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HomeFinanceWhat is a Recession and How Can You Prepare?

What is a Recession and How Can You Prepare?


Let’s get official: according to the National Bureau of Economic Research, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Another common definition of a recession is when the economy shrinks for two straight quarters. This “shrinking” comes in the form of negative GDP (or Gross Domestic Product) growth.

No matter how you slice it, a recession is a negative economic occurrence that often results in financial pain for many of us.

What’s the Difference Between a Recession and a Depression?

Like getting a cold, recessions can be mild, severe, or anything in between. While recessions aren’t a good thing, they don’t always need to be catastrophic for the economy. In fact, many experts are projecting that if the U.S does enter a recession soon (if not already), it will be milder than the previous large recessions the country has faced.

Unlike a recession, there’s no standard economic definition for a depression. The only real frame of reference we have for a depression is the Great Depression that followed the stock market crash of 1929. That period was marked by deep and sustained job losses, poverty, and hopelessness. It lasted about 10 years versus the 2008 financial crisis recession that lasted 18 months.

What Causes a Recession?

Source: makeameme.org

Our economy is made up of people, businesses, and governments spending money. Whenever one of these groups spends on something, that money goes into the pocket of someone else. This circular movement of money and how much money is available to be spent is the underpinning of how the economy works.

In the U.S, about 70% of economic activity is driven by something called “consumer spending,” which is how much people spend on goods and services.

This willingness to spend, and the availability of money, changes over time due to many macro factors, creating the business cycle.

Consumer Negativity and Psychology

Not surprisingly, the better you feel about your future financial prospects, the more likely you are to spend money on those sneakers or new iPhone in the next 12 months. That’s consumer sentiment or confidence. It’s a leading economic indicator that can predict how willing consumers are to spend — and as a result, predict an upcoming recession.

But since there are so many things that can impact our collective willingness to spend (and our feelings about the future), dips in consumer confidence/sentiment don’t always result in recessions.

Rising Interest Rates

Interest rates are a key driver of general financial conditions.

When times get tough, financial institutions tend to lower things like interest rates and lending standards, to boost the availability of money (credit) and consumers’ and business’ ability to spend it. Armed with more money and cheaper rates, consumers are incentivized to spend on goods and services, while businesses spend on hiring or other investments. This is the environment that was created in 2020 by the Federal Reserve and U.S government.

But when the economy gets going again and starts running too hot, those same institutions increase interest rates and tighten lending standards, making money more expensive and less available. This reduction of money availability and higher costs for existing debt reduces consumers’ and businesses’ ability to spend.

As spending slows, so does the economy. A common reason for raising interest rates is when the strength of the economy creates too much inflation. This is exactly what’s happening right now as the world struggles with high inflation coming out of the pandemic.

On their own, rising interest rates don’t always result in recessions, but they do have a major impact on consumers, investors, and the economy.

Read More: Understanding the Yield Curve: The Most Important Market Indicator You’ve Never Heard Of

Asset Bubble Blow-Ups

Asset bubbles happen when market prices for different types of investments rise to the point where they trade well above what they are worth.

These bubbles tend to occur due to a mix of investor psychology, low interest rates, and temporary imbalances in supply and demand.

Read more: Economic Bubbles: What They Are, Why They Happen, and Why You Should Care

There are many well-documented instances in economic history where the popping of an asset bubble is followed by a recession. The 2008 collapse of the housing market, and the financial assets tied to it, pushed the U.S into one of the deepest recessions on record.

The popping of an asset bubble is driven by many factors and when they happen, access to credit and consumer/investor optimism tend to dry up, leading to reductions in consumer and business spending, as well as job losses.

All these factors combined lead to a recession.

Source: imgur.com

Deflation

While inflation can lead to a recession, so can deflation. Deflation happens when prices for goods and services decline, causing consumers to delay purchases in anticipation of prices declining further. This results in negative inflation.

Source: Giphy.com

Deflation causes a feedback loop where both consumers and businesses stop spending, resulting in job losses, contractions in wages, and the slowing of the economy. A weak economy can heighten the fears of deflation which, in turn, drives a further downward economic spiral.

To beat deflation, central banks cut interest rates to incentivize spending and governments adopt policies to increase discretionary spending capacity.

Many countries have experienced deflation over the years, but the modern poster child of deflation has been Japan’s struggles with it since the mid-1990s.

How to Prepare for a Recession

Despite the fact it’s impossible to predict when we’ll fall into a recession, there are several things you can do to prepare.

Get Educated and Don’t Panic

The more you know about what recessions are, how they work, and how long they last, the better psychologically equipped you’ll be to deal with them. Although they are scary, keep in mind that dating back to 1945, the average recession lasted 11 months and resulted in a 2.4% drop in GDP.

These average figures are far less severe than the 5.10% GDP contraction that happened during 2008 financial crisis and the 19.2% contraction that happened during the height of the 2020 pandemic.

In fact, most recessions that have occurred since 1945 resulted in a 0.30% to 3.70% contraction. Therefore, whenever the recession talk starts, don’t panic. Since there is only so much you can control, the best thing to do first is focus on what you can control and remind yourself that this too shall pass.

Source: Ben Carlson, A Wealth of Common Sense

Save More

Since recessions typically come with job losses, it would be a good idea to start building additional padding in your emergency fund in case your job is at risk.

When the economy falls, jobs related to sales, marketing, product management, and recruitment can be hit the hardest, especially if they are related to a company’s non-core business.

Conventional wisdom tends to suggest that you build an emergency fund of three to six months, depending on the type of job you have. But increasing that amount to 8 to 11 months may give you more of a financial cushion and greater piece of mind.

Use our Emergency Fund Calculator to determine how much you should have in yours.

Start a Side Hustle

The most unfortunate thing about a 9-5 is that your main source of income is reliant on one organization. In a downturn, that income can evaporate, leaving you out to dry.

With so much job instability these days, starting a side hustle can be one of the best things you can do to reduce your reliance on your 9-5 employer. Think of it like an insurance policy.

There are many ways you can start a side hustle; you just need to think creatively and get started.

Read more: Side Hustle Ideas: 35+ Ways Anyone Can Earn More Money on the Side

Reduce Debt

Having too much debt going into a recession can be the quickest way to put yourself in real financial trouble. When times get tough, debt can either provide you a lifeline to bridge temporary shortfalls or can kill you if you must make payments on high-interest obligations.

The best way to mitigate these risks is to keep your outstanding debt low during good times, make paying off debt a priority when you have extra cash, and avoid credit card debt.

Read more: How to Pay Off Credit Card Debt Fast

The Bottom Line

Despite how scary recessions are, remember that while they are inevitable, they don’t last forever and aren’t always deep or long. As an individual, there is only so much you can do leading up to one and during one, so focus on the things you can control.

The best thing to do is always be on the lookout for the signs of a recession and make sure you put yourself in the best position to get through it — before they happen. Sadly, recessions are a feature, not a bug of how the economy works.

Featured image: gguy/Shutterstock.com

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