Recession for Beginners

(For the complete set of Beginners articles, see the Financial Crisis for Beginners page.)

So, it looks like we’re in a recession. What’s a recession?

A recession is a period when overall economic activity contracts. In most times, overall economic activity increases, for two reasons. First, each year there are more people in the workforce, because the population of the US, like most but not all countries, is increasing. Second, most years, the average person is able to produce a bit more than in past years because of improvements in technology, processes, and so on. For a recession to occur, per-capita economic activity has to decline more than enough to compensate for population growth.

How is economic activity measured? The most common (and official) measure is gross domestic product (GDP), which is the aggregate value of all the goods and services produced or provided in the country. GDP is calculated by adding up private consumption (all the stuff that ordinary people buy), capital investment (factories, houses, etc.), government spending, and net exports (exports minus imports).

Why does GDP matter? Because GDP measures all the stuff that we produce, it also, roughly speaking, measures all the stuff that we can have as consumers. I say “roughly speaking” because, in the short term, we can consume more than we produce, by importing more than we export. But in the long term, while it may be possible to maintain a reasonable trade deficit indefinitely, it’s tougher to finance increases in consumption – what we need to have a higher standard of living – through ever-increasing imports. So if we want our children to lead better (material) lives than we do, we need GDP to increase.

Why do recessions happen? There are many, many reasons, but every recession is overdetermined – you can point to multiple explanations of why it happened, so you can never isolate one specific cause. One important thing, however, is that however they start, recessions are self-reinforcing. As consumers spend less, businesses sell less, so they need to reduce costs, so they lay people off or reduce hours, so consumers have less money, so they spend less, etc. As business profits decline, stock prices fall, so people feel less wealthy, so they spend less, etc. As people have less money, housing prices fall, so people can get less money from their home equity lines of credit, so they spend less, etc. As people make less money, state and local tax revenues fall, so those governments have less money to spend, reducing government spending, etc. And so on.

There is another self-reinforcing factor at work that may be particularly pronounced this time around. The more people hear about a recession (or a global economic crisis), the more worried they get, the less they spend, etc. And this is one reason why many economists are worried about this quarter (October-December). We arguably have never before seen the concentration of bad news, amplified by the always-on nature of the contemporary news media, that we saw between the Lehman bankruptcy on September 15 and the bank recapitalization announcement of October 15. Very little of that impact showed up in the Q3 (July-September) personal consumption figures, which were already bad; given how jittery many people are about spending (on which I’ve already expressed my opinion), this quarter could be much, much worse.

What can you do about a recession? As you might guess, there is a wide variance of opinion on this question. However, the following three options cover most of the spectrum:

  1. Stimulate demand. If consumers and businesses won’t spend enough, the goal is to get them to spend more, or to otherwise compensate for their lack of spending. This can be done via tax rebates, increased welfare benefits, or other measures that put more money in people’s pockets, or through increased government spending. In either case, the goal is to break the self-reinforcing cycles described above.
  2. Stimulate supply (aka “supply-side economics”). The goal is to increase incentives to produce stuff by reducing tax rates on things like income and capital gains. This is different from stimulating demand because the focus is not on putting money in people’s pockets so they will spend it, but on giving people the incentive to produce more.
  3. Reduce interest rates. In general, reducing interest rates makes it easier for people and businesses to get credit, which increases their purchasing power and therefore their spending and investment.

One problem we have today is that there is little additional benefit to get by reducing interest rates. First, interest rates that the government has control over are already extremely low (the federal funds rate is currently 1.0%). Second, the availability of credit seems to be constrained more by banks’ low capital ratios and fear of risk than by the price of money.

That leaves government action to stimulate demand or stimulate supply. I separately discussed the stimulus plans of Barack Obama and John McCain. Roughly speaking, Obama favors stimulating demand; McCain, stimulating supply.