What Is a Recession?
A recession, as defined by the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee, is “the period between a peak of economic activity and its subsequent trough, or lowest point.” The committee also states that a recession must be a significant decline that lasts more than a few months and is spread across the economy.
Recessions are determined by measuring economic activity throughout all sectors of the economy. The NBER looks at indicators including industrial production, personal consumption expenditures and the unemployment rate to determine where the peaks and troughs of the economic cycle start and end.
This means that whether an economy is in recession is usually a retrospective determination. The NBER waits until there is sufficient data available to announce whether the economy is in a peak or a trough. The Business Cycle Dating Committee will typically not announce that a recession has occurred until the committee is confident that the economy is returning to its normal state, which is called expansion.
What Causes a Recession?
All periods of economic expansion eventually end as the cycle shifts to recession. In general, the factors that bring about a recession can be categorized into three causes: accelerating inflation, asset bubbles or external economic shocks.
The first cause of a recession is also referred to as “overheating.” The defining characteristics of an overheating economy are rapidly rising inflation and unemployment below the natural rate. High inflation has preceded nearly every recession since World War II. Prior to all but two of those recessions, the unemployment rate fell to 5% or lower.
Two of the most recent recessions in American history were caused by asset bubbles growing rapidly and then bursting. The “Great Recession” of 2007-2009 was caused by the housing bubble, while the earlier 2001 recession was preceded by the “dot-com” stock bubble.
Asset bubbles form when the price of something, such as real estate or stocks, rises to unprecedented levels very quickly. Inevitably, this bubble becomes unsustainable and “bursts,” leading to a crash in the asset’s price and rapidly lowered demand.
The third factor that can bring about a recession is an external economic shock. This is a sudden event that can disrupt an economy’s normal state of expansion. The coronavirus pandemic is a classic example of an external shock, a force outside the economy that had far-reaching effects on every aspect of life.
What Happens During a Recession?
During a recession, demand for goods and services falls and consumers and businesses feel more uncertainty about the future. This causes businesses across many sectors of the economy to lose revenue and have less cash to fund their operations, leading to layoffs that increase the unemployment rate and further decrease consumer spending.
Though rapid inflation can be the cause of a recession, asset prices tend to fall during the period of economic contraction. This is because of the reduced demand throughout the economy. Interest rates are usually lowered during a recession to stimulate economic activity, and firms cut back on investing.
Most recessions are relatively brief. Since World War II, recessions have lasted roughly 11 months on average. This includes the longest recession since that time, the Great Recession, which lasted a total of 18 months, as well as the shortest and most recent economic contraction, the Pandemic Recession.
The most recent recession in 2020 officially lasted only two months, from February 2020 to April 2020. But the effects of this recession were drastic, and in some ways the economy and the American people are still recovering. The 2020 recession was caused by the COVID-19 pandemic and saw unemployment rise to unprecedented levels, with nearly 21 million jobs lost during those few months.
Before 2020, the American economy had been in a long period of expansion, having not gone through any significant periods of contraction in over a decade. In recent decades, recessions have in general been less frequent and less harsh, in part due government measures aimed at managing the country’s economy.
The longest recession since World War II, the Great Recession lasted 18 months, from December 2007 to June 2009. The forces that led to this recession began in the 2000s, as economic prosperity and policies designed to increase homeownership led to a housing bubble that began to burst in 2006.
By the end of the following year, the economy fell into one of the worst recessions in the nation’s history. When the housing bubble burst, home prices plummeted and foreclosures rose. The Department of Labor estimated that roughly 8.7 million jobs were lost, shrinking median household income and consumer spending.
The United States government attempted to mitigate the effects of the crisis through fiscal stimulus programs. These programs utilized government spending and tax cuts to try to revive the economy. The Federal Reserve implemented credit easing programs and large scale asset purchase programs to drive down borrowing rates.
In the aftermath of the Great Recession, Congress passed the Dodd-Frank Act, which aimed to correct some of the causes of the recession. The act imposed more strict standards on banks and gave the Federal Reserve more authority to investigate the activities of financial institutions other than banks. The Dodd-Frank Act also established the Financial Stability Oversight Council, which serves as a forum for financial regulatory agencies.
The eight-month recession that took place in 2001 is often referred to as the “Dot-Com Recession,” caused by the “Dot-Com Bubble.” Like the Great Recession, the 2001 recession was brought on by the bursting of an asset bubble.
In the late 1990s, the internet was rapidly becoming commercialized, and businesses were popping up all over the web. Many investors speculated that internet startup companies would become very profitable and started buying up stocks for these companies, causing a bubble to form as these stock prices rapidly rose.
Not all these dot-com companies turned out to be good investments; many struggled with cash flow and did not have viable business models. This led to a crash when the overvalued stocks collapsed, resulting in stocks being sold off at rapid rates as demand dissipated.
The effect of the dot-com crash on the employment rate was not as drastic as the Great Recession or the Pandemic Recession, but job losses still totaled over 1 million in 2001. The main consequence was a downturn in manufacturing, while retail sales and the housing market remained strong through the year.
Gulf War Recession
From July 1990 to March 1991, the United States experienced a relatively brief and mild recession. This period of economic downturn is often referred to as the Gulf War Recession because it coincided with and was indirectly caused by the Persian Gulf War.
The 1990 invasion of Kuwait created an oil shortage, which then led to a sharp increase in petroleum-based energy prices. Rising energy prices resulted in significant inflation throughout the economy. Inflation for items that weren’t food or energy rose 5.2% in 1990, more than double the desired rate of 2%.
Though the recession officially ended in March 1991, the unemployment rate continued to rise, peaking at roughly 8% in 1992. The next year, it began a gradual decline as the economy returned to its normal state of expansion.
Are We Heading Towards a Recession in 2022?
Because recessions are typically not declared as such until they have already occurred, it is difficult to say whether the country is headed towards a recession.
Current economic conditions, such as aggressive inflation and energy supply constraints caused by the Russian invasion of Ukraine, have many Americans nervous that a recession may be inevitable. But economists say this may not be the case.
The economy still has several strengths working in its favor. The unemployment rate remains low, and the country is creating roughly 400,000 new jobs each month. Consumer spending showed modest growth in the first two quarters of 2022, another good sign for the overall health of the economy.
Still, some economists point to a few indicators that may show America is at greater risk of entering a recession. The housing market has slowed significantly in the summer of 2022, while the Federal Reserve has issued multiple interest rate hikes to try and curtail inflation.
Rising interest rates mean the cost of borrowing increases, a factor that usually leads to slowed consumer spending, reduced corporate investments and even layoffs. High inflation and high interest rates together have traditionally shown to be hallmarks of economic deterioration.
Regardless, the aftermath of the coronavirus pandemic has made it difficult to parse what direction the economy could be heading. “It’s harder than usual to read the economy because we’re still in such an odd period,” Harvard economist Karen Dynan told The New York Times. “We’re seeing this post-Covid reorganization of the economy in addition to the loss of momentum, so the signals aren’t clean.”
What’s the Best Way to Prepare for a Recession?
Whether the country is headed for an economic downturn or not, it’s always a good idea to be financially prepared for potential hardships. Having a safety net to weather hard times is an important component of financial wellness.
An important step you can take toward preparing your personal finances for a recession is to focus on paying off debts quickly. Recessions often coincide with rising interest rates that make borrowing more expensive, so a high credit card bill can become a big liability. Paying off debts also lowers your debt-to-income ratio, which can be helpful if you do need to access credit to get by if you lose a source of income.
You should also consider building an emergency fund if you don’t have one already. Experts recommend saving between six and nine months’ worth of expenses. Having a stockpile of savings can help you pay your bills if you lose your job during a recession without having to take on debt.
Recessions can have a disastrous impact on your investment portfolio, but there are steps you can take to mitigate potential loss. A big one is diversifying your investments. You want to have a good mix of low-risk, low-reward and high-risk, high-reward assets in your portfolio. What ratio of those assets you want will depend on your age, risk tolerance and financial goals.
You may want to add some traditionally recession-proof assets to your portfolio. This includes investing in stocks for companies in historically stable industries, such as utilities, consumer staples and budget retailers.
If you’re concerned about how a recession might affect your retirement plans, you may consider supplementing or growing your existing retirement savings with an annuity. These products offer guaranteed income you can’t outlive. Annuities are an insurance product, not an investment, so you won’t lose your principle even if the equity market crashes.