Which scenario best reflects the relationship between production and demand in a recession?

Investopedia / Laura Porter

What Is a Recession?

A recession is a significant, widespread, and prolonged downturn in economic activity. A popular rule of thumb is that two consecutive quarters of decline in gross domestic product (GDP) constitute a recession. Recessions typically produce declines in economic output, consumer demand, and employment.

Economists at the National Bureau of Economic Research (NBER) define a recession as an economic contraction starting at the peak of the expansion that preceded it and ending at the low point of the ensuing downturn. The NBER considers nonfarm payrolls, industrial production, and retail sales, among other indicators, in pinpointing the start and end of a U.S. recession.

Key Takeaways

• A recession is a significant, pervasive, and persistent decline in economic activity.
• Economists measure a recession's length from the prior expansion's peak to the downturn's trough.
• Recessions may last as little as a few months, but the economic recovery to the former peak can take years.
• An inverted yield curve has predicted the last 10 recessions, along with a couple that never materialized.
• Unemployment often remains high well into an economic recovery, so the early stages of a rebound can feel like a continuing recession for many.
• Nations use fiscal and monetary policies to limit the risks of a recession.
  

A downturn must be deep, pervasive, and lasting to qualify as a recession by NBER's definition, but these are retrospective judgment calls made by academics, not a mathematical formula designed to flag a recession as soon as one begins.

For example, the depth and widespread nature of the economic downturn caused by the COVID-19 pandemic in 2020 led the NBER to designate it a recession despite its relatively brief two-month length.

In June 2020 the NBER said the U.S. economy's expansion peaked in February 2020, falling into a recession caused by the COVID-19 pandemic the next month. The economic expansion dating from June 2009 had lasted 128 months, surpassing the 120-month expansion from 1991 to 2001 as the longest stretch of uninterrupted growth in U.S. history. In July 2021, the NBER concluded the recession that followed was the shortest on record at two months, with economic activity bottoming in April 2020.

Understanding Recessions

Since the Industrial Revolution, economic growth has been the rule in most countries, and contractions a recurring exception to that rule. Recessions are the relatively brief corrective phase of the business cycle; they often address the economic imbalances engendered by the preceding expansion, clearing the way for growth to resume.

Though recessions are a common feature of the economic landscape, they've grown less frequent and shorter in the modern era. Between 1960 and 2007, 122 recessions affecting 21 advanced economies prevailed roughly 10% of the time, according to the International Monetary Fund (IMF).

Because recessions represent an abrupt reversal of the typically prevalent growth trend, the declines in economic output and employment that they cause can spiral, becoming self-perpetuating. For example, the layoffs caused by diminished consumer demand hit the income and spending of the newly unemployed, depressing demand further.

Similarly, the bear markets in stocks that sometimes accompany recessions can reverse the wealth effect, curtailing consumption predicated on rising asset values and increased net worth. If lenders pull back, small businesses will find it difficult to keep growing, and some may go bankrupt.

Since the Great Depression, governments around the world have adopted counter-cyclical fiscal and monetary policies to ensure that run-of-the-mill recessions don't turn into something much more damaging to their long-term economic prospects. Some of these stabilizers are automatic, like increased spending on unemployment insurance that makes up a fraction of lost income for laid off workers. Others, like interest rate cuts designed to prop up employment and investment, require the decision of a central bank like the Federal Reserve in the U.S.

For investors, one of the best strategies to have during a recession is to invest in companies with low debt, good cash flow, and strong balance sheets. Conversely, shares of companies that are highly leveraged, cyclical, or speculative are best avoided until the recession is done, when the survivors among them often start outperforming.

The timing of such economic turning points remains difficult to discern except in retrospect. It doesn't help that investors, economists, and workers are all liable to define a recession differently in terms of its relevant effects. Since unemployment often remains high well past the economic trough, workers may not consider a recession over until the economic recovery has been under way for months or even years.

Meanwhile, because stock-market declines often anticipate economic downturns, an investor may assume a recession has begun as capital losses pile up and corporate earnings wilt, even if consumer spending and employment remain healthy.

Recession Predictors and Indicators

While there is no single sure-fire recession indicator, an inverted yield curve has anticipated each of the 10 U.S. recessions since 1955 (while also setting off a few false alarms).

Because longer-term debt has more duration risk, it usually offers higher yields than shorter-term obligations. A 10-year bond tends to yield more than a 2-year note usually, since there is more risk that inflation or higher interest rates will lower its market value before redemption.

The yield curve inverts because the yields on longer-dated debt decline, sending prices higher, as traders anticipate economic weakness and interest rate cuts in the future. Meanwhile, shorter-term rates are more dependent on the federal funds rate and the near-term expectations for monetary policy. If the Federal Reserve is expected to keep raising the federal funds rate, those expectations will tend to lift 2-year yields more so than 10-year ones.

Investors also rely on leading indicators to anticipate economic turning points. These include the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, and the OECD Composite Leading Indicator.

What Causes Recessions?

Numerous economic theories attempt to explain why and how the economy might fall off of its long-term growth trend and into a recession. These theories can be broadly categorized as based on economic, financial, or psychological factors, with some bridging the gaps between these.

Some economists focus on economic changes, including structural shifts in industries, as most important. For example, a sharp, sustained surge in oil prices due to a geopolitical crisis might raise costs across the economy, while a new technology might rapidly make entire industries obsolete, with recession a plausible outcome in either case.

The COVID-19 epidemic in 2020 and the public health restrictions imposed to check its spread are another example of an economic shock that can precipitate a recession. It may also be the case that an economic shock merely accelerates the start of a recession that would have happened anyway as a result of other economic factors and imbalances.

Some theories explain recessions as dependent on financial factors. These usually focus on credit growth and the accumulation of financial risks during the good economic times preceding the recession, the contraction of credit and money supply at the outset of a recession, or both. Monetarism, which associates recessions with insufficient growth in money supply, is a good example of this type of theory.

Psychology-based theories of recession tend to focus on the over-exuberance of economic booms and the deep pessimism rampant during downturns to explain why recessions can occur and even persist. Keynesian economics focuses on the psychological and economic factors that can reinforce and prolong recessions. The concept of a Minsky Moment, named for economist Hyman Minsky, integrates the psychological and financial frameworks, emphasizing the way bull market euphoria can distort the incentives of economic actors and encourage unsustainable speculation.

Recessions and Depressions

According to the NBER, the U.S. has experienced 34 recessions since 1854. Only five have occurred since 1980. The downturn following the 2008 global financial crisis and the double-dip slumps of the early 1980s were the worst since the Great Depression and the 1937-38 recession.

Routine recessions can cause the GDP to decline 2%, while severe ones might set an economy back 5%, according to the IMF. A depression is a particularly deep and long-lasting recession, though there is no commonly accepted numerical formula defining one.

The Great Depression caused U.S. economic output to drop 33% while stocks plunged 80% and unemployment reached 25%. The 1937-38 recession caused real GDP to drop 10% while the unemployment rate jumped to 20%.

Frequently Asked Questions

What Happens in a Recession?

Economic output, employment, and consumer spending drop in a recession. Interest rates are also likely to decline as the central bank (the Federal Reserve in the U.S.) cuts its benchmark rate to support the economy. The government's budget deficit widens because tax revenues tail off, while spending on unemployment insurance and other social programs rises as more people qualify for the benefits.

When Was the Last Recession?

The last U.S. recession took place in 2020, at the outset of the COVID-19 pandemic. According to NBER, the two-month downturn ended in April 2020, qualifying as a recession despite its record short length because it was deep and pervasive.

How Long Do Recessions Last?

The average U.S. recession since 1857 lasted 17 months, while the six recessions since 1980 have lasted less than 10 months on average.

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