When the term “recession” comes to mind, most people do not associate that word with a positive outlook. Everybody remembers the Great Recession that happened in 2008 which unfortunately left many people unemployed and the country in a financial crisis. It is safe to say that it was a hard time for many families being that it was the longest and deepest economic downturn since the 1930s. So, what is an economic recession and what exactly happens in a recession? These questions are great to know, especially if you want to be prepared the next time a widespread financial crisis occurs.
What happens in a recession?
During a recession, three main things happen: Economic output, employment, and consumer spending drop. In other words, the economy slows down.
What happens in a recession on the governmental side is that interest rates are likely to decline because central banks want to support the economy. They also usually try to spend more money into supplemental programs such as unemployment insurance. If interest rates go up, then the Fed is trying to slow the economy and bring inflation down. During this time, it is important for people to protect themselves financially and to maximize their money in the best way possible. Diversifying your investments into recession-optimal stocks (defensive stocks) such as healthcare and utilities and learning saving and budgeting skills may not necessarily save you in a short term financial crisis, but they will pay off in the long-run.
Why do recessions happen?
Everything in life has a cycle. If there is up, there is a down. If you are happy, you will also experience sadness. If there is good, there is bad.
Stay with me.
In the same sense, the economy works that way. There are times when the financial market is booming but, inevitably, tougher times are going to come also. So then the question may be: “if we know that recessions are going to happen, why do they start in the first place and can we prevent it?” Well, the hard part about pinpointing a recession is that no one can really explain why and how the downturn starts. However, economists have theories that can be categorized as economic, psychological, and financial.
On the economic side of what happens in a recession and why, theorists believe that structural changes in certain industries, such as a huge surge in oil prices, can lead to a recession. Some people think that on a psychological spectrum, over-spending during economic booms and being in a deep negative state of mind during downturns can explain why recessions persist. Other theories focus on financial factors such as credit growth during good economic times and the contraction of credit and money supply. Additionally, many occurrences like loss of consumer confidence, high interest, and a stock market crash can be indicative towards the start of a recession, but do not mean it will actually occur.
What are the effects of a recession?
What happens in a recession affects many different elements of the economy. Here are some key factors that are impacted:
- House Prices
In the instance where a recession occurs, the value of a home usually declines. As people are losing their jobs, it becomes harder to repay mortgages. As a result, there are lower prices on houses and they stay in the market longer.
Similarly, the stock market will generally decline during a recession. On average, the S&P 500 returns are negative during the first six months. This is due to the fact that investors basically lose hope towards the market as it reflects the deterioration of corporate earnings. However, there are recession-proof companies like utility businesses that tend to perform well in spite of the declining economy. There are just some industries that have to stay open regardless of the way the economy is looking.This is why it is important to diversify your portfolio!
This is something that a lot of people don’t think about once a recession hits. With that being said, during a recession and even leading up to one, you are likely to see the value of your 401 (k) investments decline. Since it is invested into stocks, if the market drops, so will your investments. When this happens, the urge to withdraw money can be strong so you have extra money on hand but consider pulling through – continue to contribute and even increase your contributions if that is possible. The loss in compounding earnings typically outweighs any potential for saving you think you are getting by keeping cash out of your retirement savings account.
It is no secret that the economy is the cornerstone of what declines during a recession. In fact, a recession is literally defined as two consecutive quarters of negative economic growth. As a whole, what happens during a recession is that the economy is going to go through a period of temporary decline in which trade and industrial activity are reduced. As a result, the basic functions of an economy such as economic output, employment, and consumer spending drop.
If you have not guessed it by now, prices also tend to fall during a recession. Just like the housing market, people are buying less which makes businesses sell less as well. Disposable income affects prices so it depends on the labor market and wages to know whether or not the prices of essentials like food and utilities are going to stay the same. However, even as most products decline, there are some items that may even become more expensive. An example can include gas prices that could rise if there is a higher demand and not enough supply.
Because there is a slowdown of economic growth in a recession, companies sell less which requires fewer employees. This is why the unemployment rate rises during a recession. During the 2008 recession, in the first five months the United States unemployment rate was at 5%. By the time it was over in October 2009, the rate doubled to 10%. This was four months after the official end of the recessions and seven after the stock market crashed. Additionally, during the slight recession as a result of COVID-19, unemployment jumped from 3.5% in February to 14.7% in April 2020. The crazy thing about this is that it was the first time in about 70 years that recessional unemployment spiked before the economy was well into recovery.
How to prepare for a recession?
What happens during a recession can be tough to get through, but there are key things that can help you protect yourself. Preparing for a recession can include:
- Increasing savings
This is easily a no-brainer. Why would you not try to save more money during a time when the economy is slowing down, though increasing savings looks different for every person and family. Here are some helpful tips if you want to cut back on spending:
If you have not already, pay careful attention to groceries. It might be more efficient to get the store brand box of cereal instead of the name brand. Or if your family is into a lot of subscription services like Netflix, Hulu, or AppleMusic, it wouldn’t hurt to cut back on these services for a while.
- Clearing any debt
Getting a handle on your debt, whether it is credit card debt, a loan, or something else, will ultimately help save you more in the long run. A recession can make it extremely difficult to pay off your debt, so it is good to prioritize paying off high-interest debt, which will, in turn, reduce the total interest you pay in the future. After all, no one wants to be caught with outstanding interest payments.
- Limiting large purchases
Another no-brainer! Making large purchases like cars, appliances, and furniture are not ideal during a recession. Unless the item is a necessity, and it wouldn’t cause too much damage to your bank account, it is beneficial to hold off on expensive products. After all, no one can exactly guess how long a recession is going to last.
- Ensure your income and career is recession proof
This one might be the most complicated to sort out, but in order to survive a recession you may have to adapt to a new environment – and maybe pick up some new skills. If you already have a career that is recession proof, then great! You’re one step ahead! For everyone else, going into healthcare or becoming a correctional officer is not going to happen anytime soon. Let alone happen before a recession is over. If you have other skills, you can try to get into auto maintenance, daycare and childcare, or being a substitute teacher.
Unfortunately, people who lose their jobs during a recession, especially if we are going through a really bad one, are more likely to be long-term unemployed. This makes it harder to find jobs after one has officially ended. Out of everyone who lost their jobs in the 2008 recession, only about 40% had a full time job by January 2010. This just goes to show that picking or adapting to the right job is extremely beneficial during tough economic times. If not, try to look to have multiple streams of income to help support you and your family.
What are the differences between recession and depression?
So now we know the basics of what happens in a recession. Low employment rate, money running low, families struggling. Do these sound similar to another major time period in American history? The Great Depression was also a time when the economy was not doing so well. So, does that mean that the Great Depression was a recession? Well, the difference between these two events is that a depression is a very severe recession. The effects are much more widespread and impactful. A recession will usually last anywhere from two months to 18 months. On the other hand, a depression period will last for years. For example, the Great Depression lasted a whole decade!
Frequently asked questions
If you still want some bullet-proof answers, here are some popular asked questions regarding what happens in a recession.
- What is a recession?
A recession is a temporary period of time, usually categorized by two consecutives negative GDP quarters, in which widespread and prolonged economic activity declines.
- When was the last recession?
If we want to get really technical, the last recession happened for two months from February 2020 to April 2020. However, this was caused by the pandemic, which makes sense of why the economy slowed down and the GDP was negative. This is not usually the case because, as mentioned before, no one knows the actual start of a recession. The last “real” recession occurred from December 2007 to June 2009. It became the longest recession since World War II!
- How long do recessions last?
The length of recessions can vary. Some last a couple of months while others may last up to two years. However, the effects of a recession can last longer than the event itself.
- Can recessions be predicted?
The short answer is no. Economists cannot predict the timing of the next recession because forecasting business cycles is hard to do. It is just like how nobody knows for sure what is going to happen in the stock market. The most you can do is stay up-to-date in what is going on with the economy and be prepared for it when it comes!
A recession is an event with difficult effects that can bring hardship to people and families. It is harder to quickly come up with cash in a shorter time period especially when the pressure is high. Being wise with money, saving, and investing can all help with the process. A good resource to help you learn and get started is our kids investment app ‘Invstr Jr’. If you are looking to get your kids into money management then Invstr Jr is the ultimate tool for you and your family! Getting ready by being financially stable is extremely helpful during a recession.
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