What is a Recession?

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Everyone knows how difficult it can be during a recession. But not everyone knows what a recession really is. Ronald Reagan said a recession is when your neighbor loses his or her job. A depression is when you lose yours. That’s a good starting point, but let’s dive in a bit deeper.

What is a recession?

A recession is basically part of the most painful part of the business cycle. Things slow down. Factories produce less. Unemployment rises. People (and sometimes governments) spend less. Factories lay idle. Business profits drop and so do stock prices. More people declare bankruptcy. Not many people are having fun.

What causes a recession?

Generally, recessions start for three reasons:

1. Spending

When people spend less money, there is less demand for products. Since there is less demand, production drops. Factory owners don’t want to manufacture something if nobody is going to buy it. When production drops, so does employment. That’s because employers don’t need workers in the plants. This is a vicious cycle that repeats itself, creating greater and greater unemployment and resulting in people having less and less money to spend. Ultimately that means factories create fewer and fewer goods, which means they hire fewer and fewer people, etc., etc., etc.

2. Supply

If a great deal of supply comes off the market due to some man-made or natural disaster (like the earthquake in Japan in 2011), that disrupts the production process. People can’t spend money if nothing is available to buy. As a result, companies have lower sales and lower profits. If the supply chain is interrupted for any length of time, employers lay off workers and the whole ugly process reinforces a business slowdown and a recession.

3. Bubble Pop

If asset prices rise quickly (stocks, real estate or any other asset), at some point they rise beyond the reach of consumers. It’s like musical chairs with money. At some point suppliers are caught with inventory but without anyone to sell their products to. When that happens, suppliers become desperate. The last thing they want is to create more inventory they can’t sell. As a result, they lay off workers who then have no money and therefore consume less. Again, this kick starts a slowdown that can easily become a recession.

Why does the government intervene when we have a recession?

The government is interested in ending recessions as soon as possible. They want happy citizens because happy citizens vote for incumbents. And typically, unemployed people aren’t very happy.

What is usually done to combat a recession?

The government wants people back at work. They try to get people working in a few ways. The first tool they have is to increase the money supply – just print up a ton of money. When they do that, interest rates drop. That’s because there is a flood of cash available and banks want to loan that money out as quickly as they can. As rates drop, it’s (hypothetically) easier for business to get loans. As a result, businesses invest more into their business and that creates jobs.

Another tool government uses is to just spend lots of money. That theoretically ends up in the hands of consumers who spend it, which creates jobs too. (Of course the problem is that this money has to be repaid at some point. As a result, this is just a short-term fix and more of a Band-Aid than a real solution.)

The final arrow in the government’s quiver is to reduce tax rates. That also puts more money in the hands of consumers for spending and stimulating the economy.

In short, to get out of a recession the government tries to stimulate demand. If the government does nothing, eventually we get ourselves out of the recession anyway. This is part of the business cycle too. We get out of the recession without government intervention once demand starts building up again. It’s an open debate whether government action helps or not. But that’s also a topic for another day.

How do we know when we are in a recession?

There are a few different official definitions. It’s generally agreed by economists that if the GDP declines for two consecutive quarters, we’re in a recession. The only problem is that this data is reported well after the fact. In many cases, we’re on our way out of the recession by the time we realize we are in one. For example, people really took notice of the tough economic conditions right around the middle of 2008, but the recession actually started in December of 2007. And while many people may still think we are in a recession, it officially ended in June 2009.

Do investors lose money during recessions?

Yes and no. Usually the stock market anticipates a coming recession up to 13 months prior to it actually arriving. According to Wikipedia, the average recession lasts about six months.

Why is this important?

It’s important for you to understand what a recession is for a few reasons.

First, as you can tell from the discussion of what causes recessions, they are inevitable but not lethal. They pass. Investors often project out current circumstances. They are sure that if we are in a recession now, it will never end. Likewise, when the economy is strong and the market is humming along, investors are sure those rosy will times will continue forever as well. Neither scenario is correct.

The second reason why this discussion is important is to illustrate that we clearly can’t predict when we’ll enter our next recession or when we’ll emerge from it. It’s simply impossible to predict these things. If you are a buy-and-hold investor (something I don’t recommend), you ignore recessions when it comes to your investments.

If you invest strategically (as I suggest you do) you can ignore recessions – but not the market. Since the market often anticipates recessions, why not follow its lead rather than try to predict the future and possible future recessions? There are a variety of market timing strategies that do exactly that.

Do you shift your investments during a recession? How? What do you use as a signal?