Recession imposes a significant threat to the lives of individuals and businesses since it affects one sector after another in a domino manner. Knowing there are no fixed terms on how long this economic phase lasts before another one approaches makes it even worse and contingent.
Although the recession is inevitable, learning about its causes will help us understand the signs leading to it. In a way, we can also prepare measures to prevent complicated financial repercussions.
Causes of recessions
A previous article has mentioned how a two-quarter declining GDP can indicate an economic recession. But more than that, recession can be due to more diverse causes, which are as follows:
1. Supply Shock – Three primary elements trigger a supply shock that leads to recession: declining production, employment and inflation. All these happen when inputs and resources, including labor and technology, become too expensive and relatively short, pushing price hikes and a shortage in output. A classic example of this is an oil crisis. Listed in history was the oil embargo instituted by the Organization of Petroleum Exporting Companies (OPEC) against the United States, which slowed their oil import down and pushed prices up.
2. Demand Shock – Demand shocks happen when external factors cause consumers and businesses to reconsider spending. Shortened outputs may be typical between supply and demand shocks, but prices in a demand-shock-infested recession show a downward trend, often identified as deflation. One example of a demand shock was after World War II when governments like the U.S. cut their expenses because of excessive spending during wartime.
3. Financial Crisis – Uncontrollable credit risks often lead to financial crises, which, later on, trigger recession. Institutions suffer from losses which push them to tighten credit policies and reduce lending capacity. In effect, enterprises and consumers get fewer chances of a loan or investment, cutting the chances of expansion. A classic illustration of this cause is when housing prices skyrocketed during the 2008 Global Financial Crisis. Mortgage borrowings for the housing market increased but with a tradeoff on compromised underwriting quality. Housing prices eventually fell and credit risks plagued institutions and made them narrow credit conditions.
4. Psychological reasons – Economists believe that psychological factors can also cause recessions. They point out that the irrational exuberance of investors can trigger such an economic phenomenon because of subjective expectations of an upward mindset. While optimism is often essential, it can fuel a potential financial downturn.
Early indicators of a recession
Recession is almost always a part of the economic curve. Here are a few indications that a recession is underway:
1. Low industrial sales – Cuts in raw materials and labor demand are evident. Due to a desire to minimize risk, enterprises subsequently tone down sales.
2. Unemployment – The Sahm Recession Indicator uses a model that predicts a recession when the three-month national unemployment rate moving average increases by 0.50 percentage points.
3. Inverted Yield Curve – Inverted yield curves suggest that the market loses confidence and shifts its money from short to long-term bonds.
It may sound adverse, but recessions are part of the economic cycle. But while it brings challenges and threatens people’s lives and the future of businesses, there is no better way to face it than to know about it well.
In the end, it is how familiar we are with these economic phenomena that will help us handle them.
