, the economy will enter a recession.
I’ll explain more about asset bubbles in the next sections.
What Does the International Monetary Fund Say About Recessions?
Besides certain economic contractions, most nations have seen stable economic activity and growth since the “Industrial Revolution.” According to the International Monetary Fund, there were approximately 122 recessions between 1960 and 2007.
These recessions affected approximately 21 advanced economies. Thankfully, recessions over the past decade have become shorter and less frequent.
What Can Cause a Recession?
There are many theories that try to explain why a nation’s economic activity can go through a recession. Most of these theories tackle the following factors:
Economic
Psychological
Financial
In any case, two of the most common consequences people will experience are negative GDP growth and unemployment.
Let’s address some of the most common signs we may be going through a period of recession:
Economic Shocks
Economic shocks are considered “surprise” problems that can take a huge toll on a nation’s economy. A great example of this factor is when the OPEC cut off its oil supply to the US in the 1970s. This caused long lines at gas stations, excessive prices, and therefore, a recession. A sudden change in oil prices could also drive a recession.
Is there a recent example of an economic shock? Yes. The COVID-19 outbreak was certainly “sudden,” and it shut down most economies on a global scale.
Debt
When I talk about “debt” as a sign of recession, I’m referring to excessive debt. If a person or business takes on more debt than it can handle, it will reach a point where it won’t be able to pay.
At a small scale, this probably wouldn’t cause too many problems, but what happens when big corporations declare bankruptcy or there’s a growing debt default in a country? We would likely experience a recession.
Asset Bubbles
Many investment decisions are based on emotions, and that’s not good. During times of economic certainty, investors tend to take more risks and make bigger investments.
However, becoming too optimistic during these times and taking risky decisions will eventually inflate real estate/stock market bubbles.
Once these “bubbles” pop, investors tend to panic and sell as soon as they can, which can easily crash the markets and cause a recession.
Deflation/Inflation
Both inflation and deflation can be significant factors when it comes to recessions. Let’s go over inflation first.
We know inflation as an upward trend in prices during a particular period. While many people believe inflation is always bad, it isn’t. The problem is when there is too much inflation.
In these cases, most central banks try to control excessive future inflation by raising interest rates. Unfortunately, higher interest rates can eventually depress a nation’s economic activity.
An example of interest rates causing a recession can be traced back to the 1970s, when the US was going through a significant inflation problem, and in an effort to solve it, the Federal Reserve raised the interest rates. Needless to say, increasing the interest rates caused a recession.
Now, what about deflation? Surprisingly, its effects can be even worse than the ones from inflation. As opposed to inflation, deflation refers to a “decline” in prices over a particular period. Whenever people are going through deflation periods, wages tend to contract, which makes prices decline even further.
When deflation problems get out of control, many individuals and companies limit or stop their spending, which affects the economy and increases the chances of experiencing a recession.
Technological Changes
Finally, a nation could go through a recession because of advances in the technology sector. In essence, a breakthrough in technology can help a nation’s economy in the future, but in the short term, it could also cause a recession, as people would have to adapt to these breakthroughs first.
With the recent popularity of AI and robots, some financial experts believe that they could cause a recession. This is because some people are worried that robots will take over several job categories, which could cause a nationwide or global recession.
Is There Any Difference Between a Recession and a Depression?
Even though both events are similar, there are certain differences. In a nutshell, depression periods are much worse than recession ones.
First, a depression can cause:
Many job losses
High unemployment rates
Significant declines in GDP growth
Moreover, depressions tend to last years, as opposed to recessions, which can last only a few months. The economic recovery period after a depression tends to be much more complicated and longer.
The best example of this event is “The Great Depression,” which lasted from 1929 to 1933. Even though the Great Depression technically ended in 1933, the economy wasn’t considered “recovered” until World War II, which happened almost a decade later.
During this period, the GDP declined by 30%, and the unemployment rate raised to 25%.
Now, how does this compare to “The Great Recession,” which was the worst recession period to date? In this period, unemployment rates were approximately 10%, and it lasted for a year and a half.
The global financial crisis that came from the coronavirus was thought to cause the next big depression, as unemployment rates were hovering around 14.7% during 2020. That rate is even worse than the one during the Great Recession.
Is There a Way to Predict a Recession?
First, it’s important to acknowledge that there isn’t a 100%-certain way to predict a recession. Even though we’ve had steady economic and investment growth rates over the past years, the COVID-19 outbreak reminded us that the economic future is uncertain.
Now, there are a few ways to predict a future recession, although they may not be 100% accurate. Let’s go over each of them.
Inverted Yield Curves
These are graphs that can plot the “yield” of several US government bonds. During times of “normal” economic activity, the yield should be higher on long-term bonds. On the contrary, if the yield for a long-term bond is lower than the one for a short-term yield, that shows that investors fear a recession.
Typically, long-term bonds yield more because investors are taking risks on high interest rates and future inflation, so if the contrary happens, we could be entering a recession period.
However, while an inverted yield curve can be used to predict a recession, it doesn’t guarantee that one will happen, as some inverted yield curve periods in history weren’t followed by a recession.
Drops in the Leading Economic Index
The Conference Board publishes the Leading Economic Index (LEI) monthly, and its goal is to predict economic trends for the future.
Some of the factors that the LEI uses to measure economic activity include the performance of the stock market, applications for unemployment insurance, and others.
If, for any reason, the LEI declines or drops, that could be a sign of an upcoming recession.
Declines in Consumer Confidence/Spending
The main driver of an economy (and particularly the US economy) is consumer spending. When people aren’t confident about spending more money, that shows a decline in “Consumer Confidence.”
If consumer confidence declines suddenly, that could also translate to a spending decline, which can slow down the economy and cause a recession.
Declines in the Stock Market
The stock market isn’t a stranger to declines. However, whenever the markets experience a sudden or large decline, that could be a sign that a recession may come up.
In the event of a stock market decline, investors tend to sell most (or all) of their holdings to protect themselves from an economic slowdown.
Unemployment
High unemployment rates are one of the most obvious signs that a recession may be around. If there’s a long period of consecutive job losses in a country, then that could lead to a recession.
With the coronavirus outbreak, for example, many people worldwide lost their jobs, as not all businesses were able to adapt. This caused the unemployment rate to go up, and a recession to happen.
Does a Recession Affect Economic Growth and the Global Economy?
Some people claim that two consecutive quarters of GDP growth constitute a recession, but what does this mean for you? We already know that, at a global scale, it means many people losing their jobs, less spending, etc. Now, let’s narrow things down a bit.
A recession can affect you in many different ways, so let’s address each one.
Unemployment
The primary consequence of a recession is a decline in job opportunities. This happens because consumer spending slows down, which makes the economy shrink and the company’s profits to go down.
In an effort to save money, companies either stop hiring or start firing people. According to a study by Brookings, over 22 million people lost their jobs due to the COVID-19 pandemic.
Even if you got fired, finding another job will also be hard, as the average company will be less likely to hire you unless you’re considered a high-value asset.
Unemployment can, therefore, cause you many problems regaining financial stability. Thankfully, the job market has been growing steadily these past couple of years.
Tight Budgets
During recessions, prices are likely to increase a lot. Even if you keep your job and earn a good amount of money, you may still find yourself tightening your budget because you cannot afford everything you could before.
Moreover, the higher interest rates that come during a recession will affect your ability to buy a car, house, or any other item on credit. This is why it’s important to always have a financial cushion in case of unexpected financial hardships.
Problems with Insurance Coverage
It’s well-known that a recession can cause people to lose their insurance coverage, especially employment-based insurance coverage. This is because employers are less likely to pay for the bills that insurers ask for during these times.
Losing your insurance coverage could mean that you’re uninsured until you find a new job, and if you ever go through a medical emergency, you could get overwhelmed by out-of-pocket expenses.
Problems with Your Investment Portfolio
As you may have been able to notice, the stock market and recessions go hand in hand. The fear of an upcoming recession often encourages investors to liquidate their portfolios, either to protect their profit or just to prevent further losses.
However, if you cash out your assets, you may have a harder time recovering your losses as the stock market recovers.
Every investment journey is different, but it’s always recommended to stick to your long-term investment strategies, as that will likely give you more positive outcomes in the future than deciding to liquidate everything.
Less Bargaining Power
Employers and workers in general are greatly affected by recessions. Overall, an employer may be forced to lower wages, remove benefits, or decrease bonuses in order to cut down financial losses.
On the other hand, employees may lose their ability to have a flexible schedule or request special accommodations like remote working. In any case, both parties are greatly affected, although employees may be getting the bigger hit.
If the employee doesn’t agree with an employer’s new terms, they can leave, but it’s vital to note that finding a new job during a recession can be harder than usual.
Less Credit Access
Lenders are less likely to lend you money during a recession, even if you meet all the requirements to ask for credit. The restricted access to low-interest credits can make people stop their real estate or vehicle purchase process.
What About Psychological Consequences?
We’ve talked about all the tangible consequences of a recession, but what about the psychological consequences?
It’s no secret that a recession is one of the most stressful situations a person can go through, especially if they were already struggling financially.
Even if you’re able to secure your job, a stable income, and everything you need to “stay safe,” it’s normal to get nervous or anxious about what will happen.
One common factor about recessions is that they can be unpredictable sometimes, so the best thing you can do to avoid getting hit too hard with the consequences is to stick to your long-term financial strategies and not make any harsh decisions.
How Long Does a Recession Usually Last?
The National Bureau of Economic Research states that the average span of a recession since 1854 is 17 months. Thankfully, recessions in the US have been significantly shorter after World War II.
Today, a recession can last up to 10 months. To put things in perspective, the COVID-19 recession in 2020 had an “official” period of only two months in the US.
Telling how long a recession will last can be complicated, as there are many factors that go into play. Still, recent history tells us that recession periods are getting much shorter.
Are We Facing a Recession (2023)?
According to a poll from economists at the World Economic Forum, almost two-thirds of the people who participated believe there will be a recession this year.
In this case, economists believe that the reason is that the Federal Reserve is forecasting an inflation rate hike of up to 5.1%, which will affect the housing market that already experienced a decline last year.
Even though some websites online make this recession to be catastrophic, it’s important to remember that these are normal cycles that eventually happen.
There’s no way to know with certainty how bad this recession will last, but many economists believe we should be able to recover from it fairly quickly.
How to Prepare for a Recession
There are many things you can start doing to prepare for an upcoming recession, and those include:
Evaluate/review your finances, including living expenses, debt, savings, and upcoming life events. Make sure you adjust your expenses and only spend what’s necessary so that you have a financial cushion.
Create an emergency fund with at least three months’ worth of expenses saved up. The bigger the fund, the better.
Keep making your debt payments whenever possible.
Try to get a backup plan in case you lose your job. It’s also a great idea to update your resume, work on new skills, or even try out freelancing.
Bottom Line - Complement Your Economic Research with Our Posts!
A recession is certainly a scary situation for everyone, but if you prepare for it, its consequences won’t hit that hard. Make sure you save this information for later, and prepare in the best way possible for any economic event!
About Arthur Karter
Hi, I’m Arthur, and nobody wants to wake up in their 50s like me that they are in serious debt with minimal assets. This wake-up call forced me to reevaluate everything. After going through the school of Hard Knocks, I’m ready to help you by sharing the best retirement choices and how they differ from all the same-old, same-old options that financial advisors sell. These alternatives will help you build and protect your wealth.
