NBER (National Bureau of Economic Research)

Recession [noun] — a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

ELI5

The NBER definition explains that a recession is a drop in economic activity apparent through GDP (gross domestic product) decreasing for more than a few months. GDP is simply the financial value of all goods and services (cars, planes, candy, IT consulting, etc.) created within a nation’s borders. Intuitively, this makes sense as when the economy struggling, you expect to see a decrease in overall productivity. Typically the GDP growth rate (how much it increases from one month/quarter/year to the next) is negative.

More importantly — what exactly happens during a recession? Here’s a short list of typical scenes.

    • Unemployment – This will tend to increase during a recession. Companies start to struggle as demand for goods and services will decrease thus reducing the number of employees necessary to make goods and services.
    • Home prices – Home prices tend to drop as well. People might struggle to pay their mortgages due to financial hardship, and foreclosures become commonplace. An oversupply of homes and dwindling demand leads to a decline in housing market prices.
    • Interest rates – The Federal Reserve will decrease interest rates during a recession to help incentivize people to borrow money and spend. Lower interest rates makes it ‘cheaper’ to acquire a loan. This is a move made to help stimulate the economy during a downturn.
    • Consumer & business spending – Just as unemployment increases and consumers have less cash to spend, businesses also tend to become more cautious just as consumers during a recession. They tend to refocus on cash generating aspects of the company cutting on departments such as R&D and taking steps to reduce risk.
  • Government debt – As business spending decreases, the government tends to ratchet up spending to help with unemployment benefits and other social welfare programs to assist those in need.

Recessions are a natural part of the economic cycle we live in, but most people are probably just wondering — how do I protect my family’s fiscal health during one? Here’s a short list of actions to take before and during one.

  • Before
    • As mentioned in the budgeting section, ensuring you have an emergency fund with at least 6 months of money will help you get through this downturn. It’s worth increasing your savings rate during a recession to handle any unforeseen mishaps.
    • Tackle as much debt as you can before the recession. Job loss is one of the toughest parts of a recession so making sure you are in a position to handle loan payments successfully is critical.
  • During
    • If you don’t have enough money to last through the recession, it’s crucial to cut down on discretionary spending. Look at the budgeting article to get an idea of what to drop. Some low hanging fruit would be eating out and entertainment costs.
    • Be a stellar employee – keep your head down, ignore what might be happening to your portfolio, and get your work done. Battling through a recession is as much mental as it is material. If you can put yourself in the right mindset and brace yourself for impact, you’ll be better off for it.
    • Do not panic sell your investments. Stock market drops significantly before and during a recession. Put some money into fixed-income investments that will provide cash flow through dividend and yield income.
      • In fact, periodically investing your money into the market can have significant upside during a recession. The S&P 500 has gone up ~275% since it’s low point in 2009 (that’s a 2.75x return)! Don’t try to predict the ‘lowest point’ of the stock market in a recession, it’s like catching a falling dagger, just be disciplined and invest with a schedule.

Detailed Definition

What causes a recession?

In the US economy, there is typically only a small fraction of cash circulating. Most goods and services aren’t purchased with cash — they are acquired with credit. This enables individuals and businesses to accelerate their growth by having access to money that they don’t have right now.

The creation of credit is balanced by the creation of debt. Of course, the individual or business will have to repay their loan with interest. With the distribution of more credit, the economy becomes more and more leveraged. Businesses will grow as inflation and interest rates tend to rise while the market ‘heats up.’ With prices for goods and services rising quickly, demand for them might start to wane if income doesn’t increase concurrently.

There are situations where industries or markets (i.e. subprime mortgages) pass a tipping point and become over-leveraged when folks aren’t able to make their payments on time. This leads to an increase in the default rate with banks not acquiring their expected payments during a loan period.

As a result of banks having a liquidity shortage, and they end up reducing their level of lending which makes makes borrowing more challenging for businesses to start, grow, or sustain themselves. Since businesses aren’t as productive as they once were, this typically contributes to a decreasing GDP since fewer goods and services are being produced – marking a recessionary period if this occurs for at least a few months.

When individuals and businesses overextend themselves and become too aggressive with their spending plans, it creates a credit crunch that serves as a catalyst for an economic recession.

Consumer confidence predicts how likely consumers are to spend their money. When consumers sense a recession coming about, this metric declines as people choose to save their money rather than invest. Individuals begin to sell assets and store cash while divesting from the market. More people see stocks tumbling and consumer confidence dropping it creates a positive feedback cycle.

How does country overcome a recession?

Now how do you combat a recession now that it’s in full swing? The government and Federal Reserve are the primary fighters in this battle. That’s right the Federal Reserve is actually a completely independent entity from the government! They end up serving both public and private markets and act as an in-between of sorts.

There is a blend of fiscal policy and monetary policy. Fiscal policy involves the government cutting taxes and increasing spending while monetary policy is the Federal Reserve decreasing interest rates and increasing the money supply to steer the economy in the right direction (the cases I listed are generally true, but not always). For a much better detailed explanation of the two policies, check out this link. which details the the various levers of the government and Federal Reserve during a recession.

Other than the subprime mortgage crisis, two other debt markets susceptible to defaulting are ballooning credit card & student loan debt. Credit card debt levels surpasses $1 trillion while student loan debt bumped passed $1.5 trillion in 2018!