Recessions: Causes and government interventions

In most countries, most of the time, the economy expands, propelled by population growth and productivity improvements. However, from time to time, the economy enters recession. Recessions have many negative consequences for households, businesses, and markets.

There is no single definition of a recession. A recession is often defined as at least two consecutive quarters of negative growth in real GDP, but this is not universally accepted.

National Bureau of Economic Research (NBER)

In the US, the NBER is responsible for maintaining a chronology of business cycles. The NBER effectively decides when US recessions begin and end.

It defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

Therefore, the NBER does not focus exclusively on real GDP, but combines GDP data with other data to identify recessions.

Center for Economic Policy Research (CEPR)

In the euro area, the CEPR is responsible for setting the dates of business cycles. The CEPR has adapted the NBER definition to reflect the specific features of the euro area.

It defines a recession as “a significant decline in the level of economic activity, spread across the economy of the euro area, usually visible in two or more consecutive quarters of negative growth in GDP, employment and other measures of aggregate economic activity for the euro area as a whole, and reflecting similar developments in most countries.”

In other words, the CEPR looks for signs of slowdowns across the euro area as well as within the countries that make up the euro area in order to identify periods of recession.

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Impact of recessions

Recessions are painful. People lose their jobs and households struggle to earn enough income to afford the goods and services they need. Crime increases and rates of mental illness rise. Markets typically suffer, and asset prices may fall, eroding wealth. Because recessions are harmful for society, governments are widely expected to intervene to shorten or end them.

It is therefore important to understand why recessions happen. If the government understands what is causing a recession, it can make the correct decisions about what policies to enact to counter it. Understanding what causes recessions will also help market observers to predict when a recession is likely and adjust their portfolios accordingly.

What causes recessions?

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Over the long-term, economic growth is driven by productivity improvements and population growth.

In the short-term, however, the economy can contract despite growth in these areas.

For example, during the Great Depression, between 1929 and 1933, US GDP fell by 30 percent.

However, the population did not decline during this period, nor did any productivity-enhancing technologies disappear.

In theory, the US was capable of producing the same amount of goods and services in 1933 as it was in 1929. Yet real output shrank by nearly a third and unemployment hit 25 percent.

Economists have developed various theories to explain why economies experience such contractions.

Demand-side economists argue that, in the short term, changes in demand can affect the supply of goods and services.

For example, if house prices fall, people may feel less wealthy and they may spend less, causing demand to fall.

Lower demand means that companies will sell less, causing them to lower production and cut jobs. This reduces income, which further lowers demand. The result is a recession.

Recessions may also be driven by short-term supply upheavals.

For example, oil prices may rise unexpectedly. This affects the supply of goods and services because companies’ costs rise; and higher costs discourage production by lowering profits.

Lower production means job cuts and less money for suppliers. This lowers income in the economy and thus reduces demand. The result is a recession.

Recessions and government policy

Recessions have a powerful, negative impact on society. Therefore, when recessions strike, governments do not wait for the economy to return naturally to its growth path.

Instead, depending on the specific cause of the recession, governments attempt to use policy to increase demand or support supply.

• Interest rates: The government may lower interest rates to increase the availability of credit and encourage borrowing and investment.
• Taxes: The government may cut tax rates to increase disposable income and stimulate consumption spending.
• Spending: The government may increase its spending to raise aggregate demand directly – this spending is typically financed by the issuing of government debt.

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Macroeconomic developments can have far-reaching effects on financial markets. Changes in monetary policy, inflation, economic growth, and employment levels can impact asset pricing and the broader outlook for capital markets.

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