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What is a Recession?

By Rebecca Lake · May 14, 2021 · 9 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What is a Recession?

Just the very word “recession” itself can be unsettling, conjuring memories of the economic hardships during the Great Recession of 2007–2009 and maybe even sparking fears of personal financial troubles.

Recessions tend to have a wide-ranging economic impact, affecting businesses, jobs, everyday individuals, and investment returns. But what are recessions exactly and what kind of long-term repercussions do they tend to have on personal financial situations?

Here’s a deeper dive into these economic events and how to best prepare for recessions.

Definition of Recession

Generally speaking, a recession is a period of economic contraction. 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.

But this is not an official definition of recession, according to the National Bureau of Economic Research (NBER) . Instead, the NBER choose to define recession in terms of monthly indicators, including:

•  Employment. Job growth or job loss can be used to gauge the likelihood of a recession and serve as a litmus test of sorts for which way the economy is moving.
•  Personal income. Personal income can play a direct role in influencing recessionary environments. When consumers have more personal income to spend, that can fuel a growing economy but when personal income declines or purchasing power declines because of rising interest rates, that can be a recession indicator.
•  Industrial production. Manufacturing is a measure of supply and demand, both of which are central in promoting a healthy economy. If manufacturing begins to slow down that could suggest slumping demand and in turn, a shrinking economy.

These indicators aren then viewed against the backdrop of quarterly gross domestic product growth to determine if, in fact, a recession is in progress. For that reason, the NBER doesn’t follow the commonly accepted rule of two consecutive quarters of negative GDP growth, as that alone isn’t considered a reliable indicator of recessionary movements in the economy.

Recommended: Investing With the Business Cycle

History of Defining Recessions

The concept of using two negative quarters of GDP growth can be traced back to a definition of recession that first originated in the 1970s with Julius Shiskin, once commissioner of the Bureau of Labor Statistics. Shiskin defined recession as meaning:

•  Two consecutive quarters of negative gross national product (GNP) growth
•  1.5% decline in real GNP
•  1.5% decline in non-farm payroll employment
•  Unemployment reaching 6%
•  Six-months or more of job losses in more than 75% of industries
•  Six-months or more of decline in manufacturing

It’s important to note that Shiskin’s recession definition used GNP whereas modern definitions of recession use GDP instead. GNP or gross national product measures the value of goods and services produced by a country both domestically and internationally. Gross domestic product only measures the value of goods and services produced within the country itself.

How Often Do Recessions Occur?

While economic recessions aren’t common, they are a normal part of the business cycle. According to the NBER, the U.S. experienced 33 recessions prior to the coronavirus pandemic. The first recession occurred in 1857, and the last was the Great Recession in 2007, which lasted through June 2009. A recession occurs on average every 4.5 years, though the actual timing can and has varied.

For example, the most recent recession occurred nearly a decade on from the Great Recession. On June 8, 2020, the NBER determined that economic activity in the U.S. peaked in February 2020 and that the economy had entered a recession that same month. According to the data, the economic peak occurred in the fourth quarter of 2019 just before the pandemic began.

Recommended: U.S. Recession History

How Long Do Recessions Last?

According to the NBER, the shortest recession took place in the 1980s and only lasted six months while the longest went from 1873 to 1879, lasting 65 months. However, clocking in at 18 months, the Great Recession has been the longest recession since World War II.

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.

Statistically, periods of expansion tend to last longer than periods of recession. From 1945 to 2019, the average expansion lasted 65 months while the average recession lasted 11 months.

Between the 1850s and World War II, expansions lasted 26 months on average while recessions lasted 21 months on average. The most recent expansion, i.e. the one that occurred between 2009 and the beginning of 2020, lasted 128 months.

In terms of severity, the Great Recession that occurred between 2007 and 2009 was the most severe economic drawdown since the Great Depression of the 1930s. This recession was considered particularly damaging due to its duration, unemployment levels that peaked around 10% and the widespread impact on the housing market.

Recommended: A Brief History of the Stock Market

Common Causes of Recessions

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. The recession that occurred in 2020 could be considered an outlier, as it was sparked largely by an external global event, rather than internal economic causes.

The mechanics behind a typical recession work something like this. As consumers lose confidence, they stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing and a continued decline in consumer spending.

Here are some common characteristics of recessions:

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 or prevent the economy from overheating, which has at times 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 Fed 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 by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession, since the net worth of individual holdings also decline. It can also cut into confidence among people, causing them to spend and hire less.

As stock prices drop, businesses may also face less access to capital 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.

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 tech 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?

When the economy begins to slow down, businesses may have fewer customers because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.

As more people lose their jobs, they have less to spend on discretionary items, which means less sales and revenue for businesses. Individuals who are able to keep their jobs may choose to save their money rather than spending it, which again, leads to less revenue for business.

Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.

When consumer spending declines, 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

Alongside a recession, the stock market often enters a bear market. For example, in response to the coronavirus outbreak in 2020, equity markets plunged, ending an 11-year bull market.

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

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.

Recession vs. Depression

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 34 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

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. First, in 1928 and continuing through 1929, the Fed 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 Fed 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 Fed 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.

What is a 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 policy stimulus. The Fedcan 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 trillions in Covid-19 stimulus packages 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.

How to Invest During 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. If investors can hang on to their stocks for the long run, they have a good chance of yielding a return. Selling when stocks are down ensures that investors lock in their losses and means they will miss out on gains when markets rebound.

The Takeaway

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 recessions 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, an investor is often recommended to have an asset allocation in their portfolio that consists of 70% stocks and 30% bonds.

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, members have access to Certified Financial Planners, who can provide personalized insights for investors.

Download the SoFi Invest mobile app today.


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