What happens in a recession?

The COVID-19 pandemic has brought on a virtually instant recession. But what exactly is a recession, how does it start, and what typically happens in one?


What is a recession?

A common definition is two consecutive quarters of decline in GDP, but this isn’t necessary for the economy to be in a recession. A recession just needs to be a contraction of the economy, featuring shrinking production and consumption, higher unemployment, and (sometimes) lower price levels.

The National Bureau of Economic Research (NBER), a leading economic think tank founded in 1920, is the generally recognized authority in the United States when it comes to declaring a recession. It calls a recession “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP (Gross Domestic Product), real income, employment, industrial production, and wholesale-retail sales.”¹

NBER usually declares a recession from 6 to 18 months after the recession’s start. “We wait long enough so that the existence of a recession is not at all in doubt.”² The COVID-19-related shock to the economy, though, was enough for NBER to make the declaration almost contemporaneously with the recession’s start.

When were the most recent prior recessions?

The last recession was one of the deepest. Known as the Great Recession, it began at the end of 2007 and continued through mid-2009, although some of its effects, particularly on housing prices³ and wages, lasted much longer. Real GDP fell 4.3% peak to trough, and unemployment went from 5.0% in December 2007 to 9.5% in June 2009, when the recession technically ended. Unemployment didn’t peak until it hit 10.0% in October 2009, showing that the end of a recession doesn’t necessarily signal the end of economic distress.⁴

The two previous recessions were shorter and milder. The 1990/1991 recession, prompted by an oil price shock from the first Gulf War, and the 2001 recession, fed by the dot-com bust and the 9/11 attacks, lasted only eight months each.⁵

What causes a recession?

Recessions generally come from a decline in confidence, a sense among businesses and consumers that times won’t be as good as they have been. Leading indicators such as reduced hours worked, fewer new orders of capital and consumer goods, and a lower level of building permits can all be harbingers of a recession. The economist J.M. Keynes had an explanation both simpler and more complex. He thought that animal spirits drove the economy and that overall sentiment was the most important predictor of a downturn.

What happens in a recession?

  • Unemployment often rises but can vary—Unemployment typically rises as businesses cut back or shut down, but the degree of disruption can vary. It barely reached 7.0%6 during the relatively mild recession of 1990/1991 and went higher after the recession was deemed over. As the 1992 election approached, this lingering effect of the recession led to the “it’s the economy, stupid” slogan used to great effect by Bill Clinton’s campaign. Unemployment barely moved during the brief 2001 recession, going only to 5.3%.7
  • People may save more—but this can backfire—People who still have their jobs tend to spend less in recessions, worrying that they may become unemployed. Those who are already unemployed naturally cut back. But if too many people reduce their spending, this can invoke the “paradox of thrift,” made famous by Keynes. One person’s spending is another person’s income, and if too many people spend less, the result is a negative spiral resulting in progressively lower income and higher unemployment. What makes sense for an individual can harm the economy.
  • Manufacturing and services can decline—The Institute of Supply Management’s Purchasing Managers’ Index, which surveys senior executives in a wide variety of industries, showed 131 consecutive months of manufacturing growth from the spring of 2009, when the last recession ended, to our current pandemic-induced recession. An index reading of over 50 indicates economic expansion, while below 50 represents contraction.
  • Prices can fall—Severe recessions can involve deflation, a reduction in prices, especially of discretionary items and real estate. Spending focuses on relatively low-priced necessities. But recessions can also be responses to efforts to fight inflation, as with the recessions between 1980 and 1982, when the U.S. Federal Reserve kept short-term interest rates well into double digits. Inflation has not, however, been a concern for some time.
  • Liquidity can dry up—Banks become less motivated to lend in recessions for fear of not being repaid. Interest rates also tend to fall, shrinking banks’ profit margins.
  • Deficits can increase—Governments often increase spending to offset the recession’s effects. At the same time, tax receipts fall as corporate and personal incomes decline.

Can recessions be predicted?

Economists often look for a so-called inverted yield curve as a recession predictor and companion. The curve inverts when short-term U.S. Treasury securities yield more than longer-dated ones, which normally provide greater income to reward investors for tying up their money for longer periods. When the curve inverts, it may be a sign that companies have little desire to invest in long-dated projects, which they typically finance with long-dated borrowing. This caution may be suggestive of an impending recession. Also, since banks borrow short term and lend long term, an inverted curve makes their business unprofitable. If it’s unprofitable for banks to lend, it’s hard for the economy to grow.

Stock market activity can send mixed signals

Stock market declines often precede recessions, but the timing can be hard to predict. Paul Samuelson, the Nobel Prize-winning economist, famously said that the stock market has predicted nine of the last five recessions.

Not only are falling markets poor predictors of recessions (the 1987 crash, featuring the biggest one-day percentage drop in history, didn’t lead to one), but recessions don’t necessarily imply stock market declines. In six of the eleven recessions since the late 1940s, the S&P 500 Index rose.⁸ Then again, the market fell 37% during the Great Recession itself and was down 57% peak to trough during that period. Still, the immediate onset of a recession with a nearly 40% market decline, as we’ve experienced in the current pandemic, is an extraordinary event.

Recessions versus depressions

Some believe a recession is the best time to start a new business. With unemployment rising, labor is cheap, and for those who can obtain financing, money may be as well. We often hear of Hewlett and Packard founding their company in a Palo Alto garage during the later years of the Great Depression.

A depression is a severe recession whose duration is usually measured in years rather than months. Depressions may also feature the breakdown of a key part of the economy, particularly the financial system. The main reference point is the Great Depression, which lasted throughout the 1930s, but the United States had a series of panics, resulting primarily from land speculation and other excesses in the 19th  and early 20th centuries, until the 1913 creation of the U.S. Federal Reserve (Fed), designed “to provide the nation with a safer, more flexible, and more stable monetary and financial system.”⁹

The Fed didn’t prevent the relatively brief post-war depression of 1920/1921, and it likely exacerbated the Great Depression by keeping money tight when the economy was starved for cash and caught in a deflationary spiral. It’s now generally accepted that severe recessions need a major influx of cash from fiscal (government spending) and/or monetary policy (low interest rates created by the Fed) to keep them from becoming depressions. Today, and despite trillions of dollars of economic support, some noted economists fear we could be headed for, or are already in, another depression. Former Fed Vice Chair Alan Blinder said, “We think of a depression as a recession that is very, very deep and very, very long. That’s the kind of thing that could happen.”¹⁰


1 National Bureau of Economic Research, 1/7/08. 2 National Bureau of Economic Research, Business Cycle Dating Committee, 10/21/03. 3 Prices fell 30% from their mid-2006 peak to mid-2009, federalreservehistory.org. 4 Federalreservehistory.org. 5 Federal Reserve of St. Louis. 6 Unemploymentdata.com. 7 Unemploymentdata.com. 8 Seeitmarket.com. 9 Federalreserve.org. 10 ccn.com.