HOW RECESSIONS WORK
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How do recessions work?

It was very early in 2008 when the stock market crashed, the housing market plummeted and people started whispering about a recession. This economic plunge, which occurred mainly in the United States, affected the global economy and just days later economic stimulus packages were being distributed by news outlets in order to try and stop a recession from happening. But regardless of the different strategies that were designed, a recession occurred nonetheless, and no one was too surprised by it. This certainly wasn’t the first recession the United States had ever seen as 2001 was also a time of recession for the States and Canada spent almost all of the 1990s in a recession, which was also originally started by a stock market crash in the States in 1987.

Regardless of the cause of any recession or when it hits, it always gets people talking and asking the same sort of questions. What exactly is a recession and how is there any hope for recovery? How does a recession begin and who determines that there is in fact a recession going on? All of these are important questions and ones that need to be answered in order to grasp a better understanding of the global economy as a whole. So what exactly is a recession and how do they work? Although recessions certainly happen in countries other than the United States, it is the States that is known as an independent entity financially throughout the world and because of this, their economy is a huge factor in determining the economy of many other countries. For these reasons, we will focus on how a recession works in the United States. Although other countries may vary slightly, recessions work in generally the same way from country to country.

What is a Recession?

The actual definition of a recession may not help in understanding what one actually is, as it is very vague and could be interpreted many different ways. A recession is defined as a significant period of time in which the economy of a nation is slowing down or contracting. There are many possible reasons for such a slow-down including a drop in people’s personal incomes, leading to them spending less and buying less; a drop in production at factories, also partly due to the drop in personal income and consumers buying less; a growing unemployment rate, especially at alarming rates; and an unstable stock market.

Understanding the Economy

To understand what a recession is, you must also understand what the economy is. The economy is made up of producers and consumers. The producers make things for the consumers and the consumers purchase them. Without producers, consumers would have nothing to buy and without consumers, producers don’t have anyone to develop things for. Because of this, every single person in a country that buys things is part of the economy. They are buying something that a producer made, and therefore giving the producer reason to continue producing. And this is how they say money makes the world go round!

Understanding how markets work is also important in understanding the economy. While many may think that this mostly pertains to stock markets, there are actually several different markets that have a role in the economy. It may be easiest to understand the concept of markets by thinking of your local market. You go there when you need food and in exchange for that food, you pay them money. They are producing the food and you are consuming it. A labor market works much the same way, although it’s much more intangible. In a labor market, companies and businessmen look for workers to pay for a service. In this market, the workers are the producers, as they are producing the work, and the companies are the consumers, as they are purchasing that work. Because of this, a large percentage of consumers are producers and vice versa. You are a consumer when you go to the grocery store and you are a producer when you go to work.

Produces and consumers also make up what is known as supply-and-demand and each has a very important role to play within this process. Producers create the supply for the consumers to purchase and although they ultimately determine how much the price of their product, or supply, will be, they do this based on what they know about consumers and what they are willing to pay. If a producer makes a product but a very small percentage of consumers buy it, it is not worthwhile for the producer to continue making the product. They will then need to stop making the product or reduce the prices on it. Reducing the prices may attract more consumers and make the product more popular, making money for the producer while sometimes a product costs so much to make that if the producer can’t offer it at a lower price, they will stop making it entirely. And although producers control what the prices of their products are and what they will continue to make, they must make it reasonable for the consumer. If a producer makes very common items but charges too much for them, the consumer will easily be able to find the product from another producer at a lower price.

So what does all of this have to do with a recession? It all connects to form what is either a growing economy, which is thriving, or a contracting economy, which is headed towards, or already in a recession. How do these two different kinds of economies work?

Growing Economy vs. Contracting Economy

When an economy is thriving consumers are buying more and therefore demand is rising. This generally happens when consumers are confident in the future of the economy and therefore, feel more secure buying more things. In order to keep up with the growing demand, producers need to continuously make more products for the consumers to buy. In turn, producers need to increase their own demand from the labor market and begin to consume more labor as well as more products and services to continue making their product. The labor market can also increase the prices of their supply because the demand is so strong and therefore, people begin to get paid more.

Because people are getting paid more, they have even more money to spend on products and so the cycle continues. When a producer runs out of supply, they can begin to charge more for their supply so that the demand will decrease and if this happens too quickly, this is when inflation can occur. However the case needs to be fairly severe for this to happen. When the economy is growing although not all consumers and producers will fair well, most will and the economic outlook will be bright. It’s also in a growing economy that consumers will begin to invest in stock, which is the purchasing of a product (the stock) and keeping it with the expectation that its value will grow during that time. After the stock has grown to an amount that makes the consumer happy, they can then sell it and make money simply by buying and selling stock.

It is impossible for any economy to constantly experience growth. Eventually both supply and demand have to go down and this is when the economy will begin to contract. Although this is perfectly natural, and inevitable, for an economy to experience, it’s only when the contraction continues for a long period of time that it is considered to be in recession. Recessions, although it’s possible to overcome them, can hit particularly hard and for a particularly long time. This is when the economy will move from a recession to a depression.

While economic growth certainly spells good news for both consumers and producers, no economic growth can continue forever and no economy will ever see an eternal upswing. Just as there are reasons for economic growth, there are reasons for an economic downturn, or a contracting economy, and the steps in this process are very similar to the steps in the growth process, but they work in reverse.

Just as it does during a time of growth, contracting economies generally begin with consumers and their lack of confidence in the future of the economy. Because of this, consumers don’t feel as though the national economy is very good and so they become insecure about their own financial situation and they stop buying products. Producers in turn, have no consumers to produce their products for and so, they no longer have the need or the ability to consume from the labor market and so they begin to lay off their workers. These workers will now contribute to the unemployment problem and they will not have extra money to buy things from producers. Investors will also become uncomfortable investing in new stock and new companies because of the overall outlook of the economy and the stock market will in turn, fall or crash.

Recognizing a Recession

Although there is no one person or one factor alone that determines a country is in a recession, there are general patterns that can be looked at to determine if a nation is headed towards, or already in, a recession. The United States for example, sees a very typical pattern of economic growth and economic contractions. The economy here will typically grow for 6 – 10 years when it will then see a contraction lasting for approximately 6 months to 2 years. The time at which the recession or contraction begins is known as the peak and when it is over it is known as the trough. Once the trough is over, the economy will begin rebuilding and growing again, leading up to another cyclical contraction. This period of time between 2 different peaks in 2 different cycles is what economists call the business cycle.

Once a nation begins to head towards a recession, it cannot really be determined if the country is actually in a recession. This is because not all downturns point to a recession. The stock market could be drastically down one day, or the interest rate for the housing market could skyrocket, causing for a brief downturn. It could then all come back a few days or a week later and so, this would not qualify as a recession, it’s just a slight bump in the road. Economists will need at least 6 months to gather economic and financial data to determine whether a country has a recession in its near future and even then, they use different definitions to qualify that a recession is about to take place.

Many economists look at the consecutive financial quarters, with each quarter making up 3 months of the year. When two consecutive quarters show a significant fall in Gross Domestic Product (GDP), this is when they declare that the country is in a recession. The GDP is determined by totaling the value of the goods and services the people of the country have produced during that time. When the GDP shows a steady decrease, it suggests that consumers have decreased demand in several different markets. The GDP is also an indicator that the stock market is down because people are no longer investing and that the labor market is also seeing a decrease because producers don’t have the money to invest in the labor market. Overall the GDP is a good measuring stick of the shape of the economy.

The economists however that keep a close eye on the GDP are not those who claim that a recession is in place although they are great studiers of the economy and provide valued input. The people who claim that a recession is happening within the United States make up the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). This committee is made up mostly of university professors who are also experts on the economy and while they do take into consideration what the GDP is doing, this is not the only, or even the most important factor, that they look at. The NBER documents the nation’s business cycle and they pass this information on to the Business Cycle Dating Committee. This committee will then take into consideration factors such as consumers’ income, national unemployment rate, production sales and the GDP before determining whether or not the country is in a recession. Although the NBER is not part of the government itself, they are a private, non-profit company that the government hires to study the state of the economy. Once the committee has determined that the country is in a recession, they will report this to the government who will quickly take action to get the country out of the recession.

Turning it All Around

Because economies are cyclical and see typical patterns of growth and downturns, it’s reasonable to assume that once a recession hits, it’s likely the country will come out of it to see a time of growth again. While it’s true that it’s entirely possible and countries do generally come out of recessions, it’s not done by simply waiting for the economy to turn itself around. The economy will change only once the choices and actions of the millions of people that make up that country’s population change. However, the government does have a lot of say in how the economy changes and while they can certainly help to turn the economy around, it is something that takes time. In the United States the government has two different kinds of policies that it will use during a time of recession. These are known as fiscal policies and monetary policies.

Fiscal policies are when the government decides to change the way the government itself spends its money. These types of policies may include tax cuts and breaks for companies and individuals, which will give them more money to spend in the economy; creation of government jobs which places more demand on the labor market and lowers unemployment rates; and automatic fiscal policies such as unemployment insurance which is effect immediately after an individual loses their job and provides a source of income while they are not working. It is the President and Congress that determine fiscal policies.

Monetary policies however, deal with guiding the money already available within the country to work in certain ways. In the United States it’s the Federal Reserve System, otherwise known as The Fed that controls monetary policies. The Fed is the national center of banking. It is the bank that the government itself uses and it is the bank for every national commercial bank. The Fed oversees the operations within the banks themselves and it is also responsible for issuing currency.

It’s a requirement of The Fed that all national banks keep a percentage of their money in a national reserve, where it will not earn any interest. These national reserves are kept in one of many banks owned by The Fed. The money held in these banks is known as reserves and the percentage the bank is required to keep within the reserve is called the reserve ratio. The reserve ratio is determined upon a percentage of the bank’s assets and because this amount is always changing, the banks are constantly adjusting their reserve amount.

How much are in the reserves is critical because while banks are required to keep a certain amount in them, they also don’t want to overstock their reserves, as the money could be earning interest elsewhere. Because of this, banks often work together to ensure that their reserves are properly filled. One bank may find a shortage in their reserve and so they will take out a loan with another bank that is in excess in their reserve. The lending bank will charge interest for this loan and the interest rate will be determined according to the federal funds rate.

All of this is key to understanding how The Fed works to control the funds within the economy already. There are 4 main steps The Fed can take to help curb a recession. These are to reduce the reserve ratio, which will give banks more of their money to spend and put back into the economy; lower the federal funds rate, which will also give banks more money to put back into the economy; lower the rate on federal loans, also known as the discount rate; and use the money The Fed has in reserves to buy bonds, which would give the government more money to put back into the economy.

While The Fed has a lot of power in deciding how the economy works, it also needs to be very careful. Too much manipulating of funds and the economy could face financial disaster.

 

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