Two consecutive quarters of negative growth in the Gross Domestic Product (GDP) is the most common definition of a recession, according to The National Bureau of Economic Research. A broad range of economic factors come together to influence whether the GDP grows or contracts. Sometimes these factors come together to create a "perfect storm" for a robust economy or a recession.
The Main Five Causes of Recessions
The GDP is defined as the sum of four components: consumption, investment, government spending, and net exports (i.e. exports minus imports). Any one of these factors alone may not trigger a recession, but together they can -and do- spur recessions.
1. Reduced Consumer Spending
A slowdown in consumer spending, also known as consumption, is one contributing factor to a recession. Spending money on anything that is not an investment is classified as consumption. Food, clothing, gasoline, utilities, and healthcare are but a few examples of consumer spending.
Spending may slow for a variety of reasons. People losing jobs, interest rates rising, or credit markets tightening are all factors that can lead to decreased spending.
2. Decreased Levels of Investing
People not having adequate funds for investments can also contribute to a recession. Stock prices fall, retirement accounts shrink or stagnate, and savings dwindle, all of which shrink the GDP.
Lack of corporate investing also diminishes the GDP. Gerald Friedman, Professor of Economics at the University of Massachusetts-Amherst, believes that corporate profits outpacing investments contributed to the 2009 recession and continues to threaten the current recovery.
3. Reduced Government Spending
Government spending on things like Social Security, education, defense, infrastructure and more all contribute positively to the GDP. When tax bases shrink or government spending is reduced, recessions can result.
Government spending makes up approximately 24 percent of the GDP, according to FactCheck.org. When government spending slows, the GDP takes a direct hit.
4. Imports Exceed Exports
When the value of imports exceeds that of exports, the GDP shrinks, and this contributes to recessions. The greater the imbalance, the greater the impact to the GDP.
Imports continue to outpace exports resulting in a trade deficit of $39.1 billion in July, 2013. While this is less than one percent of the GDP, it is still a detriment to the economy.
Though fear cannot be empirically figured into economic formulas, it absolutely impacts the GDP. When stock market values drop, investors sell off their holdings. When people believe their income may not be secure they make fewer purchases. Stores and companies that depend on consumers' business may be forced to close or reduce inventories. This can lead to reduced manufacturing, and snowball into job cuts.
Signs of a Recession
Any number of economic indicators converge to influence the four components of the GDP. Many look to the Composite Index of Leading Indicators, which is comprised of ten economic indicators, to determine whether a recession is on the horizon. Additional signs include:
- High interest rates that deter people from borrowing
- A weakening dollar or strengthening foreign currencies that lead to decreases in exports
- Reduced access to credit
- A decline in real wages
- Rising oil prices
- National debt growing faster than the GDP
When a recession occurs, followed by a period of recovery, and then another recession, it is known as a double-dip recession. In the second quarter of 2011 the GDP contracted sharply, spurring considerable speculation about a double-dip recession, but in this case, it did not happen.
The data is the chart below clearly shows both the Great Recession as well as the 2011 dip.
Preparing Yourself for a Recession
Instead of worrying over news reports about the state of the U.S. economy, consider taking steps to prepare yourself for a recession. For example:
- Plan for the worst case scenario. It may be a frightening thought to consider losing your job or having a loved one come down with a serious illness, but you need to have a plan that will allow your family to make it through this difficult time.
- Cut unnecessary expenses. Part of preparing for the worst involves having an emergency fund to help your family though hard times. If you don't have money saved, consider cutting restaurant meals, expensive entertainment, or other luxury items from your household budget and putting the extra money into your rainy day savings account.
- Monitor your investments. During a recession, stock prices can change dramatically. If you have invested in stocks as part of your retirement savings, try to diversify to reduce the risk to your portfolio.
- Avoid taking on new debts. If you're concerned about a possible recession, try to put off the purchase of new items as long as you can. If you already have a car that's paid for and provides reliable transportation, for example, think twice before taking out a loan for a new one.
- Evaluate your employment situation. Some jobs are more recession-proof than others. Are you in one of them?
Recession vs. Depression
Although the general public often uses the terms interchangeably, a recession is not the same thing as an economic depression. A depression is a severe recession, often defined by economists as a period in which the real GDP declines by more than 10 percent. Using this definition, the last depression in the United States was during the period from May 1937 to June 1938.
Maintain Your Perspective
The factors that make up the GDP are interconnected, and they can work in unison to create wealth or conspire to take it away. Safeguard your finances as well as you can, and recognize that markets fluctuate. Some believe that recessions are a natural part of the capitalist economic system and help pave the way for periods of economic expansion.