What is Economic Recession

An economy faces several ups and downs in its journey across the years and decades. These are defined in terms of peaks and troughs on a wave graph. The graph itself represents a business cycle chart. In a business cycle, the peaks are booms or periods of high economic growth while the troughs are recessions. These economic recessions are brought about by a steady decline all the way from a peak to a trough through contractions in the economy. This contraction implies that economic activity experiences a sudden or gradual downturn which seizes most activity and brings about a state of economic recession.

Recessions or economic slumps and crises are being discussed galore in the media today, making it seem as though this is a one-time, highly distressing phenomenon. However, contrary to popular belief, recessions have been occurring periodically since the very system of a free economy has emerged in the economic order of the world. These phenomena usually occur within a country depending on the state of production and financial health of the economy. There has been increased cause for concern with the 2008 recession since it has seemed to affect nearly all major parts of the world, even culminating in a crisis situation in the Eurozone. Increased globalisation and inter-linking of economies is the reason behind such a global ripple effect.

If we look at some historical figures, it becomes quite clear that economic recessions have been prevalent even in the past. The figure below displays some major recessions in the US that are worthy of noting.

economic recession

Source: https://www.americanfunds.com/resources/basics/risk-and-volatility/recessions-perspective.htm

As observed, economic recessions may occur suddenly due to a particular historical, economic or political event or there could be a gradual build up as in the case of an economic bubble which ultimately culminates into a recessionary situation. The figure also demonstrates that there is no particular timeline followed by economic recessions, they occur at different time intervals and may last for a long or short period of time. It follows that the intensity of an economic recession varies with the cause, current domestic and global conditions as well as the way in which the recession is handled.

The main indicators of an economic recession are the changes in major macroeconomic indicators such as GDP, per capita income, investment spending, employment and inflation. All these factors point towards the economic health of a nation. Thus, a continuous adverse change in their values indicates the onset of an economic recession. As in the case of the 2008 recession, the sub-prime housing bubble burst leading to panic in the financial markets. This panic led to numerous bank runs and since the banks could not hold themselves against the crashing real estate prices, many declared bankruptcy. This was a situation of financial meltdown. A financial meltdown such as the one described above usually affects other factors in the economy such as the major macroeconomic indicators. When these indicators plunge in value, a state of recession occurs. This is almost always the order of events – a financial crisis ultimately leads to an economic recession.

Due to the fast rehabilitory action of the US government, numerous bailout packages were disbursed at a rapid pace which controlled the turmoil within the financial institutions of the country. A similar case was documented in Japan when due to an asset price bubble creation and its subsequent burst; the economy plunged into a financial crisis. Real estate and stock prices continued to fall steadily over a period of ten years.  Noted economists such as Paul Krugman made arguments suggesting that Japan fell into a ‘liquidity trap’.  A liquidity trap is a common situation associated with economic recessions in which the major financial institutions, particularly banks, lose their liquidity or cash availability due to the negative sentiment among the investors and public. Even near zero interest rates implemented by banks do not effectively stimulate the economy. Thus, it becomes even more difficult to emerge from the recession.

This was observed in the case of the Great Depression of 1929-30 when even extremely low interest rates offered by banks did not stimulate borrowing by the public. This displayed the reluctance of the public to invest or spend. Lower consumption affected demand and created huge supply surpluses. These inventory pile-ups instigated producers, i.e, factory owners to decrease production activity and lay off a large chunk of their work force. The rising unemployment coupled with falling prices led to a liquidity trap and the economy plunged into further unemployment and deflation. This state of affairs continued for a prolonged period and was further intensified by the Gold Standard. This convertibility of the dollar to gold was suspended for some time to help recover from the recession. The events leading up to this recessionary phase was the stock market plunge on October 29, 1929 often referred to as Black Tuesday. Thus, a financial crisis led to a fall in macroeconomic variables such as GDP and unemployment as indicated by the graphs which culminated in the recession.

economic recession

Source: Wikipedia

Macroeconomic Indicators of Economic Recession

The important points that came up after the shock of the Great Depression were how to identify the approach of an economic recession. We have been mentioning time and again that a few macroeconomic variables and variations in their values are key in predicting the extent of damage that such recessions wreak on the economy. Here are a few:

  • Unemployment Rate – The level of unemployment in an economy always rises when an economic recession occurs. The fall in investment and production activity leads to lay-offs in the financial as well as manufacturing sectors.
  • Deflation – A fall in asset prices is another major indication of a recessionary environment. Due to the low demand for products and services caused by reduced income (unemployment), there are supply surpluses. These surpluses goad producers to reduce prices in order to finish the excess inventory. Such a fall in prices reduce profits and make investment in such enterprises a low-returns venture.
  • Interest Rates – The interest rates in the economy represented by the rate offered on Treasury bonds/notes (in most countries), often fall during a recession in order to stimulate the economy by providing ease in borrowing money. An increase in borrowings would lead to higher investment (and consumption) and production activities would start their recovery.
  • GDP – The GDP of a country falls as a result of the decreased production, low income and high unemployment. Though rejected by many as being a primary indicator of economic recessions, a country’s negative growth, which does tend to happen during a recession, is reflected primarily through its GDP.

There are no hard and fast rules on which factors are the most apt in predicting economic recessions, but a general idea has been formulated on the same. Economic recessions will continue to come and go, affecting our lives to varying extents. Since they seem to be such a force of (financial) nature, it would be wise to be acquainted with them to a reasonable extent and be informed of how to cope in such times.