‘What causes a recession’ is a fair thought at the moment. We’re heading into one, and it could be a tough one. But this recession is fairly unusual. It’s coming off the back of the pandemic, high inflation, and a fuel crisis affecting much of the world, all of which is being made worse by the brutal full-scale invasion of Ukraine.
As happens when every economic cloud comes, we’re hearing a lot of buzzwords and phrases that can seem pretty trite. That’s why we’re here: to help demystify what causes a recession. We’ve even thrown in a handy glossary of some of the key terms you’re going to hear a lot in 2023.
In this article, we’ll cover;
- Too much supply, not enough demand
- Mistakes are made
- A key part of the economy suffers a shock
- High interest rates, spending drop ensues
- A major world event shakes markets
- Recession glossary
1. Too much supply, not enough demand
In this recession, this rule may have been turned on its head, but it’s been the rule of thumb throughout many a downturn. Take the Great Depression as an example.
After WW1, there was a huge boom in consumerism as the world got back on its feet. But nothing lasts forever, and this was true in the 1920s too. By 1929, far more goods were being produced than were actually needed, which led to a sharp drop in prices at the ‘C’ end of B2C, particularly in heavy and agricultural industries.
As the value of everyday goods plummeted, it hit companies in their pockets. In time, this led to the infamous stock market crash of October 24 1929.
2. What causes a recession? Mistakes are made
When mistakes happen in the financial world, it can have some pretty tremendous consequences right across the board. We had a great example of that from the UK in 2022.
The British Government announced a series of unfunded tax cuts for the highest earners. This caused a run on Pound Sterling, as investors feared that the government would not handle the country’s finances responsibly. Even once the markets calmed, Pound Sterling remained volatile due to the wild swings that had just been seen in the economy, leading to a market correction, where the market fell to meet the new reality of the weakened Pound. This led to an increase in interest rates, meaning that people with mortgages were hit, leaving them with less money to put into the economy elsewhere.
In short, chronic mismanagement worsened the incoming recession, and the eye-watering cost-of-living crisis in the UK. Today, the world’s economies, particularly the major ones, are deeply intertwined. So the slump in the UK could cause a recession elsewhere too.
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3. A key part of the economy suffers a shock
What causes a recession is that one drop can cause ripples when it comes to the economy. And we’ve seen that happen time and again. Take the Great Recession as an example.
There were many things that led to the Great Recession. Many of them were systemic. But, arguably, the tipping point was the bursting of the US housing bubble. This was caused by years of lax and irresponsible lending by banks and credit brokers, which led people to borrow far more than they could realistically repay.
As people had their homes repossessed, it led to a huge drop in consumer spending. As the US is such a huge part of the global economy, it had knock-on effects elsewhere – most acutely in Europe. There, Germany, Spain and the UK were particularly badly hit, while Greece, Cyprus, Portugal and Ireland all declared bankruptcy. Across the world, labor markets saw a huge downturn, and major high street names, like Woolworths, went under.
There were a lot of factors involved in the Great Recession. But the crash of the US housing market was the tipping point that caused a recession.
4. High interest rates, spending drop ensues
In 1979, the Iranian Revolution led to a sharp drop in output and increased oil prices. The leap in oil prices led to higher inflation, which led to a hike in interest rates. This, you guessed it, caused a recession.
There are a couple of reasons why higher interest rates can cause a recession.
When interest rates are higher, the general public is less able to borrow money. This doesn’t just mean larger sums, like a mortgage or car loan, but also things like €1000 or so for a holiday or some small home improvements.
Equally, the ways in which governments borrow isn’t actually too dissimilar from that of the general public. They still need to convince big, multinational creditors that they can repay what they’re borrowing.
So, higher interest rates lead to less borrowing as things get more expensive. So, when interest rates are hiked, €50,000, for example, doesn’t go as far in scaling a business as it did beforehand.
In turn, this causes a downturn in spending – both consumer and governmental. It’s important to note that higher interest rates don’t always predicate a recession, but it is a good indicator. For example; think of the austerity policies that a lot of Eurozone countries put in place in the wake of the Great Recession.
Read also: 7 tips on how to sell during a recession
5. Recession reasons: A major world event shakes markets
Major world events can be a big factor in what causes a recession. Right now, the full-scale invasion of Ukraine is contributing to our overall economic woes. But there are other examples of this happening too.
Many of us remember where we were as news of the 9/11 attacks unfolded. It was certainly a history-altering event, and it also had an economic impact. The New York Stock Exchange, which is near the World Trade Center, was closed for several days, causing the US Dollar to drop in value on other markets in Europe and Asia.
This caused a sharp shock to the US economy, particularly as New York is such a nervecenter of the global economy. But the shock was short-lived, as the Stock Exchange reopened. By the summer of 2002, the US economy had mostly returned to normal.
This is a great example of how a single event can be a part of what causes a recession. Or, in this case, more of a shock. However, the impact can be more prolonged. Take the Great Depression as an example here once again.
Finally, A recession glossary
We’re seeing a lot of economic terms bandied about at the minute. But what do they actually mean? We’re put together a glossary of these terms, to help you understand more about what causes a recession.
- Interest rates – This is the amount of the total money borrowed that you’re charged for borrowing that money. So, for example, if you borrow €400 at an interest rate of 3%, you’ll have to repay €412 in total.
- Inflation – This is the big one at the moment. Inflation is basically a tracking measurement that’s used to keep track of the general cost of goods. So when inflation’s high, like at the moment, you can’t buy as much for the same amount of money.
- Debt – There’s good and bad debt. Good debt can increase worth, for example; a company taking a loan as part of a well-strategized scale-up. Bad debt comes when money has been borrowed, but needs to be written off.
- Quantitative easing – More money is printed or created to ease the strain on an economy. If not used carefully, this can make things worse.
- Supply chains – These are the coordinated routes that get something from A to B. For example; a logistical supply chain gets bananas from the trees in Costa Rica to the supermarkets of Stockholm as quickly as possible.
- Production capacity – This measures the maximum possible output of something. In a recession, it can go down as it costs more to produce goods.
- Fiscal drag – This is pretty common during a recession. Higher inflation, or income growth, leads to earners paying a higher percentage of their income in tax.