A recession is a significant decline in economic activity that can last for months or even years. Experts declare a recession when a nation’s economy experiences negative gross domestic product (GDP), rising levels of unemployment, falling retail sales, and contracting measures of income and manufacturing for an extended period of time.
Recessions and the Business Cycle
Recessions are considered an unavoidable part of the business cycle, which describes the way an economy alternates between periods of expansion and contraction. As an economic expansion begins, the economy sees healthy, sustainable growth. Over time, lenders make it easier and less expensive to borrow money, encouraging consumers and businesses to load up on debt. Irrational exuberance starts to overtake asset prices.
As the economic expansion ages, asset values rise more rapidly, and debt loads become larger. At a certain point in the cycle, one of the phenomena from the list above derails the economic expansion. The shock bursts asset bubbles, crashes the stock market, and makes those large debt loads too expensive to maintain. As a result, growth contracts, and the economy enters a recession.
What causes a recession?
Generally speaking, expansion and growth in an economy cannot last forever. A significant decline in economic activity is usually triggered by a complex, interconnected combination of factors, including:
Economic shocks. An unpredictable event that causes widespread economic disruption, such as a natural disaster or a terrorist attack. The latest example is the recent COVID-19 outbreak.
Loss of consumer confidence. When consumers worry about the state of the economy, they slow their spending and keep whatever money they can. Because close to 70% of GDP depends on consumer spending, the entire economy can drastically slow.
High interest rates. High-interest rates make it expensive for consumers to buy houses, cars, and other large purchases. Companies reduce their spending and growth plans because the cost of financing is too high. The economy shrinks.
Deflation. The opposite of inflation, deflation means product and asset prices fall because of a large drop in demand. As demand falls, so do prices as sellers try to attract buyers. People put off purchases, waiting for lower prices, causing an ongoing downward spiral of slow economic activity and greater unemployment.
Impact of a recession
One of the consequences of a recession is unemployment, which tends to increase, especially among low-skilled workers, due to companies and even government agencies laying off staff as a way of curtailing expenses. Another result of a recession is a drop in output and business closures.
The fall in output tends to last until weaker companies are driven out of the market, then output picks up again among the surviving firms. With more people out of work, and families increasingly unable to make ends meet, there will be demands for increased government-funded social schemes. With a drop in government revenues during a recession, it becomes difficult to meet the increased demands on the social sector.
Economic damage
Recessions result in higher unemployment, lower wages and incomes, and lost opportunities more generally. Education, private capital investments, and economic opportunity are all likely to suffer in the current downturn, and the effects will be long-lived.
While economies often see rapid growth during recovery periods (as unused capacity is returned to work), the drag due to the long-term damage will still prevent the recovery from reaching its full potential.
Credit Impairment and Bankruptcy
One of the first impacts recessions have on businesses is the tightening of credit conditions. Early in a recession, interest rates may initially rise, then fall as the monetary floodgates open. Still, throughout the recession, standards for lending in the market tend to be tighter, and lenders are more selective of the risks they are willing to take on at any interest rate.
A recession will also dampen a company’s accounts receivable (AR), and liquidity issues impact consumers and businesses up and down the supply chain. Customers who owe the company money may make payments slower, later, or not.
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