Ah the “R” word. Gracing front pages, blogs, shop windows and “75% Off!” flyers everywhere. But what exactly is a recession and what causes one? Unfortunately, the answer to that is a relatively contentious one and different economists will probably tell you different things. One thing is for certain though; recessions are a natural part of the economic life cycle. They have happened before and will certainly happen again.
According to the widespread technical definition, a recession is a period of reduced economic activity, or negative growth, which lasts for at least two quarters. It is usually marked by a rise in unemployment, reductions in retail sales and a slowing of demand for big purchases like houses and cars. Simply put, it is a contraction – a bit like breathing. In order to have life you have to breathe, to expand and contract. In the same way, in order for the economy to have life, money has to expand and contract too. While recessions are clearly unpleasant, they do tend to spring clean and reboot the economy, and this makes for a healthy economic environment over the long run.
A wide variety of things are often linked to recessions, from inflation and interest rate changes, to wars or financial crises. It is thought that the main cause of the recession the world is currently experiencing was kicked off by the “credit crisis” that erupted in 2007 and has still not been stabilized.
Roll back a couple of years and life was good. Business was booming and people were spending; but, it was a false prosperity, as they were spending more than they actually had and borrowing more than they could actually afford.
In early 2007, banks in the US – the world’s largest housing market – found that they were confronting the so-called subprime crisis, due, in part, to their leniency in who they gave credit to. In the line with the old adage, “what goes up must comes down,” after the boom levelled off house prices started to fall. All of a sudden, these bank-owned “assets” were worth far less than the debt borrowed to buy them in the first place – which of course still needed to be repaid – and banks found themselves having to write down huge losses. As these losses mounted they in turn led to frozen banking functions and failing banks, and what followed is the worst financial crisis the world has seen since the 1930s; and it wasn’t long before the crisis spread to the economy and businesses started to fail too.
Understandably, banks suddenly got a lot stricter with who they gave credit to, meaning fewer people could buy houses and prices began to fall even further. The high energy prices which characterized 2007 and early 2008 weren’t helping either, reducing disposable incomes which were already growing smaller as businesses were closing or scaling back. Things were getting expensive, there was a total collapse in confidence and banks had stopped lending to each other, too. Finally, after the US investment bank Lehman Brothers failed in September 2008, the banking system was vulnerable to a total collapse, credit dried up, and the global economy experienced a sudden contraction that was the sharpest downturn for over 75 years. And with that, we found ourselves plunged into a deep recession.
Now, the question on everyone’s minds is when will it all end? According to some UBS economists, the slow climb towards normality could begin towards the end of this year, with a slightly stronger economy being seen midway through next year.
Many now hope that bailouts, government spending, and improvements in the banking industry will eventually cause banks to give out more credit under less strict terms. But ‘eventually’ may take a long time and governments will have to find a solution to the problem of the trillions of dollars of bad assets that banks are sitting on before we can all take a big breath and watch the economy expand once more.
