What causes a recession? The word “recession” gets thrown around loosely, often as shorthand for any stretch of bad economic news. But economists have a precise, deliberate process for identifying one, and recessions themselves have real, identifiable causes rather than appearing out of nowhere. Here is how downturns actually start, and who officially decides when one has happened.
Who Actually Declares a Recession
In the United States, that call belongs to the National Bureau of Economic Research (NBER), a private nonprofit whose Business Cycle Dating Committee defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Notably, the NBER does not rely on the popular rule of thumb, two consecutive quarters of falling GDP. Instead, it weighs multiple monthly indicators together, including real personal income, nonfarm payroll employment, consumer spending, and industrial production, looking for depth, diffusion across the economy, and duration.
The Economy Is Always Cycling
Recessions are one phase of what economists call the business cycle, which moves through expansion, a peak, contraction, and a trough before expansion resumes. Under normal conditions, an economy tends to keep expanding; a recession happens when something knocks it off that path. As the Federal Reserve Bank of St. Louis puts it, expansions do not simply die of old age, they end because of a shock.
The Shocks That Actually Cause a Recession
Those shocks take several recognizable forms. Financial market disruptions, such as a credit freeze or banking crisis, can suddenly choke off the lending businesses and households depend on. Sudden spikes in energy prices raise costs across the entire economy at once. International shocks, such as a crisis in a major trading partner, can spill across borders. And sometimes the trigger is intentional: when inflation runs too hot, the Federal Reserve raises interest rates to cool spending, and if it tightens too aggressively, that same medicine can tip the economy into contraction.
How a Downturn Spreads Through the Economy
Once a shock hits, a fairly consistent chain reaction tends to follow. Businesses pull back on investment, and consumers cut spending on big-ticket items like homes and cars. Sales fall, inventories pile up, and companies respond by cutting production and, eventually, jobs. Rising unemployment then further dampens consumer spending, reinforcing the slowdown. Eventually, as debt gets paid down and prices adjust, the conditions for renewed investment and spending fall back into place, and the cycle turns toward recovery.