In the ongoing discussions of economic news and information in the media, we often come across talk of recession and recovery in reference to the performance of the economy. What is a recession? And how do we know when one occurs?
The Business Cycle: Expansion And Contraction
The economy, while encompassing a large group of indicators like growth, employment, inflation and interest rates, is understood as a whole to be a dynamic phenomenon that grows and shrinks, or "recedes." This process has been defined by economists as "the business cycle," and recession is a phase of the business cycle when the economy is on a shrinking trajectory.
A Scarcity Of Money?
The notion of recession in the business cycle has been recognised in one form or another since the formal development of modern economic theory in the late 18th century by Adam Smith. He referred to the "scarcity of money" caused by "over-trading." Early economists in continental Europe referred to an economic downturn as a "commercial crisis," and in England, a sudden reduction of market confidence and economic activity came to be known as a "panic."
Explaining The Big Crash
The formal notion of a recession began to take form in the 1930s following the outset of the Great Depression, as economists struggled to determine how economic activity in the U.S. and around the world had suddenly come to a halt following a period of exuberant economic activity in the 1920s. While the term depression had been used as early as 1820 by President James Monroe to refer to the "Panic of 1819," the term recession appeared in popular usage following the market crash of 1929 in an article in The Economist.
The term gained more refined definition over the following decade from renowned economists like John Maynard Keynes, who referred to "recession and recovery" in his book The General Theory of Employment, Interest and Money. There was also Joseph Schumpeter, who in his work Theory of Economic Development and Business Cycles stated the business cycle undergoes four phases: Expansion, Crisis, Recession and Recovery.
Peaks And Troughs: Measuring the Data
Since 1978, recessions in the U.S. have been formally defined by the National Bureau for Economic Research (NBER), a private, non-profit organisation that has a business cycle dating committee dedicated to the subject. In Europe, a similar agency, the Centre for Economic Policy Research, carries out that task.
The NBER defines a recession as follows:
"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. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion."
The bureau notes that "most recessions are brief" and that "expansion is the normal state of the economy."
Two Quarters Of Decline
In a popular definition used by many investors and the press, a recession is determined by a negative economic growth rate for two or more consecutive quarters. This rule of thumb was first proposed in 1974 by the Commissioner of the U.S. Bureau of Labor Statistics, Julius Shiskin, in an article in the New York Times.
The NBER admits that most recessions it identifies consist of two or more quarters of contracting GDP but are not necessarily limited to that definition. The bureau says that other factors, particularly the trajectory of gross domestic income, can take on equal importance in the determination. The NBER says it doesn't identify depressions but recessions within the cycles of peaks and troughs of economic activity. It notes only that the the term depression is "often used to refer to a particularly severe period of economic weakness."
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…