Definition of recession
A recession is a contraction in the size of an economy. This means that the total value of goods and services produced by the economy was less than the previous quarter. The size of an economy can be measured by the statistics known as Gross Domestic Product (GDP). An economy can be said to have entered recessionary territory when GDP experiences negative growth.
Recession versus technical recession definition
While government statisticians have formed their own policies and definitions of what they class as a recession, the internationally recognised point at which a country has entered a ‘technical recession’ is when the nation records two consecutive quarters of negative GDP growth.
Requiring a second quarter before a technical recession is declared improves the reliability of the finding.
Different economies will regularly encounter a single quarter of contraction as a result of seasonality.
For example, countries such as Turkey or Greece that have large tourism industries will naturally see a fall in output after the peak visitor season finishes. Western economies also see high levels of consumer spending leading up to the Christmas period which causes a lull in January & February.
Such seasonality could result in a single quarter of negative growth, but not back-to-back losses to GDP.
Some countries use an even higher bar before a recession is formally declared by authorities. This means that a country can be simultaneously in technical recession while their Central Bank does not disclose the same.
This occurred in July 2022, when the US economy registered a second quarterly contraction but no announcement was forthcoming from the Federal Reserve.
Bank of England recession definition
The Bank of England adopts a consistent interpretation of what constitutes a recession. Its website states that “The economy is in recession when it has two consecutive quarters (i.e. six months) of negative growth.”
The last time the UK economy officially hosted a recession was in the first and second quarter of 2020 – the period when parts of the economy were shut down by Covid-19 safety rules.
The British economy is likely to experience negative GDP growth in late 2022 as a result of rising inflation and interest rates. Whether this will result in two-quarters of negative growth remains to be seen.
What causes a recession?
There are many potential triggers for a recession, and there is often more than one contributing factor. It can be a matter of debate among economists as to which cause was the most significant because their independent effects cannot be scientifically proven.
Here are some common reasons for recessions:
Lack of finance. As the appetite for risk among investors and lenders wanes, access to finance becomes difficult, resulting in the cancellation of expansion plans, projects being cancelled and companies entering bankruptcy. This occurred during the 2008 – 2011 financial crisis, where banks reacted to losses suffered on sub-prime mortgage financial instruments by dramatically reducing lending. This was known in the UK as the ‘credit crunch’.
Money supply constriction. Actions by the Central Bank (such as raising interest rates) cause the cost of borrowing to rise noticeably. This has several effects across an economy, such as a reduction in consumer spending, conservative businesses and bankruptcy of overly indebted businesses.
Supply shocks. War, natural disaster or pandemic prevents an economy from producing or importing enough inputs to allow the whole economy to run at its full potential. A recent example includes the silicon chip shortage which has resulted in car manufacturers & tech firms being unable to meet the demand for their products.
Energy crises. Usually, as a result of geo-political risk, the price of oil and gas surges in global markets, which ripples through the supply chain of all international economies. Energy-intensive industries such as transport & heavy industry are especially hard-hit. Some plants may cease to become viable to operate, because the sales price of outputs (e.g. steel) may not be high enough to cover the total costs of producing them.
Bursting of a bubble. Speculative investment manias can lead to massive over-allocation of savings and investments to low-value businesses or assets. The subsequent crash in prices following the bursting of the bubble can lead to low consumer confidence and spending, together with the corporate failure of associated enterprises. The dot com boom (tech shares) and the 1929 Wall Street crash (all US public shares) are great examples of crashes that cascaded across the wider economy.
Conservative fiscal policy. Government spending policies dictate the amount spent and therefore the pace of growth in large parts of economies, such as education, healthcare & defence. Severe cutbacks in governmental budgets can quickly filter down into the institutions (and supply chains) that rely upon central funding. The austerity policy pursued by the UK Conservative Government following 2011 is a good example of fiscal decisions that slowed economic growth.
What happens during a recession?
Because recessions can be triggered by different events, the consequences of a recession may be felt differently. However, here are some general scenarios that economics textbooks agree tend to unfold in most recessions:
Tax receipts shrink. The tax base on which taxes are levied (incomes, consumer spending, corporate profits) may all contract in line with the economy.
Inflation falls, as fewer consumers shift the supply & demand equation. Businesses with high inventory levels begin discounting heavily to maintain turnover or minimise the loss in revenues. Companies begin to compete fiercely on price, rather than quality, in an effort to retain the custom of their patrons.
Unemployment rises. Companies cut back graduate hire schemes (often asking applicants to defer their application to the following year), and those really struggling to begin mass redundancy programmes. New start-up companies delay plans for expansion and aren’t as prepared to take the risk of hiring staff ahead of growth.
Wage growth stalls. Facing troubled times ahead, and with access to a large pool of desperate job seekers, companies have little incentive to provide generous wage rises to their workforce. This becomes part of a reinforcing cycle whereby low wage growth further depresses consumer spending.
Government spending increases. Keen to stimulate the economy, government ministers will usually increase spending across broad programmes to keep people in employment. This spending is usually financed by borrowing.
Interest rates fall aggressively. Central banks loosen monetary policy to encourage bank lending to businesses and individuals.
The stock market falls. The stock market typically falls in advance of the most severe part of a recession, as investors look ahead and predict that dividends and corporate earnings will soon take a hit. The stock market will usually experience a strong rally at the point where investors decide that the ‘worst is now behind us’.
Saving rates increase. Households make an active choice to save more of their earnings rather than spend. This is done to protect oneself from job losses or other adverse financial circumstances or to replace lost wealth from stock market crashes.
How long do recessions last?
Recessions are not typically long-lived. The 20 years to 2022 consisted of 80 quarters. Only 7 were in recessionary status. They were clustered as two recessions:
- The five quarters beginning Q2 2008, known as The Great Recession.
- The two quarters beginning Q1 2020
Can recessions be predicted?
Recessions can be predicted to quite a great extent when they are imminent, however, it’s difficult to forecast more than one year ahead.
That’s because economists can monitor several live metrics to keep their finger on the pulse of an economy, and are quick to spot signs of decline months before the negative GDP growth is officially reported.
When forecasting the performance of future quarters, this is when it becomes more difficult. Economists cannot currently decide whether investors need to prepare for a recession in late 2022.