Economic Recession: Causes, Effects, and Possible Solutions

What’s it: An economic recession is a period more severe contraction in which real GDP is negative for two consecutive quarters and can last until three years. A severe recession we call depression.

Depression lasts longer than a recession. It can last for more than three years, even up to a decade. Meanwhile, since World War II, the average recession lasts for about 11 months. It can be longer than the Great Recession, which is about 18 months. Apart from being more lasting, the economic downturn during the depression was deeper, where real GDP fell 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.

What are examples of economic recession

Citing the Wikipedia page, the following is a list of recessions in the United States.

1. Recession 1973–75 resulted from a combination of a stock market crash and a sharp spike in oil prices. The recession lasts 1 year 4 months.
2. 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.
3. 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.
4. 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.
5. 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.

What are the signs of an economic 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, the short-term returns are higher than the long-term returns. That causes 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. Therefore 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 are a reflection of investors’ expectations of the 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.

Why do economic recessions occur

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 fuel 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. That’s not only giving rise to a recession but also 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 in 2007-2009. Likewise, the recession in the 2001 – 2001 recession began with the collapse of the dotcom bubble. The burst of the bubble brought panic in the economy. It spread to other economic variables such as spending and investment.

Speculative activity

The Asian financial crisis in 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. It forced 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 on 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, leading to a recession.

How the recession affects the economy and business

During a recession, we will see a worsening of several indicators of economic activity.

Economic output falls. You will see real GDP falling for more than two consecutive quarters. That creates negative expectations among businesses and households. Household and business spending weakened, 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, 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.

The 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 and encourages 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.

Deflation emerged. 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.

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 product 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.

Investors relocate portfolios to safer assets. Government bond assets and safe haven instruments are the main targets of investors. They also shift stock investments to defensive stocks, such as utility companies, which offer stable cash flow. During a recession, another strategy is to invest in companies with low debt, good cash flow, and strong balance sheets.

Conversely, investors stay away from riskier assets. Junk bonds saw a significant price fall as their default risk increases. Also, investors avoid stocks of high leverage, speculative or cyclical companies.

What are the possible solutions to overcome the 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. It becomes a source of income for unemployed people so that their purchasing power and consumption do not fall deeper.

Capital investment by the government is vital. The economy cannot rely on private investment. The private sector is profit-oriented. When a recession, demand, and sales fall, their 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 more significant 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 stimulate economic growth.

What to read next

• Business Cycle: Its 4 Phases, Characteristics, and Effects
• Economic Boom: Meaning, Characteristics
• Economic Collapse: Signs, Causes, and Examples
• Economic Contraction: Meaning, Causes and Impacts
• Economic Crisis: Types and Effects
• Economic Depression: Causes, Examples, Effects, Possible Solutions
• Economic Expansion:  Meaning, Characteristics
• Economic Recession: Causes, Effects, and Possible Solutions
• Economic Recovery: Meaning, Types, and Characteristics
• Kondratieff Cycle: Meaning, Details of the Cycle and Criticism
• Peak Phase of the Business Cycle: Meaning, Characteristics
• Real Business Cycle: Meaning, Assumptions, Causes, Criticism
• Trough Phase of the Business Cycle: Meaning and Characteristics