Causes of an Economic Recession

Kimberly Amadeo is an expert on U.S. and world economies and investing, with over 20 years of experience in economic analysis and business strategy.

Economic recessions are caused by a loss of business and consumer confidence. As confidence recedes, so does demand. A recession is a tipping point in the business cycle when ongoing economic growth peaks, reverses, and becomes ongoing economic contraction.

12 Typical Causes of a Recession

A decline in the gross domestic product growth is often listed as a cause of a recession, but it’s more of a warning signal that a recession is already underway. The GDP is only reported after a quarter is over, so the recession has probably already been underway for a couple months by the time the GDP turns negative.

An economic dip, as measured as a decline in GDP, must occur for two or more successive quarters to qualify as an official recession.

1. Loss of Confidence in Investment and the Economy

Loss of confidence prompts consumers to stop buying and move into defensive mode. Panic sets in when a critical mass moves toward the exit. Businesses run fewer employment ads, and the economy adds fewer jobs. Retail sales slow. Manufacturers cut back in reaction to falling orders, so the unemployment rate rises. The federal government and the central bank must step in to restore confidence.

2. High Interest Rates

Interest rates limit liquidity—money that’s available to invest—when they rise. The Federal Reserve has been the biggest culprit here in the past. The Fed has often raised interest rates to protect the value of the dollar. For example, it did so to battle the stagflation of the late 1970s, and this contributed to the 1980 recession.12

The Fed did the same thing decades ago to protect the dollar/gold relationship, worsening the Great Depression.

3. A Stock Market Crash

A sudden loss of confidence in investing can create a subsequent bear market, draining capital out of businesses.

4. Falling Housing Prices and Sales

Homeowners can be forced to cut back on spending when they lose equity and can no longer take out second mortgages. This was the initial trigger that set off the Great Recession of 2008. Banks eventually lost money on complicated investments that were based on underlying home values, which were in decline.3

5. Manufacturing Orders Slow Down

One predictor of a recession is a decline in manufacturing orders. Orders for durable goods began falling in October 2006, long before the 2008 recession hit.4

6. Deregulation

Lawmakers can trigger a recession when they remove important safeguards. The seeds of the S&L crisis and the subsequent recession were planted in 1982 when the Garn-St. Germain Depository Institutions Act was passed.5 The law removed restrictions on loan-to-value ratios for these banks.

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