An economic recession is a significant fiscal downturn lasting more than two quarters. Recessions are standard parts of the economy and can have good and bad effects depending on your financial position. There are various warning signs to tell if an economic recession is incoming and several ways to prepare for it. These tips will tell you everything you need to know.
Economic recessions are widespread, prolonged trade and industry activity downturns that cause decreased output, consumer demand, and employment. An economic recession can last for just a few months, but the recovery period can take years.
An economic recession can be detrimental to individuals, businesses, and the general welfare of a community. How can you tell if a recession is incoming, and what can you do to prepare for it? Here is what you need to know.
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“An economic recession is when the gross domestic product (GDP) declines for two consecutive quarters.”
The National Bureau of Economic Research (NBER) — a nonprofit research group that tracks business cycle changes — determines when the economy is in a recession. To determine when a recession starts, the NBER tracks, and measures factors like:
- A Decline in Real GDP
- A Decline in Income
- Increased Unemployment
- Stagnant Industrial Production and Sales
- Decreased Consumer Spending
Changes in just one area aren’t enough to cause concern and signal a recession. However, it’s essential to keep in mind that all these factors are connected. For example, if unemployment rises, consumer spending will decrease, which means retail sales will decline. To understand the full scope of an economic recession, you must acknowledge the relationship between recessions and business cycles.
Business cycles are fluctuations within the economic activity of a nation. It’s a cyclical motion consisting of expansions and contractions, or recessions. An economic recession often starts at the business cycle’s peak when the growth ends. Then the recession ends once the next expansion begins, and so on. Thus:
“Economic recessions are a normal part of the business cycle.”
While business cycles have set phases to follow, they don’t occur predictably. Business cycles are irregular in terms of length and timing, often responding to economic variables within the world at any given time. When there is an economic recession, analysts measure its severity with the three Ds:
Depth is determined by the size of a business cycle’s peak-to-trough decline by measuring output, employment rates, income, and sales. In the pre-World War II era, recessions were quite profound. However, over time the depth of economic recessions has decreased while expansions have appeared to increase.
Diffusion is determined by the extent of the recession’s spread across industries, economic activities, and geographic regions. It is powered by a domino effect. For example, when employment is low, so are incomes, thus resulting in fewer sales. This drives diffusion and allows the economic recession to spread and influence markets further.
Duration measures the time between a cycle’s peak and trough. While expansions have historically lasted longer than recessions, it’s difficult to predict a recession’s duration as they’re very irregular and reactive.
Though recessions are a normal part of the business cycle and the general flow of the economy, they can still be painful and hard to adjust to. While the NBER has specific indicators to determine an origin, some other causes that can lead to an economic recession include:
- Economic Shocks
- Asset Bubbles
- High-Interest Rates
- Stock and Housing Market Crashes
Unpredictable events that cause significant economic disruption can lead to a recession, like natural disasters or terrorist attacks. Most recently, there was the brief recession that occurred in 2020 in response to the beginning of the COVID-19 pandemic.
Deflation is the opposite of inflation and occurs when prices fall due to a decline in demand. When demand is down, sellers try to attract consumers by lowering costs. However, as consumers see the downward trend, they wait for prices to drop even further. This can reduce the demand more, causing a downward spiral of slow economic activity.
Asset bubbles occur when the price of investments like gold, stocks, and housing become significantly inflated. These high prices are sustained by equally high demand, which eventually decreases. When the market declines, the asset bubble bursts. This is what happened to cause the Great Recession in the late 2000s when the “housing bubble” burst.
When interest rates are high, borrowing money is more costly, so consumer spending will likely decrease, especially regarding significant purchases like real estate and cars. Reduced expenditure on both the consumer and business front can lead to an economic recession.
Like when the housing market crash led to a recession in the late 2000s, a stock market crash can have a similar effect. Less confidence in investing can lead to a bear market, a period when the market sees prolonged price declines, which can drain business capital.
“Depending on your unique position, an economic recession can have good or bad effects.”
Most economists state that a steady rise in job losses is the clearest sign of an impending recession. Other signs to look for to tell if there’s a recession include:
- Rising Gas Prices
- Decreased Home and Auto Sales
- Rising Inflation
- Increased Hiring Freezes
- Consistent Stock Market Losses
A growing number of economists predict the U.S. is headed for a recession within a year. At the same time, some believe we’re already in one. However, it often takes the NBER a year to announce a recession. That means we could already be well into it or preparing to exit by the time it’s officially announced.
While there are general rules of thumb, there aren’t any hard-and-fast rules or set timetables for determining economic recessions. Because of this, it’s crucial to be aware of the warning signs to ensure you’re prepared.
Economic recessions impact businesses and individuals in various ways. There are several short-term, immediate effects of an economic downturn. Still, they can also have long-term consequences called economic scarring –long-lasting damage to an individual’s fiscal situation.
For example, economic recessions can lead to job loss and less family income, leading them to delay or forgo spending on college education for their children.
“Human capital is critical in driving growth and preventing an economic recession.”
Less education means less development.
Economic recessions can also impact private investment spending and significantly decrease the long-term economic opportunity for individuals and families. Other effects of economic recessions include these:
- Forced Lifestyle Changes
- Layoffs and Benefit Reductions
- Falling Stock Prices
- Too Much Supply, Not Enough Demand
An economic recession can have many adverse effects on families, from layoffs to decreased income to heightened stress and anxiety levels. When earnings decline, it often leads to forced lifestyle changes.
Families likely won’t have the budget to spend on entertainment, dining out, or other extracurriculars.
“Most people reduce spending on these things during a recession to manage financial uncertainty.”
Not only does this impact an individual’s overall satisfaction, but it also negatively affects the industries missing out on customers, like hospitality, travel, and restaurants.
During an economic recession, big and small businesses will likely issue layoffs with cutting costs, especially if their company faces less demand. Typically, small businesses will be the first to lay off workers, but those at large corporations aren’t immune. Companies may reduce benefit packages, cut 401(k) matching, stop complimentary memberships, or require employees to contribute more to company health-plan costs.
During a recession, public companies can experience revenue challenges that can cause their stock prices to decline due to decreased earnings. Capital markets are a vital source of funding for public companies. When their stock prices are down, they’re less likely to receive significant capital.
Many investors pause investments during an economic recession because of a lack of money or fear of the unknown. When profits are tight within public companies, dividend payouts may also be less than expected, upsetting shareholders and hurting the company’s reputation.
Decreased demand for products and services is one of the most significant pain points for businesses during an economic recession. When demand is down, supply is up. During a recession, companies often face bloated inventories they can’t get rid of, causing them to lose money. It also doesn’t help that people are losing their jobs and not spending as much as usual, forcing businesses to drop their prices. This can start a price war with other companies.
It’s important to know that recessions aren’t all bad. While facing unemployment and higher poverty levels are harrowing experiences, some benefits can come from a recession. For example, recessions can help balance growth within the economy and force people into a position where they must think about their savings and future financial goals.
Recessions also allow some industries to thrive, like healthcare, grocery stores, and financial advisors. Jobs in the technology sector have also proven to be pretty recession-resistant. They’re often digitally based and can allow for remote work, providing some barriers against job losses.
“For some industries, an economic recession can present investments and future growth opportunities.”
While investing isn’t often top-of-mind for most during a downturn, it can benefit your company in the long run by setting you up for success once the recovery starts.
One industry that can be beneficial to invest in during an economic recession is fintech, specifically, if you’re a financial institution. Why should you invest in fintech during or during an economic recession? Here are three excellent reasons:
- Better Pricing
- Access To Top Tech Talent
- New Fintech Startups are Emerging
During an economic recession, the number of people and businesses actively investing is often diminished, which means fintech companies may be hunting for investors. Due to a lack of competition in the market and fintech businesses‘ increased demand for investments, the cost of investing may be significantly lower than before the recession.
While the tech industry may see fewer layoffs than others, it’s not immune. A pool of talented tech employees may search for jobs, making it a perfect time for hiring and investing in fintech.
“You could use this time to allow your business to capitalize on new talent, especially tech-focused college graduates.”
This will allow your business to maintain a competitive edge amid economic recovery.
“You can utilize the downturn to invest in starting your own fintech venture or to keep an eye out for emerging startups to invest in.”
It may sound crazy, given the harmful effects of a recession. Still, due to the lower cost of labor and capital, an economic recession can be a great time to start a new business venture.
Economic recessions are unavoidable parts of the economy, but they can be unpredictable. On average, they last about 11 months. However, the 2020 economic recession lasted just three months. While their unpredictable nature may make economic recessions seem impossible to prepare for, that’s not the case.
If an economic recession is approaching, or if you’d just like to prepare your budget for change, there are several steps you can take. Some tips to prepare for an economic recession include:
- Increase Savings
- Pay Debts
- Boost Emergency Funds
- No Knee-Jerk Reactions with Investments
- Reevaluate Your Budget
- Build Up Your Skills, Resume and Sources of Income
An economic recession can change your financial situation on a dime, so make sure you save any extra money you have while you can.
“The standard advice is to ensure you have about three to six months’ worth of living expenses saved up, but in the case of a recession, you may find that’s not enough.”
It’s also not a great time to acquire debt, especially if you experience a layoff or reduced hours that impact your income. To err on the side of caution, it may be a good idea to have up to a year’s worth of savings to fall back on.
If you have the means, it’s a good idea to work on paying off high-interest debts, like credit cards. Interest rates often increase during a recession, so paying your high-interest debts before the situation gets too bad can save you a lot of money.
It’s also good to pay down your debts if you’re considering ramping up on investing. The cost of your interest payments could exceed the return your investments generate, resulting in you losing more money than you’re making.
Like you should be increasing your savings, bulking up your emergency funds is also a good idea. The more money you have set aside to cover basic living expenses, the better off you’ll be, especially if you face prolonged unemployment. In some cases, it can be helpful to have a backup emergency fund for genuinely dire circumstances, like a home equity line of credit.
Often, economic recessions come with stock market downturns. When investors see the market start to tank, they panic and pull their investments, which can negatively affect their financial security and goals.
“Stay calm regarding your investments and consider making regular contributions to use the economic recession as a growth opportunity.”
It’s also a good idea to ensure a well-diversified investment portfolio spread across multiple industries. That way, you won’t lose all your money if one industry collapses during an economic recession.
Because economic recessions are so unpredictable, knowing where you stand financially is helpful. Figure out what your monthly budget is and what your expenses are.
“Reduce expenses and prioritize the essentials.”
Separating wants and needs is critical when preparing for a recession. It will help you identify areas where you may have extra cash to relocate into your savings or emergency funds.
When preparing for an economic recession, it may be a good idea to also prepare for less job security as layoffs become common.
“This may be the time to go back to school for an advanced degree or additional skills training to improve your employment opportunities, whether there’s an economic recession or not.”
If possible, establishing multiple income streams can also be beneficial. You can find a side gig, turn your passion into a side hustle, or even pursue a recession-proof business like childcare, freelance services, tech, and IT. Having multiple sources of income can provide a buffer in case you lose one.
Economic recessions are widespread, prolonged downturns in economic activity that cause decreased economic output, consumer demand, and employment. An economic recession can last for just a few months, but the recovery period can take years.
There are general rules of thumb but no hard-and-fast rules or set timetables for determining recessions. Because of this, it’s essential to be aware of the warning signs to ensure you’re prepared for an economic downturn when it happens.