Recession – What Is It? What Causes It?

What is a recession?

A recession is a macroeconomic term referring to a substantial decrease in the general economic activity that lasts several months and sometimes even years. A decline is seen in real income, industrial production, wholesale and retail trade, and employment.

Generally, this term is used to define a period when the Gross Domestic Product (GDP) decreases for two consecutive quarters. This definition was popularised in 1974 by Julius Shiskin a renowned economist.

However, in practice, this economic downturn is not limited to declining real GDP. It also results in other effects, such as a decrease in real personal incomes, increasing unemployment rates, and a reduction in production and manufacturing activities.

What are the causes of recession?

There are various causes and reasons of such economic downturns, six of which are as follows:

Sudden economic shock

An economic shock is an unexpected problem resulting in severe financial damages. The most recent example of a sudden economic shock is the COVID-19 pandemic that put the entire world at a standstill, resulting in a decline across the global economies.

Technological changes

New technologies enhance productivity and are beneficial for growth and development in the long term. However, economies may face short-term difficulties during the periods of adapting to such technological developments.

The 19th century witnessed several breakthroughs with labor-saving improvements. The Industrial Revolution made several professions redundant, resulting in difficulties and economic declines.

Today, most economists believe that artificial intelligence (AI) and robotic technologies will eliminate several jobs over the next few years, resulting in higher unemployment.

Excessive debt

When companies and individual borrowers assume excessive debt, servicing can result in situations when they are unable to meet their obligations. Higher defaults and bankruptcy filings may then capsize the economy.

The housing bubble that caused the Great Recession is an example of excessive debt causing widespread downturns.

Excessive deflation

Deflation occurs when prices of goods and services decrease over a period. This results in a reduction in wages and salaries, which further decreases the prices.

When deflation becomes out of hand, businesses and individuals reduce their spending that has a negative impact on the economy. Economists and central banks may use several tools to rectify the underlying problems causing deflation.

For instance, Japan struggled with deflation during the 1990s, which led to a severe impact on the economy during this period.

Asset bubbles

When investing decisions are made emotionally, a negative impact on the economies is often inevitable. During a strong economy, investors may become optimistic, resulting in ‘irrational exuberance.’

This phenomenon can inflate the real estate or stock markets and when the bubbles burst, panic sets in among people, leading to excessive selling, which can crash the markets and the economy.

Excessive inflation

Inflation is a steady increase in prices over a period. Inflation is not bad, but excessive inflation can be dangerous. Central banks curb inflation by increasing interest rates, which in turn decreases economic activities.

During the 1970s, the United States of America (USA) faced out-of-control inflationary pressure and the Federal Reserve rapidly increased the interest rates to curb this phenomenon, which resulted in an economic downturn.

What happens in a recession?

Economic downturns often result from a decline in confidence among companies and individuals that the future period may not be as good as it has been.

According to well-known economist J. M. Keynes, overall sentiment is one of the most important predictors of an economic downturn. This is what can happen during recessions.

Rise in unemployment

As companies reduce the workforce or shut down operations, unemployment rises. However, the unemployment rates may vary during various recessionary periods.

A decline in production and services

As demand for goods and services reduces due to loss of employment or lower wages, individuals may reduce their spending. This can further result in the decline of manufacturing activities and services.

Increase in savings

People who still have a job during recessionary periods may often increase savings and cut down their expenses because they are afraid of losing their employment.

The ones who have lost their job naturally reduce their expenses. One person’s expense is income for someone else. When too many people spend less, it results in a negative spiral, which further increases unemployment and reduces incomes, further escalating the recessionary pressure.

How long does a recession last?

Generally, recessionary trends can last a few quarters and if they continue for years, they are known as depression.

However, these are rare and the last was the Great Depression Year that started in 1929 in the USA.

Moreover, no two recessionary trends are the same. As per the National Bureau of Economic Research (NBER), the average length since the Second World War has been 11 months.

Recessionary trends can be of different types, which are as follows:

• V-shaped is characterised by sharp decline followed by strong rebounds
• U-shaped bumps at the bottom for a while before gradually coming up
• W-shaped, also known as double-dip, features a decline followed by a rise and then reduces again before rising
• L-shaped is a huge decline with no reversal for a long-time

How could a recession affect you?

There are chances of losing your job as unemployment rates rise. You may also find it difficult to find another job as more and more people become unemployed.

If you are fortunate to retain your job, there may be salary cuts with difficulty in negotiating future appraisals.

Your savings may decrease as the value of the real estate, bonds, and other assets reduces. Moreover, if you are unable to pay your bills and make debt repayments, you may be at risk of losing your home or other properties.

Companies see a decline in sales and may even face bankruptcy. With government supports, keeping all businesses afloat may be challenging.

As people face difficulties in paying their bills, lenders tighten rules for all types of financing. You will need a higher credit score to qualify for a loan during recessionary periods.

Examples of recession

Some examples of recession in the Indian economy are as follows:

Balance of payment (BoP) crisis – Financial Year (FY) 1958

The agricultural sector faced severe difficulties in 1957 due to a weak monsoon affecting production, which resulted in higher prices. The government needed to import 40 lakh tons of food.

During 1957–58, the country faced the first decline in economic growth with a negative GDP (-1.2%). The primary reason was the higher import bill that increased by over 50% between 1955 and 1957.

During the same period, exports slowed, and the trade deficit increased by more than nine times while foreign reserves and gold stocks decreased.

Severe drought – FY 1966

After the wars with China (1962) and Pakistan (1965), India was recovering but the severe droughts in 1966 had a huge impact on the economy.

Foodgrain production was reduced by 20% and foreign food aid came to the rescue of the population. During 1965-66, India’s economy contracted by -3.66%.

Energy crisis – FY 1973

In 1973, the Organisation of Arab Petroleum Exporting Countries (OAPEC) proclaimed an oil embargo targeting countries that supported Israel during the Yom Kippur War.

Oil prices increased by 400%, resulting in India’s oil import bill rising to $900 million in 1973–74. The bill was two times the foreign exchange reserves, which contracted the Indian economy by 0.32%.

Oil shock resulting in BoP crisis – FY 1980

The Iranian Revolution decreased oil production and increased its prices, which led to the second oil shock during 1979–80. The Iran-Iraq war further reduced production and increased prices.

This crisis increased India’s imports, which doubled between 1978–79 and 1981–82. Exports also contracted by 8%, resulting in a BoP crisis.

Coronavirus pandemic – FY 2020

The technical recession resulting due to the COVID-19 pandemic affected not only India but also the entire world. Most economists predicted a decline in India’s economy as soon as the lockdown was announced in March 2020.

Key indicators or predictors of recession

• Inverted yield curve when the long-term yields are lower than the short-term yields
• A drop in consumer confidence resulting in lower spending
• A decline in economic indicators like new manufacturing orders, unemployment trends, and stock market performance
• Higher rates of unemployment
• Sudden decline in stock markets

Difference between recession and depression

A recession lasting a long time is known as depression. During the recessionary period, the GDP declines for two consecutive quarters while depression can last many years. Although no specific criteria indicate depression, a decline of GDP by more than 10% and an unemployment rate touching 25% can determine this phenomenon.

Even though recessionary declines have severe consequences, one benefit is the curb of inflationary rise. Most central banks try to achieve a balance between slowing down the economy to prevent inflationary price increases without resulting in recessionary declines.