In economics, a recession is a period of time with a prolonged or significant decline in economic activity. This can involve high levels of unemployment and inflation, and cause many people to experience economic distress. Although this term is used by politicians and laypeople frequently, economists may disagree about when a recession is occurring.

Causes of a Recession

Recessions are natural phases of the business cycle that can “cause” significant economic damage (the underlying cause of any given recession is what affects economic outcomes, not the label “recession” itself). Almost always during a recession, productivity and employment fall. Lower output and lower employment translate to lower economic growth and less overall utility. Usually, consumer spending falls as well, especially as demand for non-essential goods and services declines.

Recessions are often caused by a mixture of exogenous and endogenous factors. When different factors in an economy create a negative feedback loop, these factors may feed into each other and lead to a full-blown recession. In this case, the causes are endogenous, because they occur due to interactions of market forces and market participants.

An example is the Great Recession of 2008, which began due to moral hazard-induced risky lending behavior (among other market-related factors). In short, banks packaged high-risk loans together and sold them, leading to a market with over-valued assets. Once people began to default on their loans, many of these assets were revealed as worthless as the housing bubble burst. This led to a series of bank crises that crashed the world economy.

Other times, a recession can be prompted by an external, or exogenous, event that isn’t caused by market forces – like a drought. These events can cripple the economy’s ability to function normally, and are often depicted in economic models as negative shifts of aggregate demand or supply.

Regardless of its cause, the welfare impact of a recession is not evenly distributed. People who lose their jobs due to a recession will find their well-being severely reduced, while some individuals may even benefit. For example, wealthy individuals can sometimes utilize a recession to buy property or capital at cheaper rates than during normal economic times.

Identifying a Recession

One often-touted method to identify a recession is the idea that two consecutive quarters of reduced economic activity signals one. However, this is not an official definition. It is merely a rule of thumb.

In practice, an official government body may declare when a recession is or has occurred. For example, in the United States, this is the National Bureau of Economic Research’s “Business Cycle Dating Committee”.

Other times, a recession may be recognized when a majority of economists believe the time period qualifies as one. Regardless of who recognizes them, most recessions are not labeled immediately. Macroeconomic variables used to detect recessions, such as the unemployment rate, take some time to be measured. For this reason, policy responses to recessions tend to lag behind as well.

One useful tool to help identify a likely recession is the yield curve. The yield curve is a graph that shows the relationship between time to maturity and the yield (i.e., payout) for various debt instruments like government bonds. This tool is one of few that can be used in an up-to-date fashion, because debt instruments for sale on the market can be measured now. But, yields are still in anticipation of the future, so this curve still relies on the market’s predictions about the future and as such is not perfectly accurate.

During ordinary times, the yield curve is upward-sloping, i.e. yield increases for bonds with longer time-to-maturity. But during a recession this yield curve often becomes inverted, meaning that short-term bonds have higher rates of return than long-term bonds. This happens when the risk of default in the short term is high, so rates of return must be increased to make those investments attractive. Alternatively, this might signal that lenders expect interest rates to fall in the future. This is one indication that the economy is performing poorly at present and can help identify a recessionary period, though it is not a foolproof method.

Despite the uncertainty, some telltale signs of a recession include increasing unemployment and falling productivity (perhaps as measured by GDP or GDP growth).

Further Reading

COVID-19 is one example of an exogenous shock that caused a recession in recent times. In his 2021 book, Shutdown: How Covid Shook the World's Economy, Adam Tooze recounts the tumultuous year 2020. He examines the pandemic through the lenses of finance, business, and politics to explain how the exogenous shock caused the world’s economy to fracture, and reveals the vulnerabilities in the ways people typically conduct commerce.

Good to Know

Although we hear about recessions often in the news and in politics, the IMF has estimated that the countries of the world from 1960-2007 were only in recession 10% of the time. Moreover, they find that recessions lasted about one year on average and decreased GDP by 2% on average.

A recession that is severe enough may be labeled a depression instead. Economic depressions are extreme recessions that damage the economy more and last longer than a recession, like the Great Depression that began in 1929. In comparison to the rule of thumb for labeling a recession, economists usually label one a depression when there is at least a 10% drop in GDP. Unlike recessions, depressions usually last for multiple years¹.

Sources:
1: https://www.imf.org/external/pubs/ft/fandd/basics/recess.htm