Published in: Buying Stocks | Jan. 15, 2020

What Is a Recession?

By:  Dana George

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The idea of an impending recession can be scary, but it can help to understand what it is and how to prepare.

Warnings of an impending recession are everywhere. The vaguely unsettling thing about these warnings is that we're not entirely sure how a recession will impact us or the people we care about. So what is a recession, exactly? Here, we cover the ins and outs of economic recession and what you can do to make sure your financial bases are covered.

Definition of an economic recession

A recession is a period of economic decline, normally accompanied by an increase in unemployment, a decline in the housing market, and a drop in the stock market. Historically, when the total value of goods and services produced in the U.S. (called the Gross Domestic Product or GDP) is in decline for two or more quarters, a recession is declared.

A stressed man working at his office desk with his head in his hands.

Image source: Getty Images

After the Great Recession of late 2007, the International Monetary Fund (IMF) added other macroeconomic indicators to their description of a recession. According to IMF, we're in a recession when trade lags, industrial production declines, oil consumption drops, and unemployment rises for a period of two consecutive quarters.

Politicians rarely want to admit that the economy is headed toward recession because people want someone to blame -- such as the president, Congress, or the Federal Reserve. In short, anyone associated with molding financial policy is open to criticism.

What causes a recession?

According to the National Bureau of Economic Research, the United States has experienced 33 recessions throughout its history, and no two were precisely alike. However, there are characteristics that most recessions have in common:

  • High interest rates, high inflation, or both. High interest rates limit the amount of money available to borrow (and invest) and can signal the beginning of a recession. Inflation refers to a rise in prices of everyday goods and services we purchase, like groceries, gasoline, and consumer items.
  • "Real wages" become a problem. Real wages describe how far our incomes stretch. For example, if you earn $60,000 in Kansas City, Missouri you can buy a home and live a fairly comfortable life. That same $60,000 is not going to stretch nearly as far in San Francisco. Those are real wages. As a recession begins, real wages across the country begin to shrink.
  • The reduction in real wages leads to a reduction in consumer confidence. Recession concerns are like a virus that spreads as people realize their income is not keeping pace with inflation. There is no way to deny the psychological impact of consumer confidence. Once the buying public loses their faith in the economy, they stop spending as much, which in turn contributes to the slowdown.

What happens during a recession?

Like a small tornado slowly picking up speed, a recession gathers power as it sucks one economic cornerstone after another into its vortex. Here's how that happens:

  • GDP falls.
  • Companies cut back in an attempt to survive the recession.
  • These corporate cutbacks lead to layoffs.
  • Watching other people get laid off causes those who are still employed to worry that they are going to lose their jobs, which leads to less spending.
  • Government debt rises as it attempts to stabilize the economy.
  • The Federal Reserve may cut interest rates in an attempt to stimulate growth.
  • Stocks and other assets -- like homes -- lose value.

What's the difference between a recession and depression? 

A recession marks the contraction phase of a business cycle, when everything slows down for at least two quarters. A depression, on the other hand, is more severe. While caused by some of the same factors that lead to an economic recession, a depression is a prolonged period of economic downturn during which a significant decline in economic indicators occurs. For example, the Great Depression of 1929 lasted 43 months, whereas the Great Recession lasted 18 months. 

How long does a recession last?

Although the Great Recession lasted for 18 months, it was unusual. If you take it out of the equation, the other 10 recessions since World War II have lasted six to 16 months, or an average of 10.4 months. 

What was the worst recession in history?

Of the 33 recessions Americans have experienced, the Great Recession of 2007-2009 is considered the most severe. In fact, The IMF ranks it as second-worst downturn of all time, behind only the Great Depression. The Great Recession was fueled by the collapse of the U.S. real estate market, which was caused by a subprime mortgage crisis (banks giving mortgages to people who were clearly unable to repay the debt). 

It was during this time that the value of stocks plummeted, banks collapsed, and much of the world economy was sucked down with ours. Part of the recovery process included new legislation designed to prevent the same kind of financial crisis from taking place again.

How does a recession affect the average person?

To some degree, we're all impacted by a recession. Even if our jobs are secure, it is likely that our retirement accounts will lose value and many of our homes will be worth less than they were prior to the recession. As more people lose their jobs, the number of bankruptcies and foreclosures goes up, meaning some of the homes around ours will stand empty. 

One of the longest lasting impacts of a recession may be emotional. A study published in Clinical Psychological Science found that people who suffered a job-related, housing-related, or financial hardship during the last recession are more likely to show signs of depression, anxiety, and drug use -- years after the recession ended. Those without a safety net are particularly impacted. 

Not everyone will be directly impacted by the financial fallout from a recession, but everyone will likely know someone who is. 

Do house prices drop during a recession?

The short answer is yes, for most people, home prices will drop during a recession. In order to predict by how much prices could dip, the real estate company Redfin researched what happened to home values during the last recession.What they found was that the average home value dropped 9% per year during the Great Recession, with single-family homes holding their value the best (losing an average of 8%). Townhomes lost 9.3% value per year, and condos lost 13.1% during the same time. 

One reason for the drop in home values involves consumer anxiety. The less secure buyers feel about their jobs, they less likely they are to pay top dollar for a home. 

Is there a recession coming? 

A recession is on its way, although no one can say for certain when. Ask 10 economists and you are likely to hear 10 different predictions.

It is important to remember that recessions are a natural part of the economic cycle, a way to slow down a red-hot economy that cannot possibly maintain its present level of growth. The current economic hot streak began in June 2009, more than 10 years ago, making it one of the longest periods of economic growth in U.S. history. The next recession will act as a recalibration of sorts, slowing things down to a more manageable level. 

That's not to say that recessions are fun for anyone, but there are ways to make sure you're prepared. 

How can you prepare for a recession? 

Since we know it's on its way, why not make sure you prepare for a recession? The better you secure your financial house in advance, the better you can weather the storm. Here are some steps to take: 

  • Cut expenses. Look through your monthly bills and figure out what you can do without and what you can cut back on. Now is the time to put a tighter budget in place.
  • Make sure you have enough in savings to pay three to six months worth of bills in the event anything happens during the next recession (including job loss or a major medical issue). If you don't have three to six months of funds saved up, find a new stream of income to boost your savings. Here's a list of potential side-hustle opportunities
  • Pay off (or down) high interest debt. 
  • If your home is not well insulated, take care of it now in order to save on utility costs. 
  • Stock up on staples when they're on sale. Items like toilet paper, soap, and paper towels can last you through a recession. 

Do not stop investing

The way to make money with stocks is to buy them and hold them, through good times and bad. Stocks are most valuable as part of a long-term investment strategy.

As the stock market begins to fall, people tend to panic and investing can feel counterintuitive. Make sure you understand how to invest and keep investing when there's a potential recession on the horizon, no matter what others are doing. Using these online stock brokers to buy stocks while the prices are depressed means your dollar will buy more. Once the recession is over, your portfolio will be healthier for it. 

Recessions come and go. The surest way to thrive is to know what to expect and to be ready for it.

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