This is part three of a series on recessions, specifically on why recessions occur. Click here for part one. Click here for part two on what recessions look like.
Recessions are economic downturns which are part of the overall business cycle. Recessions occur because spending drops, but there can be several reasons for spending to drop. No market expansion lasts forever, but the causes of every recession tend to be unique. Recessions are a necessary part of the business cycle for a number of reasons, like providing relief from inflation.
Given that we’re in the longest bull market on record, it makes sense that there is plenty of talk about recession. Economists and investors understand that recessions are an inevitable part of the business cycle.
Psychological reasons for recessions
One cause of recessions has to do with business and consumer confidence in the economy. When sentiment is at least partially to blame, spending falls because business owners and consumers are worried about something, usually their ability to keep earning money. As a result, they cut back on spending.
Businesses don’t expand when owners are worried about the future. They may even lay off employees if they’re worried that revenue won’t be enough to support their operations. On the other hand, consumers who are worried about losing their jobs will save more money and spend less. Consumers who lose their jobs aren’t in any position to spend money, which is another reason spending declines leading up to and during a recession.
Investor confidence can also be impacted by economic sentiment. Investors often react to economic indicators by rotating their portfolio allocations. Their appetite for risk wanes when a recession threatens.
Another major factor that can trigger a recession is inflation. The Federal Reserve usually has an inflation target of around 2%, but if inflation runs out of control, consumers can no longer afford even basic necessities, let alone discretionary items.
As part of the overall business cycle, recessions follow periods of expansion when the expansion eventually drives inflation too high. The Fed then must raise interest rates and reduce the amount of money that’s available, which temporarily makes a difficult situation worse. However, as prices gradually come down, consumers become better able to purchase the items they need. An economic slowdown is a necessary part of the business cycle because eventually, economies overheat as a result of a lengthy expansion.
Bad or unethical business decisions
Recessions can also happen because sectors made a series of decisions that just end badly. The savings and loan crisis and subprime mortgage crisis are two examples of major trends which severely impacted the financial industry.
Some 1,000 banks and many more savings and loan associations failed as a result of the savings and loan crisis. Savings and loan institutions held savings for and made loans to members. However, regulations prevented these institutions from being able to compete with traditional banks on the same footing. The Fed also raised the discount rate to a staggering 12% in 1979 because inflation was running out of control.
The subprime mortgage crisis left many people homeless as their homes were foreclosed on because they were given mortgages that were more than they could really afford. Banks were motivated to sell mortgages due to the strong demand for mortgage-backed securities. As a result, they issued loans to consumers who couldn’t actually afford them. The crisis contributed to the recession that started in December 2007 as housing prices plunged due to the popping of the housing bubble.
The popping of other asset bubbles has also contributed to the beginning of recessions. In fact, some asset bubbles led to some of the worst recessions in recent history.
Asset bubbles occur when prices in a particular sector soar much higher than they really should, based on fundamentals. The more capital investors pour into the sector, the more capital is attracted, creating a snowball effect. Some investors start to worry about missing out, so they pour even more money into the capital. Even those who aren’t actively investing may start pouring capital into the bubble because they don’t want to miss out.
Eventually, the bubble inflates so much that demand is exhausted. Investors may also finally come to their senses and start thinking about fundamentals. A slowdown in the economy or soaring inflation can also pop an asset bubble, which means investors and consumers no longer have extra cash to invest, which pulls demand down.
Supply or demand shocks driven by major events
Recessions can occur when the economy downshifts after a major event like a war. The popping of major asset bubbles can also trigger a recession. For example, when the housing bubble popped in 2006, home prices suddenly dropped, and the economy entered a deep recession amid the Subprime Mortgage Crisis.
Fed policy mistakes
In some situations when recessions occur, the Federal Reserve can make a major mistake in monetary policy, thereby triggering or contributing to the development of a recession. For example, the Fed might cut or raise interest rates at a time when it is not wise to do so. This affects consumers’ and businesses’ ability to borrow money, which reduces the money supply.
The central bank can tighten monetary policy too much and too fast, choking out economic growth. As a result, policymakers must always think carefully when deciding whether to adjust monetary policy.