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Politics & Society

What Is a Recession and How Does it Happen?

Written by MasterClass

Dec 20, 2018 • 9 min read

The Great Recession of 2008 had a lot of people questioning what a recession was—and why it happened in the first place. History provides invaluable lessons to economists who study upturns and downturns, but it is also important for the average citizen to understand how consumer behavior may impact markets, especially those that end up in a significant decline.

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What Is a Recession?

A recession is a slow down or contraction of the economy over a business cycle. The period of time and what exactly indicates a recession are not tightly defined. Some countries and economists define a recession as a contraction over two consecutive quarters, some define it as six months, and some do not define the time period at all taking a more complete and nuanced view of different data points to indicate a recession.

What Causes a Recession?

Negative Gross Domestic Product (GDP) growth, a reduction in consumer spending and in asset prices, and drops in the stock market and in interest rates are all indicators of a recession. Recessions, and therefore things like negative GDP growth, unemployment, drops in interest rates and asset prices, etc., have been caused by bank runs and asset bubbles (see below for explanations of these terms).

What Are the Indicators of a Recession?

There are a number of factors that can indicate a recession:

  • A rise in unemployment
  • A rise in bankruptcies
  • Lower consumer spending and consumer confidence
  • A reduction in asset prices

This includes the cost of homes, and a fall in the stock market, to name the main indicators.

All of these factors can lead to an overall contraction of the Gross Domestic Product. The European Union and the United Kingdom define a recession as two or more consecutive quarters of negative real GDP growth.

In the United States, the National Bureau of Economic Research (NBER) tracks the indicators of a recession, and will determine whether the US economy is in recession. The NBER takes into account many different factors, like those listed above, to determine whether the US economy is in recession. For example, the NBER declared a recession in the early 1990s even though the GDP contracted three quarters, none of them consecutive.

The yield curve is another indicator of recessions, and one the NBER also uses to predict or declare a recession. A yield curve is a line on a graph that tracks the interest rates of bonds that are equal in credit but have different times at which they mature. A common yield curve looks at US Treasury Debt at three month, two year, five year, ten year, and 30 year maturity benchmarks.

There are three different types, or shapes, or a yield curve that indicate different stages of economic growth.

1) Normal

A normal yield curve means that longer term bonds have a higher yield than short term bonds. This generally indicates a healthy economy and positive economic growth.

2) Flat

A flat yield curve means that longer term bonds are beginning to have yields that are about the same as those for short term yields. This means that the economy is in transition, or about to enter a recession, as investors are locking in longer term bond rates before they decline further.

3) Inverted

An inverted yield curve is one where longer term bonds have a lower yield than short term bonds. This is an indicator of a recession, as it suggests that interest rates are falling or will continue to drop.

How Banks Contribute to Recession

Consumer confidence is key to keeping banks, and their processes, in equilibrium. After the stock market crashed in 1929, panic spread and consumers began pulling money out of banks, further worsening the situation (which we now know resulted in the Great Depression).

How Banks Work

Banks take in deposits from their customers and lend those deposits out to borrowers. The banks promise their depositors that they can get their money back whenever they want, and at the same time they promise their borrowers that they only have to repay their loan slowly on a fixed schedule. This system gives both depositors and borrowers the sense of certainty they need to plan their lives. But to accomplish this the bank must absorb and then manage a very specific type of risk: the risk of a run.

Defining a Bank Run

If all of a bank’s depositors decided to withdraw their money on the same day, the bank would not be able to honor all or even most of the requests.Normally, of course, this would be extremely unlikely. It can happen, however, as a the result of a type of self-fulfilling prophecy known as a “bank run.” Suppose that—rightly or wrongly—depositors become afraid that the bank has made bad loans and soon will not have enough money to honor its deposits. They will rush to take their money out before the bank runs out of money. Other depositors see this happening and rush to get ahead of the first wave of depositors. Soon every depositor is asking for their money back and the bank is unable to honor all of the withdrawals. If a bank run happens at one bank, it can frighten customers at another bank causing a bank run there as well. This type of cascade can soon lead to a wave of bank failures.

Waves of bank failures occurred during the Great Depression. After the Depression, the government began insuring deposits and requiring banks to follow strict safety guidelines to ensure this wouldn’t happen again. Slowly, however, new institutions popped up that weren’t officially banks but nonetheless made their money by taking bank-type risks. These institutions created a shadow banking system, and by 2008 they handled almost ten times more money than the regular banking system.

Bank Runs and Asset Bubbles

Bank runs are often associated with asset bubbles. The fundamental value of an asset is the return an investor believes he or she would receive if he or she bought an asset and never sold it.

For real estate, the fundamental value is based on the rent the property will earn over its lifetime. For stocks, the fundamental value is based on the profits the company will earn. Asset bubbles occur when investors are willing to pay far more than a reasonable estimate of fundamental value in the hopes that they will be able to sell the asset later to other investors for even more money.

This process can continue for a while, but eventually the flow of new investors slows. As it becomes harder to find new investors, old investors panic and sell all at once. This is sometimes called a Wile E. Coyote moment, after the famous cartoon character who would run off a cliff but only begin to fall when he noticed the ground was no longer beneath him. In the same way, the price of an asset in a bubble continues to rises above its fundamental value until investors notice that they are running out of new investors to whom they can sell.

close up image of benjamin franklin on a dollar bill

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How to Fix a Recession

In most cases, governments can mitigate and reverse downturns by printing more money and effectively loaning it out at low interest rates.

Lower interest rates make it easier for households and businesses to borrow money from banks. The loans that banks make inject more money into the economy and allow it to recover from the recession.

Zero Lower Bound and Liquidity Traps

Both strategies, however, faces a limitation: the Zero Lower Bound. When interest rates hit zero increases in the money supply have no effect. Households and businesses no longer have an increased incentive to take out loans, so the extra money that was printed sits in banks without being spent.

If the economy reaches the Zero Lower Bound during a recession, it is said to be in a liquidity trap. The Federal Reserve would like to increase economic activity to bring the economy out of recession but it can’t because its primary tool, printing more money, is no longer effective.

Read more about inflation and the IS-LM model, which outlines when a liquidity trap occurs.

The Economic Downturn and Great Recession

In 2008, the United States entered the worst recession in 75 years and the rest of the world soon followed. Many other economists had become complacent about the possibility of not just garden variety recessions, but the type of major recessions caused by banking crises.

The subprime crisis in 2008 combined the elements of a bubble with a bank run. The shadow banking system took loans from subprime borrowers. It then combined thousands of those loans into a single pool. As long as all borrowers didn’t default at once, the pool would collect a relatively predictable number of payments each month. When the housing bubble burst, however, many of the subprime borrowers defaulted all at once. Payments into the pools stopped. Without that income, shadow banks such as Accredited Home Loans or Freedom Mortgage Company could not honor their obligations.

Shadow banks were providing a lot of the economy’s credit; when they went down that credit was cut off. This caused spending in the economy to fall. The fall in spending led to a fall in prices of not only houses but commercial property, automobiles, and other assets. The fall in prices made it even more difficult for borrowers to get or repay loans, which led to further declines in spending and prices.

Economists refer to this as “debt deflation.” This type of crisis is too large even for the Fed to stop. As a result of this snowball effect, unemployment soared from 4.5% to around 10%. An unemployment rate of 10% meant that roughly 15 million Americans who wanted to find a job could not. Now referred to as the Great Recession, this was the worst economic crisis since the Great Depression. Millions of manufacturing jobs were lost during the Great Recession. This wasn’t a result of anything that the workers did or even anything that their employers did.

The crisis of 2008 negatively impacted millions of people. The massive job loss and potential scarring of entire career paths means that a recession is more than just an abstract economic concept. Recessions take an enormous toll on those who live through them.

Fixing the 2008 Recession in the United States

When the Great Recession began in the United States, Ben Bernanke, the Chairman of the Federal Reserve, was aware that there was only a very small chance that he would be able to turn around the United States economy before it hit the liquidity trap. Bernanke responded by printing money aggressively. Economists and other commentators who were not familiar with Japan’s experience became frightened that he would cause extreme inflation. However, most of the money sat in banks and did not circulate in the wider economy.

There were huge increase in the money supply but only a very small increase in prices. Bernanke’s efforts had helped slow the economic collapse, but the shock the financial system experienced was too great to be overcome entirely. The United States found itself in a liquidity trap. Once in the liquidity trap, the Fed’s tools are useless.

President Obama enacted a stimulus plan in 2009. Known as the American Recovery and Reinvestment Act, the stimulus contained approximately $288 billion in tax cuts and $499 billion in spending. That plan, combined with Bernanke’s efforts, prevented the United States from repeating the Great Depression. Though it wasn’t strong enough to avoid the liquidity trap completely, it was able to alter the economy’s trajectory.

When the Great Recession first began in 2007, it was following nearly exactly the same track as the Great Depression. Yet, by early 2010, the descent leveled off. The unemployment rate peaked at 10 percent in October of 2009 and hovered around 9.9 percent until April of 2010, when it dropped to 9.6 percent. From there it began a downward trend that so far has lasted through the summer of 2018. The downturn was difficult, but for the United States, it didn’t approach the depths that occurred during the Great Depression.