Why do Recessions happen?

Recession, recession, recession - barely a week goes by without reading this term on the front page of a business journal.

Why do we care? And why do they always seem to be around the corner, in our future?

For starters, there is no universal definition. One common view is to consider a recession as negative growth in 2 successive quarters: when our measure of growth - typically GDP - has contracted in comparison to the previous quarter for 2 quarters in a row.

If this goes very negative and is sustained for a couple years or more, we use the more severe term “Depression.”

Generally our economies today - market-driven economies led by governments that represent their people - can avoid depressions, achieving economic growth quarter to quarter, year by year. (To understand the drivers of fast economic growth, see “How does growth happen?”)

But why do these freak events we call recessions happen to us? Let’s study this with some data.

When we look at the US over the last 250 years or so, there have been no fewer than 50 recessions in this period. 50! Yes, that sounds massive.

Over the course of 25 decades, this implies an average of 2 recessions per decade. But some decades have had up to 4 recessionary periods, and some have had just one. Every decade in the history of US growth - since Independence - has had some form of economic recession. The table below shows the distribution of crises over the 25 decades:

They are indeed a big fact of our lives. We will each go through between 5-10 of these periods in the course of our working lives.

Why do they happen? And do they have to?

I’ve studied the history of 50 economic recessions and developed a classification system for them.

As you can see, the 4 driving factors of the majority of recessions are:

• Wars

• Financial system driven

• Inflation / sudden price changes

• Industry failure

Let's look at each of these one by one.

How does war cause a recession?

During an intense war period, the government spends to win the war. War-related industrial production has to increase. Spending for the armed forces and its personnel has to increase. In very intense wars - like the Second World War - the economy can even be transformed so almost all sectors are producing to support the war effort.

The government has to fund this expense. Typically it funds via public debt / bonds - which pays for the increase in production. Economies typically boom during a war, providing they are winning. 

Following the war, the government has to pull back expenditure (fiscal spending) so it can afford to pay down its debts, or more boldly, it reduces interest rates and tolerates higher inflation, to reduce the real value of its debts. These post-war effects can suddenly reduce economic activity, causing a recession.

How does a financial system cause a recession?

We have 2 articles that explain this in detail:

• “Why is financial services at the heart of the economy?” and

• “What are financial crises?”

The financial system plays a central role in the economy, similar to the role the circulation system (the flow of blood) plays for the human body. If circulation stops, the body quickly dies. 

There are 3 dominant types of financial crises: bank failures, asset price crashes, and debt crises. “What are financial crises?” explains each of these in detail and illustrates why they are so damaging to an economy.

How does inflation cause a recession?

Inflation - as a direct cause - rarely causes a financial crisis. High inflation is actually associated with periods of growth, because high demand (which drives growth) leads to upward pressure on prices. Or alternatively, higher growth leads to higher demand for workers, which pushes up wages and can drive inflation.

Inflation will typically cause a recession because governments have to take action to control inflation. The most effective tool is using interest rates, and increasing the reserve rate / base rate of interest that the central bank charges the banking system for funds. This has a cascade effect on all costs for capital in the economy - all interest rates leading up to what consumers experience for credit needs such as personal loans, auto-financing or mortgages. 

When capital costs more, business invests less, and consumers can buy less. This reduction in consumer expenditure and business investment can lead to a recession. The strongest example of this was the 1973 oil price shocks, caused by the actions of OPEC in this period.

How does an industry failure cause a recession?

This happens rarely. It requires a single industry to be playing a driving role in an economy’s current growth. To understand the different industries in an economy, see our article “What Is The Economy Stack.”

A well-developed economy has many sectors (up to 26), so a crash in one of them is unlikely to cause a recession (unless it’s financial services or energy - see the above 2 examples). But during a fast growth phase of an economy, some sectors have a very high influence on growth. This happened in the fast growth phase of the US during the period to 1870 to 1900, following the Civil War, when railway construction was the booming industry of the country.

Due to a crisis in the railways, growth was slowed down and there were periods of recession. The railways were so key to economic growth - both because it was a high investment / high spend industry and because it spurred so many other industries by enabling connectivity across the US.

So what’s causing the current recession?

Right now, in June 2022, many are forecasting that we’re entering another recessionary period, or if we’re lucky, a period of slowdown.

Studying the 4 driving factors, we can see which one is to blame: it’s the issue of inflation, fast-rising prices.

A unique confluence of events have suddenly come together:

1. Post pandemic spending has increased. Consumers have latent demand and they have savings built up, from during the pandemic, which they want to spend now.

2. The supply side of the economy has been slow to react to the sudden resurgence. We have had supply chain bottlenecks, so fewer goods and, in some cases, services, have reached their destination fast enough to meet the rising demand.

3. There’s a war in Europe between 2 economies. It’s not large enough to directly affect the US economy, but the war has caused reduction in supply in 2 critical commodities: oil and wheat. When supply reduces, this pushes prices up, affecting the eventual prices in the basket of goods that an individual consumer will buy.

As explained above, the actions of the US government and the Federal Reserve will have the effect of making the cost of capital, and the cost of credit, more expensive, which will impact economic growth.

As of now, we have not seen measurements showing we’re in a recession. We have not had 2 successive quarters of economic contraction. But medium-term effects (over the next 2 years) are beginning to show up: as a result of the Fed’s planned increase in interest rates (up to 3% and potentially more), many participants in our economy - especially the investing classes - are expecting a recessionary period in the 2023-2024 period.

It is not a given. It is a forecast. We’ll continue to watch the environment and the key data, and we’ll share more analysis and explanations as 2022 develops.