Recession: Definition, Causes, Examples and FAQs

What Is a Recession?

A recession is a significant, widespread, and prolonged downturn in economic activity. A common rule of thumb is that two consecutive quarters of negative gross domestic product (GDP) growth indicate a recession. However, more complex formulas are also used to determine recessions.

Economists at the National Bureau of Economic Research (NBER) measure recessions by looking at nonfarm payrolls, industrial production, and retail sales, among other indicators. NBER also points out that there is “no fixed rule about what measures contribute information to the process or how they are weighted in our decisions.”

A downturn must be deep, pervasive, and lasting to qualify as a recession by NBER's definition. Since some of these qualities may not be evident when a downturn first begins, many recessions are called retroactively.

Understanding Recessions

Since the Industrial Revolution, most economies have grown steadily, seeing few economic contractions. However, recessions are still common. Between 1960 and 2007, there were 122 recessions affecting 21 advanced economies, according to the International Monetary Fund (IMF). In recent years, recessions have become less frequent and shorter in duration.

Declines in economic output and employment that recessions cause can become self-perpetuating. For example, declining consumer demand can prompt companies to lay off staff, which affects consumer spending power, and can further weaken consumer demand.

Similarly, the bear markets that often accompany recessions can reverse the wealth effect, suddenly making people less wealthy and further trimming consumption.

Since the Great Depression, governments around the world have adopted fiscal and monetary policies to prevent a run-of-the-mill recession from becoming far worse. Some of these stabilizing factors are automatic, such as unemployment insurance that puts money into the pockets of employees who lose their jobs. Other measures require specific actions, such as cutting interest rates to stimulate investment.

Recessions are most clearly identified after they are over. Additionally, investors, economists, and employees may have very different experiences in terms of when a recession is at its worst.

Equities markets often decline before an economic downturn, so investors may assume a recession has begun as investment losses accumulate and corporate earnings decline, even if other measures of recession remain healthy, such as consumer spending and unemployment.

Conversely, since unemployment often remains high long after the economy hits bottom, workers may perceive a recession as continuing for months or even years after economic activity recovers.

What Predicts a Recession?

While there is no single, sure-fire predictor of a recession, an inverted yield curve has preceded each of the 10 U.S. recessions since 1955. That being said, not every period of inverted yield curve was followed by a recession.

When the yield curve is normal, short-term yields are lower than long term yields. This is because longer-term debt has more duration risk. For example, a 10-year bond usually yields more than a 2-year bond as the investor is taking a risk that future inflation or higher interest rates could lower the bond's value before it can be redeemed. So, in this case the yield goes up over time, creating an upward yield curve.

The yield curve inverts if yields on longer-dated bonds go down while yields on shorter-term bonds go up. The rise of near-term interest rates can tip the economy into a recession. The reason why the yield on long-term bonds drops below that on short-term bonds is because traders anticipate near-term economic weakness leading to eventual interest rate cuts.

Investors also look at a variety of leading indicators to predict recession. These include the ISM Purchasing Managers Index, the Conference Board Leading Economic Index, and the OECD Composite Leading Indicator.

What Causes Recessions?

Numerous economic theories attempt to explain why and how an economy goes into recession. These theories can be broadly categorized as economic, financial, psychological, or a combination of these factors.

Some economists focus on economic changes, including structural shifts in industries, as most important. For example, a sharp, sustained surge in oil prices can raise costs across the economy, leading to recession.

Some theories say financial factors cause recessions. These theories focus on credit growth and the accumulation of financial risks during good economic times, the contraction of credit and money supply when recession starts, or both. Monetarism, which says recessions are caused by insufficient growth in money supply, is a good example of this type of theory.

Other theories focus on psychological factors, such as over-exuberance during economic booms and deep pessimism during downturns to explain why recessions occur and persist. Keynesian economics focuses on the psychological and economic factors that can reinforce and prolong recessions. The concept of a Minsky Moment, named for economist Hyman Minsky, combines the two to explain how bull-market euphoria can encourage unsustainable speculation.

Recessions and Depressions

According to NBER, the U.S. has experienced 34 recessions since 1854, but only five since 1980. The downturn following the 2008 global financial crisis and the double-dip slumps of the early 1980s were the worst since the Great Depression and the 1937-38 recession.

Routine recessions can cause the GDP to decline 2%, while severe ones might set an economy back 5%, according to the IMF. A depression is a particularly deep and long-lasting recession, though there is no commonly accepted formula to define one.

During the Great Depression, U.S. economic output fell 33%, stocks plunged 80%, and unemployment hit 25%. During the 1937-38 recession, real GDP fell 10% while unemployment jumped to 20%.

Recent Recessions

The COVID-19 pandemic and the public health restrictions imposed to stop it are an example of economic shocks that can cause a recession. The depth and widespread nature of the economic downturn caused by the COVID-19 pandemic in 2020 led the NBER to designate it a recession despite its relatively brief two-month length.

In 2022, many economic analysts debated whether the U.S. economy was in recession or not, given conflicting economic indicators.

Analysts with investment advisory firm Raymond James argued in an October 2022 report that the U.S. economy was not in recession. Despite the fact that the economy met the technical definition of recession after two consecutive quarters of negative growth, numerous other positive economic indicators showed that the economy was not in recession, the report argued.

It cited the fact that employment continued to increase even as GDP contracted. The report further pointed out that although real personal disposable income declined in 2022, much of the decline was a result of the end of the COVID-19 relief stimulus, and that personal income excluding these payments continued to rise.

Data from the The Federal Reserve Bank of St Louis as of late October 2022 similarly showed that key NBER indicators did not point to the U.S. economy being in recession.

On February 6, 2023, Janet Yellen, U.S. Treasury Secretary, indicated she was not worried about a recession. "You don't have a recession when you have 500,000 jobs and the lowest unemployment rate in more than 50 years," she said to Good Morning America.

The Bottom Line

A recession is a significant, widespread, and prolonged downturn in economic activity. Recessions are commonly characterized by two consecutive quarters of negative gross domestic product (GDP) growth, though there are more complex ways to assess and classify downturns.

The unemployment rate is a key recession indicator. As demand for goods and services falls, companies need fewer workers and may lay off staff to cut costs. Laid off staff then have to cut their own spending, which in turn hurts demand, which can lead to more layoffs.

Since the Great Depression, governments around the world have adopted fiscal and monetary policies to prevent recessions from deepening into depressions, such as unemployment insurance or cutting interest rates.