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- A recession is when the economy shrinks, but it differs in severity, duration, and scale from a depression.
- A recession is a decline in economic activity spread across the economy that lasts over a few months.
- Depression is a more extreme economic downturn, and there has only been one in US history.
Economic downturns are a lousy time for everyone. You may be worried about losing your job and being able to pay your bills — or you may be alarmed at just how abruptly that little red line that represents your investment portfolio has dropped.
A depression is a more severe, long-lasting recession that extends beyond the confines of a single country's border and into the economies of other nations.
To help you better understand the business cycle and prepare for the twists and turns of a possible recession, here's what you need to know and the best ways to prepare your investment portfolio.
Understanding a recession
Defining a recession
A recession can be defined as a time during which the economy shrinks, businesses make less money and the unemployment rate goes up. Never ending increases in GDP do not characterize the business cycle.
The technical definition of a recession is "a significant decline in economic activity that is spread across the economy and that lasts more than a few months," according to the National Bureau of Economic Research (NBER), a nonprofit organization that officially declares U.S. recessions and expansions.
Over the course of a business cycle, you might see GDP contract for a period of time, but that doesn't necessarily mean that there's a recession.
Characteristics of a recession
The NBER defines the following recession indicators:
- Decline in real GDP
- Decline in real income
- Rise in unemployment
- Slowed industrial production and retail sales
- Lack of consumer spending
The NBER's view of recessions takes a more holistic outlook of the economy, meaning recessions are not necessarily defined by one single factor. But many of these factors are intertwined, meaning a significant drop in something like GDP could rattle consumer spending or unemployment.
Lifespan of a recession
According to figures provided by the International Monetary Fund (IMF), recessions frequently last about a year. During these times, many economic indicators experience notable declines.
Investment and production both decline. Consumption also declines, reducing the overall demand for goods and services created by corporations. This, in turn, can reduce profitability and motivate companies to lay off employees to ensure their bottom line remains healthy.
It is worth noting that while recessions frequently last about a year, expansions generally last longer, as the economy is usually growing, according to the IMF.
Causes of a recession
Generally speaking, expansion and growth in an economy cannot last forever. A significant decline in economic activity is usually triggered by a complex, interconnected combination of factors, including:
Economic shocks
An economic shock is an unpredictable event that causes widespread economic disruption, such as a natural disaster or a terrorist attack. The most recent example of such a shock was the COVID-19 outbreak, which triggered a brief recession.
Another example of an event that served as a shock to the economy was Hurricane Katrina. One estimate was that this natural disaster caused $200 billion worth of damage, according to figures from the U.S. Bureau of Labor Statistics.
High interest rates
High interest rates make it more expensive for consumers to borrow money. This means that they are less likely to spend, especially on major purchases like houses or cars. Companies will probably reduce their spending and growth plans as well because the cost of financing is too high.
Asset bubbles
During an asset bubble, for example, a housing bubble, the prices of investments like tech stocks in the dot-com era or real estate before the Great Recession rise rapidly, far beyond their fundamentals. These high prices are supported only by artificially inflated demand caused by overly optimistic expectations of future asset values. This artificially inflated demand eventually dissipates, and the bubble bursts.
At this point, people lose money, and confidence collapses. Both consumers and businesses cut down on spending, and the economy goes into recession.
Loss of confidence
The sentiment of consumers has a substantial impact on the economy. Consumer spending accounts for close to 70% of U.S. GDP, so when these individuals tighten up their purse strings, it can tip the economy into recession. Even if this change in mindset is not enough to trigger a recession, a drop in consumer demand gives companies less incentive to produce goods and services, which can in turn motivate them to lay off employees in order to maintain profitability.
It is worth noting that the confidence of business executives, as well as other key decision makers in corporations, has a substantial impact on the health of the economy. If these decision makers become less confident, then they could cut budgets, laying off workers and potentially reducing expenditure on capital equipment in an effort to bolster profitability.
Recessions and the business cycle
To understand the macroeconomic variables that constitute recessions, Giacomo Santalego, PhD, a senior lecturer of economics at Fordham University, says it's important to acknowledge the relationship between recessions and the business cycle.
A business cycle tracks the up-and-down fluctuations natural to any capitalistic economies. Because the cycle traces the wide-ranging upward and downward movements of economic indicators, it is often a focal point for monetary and fiscal policy as governments attempt to curtail the effects of these peaks and valleys.
Phases of the business cycle
Business cycles are understood as having four distinct phases:
- Expansion: This phase represents a period of economic growth, also considered the "normal" phase of the business cycle. It is often characterized by an increase in employment and a swelling of consumer spending and demand, which leads to an increase in the production and cost of goods and services.
- Peak: The highest point of a business cycle that signifies when an economy has reached its crest of output. Here, there's nowhere to go but down, sending the economy into a contraction phase. This can happen for any number of reasons, either investors get too speculative and create an asset bubble or industrial production starts outpacing demand. This is commonly seen as the turning point into the contraction phase.
- Contraction: A period that is marked by a decline in economic activity often identified by a rise in unemployment as well as a bear market. Additionally, GDP growth falls under 2%. As growth contracts, the economy enters a recession.
- Trough: A peak is to an expansion what a trough is to a contraction. A trough marks the bottom of a business cycle's economic activity and marks the start of a new wave of expansion and a new business cycle. This is a turning point that's followed by a new wave of expansion.
It's important to note that business cycles do not occur at predictable intervals. Instead, they are irregular in length, and their severity is reflected by the economic variables of the time. That said, the average post-World War II business cycle lasted 65 months, according to the Congressional Research Service.
Differences between a recession and a depression
What is a depression?
An economic depression is typically understood as an extreme downturn in economic activity lasting several years, but the exact definition and specifications of a depression are less clear.
"The way people think about it is a depression is a more widespread and severe recession," says Laura Ullrich, senior regional economist with the Federal Reserve Bank of Richmond, says, "but there is no clear-cut moment where we can say 'we hit X unemployment rate or Y GDP growth — we're now officially in a depression.'"
The NBER notes that economists differ on the period of time that designates a depression. Some experts believe a depression lasts only when economic activity is declining, while the more common understanding is that a depression extends until economic activity has returned to close to normal levels.
Recession vs. depression
A depression is a more severe recession. However, it's a little tricky to concretely, quantifiably describe the difference between a recession and a depression, mainly because there's only been one.
Because economists do not have a set definition for what constitutes a depression, the general public sometimes uses it interchangeably with the term recession. However, the difference makes itself evident when you compare the Great Recession to the Great Depression.
Generally speaking, a depression lasts years rather than months and typically causes higher unemployment rates and a sharper decline in GDP. While a recession is often limited to a single country, a depression is usually severe enough to have global impacts.
Consequences of a recession
Job losses
One major consequence of economic downturns is job losses. When the economy starts to contract, revenues decline, which gives companies substantial incentive to lay off employees to turn a profit.
A perfect example of how a downturn can cause employers to eliminate jobs is the recession that coincided with the COVID-19 pandemic. The global pandemic began in early 2020, and during March, April and May of that year, the nation's employers shed 1.5 million jobs, according to figures from the Bureau of Labor Statistics.
Further, economic downturns result in reduced tax revenue, which can prompt governments to lay off workers. Many state governments, in particular, must balance their budgets each year, which can cause them to slash jobs.
Reduced income
Economic downturns can lower residents' income by eliminating jobs and lowering wages. In addition, companies reduce investment in capital equipment during recessions, which lowers productivity. This can, in turn, adversely impact wages.
Lowered incomes can significantly impact the economy in the long term, for example, undermining nutrition and making it more difficult for people to pursue a college education. Both of these adverse effects can impact productivity in the long run.
Difficulty finding work
One very noticeable impact of an economic downturn is a tighter labor market. When the economy goes into recession, many jobs will be eliminated, both in the public and private sectors. This can increase the number of applicants for every available position, resulting in a highly competitive labor market.
This increased competition for jobs can undermine employees' power to demand adequate compensation, which can, in turn, place downward pressure on salaries and wages.
Declining investments
One common challenge that investors encounter during economic downturns is the impact that falling asset values can have on their net worth. When the economy goes into recession, the value of assets held by everyday investors, for example, stocks and real estate, can decline substantially.
This can undermine the value of their retirement accounts and also the wealth they hold outside of these accounts, for example, in brokerage accounts. When investors feel less wealthy, it can make them less likely to spend, something referred to as the wealth effect. This can, in turn, contribute to further economic contraction.
Recession FAQs
The length of a recession varies, from a matter of months to multiple years. According to IMF research cited in this piece, recessions typically last a year.
Economists at the National Bureau of Economic Research (NBER) officially declare US recessions.
Yes, you can prepare for a recession by paying off debt, building up savings and also creating a diversified investment portfolio.
Governments may respond to recessions by cutting taxes or spearheading other forms of economic stimulus in order to fuel expansion.
Yes, there are different types of recessions, which can vary in terms of length and intensity. A depression, for example, is a severe recession.
