- A Recession or Depression occurs when the economy declines either a substantial amount or for an extended period of time.
- There is commonly an identifiable trigger for the economic pullback, but it also could be caused by the timing of the economic cycle.
- A depression is simply an extended recession or a combination of multiple recessions within a short time frame.
What Is a Recession and Why Are Analysts Talking About It Now?
We believe there have been more and more rumors of a potential economic recession coming for the United States. A recession is when the economy experiences a slowdown in an array of data or indicators, such as production or employment.
We recently posted a blog detailing how rate of change can be used in economic analysis. This concept is helpful in understanding the economic cycle. Please check it out if you haven’t yet!
The Economic Cycle: Peaks, Troughs, and Recessionary Risks
Essentially, we have seen that the economy follows a rollercoaster-type pattern. It is a series of ups and downs that create peaks and troughs over time. The recession/depression risk occurs when the economy makes a cycle top and then heads down towards the cycle bottom. Not every top-to-bottom move causes the economy to enter a recession or depression, though.
This economic cycle and the rate of change data allow investors to understand when the risk is becoming larger or smaller and allows analysts to adjust their forecasts for the future.
How Do Economists Define a Recession?
So what are the requirements for a recession then? Unfortunately, the answer is not very clear since every analyst or economist has their own opinion as to what constitutes a recessionary or depressionary environment.
We believe it is much easier to identify these instances in the rearview mirror and much harder for people to identify before or during the slowdown.
Negative GDP Growth and Consumer Spending
However, we believe there are a handful of common agreed-upon characteristics. The most common rule of thumb is that a recession occurs when the economy experiences two-quarters of negative GDP growth.This means country-wide growth needs to be heading backward for two consecutive quarters, which would equate to a reduction in the amount of goods/services sold within the economy.
A component of this could be the nation’s trade surplus and deficit and the rate of change of international trade. A trade surplus occurs when a country exports more than it imports, and a deficit occurs when a country imports more than it exports.
The Role of Trade Deficits, Inflation, and Unemployment
You may be able to tell a country is struggling when it manages to go from a surplus to a deficit or from a larger to smaller surplus or a smaller to larger deficit.
The consumer is another potential factor of a recession since the economic slowdown will be visible on the household level. A slowdown in consumer spending may mean that the average household is spending less because they either have less money or their purchasing power has declined due to a weak currency or high inflation.
If consumers are not able to spend as much as they used to, this could hurt corporations and the overall economy. Unfortunately, a company may consider reducing its workforce if it is struggling to generate a profit.
Unemployment is another potential factor in a recession since a strong economy requires more workers, while a weak economy will cause layoffs and hiring freezes. This can potentially create a vicious cycle as consumer spending slows, companies make less, and they lay off some staff, so consumer spending decreases even further, and the cycle continues until an economic bottom is formed.
Triggers Behind a Recession or Depression
A trigger typically causes a recession or depression, but the underlying economic setup is usually visible in hindsight.
For example, the great financial crisis was caused by the collapse of the housing bubble that was created/triggered by large Wall Street firms.
Up until the collapse, the economy was roaring and nobody was concerned about what could potentially happen next.
It wasn’t until consumer debt reached unimaginable levels, investors were buying into mortgage backed securities heavily, then homeowners couldn’t make their payments and the entire system collapsed like a domino effect.
The busting of the bubble caused the recession, but the economy was peaking before that point.
It is not common for a recession to occur in an economy that is already experiencing slow growth. It’s not impossible for a recession to develop on its own during the economic cycle, but typically there is an underlying catalyst that causes the ordinary slowdown to become the extraordinary.
The Difference Between a Recession and a Depression
The difference between a recession and a depression can be hard to see in real-time. It is not until after the slowdown that the difference may become clear to economists.
A Depression is simply a recession that occurs for a longer period of time and is usually to a greater extent as well.
The U.S. economy has actually only experienced a single depression and this was the Great Depression of the early 1940’s. (money.com.)
In fact, many would argue this depression was just two recessions that occurred within a short time frame.
A Depression is normally expected to last for more than a year or two, and a recession is a temporary slowdown in the economy. Both are bad for the nation and the citizens, but depression can be much worse with much longer lingering effects afterward.
Speak With a Trusted Advisor
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Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Best Regards,
Sincerely,
Zachary A. Bachner, CFP®
with contributions from Robert Wink, Kenneth Wink, James Wink, James Baldwin
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