Recession

Understanding Recessions: A Business Cycle Contraction

A recession is a business cycle contraction caused by a widespread drop in spending, often triggered by events such as financial crises, external trade shocks, or large-scale disasters.

The Definition of a Recession

Recessions can be defined by various criteria. Economists and policymakers use different indicators to identify when an economy is experiencing a recession. The National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months.

Key Indicators of Recessions

Recessions are complex and result from the interplay of various factors. Economists use multiple indicators to predict recessions, including:

• GDP contraction: A two-quarter decline in GDP indicates a recession due to reduced economic activity, lower consumer demand, and decreased employment.
• Unemployment rate: Rising unemployment is one of the most visible signs of an impending recession. The Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months.
• Consumer confidence: Declines in consumer expectations and confidence surveys can signal an economic slowdown. The U.S. Conference Board’s Leading Economic Indicator year-over-year change turning negative is another key indicator.

Economic and Financial Factors Contributing to Recessions

Recessions are often triggered by a combination of economic and financial factors, including:

• Supply shocks: Input price shock can disrupt production and lead to higher costs for consumers.
• Fiscal policies or monetary policies: Contractionary fiscal or monetary policies can reduce spending and investment in the economy.
• Demand shocks: Adverse demand can cause a sudden drop in consumer spending, leading to reduced economic activity.
• Credit risk and financial market problems: Concentration risk, systemic risk, refinancing risk, model risk, business risk (political risk), profit risk, and excessive debt accumulation can all contribute to a recession. The Minsky Moment, characterized by euphoria, speculative borrowing, and unsustainable financial practices, often precedes economic downturns.

Types of Recessions

The type and shape of recessions are distinctive. In the U.S., V-shaped recessions occurred in 1954 and 1990-1991, while U-shaped recessions occurred in 1974-1975. Japan’s 1993-1994 recession was U-shaped, while its 1997-1999 recession was L-shaped.

Behavioral Economics and Recessions

Economists have identified various psychological biases that may trigger a recession. The availability heuristic, the money illusion, and normalcy bias are just a few examples of how human behavior can impact economic outcomes. Excessive levels of indebtedness or the bursting of a real estate or financial asset price bubble can cause a ‘balance sheet recession,’ where large numbers of consumers or corporations pay down debt rather than spend or invest, slowing the economy.

Monetary and Fiscal Policies During Recessions

Economists use various indicators to predict recessions. The U.S. Conference Board’s Present Situation Index year-over-year change turning negative by more than 15 points is one such indicator. Other key indicators include the CFNAI Diffusion Index dropping below -0.35, analysis of manufacturing indicators like average weekly hours in manufacturing and manufacturers’ new orders for consumer goods and materials.

Conclusion

The definition of a recession varies across countries, but generally includes significant declines in economic activity spread across the market, lasting more than a few months. Understanding these complex dynamics is crucial for policymakers and businesses alike to navigate through challenging economic times. By staying informed about key indicators and factors contributing to recessions, we can better prepare for and mitigate their impact.