How Recessions Work

by Tom Harris

Browse the article How Recessions Work

Introduction to How Recessions Work

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A cyclist passes a financial display screen showing the FTSE 100. See more recession pictures.

On Jan. 21, 2008, stock prices tumbled around the world. Most analysts pointed to fears surrounding the United States economy and a possible recession as the reason for the drop. Ironically, economic conditions in the United States were affecting the world economy on a day when its own markets weren't even in session -- they were closed for the Martin Luther King Jr. Day holiday. Three days later, news outlets were already reporting a new economic stimulus package, designed in part to try to prevent a recession.

This isn't the first recession news in recent memory. On Nov. 26, 2001, the news media announced the United States was officially in a recession and had been since March of that year. To most Americans, this wasn't all that surprising: Rising unemploymentand a weak stock market had been in the news for months.

More on Recessions Recession Quiz What's the difference between a recession and a depression? PlanetGreen.com: Get Recession-Ready

Both the 2008 market drop and the 2001 news blitz raised a lot of questions. Who decides when the economy is in recession, and on what grounds? What actually constitutes a recession, anyway? When a nation's economy enters a recession, is life guaranteed to get harder for most of its citizens? And how often does a recession lead to a depression?

In this article, we'll find out what recessions are, see why they occur and examine the criteria economists use to identify them. We'll also look at the effects of recession as well as explore some of the ways a country can turn the economy around again.

Money Makes the World Go Round

Photo courtesy NARA
In the Great Depression of the 1930s and '40s, laid-off U.S. workers lined up daily at employment agencies.

A recession is a prolonged period of time when a nation's economy is slowing down, or contracting. Such a slow-down is characterized by a number of different trends, including:

• People buying less stuff
• Decrease in factory production
• Growing unemployment
• Slump in personal income
• An unhealthy stock market

By the conventional definition, this slow-down has to continue for at least six months to be considered a recession.

This definition really raises more questions than it answers. What does it mean for the economy to slow down? Why does this happen? How are all these factors related? And what exactly is "the economy"?

People talk about the U.S. economy as an independent entity, but it is actually the result of millions of people's actions. Economists use all kinds of esoteric terms to describe the connection between people's actions and the economy as a whole. But you can understand the basic idea of this connection by looking at only a few basic concepts: producers, consumers, markets, supply and demand.

Producers and Consumers

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A pedestrian passes before a share prices board in Tokyo, Jan. 22, 2008.

Broadly speaking, a nation's economy is the production and consumption of goods (food, clothes, cars) and services (repairs, lawn-mowing, haircuts) in that nation. Anybody producing or consuming things in a country (and that's just about everybody) plays some role in the economy.

Production and consumption are intertwined. In order for people to consume things, someone has to produce those things. And in order to produce things, you need to consume things (you need to consume natural resources and people's labor, for example).

Markets

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People walk past a stock board displaying the Hang Seng Index in Hong Kong, Jan. 22, 2008.

In a market economy, or a modified market economy such as the U.S. economy, production and consumption are connected in various "markets." A market is simply a place where consumers can go to buy things from producers and producers can go to sell things to consumers.

A grocery store is an example of a physical market. People who want to consume food go to the grocery store and buy it from producers through a series of middlemen. The store itself is one of the middlemen, and there are usually others along the way (distribution companies, for example). The labor market is a more abstract sort of market. In this market, businesses who want to consume work pay people to produce labor. In the stock market, consumers and producers buy and sell percentages of ownership of companies (seeHow Stocks and the Stock Market Work for more information).

As you can see, almost everybody is both a producer and a consumer acting in more than one market. If you have a job, you are a producer of labor. Whenever you go shopping, you are a consumer of goods.

Supply and Demand

© Photographer: Jason Yoder Agency: Dreamstime.com
The supply curve and the demand curve -- where they meet determines the price of a particular item or service.

The ultimate goal of producers is to make money -- to bring in more money than they spent producing the product. Consumers may want to satisfy their wants and needs by buying products, or they may buy products in order to make money (by reselling the products or by using the products to produce other products). In any case, consumers generally want to pay as little for goods and services as they can.­­

In a market, the actions of producers and consumers determine the value of goods and services. Producers are the ones who actually set prices, but they do so based on the behavior of consumers. If nobody buys a product at a particular price, the producer knows the price is too high. If some consumers buy it, but not enough to buy everything produced, producers must either decrease the price or decrease the supply. The willingness of consumers to pay for products is known as demand. Even if there is constant high demand for a product (toilet paper, for example), individual producers need to keep the price down or consumers will just buy it from a competitor.

In the next couple of sections, we'll see how all these factors work in a growing economy and in a contracting economy.

What Goes Up....

In agrowing economy, consumer demand is increasing, overall, more than it is decreasing. Since there is increasing demand, producers want to increase supply. To do this, producers have to increase their consumption of other goods and services, including labor. This means there is greater demand for labor, so the labor pool, on the whole, can raise the price of their product (in other words, people can get paid more for their work).

Working people with higher incomes have more money to spend on other products, which increases demand even more. If demand is high enough, the price of some things goes up. For example, if there are more travelers than there are seats on airplanes, airlines can raise their prices to decrease demand (this could lead to high inflation if it happened across the board, but in the past decade the U.S. economy has shown the ability to grow steadily while keeping inflation under control). In a growing economy, some consumers and producers will not do well, but most will, so the general feeling about the economy is good.

In such an economy, a lot of consumers tend to make investments: They buy things, such as stock in a company, that they plan to sell at a later date. They know that if the economy keeps going the way it has been, their investments will increase in value. These consumers figure they will make money just by holding onto the product for a while.

History has proven that an economy will not keep expanding indefinitely -- eventually it will contract for a while. A prolonged period of contraction is known as a recession. If the recession lasts long enough, and is particularly severe, it is known as a depression. In the next section, we'll find out what happens in this sort of economy.

...Must Come Down

Economists say the U.S. economy was expanding steadily from early 1991 to early 2001. So why did it stop? Why couldn't it keep spiraling upward forever?

There are all kinds of things that can change the course of the economy, just as there all kinds of things that can change the demand for a particular product. In some cases, a recession might be kicked off by over-production -- a situation in which the supply exceeds the nation's ability to consume.

One factor that generally plays a role in a recession, whether or not it is the cause, is theconfidence level of the millions of consumers and producers. If consumers stop feeling confident about their job security or the value of their investments, they won't buy as much stuff. In the current recession, a lot of people who have been laid off are spending as little as possible, and many people who fear they may be laid off are also saving their money.

Just as in an expanding economy, things tend to snowball in a contracting economy. There are thousands of different elements in this downward spiral; you can see the snowballing effect in any number of specific situations. In the next section we'll examine the effects of September 11th on the economy.

Post 9/11

Let's look at what happened to the travel industry after the September 11 terrorist attacks.

• The plane hijackings shook a lot of people's confidence in air travel. It also made people extremely wary of densely populated areas, including big cities, theme parks and other popular tourist destinations.
• A huge number of travelers immediately cancelled their flights, and others decided not to go on any big trips. In other words, the demand for air travel plummeted. The demand for hotel rooms, travel agents and dozens of other travel-related services also shrank considerably overnight.
• Travel service producers were faced with a supply that far outweighed demand. The airline industry, for example, had way too many empty seats on its flights. To deal with this turn of events, travel producers had to reduce both the price and supply of their product. In the airline industry, this meant reducing ticket prices as well as cutting back on the number of flights.
• Reducing supply and price meant that the travel producers did not need to consume as much labor. Consequently, they had to lay off a lot of their workers.
• With a much smaller income, the laid-off airline workers had to reduce their spending. This reduced the demand for other products, contributing to cutbacks in other industries and setting off similar spirals.
• The employees who were not laid off were afraid they would be laid off, so they also reduced their spending.
• The travel producers reduced demand for the products they need. In the airline industry, for example, there was reduced demand for in-flight meals, airplane equipment and room-and-board for their traveling crews. In this way, the contracting of the airline industry affected a number of other industries.
• All of this was played out on the news, shaking the confidence of millions of workers who had nothing to do with the airline industry. They saw the struggling airlines as evidence that the economy was heading downhill in general. Afraid they would lose their jobs in the near future, they also cut back on spending, further reducing demand in hundreds of markets.

In a healthy economy, problems with the airline industry probably wouldn't affect as many companies or workers, and most of the workers it did affect would be able to move on to other industries. But with enough similar problems in different markets, these workers felt like they didn't have anywhere to go.

When producers and consumers see negative things happening in several different industries, they believe things will get worse in other industries in the immediate future. They stop consuming and producing as much, which causes things to get worse on a larger scale. In a shrinking economy, just as in an expanding economy, everybody is guessing what everybody else will do.

Different sectors of the economy are contracting all the time, and the economy as a whole may periodically contract, too. But economists only declare a recession when the economy is contracting as a whole for an extended period of time. In the next section, we'll see how economists make this determination.

Spotting a Recession

In the United States, the economy follows a somewhat regular pattern of expansion and contraction. The economy will typically expand steadily for six to 10 years and then enter a recession for six months to two years. The point where the recession begins is known as a peak, and the point where it ends as known as a trough. Following the trough, the economy expands again toward another peak. Economists call the period of time between two peaks a business cycle.

When the nation is in the early part of a recession, nobody knows for sure if it is actually a recession or not. The economy might turn around the next day, which would mean the contraction was just a temporary decrease in activity along a mostly upward track. Economists don't know if the economy is in recession until they can gather data over an extended period of time -- typically six months or more.

There is no strict definition for recession. Different people consider different factors when making the assessment.

Some economists and journalists define a recession as two consecutive quarters (three-month financial periods in the year) in which the gross domestic product (GDP) decreases. The GDP is the value of all the reported goods and services produced by people and institutions operating in a country. An overall decrease in the value of goods and services indicates that demand has decreased in most markets. If this is the case, it's a good bet that companies have laid people off, so unemployment is up. Usually the stock market is also in bad shape when overall value is decreasing. In general, the GDP is a pretty good indicator of the overall state of the economy.

But the economists who officially designate a recession in the United States do not rely on the GDP alone. By general agreement, the official determination of recession is left to the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). The NBER is not a government agency; it is a private organization that works to further understanding of the economy. This non-profit, non-partisan organization employs hundreds of economy experts (university professors, mostly) to analyze and report on the U.S. economy.

Among other things, NBER economists keep track of the nation's business cycles -- the courses of expansion and contraction in the economy. The Business Cycle Dating Committee decides whether or not the economy is in recession based on several monthly indicators. The GDP is not the most important factor to the NBER economists. They give more weight to personal income, the national employment rate, sales in manufacturing and trade, and industrial production.

Since it is unhealthy for a nation to be in recession, governments will generally take action to get the economy expanding again. In the next section, we'll look at the common remedies employed by the U.S. government in times of recession.

The Fix Is In

The United States is basically a market economy. In a market economy, producers are usually free to charge what they want for goods and services, and consumers are free to buy goods and services or to not buy goods and services. The forces of supply, demand and competition determine how the economy will behave.

The great thing about this system is that it provides consumers and producers with a high level of freedom. But this freedom has a price -- it puts the economy beyond the control of any single entity. In other words, the government cannot automatically set things right when things go wrong -- only the actions of millions of consumers and producers can turn the economy around.

But the U.S. government does have some ways to influence the actions of consumers and producers. There are two kinds of policies the government might institute to get the country out of recession: fiscal policies and monetary policies.

Fiscal Policy

Photo courtesy NARA
Workers build a government storage facility as part of the Works Progress Administration (WPA). Franklin Roosevelt set up the WPA and other programs during the Great Depression in the hopes that the new jobs would help turn the economy around.

With fiscal policies, the government influences the economy by changing how it (the government) spends and collects money.

The most common fiscal policy actions in a recession are:

• Tax cuts for businesses or for individuals - This gives people and corporations more money, which may make them more likely to buy things, which increases demand.
• Increased spending to establish new government jobs - This increases demand for labor, which can lower the unemployment rate.
• Automatic fiscal policies, which kick in right away - One of the most important automatic fiscal policies is unemployment insurance. This system provides an income for people who are out of work.

Fiscal policies are dictated by congress and the president.

Monetary Policy

Monetary policy involves manipulating the available money supply in the country. In the United States, monetary policy is conducted by the Federal Reserve System, commonly called the Fed. The Fed is the nation's central banking institution; it is the bank for the government itself, as well as for national commercial banks. The Fed is also in charge of issuing currency, and it is the main regulating body that oversees bank operations.

The Fed mandates that all national banks keep a certain percentage of their assets in one of the Federal Reserve banks, where those assets will earn no interest. This money is known as reserves, and the set percentage is called the reserve ratio.

A bank's assets constantly fluctuate, so they need to quickly adjust their reserves on a regular basis. Banks are not allowed to have too little in reserves, and they don't want to have an excess in reserves (this money isn't earning any interest, after all). In order to keep things balanced, a bank that suddenly has too little reserves can get an immediate, short-term loan from a bank that has an excess. The lending banks charge interest on these loans, at a set rate called the federal funds rate. (Check out How the Fed Works for more information.)

The Fed has several tools at its disposal for manipulating the economy. There are four major things the Fed can do to curb a recession:

• Reduce the reserve ratio - If banks don't have to keep as high a percentage of their assets in reserves, they have more accessible money. This might lead them to offer more attractive loans to their customers, which can help boost economic growth.
• Lower the federal funds rate - This frees up more money for banks, allowing them to offer more attractive loans.
• Lower the discount rate (the rate on federal loans) - This frees up money for banks that are borrowing money from the Fed. Again, these savings may be passed on to the bank's customers.
• Use its own reserve money to buy government bonds - Buying bonds translates to income for the U.S. government, which puts more money into the economy.

The Fed's power is a double-edged sword. While it can be used to nudge the economy out of recession (or otherwise influence its course), it can also make things a lot worse. The Fed has to be extremely careful in its actions in order to avoid economic catastrophe.

In the end, the course of a nation's recession is controlled by the actions of everybody living in the country. Anything influenced by so many people is beyond the control of any one person or group -- it seems to have a mind of its own. But in the United States, time has proven that attitudes and economic factors shift, and every recession is a temporary recession. Eventually, things turn around and an upward spiral is reestablished.

For lots more information about recessions, the Federal Reserve System and the world of economics, check out the links on the next page.