To understand what a recession is, it is essential to know what GDP measures. The Gross Domestic Product (GDP) measures how large a country’s economy is by valuing the total sales price of all its economic activity in a year. The sales price of all the trucks sold? That is in there. So are all the cheeseburgers sold in a year and the value of plumbing services, thumbtacks, and heart surgeries. Add up all the things purchased in an economy in a calendar year and you get that country’s GDP. The GDP of the United States in 2018 was $20.4 trillion, which is a large number. But in fact, it has grown from only $2.5 trillion forty years ago.
The GDP of the United States, the total value of its business output in a year, is typically in a state of growth. The population of the U.S. grows every year due to new babies born and immigration inflows. There are more people every year to work for money and buy things, and this causes the economy to grow and prosper. But there are periodic episodes where the economy does not in fact grow but shrinks slightly. These periods are called recessions. A recession is a period in which the economy declines significantly for at least six months. Usually during recessions there is a drop in five very important economic measures, which are GDP, income, employment, manufacturing, and retail sales.
The minimal period of economic decline needed to be called a recession is at least two financial quarters of negative economic growth. Typically, a recession lasts from between six and eighteen months, and these short periods are a normal part of the business cycle. Every normal business cycle has a beginning and an end. But recessions can be times of great economic strife. That’s because usually a slowdown in business activity causes worker job losses, a decline in consumer confidence, and a decline in business profits.
Economic expansions over the past forty years have averaged five to seven years, followed by periods of recessions of between two and four quarters. Periods of economic expansions typically last far longer than periods of recessions; although recessions do cause much consumer and business angst due to the negative economic effects on the health of the economy in a downturn.
When a recession is evident, the Federal Reserve will usually reduce the level of interest rates to spur economic activity. Lower rates on home mortgages and auto loans tend to increase demand for these large ticket items and may help the economy recover. The Federal Reserve can also inject money into the economy by purchasing government bonds from the open market. The government buys the bond, and the seller of the bond receives funds that he then invests elsewhere in other assets or loans.
Politicians in Congress can also help spur an economic recovery by lowering tax rates for both consumers and businesses. This gives them more money to spend. Congress can also increase spending on social programs to help workers who have lost their jobs. This type of fiscal stimulus also injects money into the economy and helps folks that are financially hurting due to the recession.
A recession can begin for many reasons, but a recession does not start just because the economy has been expanding for a long period of time. Things that have caused previous recessions include a large increase in energy prices, the Y2K spending binge that pulled forward years of technology spending into two years, and a mania in the housing market that caused demand and prices to rise far too sharply, which resulted in a crash of that housing market.
Recessions in the past were much more common prior to the creation of the Federal Reserve system. There was no government backstop during times of economic strife nor monetary policymaker that controlled the money supply for the government. This frequently led to chaos and financial panics.
The ebbs and flows of our economic cycle usually cause many investors to anticipate and worry about the next economic slowdown. Although it may seem like there is risk and volatility in today’s economic cycles, a little historical perspective could make us much more comfortable with the current state of economic affairs. This is especially true when we compare the previous two-hundred years of economic expansion and decline. The economy in the past was far more volatile than it is now
During the period of 1870 to 1910, the United States economy was in a state of recession 50 percent of the time, and the average length of economic expansions was a short twenty-five months. The depths of the resulting recessions were also deep. An average decline in GDP was 3.7 percent. Boom and bust cycles were common. With no government financial backstop or monetary authority or plan, there was the need for private lenders such as J.P. Morgan himself to step in and loan the government funds to head off full-scale panics.
With the adoption of the Federal Reserve in 1913 and its assumption of control of United States monetary policy, our economy became more stable and less prone to shocks. However, from the period of 1910-1980, the economy was still in a state of recession 26 percent of the time, with short average economic growth periods of just 44 months, and average recession GDP declines of 4.3 percent.
Only in the more recent era of economic policy in the United States, from 1980 to 2018, have we seen recession periods that are much shorter than in the past, at only 8 percent of the time, with longer economic expansions averaging 101 months and lower GDP declines during recessions of 2.1 percent.
With the creation of the Federal Reserve, this powerful government body became the lender of last resort in economic crises, and its influence helped to curtail risks of large-scale financial panics before they began. A major factor for the smoothing of the economic growth cycles over time has been the Federal Reserve’s responsibility for a dual mandate of price stability and full employment. The transparent economic policies and the focus on a stable inflation rate over the past forty years has allowed economic expansions to last longer and the succeeding recession periods to be much less severe.
In addition to the influence of the Federal Reserve, a shift in what our economy produces has also smoothed economic cycles for the better. During the 1800s, our economy was much more focused on the production and sale of hard goods. Boom and busts in the railroad, agriculture, and industrial segments were common. Our economy has now moved away from a goods economy to a services economy. Services are by nature less volatile and do not depend on raw materials pricing and availability, transportation of products, or inventory management. This shift from goods to services has greatly moderated our economic volatility.
While we may fear the ups and downs in our economy with the resulting harmful effects on GDP growth and unemployment, our economy and its growth and decline cycles are far healthier and more stable than any time in the last two-hundred years.
While recessionary periods are typically short in duration, they can be quite painful for those who lose their jobs, homes, or savings. The economy has always rebounded after a recession, however, and has recovered and gone on to new highs.
