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The phrase “recession” tends to strike fear in the hearts of, well, everyone. Defined as an economic downturn lasting more than a few months, recessions can be an especially difficult period for business owners. Reduced economic activity can place nearly any type of enterprise at risk of going under, including businesses with seemingly solid balance sheets. However, understanding why recessions occur and how they impact your business operations can help you better prepare for an economic downturn. Below, we explore what causes a recession, how long a recession typically lasts, and, most important, what a recession means for your business.
What Is a Recession?
An economic recession describes a period of severe economic contraction. The general consensus is that two consecutive quarters of negative growth in an economy constitute a recession. This decline in economic activity often results in higher unemployment and lower income.
While recessionary periods in major economies can often spur recessionary periods in economies around the globe, this isn’t always the case. Recessions can be specific to a single nation or span multiple economies simultaneously.
What Causes a Recession?
A recessionary period often results from numerous poor economic conditions creating a negative outcome. Let’s take a look at a few conditions that can result in an economic recession:
Rising interest rates
When the cost of capital is high, economic activity can falter. Businesses require need cheap capital to invest in growth, meaning higher interest rates can be bad news for the economic environment. If capital is too expensive for businesses to acquire, a recession can occur.
Low investor confidence
If lenders are not confident they’ll see returns on their investments, markets can suffer, causing economic activity to slow. Why do investors lose their confidence? This can happen because of uncertainty related to political environments, regulation concerns, natural disasters, and many other contributing factors.
Poor management or regulation
A recessionary period can also occur because of poor business management or government regulation. If subpar regulation allows business practices to weaken, fraud and other issues can occur, resulting in economic losses for investors and stakeholders.
Asset bubbles can damage investor and consumer confidence. This happens when asset prices become overinflated and then drop drastically. The Great Recession and Dot-Com Recession are good examples of asset bubbles contributing to recessionary periods. In the Great Recession, there was a housing bubble; in the Dot-Com Recession, there was a bubble in tech-related stock prices.
While inflation is more widely discussed than deflation, it’s deflation that can more often result in an economic recession. Deflation is an overall reduction in prices. This reduces overall demand. As a result, the economic output can suffer.
For example, from 1991 to 2001, Japan suffered a “Lost Decade.” This term refers to a prolonged period of deflation in the Japanese economy, resulting in a stagnant marketplace and lack of growth.International Monetary Fund. “Japan’s Lost Decade Policies for Economic Revival“. Accessed August 3, 2022. This is one of the most striking examples of deflation’s effect on a previously successful economy.
Stock Market Crashes
A sudden stock market crash can send the world into shock. As individuals panic sell equities and other investments, it can create a loss of confidence in the market. This can cause lower spending, reduced lending, and a host of other problems contributing to a reduction in economic activity.
While the above six conditions can prompt an economic recession, they are not alone. Other issues—such as manufacturing problems, wage-price controls, and post-war slowdowns—can also cause recessionary periods.
Economic Indicators and Predictors of a Recession
You may be wondering if we are in a recession. A recessionary period is typically announced after two consecutive quarters of negative gross domestic product (GDP) growth, but some indicators can warn that the economy will contract before it does so.
Let’s take a look at some of the indicators and predictors that economists examine to predict US recessions:
- Employment Figures: The unemployment rate is a good indicator of how the economy is functioning. Increases in unemployment can indicate a slowdown in economic growth.
- Real Income: Economists adjust income by inflation to identify “real income.” If real income is declining, this can result in a reduction in activity. Keep in mind that a decline in real income can happen even if nominal income doesn’t decline. If inflation is high, reducing the true value of a currency, this may result in a reduction in real income.
- Manufacturing Output: Manufacturing output is yet another indicator of how well an economy is functioning.
- Retail Sales: If there is a reduction in retail sales, this may indicate that consumer demand is declining.
- Real GDP: Lastly, analysts look at monthly GDP predictions. This can help them determine the economy’s strength before quarterly reports.
Understanding Recessions and the Business Cycle
While economic recessions are painful for business owners, employees, and consumers, they are a reoccurring element of modern capitalism. Below are the four stages of the business cycle to help you contextualize recessionary periods:
- Expansion: As economic activity increases, unemployment decreases, and output improves, an economy expands. This can result in higher production, higher asset values, and other positive economic conditions.
- Peak: Eventually, an expansion reaches its peak. This is the top of the market. The economy will soon begin contracting. This contraction can occur due to speculation, too much industrial production, or various other factors.
- Contraction: The contraction phase occurs when the economy shrinks as a result of an economic slowdown. If this happens for two consecutive quarters, an economic recession is declared.
- Trough: A trough is the inverse of a peak. It’s the bottom of the market. Once this point is reached, the economy begins to turn around and economic activity increases. This pivot to a new expansion restarts the business cycle.
Recession vs. Depression
The phrases “recession” and “depression” are often used interchangeably, but doing so is incorrect. An economic recession typically lasts a few quarters, sometimes a bit longer. Meanwhile, an economic depression is a downturn lasting several years. While there is no set period for how long a contraction needs to occur before it is deemed a depression, the last depression in the United States was the Great Depression, which lasted from 1929 to 1939.
Depressions have much worse economic conditions than recessions. For example, during the Great Depression, there was a point when over 12 million Americans were jobless. At the time, this was 24.9 percent of the workforce.Franklin D. Roosevelt Library & Museum. “Great Depression Facts“. Accessed August 3, 2022.
How Long Do Recessions Last?
Recessionary periods vary in length. Fortunately, there has been considerable research into economic recessions, providing us with clear numbers on what to expect regarding the length of recessionary periods. If you measure the length of all recessions from 1857 until now, they lasted an average of 17.5 months. However, due to changes in regulation and central banking, the average length of a recession following World War II has been only 11.1 months.
Examples of Recent Recessions
Since 1990, the United States has experienced three major economic recessions. Let’s take a look at the context surrounding each recent economic contraction:
The Great Recession (2007 to 2009)
The Great Recession was the most severe downturn in the US economy since the Great Depression. It began due to a housing bubble, which was created by subprime mortgage lending. These subprime loans were securitized and passed on as high-rated bonds. When borrowers defaulted on their loans en masse, causing the housing bubble to collapse, it incited widespread panic and a reduction in consumer confidence.
At one point during the Great Recession, the S&P 500 was reduced by more than 50 percent. Unemployment reached 10 percent in 2009.
The Dot-Com Recession (2001)
Before the Great Recession was the Dot-Com Recession. This economic downturn was also linked to an asset bubble.
As stock prices for tech companies rose rapidly, speculation created a bubble. Eventually, the stock market crashed. This, coupled with 9/11 and issues in other industries, resulted in a small economic contraction and a mild increase in unemployment. At its peak, the Dot-Com Recession saw a 5.5 percent unemployment rate.
The Gulf War Recession (1990 to 1991)
Relatively mild in comparison to the Great Recession, the Gulf War Recession occurred as a result of higher interest rates as an effort to combat inflation and higher oil prices due to the Gulf War. Overall, unemployment reached around 7 percent.
What Does a Recession Mean for You and Your Business?
Because recessionary periods are a natural element of the business cycle, it’s critical that you understand how one might impact your enterprise. Let’s take a look at some common challenges business owners may experience during an economic recession:
Lower consumer demand
As the economy weakens and unemployment increases, consumers may cut their spending. And as overall demand decreases, so can the demand for your goods or services. Resulting cash flow issues can challenge your ability to meet financial obligations.
Limited access to capital
While central banks often lower interest rates during recessionary periods to spur growth, this doesn’t always mean it’s easier to access capital. Lenders can be particularly wary during recessions, as they understand that many businesses may be on the verge of bankruptcy. Because lenders may reduce the number of loans that they issue, it can be particularly challenging for businesses without established business credit scores to access capital.
Supply chain issues
Downturns in economic activity can also create supply chain issues. With some suppliers opting to produce less in anticipation of a contraction, it can be difficult for your business to source the materials it needs to operate at full capacity.
Difficulty cutting costs
The above economic stresses can result in the need for difficult cost-cutting. Entrepreneurs should strive to make cost reduction decisions that reduce business expenditures without jeopardizing output. That said, deciding which costs to cut can be challenging.
Understanding Economic Recessions: Closing Thoughts
As the saying goes, knowledge is power. The first step in preparing for an economic recession is understanding why they occur and what happens when they occur. Now that you’re armed with this knowledge, you can ensure your business is prepared for an economic downturn by assessing whether your operations can withstand the challenges.
Nevertheless, predicting the next recession’s exact point of arrival is near impossible, even for the most responsible entrepreneur. If a recessionary period catches your business flat-footed, there are numerous business funding options to help you stay afloat during an economic downturn. And if the going gets tough, remember that recessions are followed by expansions.
When was the Great Recession?
The Great Recession, ignited by the subprime mortgage crisis, started in December 2007 and lasted until June 2009. It was one of the United States’ most impactful economic disasters.
What caused the 2008 recession?
While numerous factors contributed to the Great Recession, most analysts agree the primary culprit was the subprime mortgage crisis. This crisis occurred because subprime mortgages were packaged into securities and sold as high-rated bonds. As a result, many worldwide investors bought mortgage-backed securities they believed were secure, only to later find out they were junk bonds.
What happens during a recession to the economy?
When a recessionary period occurs, the economy contracts. This means that businesses can lose money, unemployment rates can increase, asset values can decrease, and other such issues can arise. Overall, a recession can reduce the consumer demand in an economy, lowering economic activity.
Does a depression always follow a recession?
No. The last economic event classified as a depression in the United States was the Great Depression (1929 to 1939). If a depression followed every recession, we would have experienced many depressions throughout the 20th Century. Since 1948, the United States has experienced 11 recessions, but no depressions.
What happens in a recession to interest rates?
While recessions prompt varying responses from central banks, a common response is a reduction in interest rates in an attempt to stimulate the economy. Lower interest rates allow businesses to borrow money and invest in growth, which can help spur economic activity and reverse a contraction.
What type of unemployment is created by a recession?
Recessions often result in increased unemployment levels, which can reduce the overall demand in an economy. The type of unemployment created by a recession is commonly referred to as “cyclical unemployment.” This type of unemployment arises due to the business cycle.
While economists have eight different classifications of unemployment, two of the most discussed, outside of cyclical unemployment, are frictional unemployment and structural unemployment. Frictional unemployment occurs as people leave their jobs. It takes time for individuals to find other work, resulting in short-term unemployment. Meanwhile, structural unemployment occurs due to changes in an economy, such as the development of a new technology creating major shifts in the labor landscape.
What causes economies to go into recession?
Various factors can trigger an economic recession. As such, the underlying reasons behind each recession tend to vary. For example, a recession may occur because fuel costs increase rapidly and cause an economy to falter. On the other hand, an economy may enter a recession due to speculation resulting in an asset bubble. In most cases, there is more than one underlying cause for a recession.