Last Updated on October 11, 2023
“Recession” has been one of the most used words by economists in the past few years, replacing terms like “economic recovery” and “GDP gains.” This trend worries all market participants since recessions impact everyone – from the world’s biggest companies to the small shop owner around the corner and the consumer. However, as bad recessions can be, they are a natural part of the market economy, and without them, we practically can’t experience economic booms.
In this guide, we will go through everything you need to know about recessions – from how they arise and how they differ from depressions to how to spot when a recession is looming and when it is about to end. Furthermore, we will explore the most severe recessions in global history and see how the world has recovered from them. After going through this article, you will be better prepared to time the market and predict looming economic crunches to better protect and grow your portfolio.
What is a Recession?
A recession is a notable prolonged decline in economic activity usually spread across single or many economies worldwide. The economic contraction usually starts at the peak of a market cycle and ends at its lowest point. After that, it is again followed by a period of economic expansion.
Economic, financial, or psychological factors can trigger a recession. Think of recessions as a way for the market to correct the imbalances resulting from an economic boom. These brief corrective phases serve as a “restart” for the economy to ensure that its future growth can continue. In that sense, recessions can even be considered healthy for the market.
A state of recession affects all parts of the economy. It sees key parameters decline, including economic output, consumer demand, employment, investment activity, etc. According to the IMF, a recession usually leads to a 2% GDP drop, but severe periods of economic downturn can lead to up to a 5% decline.
Recessions aren’t very common. In the case of the leading global economic superpowers, recessions occur once a decade at most. The market history knows periods without a recession lasting for over 25 years.
A state of recession can last anywhere from a few months to a couple of years, based on its origin and severity. For example, the average U.S. recession since 1857 lasted 17 months. The six recessions since 1980 have lasted less than ten months on average.
Countries rely on various fiscal and monetary policies to limit the risk of recession. Those might include interest rate cuts to ensure access to funds and support for the economy, fiscal stimulus in the form of quantitative easing, and more.
Recession vs. Depression
Economic depressions are particularly deep and long-lasting recessions. While recessions cause economic decline, depressions lead to economic nose-dives where the market is in freefall. Think of depressions as the lousy cousin of recessions that causes chaos in markets and global economies that can take decades to recover from.
To put that into perspective, let’s look at some numbers. The 1937 – 1938 recession in the US, one of the most severe in history, caused a 10% GDP drop and a 20% decline in employment rates. In comparison, the Great Depression, the worst economic crisis ever, caused a 33% GDP drop, an 80% stock market plunge, and a 25% unemployment rate. It took nearly a decade for the world to recover from it.
A recession can turn into a depression if the decline in economic output starts spiraling out of control and reaches massive proportions. Such a self-perpetuating decline is usually a result of several crisis events that happen simultaneously, which can exacerbate their devastating effect on the economy.
Economists don’t have a set of measures to define whether the economy is in a recession or a depression. Rather than an exact science, this is more of a judgment call – when the economic downturn is more severe and lasts longer, it is considered a depression. However, bear in mind that these conclusions are usually made in retrospect so that the full scale of the economic crisis is well-known.
Yet, it is worth noting that the economy might be considered in a state of depression if GDP drops by more than 10% for a prolonged period. One similar case in modern history was in the early 1990s in Finland, when the economy shrank by 14%.
Inflation vs. Recession
Inflation is the rate at which prices increase over a specific time frame. Inflation isn’t bad per se. In fact, it is always present in the economy but usually remains at low levels (around 2%). When it gets higher (5% – 10% or more) and remains at such levels for an extended period, then it starts significantly impacting the purchasing power. Each unit of currency starts buying fewer goods and services, resulting in a higher cost of living for the average consumer.
There is a strong link between inflation and recession. Usually, when the economy is in a recession, inflation is high. In some cases, it can go above 10% or 15% and remain at such levels for an extended period.
Inflation can also indicate the start of a recession. Usually, the longer inflation remains high, the bigger the chance for a recession to unfold. For example, an oil price increase is usually a harbinger of an inflation rise since it naturally increases the prices of goods and services. This takes a toll on purchasing power and can lead to a decline in aggregate demand.
Governments have different measures to control inflation, including monetary and fiscal policies (e.g., raising interest rates). However, the process is very tricky since, if these measures are applied excessively, they can lower the demand for goods and services. If this demand drop is severe and remains for an extended period, it can trigger a recession.
Examples like these help understand the link between recession and inflation. However, it is worth noting that high inflation isn’t necessarily an indicator of a recession. Often, inflation can rise due to sudden spikes, and if its effect gets tamed in the short term, a recession is unlikely.
Are We In a Recession?
To answer this question, we need to focus on the factors that determine whether the economy enters a recession phase, and this is a tricky task. The question of how to define whether an economy is in a recession has sparked fierce disputes over the years, and economists still haven’t come to a definitive answer.
One of the most common ways to determine whether the economy is in a recession is to look at the GDP drop – if the economic output declines for two straight quarters, the economy can be considered in a recession.
Many countries and leading economists use this metric as a foundation of their recession forecasting models but also complement it with other variables. For example, many also monitor key economic parameters like real income, employment, industrial production, consumer demand, retail sale levels, and more. The combination of all those factors helps paint a more accurate picture. On the contrary, they can be very deceiving if used on their own. For example, unemployment levels usually remain low even after the economy has rebounded and started growing again. This lag will deceive you if you look only at unemployment rates to determine whether the economy is still in a recession.
That is why the best way to define whether the economy is in a recession is to take a holistic look at the data and monitor everything from the GDP to the labor market, consumer and business spending, industrial production, and incomes. This is what the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, the official recession arbiter in the US since 1978, does.
Looking at the inverted yield curve is another reliable way to predict recessions. Since 1955, it has correctly identified all 10 US recessions.
Is Recession Coming In 2022?
While nobody can say for sure, we can look at the recession indicators and try to interpret what they are telling us about the current state of the global economy.
According to FRED and its NBER-based recession indicators, currently, the US economy isn’t in a recession. Most of NBER’s recession indicator variables are marking a positive trend, meaning a recession remains unlikely for now. Other recession indicators and probabilities also confirm this.
At the same time, the US Leading Economic Index (LEI), published by the Conference Board, warns about an increased risk of near-term recession. Such signals also come from Wall Street’s most talked about recession indicator, the yield curve, which is now the most inverted it has been in decades.
Similar conflicting signals are also coming from EU economies where the economic performance is shaky while inflation is hitting new heights. Usually, economies can show signs of weakening months before a recession begins, meaning that a recession might be on the cards.
Ultimately, whether we are in a recession or not depends on who you ask and what indicators they are looking at. At the time of this writing, the leading global superpowers aren’t in an “official recession.” However, bear in mind that states of recession are usually officially announced in retrospect. For example, it took the NBER committee a year to declare the Global Financial Crisis a recession. That is why it is worth noting that the moment you start hearing from recession monitoring authorities that we are in a recession, we would probably already be halfway through it, or it might have even passed.
The Greatest Recessions in History
For the period 1960 – 2007, forecasting models have identified 122 recessions in 21 advanced economies, meaning that there is a sufficient sample size to analyze. Since 1857, the US alone has experienced 34 recessions. Their length varied between two months to over five years. On average, they lasted 17 months.
These findings also draw an interesting pattern – over time, recessions have grown less frequent and shorter. According to data from NBER, recessions in the period 1945 – 2009 lasted 11 months on average. In comparison, the average duration from 1854 to 1919 was 21.6 months.
Which events make the list of the most significant recessions in history depends on whether we are looking at worldwide recessions or isolated cases in particular countries. Here are some examples of the most defining recession periods in history to get a clearer understanding of the impacts such events can have on global and regional economies:
The 1873 Recession (the “Long Depression”)
This economic crisis lasted 23 years which is why many refer to it as the “Long Depression.” In fact, some analysis pieces consider it to be the “original” Great Depression.
It started with the collapse of the Vienna Stock Exchange, which was then followed by bank collapses in several countries. The most severe consequences were felt in the UK, where the economic stagnation lasted two decades and led to a 50% jump in unemployment and a 25% drop in exports. The German industry also suffered, with cast iron prices falling 27%. In the US, the New York Stock Exchange was forced to halt trading for the first time.
Some of the cited triggers include speculative investing and the demonetization of silver in Germany and the US. But some experts conclude that among the chief reasons for the economic crash was the rapid commercial and industrial productivity growth. While this might sound strange to you, in fact, it is considered a possible recession trigger since new products and technologies make established industries shrink, leading to job losses.
The Recession of 1937 – 1938
With a 10% real GDP drop, a 20% unemployment rate, and a 32% drop in industrial production, the recession of 1937 – 1938 isn’t the worst in US history. Still, it is worth mentioning since it occurred during the recovery years after the Great Depression. Research later would refer to it as “the recession within [the] Depression” – a one-off market phenomenon.
But there is another interesting angle that we can look at when analyzing this recession. It was caused due to a contraction in the money supply caused by the FED and the Treasury Department fiscal policies. The goal of authorities was to prevent potentially-dangerous credit expansion. As a result, banks’ reserves increased massively.
The recession ended after the FED rolled back its reserve requirements and started to conduct a more expansive fiscal policy.
Contrary to the Great Recession, this case shows that too restrictive fiscal policies aren’t good for the economy either.
The OPEC-Caused Recession of 1973
In 1973, the Organization of the Petroleum Exporting Countries caused a global recession by declaring an oil embargo on the US and its allies. The decision came as a response to the countries’ decisions to send arms supplies to Israel during the ongoing conflict at the time.
As mentioned already, oil market disruptions are a major prerequisite for increased inflation, which, if long-lasting, can cause a recession. The 1973 crisis is a glaring example of this. The oil embargo led to an immediate and significant oil shortage and a severe oil price spike (prices quadrupled), which caused very high inflation, triggering economic stagnation.
The recession lasted around 16 months and led to a GDP drop of 4.7% in the United States, 2.5% in Europe, and 7% in Japan.
The Global Financial Crisis (The Great Recession) – 2007 – 2009
The biggest recession in recent years started in 2007 and officially lasted until 2009, although its impact was felt way longer globally. In fact, it was almost double the length of other recent US recessions.
The recession was triggered by a credit risk imbalance where the financial system accumulated massive amounts of subprime mortgages. Reckless risk management strategies by banks, investment firms, and corporates also threw fuel to the fire.
The recession affected the entire world, shaving close to 4% of global GDP. According to the IMF, 91 economies representing two-thirds of global GDP saw their output decline in 2009. It also led to a massive loss of jobs, increased inflation, corporate defaults, significantly reduced purchasing power, and other negative implications.
The crisis is referred to as the Great Recession to indicate that it was the second most significant economic crash since the Great Depression of the 1930s.
The COVID Recession of 2020
This is the most recent official recession on records in the US. It is also the shortest in history, starting in February 2020 and lasting just two months.
It is an interesting case for analysis since, according to researchers, it is strikingly different from other recessions on record. The main differences were in its speed, the types of industries and firms affected, the regulatory response, and more. For example, in the US, unemployment has hit its worst levels since the Great Recession. Countries like the Philippines and Italy experienced an 8.9% and 9.3% GDP decline. In total, global GDP dropped 3.4% in 2020, while the average global unemployment rate hit 6.57%.
Conclusion
While the word “recession” often sparks fear all the way from institutional investors to the average consumer, economic downturns are a natural part of market cycles. Similar to how a summer can’t pass without a storm or two, in the end, the sun always comes up. So is the case with economic crunches.
This is not to say that recessions can’t make us struggle. Companies go bust. People lose their jobs, industries decline, or are entirely replaced – things like these happen. However, recessions shouldn’t be viewed as times of doom and gloom. Just the opposite – they can also help shape the companies that will lead the recovery, allowing investors to position themselves for future growth.
Despite the presence of very severe recessions in our history, the modern economic era rarely sees such. Recessions are now less frequent and way shorter than a few decades back, and, thanks to globalization and technological evolution, the recoveries are way quicker and allow for bigger economic gains.
Whether or not a recession will occur and when it will happen exactly is a question that even the best economists can’t answer. What’s important is to keep your sight on the broader picture – the economy will, first, drop, just to reach new highs later on. Similar to how one crouches down right before jumping.
