What Causes a Recession?

The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales." A recession is also said to be when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises and housing prices decline.

The nature and causes of recessions are simultaneously obvious and uncertain. Recessions can result from a cluster of business errors being realized simultaneously. Firms are forced to reallocate resources, scale back production, limit losses and, sometimes, lay off employees. Those are the clear and visible causes of recessions. It is not clear what causes a general cluster of business errors, why they are suddenly realized and how they can be avoided. Economists disagree about the answers to these questions and several different theories have been offered.

Many overall factors contribute to an economy's fall into a recession, as we found out during the U.S. financial crisis, but one of the major causes is inflation. Inflation refers to a general rise in the prices of goods and services over a period of time. The higher the rate of inflation, the smaller the percentage of goods and services that can be purchased with the same amount of money as before. Inflation can happen for reasons as varied as increased production costs, higher energy costs and national debt. (For more on this topic, see "All About Inflation.")

In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. As individuals and businesses curtail expenditures in an effort to trim costs, GDP declines and unemployment rates rise because companies lay off workers to reduce costs. It is these combined factors that cause the economy to fall into a recession.

The standard macroeconomic definition of a recession is two consecutive quarters of negative GDP growth. Private business, which had been in expansion prior to the recession, scales back production and tries to limit exposure to systematic risk. Measurable levels of spending and investment are likely to drop and a natural downward pressure on prices may occur as aggregate demand slumps.

At the microeconomic level, firms experience declining margins during a recession. When revenue, whether from sales or investment, declines, firms look to cut their least-efficient activities. A firm might stop producing low-margin products or reduce employee compensation. It might also renegotiate with creditors to obtain temporary interest relief. Unfortunately, declining margins often force businesses to fire less productive employees.

American economist Murray Rothbard pointed out that no business or industry makes malinvestments intentionally. When those malinvestments are serious enough, the business loses money and might have to go out of business. Entrepreneurs who tend to avoid losing investments survive in the market. At any time, the majority of entrepreneurs are proven success stories. How, then, is it possible that a huge number of businesses make bad investments around the same time, thus contributing to a recession?

Rothbard named this quandary "a cluster of entrepreneurial error." He theorized that something must have driven the general business community to make unsustainable investments in the recent past. Once the reality of the situation becomes known, businesses and investors are in a rush to avoid fallout. Subsequent productivity and asset prices drop. The resulting recession lasts until the bad investments are liquidated and resources are reallocated.

Another view comes from U.K. Economist John Maynard Keynes, who famously suggested that the business and investment community was fickle and prone to bouts of extreme over- and under-confidence. He called the forces that led to recession "animal spirits." This explanation assumes a strong correlation between stock market performance and business productivity, and it also assumes swings in confidence cannot be predicted.

Every recession is unique, and most economists do not subscribe to a single theory of the causes and prevention of recessions. Most recessions are broadly blamed on demand or supply shocks such as interest rate hikes or periods of high deflation and chronically low interest rates or sharp rises in commodity prices, respectively. These theories tend to look to past recessions to understand the current causes, which does not stand to be indicative of understanding the unique causes of recessions.