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What is a Recession and How Long Does It Take to Get Out of One?

Posted on November 9, 2016 11:00 pm;

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By John Alexander Adam

Anyone over the age of 20 will have experience of a recession, with the ‘Great Recession’ of 2008-13 still fresh in the memory. While the answer to the second part of our question may seem to be already apparent, with it taking 5 years for the global economy to officially come out of recession 3 years ago, the amount of time required to come out of a ‘recession’ can vary from anything to a few months to several years.

What is a Recession?

The obvious place to start is an explanation of what exactly a recession is. While there are different schools of economics theory, all those that we accept as having merit in explaining our modern capitalist economy have as a basic principle the cyclical nature of economies. As such, recessions are an integral part of the business cycle and essentially unavoidable. The official technical definition of a recession is two consecutive quarters during which economic growth is negative. The economic growth of a country is measured by its Gross Domestic Product (GDP), which is the combined value of things like manufacturing, employment, real income and the balance of trade in and out of the country.

A global recession such as the recent ‘Great Recession’, is a rarer event when recession impacts countries across the world simultaneously. In the lead up to a recession business activity slumps and this leads to a downward spiral in economic activity which can be difficult to reverse. Recessions can often be triggered by a significant shock to the world’s financial markets, such as the US subprime mortgage crises which triggered the Great Recession. Large banks in the US, and around the world, had exposed themselves to risky mortgage-based derivatives which lost value quickly when financial markets realised how risky they actually were. The significant negative impact this had on so many international financial institutions meant that lending around the world collapsed, and with capital so hard to access spending nosedived, plunging the global economy into one of its worst ever recessions.

Recovery from a Recession

While the technical definition of a recession is two consecutive quarters of negative GDP growth, it is a little more complex than that. A recession has leading and lagging indicators. Some results of a recession take longer to become apparent as companies take some time to fully appreciate the changed environment and react. The stock market is one example of a leading indicator as stock prices are largely based on future expectations. So when markets get nervous that trouble is afoot, falling stock prices quickly reflect that. Employment is a lagging indicator as companies generally reduce salaries and staff numbers at the point where they feel they have no choice but to do so.

Conversely, when an economy moves into the recovery phase and starts to come out of a recession, stock markets will reflect growing optimism quickly but companies won’t start to hire more staff until their turnovers and finances have recovered to a healthy level.

Momentum is key to both economic decline and growth. Economic contraction takes place as economies cannot, at least based on all historical evidence, remain on an indefinite trajectory of growth. At some point the growth slows and when it drops to a slow enough pace it begins to move backwards into negative growth. This is, according to most economists, a natural pattern of the economy finding equilibrium. Recovery happens when the pace of the decline is also reduced to the point where it can be pulled out of reverse and into growth again.

When an economy contracts, governments and central banks have a number of tools at their disposal to reduce the velocity of contraction and eventually drive it back to growth. The two most commonly utilized tools are interest rates and Quantitative Easing. When central banks reduce interest rates they reduce the cost of borrowing. This encourages companies and banks to increase borrowing and invest, which increases the overall flow of money and spending in the economy, the basis of economic growth.

Quantitative Easing also reduces the cost of money and increases its flow but through a different technique. Central banks print money and use this to buy bonds and other financial assets from financial institutions and banks. This provides them with a greater flow of cheap cash with which they can then lend to companies and individuals in greater volumes and more cheaply, stimulating spending and growth further down the economy.

How long the recession from recovery takes largely depends on the scale and success of such intervention and how long it needs to take hold. There is a school of thought that such artificial stimulation by central banks is gradually reducing the value of money and building up problems for the future.

If you would like to improve your understanding of economics, business and finance, why not take a professional qualification such as the CFA® Program. Morgan International offers a number of different professional finance, investment and other business-related qualifications at locations across the Middle East.

 

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