What is a Recession?

What is a Recession and How Will It Affect Investing?

A recession represents a significant decline in economic activity over a sustained period of time. When the economy is healthy, economic activity accelerates as more people enter the workforce and consumers buy more products and services, but recessions have the opposite effect. The economy contracts as more people lose their jobs and consumer spending declines.

Recessions typically hurt businesses and consumer finances. There are fewer products to choose from, fewer job opportunities, and more people will have trouble making ends meet. But recessions are just a natural part of the business cycle. Economies rise and fall over time, and recessions often follow periods of high economic growth.

Learn more about recessions and how they can affect your finances.

What Is a Recession?

Economies are always changing in size. Economists rate the health of the economy based on several factors, including the unemployment rate, gross domestic product (GDP), retail sales, manufacturing output, and the average earned income per household.

Economists will look at how these factors change over time when assessing the health of the economy. They will often compare these numbers from one quarter to the next to see whether the economy is growing or contracting. A recession occurs when the economy is headed in the wrong direction. Unemployment rises while GPD, retail sales, manufacturing, and earned income fall.

There are several ways to define a recession. Julius Shiskin came up with a popular definition in 1974 that is still widely used today. Shiskin said that a recession occurs when there are two consecutive quarters of declining GDP. Economies are expected to grow over time, so six straight months of declining economic output usually means trouble.

The National Bureau of Economic Research (NBER) uses a separate definition that takes a closer look at how the economy is working for everyone. They define a recession as a significant decline in economic activity that spreads across the entire economy. It must last more than a few months with a visible impact on GDP, income, employment, manufacturing, and retail sales.

Economic activity rises and falls on a curve. Recessions are considered a natural part of this process. What goes up must come down. Consistent growth isn’t always sustainable. After the economy surges, growth will usually stall once hiring and consumer spending starts to cool off. But recessions don’t always follow straight lines.

For example, the U.S. experienced a W-shaped recovery after the COVID-19 pandemic. The economy fell sharply during the spring of 2020 before rebounding slightly during the summer. The economy plummeted again during the fall and winter as the Delta and Omicron waves derailed the recovery, but now the economy is getting back to where it was pre-pandemic. This wouldn’t qualify as a recession under Shiskin’s definition because the economy didn’t contract for two consecutive quarters, but it does meet the criteria laid out by the NBER.

What Causes a Recession?

Recessions tend to occur naturally, but outside events can easily shock the economy into a recession. Common causes may include:

Environmental Disasters, Pandemics, and War

If the country experiences hardship and millions of people are forced to flee their homes, they won’t be able to go to work, which can send the economy into a sudden downward spiral. The COVID-19 pandemic also prevented people from going to work. This is one of the most important aspects of economic growth.

Asset Bubbles

A recession can also occur when a subset of the market gets too hot. Investors will throw money at a particular industry or type of asset, such as the dot-com boom of the late 1990s and the housing market collapse of 2008. These assets usually get too much hype with investors paying too much for them. But bubbles were designed to be popped. These assets will eventually lose value, which triggers a rapid sell-off in the market, which usually ends in a recession.

Deflation/Inflation

Modest inflation is a sign of economic growth, but too much inflation can trigger a recession. Consumers will lose buying power and dramatically scale back their spending, which forces companies to either further raise their prices or go out of business altogether. The Federal Reserve will typically raise interest rates during inflationary periods, but raising them too fast can lead to a recession.

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Rapid deflation can also spell trouble for the economy. Consumers will have more buying power, but this usually leads to a drop in income for consumers and businesses. Prices will continue to drop as more people lose their jobs, which will result in a recession.

Prices need to stay stable for economic growth to occur.

Technology

New machines can also make workers obsolete. The country may see a dramatic spike in productivity, but millions of people will likely lose their jobs, which will reduce demand for products and services. This technology may ultimately benefit society, but not everyone will benefit from these changes equally.

How Long Do Recessions Last?

Recessions can last anywhere from a few months to several years. The pace of economic recovery all depends on what caused the recession in the first place. Getting the economy back on track means restoring the equilibrium of supply and demand. There needs to be enough workers in the workforce to meet demand, and individuals need to earn enough to spend money on goods and services to keep the economy humming.

If new technology caused the recession, it would take a while for demand to meet supply. If buildings were destroyed and lives lost, the country would need time to replace these resources. 

Depressions are typically much worse than recessions. They last for years and tend to have a much wider impact on the economy. The Great Depression lasted from 1929 to 1933. WWII and the New Deal eventually helped Americans recover their finances.

How to Prepare for a Recession

If a recession occurs, you may lose your job, or your business may lose revenue. You may need to live off savings or unemployment insurance until you can start earning a living again. If you run a business, you may have to let some of your workers go to keep your costs down. If demand for your products and services dries up, you may have to file for bankruptcy.

How Will a Recession Affect My Assets?

Assets, including stocks, bonds, and even real estate, typically lose value during a recession. You may be tempted to sell off these assets, but there’s a chance the price could rebound after the recession ends.

If you are planning on living off these assets in retirement, you likely won’t have as much money to live off. You may need to hold off on retiring or reign in your expenses to make ends meet until the economy recovers.

Does Gold Go Up in a Recession?

The value of gold sometimes goes up during times of economic crisis. That’s because gold is a rare natural resource, which means it is inherently valuable. Gold is seen as more stable than other types of assets during a recession. Once the economy recovers, gold will still be in demand. Gold prices tend to jump during recessions as more investors buy up these assets.

Will Crypto Rise in a Recession?

Cryptocurrency has only been around for a relatively short amount of time, and it’s still not clear how it will fare during a recession. Some believe crypto prices will fall during a recession, just like other assets. Crypto is loosely tied to the health of the economy, just like the stock market.

The Bottom Line

Recessions generally lead to a lot of pain and suffering, especially for those that don’t have a lot of money in savings. The good news is that recessions are temporary, and the economy will eventually recover. It’s just a matter of time.

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