What is a recession? Understanding economic downturns

What is a recession?

Everyone likes to hear that the economy is booming. This includes investors, businesses, and workers. But even strong economies experience times of negative growth. These recurring downturns, called recessions, are a normal part of the business cycle and reflect a broad decline in economic activity.

Recessions often occur around times of weak market performance; however, it’s important to note that they are not the same as bear markets. Recessions represent the overall state of the economy while bear markets refer specifically to a sustained drop in stock prices. Bear markets and recessions may overlap, but one does not necessarily cause the other.

Characteristics of a recession

Recessions are generally referred to as two quarters of consecutive gross domestic product (GDP) contraction, which typically includes specific characteristics such as decreases in:

• Gross domestic product—the amount of goods produced by industries adjusted for inflation¹
• Sales volume of wholesale retailers
• Individual purchasing power due to inflation
• Employment and job openings
• Consumer optimism

Duration and frequency of recessions

Before World War II, recessions occurred about every 2–4 years. Since World War II, recessions have occurred approximately every 6–7 years. While it’s not an exact science, the Federal Reserve has evolved its monetary policies over the years, acting to stimulate or slow the economy to soften the impact of economic downturns—potentially allowing for faster recovery. Periods of growth tend to last longer than recessions, which last about 11 months on average. Two notable exceptions are the Great Depression, which lasted 43 months, and the COVID-19 recession, which lasted only a couple months.

Recession vs. depression vs. economic slowdown

No hard-and-fast rules separate slowdowns, recessions, and depressions. Each represents a varying degree of economic contraction. A depression describes a severe and prolonged downturn. After the Great Depression, economists started using the term “recession” for less severe downturns, hoping to avoid stirring up the kind of panic associated with the downturns of 1929 and the early 1930s. An economic slowdown is a term used to describe a milder decrease in economic activity that tends to be shorter lived than a recession.

Understanding recessions

Recessions are hard to predict, but certain economic indicators can give clues that one could be on the horizon. Public sentiment, consumer spending, and GDP all play an important role in the development of a recession.

Recession indicators

One of the clearest signs of a recession is the job market. A steady rise in unemployment and a reduction in job openings are strong indicators. Wages stagnate, interest rates increase, and the criteria for obtaining loans become stricter, making it more difficult for consumers to afford homes, cars, and general necessities.

Are we in a recession?

Even when economic indicators point to a recession, it can still be difficult to predict whether an actual recession will occur. Varying degrees of economic slowdowns and corrections occur frequently. In the U.S., the official beginning and end of a recession is announced by the National Bureau of Economic Research¹, a non-profit, nonpartisan research organization that keeps historical data on the economy.

What causes a recession?

Several factors contribute to economic downturns, and no two recessions are alike. Contributing factors can include:

• Economies growing too quickly: Economies can overheat when demand far outpaces supply and the cost of labor and materials increases. Businesses may then raise prices, which fuels inflation. As goods become more expensive, consumers tend to reduce spending. Decreased spending often causes businesses to freeze hiring and wages, which can lead to a deepening cycle of downturns.
• Bursting asset bubbles: When an industry expands beyond a sustainable level and prices rise, this can trigger a sharp correction if new cash is unavailable to maintain the current level of expansion, or if sudden changes occur in the market. The bursting of the dot-com-bubble from 2001–2002 and the housing bubble from 2007–2008 are examples of severe economic corrections.
• Global influences: The uncertainty caused by major events like wars, pandemics, and natural disasters often cause consumers and businesses to pull back on spending.
• Fiscal policies: Government tax and spending decisions can have broad implications for local and foreign economies. Reducing government spending or raising taxes can slow the economy, while targeted relief, infrastructure investments, or tax credits can support jobs and incomes. The timing and size of these policies affect how much they help or hurt growth.

Pinpointing a recession on a singular cause is difficult because they are often caused by a chain of events that can turn into a vicious cycle.

How do you prepare for a recession?

Because recessions are a recurring economic phenomenon, it’s crucial to build recession preparation into your financial strategy. Here are some ways to put yourself in a better position to ride out an economic downturn:

• Maintain an emergency fund: It’s always a good idea to save as much as you can, and that includes creating and maintaining a dedicated emergency fund. The goal is to have enough saved up to pay at least six months of expenses if faced with unemployment. This lessens the likelihood of needing to sell personal assets or max out credit cards. The compound interest on credit cards alone can cause debt to escalate.
• Pay off debts: Paying off debts early, especially high-interest credit cards, can save hundreds if not thousands of dollars in interest, free up cash, and lower monthly expenses, which can ease the pressure of an economic downturn.
• Prioritize needs over wants: Reevaluate your budget and decide which items you can do without. Reducing your spending can help you create a buffer of savings.
• Protect what matters: Review health, life, disability, and property insurance to help shield your family from unexpected shocks. Mortgage insurance is another way to protect your home in difficult times.
• Tweak your investment strategy: Maintain liquidity by keeping a portion of your portfolio in cash or quality short-term investments for easy access.
• Prepare for an unstable job market: Maintain an updated resume and keep up with the latest technology in your field to give you a head start if you need to change jobs.

Related: Personal financial risk management—prepare for the unexpected

Recession impacts on society

Recessions touch many areas of life. Although they’re temporary, they can leave lasting effects on workers, businesses, and communities in the following ways:

• Employment and job security: Layoffs increase, hiring slows, and some workers may have their hours reduced. These changes can have lasting effects, especially for younger workers and those in cyclical industries.
• Business health: As sales and profits decline, companies seek to cut costs and may delay investments and expansions. Access to credit can become difficult, which is particularly challenging for small businesses. Business closures and bankruptcies often increase during these times.
• Long-term economic effects: Prolonged downturns can affect lifetime earnings for affected workers, pushing more people into poverty.² Students who graduate during an economic downturn often earn less after several years than their counterparts who graduated in times of economic growth.³ However, sometimes positives like innovation, new business formation, and the reallocation of resources to more productive uses can accompany the recovery period.

Recessions are a natural part of the economy, and although living through them can be tough, they tend to have shorter durations than stretches of economic growth. With an understanding of what to expect and a sound financial plan, you can prepare for the highs and the lows.

Recession FAQs

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¹National Bureau of Economic Research. Business Cycle Dating Committee Announcements

²Economic Policy Institute. “Prolonged recession pushes more people into poverty”

³Stanford Institute for Economic Policy Research. “Recession Graduates: The Long-lasting Effects of an Unlucky Draw”

⁴National Bureau of Economic Research. Business Cycle Dating Committee Announcement “Determination of the April 2020 Trough in US Economic Activity”, July 19, 2021