11 Causes of Economic Recession

When the Asset Bubble Bursts, a Recession Typically Follows

Illustration of hand with needle popping a balloon with a dollar sign representing economic recessions.
••• Katie Edwards / Getty Images

Economic recessions are caused by a loss of business and consumer confidence. As confidence recedes, so does demand. This is the tipping point in the business cycle. It's where the peak, accompanied by irrational exuberance, moves into contraction.

This loss of confidence makes 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.

A decline in the gross domestic product growth is a sign that a recession may be underway, but it's not the cause. GDP is only reported after the quarter is over. By the time GDP has turned negative, the recession may already be underway.

You want to identify the causes and signs of a recession before it occurs. Here are some important causes of recession:

  1. High-interest rates. When rates rise, they limit liquidity. It's the amount of money available to invest. The biggest culprit was the Federal Reserve, which often raised interest rates to protect the value of the dollar. The Fed raised rates to battle stagflation, causing the 1980 recession. It did the same thing to protect the dollar/gold relationship, worsening the Great Depression.
  2. stock market crash. The sudden loss of confidence in investing can create a subsequent bear market, draining capital out of businesses. That's just one of the ways a stock market crash can cause a recession.
  1. Falling housing prices and sales. As homeowners lose equity, it forces a cutback in spending as they can no longer take out second mortgages. Over time, it will cause foreclosures. This was the initial trigger that set off the Great Recession, but for different reasons. Banks lost money on the complicated derivatives that were based on underlying home values.
  2. A slowdown in manufacturing orders. Orders for durable goods started falling in October 2006, before the 2008 recession actually hit.
  3. Massive swindles. 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. 
  1. Deregulation. The seeds of the S&L crisis 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.
  2. Wage-price controls. Fortunately, this only happened once, when President Nixon kept prices too high, cutting demand. Employers laid off workers because they weren't allowed to lower wages.
  3. Slow down after a war. This caused both the 1953 recession, following the Korean War, and the 1945 recession, following World War II.
  1. Credit crunch. This occurred 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.
  2. Asset bubbles: This is when the prices of internet companies, stocks, or houses become inflated beyond their sustainable value. The bubble itself sets the stage for a recession to occur when it bursts.
  1. Deflation, which encourages people to wait until prices are lower. This aggravated the Great Depression.

Cause 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. The Fed should have raised interest rates in 2004. Low-interest rates in 2004 and 2005 helped create the housing bubble. Irrational exuberance set in again as many investors took advantage of low rates to buy homes just to resell. Others bought homes they couldn't afford thanks to interest-only loans.

In 2006, the bubble burst as housing prices started to decline. This 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 now we're facing huge losses.

By August 2007, banks became afraid to lend to each other because they didn't want these toxic loans as collateral. This led to the $700 billion bailout, bankruptcies, and government nationalization of Bear Stearns, the American International Group IncFannie 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 percent and many business leaders still expected a W-shaped recession by the end of 2010. High unemployment rates still persisted into 2011.

Causes of the 2001 Recession

Irrational exuberance in high tech caused the 2001 recession. In 1999, there was an economic boom in computer and software sales caused by the Y2K scare. Many companies and individuals bought new computer systems to make sure their software was Y2K compliant. This meant that the operating code would be able to understand the difference between 2000 and 1900. Many fields within that code only had two spaces, not the four needed to fully differentiate the two dates. As a result, the stock price of many high-tech companies started to increase.

This led to a lot of investors' money going to any kind of high tech company, whether they were showing profits or not. The exuberance for dot-com companies became irrational.

It became apparent in January 2000 that computer orders were going to decline. The shelf life of most computers is about two years. Companies had just bought all the equipment they would need. This led to a stock market sell-off in March 2000. As stock prices declined, so did the value of the dot-com companies and many went bankrupt.

In spite of the stock market decline in March 2000, the Federal Reserve continued raising interest rates to a high of 6.25 percent in May 2000. The Fed didn't start lowering rates until January 2001. It lowered them a half a point each month, resting at 1.75 percent in December 2001. This kept interest rates high when the economy needed low rates for cheap business loans and mortgages.

What Will Cause the Next Recession

It's hard to say exactly where the next recession would occur. But you can bet it will be some combination of low-interest rates that creates irrational exuberance on the part of investors. If the Fed raises rates too soon or too fast, it will pop the bubble, leading to panic and causing a recession.