Despite all the fear, pain and uncertainty they bring, recessions are a natural part of the economic cycle. In the following we will explain what they are, what causes them, how they hurt – and how they help.
What is a recession?
Let's start with recessions. Broadly, a recession is defined as two or more consecutive quarters of negative economic growth, most often measured by real gross domestic product (GDP). The National Bureau of Economic Research (NBER) criteria are more nuanced and include employment levels, real incomes, retail sales and industrial production.
Recessions can occur for a variety of reasons, including exogenous shocks such as wars or sudden declines in the supply of key goods. They often arise due to the cyclical nature of the economy, but without input from the outside. For example, when the economy is growing, businesses have an incentive to produce more and increase profits. This trend can lead to oversupply, which can hurt profits and lead to layoffs, falling stock prices and a recession. Alternatively, competition among firms over labor can drive up household incomes, causing firms to raise prices and cause inflation. If the inflation rate gets out of control, households will begin to cut back on spending, resulting in oversupply. In each case, the expansion of the economy contains the seeds of the next recession.
In the U.S., there have been 33 recessions since 1857, ranging from six months (January to July 1980) to 65 years (October 1873 to March 1879), according to NBER data. The average contraction lasts 17.5 months, but since 1945 the duration has shortened considerably, averaging 11.1 months.
What is a depression?
Depressions are drastic economic downturns in which real GDP falls by 10% or more. They are far worse than recessions and their effects have been felt for years. It is well known that depressions in banking, commerce, and manufacturing lead to disasters, as well as falling prices, extremely tight credit, low investment, rising bankruptcies, and high unemployment. Here's how it can be challenging for consumers and businesses to overcome depression. (See also "The importance of inflation and GDP.")
Depressions occur when several factors occur simultaneously. Overproduction and soft demand combine to create panic among businesses and investors. Investment falls, unemployment rises and wages fall. Consumers have drastically cut spending, put additional burdens on businesses, and cut more jobs. This vicious cycle reduces consumer purchasing power and business income to the point where they miss mortgage and business loan payments. Banks then have to tighten their lending standards, further slowing the economy down.
In the U.S., the best-known example is the Great Depression of the 1930s. This term actually refers to two depressions: The first occurred from August 1929 to March 1933, during which GDP fell 33%. The second ran from May 1937 to June 1938, during which GDP fell 18%. (See also " What caused the Great Depression?")
Negatives of recessions and depressions
Recessions and depressions have both negative and positive effects, and understanding them is one of the best ways to survive a downturn. First, the negative impact:
1. Increasing unemployment
Rising unemployment is a classic sign of recessions and depressions. As consumers cut spending, businesses reduce wages to cope with falling revenues. Unemployment is far worse in a depression than in a recession. Generally, the unemployment rate in a recession is 6% to 11%. In contrast, the unemployment rate reached 25% in 1933, the end of the first period of the Great Depression. Studies have shown that the involuntarily unemployed tend to suffer from higher levels of anxiety, stress, and depression than employees, as well as more frequent hospitalizations and premature deaths.
Each of the spikes in unemployment corresponds to a recession.
2. Cause anxiety
Recessions and depressions create great anxiety. Many lose their jobs or businesses, but even those who hold on are often in a precarious position and worry about the future. Fear, in turn, causes consumers to reduce spending and businesses to cut back on investment, which slows the economy even further. ( See also, "When fear and greed take over."
3. Pulling values down
Asset values decline in recessions and depressions as profits slow along with the economy. For example, stock prices fall as declining profits and negative corporate outlook turn investors away, while home values fall as demand declines in the face of economic uncertainty.
Positives of recessions and depressions
1. Excess
get rid of The economic decline allows the economy to eliminate the surplus. Stocks drop to more reasonable levels. Moribund that had slid along during an expansion phase are going out of business, allowing capital and labor that had been dedicated to them to be put to more productive use. This process of creative destruction is closely linked to the Austrian economist Joseph Schumpeter, who saw capitalism as a continuous process of destruction and renewal, in which entrepreneurs play a key role in overhauling the system. Most followers of his ideas see the process as a possible long-term growth (although Schumpeter himself suspected that the whole system would eventually collapse, as medieval feudalism had done).
2. Balanced economic growth
recessions and depressions help keep economic growth balanced. Uncontrolled growth over many years would likely lead to overcapacity or high inflation (although Australia has recovered well since 1991 without suffering a recession).Layoffs, recessions and depressions prevent competition for labor from raising wages to the point where prices rise, corporate profits rise, cause them to hire more, and so on in an inflationary spiral. By forcing companies to cut back on production, they also prevent the kind of chronic overcapacity that is affecting China at the time of writing.
3. Creating opportunities to buy
Difficult economic times can create tremendous buying opportunities. When the downturn gives way to recovery, markets often reach higher highs than before the recession or depression. Contractions are therefore an opportunity for investors to make money to wait out a recovery. For example, the stock index S & P 500 from the low point of 2009 to 20. October 2017 up 285.
4. Changing consumer attitudes
Economic distress can bring about a change in consumer mindset. When consumers stop living beyond their means, they are forced to live within their incomes. This usually leads to an increase in the national savings rate and causes investment in the economy to rise again.
The Bottom Line
To weather recessions and depressions, you need to understand what causes them and what impact they have on the overall economy. Among the positive effects are taking the excesses out of the economy, balancing economic growth, creating buying opportunities in different asset classes and bringing about changes in consumer attitudes. The negative effects include rising unemployment, pervasive fear, and sharp declines in asset values.