What Is an Economic Contraction?

Economic Contractions Explained

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An economic contraction is a decline in national output as measured by gross domestic product (GDP). That includes a drop in real personal income, industrial production, and retail sales. It increases unemployment rates.

Learn more about economic contraction, how it works, and famous examples of contractions throughout the past century.

Definition and Examples of an Economic Contraction

An economic contraction happens when domestic output, such as GDP decreases. It leads to a decrease in other areas, such as individual income, production, and sales. Unemployment rates may increase.

One recent example of a major economic contraction was the one caused by the COVID-19 pandemic. As a result, the Business Cycle Dating Committee of the National Bureau of Economic Research determined:

"A peak in monthly economic activity occurred in the U.S. economy in February 2020. The peak marks the end of the expansion that began in June 2009 and the beginning of a recession. The expansion lasted 128 months, the longest in the history of U.S. business cycles dating back to 1854. The previous record was held by the business expansion that lasted for 120 months from March 1991 to March 2001."

How an Economic Contraction Works

An economic contraction is caused by a loss in confidence that slows demand. An event, like a stock market correction or crash, triggers it. But the true cause precedes the well-publicized event. For example, it may be precipitated by an increase in interest rates that decreases capital spending. 

Investors sell stocks, sending prices downward and reducing financing for large corporations. Businesses cut spending, then lay off workers. That dries up consumer spending, which creates further business losses and layoffs. To understand this economic downturn, one has to be aware of the causes of the business cycle, especially the causes of a recession.

A contraction ends when prices fall enough to attract renewed demand. Central bank monetary policy and government fiscal policy can end a contraction more quickly. They will lower interest rates and taxes and increase the money supply and spending. These policies are integral to a nation’s strategies for supplying the best unemployment solutions.

Notable Happenings

1920s

There were plenty of economic contractions during the "Roaring Twenties." The first contraction began in January 1920. One reason was the high maximum income tax rate of 73% on incomes more than $1 million. Nearly 70% of federal revenue came from income taxes. In 1921, Warren Harding became president. Fortunately, the recession ended in July without any intervention.

Congress increased the corporate tax rate from 10% to 12.5%. It also passed the Emergency Immigration Act to restrict the number of immigrants to 3% of the 1910 population. In 1922, Harding lowered the top tax rate to 58%. In 1923, Calvin Coolidge, a Republican, became President. His approach was to lower the top tax rate again to 43.5%. The U.S. Supreme Court revoked the minimum wage for women in Washington, D.C.

The recession began in May 1922 but ended in July 1924. Despite the contraction, the stock market began a six-year bull market. It was fueled by speculation and leverage. Coolidge raised the top tax rate to 46%, then lowered it the following year to 25%. 

Another contraction began in October 1926. It ended in November 1927, after the Federal Reserve lowered interest rates. Congress raised the corporate tax rate to 13.5%. 

1930s: The Great Depression

The Great Depression was the biggest economic contraction in U.S. history. It began in 1929, the year Herbert Hoover became president. He lowered the top income tax rate to 24%, and the top corporate tax rate to 12%.

But it was too late. The economy contracted in August, signaling the beginning of the Great Depression. In September, the stock market peaked, crashing on October 24.  

1940s

There were two recessions in the 1940s. Both were caused by adjustments in demobilizing after World War II. The government cut back production of military weapons. It took years before business production completely replaced it.  

The first recession occurred between February and October 1945 according to the National Bureau of Economic Research. That sent economic growth for the year down 1.0%. In 1946, it dropped by 11.6%. It fell by 1.1% in 1947.

The economy contracted again between November 1948 and October 1949. That time, GDP fell by just 0.6% in 1949.

1950s

In July 1953, the economy contracted for 10 months, due to the end of the Korean War. Unemployment peaked at 6.1% in September 1954. GDP contracted by 0.6% in 1954.

In August 1957, the economy contracted until April 1958. GDP fell by 0.75% in 1958.  Unemployment peaked at 7.1% in September 1958.

1960s

Starting in April 1960, the economy contracted for 10 months, but it recovered enough so that growth was 2.6% for the year. Unemployment reached a peak of 7.1% in May 1961. President Kennedy ended the recession with stimulus spending.

1970s

From November 1973, the economy contracted until March 1975, but it was relatively mild. The economy shrank by 0.5% in 1974 and by 0.2% in 1975.

President Richard Nixon fought back hard. He authorized wage-price controls, which kept prices and salaries too high. Consumers cut back on demand. Businesses laid off workers. Second, Nixon removed the United States dollar from the gold standard, which created inflation. The price of gold skyrocketed to $120 per ounce, and the dollar's value plummeted. His destructive policies created stagflation and three consecutive quarters of contraction

1980s

The 1980 recession was the third-worst economic contraction in U.S. history. It was tough to beat, because there was also double-digit inflation. A contraction with inflation is called "stagflation." That was due to President Nixon's economic policies. The Fed raised interest rates to 20% to combat inflation. That hammered business spending and created the contraction.

It began in January 1980. It seemed like it was over in six months. In 1981, President Ronald Reagan took office. The Fed began lowering interest rates since inflation was at normal levels. But the contraction returned in July 1981 and lasted until November 1982. The economy contracted for six of the 12 quarters. That sent GDP down 0.3% in 1980 and 1.8% in 1982.

Unemployment increased to a record 10.8% in November 1982. It stayed above 10% for 10 months.  

Reagan lowered the top income tax rate from 70% to 28%. He also reduced the corporate tax rate from 48% to 34%. Although he promised to reduce government spending, he doubled spending instead. His expansionary fiscal policies ended the recession.

1990s

From July 1990, the economy contracted until March 1991. It was caused by the Savings and Loan Crisis in 1989. Overall, the U.S. GDP shrank by 0.1% in 1991.

2000s

In the 2001 recession, the economy contracted until November 2001. The Y2K scare caused it by driving demand for computer equipment. That created a boom and subsequent bust. It was aggravated by the 9/11 attack. The economy contracted in two quarters: Q1 by -1.1% and Q3 by -1.7%.

In 2008, the Great Recession was the worst U.S. contraction since the Great Depression. The economy shrank by 0.1% in 2008 and by 2.5% in 2009. Once The Great Recession ended, an expansion began that lasted 128 months, the longest in the history of U.S. business cycles dating back to 1854, ending with the COVID-19 crisis in spring 2020. Markets then rebounded from the initial COVID crash, reaching new highs into the summer of 2021.

Key Takeaways

  • An economic contraction is a decline in economic output. It's accompanied by falling incomes and rising unemployment.
  • An economic contraction is caused by a loss in confidence that slows demand and is often triggered by an event. But the true cause precedes the well-publicized event.
  • One recent example of a major economic contraction was the one caused by the COVID-19 pandemic, though there have been many over the past century.
  • A contraction ends when prices fall enough to attract renewed demand.