What is a recession?
For over a decade, the U.S. economy was going pretty strong. Unemployment and inflation were both under control. The COVID-19 pandemic brought that to an end, driving the country into a brief but severe recession.
Now, as the pandemic slowly fades, trouble may be brewing on the horizon once again. Inflation is climbing, and the Federal Reserve (Fed) is planning a series of interest rate hikes to control it. Many economists believe these measures could drive the U.S. into a second, milder recession.
This news has many Americans troubled. Internet searches for “recession” are trending as people wonder whether a slowdown is coming and what it could mean for them. To answer that question, you need to know what a recession is and what it does to the economy.
What Is an Economic Recession?
A recession is a period of reduced economic activity. Consumers spend less, which means businesses earn less. In response, they produce less and cut wages or lay off workers. This can lead cash-strapped consumers to spend still less, so the recession feeds on itself.
One common definition of a recession is two consecutive quarters, or six months, of negative economic growth. Julius Shiskin of the Bureau of Labor Statistics proposed this definition in 1974. His exact definition also factored in other measures, such as jobs and manufacturing.
However, the National Bureau of Economic Research (NBER), which is in charge of declaring recessions in the U.S., uses a different definition of a recession. It says it’s “a significant decline in economic activity spread across the economy, lasting more than a few months.”
Official Indicators of a Recession
To determine when the U.S. economy is in a recession, NBER economists look at five economic indicators:
- Real GDP. The gross domestic product, or GDP, is a measure of all the goods and services the economy produces. Real GDP is the same figure measured in inflation-adjusted dollars. The NBER checks monthly estimates of real GDP from the U.S. Bureau of Economic Analysis and from private research firms
- Real Income. This is a measure of personal income adjusted for inflation. It does not count government benefits such as Social Security as part of income. A drop in real income usually goes with a drop in consumer spending.
- Unemployment Rate. Employment is another good measure of the health of the economy. More people out of work means lower incomes and less spending.
- Industrial Production. The NBER also looks at measures of how much U.S. manufacturers are producing. It gets this information from the monthly Industrial Production Report produced by the Fed.
- Wholesale-Retail Sales. Finally, the NBER looks at measures of how much businesses are selling. This gives a more complete picture of how U.S. companies are responding to consumer demand.
The NBER declares a recession when most or all of these indicators fall for more than a couple of months. It dates the start of the recession at the peak of economic activity — the point when the economy first starts to decline. This means that by the time the NBER declares a recession, it’s already in progress. Short recessions may be officially over by the time they’re declared.
This also means recessions aren’t always terribly hard times for consumers. When the U.S. is coming off a high economic peak, it’s still pretty strong even if it’s in decline. A recession can be easier than an economic expansion when the economy is coming up from a deep low.
Types of Recessions
Economists further classify recessions based on their “shape” — the plot of economic growth over time. Recessions fit into several different types:
- V-Shaped. A V-shaped recession is short and sharp. Economic activity declines suddenly, then just as quickly recovers. The recession of 1990 to 1991 was a V-shaped recession.
- U-Shaped. A U-shaped recession is a prolonged slump. After declining, the economy takes a long time to recover. The slowdown of 1973 to 1975 was a U-shaped recession.
- W-Shaped. This is sometimes called a “double dip recession.” Economic activity declines, starts to recover, then drops again. This kind of recession occurred in 2001. Shiskin’s definition of a recession as two quarters of falling GDP doesn’t account for W-shaped recessions, which is one reason the NBER doesn’t use it.
- L-Shaped. An L-shaped recession is the worst kind. After the initial decline, economic growth stays nearly flat. The economy can take years to return to its previous level. The Great Recession of 2008 is an example.
- K-Shaped. Recently, economists began talking about a new type of recession: K-shaped. In this kind of recession, the recovery is uneven. Parts of the economy recover quickly, as in a V-shaped recession. But other parts remain sluggish, as in an L-shaped recession, or even continue to decline. That’s what happened as the U.S. recovered from the COVID-19 recession of 2020.
What Causes a Recession?
It’s normal for a market economy to alternate between periods of growth and periods of decline. Economists call these ups and downs the business cycle. Recessions are a normal, expected part of that cycle.
However, they don’t just happen out of the blue. In most cases, there’s some specific event — or several — that sets them off. Common recession triggers include economic shocks, excessive consumer debt burdens, and stock market crashes.
Economies can chug along smoothly for years as long as nothing changes much. They can even adjust to gradual changes, such as some industries slowly declining while others rise. But any sudden change in the way things work can send the economy off the rails.
Economists call these sudden changes economic shocks. One example from U.S. history is the 1973 oil embargo that sent oil prices soaring. Drivers had to wait in long lines at gas stations, and the high prices they paid to fill the tank dampened their other spending. More recently, the lockdowns at the start of the COVID-19 pandemic slowed both production and spending.
Excessive Consumer Debt
To a certain extent, borrowing is good for the economy. Companies need loans to help them expand their business. Consumers also rely on loans to fund home purchases and college education. All this spending is productive and helps the economy grow.
But when consumers and businesses take on too much debt, they have trouble paying their bills. Eventually, some default on their debt or go bankrupt. A major cause of the Great Recession was overstretched borrowers defaulting on home loans.
Stock Market Crash
The worst economic downturn in U.S. history, the Great Depression, began with a stock market crash. When stock values plummet, it makes investors understandably nervous. Many of them panic and withdraw from the market entirely.
This means there’s less money flowing to businesses. With less to spend, they respond by cutting back on production, worker pay, and funding for retirement plans. This can send the entire economy into a downward spiral.
An asset bubble occurs when a particular asset, such as stocks or real estate, becomes highly overvalued. Sooner or later, the bubble bursts and prices drop rapidly. This leads investors to panic and sell, often resulting in a market crash that sends the economy into a recession.
The drop in housing prices prior to the Great Recession is a classic example of an asset bubble bursting. Another case occurred in 2001 as the dot-com bubble of the late 1990s burst.
High inflation — a steady rise in prices — does not cause recessions directly. In fact, it’s almost the opposite. Inflation tends to be highest when the economy is booming and consumer spending is high.
However, governments often respond to high inflation by raising interest rates. This encourages people to save rather than spend. But sometimes, the government overshoots and spending falls off too much. Businesses make less money and a recession results.
While high inflation can indirectly lead to a recession, deflation — a prolonged drop in prices — can create one directly. When prices fall, wages fall as well, leading people to spend less. Then businesses lose revenue, cut back, and lay people off.
Deflation can occur for various reasons. New technology can make goods cheaper to produce, or government actions can tighten up the money supply. In the 1920s, an insufficient supply of gold — which, back then, was the world’s universal form of money — led to deflation that became one of the factors behind the Great Depression.
In the long term, advances in technology help an economy grow and produce more. But in the short term, new technology disrupts the economy. It can make jobs and even whole industries obsolete, putting many people out of work.
This has happened several times throughout history. Two examples include the advances of the Industrial Revolution and Henry Ford’s assembly line in the early 20th century. Some economists fear artificial intelligence may cause similar job losses in the near future.
Effects of a Recession
Recessions cause ripples throughout the entire economy. They harm workers, companies, and pretty much everyone who uses money. The effects of a recession include higher unemployment, higher business failure rates, and lower spending by businesses and consumers.
When sales fall off, businesses cut back spending. Often, this means laying off workers. Many people lose their jobs, and new jobs become harder to find. Even those who keep their jobs can face cuts to their wages and benefits.
Nearly all businesses make less money during a recession. But some companies can’t even make enough to stay in business. Many businesses close their doors during recessions, putting still more people out of work.
When workers lose jobs or see their paychecks cut, they naturally spend less. But less consumer spending means less money flowing to businesses, which leads them to cut back still more. It becomes a vicious cycle in which business and workers both lose out.
Higher Government Debt
Governments often try to support a weak economy by spending more. They can funnel money to businesses or directly to consumers, as the U.S. did with the COVID-19 stimulus payments. This helps fight the recession, but it also increases the national debt.
During a recession, businesses produce less and make less money. As a result, their stocks decline in value. If stock prices drop by at least 20% over a period of 2 months or more, it’s called a bear market.
In a bad recession, real estate can lose value too. When people can’t make mortgage payments, foreclosures rise, driving home values down. Both stock and real estate investors lose money, and some go bankrupt.
As noted above, deflation can cause or contribute to a recession. But it can also be an effect of one. When people are spending less, retailers respond by cutting their prices. The resulting deflation lowers wages, making the recession worse.
Lower Interest Rates
As noted above, governments often respond to inflation by raising interest rates. In a recession, they do just the opposite. They cut interest rates to discourage saving and encourage spending, borrowing, and investment.
Historical Examples of Recessions
Few people alive today remember the Great Depression. But there have been several more recent recessions in the U.S. that many American adults can recall. Recessions of the past 50 years include:
Technically, there were two recessions close together in the early 1980s. One was in early 1980, and the second ran from 1981 to 1982. However, some economists treat the two as a single double-dip recession, especially since unemployment remained fairly high in between.
There were two main factors behind this period of recession. One was the Fed raising interest rates to ultra-high levels to fight the inflation of the 1970s. The other was the 1979 energy crisis, which drove up oil prices.
The recession of 1990 to 1991 is sometimes known as the Gulf War recession. Like the previous one, it was triggered by a combination of high interest rates and oil prices. Growing consumer debt was also a factor. But this recession was shorter, lasting only eight months.
The long economic expansion of the 1990s ended with the bursting of the dot-com bubble in 2000. This set off a recession in early 2001 that was worsened by the economic shock of the 9/11 attacks. Officially, this recession lasted only eight months, from March through November. However, the job market did not fully recover until the middle of 2003.
The 2001 recession is an example of the flaws in Julius Shiskin’s definition of a recession. Instead of two consecutive quarters of decline, this W-shaped recession featured a decline, a brief rally, and another decline.
As discussed above, the recession that started in 2008 was due mainly to a real estate bubble and unsustainable debt. Known as the Great Recession, it was the worst recession since the Great Depression, lasting 18 months. Many large financial institutions failed, and the auto industry suffered a crisis as well.
In late 2019, the economy went into a decline that was worsened by the COVID-19 pandemic. The 2020 recession was intense but brief. It lasted only two months, making it the shortest recession in U.S. history. But during those two months, the unemployment rate rose to nearly 15%, its highest level since the Great Depression.
Signs a Recession May Be Coming
It’s not always possible to predict a recession. For instance, no one knew a global pandemic would turn the slowdown of late 2019 into a severe recession. But often there are warning signs a recession is on its way.
Economists watch the following economic indicators to predict future recessions. Some are early signs that a recession is coming, while others confirm that one has already started.
A drop in real GDP doesn’t always mean a recession is brewing. Sometimes GDP dips down briefly but rebounds in the next quarter. But a six-month decline in GDP, combined with other indicators, always means a recession is in progress.
Inverted Yield Curve
The Treasury bond yield curve is a plot of the interest rates, or yields, of short-term and long-term Treasury securities. Normally, yields get higher the longer the term of the bond is. Investors demand a higher return for long-term bonds because they tie up their money longer.
But sometimes, the yield curve inverts. Short-term bonds start paying higher interest rates than long-term ones. This means more investors are putting more money into long-term bonds because they’re a low-risk investment. That’s typically a sign they’re worried about the economy.
A yield curve inversion is one of the earliest indicators of a recession. However, it matters which securities you’re looking at and how long they stay inverted.
If the interest rate for ten-year Treasuries dips below the rate for three-month Treasuries and stays lower for three months, that’s a very accurate sign that a recession is coming. But a shorter-term inversion, or an inversion involving ten-year and two-year Treasuries, might not mean anything.
Stock market prices are extremely volatile. They can shoot up and down in ways that have little relationship to the state of the economy. Thus, a sudden drop in the stock market doesn’t always mean a recession is coming.
However, it’s still a cause for concern. When lots of investors sell off their stocks at once, it’s a sign they’re not feeling confident about the economy. And if stock prices stay low long enough, the bear market itself can trigger a recession by starving businesses of funds.
Low Consumer Confidence
The U.S. economy depends heavily on consumer spending. And in general, consumers spend more when they feel confident about where the economy is going. If they expect their wages to remain high, they’re more willing to spend.
That’s why economists look at surveys that measure consumer confidence. When levels of consumer confidence fall, that suggests consumers are becoming more cautious about spending. If they stay that way, a recession could result.
Declining Leading Economic Index (LEI)
The Leading Economic Index, or LEI, is a monthly indicator published by the Conference Board. The LEI combines a variety of economic factors into a single number. These include stock market performance, new orders for manufactured goods, and unemployment applications.
This index serves as a broad measure of how the economy is doing. When it starts falling — especially if it drops below zero — that’s an early sign the economy is headed into a decline.
When unemployment rates rise, that’s a sign the economy is already in a recession — even if the NBER hasn’t declared one yet. Rising unemployment means businesses are closing or cutting back spending. And it also means many consumers have less money to spend.
Thus, unemployment rates are less a warning of a recession than a confirmation. However, a decline in manufacturing jobs specifically can be an early indicator. Factory jobs tend to drop off when orders for goods do — a sign of declining consumer demand.
According to Shiskin’s definition, a recession must involve an increase of at least two percentage points in the unemployment rate. In addition, total unemployment must hit a level of at least 6%. However, the NBER is less specific about exact numbers. It looks more at whether unemployment is rising along with other signs of a recession.
Recession vs. Depression
A severe recession that lasts for several years is called a depression. Economic texts sometimes define a depression as a recession that lasts at least 3 years or causes a significant decline in GDP. Significant, in this case, means a drop of 10% or more in a given year.
But economists don’t stick very closely to this definition. For instance, the U.S. economy entered a recession in 1945 after World War II, and GDP declined by 11% in 1946. But economics texts don’t refer to this period as a depression.
In fact, economists have not used this term to refer to any slowdown since the Great Depression. This downturn was both long and severe, lasting more than three and a half years. It saw a 33% decline in the production of goods and services, an 80% drop in stock market value, and unemployment rates as high as 25%.
The deepest prolonged slump since then, the Great Recession, was both shorter and milder by comparison. Although it lasted 18 months and saw unemployment as high as 10%, it didn’t meet the standards for economists to call it a depression.
There’s lots more to learn about how recessions happen, their effects, and how to prepare for one. Here are some common questions and their answers.
How Long Do Recessions Last?
A recession can last anywhere from two months to three years. Once it passes the three-year mark, it’s considered a depression. Since the Great Depression, recessions in the U.S. have lasted anywhere from two to 18 months, averaging 11 months.
But from 1854 through 2019, the average was nearly twice as long, and several recessions lasted two years or longer. The lessons of the Great Depression helped the U.S. government learn to react to recessions early and minimize the damage.
How Can You Prepare for a Recession?
Recessions aren’t good for anyone, but they’re worse for some than others.
For instance, people in some professions are less likely to lose their jobs. These include many of the people labeled as “essential workers” during the pandemic: medical professionals, firefighters, police, utility workers, and grocery store workers. Having one of these jobs can protect you when a recession hits.
While you may not be able to change your career, you can protect yourself financially. One of the most important steps you can take is to have an emergency fund. Those savings can help you get through a job loss or a cut in wages.
It also helps to pay down debt. Debt payments weigh down your budget. Reducing them makes it possible to get by on less if you have to.
Finally, you can protect your investments by diversifying your portfolio. Don’t put all your money in stocks that can lose their value in a slump. Keep some in safer investments like Treasuries. Other good investments in a downturn include dividend-paying stocks and rental properties.
What Should You Do in a Recession?
Even if you didn’t prepare ahead of time, there are a few steps you can take once a recession starts to help you get through it. First, avoid taking on new debt if possible. Especially avoid adjustable-rate debt, as interest rates on these debts will rise when the recession ends.
If you have a steady job, do all you can to hold on to it. Be conscientious about coming to work on time and meeting your deadlines. If you lose your job in a recession, it’s hard to find another.
If you own stocks, don’t panic and sell them at a loss. Hold on to them, and they’ll recover when the recession ends. In fact, if you have extra money, you can profit from a recession by buying more stocks while they’re cheap. If you use dollar-cost averaging, you will do this automatically.
What Happens to Interest Rates During a Recession?
During a recession, the government typically cuts interest rates. This discourages saving and encourages spending, which can help get the economy going. It also helps businesses borrow money to finance their operations.
What Happens to Unemployment During a Recession?
Unemployment rates rise during a recession. Cash-strapped businesses look for ways to cut expenses, and laying off workers is one of them.
What Happens to GDP During a Recession?
By definition, a recession is a period when GDP is falling. According to Shiskin’s definition, a recession means real GDP has fallen at least two quarters in a row and lost at least 1.5% of its value.
Like bad weather, recessions are an unfortunate fact of life. They’re not good for anyone, but there’s no way to avoid them entirely. The best you can do is try to keep from getting soaked when the storm hits.
Take the appropriate steps to prepare for a recession ahead of time. That way, when it comes, you’ll be able to ride it out. You may have to tighten your belt for a while, but just like storms, recessions always come to an end. Eventually, the economic forecast will be sunny once again.