What Is An Economic Recession?

Recession, it’s a term you see reporters and economists use a lot. But what’s it matter for me and you?

A recession means the economy is struggling. In economics, the term ‘recession’ describes a scenario in which an economy shrinks for two consecutive quarters.

Classifying An Economic Recession

How do we tell if an economy is growing or shrinking? It all depends on an imperfect metric called gross domestic product (GDP). Governments and policymakers rely on GDP data to help them better understand how the local and global economy is tracking.

GDP figures are released every three months (i.e., every quarter). In very simple terms, if quarterly GDP rises, the economy is tracking along okay. If GDP falls for the quarter, the economy is said to be contracting.

If this contraction in GDP happens twice in a row, the economy is deemed to be in recession. Note, opinions vary on what consitutes a recession. That said, GDP falling for two straight quarters is the most widely used rule of thumb for declaring a recession.

Recession vs. depression

You’ve likely heard of something called an ‘economic depression’. This is different to a recession. In fact, it’s actually a lot worse.

A depression is what happens when an economy is unable to get out of a recession for years. So basically, you can think of economic depressions as recessions that go for a really long time. (The most recent one, the Great Depression, happened nearly a century ago.)

Effects Of An Economic Recession

So, you now know that an economic recession is two consecutive quarters of negative GDP growth. But why is a recession bad? What does it mean for you?

Recessions have a massive impact on you, your wealth, and your quality of life. They are bad for individuals, businesses, and governments. Let’s go over how an economic recession negatively affects each of these groups.

Why recessions are bad for individuals

When a country’s economy enters recession, its population suffers. The unemployment rate increases. A lot of people lose their job. The ability to find a new job gets more difficult.

The underemployment rate also climbs whenever there’s a recession. (An underemployed person is someone who has a job but isn’t getting the number of hours they want.) Casual workers stop getting as many shifts as they normally get. Many full-time workers become part-time workers, too.

How come more people lose their jobs or get less working hours in a recession? Because there’s less overall demand for goods and services. This is a result of households tightening their budgets. Consumers don’t have as much money to spend. They’re also less optimistic about the economy in general.

This isn’t to say they stop spending completely in a recession. The majority will continue spending the same amount on essentials like staple food, utilities, and mortgage repayments. However, a lot of people will slash their spending on things like holidays, cars, and entertainment.

Why recessions are bad for businesses

An economy in the midst of a recession puts a lot of pressure on business owners and company executives.

Overall demand from individuals falls due to the increase in unemployment and underemployment. That means businesses don’t need to produce as much. When this happens, businesses put off hiring new staff. Many will also reduce the hours of existing staff. And many others will lay off workers.

As you can see, the way recessions impact individuals and businesses overlaps significantly. Less consumer spending begets more unemployment, which begets less consumer spending. It’s a classic chicken-or-the-egg scenario. Consumers aren’t confident, and nor are businesses.

Why recessions are bad for governments

An economy in recession is a nightmare scenario for any government. A big reason why is because recessions mean that governments generate less tax revenue. Making matters worse, governments end up increasing their spending significantly on things like unemployment welfare.

Regardless of whether they are directly responsible for the economic recession, governments also feel increased political pressure and public scrutiny when a recession hits. Civil unrest, crime rates, and societal discontent often rise during these times.

What Happens To Stock Markets During Recessions?

When you hear the word ‘recession’, think ‘economy’. Don’t think ‘stock market’. A stock market can’t enter a recession. An economy can.

That said, a stock market will most definitely face challenges whenever a recession hits. That’s because the price of a company’s shares are essentially a reflection of the sum of its expected future earnings discounted to present value.

Expected future earnings will fall for most, if not all, companies amid a recession. These falls would result in lower prices across the share market, wiping hundreds of billions off retirement fund balances and investment portfolios.

How An Economy Gets Out Of a Recession

A recession is largely the result of consumer, business, and investor confidence. And so, a big part of getting out of a recession has to do with boosting these groups’ confidence levels. If this happens, consumer spending and business investment will rise and GDP will start growing once again.

The main ways to boost confidence—and thus, stimulate economic growth—are through government and central bank intervention. Both of them can affect the level of economic activity in unique ways.

The government can do this through something called fiscal policy, which simply means policy in relation to government spending or tax. In a recession, governments need to stimulate the economy. They often do this by cutting tax rates and spending more on public infrastructure.

Central banks are able to speed up or slow down the level of economic activity through monetary policy. With the use of various monetary policy tools, a central bank manages the money supply and interest rate. This directly impact the availability of credit, which in turn influences the level of economic activity.

Traditionally, when battling a recession, central banks will cut interest rates and/or increase the total supply of money in the economy. By making credit less expensive, it theoretically encourages businesses to increase borrowing and investment.

Ideally, the government and central bank are always working towards the same outcome. If they do, then fiscal and monetary policy will complement one another. If this is the case during a recession, this alignment will generally mean an economy can escape it much faster than otherwise possible.