What is a Recession? And How They Happen

Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.

By now you’ve surely heard the media and investment gurus declare that after ten years of growth and the emergence of the coronavirus, much of the world is headed for a recession. What does this mean for you? Let’s talk about recessions and how they affect the economy and the average worker.

What is a recession?

A recession is a substantial decline in economic activity in a particular area of the world. Most economists declare a recession after two quarters (six months) of decline in the GDP, but it’s usually more complex than that. Countries and individual investors often use their own definitions.

Finances can be complicated, we make them simple. And offer low fees and friendly financial advice along the way. Use our state of the art technology to get started investing investing or saving.

In the United States, for example, the National Bureau of Economic Research (NBER) defines an economic recession as:

A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Recessions are challenging for consumers because they create widespread unemployment, which leads to people making fewer purchases, forcing many businesses to downsize or close. The cycle repeats.

If a recession lasts long enough, it may become a depression. The economic symptoms of a depression are worse than a recession and they last much longer. For example, in the last recession, unemployment peaked at 10.8% in 2009. It only lasted about two years. The Great Depression, however, lasted ten years and unemployment reached 25%.

Unfortunately, recessions are normal parts of economic activity. Economies can’t grow linearly forever. Sometimes we have to take a few steps backwards. As a consumer and investor, it’s important that you understand that recessions are inevitable, but recoverable. If you’re prepared, it’s possible to survive a recession without losing everything.

Types of recessions

Not all recessions are the same. They vary in terms of duration and damage to the economy.

Boom and bust recession

Many recessions occur right after an economic boom. This is because dramatic economic growth causes inflation. Central banks then raise interest rates to control inflation. Higher interest rates mean less borrowing and spending. Consumers start paying off debt and increasing their savings rather than spending more.

Balance sheet recession

This kind of recession occurs when the banks and financial firms see declines in their balance sheets due to bad loans and falling asset values. These losses force them to restrict their lending, which diminishes overall economic activity.

Demand-side shock recession

A demand-side shock recession occurs when there’s a sudden fall in aggregate demand. This is when some event causes people to stop buying. For example, there was a small recession in 2001 due to a fall in consumer confidence after the 9/11 terrorist attacks.

Supply-side shock recession

A supply-side shock recession occurs when there’s a sudden drop in the supply of a good. People stop spending money on that good because it’s not available. This type of recession is not very common.

Cumulative recession

Sometimes we can’t point to a single cause of a recession. A cumulative recession is a recession with a combination of causes. As the global economy grows more intertwined, economists suspect most future recessions will be cumulative.

Depression

A depression is a deep recession that lasts a long time. There’s no specific criteria for a depression, but they’re characterized by massive unemployment and a dramatic GDP decline (we’re talking a 10% drop). They can last for years.

Consequences of recessions

Here are the main symptoms of a recession:

  1. High unemployment as companies downsize and close for good.

  2. Income falls as people work less (reduced hours, often called under-employment).

  3. Income fails to rise (few raises or promotions).

  4. Increased income inequality and relative poverty.

  5. Fall in the prices of assets like homes and securities.

  6. Increasing social instability, which can cause stress, health problems, addiction, and even violence.

  7. More government spending due to a decrease in tax revenue and additional programs to help people and businesses.

How much you’re affected depends on the cause of the recession. In 2009, for instance, the financial sector was hit hard. Banks suffered large-scale losses, which put many highly paid white collar employees out of work. Most businesses who dealt with housing sales struggled as well. The upcoming 2020 recession will mostly affect low paid workers in the service, leisure, tourism, and restaurant sectors.

That said, even people who work “recession-proof” jobs can’t escape all of a recession’s effects. Stress over job insecurity and reduced long term potential (no raises this year means less income over the course of your life) can still weigh on people.

What causes recessions?

Ultimately, recessions are caused by diminished economic activity. When consumers and businesses stop buying, other businesses downsize their staff or go out of business. Those unemployed people stop buying as well, which exacerbates the problem.

The real question is, “What causes a slowdown in economic activity?” The economy is immeasurably intertwined. A change to one industry can affect another, and on and on. For instance, a sudden spike in oil prices could raise costs for businesses all over the world. Businesses who can’t operate at those prices might close, leaving their employees jobless. If too many people become unemployed, economic activity slows.

Here are a few reasons economic activity might slow:

  • High interest rates prevent businesses from borrowing to invest.

  • Deregulation of certain industries can encourage businesses to behave in risky ways.

  • A decline in manufacturing orders can put a lot of people out of work.

  • Poor management, especially in the financial sector, can cause lots of people to lose money suddenly, which diminishes their ability to spend.

  • If housing values fall, some homeowners choose to walk away from their mortgages, thus creating a massive income problem for banks.

  • If prices deflate over time, consumers pause their spending because they wait for prices to fall lower.

  • Loss of consumer confidence in investing can trigger a bear market where everyone sells their stock. Businesses without capital can’t operate.

  • The economy typically booms during war time, but that comes with a subsequent post-war slowdown.

  • Sometimes people just lose confidence in the economy so they stop spending to protect themselves, thereby triggering a recession.

Past recessions

Recessions are unavoidable components of the natural business cycle. We’ve had quite a few of them:

YearContext
1797The Panic of 1797 happened when the land speculation bubble in the newly-formed United States popped.
1857The Ohio Life Insurance and Trust Company failed, which caused another 5,000 businesses to fail. It lasted 18 months.
1873Jay Cooke & Company failed, which was the largest U.S. bank. It created labor issues that led to the Great Railroad Strike of 1877. It lasted five years.
1893This recession happened due to the failure of Reading Railroad, the withdrawal of European investment, and a run on the gold supply.
1907New York's Knickerbocker Trust Co collapsed, which forced Congress to create the Federal Reserve System. It lasted only a year.
1929A banking panic led to a collapse in the money supply. Other factors (like tariffs and industrial production) contributed as well. This was the Great Depression. It came to an end due to the New Deal, the end of the Dust Bowl, and increased spending for World War II.
1945The end of World War II caused a decrease in spending. GDP fell 11.6%. It last less than a year.
1949This was a brief economic downturn as the economy adjusted to peacetime production. It lasted a year, but the GDP drop was less than 5% per quarter.
1953The end of the Korean war caused a decrease in overall spending and an increase in unemployment. GDP fell about 8%.
1957The Federal Reserve’s tightening of monetary policy caused the GDP to plummet 14% and unemployment to reach 7.5%.
1960The Federal Reserve raised interest rates and the government’s budget switched from a deficit to a surplus (so: less spending). It lasted 10 months.
1970This mild recession came after a lengthy period of economic expansion. It was caused by inflation and the closing of budget deficits after the Vietnam War.
1973In the 1973 Oil Crisis, OPEC quadrupled oil prices. President Nixon instituted wage-price controls (which forced businesses to lay off workers) and took the U.S. off the gold standard, which led to inflation.
1980The Federal Reserve raised interest rates to fight inflation (which reduced spending) and the new regime in Iran increased oil prices sharply.
1990This recession was caused by rising inflation, tightening monetary policy, the 1990 oil price shock, rampant debt accumulation, and the savings and loan crisis.
2001This recession was caused by the boom and bust of countless dot-com businesses and the September 11 attacks. It lasted nine months.
2008Known as the Great Recession, this was the worst financial crisis since the Great Depression. It was triggered by the subprime mortgage crisis, which caused a global bank credit crunch that spread through the entire economy. It lasted more than two years.

When will the next recession hit?

No one truly knows when a recession will hit. Since investors and governments define recessions based on economic symptoms over time, we never know we’re in a recession until we’ve been in it for half a year. There are plenty of pundits and analysts who will declare or denounce recessions long before they have enough information to make a good argument.

If you’re a long-term investor, however (and you should be), recessions don’t matter. You shouldn’t be trying to time the market. The market will recover at some point, so it’s best to continue funding your investment portfolio or high interest savings account if you can.

Oh, and stop watching your portfolio! It will only cause you stress.

How to prepare for a recession

During a recession, one person may lose everything while another person hardly feels any effects at all. It’s hard to know how it will affect you personally, so it’s important to be prepared.

  1. Build an emergency fund. You’ll need a chunk of cash on hand to carry you through lean times, especially if you lose your job. We recommend saving three to six months of expenses, but more always helps.

  2. Get rid of debt. It’s easy to give up your daily Starbucks during a recession, but your creditors still expect payments for your debt. You can make it easier to weather a recession by getting rid of debt as quickly as you can so you always have strong cash flow.

  3. Live a lean lifestyle. Take an honest look at the things you truly use and need. Don’t watch Hulu? Then stop paying for it. Direct that money into savings.

  4. Get access to credit. It’s good to have a credit card even if you don’t like using it.

  5. Invest in your skills. When hiring stops, the most skilled and experienced will fair the best. Look for ways to boost your skills and credentials so you’re always an in-demand job candidate.

  6. Don’t liquidate your investments! You might be tempted to convert your portfolio to cash because some talking head declares a recession, but your odds of timing the market are low. Stay the course and wait for securities to rise again.

If you’re frightened by the idea of a recession, you aren’t alone. Countless workers all over the world have the same concerns. Hopefully you see that recessions don’t last forever. Your income and investments will improve as long as you’re mindful about how you spend your money and don’t panic.

Last Updated May 14, 2020

Wealthsimple is investing on autopilot.