Causes of an Economic Recession

Bursting the economic bubble causes recession
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 Illustration by Alashi/Getty Images

Economic recessions are caused by a loss of business and consumer confidence. As confidence recedes, so does demand. A recession is a tipping point in the business cycle when ongoing economic growth peaks, reverses, and becomes ongoing economic contraction.

12 Causes of a Recession

A decline in the gross domestic product growth is often listed as a cause of a recession, but it's more of a warning signal that a recession is already underway. That's because GDP is only reported after a quarter is over. By the time GDP has turned negative, the recession is probably already been underway for a couple months.

To qualify as an official recession, an economic dip, as measured as a decline in GDP, must occur for two or more successive quarters.

Loss of Confidence in Investment and the Economy

Loss of confidence leads consumers stop buying and move into defensive mode. Once a critical mass moves toward the exit sign, panic sets in. Retail sales slow. Businesses run fewer employment ads, and the economy adds fewer jobs. Manufacturers cut back in reaction to falling orders—the unemployment rate rises. To restore confidence, the federal government and the central bank must step in.

High Interest Rates

When interest rates rise, they limit liquidity, which is money available to invest. In the past the biggest culprit was the Federal Reserve, which often raised interest rates to protect the value of the dollar. For example, the Fed raised rates to battle the stagflation of the late 1970s, which caused the 1980 recession. 

Decades previously the Fed did the same thing to protect the dollar/gold relationship, worsening the Great Depression.

A Stock Market Crash

The sudden loss of confidence in investing can create a subsequent bear market, draining capital out of businesses.

Falling Housing Prices and Sales

As homeowners lose equity, they may be forced to cut back spending as they can no longer take out second mortgages. This was the initial trigger that set off the Great Recession. Eventually, banks lost money on complicated investments that were based on underlying home values, which were in decline.

Manufacturing Orders Slow Down

One predictor of a recession is a decline in manufacturing orders. Orders for durable goods started falling in October 2006, long before the 2008 recession hit.

Deregulation

Lawmakers can trigger a recession by removing important safeguards. The seeds of the S&L crisis and subsequent recession were planted in 1982 when the Garn-St. Germain Depository Institutions Act was passed. This removed restrictions on loan-to-value ratios for these banks.

Poor Management

Bad business practices often cause recessions. The Savings and Loans Crisis caused the 1990 recession. More than 1,000 banks, with total assets of $500 billion, failed as a result of land flips, questionable loans, and illegal activities. 

Wage-Price controls

Fortunately, this only happened once. In 1971, President Richard Nixon froze wages and prices to stop inflation. But employers laid-off workers because they weren't allowed to lower wages. Demand fell since families had lower incomes. Companies couldn't reduce prices, so they laid off still more workers, causing the 1973 recession.

Post-War Slow Downs

The economy slowed down after the Korean War. This caused the 1953 recession. Similar reductions after World War II caused the 1945 recession.

Credit Crunches

This occurred in 2008 when Bear Stearns announced losses thanks to the collapse of two hedge funds it owned. The funds were heavily invested in collateralized debt obligations. When Moody's downgraded its debt, banks which were in a similar over-invested condition panicked. They stopped lending to each other, creating a massive credit crunch.

When Asset Bubbles Burst

Asset bubbles occur when the price of an item such as gold, stocks, or housing become inflated beyond their sustainable value. The bubble itself sets the stage for a recession to occur when it bursts.

Deflation

Prices falling over time have have a worse effect on the economy than inflation. Deflation reduces the value of goods and services being sold on the market. That encourages people to wait to buy until prices are lower. Demand falls, causing a recession. Deflation caused by trade wars aggravated the Great Depression.

Causes of the 2008 Recession

Irrational exuberance in the housing market led many people to buy houses they couldn't afford. Everyone thought housing prices could only go up. Low-interest rates in 2004 and 2005 helped create the housing bubble. Many buyers bought homes they couldn't afford thanks to interest-only loans.

In 2006, the bubble burst as housing prices started to decline. The decline caught many homeowners off guard, who had taken loans with little money down. As they realized they would lose money by selling the house for less than their mortgage, they foreclosed. An escalating foreclosure rate panicked many banks and hedge funds. They had bought mortgage-backed securities on the secondary market, and we're facing huge losses.

By August 2007, banks had become afraid to lend to each other because they didn't want toxic mortgage loans as collateral. Eventually the credit crunch led to the $700 billion bailout, bankruptcies, and government nationalization of Bear Stearns, the American International Group Inc, Fannie Mae, Freddie Mac, IndyMac Bank, and Washington Mutual. By December 2008, employment was declining faster than in the 2001 recession.

In 2009, the government launched an economic stimulus plan. It was designed to spend $185 billion in 2009. And in fact, it halted a four-quarter decline in GDP by the third quarter of 2009, thus ending the recession.  But, unemployment continued to rise to 10%, and many business leaders still expected a "W" shaped recession by the end of 2010. High unemployment rates still persisted into 2011.

What Will Cause the Next Recession?

It's hard to say exactly when, how, and why the next recession will occur. It may be some combination of the factors outlined above. Or it might be something totally unexpected, like a supply shock in energy or finance, or a political crisis that negatively effects consumption and demand.

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