What Is a Recession? Definition, Causes & Warning Signs

What Is a Recession in Simple Terms?

Just as corporations experience general phases of growth and contraction, known in sum as their business cycle, the economy also experiences peaks, categorized by expansion and high employment, and inevitable valleys, which are periods of decline known as recessions.

Simply put, a recession occurs when there is a reduction in economic activity. In the 1970s, economist Julius Shiskin gained acclaim for categorizing a recession as two consecutive quarters of declining GDP growth; however, today’s economists take many more factors into consideration, which we’ll discuss below. 

Who Declares a Recession?

The National Bureau of Economic Research (NBER) is considered the leading authority on U.S. economic issues. It determines whether the U.S. economy is in expansion or recession. It defines a recession as "a recurring period of decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy." Using statistics, the NBER can calculate the precise start and end dates of recessions.

Glossary of Recession Terms

• Recession: A period that experiences a significant GDP decline over months that also witnesses a decrease in personal income, employment, retail sales, and industrial production
• Expansion: The “normal state” of the economy, during which GDP grows
• Peak: The month when economic indicators are at their height, followed by a decline
• Trough: The month when the economic indicators hit their lowest point before beginning to rise over a sustained period
• Gross Domestic Product (GDP): The measure of all of the goods and services that make up the economy, such as consumer goods, business investment, government inventories, and net exports (GDP is considered more reliable than GDI because it considers a broader—and timelier—set of data)
• Gross Domestic Income (GDI): Another way of measuring the economic output via account incomes earned and costs incurred in production

How Many Recessions Have There Been in Recent History?

Since 1971, there have been seven recessions, according to NBER.

What Causes a Recession? What Are Some Examples?

A healthy economy is a delicate ecosystem composed of ever-changing variables like consumer spending, consumer confidence, maximum employment, and minimum interest rates. The Federal Reserve tries to nurture this balance through careful monetary policies and targeted interest rates.

Inflation-Triggered Recessions

Recessions are notoriously difficult to predict. “It’s a myth that expansions die of old age,” former Fed Chair Janet Yellen famously quipped. Instead, a recession can be triggered by a combination of factors; for example, when demand outpaces supply and inflation rises, effectively overheating the economy. High interest rates, stagnant wages, and rising unemployment can also lead to recession.

One example of an inflation-triggered recession is the recession of 1960, which lasted for 10 months. After the Fed started raising interest rates in 1958, unemployment levels peaked at 6.9%, and GDP dropped by 2% from April 1960 to February 1961. When President John F. Kennedy introduced a stimulus spending plan in 1961, offering tax cuts and expanded unemployment and Social Security benefits, the economy staged a rebound.

Recessions Caused by Economic Shock

A recession can also be triggered by an unexpected, one-time event that effectively rattles the economy, such as the oil crisis in the 1970s, when OPEC cut off its oil supply to the United States. Another, more recent example is the COVID-19 outbreak in 2020, which sent shockwaves around the world as economies shut down in an attempt to curb disease transmission. In the United States alone, a record 16 million people filed for unemployment benefits in April of 2020, totaling nearly 10% of the workforce.

Recessions Caused by Asset Bubbles

In the stock market, a bubble is formed when stock prices rapidly rise out of proportion to their fundamental value. The same can happen with entire sectors and industries in the economy—and what goes up and up often must come down. The inflated asset is met with panicked selling, and the market can crash as a result, triggering a recession.

The Tech Boom of the late 1990s had turned bust by 2000, as selloffs caused the tech-heavy NASDAQ to lose more than 75% of its value. Many internet companies declared bankruptcy while communications and e-commerce platforms lost a significant share of their market cap. 

Individual speculation during the lead-up to this period had been so great that Fed Chairman Alan Greenspan even invented a term for it: “irrational exuberance.” What followed was an 8-month recession from March–November 2001, which also encompassed the 9/11 terrorist attacks on the World Trade Center, further depressing the market. Unemployment peaked at 5.5%, while GDP fell by 0.6%.

What Are the Effects of a Recession?

A recession has profound implications on every facet of society. When the economy falters, people lose their jobs. Manufacturing output declines and prices fall. Businesses fold—sometimes banks do, too.

People feel the pinch in their pockets and spend less on everything from discretionary items like vacations and technology to big-ticket purchases like automobiles and real estate. But the biggest impact may be one that’s not even tangible. Psychological and emotional side effects of a recession range from a decline in confidence to a sense that “things won’t ever be as good as they have been.” 

The term animal spirits, coined by 20th-century economist John Maynard Keynes, says it all. When people rely more on basic instincts and emotion, their decision-making gets impacted and, taken in sum, like when there’s panic-based selling in the stock market, their emotions can actually affect the economy.

The Shapes of Recession

Economists look to the alphabet to describe a recession and subsequent period of recovery.

V-Shaped and U-Shaped

V-shaped recessions are short in timeframe and characterized by sharp declines with clearly defined troughs and recoveries. These recessions usually last 12–18 months. A variation on this would be a U-shaped recession, which has a longer trough. It would take a few more years to reach recovery in this instance.

W-Shaped

W-shaped recessions are also known as double-dip recessions. The economy enters a recession, then achieves a short recovery, which is then followed by another decline and subsequent rebound. These recessions typically last 2–4 years.

L-Shaped

Perhaps the most frightening shape of recession is the L-shaped recession, which is marked by a strong decline and trough that takes many years. Recovery may never happen.

Can I Predict a Recession? 

Economists look to the U.S. Treasury Department for clues on an impending recession. That’s because a rare phenomenon happens that can be predictive of an impending recession: The yield curve becomes inverted, making news headlines around the world.

Treasury bills and bonds are conservative investments that entice investors by sporting a rate of interest, also known as yield. Usually, long-term Treasuries, such as the 30-Year Treasury, have higher yields than short- or intermediate-term Treasuries. However, at times, the yields of the short-term Treasuries can become higher than the long-term Treasuries due to deteriorating economic conditions. They are perceived as having more risk (default risk) than the longer-term investments and thus offer more interest as an enticement. When this happens, it’s called an inverted yield curve.

The U.S. Treasury Department publishes yield curve rates daily on its website for all to see—and study closely.

Recession Vs. Depression: What’s the Difference? 

Both recessions and depressions are economic downturns, but a depression is more severe. The Great Depression of the 1930s, which began with a stock market crash in 1929, is an example of a prolonged period of contraction. During this time period, output fell by 30% while unemployment soared to 25%. The Great Depression also witnessed a period of deflation, when prices fell by nearly 10% per year. It took the election of President Franklin Delano Roosevelt in 1933—and, eventually, World War II—to restore jobs and improve the economy.

Are We Entering a Recession?

Every day, financial pundits try to read the tea leaves of monthly economic data, but we might not ever actually know when we are entering a recession until we’re in one. That’s because NBER’s approach is retrospective. In other words, it waits 12–18 months to classify business cycle periods. Perhaps its understanding of human nature is just as broad as its knowledge of economics.

That being said, TheStreet's Dan Weil reports that many economists do see a strong chance of recession in our near future.