What Causes Recessions

Despite their willingness to advise governments and appear on television, few economists comment on the causes of recessions. For those interested, here is a short summary of the key causes of recessions.

The financial news has not been good lately. Markets have declined, massive commitments been made on the behalf of tax payers, and jobs have been lost. But what causes recessions?

Recessions are operationally defined as two successive quarterly declines in gross domestic product, where gross domestic product, or GDP, is a measure of the total output of a given economy. A nation's GDP is the sum of domestic spending and investment, government spending, and money earned from exports to other countries, minus expenditure on imports. GDP therefore measures the monetary output of a given economy and does not capture unpaid work, or the environmental cost of that output, among a variety of deficiencies. However, GDP is the widely accepted benchmark of national financial well being and in particular allows us to discuss, in relatively simple terms, whether an economy is growing or declining.

Based on this definition then, recessions occur when the sum of the components of GDP decline for two successive quarters. For example, if consumers continue to earn, but stop buying, GDP will decline. Similarly, a reduction in government spending can also lead to a recession, if it is not accompanied by an immediate increase in general domestic spending. In fact, a direct means of increasing GDP is provided by increasing government spending. This approach has already been aggressively followed in the present recession, and should mean that GDP, as it is officially defined and monitored, can be said to be on the rise, and this recession officially, if temporarily, cured, for countries with governments able to increase their spending in the short term.

Although government spending is one measure of economic health, as governments have to acquire their funds somewhere, (typically from taxation), most people think in terms of more traditional forms of industrial and economic output when they think of production. Such measures include the numbers of nuts and bolts, potatoes, computers, cars, and television shows, for example, produced and sold. Each transaction adds to the nation's GDP. Particularly valuable to the GDP are transactions which produce transfers of money which can circulate through the economy. Here the profit from a sale is reinvested in the development of a new product, for example, or the return on a service is converted into further purchases in local stores. When the transactions of the economy are able to echo healthily and rapidly through the economy, small increases in efficiency are able to scale the entire economy positively, and GDP rises.

Hence, healthy GDPs tend to be seen where there is an interest in making improvements to existing ways of doing things and where there is an appetite to consume the resulting economic benefits.

The converse is also true. When money is extracted from the economy and not reinvested in goods, services, or transactions, then GDP shrinks. Weapons manufacturing, for example, takes commodities, goods and money permanently from the economy and places their economic value in a stockpile which typically will not ever yield any further economic circulation. Wars, where plunder has been rule out, also efficiently extract money from the economy. Not only are goods removed and transactions stopped, but large numbers of potential consumers are prevented, in one way or another, from participation in the economy.

Multi-generational bonuses and stock incentives, similarly rapidly acquire an illiquid nature and their immobility cools the economy. Thousands of bankers collecting multi-million dollar bonuses yield a multi-billion dollar loss of value from the economy. Re-injecting such large sums into the economy requires imagination, not just the acquisition of a sports car or two, so this presents a problem. Bankers are, when it comes to their own money at least, conservative and risk averse, and the siphoning of client's, and now tax payer, money into bonus accounts does little to stimulate an economy.

The economic drains of, overspending on weapons, protracted wars, and excessive bonuses remove transactions from the economy and progressively increase the chances of a recession occurring. However, as recent years demonstrate, recessions arrive suddenly, taking consumers, politicians, and august economists by surprise. Indeed, triggering events are needed. These may take the form of changes in commodity prices, changes in the availability of credit, or changes in consumer temperament.

Commodity prices necessarily fluctuate according to the balance of supply and demand. However, when oil prices, for example, vary by several hundred percent in as little as a year, while demand varies by less than 10 percent, long range planning becomes very difficult, and conservative responses will result. In the 1970s significant changes in oil production volumes caused substantial oil price variations and acted as the trigger of a major recession. More recently, speculation fueled by low interest rates, and perversely risky insurance policies (or swaps as they became known to avoid regulation), fueled dramatic and rapid variation in prices.

When volatility is high, planning becomes difficult, and financial gurus, who generally favor linear extrapolation in the development of their long term visions, fall silent. Lack of vision leads to a lack of confidence, mass market exit ensues, and the cause for recession is in place.

Once the intrinsic drag on the economy is set up in the form of wars and bonus bonanzas, and a trigger is in place, in the form of wide fluctuations in prices based on a foundation of uncertainty of values, the stage is set for recession. When the final trigger arrives, public confidence is broken, shaken by declining markets, and worrying financial news, and discretionary spending dries up. At this point the reckless consumer suddenly becomes a worried saver, and the financial wizards now in possession of that investment money, will have no thought of rapidly returning that money to the economy. It will be consigned to accounts earning only slightly less interest than their year-end bonuses and provide no immediate benefit to the troubled economy.

The twin causes of recessions then are activities which prevent the circulation of money in the economy, which prepare the ground, and triggers which break up normal spending behavior patterns. Given these causes, the antidote for recession should be the encouragement of money circulation, reversing the trend which setup recessions, and triggers which lead to reduced consumer conservatism.

It will be interesting to see if government spending policies are sufficient to reverse the current recession. Given the definition of recessions, and the inclusion of government spending in GDP, the immediate impact is likely to be positive, an important consideration for those facing re-election. However, the long term success of the economy depends on production, and this is favored by increasing the rewards of production, not simply increasing government spending.

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