What happens in a recession?

A recession is a period of negative economic growth. In a recession, we see falling real GDP, falling average incomes and rising unemployment.

us-economic-growthThis graph shows US economic growth 2001-2016. The period 2008-09 shows the deep recession, where real GDP fell sharply.

Other things we are likely to see in a recession

what-happens-in-recession

1. Unemployment

us-unemployment

The rise in unemployment 2008-09 mirrors the fall in real GDP.

In a recession, firms will be producing less and therefore will need fewer workers. Also, in a recession, some firms will go out of business causing workers to lose their jobs. For example, after the credit crunch of 2008/09, many working in the finance industry lost their jobs in banking. Then when demand for cars fell, car firms started to lay off workers too.

2. Increase in savings

saving-rateUK saving rate rose sharply in the recession of 2008/09

  • In a recession, people tend to save money because there is a fall in confidence. If people expect to be made unemployed (or fear unemployment), then you don’t want to spend and borrow, saving becomes more attractive.
  • Keynes noted that in the great depression, there was a paradox of thrift – because people saved more and reduced consumption, this makes the recession worse because it causes a further fall in consumption. Individually they are doing the right thing, but because many people are saving more – they are further reducing consumer spending and making the recession worse.

3. Lower inflation rate

us-inflation

US inflation was high in 2008 due to rising oil prices. But, the recession of 2009 caused a sharp drop in the inflation rate – for a period, there was falling prices (deflation)

With a fall in aggregate demand and lower economic growth, this puts downward pressure on prices. In a recession, you are more likely to see shops selling at a discount to sell unsold goods. Therefore, we tend to get a lower inflation rate. In the Great Depression of the 1930s – we saw deflation – when prices fell.

4. Fall in interest rates

  • In recessions, interest rates tend to fall. This is because inflation is lower and Central Banks wish to try and stimulate the economy. Lower interest rates, in theory, should help the economy from recession. Lower interest rates reduce the cost of borrowing and should encourage investment and consumer spending.

5. Government borrowing increases

us-federal-debt

US debt as a % of GDP rose after the start of the recession in 2008.

In a recession, we will see higher government borrowing. This is for two reasons:

  • Automatic stabilisers. With rising unemployment, the government will need to spend more on unemployment benefits. However, because fewer people are working, they will receive less income tax. Also, firms profitability falls, so corporation tax receipts fall.
  • Secondly, the government may also try to use expansionary fiscal policy. This involves cutting tax rates and increasing government spending. The idea is to make use of surplus private sector savings and get unemployed resources back into use. For example, Obama’s stimulus package of 2009. See Obama economics.

6. Stock market falls

  • Stock Markets may fall because firms make less profit. There is also the danger firms may go out of business. If stock markets anticipated the recession, it might already be built into share prices. But, if the recession is unexpected then profit forecasts will be downgraded, and share prices fall.

7. Fall in house prices.

us-house-prices

In this case, US house prices fell before the recession. House price falls were a cause of the recession. They didn’t recover until the end of 2012.

In a recession, with rising unemployment, many may not be able to afford their mortgages, and so we can see home repossessions. This will lead to an increase in the supply of housing and less demand. In the 2008 recession, US house prices fell sharply because of the previous housing boom. In fact, the bursting of the housing/mortgage bubble in 2005/06 was a factor behind that recession.

8. Investment. Investment will fall as firms cut back on risk-taking and uncertainty. It may also be harder to borrow if banks are short of liquidity (e.g. credit crunch of 2008). Investment is usually more volatile than economic growth due to factors such as the accelerator theory.

AD/AS Model

fall-in-adSimple AD/AS framework showing effect of a fall in AD leading to lower real GDP and lower price level.

Other possible effects

9. Hysteresis effect. This states that the temporary rise in unemployment could translate into permanently higher structural unemployment. For example, manufacturing workers who lost job in 1981 recession, took time to find new jobs in the service sector. See hysteresis effect.

10. Depreciation in the exchange rate. A recession which affects one country more than others could lead to depreciation. This is because there is less demand for the currency if interest rates fall (worse return)

In 2008/09, the UK saw a sharp depreciation in the value of the Pound because the credit crunch particularly affected the UK economy which was reliant on the finance sector.

Pound-dollar-daily-since-2006

Pound Sterling fell in 2008/09 recession

However, in the 1981 recession, the Pound was strong. In fact the strength of Pound was a factor in causing recession.

11. Creative destruction and new firms. Some economists are more positive about recessions suggesting that a recession can force inefficient firms out of business and enable more innovative and efficient firms to come to the fore.

  • However, good firms can go out of business in a recession due to temporary factors rather than long-term lack of competitiveness.

12. Current account on balance of payments. If a country experiences a sharp fall in domestic consumption – it could see an improvement in the current account deficit. This is because import spending will fall.

current-account-1980

In the 1981 and 1991 recession, UK saw an improvement in the current account. But, the improvement in current account in 2009 was relatively short-lived.

Evaluation

  • It depends on causes of the recession. For example in mid-1970s recession was caused by high oil prices. Therefore, inflation was higher than usual in a recession.
  • In the 1981 recession, the high value of the Pound hit the manufacturing (export) sector hard. In the 1991/92 recession, homeowners bore a higher burden because the recession was caused by very high-interest rates, which made mortgages expensive. In the 2008 recession, it was the finance and banking sector which experienced the biggest falls.
  • It depends on whether the recession is global or specific to a country. In 1981 and 1991, the UK recession was deeper than elsewhere in the world
  • It depends on the response of governments/Central Bank. For example, in 1931, UK tried to balance the budget – causing further falls in aggregate demand.

Related

8 thoughts on “What happens in a recession?

  1. when there is a recession people are more likely to save than spending as rate of interests are rising..
    recession also causes unemployment as firms face less demand for their goods and thus needing less workers to produce goods..demand for most goods and services fall..
    there is also a fall in GDP(gross domestic product)
    the standard of living also falls!!

  2. This is pretty confusing. Saving is a function of income and both should decrease during a recession. The data usually show that saving at least stops increasing during a recession until the Fed increases the money supply. I think the confusion here is the fundamental difference between trying to “save money” when consuming and saving in an economic sense. During a recession, incomes decline, and because consumption and saving both come from income they should also both decline. People try to “save money” by consuming less but this is because they have less income or otherwise reduced wealth due to a stock market crash. They also have less money to save and this should be made clear. Total saving may increase in the mid-point of a recession but this is only due to the Fed’s actions. It’s also pretty stupid for someone to save their money during a recession only to be left with plenty of saving when things get better and their income increases. It’s much wiser for people to conduct precautionary saving during good times so they can use it during bad times.

  3. I am doing business as a qualification and one of my questions is, analyse the effects of a fall interest rates for coco-cola and Gucci, i dont understand how this would effect both businesses because they are both so large.

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