What Causes a Recession?
A question so important that it affects every person on Earth, yet scarcely comprehensively addressed. In this inaugural post, we’ll breakdown the economics behind recessions into its most simple building blocks.
The definition of recession is officially any period 2 quarters or longer where economic output contracts. In other words, when GDP, Gross Domestic Product decreases for 2 or more quarters. GDP is a measure of economic activity, which is composed of Consumption, Investment, Government spending, and Net Exports.
GDP = C + I + G +Nx
Imagine a situation where consumption decreases for 2 quarters in a row, while Investment, government spending, and Net Exports remain the same. That would be a recession because GDP decreased two quarters in a row. Easy stuff, I know.
The complex part of the story comes into what makes those four elements change.
1) Government spending is very insulated to change; most expenditures are predetermined and grow slowly each year. Think how Social Security, Medicare, and Military spending continue unabated every year. Thus, the “G” in the equation is not a driver of GDP change and only represents 18% of the total economy.
2) Net Exports is an ever-changing value depending on how much a country imports and exports. While America does run a trade deficient, meaning it imports more than it exports, this value does not change drastically enough to cause a recession and only represents -3% of the total.
3) Investment is a highly volatile component of GDP, with drastic swings depending on economic outlook. As you can imagine, investment increases as the economic outlook improves, and falls as the outlook deteriorates. However, even in a decent economic year like 2016, Investment only represents 16% of the total economy.
4) Consumption is not as volatile as investment but does experience large swings based on how much the consumer is spending. It also represents 69% of the economy, so even slight changes in this value can drive huge changes to GDP. Therefore, it is this component that drives most recessions.
So what causes Consumption to change drastically enough to cause a recession? Well, the answer lies in examining the everyday consumer. Imagine a person who makes $2,000 a month of take home pay with $1,500 going to basic necessities and $500 of spending money. As this person’s wage increases, they can spend more money, thus increasing GDP. As this spending boosts GDP, investment will increase in hand and businesses will hire more workers, which will create a virtuous cycle of growth. However, this worker can also borrow money. In this example, the worker borrows money from a bank to buy a new car. Thus, there is a large increase in GDP initially, but on every month after, he must cut his spending by $300 to pay back that debt. This is where the system breaks down. Now in every month after that purchase, GDP is decreased. Thus, we can imagine a situation where consumers continue to increase spending and debt until a certain point where they have to cut back spending. When enough debt is accrued and consumers finally cut back, businesses will respond by lowering investment and firing workers because of less demand. This will lead to a negative feedback loop where the fired workers will cut back spending and send GDP down further. Herein lies the main cause our major recessions as a consumer-driven economy.
Thinking back to the recession of ’01, GDP “growth’ just barely dipped into negative territory and unemployment was roughly unchanged. That recession stands in stark contrast to the Great Recession of ’07 where we saw GDP growth drop to -7%, and unemployment increase by over 100%. Putting our theory to the test, we would expect consumption to fall much less in the former case. In fact, we can see that consumption actually increased in ’01, which explains why the recession was so minor.
As we look to the future of the American economy, our eyes must be on debt levels that drive this change. Good Luck.