A recession is defined as when the national economy declines for two consecutive quarters, or six straight months. Recessions are officially declared in the US by a committee of experts at the National Bureau of Economic Research (NBER), a non-profit research entity that performs and disseminates neutral economic research for public policymakers, academic institutions, and the private sector.
A recession is reasonably short, lasting on average 18 months. It should not be confused with a depression, which is a severe economic downturn that can take several years.
That said, the pain is real, and the negative effects can linger for a long time, though there are still some positive effects.
During a recession, unproductive and incompetent firms will close their doors and shut down, unable to sustain their businesses from economic shock. The productive and competent organizations will take over these assets and become more industrious in the long term.
A common trend following a recession is the boom in self-employment and the rise of new businesses. Because the price of assets – valuable things, like houses – will usually fall during a downturn, it makes it easier for entrepreneurs to start businesses.
Recessions will lower inflation (the increase in the money supply) and price inflation (the rise in the cost of goods and services), making life more affordable for those who are fortunate enough to keep a job. The Federal Reserve is required to strike a balance between preventing inflation and slowing the economy without igniting a recession.
Unemployment is the biggest negative effect of a recession. In addition to losing their jobs, people may have a hard time finding work and could experience long-term joblessness. This has a domino effect, particularly a financial one because the unemployed may see their savings wiped out or their credit cards maxed out just to keep a roof over their heads and food on the tables.
In any type of downturn, there will always be a decline in investment. Unfortunately, when investment falls, the damages can be in the form of lost long-term productive capacity. Of course, if a recession is over in just six months, the lost output could be made up during the boom phase. However, if the recession is prolonged, like the 2009 financial crisis, then the lost output intensifies.
For the government, a recession weighs on the public purse. In addition to a stimulus program employed by the state, policies aimed to revive growth, the government will experience a decline in tax revenues. This adds to the budget deficit, contributes to the national debt, and raises taxes in the future because the bills need to be paid somehow. To fund expenses, the state will need to borrow by selling bonds (debt) on the open market. We call this kicking the can down the road because instead of dealing with the problem now, it delays it two, 10, 20, or 30 years. But the problem must still be addressed, and the longer it takes the more it costs.
Are They Inevitable?
You routinely hear that the market is due for a recession and that prolonged downturns are effects of a free market economy. This has been prevalent for the last few months. But it doesn’t work this way; an economy just doesn’t suddenly say, “Humph. You know what? I need a recession!” There are many factors at play, such as investors misreading market signals, changing consumer demands, market distortions by the Federal Reserve, and unwise public policy (trade or taxes). An economy is never due for a recession, but the boom could happen at any time – as well as the bust.