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What is a Recession?

April 08, 2020 · 8 minute read

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What is a Recession?

The coronavirus pandemic has sent the stock market reeling and pushed the country toward recession. The word itself can be unsettling, perhaps conjuring memories of the economic hardships during the Great Recession of 2007–2009 and maybe even provoking fears of a depression.

Recessions have a big impact on the economy, affecting businesses, jobs, and stock market returns. Here’s a look at what you should know to better understand what a recession is and some tips to prepare for one.

At its most basic, a recession is a period of general economic decline. Recessions are typically accompanied by falling stock markets, a rise in unemployment, a drop in income and consumer spending, and increased business failures.

Usually, a recession is declared when U.S. gross domestic product (GDP)—which represents the total value of goods and services produced in the country—drops for at least two quarters in a row.

However, that’s not the only criterion for declaring a recession. For example, during the Great Recession in 2007, the International Monetary Fund (IMF) added a number of economic indicators to describe a recession, including declines in industrial production, falling oil consumption, and increased unemployment for two quarters. The National Bureau of Economic Research (NBER) defines recession as a decline in economic activity lasting more than a few months, visible in GDP, real income, employment, production and sales.

While economic recessions aren’t common, they are a normal part of the business cycle. According to the NBER, the U.S. has experienced 33 recessions , the first of which occurred in 1857, and the last was in 2007.

What Causes a Recession?

No two recessions are exactly the same, and that goes for what causes them. But generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers.

As consumers lose confidence they stop spending, driving down demand. And as a result, the economy shifts from growth to contraction. Here’s a look at some of the characteristics that recessions share in common.

High Interest Rates

High interest rates make borrowing money more expensive, and therefore limit the amount of money available to spend and invest. In the past the Federal Reserve has raised interest rates to protect the value of the dollar, which has resulted in recession.

For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation .” In an attempt to fight it, the Federal Reserve raised interest rates throughout the decade, which created the recession of 1980–1982.

Falling Housing Prices

If demand for housing falls, so too does the value of people’s homes. Homeowners may no longer be able to tap the equity in the houses through vehicles such as second mortgages. As a result homeowners may have less money in their pockets to spend.

Stock Market Crash

A stock market crash occurs when a stock market index drops severely. If it falls far enough, by 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession.

As stock prices drop, businesses grow less and may produce less. They may have to layoff workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.

Reduction in Real Wages

Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.

When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, which can lead to less spending and economic slowdown.

SoFi has built a Recession Help Center
that provides resources to help guide you
through this uncertain time.


Bursting Bubbles

Asset bubbles are to blame for some of the biggest recessions in U.S. history, including the stock market bubble in the 1920s, the dot-com bubble in the 1990s, and the housing bubble in the 2000s.

An asset bubble occurs when the price of an asset such as stock, bonds, commodities and real estate, quickly rises without actual value in the asset to justify the rise.

As prices rise, new investors jump in hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts—for example, if demand runs out—the market can collapse, eventually leading to recession.

Deflation

Deflation is a drop in prices, which can be caused by oversupply of goods and services. This oversupply can result in consumers and businesses saving money rather than spending it. As demand falls and people spend less, recession can follow.

What are the Impacts of Recession?

Recessions have an impact on almost all people and businesses. Some may lose their jobs as unemployment tends to spike.

Long-terms savings, such as the money investors hold in their 401(k)s may also take a hit. Housing prices tend to fall, leaving consumers with less equity in their homes.

When consumer spending declines during a recession, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.

Bear Market vs. Recession

Before there is talk of a recession, the economy often enters a bear market. For example, in response to the coronavirus outbreak in 2020, stock markets plunged, ending an 11-year bull market. However, while bear markets often accompany recessions, they are not the same thing and it’s important to understand how they differ.

The first thing to understand is that the stock market is not the same thing as the economy, though they are related. Investors do react to changes in the economy, because what’s happening in the economy at large can have an effect on the companies in which investors own stock.

So, if investors think the economy is growing, they may be more willing to put money in the stock market. If they think it is contracting, they are likely to pull money out of the stock market. These reactions can function as a sort of prediction of recession.

A bear market begins when the stock market drops 20% from its recent high. If you look at the S&P 500 index as representative of the market, there have been 12 bear markets since 1945 . Yet, not all bear markets result in recession.

For example, during 1987’s infamous Black Monday , the S&P 500 lost 22% and the resulting bear market lasted four months. However, the economy did not dissolve into recession. That’s happened three other times since in 1947.

Bear markets have lasted 14 months on average since World War II, and the biggest decline since then was the bear market of 2007–2009.

Recession vs. Depression

In general, a recession is an economic slowdown that lasts at least two months. A depression is a severe and prolonged downturn.

While recessions are a normal part of the business cycle, depressions are outliers that can last for years. Consider that the Great Recession lasted for 18 months, while the Great Depression lasted for 10 years, beginning in 1929.

While there have been 33 recessions, the Great Depression is our only example of a depression. During that decade, as many as a quarter of American were unemployed and GDP was cut in half.

What caused the Great Depression? In the months before the depression, the stock market doubled in value amid speculative investing. On October 29,1929, also known as Black Tuesday, that bubble burst.

Throughout the depression, actions by the federal government seem to have exacerbated the problem.

Former head of the Federal Reserve Ben Bernanke, who was Chairman from 2006 to 2014, has identified a few mistakes in an effort to learn from and avoid repeating them.

First, in 1928 and continuing through 1929, the Federal Reserve tightened its monetary policy, raising interest rates. Second, at the time, the U.S. backed its currency with the gold standard.

In 1931, gold speculation in the U.S. sparked a panic in the U.S. banking system after speculators started trading dollars for gold. In 1932, the Federal Reserve refused to reduce interest rates to increase the national supply of money, despite the fact that ongoing deflation meant borrowing was very expensive.

Finally, the Federal Reserve neglected to address ongoing problems in the banking sector. As a result runs on banks continued, banks closed in droves and Americans turned to hoarding cash.

The Great Depression came to a close beginning with the election of Franklin D. Roosevelt and the signing of the New Deal, which constituted large-scale government relief programs.

Some scholars argue that World War II was the event that finally brought the Great Depression to a close.

How Long Does it Take to Recover From a Market Downturn?

The lengths of economic recessions vary. According to the NBER, the shortest recession took place in the 1980s and only lasted six months.

The longest, from 1873 to 1879, lasted 65 months. However, clocking in at 18 months, the Great Recession has been the longest recession since World War II.

Let’s assume that’s an outlier for the moment. If you consider the other 11 recessions since 1945, they have lasted on average about 10 months. Even if the Great Recession is included in calculating the average, it’s extended less than a month.

What is an Economic Stimulus Plan?

Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus in an effort to boost employment and spending.

Central banks, like the Federal Reserve, can provide monetary stimulus. The Federal Reserve can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.

Fiscal stimulus can come in the form of tax breaks or incentives that increase outputs and incomes in the short term.

Governments may put together stimulus packages in an effort to boost economic growth. For example, stock market volatility increased wildly amid fears of the coronavirus pandemic and its economic fallout.

In an effort to ward off recession, the U.S. government put together a $2 trillion stimulus package that included direct payments to citizens, suspended student loan payments, a boost to unemployment benefits and a lending program for businesses and state and local governments.

The package included limits on corporations ability to use stimulus funds for stock buybacks. Stock buybacks occur when a corporation repurchases shares of its own stock. This reduces the amount of stock that is being publicly traded, and as a result, can cause the cost of each share to increase.

Managing Investments During a Recession

Recessions can be worrying to say the least. And watching stock prices fall can lead investors to panic and pull their money out of the market. However, this behavior can be counterproductive and possibly derail investors’ financial plans.

Stocks are an important part of a long-term investment plan, which means staying invested when markets are down. Recent recessions have lasted an average of 10 to 11 months and according to a Morningstar report from 2018, the market has always been up over any given 15-year period. Past performance is never a guarantee of what will happen in the future.

But this pattern suggests that if investors can hang on to their stocks for the long run, they have a good chance of yielding a return after at most 15 years. Selling when stocks are down ensures that investors lock in their losses and means they will miss out on gains when markets rebound.

Investment plans are usually created with an eye toward meeting long-term goals.

The resulting portfolio likely holds a balanced mix of assets that accounts for an investor’s time horizon and risk tolerance.

The inevitability of market downturns and risk management is already built into this type of portfolio. Panic selling can threaten to throw off these carefully laid plans.

It is possible during down markets that portfolios will need to be rebalanced. For example, say an investor has a portfolio that consists of 70% stocks and 30% bonds.

As stock prices drop, that portfolio will likely see its balance shift more heavily toward the bond allocation. As a result, a down market may actually be an opportunity to rebalance by buying more stock. The key to riding out a recession is for investors to stick to their long-term plans, only rebalancing when it will help them reach their long-term goals.

Investors who have questions about their portfolio during an economic downturn may find comfort in getting advice from a professional. At SoFi, all members have access to SoFi Financial Planners, who can provide personalized insights for investors.

To help manage your investment accounts, make an appointment with a financial planner at no cost. And for up-to-date market information, download the SoFi App.


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