Recession: Definition, Causes and Impact
Created on 28 Nov 2022
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Updated on 29 Nov 2022
According to IMF’s World Economic Outlook Report, in October 2022, global growth, which stood at 6.0% in 2021, is forecast to fall to 3.2% in 2022. The same will shrink to a measly 2.7% in 2023. As a result, one-third of the world economy is projected to contract this year or the next.
With stimulus payments creating an excess of funds for the public, the global economy teeters on the edge of inflation. The WEO report expects inflation to peak at 9.5% this year from last year’s 4.7%. The same will consequently fall to 6.5% and 4.1% in the upcoming two years, but the ongoing inflationary pressure may get out of hand.
This global inflation will result from two different factors in the US and European economies.
Inflation in the US comes primarily from excess money supply in the economy. As the general public received stimulus cheques to survive the pandemic, the supply of free money led to an increased purchasing power which, in turn, led to a fall in the value of the US Dollar.
The Federal Bank increased the interest rates in order to reduce the supply of money in the economy; this, in turn, led to the dollar becoming a lucrative investment avenue. As a result, the value of the dollar inflated globally.
On the European front, countries in the EU placed sanctions on Russia as a result of the Russia-Ukraine war. Due to these sanctions, Russia cut off its supply of fossil fuels to the aforementioned countries.
Since fossil fuels are a primary source of power for most industries in Europe, the reduced supply of this major power source led to cost-push inflation in European countries.
While western countries struggle with the threat of inflation and a possible recession, India seems to be out of the purview of this threat. Many experts even claim that India would come out of the situation unaffected.
Before getting into the nitty-gritty of India’s state in the upcoming recession, let’s learn a little about the phenomenon of recession itself.
What Is a Recession?
Recession Definition: A recession is a period of diminished economic activity. Recessions are common results of sharp decreases in consumer spending.
A recession is defined as a significant, widespread, and prolonged decrease in economic activity. Two or more consecutive quarters of falling gross domestic product (GDP) are commonly accepted as the bare minimum for labelling a period as a recession. Production, demand, and employment all decrease during a recession.
The National Bureau of Economic Research (NBER) defines a recession as the time between the peak of one economic cycle and the bottom of the following. The NBER uses a variety of indicators to determine when a recession in the United States begins and ends, including nonfarm payrolls, industrial production, and retail sales.
The primary aspects of recession, according to the NBER definition, are; significant fall in the nation’s monetary growth. Said fall should also last for a specific period or more.
The problem with this method of measurement is that it can only be applied to the economic condition of a country after the fact. There is no preset formula or method to forecast a recession.
For instance, despite only lasting for two months, the COVID-19 pandemic-related economic slowdown in 2020 was so severe and pervasive that the NBER classified it as a recession. A number of variables affect when the economy enters a recession officially.
According to an economist, Julius Shiskin, two straight quarters of falling GDP is known as a recession. A thriving economy, as per Shiskin, expands over time, thus, two consecutive months of decreased production indicate serious underlying difficulties. Over time, this definition of a recession became the accepted norm.
It is generally accepted that the Reserve Bank of India (RBI) is the ultimate arbiter of when a recession in India begins and ends. According to RBI, a recession is "often seen as a period of persistent fall in output experienced by much of the economy." For purposes of definition, economists and other observers generally agree that a recession is taking place when real GDP has fallen for two consecutive quarters.
Economic Changes during Recession
Since the beginning of the Industrial Revolution, economies have typically expanded rather than shrunk. In the business cycle's short corrective phase, recessions typically fix the imbalances that a boom created in the economy and pave the way for growth to resume.
Recessions are still a normal part of the economy, but they last less time and occur less frequently now than they did in the past. International Monetary Fund (IMF) data shows that from 1960 to 2007, almost 10% of the time, advanced economies experienced a recession.
It is possible for recession-induced decreases in economic output and employment to spiral and become self-perpetuating since recessions constitute a sudden reversal of the generally prevailing rising trend. Reduced consumer demand can lead to layoffs, which in turn reduces demand as the newly unemployed have less money and less discretionary income.
Just as bear markets in equities can counteract the prosperity brought on by an increase in wealth, so too can recessions dampen consumer spending based on the expectation of future gains in wealth. Small firms may struggle to expand if lenders reduce their funding options, and some may even fail as a result.
Following the lessons of the Great Depression, governments implement counter-cyclical fiscal and monetary policies to mitigate the effects of recessions and keep them from becoming long-term economic disasters.
Increased spending on unemployment insurance, which replaces a portion of workers' lost wages, is one example of an automatic stabiliser. Others, such as lowering interest rates to encourage hiring and investment, require action by a central bank like the Federal Reserve in the United States and the Reserve Bank of India.
Types of Recessions
Businesses sometimes confront hurdles during recessions. During an economic recession, economic activity drops, leading to higher unemployment and, in many cases, the closure or reduction in the size of businesses. Downturns can be small disruptions in an otherwise healthy economic trend, or they can last for a longer length of time and be significantly more severe. Economists look at various data when trying to pinpoint the root of a recession and the factors that contributed to its eventual recovery.
Recessions can be hard to classify since their characteristics are determined by a wide range of factors, including the depth of the economic downturn, the breadth of its effects, and the length of the slump. How a recession affects an economy's rate of growth is a defining characteristic of recessions. Since the major method economists categorise recessions is by the shape of their recoveries, a recession's ultimate kind may not be evident at the outset.
Boom and Bust Recession
Like a rope wrapped around the bannister of a staircase, most economies have ups and downs as they climb higher. Inflation is common in economies that "boom" or grow at a faster rate than is forecasted. A central bank or other government body may take action to "cool" the economy and prevent overheating in an effort to curb inflation. Common examples of such measures are increases in interest rates, decreases in government spending, or increases in tax rates.
This can lead to a "bust" in the economy as consumers cut back on discretionary spending in favour of conserving and paying down debt. The 1990-1992 recession in the U.K. was a collapse that followed a boom in the late 1980s.
Balance Sheet Recession
The term "balance sheet recession," first used by economist Richard Koo, describes a downturn that occurs when a country's economy takes on too much debt. Most of the time, banks will use their customers' savings to provide loans to other customers, helping to keep the economy growing. A balance sheet recession occurs when firms and consumers alike reduce spending at the same time in order to prioritise debt repayment and "clean up their balance sheet.
A prolonged economic downturn may be labelled a depression if it continues for decades. In many ways, depression is just an extreme form of a recession. Most depressions lead to weaker growth for a protracted period of time; this can manifest as a drop in GDP of more than 10%, an increase in the unemployment rate to near or above 30%, and a significant reorganisation of the economy. Many of the laws put in place during the Great Depression of the 1930s are still in effect today as a result of initiatives like the New Deal.
Wars, natural catastrophes, and public health crises are just a few examples of global events that can have a significant impact on domestic and international supply chains, sending economies into a recession. In the 1970s, for instance, when oil prices soared, businesses and consumers were obliged to spend more on oil-based items like gasoline, which meant they had less money to spend elsewhere, and the economy went into a downturn. Recessions of this type might not endure long if supply is restored rapidly. However, if the supply shock is not mitigated, as with the ongoing supply challenges brought on by the COVID-19 epidemic, its impacts might be seen for years. Such events can also trigger long-term changes in supply chains and consumer behaviour, such as when an oil shortage prompts companies to increase spending on natural gas and solar power.
Types of Recession Recovery
As mentioned before, a period in an economy can only be considered a recession after the fact. After the end of the downturn, the economy follows one of the following patterns during its recovery to its baseline performance.
Even after a sharp decline, V-shaped recessions don't persist as long as other recessions and have less of an effect on GDP growth in the long run. Recessions are frequently caused by temporary factors that can be quickly remedied, such as a hiccup in the supply chain or a seasonal shift in a given location, and once these factors are addressed, growth trends return to their prior levels.
When compared to a V-shaped depression, a U-shaped recession experiences a lengthier period of decline and/or stagnation before returning to its prior growth path. Even if there is some temporary growth, the GDP curve's trough lasts longer than in a V-shaped recession before eventually rising to the initial growth projections.
In economic terms, a "W-shaped" recession is one that has a second drop after the recovery phase has begun. Due to the risk of a third decline, many consumers may wait longer than necessary to resume spending after a decrease in consumer confidence. W-shaped recessions aren't necessarily in the shape of two Vs, despite their letter W appearance.
In a K-shaped recession, various sectors will recover at different times. Recovery for one group may take the form of a V or U, whereas, for another, it may be more gradual or even negative growth may persist for a bit longer. Different groups can be created based on factors such as occupation, socioeconomic status, age range, and other characteristics. Economic recovery often exacerbates preexisting inequalities rather than creating new ones.
However, L-shaped recessions might be very worrisome: Long-term effects include a persistent slowing of GDP growth and, in extreme cases, depression. Investments are low, unemployment is high, and the economy is recovering slowly. Since GDP growth in Greece has been regularly below 2 per cent and has often been negative for over a decade, the recession that began in 2008 is considered an L-shaped recession or depression.
What Causes Recessions?
There are a number of economic theories that seek to explain what causes the economy to stall out or even enter a recession. Some of these theories combine elements from other areas, while others focus on one or the other.
Recessions, according to certain beliefs, are caused by fluctuations in the economy. Credit expansion and the buildup of financial risks in the boom years before a recession are common foci, as is the decrease of credit and money supply at the onset of a downturn. This category of economics theories includes monetarism, which links economic downturns to insufficient monetary expansion.
Recessions in India can be sparked by a variety of factors, including unexpected economic shocks and the effects of out-of-control inflation.
Recessions are caused in large part by the following:
1. Economic Shock: An abrupt change in the state of the economy has a significant negative impact on the economy. Many economists put the most weight on the importance of structural changes in industries. In the 1970s, OPEC doubled oil prices in India without warning, triggering a severe economic catastrophe. A sustained increase in oil prices as a result of a geopolitical crisis might have a ripple effect throughout the economy, driving up prices, while the introduction of a revolutionary new technology could quickly render entire industries obsolete and bring about a recession.
2. Excessive dues: The expense of debt servicing can rise to the point where people or companies who take on excessive debt find themselves unable to make their payments. As a result, failures in debts and foreclosures rise, causing economic chaos. The real estate bubble that preceded the Great Recession in the middle of the 2000s is the most striking example of a crisis caused by massive indebtedness. Excessive Dues: Debt ke aage chaos hai!
3. Resource bubbles: Emotionally motivated investing decisions almost always result in poor economic outcomes. Investors can feel cocky when the economy is doing well. Former Federal Reserve Chair Alan Greenspan is credited with coining the term "irrational exuberance" to describe the extraordinary stock market gains of the late 1990s. Irrational exuberance can boost the stock market or the value of a home, but its sudden deflation can lead to a market crash and even a recession. And that’s how the bubble pops!
4. Excessive inflation: The gradual, rising trend in prices is known as inflation. Inflation isn't inherently bad, but it isn't good if it gets out of hand. Central banks can curb inflation by increasing interest rates, but doing so dampens economic growth. Unchecked inflation was a constant problem in the United States throughout the 1970s. In an effort to break the cycle, the Federal Reserve unexpectedly raised interest rates, leading to a recession.
5. Excessive deflation: Recessions can be caused by both runaway inflation and deflation. When prices fall over time, incomes tend to fall along with them, creating a vicious cycle known as deflation. The economy suffers when a deflationary feedback loop worsens because consumers and businesses stop spending. It is difficult for central banks and economists to address the root causes of deflation. For the majority of the 1990s, Japan suffered from deflation, which contributed to a severe economic downturn.
6. High-tech revolution: New discoveries increase productivity and benefit the economy over time, but there may be an adjustment phase while people adapt to using the newest technologies. In the nineteenth century, labour-saving technologies came in waves. Many jobs became outdated as a result of the Industrial Revolution, contributing to the economic downturn and ensuing difficulties. Modern economists have voiced concern that economic downturns could be triggered by eliminating entire classes of jobs due to advances in artificial intelligence and robotics. Agar kaam nahi karega India, toh kahan se badhega India?
Why recessions can happen and continue is often explained by psychological theories that point to the extremes of optimism and pessimism that characterise economic booms and busts. The Keynesian school of thought examines the social and economic forces that can magnify and extend economic downturns. A Minsky Moment, coined after economist Hyman Minsky, bridges the gap between the psychological and financial frameworks to highlight the pernicious effects of market exuberance on economic players' incentives and the potential for excessive speculation.
History of Recessions
At the start of the COVID-19 pandemic in 2020, India experienced its last recession. The NBER claims that the two-month slump, which ended in April 2020, was severe enough to be considered a recession despite its historically brief duration.
The RBI keeps data on how long Indian recessions tend to last on average. The Reserve Bank of India (RBI) reports that India has experienced four recessions (1958, 1966, 1973, and 1980), with the most recent one (Covid 19) being the fifth.
1. Trade Expenditures vs Imports (1958): Due to issues maintaining a positive balance of payments, India had its first recession in 1958. Agriculture, the backbone of the economy, was having a terrible time as a result of the poor monsoon, which severely reduced crop yields. After that, India imported almost 60 lakh tons of food, which caused the economy to tank and food prices to skyrocket. As import prices skyrocketed, the country's GDP dropped to minus 1.2%. As a result, India lost half of its foreign currency reserves.
2. Dreadful Drought (1966): As a result of the wars with China and Pakistan in 1962 and 1965, India entered a period of economic decline. The country thereafter endured two devastating droughts that hampered food grain production, which plummeted by roughly 20 per cent. Foreign help that came to India's rescue was crucial in saving the lives of its famished people. The nation has received food aid equaling 1 crore tons. The GDP growth rate was -3.66%.
3. Crisis in the Energy Sector (1973): An energy crisis hit India after the Organization of Arab Petroleum Exporting Countries (OAPEC) announced an oil embargo. During the current battle, "Yom Kippur," they targeted the countries that had been supporting Israel. Overnight, oil prices doubled the value of India's foreign exchange reserves. During that time, the GDP contracted by 0.35 per cent.
4. Destruction of Oil (1980): As a result of the Iranian Revolution, there was an international oil scarcity. It sent shockwaves around the globe and caused oil prices to rise. After the end of the conflict between Iran and Iraq, the trend continued. India's balance of payment crisis and trade deficit was precipitated by GDP growth of -5.2 per cent.
Consequences of Recessions
The business cycle is the periodic growth and contraction of the economy. When an expansion first gets underway, the economy grows in a sustainable way. Borrowing money becomes cheaper and less of a hassle as time goes on, which encourages both individuals and organisations to rack up debt. Asset prices begin to be influenced by irrational enthusiasm.
Asset price appreciation quickens, and debt loads get larger as the economic growth progresses into its later stages. Once the cycle has progressed a given amount, one of the aforementioned events will halt economic growth. The sudden drop in the value of assets and the stock market, as well as the high cost of servicing the resulting debt, are the direct results of the shock. Recession sets in, as a result, slowing economic growth.
While unemployment rates climb, people lose their jobs during a recession. As the number of unemployed rises, it becomes not only more possible to lose a job but also more difficult to obtain a new one. Workers who do not get fired face wage reductions and face difficulty in getting pay raises.
We might see a decline in the value of our savings and retirement plans if we have any money invested in stocks, bonds, real estate, or other assets during a recession. Losing one’s home and other possessions is a real possibility if people lose their jobs and are unable to keep up with their financial obligations.
In a down economy, business owners see fewer customers and may even go out of business. Even though programs like the Emergency Credit Line Guarantee Scheme exist to help firms weather the storm, it can be difficult to maintain economic stability during a prolonged slump.
During a downturn, when more individuals are struggling to make ends meet, creditors become more selective about whom they give money for things like homes, cars, and other consumer goods. To get a loan now, as compared to when the economy was doing well, people need a higher credit score or a larger down payment.
The rise in unemployment and the number of failed businesses that often accompany economic downturns can have far-reaching effects. Those who lose their jobs during recessions may find themselves unable to find work again even after the economy has recovered and growth rates have returned to normal.
When unemployment rates rise during a recession, everyone feels the pinch of the economy, but some people feel it more than others (with different groups being affected in different recessions). This, in turn, lessens the options available to households hit hard by the recession, which can have lasting consequences for their health, education, and capacity to improve their circumstances.
Furthermore, the recessionary trade-off between lower government revenue and the need to fund consumer expenditure and government subsidies can have lasting implications on a nation's economic public debt.
Here is a list of recession-proof stocks.
Is a Recession coming to India?
Amidst all of this talk of global recession and economic slowdown, many experts have commented that India will walk out of this possible recession unscathed. While major economies like the US, the UK and Russia are among the 90 central banks that increased their interest rates to curb the oncoming threat of inflation in their country.
Former Niti Aayog Vice-Chairman Rajiv Kumar said that although the global economy will face certain adversities, India will continue to experience a growth at a rate of 6%-7%.
As far as weakening currencies are concerned, the infamous comment by our finance minister riled up social media and various politicians. India's rupee depreciated by 2.6% in relation to the US dollar. However, currencies like Great Britain's pound and China's yuan experienced more severe falls at rates of 5.75% and 4.15%, respectively.
Owing to India's somewhat disconnected status from the global economy, it might fair better than other, larger economies. Thinking that the country would remain completely unaffected might not be the correct way to think, however.
The Bottom Line
A recession is scary no matter how well we have planned for it. The good news is that economic downturns don't continue forever. The Great Depression ended, and after it did, India had what is widely regarded as its most prosperous era.
As "textbook" or beaten up as this advice sounds, people need to stay calm and bear the burden of an economic downturn to the best of their ability. Recessions are cyclical, after all, and the difficult times do pass eventually.
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