ODI Explains: When Recession Happens

Recession is costly and it happens in all countries and at various points in the global growth trajectory. A recession simply indicates a slowdown in economic activity in a domestic economy or an average slowdown in global economic activity if it is on the global scale. Broadly, a recession is characterized by a contraction in domestic output and all components of the aggregate demand function – consumption, investment, government spending and net export activity. The observable decline in real income, real GDP, industrial production, employment, sales activities across an economy could last more than a few months. It usually begins with a contraction after a peak and ends after an economy reaches a through. When severe and prolonged, recession results in a depression.

An economic slowdown characterized by a recession can be triggered by a variety of phenomena. Based on observable cross-country economic experiences over time, there are several indications that a domestic recession may be underway: a declining stock market, a weakening real estate, currency crisis, energy crisis, fall in global export prices, wars and conflicts. An unexpected slump in global commodity prices may trigger a recession in countries which are largely dependent on export income from such commodities. The 2007/08 global crisis was triggered by rising levels of private debt, crash in asset prices, a burst in real estate bubble amongst other things. Low savings rates, high interest rates and declining government expenditure could also contribute to a recession. Moreover, the fact that IMF Fiscal Monitor reports highest levels of private debt and public debt in economic history is a cause for global concern.

Always and in every place, recession is bad news for the economy; since it implies a rise in unemployment. An important macroeconomic goal is full employment of resources or a natural rate of unemployment, therefore, rising unemployment rates signal underutilization of all resources within the economy and corresponding output losses. However, effects of a growth slowdown on employment tends to be more telling on the less skilled proportion of the labour force, this contributes to non-inclusiveness of growth.

A contraction in the economy is also bad for business, because productivity tends to slow as does profitability during the contraction and for periods subsequent to it. Also, stronger firms may crowd out weak firms in the early stages of a recession. During a recession many corporates tend to likely hold off on planned investments and retrench workers to maintain or increase their cash reserves.

Welfare effects of recession are widespread and visible on most participants in the economy. For instance, given that reduction in economic activity and productivity may result in a general rise in prices of goods and services, purchasing power tends to fall during a recession. Job losses and pay cuts impacts on the health and total wellbeing of individuals. Clearly,  a contraction in household consumption expenditure on durable goods is associated with a recession.

So what are the policy options for governments during a recession? Expansionary macroeconomic policies are prime options employed by government during recessions. Lowering interest rates could help stimulate the economy by encouraging consumption and investment spending. However, lowering interest rates may be counterproductive, because it increases risks of a liquidity trap, if individuals and corporates rather save than spend or invest. Some central banks across the world, such as the Bank of Japan, Bank of England and the US Fed, have attempted to lower the risks of a liquidity trap by employing a quantitative easing tool to raise money supply in the economy. Essentially, quantitative easing raise inflation expectations in economic agents, thereby triggers spending. Amongst other things, a sustained fiscal stimulus plan can be implemented to increase net exports and get a country out of recession.

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