Why do recessions occur in the economy?

Hello friend, long time no see! I missed you around here, were you out on a vacation?

Helloooo…Yes, I just returned from my vacation of traveling and visiting some family. Feels good to be back home and nice to see you!

I am glad you had some time to relax because it looks like things are getting tense all around the world. I am not sure if you were following the news while you were out but things seem to have taken a turn for the worse in the economy.

Yes, I could not avoid the news even if I wanted to because everyone I talked to could not stop talking about the economy and how the chances of a recession have gone up. Let’s just say my vacation was not as relaxing as I would have wanted it to be.

I feel for you. That is the last thing you would want to worry about especially when you want to decompress and not think about doom and gloom. Of course, I missed having you here because I had so much to ask you. Without wasting any time, I would like to get the most important question off my chest, why do recessions occur?

It is great that you asked this because that is something that I also have been thinking about and talking to others about. This is also a very loaded question for which we will have to first understand how the economy actually works. We will go in steps and eventually get to the answer you are looking for.

First and foremost, what is an economy? Economy is a sum of different markets where a multitude of transactions occur. Different markets trade different things which can range from crops, fruits, steel, cars, etc. Within each market a transaction occurs when someone pays money or credit to purchase the commodity within the specific market. Typically, an economy is measured by Gross Domestic Product or GDP, which is essentially a sum total of all the money or credit spent in the economy to buy all the goods and services produced. The simplistic definition of recession is a negative GDP growth over two consecutive quarters, which means the spending in the economy decreases over a significant amount of time.

That was a good setup to our conversation because I now have a better understanding about what we call an economy, which earlier just seemed to be a nebulous term that is used frequently but not really defined. I have a very basic question on what you said, why do we expect the GDP to grow? If we did not care about GDP growth we would not have invented recession at all!

Wow..I don’t think anybody has asked me that question and I feel it is a very relevant one to ask. Is it just our expectations about the GDP that have invented the term recession? Why do we even expect the economy or GDP to grow?

I feel the answer lies in human nature to expect or want a future better than the present. Some cynics might call it greed and others would call it desire for improvement. Whatever the motivation be, the end result is everyone trying to grow by wanting to spend more which results in them wanting to earn more and this makes them want to either work more and or produce more work in the same amount of time. This desire to produce more work in the same amount of time leads to an increase in productivity, which is the most beneficial driver of economic growth. Over human history, productivity growth has happened through technological advancements that came from the innovations to improve the way we do things. Again cynics would say that a lot of technological advancements were made during wars or from a motivation to make money but regardless this speaks to human nature to want more and in pursuit of that there is an increase in productivity. Of course the economy grows because the population keeps growing. As the number of people grows, there is an increase in demand for things, which either results in an increase in prices or an increase in production of goods and services. Both of these outcomes result in the economy or GDP growth.

Therefore, when the economy stops growing during recession it means that a majority of the population cannot have more than what they have now, which is highly disconcerting for them and that is why they gave this is a term and are highly concerned about it.

Okay thanks for clarifying that! Just like everything we desire is man made, the concept of recession is also man made and behind it is the innate human nature to want more. I knew human greed is behind everything that happens in the world but never thought of connecting it to the origin of recession. 

I can now see the reason behind economic growth and why a slowdown is not appreciated. But if everyone is striving for economic growth why would we ever be in a scenario where that does not happen? I would imagine that if there is no motivation behind a phenomenon that is completely man-made, then there should be zero probability of it taking place.

Your thinking is absolutely right. If the common good is in the economy growing consistently then what would initiate a slowdown? The answer to this is again man-made and related to human nature. Before I explain why that is, let us first understand the concept of credit.

When I talked about transactions in the economy, I had mentioned two terms that are used to buy things – money and credit. Credit is different from money because it is created out of debt. Usually central banks or any lenders create credit because they can make money from lending it to others via interest and also there is a demand from borrowers to meet their needs like buying a house, starting a business, etc. Whenever the lenders create credit there is an equal amount of debt that is created for the borrower. When this debt is repaid by the borrower along with the interest, the transaction is deemed complete and both the credit and debt go away. So, you can see that credit and debt are created by humans in the desire to want more. The way money is different from credit is that when money is involved, the transaction is completed on the spot and not carried over to the future. So money is spending what you have and credit is created by wanting to spend more than what you have by borrowing. The creation of credit and debt combined with human greed is the main reason why we have recessions in our economy. Let us understand why.

First let’s talk about an ideal scenario in an economy. Credit is created in an economy by lenders who expect to get more than they lend by charging an interest. The borrowers take this credit and create a debt for themselves that they need to repay. They know that they need to pay more than they borrowed, which would be possible if they earn more than they do now so as to at least maintain their current lifestyle. To earn more than they do now either they used the borrowed credit to start a business or invest in other assets. Or if they use this borrowed money for something discretionary like a new TV or a vacation then they would have to earn more money by other means like working more hours at their job or getting a promotion. If the borrowers are successful in earning more and paying down the debt, then the lenders have made more money and also the borrowers are well off than they were before. Overall, this is good for the productivity of the population and hence the economy, as everybody is better-off. The entire population benefits because we are all connected via transactions where one person’s spending is another person’s income. So if the borrower spends more than they did before then it means someone will earn more money than they did before and this propagates throughout the entire population. In this ideal world anybody who borrows pays back the debt by increasing their productivity and economic growth continues forever.    

Now, let’s talk about what happens in reality. The borrowers borrow a lot more than what they can repay. This could be because they get greedy over time where they start borrowing higher amounts to improve their lifestyle or they get overconfident that they have been able to repay debts in the past, so they can continue doing so with even higher debts. This higher rate of borrowing means more debt is created in the economy. Even though this higher debt means higher spending and hence higher income for others in the economy, this is not sustainable since this higher debt cannot be repaid as the borrowers cannot grow their income enough to repay their debts. So, to repay their debts, they have to cut down on their lifestyle by cutting their spending. Since one person’s spending is another person’s income, someone else’s income is reduced because of which they would have to now cut their spending and this continues across the economy. This cut in spending shows up as a slowdown in the GDP growth and if this happens over a long period of time since the amount of debt was high, eventually leading to a recession.

In short, it is human nature of getting greedy and belief that the good times will continue forever due to recency bias that make them take more debt and if enough people in the economy do that it temporarily might create high economic growth but sometime in the future when all this debt needs to be repaid, it would result in cut down in spending and a recession.

This is fascinating, if the credit and debt is managed well where people borrow at reasonable rates, it results in sustained economic growth. However, if the debt levels go beyond manageable and if enough people find themselves in that situation, this creates a situation for recession sometime in the future. I understand that there is some human greed involved in wanting to borrow more than you can repay but aren’t there any checks and balances in the system that would deter people from doing that?

Yes, there are rules and regulations on who can borrow money and the amount they can borrow. If you have taken a loan already then you would know about credit check, where the lender checks your credit history and makes sure that you have been paying down your debts in time. There is also a score that shows how good of a borrower you are and this is popularly known as the credit score. A higher credit score proves that you are a trustworthy borrower and has been repaying the debt in time. For high amount loans like a house mortgage, the lender also checks the debt to income ratio and it has to be below a certain level, about 33-35%, for the lender to approve the loan. Debt to income ratio check ensures that your income will be able to handle the debt you take on without significantly impacting your current lifestyle. 

[Check out this blog about mortgage payments and what it actually costs to own a home]

I am sure your next question would be as to why these checks and balances are not effective because we end up in a recession time and again. I would say that the core reason for this is greed for more money. Some lenders get too greedy and start taking on more risk by giving credit to people who may not qualify based on their credit score or debt to income ratio. The institutions that oversee these lenders could have some bad players that willfully neglect this behavior. Something similar happened in the 2008 Financial Crisis where mortgages were approved to people who could not afford them and then these mortgages were sold to investors as safe investments via high grade mortgage backed securities. When the interest rates rose and people could not afford to make mortgage payments there were defaults which meant reduced spending, institutions going bankrupt and finally a recession. This is an example of a severe recession caused by an asset bubble in the real estate market. 

Besides people and corporations, you also have to realize that the government is also a borrower of money because like any business or household, a government has an income in the form of taxes and spends on a variety of things like military, healthcare, social security, infrastructure, etc. The amount of money the government spends makes it the highest spender in the economy and if it does not do a good job in managing its finances then it also becomes the highest borrower in the economy to sustain all its spending. Now, if the government borrows indiscriminately to cover all of its spending, then eventually it could find itself in the same situation as a regular person or corporation, where it may have to cut down its spending to repay the debt. Since the government is the biggest spender in the economy, a cut in government spending has a widespread impact as it cuts the income of everyone who is tied to the government. Therefore, a mismanagement of the government budget has far reaching consequences than probably individuals and corporations. A lot of times people just see the government as a policy maker and not in the terms of an entity that has an income and expenses. Oversight of government spending is tricky because it is only the voters that can truly restrict the government from overextending their budget but since the voters are themselves dependent on government spending, there is a conflict of interest. There are similar conflicts of interest with other regulatory bodies that might keep the government spending in check.

[Check out this blog to learn more about the US government debt and what it means for you]

Okay, I see the issue now. It again boils down to people making the right decisions especially in the positions of power. If there are strict spending rules for everyone in the economy, including the government then the probability of recession will be significantly diminished. Even though this is a simple solution, I can see it being not easy because of how difficult it is to implement these spending rules. The main difficulty is that everyone seems to benefit with more spending in the short-term and nobody bothers to question if spending is excessive when things are good. It is only when the music stops and it is time to pay the debt that everybody realizes that they messed up. Finger pointing starts and resolutions are made to not let this happen again but someone’s greed gets the better of their sound judgement and this happens again. 

I understand now why recessions occur and the challenges in preventing them from taking place. But how do we get out of a recession?

Given the fact that we have had so many recessions in our history suggests that we have managed to always come out of it one way or the other. 

On an individual or corporation level, this usually happens through spending only on the essential items and cutting down on any discretionary spending. The spending is cut enough such that it is lower than their slowed down income and they are able to start building savings up again. Another option for them to increase the savings rate is to look for other sources of income. This would mean taking additional work for individuals and corporations making their operations more efficient through innovation or technology advancements. Majority of these savings are used to pay down the debt and eventually they get back to lower levels of debt, where they again become creditworthy to borrow more money. This is how the recession ends and a new cycle of economic growth begins which sooner or later ends up in a recession. Since everybody is connected in the economy through some sort of transactions, they all go through this cycle together. 

Governments have a lot more options to get out of recession because they indirectly control the credit supply in the economy. Since recession is nothing but reduction in availability of credit, the government can borrow money from the central bank and inject credit into the economy through spending programs, buying corporate bonds, giving stimulus checks, etc. Of course this borrowing has consequences down the line but temporarily this does the trick to increase spending in the economy. Another help that the government has is through the interest rates set by the Federal Reserve Bank on loans from the central bank. The Federal Reserve Bank is not a government entity but has the dual mandate of maintaining low levels of unemployment and keeping inflation under control. During recession, the unemployment levels increase as businesses lay off people to reduce their spending on payrolls and pay down their debts. So, the Federal Reserve Bank steps in and lowers the interest rate called the Federal funds rate, which reduces the cost of borrowing from the central bank. This allows the government to borrow money at a lower interest rate which reduces the severity of higher borrowing. The risk to this strategy is that excessive spending by the government could lead to inflation as there would be a lot of credit available in the economy but the supply of goods and services may not keep up, which could lead to a price increase and hence inflation. Inflation is also not good as everything gets more expensive and people cannot save as much, which makes them spend less and could again lead to a recessionary environment. Also, for the government it is important to keep the levels of debt on its books within manageable limits. Because if their debts get too high then they end up paying more of their income towards interest payments on the debt which leads to less money available for critical needs like healthcare, infrastructure, defense and social security.

Wow, I am blown by how our economic machinery has so many levers to play with and direct it in different directions. I realize that the government is the most powerful entity that controls a lot of these levers, so it is critical for them to make sound decisions which at times may not be popular. I can now see the cyclic nature of our economy and appreciate that nothing lasts forever, which is also a philosophical way of looking at life in general. Recessions are part and parcel of life like everything else and just like everything else we need to go through this for better times ahead. Thank you so much for the discussion today, it was truly enlightening!

It has been a pleasure to talk to you and you always have the most interesting questions which I love to discuss. An unsolicited advice from me would be to keep a calm head during these times and do not panic from the headlines that are meant to catch eyeballs. Remember to make financially sound decisions and this too shall pass!