What Causes a Recession?

Recessions are an often discussed topic. It may seem like the US has experienced a lot of recessions recently, and you would be right. Recessions are normal economic occurrences, so it is expected that the economy will go into recession from time to time. There are also some recessions that are preventable. Let’s take a look at what causes a recession.

What Causes a Recession: A Summary

There are often a lot of factors involved in a recession, so it is difficult to provide a simple answer for what causes a recession. However, we’re going to try to give you a brief version of what causes a recession before we look at each of the factors in a lot of detail.

A recession is an economic fluctuation. The economy expands and contracts, and a recession is just a big contraction. An economic contraction becomes a recession when it lasts for a significant amount of time and affects the entire economy in a significant way.

If you ask an economist what causes a recession, they would answer that recessions are caused by a shock to either supply or demand. For example, a supply shock could be something like a war affecting the export of oil, which would then affect the production and delivery of goods. An example of demand shock could be difficulty obtaining credit, reducing consumers’ purchasing power.

While the causes of each recession throughout history have varied, the causes can be categorised as either a supply shock or a demand shock. Economists can point to a specific cause of each recession throughout history, but there are also usually exacerbating factors.

Based on past recessions, the most common things that cause a recession in the US are:

• Financial crises – The widespread impact of financial crises can cause recessions due to both a lack of consumption and changes to the supply chain. When the dot-com bubble crashed, the widespread impact on business and personal finances triggered a recession.
• Housing market crashes – Any time an asset class experiences a bubble, the resulting burst can trigger a recession. Because houses are high in cost and a prevalent asset class, housing market crashes impact the entire economy. The Great Recession is a perfect example of this. When the housing bubble burst, it triggered one of the biggest recessions in modern years.
• Poorly timed fiscal policies – The government works closely with economists to create fiscal policies that keep the economy healthy. When timed correctly, these policies help the country overcome stagnation in consumer activity. When timed incorrectly, it could cause economic decline as banks tighten borrowing conditions.
• Supply shocks – A few times in history, recessions have been caused by a sudden decrease in the availability of materials that are necessary for manufacturing goods. If the US no longer had access to oil, production would slow (or grind to a halt) until a suitable replacement was found.

During a recession, you can expect to see increased unemployment and decreased production. The cost of living will often increase as the costs of materials and production increase. These symptoms of a recession are often felt long after the recession has been declared officially over.

Now that we have quickly summarized what causes a recession and given you a little background into recessions. Let’s look at each of the factors in detail.

What Is a Recession

Any discussion about what causes a recession must first start with understanding what a recession is. The definition of a recession has varied throughout history. Even now, the definition of recession will vary depending on who you ask.

The NBER (National Bureau of Economic Research) is widely accepted as the unofficial expert on recessions. They have compiled a vast archive of information on recessions throughout history. The NBER define a recession as:

“A significant decline in economic activity that is spread across the economy and that lasts more than a few months.”

Under this definition, the Covid-19 recession was a recession. Many economists dispute it as a recession due to a widely accepted rule of thumb stating that the GDP must decline for at least 6 months to be considered a recession.

The NBER has responded to questions about their difference in opinion by stating that they examine monthly data in order to provide exact dates for the recession (down to the month) rather than quarterly data. They also consider the depth of the economic decline and impact across multiple indicators.

Due to the severity that the Covid-19 pandemic impacted the economy (the country essentially came to a standstill for a few months) and the way it changed how we did business for some time after the economy recovered, the NBER sees it as worthy of the classification of a recession.

Now that we know what a recession is and who is responsible for classifying recessions let’s take a look at what causes a recession in detail.

The Business Cycle

A lot of the causes of recessions that we looked at in the summary of what causes a recession are the preventable causes of recession. However, the economy naturally fluctuates, and those fluctuations include recessions.

Economists track the country’s GDP (Gross Domestic Product) because that provides broad insight into the economy as a whole. It tracks both production and business profits, as well as the disposable incomes of individuals. The peaks and troughs of the GDP are called the Business Cycle.

As the economy expands (approaches its peak), you will see increases in:

• Profits
• Sales
• Industrial production
• Incomes
• Employment rates
• Inflation

As the economy contracts (approaches its trough), all of those things will decrease.

It is not as easy to predict a recession as the name Business Cycle may indicate. It doesn’t follow a strict pattern because a lot of external factors will impact the economy. Economists will often look at economic data over a long period of time to determine whether the economy is in recession or not. Sometimes, the economy will experience small dips or a long period of slight decline without going into recession.

What Causes a Recession: The 4 Causes of Recession

There are many different answers to the question, “What causes a recession.” Most recessions will be caused by a combination of factors. However, there are 5 common causes of recession that have contributed to the US recessions over the previous 30 years.

What causes a recession can be largely broken down into two categories: a supply shock or a demand shock.

A supply shock is something that disrupts the production of goods and services or otherwise impacts the price of goods and services. Some examples of supply shocks include:

• Disrupted supply of raw materials
• Disruptions to labor or technology

A demand shock is something that disrupts the consumption of goods and services, often by impacting access to personal credit or disposable income. Some examples of demand shocks include:

• Changes to government policy
• Changes to borrowing conditions
• Widespread layoffs
• Lack of consumer confidence

Supply shocks and demand shocks will often impact each other. As businesses slow down production, they may lower wages or conduct layoffs to reduce their business expenses. This will then reduce consumer confidence and lower disposable income. As demand reduces, businesses will further slow production and so on and so forth. This interconnected nature of supply and demand can make it difficult to define exactly what causes a recession. Most of the previous US recessions have been caused by a number of factors.

Let’s look at each of the common causes of recession in detail.

1.    Supply Shocks

Severe or widespread supply shocks, like difficulty in obtaining necessary materials or rising production costs, can lead to a recession. When these kinds of disruptions to an economy’s production ability occur, then prices will increase, and fewer goods will be produced.

These supply shocks will often cause large changes to employment rates as companies seek to reduce their production costs. Companies will also reduce their output, recalculating their production quotas to ensure they are maximizing the use of their resources while reducing wastage. As companies increase their prices and layoffs happen across many sectors, demand will also decrease.

Supply shocks that cause a recession are usually due to a disrupted supply of goods and services that are necessary for production in multiple industries. For example, disruption to oil and other types of energy will be widespread and are therefore likely to cause a recession.

In the 1970s, two supply shocks caused two separate recessions. There were two disruptions to the United States’ supply of oil. The first was in 1973 due to OPEC putting an embargo on exporting oil to the US. The second was in 1978 due to the Iranian Revolution.

It is important to note that in both cases, there were contributing factors aside from the disruption to the oil supply.

Since then, the US has increased their domestic oil production and created oil reserves to prevent another recession due to a lack of oil. However, there have been a number of recent supply shocks. The Covid-19 pandemic is an example of a supply shock due to social distancing regulations making production more challenging. So, too, is the Russian invasion of Ukraine, which didn’t cause a recession but did increase energy prices and cause inflation to rise.

2.    Demand Shocks

A demand shock is anything that causes consumers – both individuals and businesses- to reduce their spending. There are some similarities between supply shocks and demand shocks because both cause production to decrease. However, there are also some differences. For example, prices won’t tend to increase when a demand shock causes a recession because the problem is a lack of consumption, and higher prices will only further reduce consumption.

What causes a recession triggered by demand shocks?

A common cause of demand shocks is a contractionary fiscal policy. When the economy is thriving, the government may increase taxes or decrease government policy. Done correctly, this is good for the economy because it temporarily slows the economy and stops it from overheating.  There will be an initial economic decline, but after that, economic activity will increase. The policy lowers interest rates, which results in increased investment and a lower rate of inflation.

However, if this change in policy is poorly timed (and it is difficult to time because the economy is ever-moving), then it can trigger a demand shock. This caused a recession post-WWII. During the war, government spending was high, and when the government reduced their spending, it triggered the recession of 1945.

The Federal Reserve also monitors the economy. They control US monetary policies and will make adjustments to keep the economy stable. The Federal Reserve sets the federal funds rate, the rate upon which all the banks set their interest rates. As needed, the Federal Reserve will change the federal funds rate to increase and decrease interest rates as necessary.

• As interest rates rise, consumer demand and prices will decrease.
• As interest rates decrease, spending will increase because people can access more credit.

This practice is called contractionary monetary policy. It is a challenging practice because it is difficult to time the economy. However, it is necessary to stabilize employment rates and the cost of living. The Federal Reserve doesn’t always get its timing right, and decreasing consumer demand as the recession declines can trigger a recession.

An example of a recession being caused by contractionary monetary policy is the recession of 1981. The Federal Reserve increased the federal funds rate in order to get inflation under control. The sudden federal funds rate increase from 11% to 18% in such a short period of time caused a recession. While the recession increased unemployment, the Federal Reserve did achieve its goal and restored low inflation. In some cases, a recession, while bringing short-term adversity, will benefit the economy in the long term.

Currently, inflation is high, and since March 22, the Federal Reserve has been slowly raising their federal funds rates, vowing to restore stability. So far, it is working, and inflation is dropping. However, the current Federal Reserve Chair, Jerome Powell, has said that in order to achieve their goal, the labor market and short-term growth will be impacted. In other words, there is a potential that the Federal Reserve’s current contractionary monetary policies may cause a recession.

3.    Financial Crisis

Financial crises can be both a symptom of a recession and a cause of a recession, depending on the circumstances. Some of the most common types of financial crises that cause recessions include:

• Asset bubbles
• Debt crises
• Lack of financial market regulation

Financial crises cause a demand shock because the disruption to the financial market makes it more difficult to borrow money and reduces asset prices. In severe cases, financial institutions may become insolvent, resulting in large financial losses and job losses. Widespread financial crises will often decrease consumer spending and investment.

An example of this is the 2007 financial crisis, which caused the Great Recession, the most severe recession the US has experienced since WWII. When the housing bubble burst, the crash sent house prices plummeting, and with them, the value of mortgage-backed securities. Lenders tightened their borrowing conditions, which further decreased consumption.

Of all the causes of a recession, financial crises can be one of the most difficult recession causes to predict. Financial crises don’t always cause a recession and it is not always possible to see a financial crises coming. The Financial Stability Oversight Council identified 14 potential causes of future financial crises that may cause a recession:

• Alternative reference rates
• Central counterparties
• Climate change
• Commercial real estate
• Cybersecurity
• Digital assets
• Investment funds
• Large bank holding companies
• Nonfinancial corporate credit
• Non-financial instruction lending
• Residential real estate
• Short-term wholesale funding markets
• Third-party service providers
• Treasury markets

4.    Housing Market

The housing market closely follows GDP. As the GDP increases, so too will residential construction and remodeling. In fact, investment in residential property has decreased ahead of most of the past recessions.

However, changes to the housing market don’t just predict recessions, they can also cause recession in some cases. What causes a recession triggered by changes in the housing market?

Residential construction employs close to 1 million people in the United States. As home prices rise, so too does spending on housing, which in turn leads to economic growth. As home prices fall, so too does spending on residential construction, which will cause economic decline.

Homeowners can borrow against their equity to access additional credit when house prices rise. They may also spend on renovations or other projects to further increase the value of their home. In that sense, residential property is both an asset (like stocks) and a consumable good. People will invest in residential property as a means of building wealth in addition to being a consumable product (shelter).

Additionally, residential real estate is a highly fluctuating asset class. It accounts for less than 5% of GDP but proportionally, it is often responsible for GDP decreases, especially just before a recession.

Recently, economists have debated the link between residential real estate and the business cycle. Many do not believe that the business cycle and the housing market are linked since the Great Recession. Other economists believe they are still linked, just not as closely.

An example of the housing market causing a recession is the Great Recession which was caused by the 2007 housing market crash.

In the early 2000s there was a housing bubble that was caused by the ready availability of large amounts of credit. People naturally began buying houses in great numbers, which artificially increased house prices way past their actual value. This continued over a long period of time where prices rose steadily. In 2007, house prices began to fall dramatically. Many people defaulted on their mortgages, but those who didn’t saw their home value plummet, decreasing consumer spending. This recession is a type of demand shock because consumers stopped buying due to their homes losing value.

While some economists point to other factors as causing the Great Recession, it is widely agreed that the housing market played a large part in the Great Recession. The US economy may have still experienced a recession if the housing market didn’t crash, but it wouldn’t have been as bad.

Depending on whether you believe declines in residential property investment precipitates a recession or not, the housing market may indicate a recession is imminent. In 2020, following the pandemic, house prices began to rise. The Federal Reserve has been raising interest rates to combat inflation and this has made mortgages more expensive. Due to the fact that the majority of homeowners have a mortgage, the housing market is greatly affected by changes in monetary policy.

The steep decreases in housing prices we have seen in the previous quarters could indicate a falling GDP, which is an indicator of a coming recession.

Focusing on businesses that are most resistant to recession can provide stability and opportunities even during economic downturns.

Can Recessions Be Prevented?

Some of the recessions in history are considered preventable. What that means is that the cause of the recession was something that the government could have anticipated and reversed. For example, the 2001 recession due to the stock market crash was preventable because it was caused by a lack of government oversight of financial institutions.

However, recessions are a normal part of the business cycle, and it is impossible to avoid them completely. There are a few things that governments do in order to prevent recessions or proactively mitigate the impact of any future recessions. Some examples of these things include:

• Changing tax revenue
• Changing government spending
• Increasing government transfers to individuals (for example, issuing stimulus checks or increasing unemployment benefits like they did during the Covid-19 pandemic.)

In this way, the government pre-empts potential causes of recessions. For example, if the government notices a reduction in consumer spending, it may enact programs designed to stimulate spending, such as help-to-buy schemes. These strategies can both prevent recessions and help the economy recover from recession.

The Federal Reserve also has the potential to impact recessions. Their responsibility is less about preventing recessions and more about keeping the economy stable by implementing monetary policies. By changing the federal funds rate, they can impact interest rates and the availability of credit in the economy. As we discussed earlier in this article, they often prioritize long-term economic health, which at times may mean that their monetary policies can contribute to causing a recession.

Both fiscal policy and monetary policy, when done right, can smooth the business cycle by ensuring the peaks don’t get too high and the troughs don’t get too low. They can even help the economy to recover quickly during a recession. For example, the government is likely to increase its spending during a recession to stimulate consumer spending so that demand rises.

The government and the Federal Reserve act independently, but often consider the other’s plans and actions before enacting policy. For example, the government may delay fiscal policy because the Federal Reserve is changing its monetary policy. This can reduce the likelihood of recessions caused by mistimed fiscal or monetary policies.

There are a lot of factors that the government and the Federal Reserve need to consider when determining whether fiscal policy or monetary policy is appropriate. When inflation occurs during a recession, the government and the Federal Reserve will often discuss how to best approach the situation. There will be times when inflation will be the bigger concern, and there will be times when unemployment rates will be the bigger concern. The government and the Federal Reserve will come to an agreement and then act accordingly.

In some ways, the economy stabilizes itself naturally. The way that taxes and government spending are set up automatically changes as the economy changes. This allows the government and fiscal policy to stabilize the business cycle automatically. Some examples of these automatic economic stabilizers are:

• Tax revenues naturally increase as incomes and employment rates rise.
• Government spending naturally decreases as the economy flourishes because fewer people need income support.
• As government spending increases during times of economic decline (as more people need support), the government’s reserves will decrease. They will also collect less tax as incomes and employment rates decrease.

In this sense, the government creates a stockpile during good economic times so that it can provide additional resources and support during times of economic hardship.

What Causes a Recession: In Conclusion

The answer to what causes a recession is not a simple one. There are a number of factors that can cause a recession, and most recessions are brought about by a combination of factors and plain poor timing. The economy isn’t static; it fluctuates over time in what is referred to as the business cycle. There are times of economic growth and economic decline, but the government and the Federal Reserve work to stabilize the economy and keep it healthy. It is not good for the economy to experience too much growth or too much decline. A financial crisis, disruption to the supply chain, or disruption to consumer spending at a time when the economy is already fluctuating downward can trigger a recession.