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Economic recessions disrupt periods of economic growth, marking a downturn in overall activity. They’re a normal part of the business cycle, but understanding their causes and impact empowers various stakeholders to navigate these challenging times. This guide will equip you with the knowledge to decipher economic recessions and their implications. Let’s delve into what an economic recession is, how to recognize it, and the factors that can trigger a downturn.
Understanding economic recession
An economic recession is a period of more severe contraction in which real GDP is negative for two consecutive quarters and can last up to three years. We call this a severe recession depression.
Depressions last longer than recessions. They can last for more than three years, even up to a decade. Meanwhile, since World War II, the average recession has lasted about 11 months. It can be longer than the Great Recession, which lasted about 18 months. Apart from being more lasting, the economic downturn during the depression was deeper, with real GDP falling by more than 10%.
Recessions may frequently occur because they are a normal part of the business cycle. It is a form of contraction, but it lasts longer and creates negative expectations for the economic outlook, income, and employment.
Recession in history
Citing the Wikipedia page, the following is a list of recessions in the United States.
- The 1973–75 recession lasted one year and four months and resulted from a combination of a stock market crash and a sharp spike in oil prices.
- Recession 1981 – 1982, about 15 months. The combination of a sharp spike in oil prices and an aggressive rate hike by the central bank triggered an economic downturn.
- Recession 1990-1991 for about 8 months. The trigger is a combination of aggressive interest rate hikes, oil price shocks, debt accumulation, and rising consumer pessimism.
- Recession 2001 – 2001 for about 8 months. The triggers were the collapse of the dot-com bubble and a fall in business and investment spending.
- The Great Recession of 2007-2009 began with the bursting of the asset bubble in the housing sector. The recession lasts for about 18 months.
Key indicators to predict a recession
It is difficult to predict when a recession will occur. There’s no sure way to find out. I’m not going to discuss how you can accurately predict a recession. Instead, I will only present a few useful indicators and signal the start of a recession.
The inverted yield curve is one predictor of a recession. At least, that applies to the United States economy. Typically, 18 months after an inverted yield curve occurs, the United States economy goes into recession.
Just before the recession, short-term yields rose faster than long-term ones. As a result, short-term returns are higher than long-term returns, causing the yield curve to invert.
The rapid rise in short-term yield implies an increase in risk in the near term. Therefore, investors are asking for a higher premium.
The inverted yield curve violates the normal yield curve, where the short-term yield is lower than the long-term yield. The normal yield curve implies that the long-term uncertainty is higher than the short-term uncertainty, so the risk premium is also more significant.
The average weekly hours worked in manufacturing decreased. At the start of a recession, manufacturers won’t cut the workforce right away. Instead, they will adjust hours worked to rationalize operating costs in response to weak demand.
They will observe further developments in demand for goods and services. If demand falls again, they are more likely to cut jobs.
New orders for capital goods. When the contraction progresses, the company will cancel or stop new orders for plant and equipment. That implies reduced future aggregate demand.
Stock composite index. Share prices reflect investors’ expectations of a company’s future growth and prospects. If the index falls, investors expect future sales and corporate profits to fall, indicating the economy’s weakness.
Falling share prices weaken demand through the wealth effect. For developed countries, stock investment is a medium for the allocation of wealth for most households. Lower share prices reduce household wealth, which can lead to lower consumer spending.
A falling share price can also affect business investment. Companies rely on equity capital to fund investments. When share prices fall, raising funds through the issuance of new shares is not optimal. So, they might delay investing.
Causes of economic recession
Recessions arise due to a combination of events such as a surge in oil prices, the bursting of an asset bubble, speculation, and aggressive economic policies. They exacerbate economic weakness by affecting the costs of production, employment, income, expectations, and aggregate demand.
The sharp rise in oil prices
The oil price surge caused a structural shift in the industry. Price spikes trigger higher costs in many industries. Oil is used not only for fossil fuels but also for many other applications, including plastics and chemicals. The increase also triggered a surge in logistics costs and production costs in the economy.
Output fell, and at the same time, inflation soared. This gave rise to a recession and inflation. We call this condition stagflation, which happened in the United States in the 1970s.
Stagflation is a dilemma for monetary policy and fiscal policy. Both policies were ineffective in overcoming stagflation because the source of the problem was on the supply side. Meanwhile, both are demand-side policies, which affect the economy through aggregate demand. An expansionary policy will only result in higher inflation. Conversely, contractionary policies will only deepen the recession.
Asset bubble collapse
The bursting of the housing asset bubble triggered a severe recession in the United States from 2007 to 2009. Likewise, the 2001 – 2001 recession began with the collapse of the dot-com bubble. The burst of the bubble brought panic to the economy, which spread to other economic variables such as spending and investment.
Speculative activity
The Asian financial crisis of 1997-1999 originated from currency speculation and hot money flows. At that time, some Asian countries, such as Indonesia, adopted a fixed exchange rate system. Speculation triggered a sharp depreciation of the exchange rate, forcing government intervention through foreign reserves and devaluation of the exchange rate.
Yet, government intervention was not sufficient to stabilize the exchange rate. That triggered a further currency crisis and soon spread to the economy.
The high debt in US dollars also exacerbates the exchange rate. Companies that borrow in dollars have to face higher repayment costs. They react by buying dollars by selling the domestic currency, which further damages the exchange rate.
Tightening of the money supply
Monetary policy affects the economy through the money supply. When the central bank adopts a contractionary monetary policy, it reduces the money supply in the economy. Liquidity in financial markets dries up, pushing up interest rates.
Increased interest rates make the cost of new loans more expensive. Households rely on loans to finance the purchase of durable goods such as cars and houses. Meanwhile, businesses rely on loans to finance investments. If interest rates skyrocket, consumption and investment (both components of aggregate demand) fall, triggering an economic downturn and leading to a recession.
Impacts of economic recession
During a recession, we will see a worsening of several indicators of economic activity.
Economic output falls. Real GDP has fallen for more than two consecutive quarters. This creates negative expectations among businesses and households. Household and business spending weakens, causing further contractions in output, employment, income, and profits.
Demand for goods and services weakened. During a recession, people spend less than before, which lowers sales and worsens business activity. Households cut expenses. Early in the recession, pruning was mainly for durable goods. However, if the recession deepens, a decrease in spending could occur for most goods and services.
The demand for new capital goods fell. Investments in capital goods will only create excess supplies and lower their prices and profitability. Therefore, at the start of the recession, businesses will cancel orders for capital goods and new factories because of unfavorable business prospects. Instead, they repair old equipment to keep it operating. Therefore, during a recession, investment in capital goods falls sharply.
Unemployment rate goes up. In response to the initial recession, businesses will first cut working hours pending further demand trends. Another effort is to reduce the number of temporary workers. They do not immediately lay off permanent workers because new hiring costs are more expensive than keeping them. But, if demand continues to weaken, the company will then make direct layoffs to maintain profitability.
Purchasing power fell. Many people don’t have an income because of unemployment. They rely on savings or transfer payments from the government for a living. As a result, purchasing power falls, encouraging consumers to reduce demand for goods and services. The decline in demand has put more pressure on business profitability. That, in turn, leads to further workforce cuts, pushing the unemployment rate even higher.
Deflationary pressure. A decrease in demand also leads to lower prices for goods and services, increasing deflationary pressures. On the other hand, companies face an accumulation of products in warehouses due to declining sales. In the end, they tried to cut selling prices to reduce the buildup of inventory in the warehouse.
Impact of recession on the financial market
A recession throws a wrench into the well-oiled machine of the financial market. Here’s a breakdown of the key consequences:
- Market volatility: Economic uncertainty breeds investor anxiety, leading to wild swings in stock prices. As businesses face weakening prospects, confidence wanes, and investors may sell off holdings, causing markets to become more volatile.
- Reduced corporate profits: Recessions stifle economic activity, leading to a decline in sales and profits for businesses. This translates directly to lower stock prices, as companies’ future earnings potential diminishes.
- Debt deflation: While deflation (falling prices) can sound positive initially, it creates a “debt burden” problem. As mentioned earlier, borrowers still owe the same amount they borrowed, even though the value of goods and services has decreased. This makes it harder to repay debts, potentially leading to defaults and financial strain.
- Investor risk aversion: As economic conditions deteriorate, investors become more risk-averse. This shift in sentiment leads to a flight to safety. Investors seek out assets perceived as less risky, such as government bonds, even if they offer lower potential returns. Conversely, riskier assets like stocks or high-yield bonds become less attractive, further dampening their prices.
- Credit crunch: During recessions, central banks may raise interest rates to combat inflation. This makes borrowing more expensive for businesses and individuals, potentially hindering investment and economic growth. Additionally, banks may become more cautious when lending, tightening credit availability.
Debt deflation
Deflation is negative inflation and occurs when the prices of goods and services generally fall. Hence, the purchasing power of money increases. You can buy more items than before for the same amount of money.
Deflation benefits lenders and hurts borrowers. Take a simple example: You borrow Rp10. With this money, you can buy 10 products XYZ. That means the price per unit is Rp1.
Deflation occurs, and prices fall by about 20%. Assume, the same percentage decline also occurs for product XYZ. So, the current price is Rp0.8.
Because you owe Rp10, then you still pay Rp10 to pay off the loan. On the other hand, with this money, the lender can buy more product XYZ than before, from 10 units to 12.5 units (Rp10 / Rp0.8).
You can also use the nominal interest rate formula to determine the impact of deflation on debt. When you borrow money, you bear the nominal interest rate, which is the formula as follows:
- Nominal interest rate = Real interest rate + Inflation rate
So, you should get a lower nominal interest rate when it comes to deflation because the inflation rate is negative.
Investor risk aversion
As economic uncertainty rises during a recession, investors become more risk-averse. This means they prioritize preserving their existing capital over potentially achieving higher returns through riskier investments.
Flight to safety: This shift in sentiment triggers a flight to safety. Investors flock toward assets perceived as less risky, even if they offer lower potential returns. These safe haven assets typically exhibit:
- Lower volatility: Their prices experience smaller fluctuations, offering more stability during market downturns.
- High liquidity: They can be easily bought and sold without significant price swings, allowing investors to access their cash quickly if needed.
- Lower default risk: They have a lower chance of defaulting on their obligations, ensuring investors receive their principal back.
Examples of safe-haven assets:
- Government bonds: They are debt securities issued by governments, considered to be very safe investments due to the low risk of default by a sovereign nation.
- Gold: Gold has historically been seen as a safe haven asset, holding its value relatively well during economic turmoil.
- Cash and cash equivalents: While offering minimal returns, cash and cash equivalents like money market accounts provide immediate access to funds and complete security of principal.
Avoiding risky assets: Conversely, riskier assets become less attractive to risk-averse investors. These include:
- Junk bonds: These are high-yield bonds issued by companies with lower credit ratings. They offer higher potential returns to compensate for the increased risk of default. However, during recessions, the risk of default becomes a more significant concern for investors, leading to a decline in junk bond prices.
- Stocks of highly leveraged companies: Companies with high levels of debt are more vulnerable to economic downturns. If their revenue falls, they may struggle to meet their debt obligations, increasing the risk of bankruptcy.
- Speculative stocks: These are stocks of companies involved in new or unproven ventures, often experiencing high volatility. Investors become wary of such companies during recessions as their future prospects are more uncertain.
- Cyclical stocks: They are stocks of companies whose performance is closely tied to the overall health of the economy. Examples include companies in industries like construction, manufacturing, and travel and leisure. During recessions, these companies tend to experience a decline in demand for their products or services, leading to lower stock prices.
Mitigating a recession
Classical economists suggest the government should not intervene. They believe that the economy will return to equilibrium on its own if a recession occurs.
A recession will lower nominal wages. A fall in economic activity increases the unemployment rate. The labor market faces an excess supply of labor, which pushes wages downward. Workers compete for available jobs.
Lower wages reduce production costs, encouraging firms to increase production. That, in turn, increases short-run aggregate supply and returns the economy to equilibrium.
Expansionary fiscal policy
Keynesian views that the government should intervene through fiscal policy. The government stimulates aggregate demand through:
- Increasing government expenditures, such as transfer payments and capital investment.
- Cutting tax rates for direct or indirect taxes
Transfer payments, such as unemployment benefits, maintain consumption. They become a source of income for unemployed people so that their purchasing power and consumption do not fall further.
Capital investment by the government is vital. The economy cannot rely on private investment, which is profit-oriented. When demand and sales fall during a recession, the private sector’s financial profile and cash flow deteriorate, so investing doesn’t make sense to them. Likewise, households do not want to increase spending on goods and services because they have less income.
Government intervention is a solution to driving aggregate demand. Such investments will create more jobs, income, and demand for goods and services. The initial government spending has a significant effect on the economy through a multiplier effect.
A reduction in taxes encourages households to spend more. Reducing tax rates means that households spend less money on taxes and more money on goods and services. Likewise, a reduction in indirect taxes will lower the price of taxable goods, encouraging more demand.
Expansionary monetary policy
The central bank would increase the money supply to encourage economic growth. Some of the options are:
- Lowering the policy rate
- Open market operations by purchasing government securities
- Lowering the reserve requirement ratio
All three increase the money supply and liquidity in financial markets, push interest rates down and increase credit availability. Households and businesses can apply for new, lower-cost loans to finance purchases of durable goods (such as cars and houses) and capital investments. That, in turn, stimulates aggregate demand and encourages the economy to recover from the recession.
Furthermore, you may have heard of monetary easing policies (quantitative easing or QE)? Yes, the Central Bank in the United States and the Eurozone adopted it to stimulate the post-crisis economy of 2007-2009.
QE is basically an open operation. Central banks buy government securities, but on a much larger scale. Purchasing means that money passes from the central bank to government securities holders (usually commercial banks). Finally, the Bank has more money to lend. That, in theory, would stimulate aggregate demand and economic growth.
