What Is a Recession?

What Can Cause a Recession?

Recessions can happen for various reasons, and economists study what causes each recession in hopes to better predict when the next one will start. Historically, three types of events can trigger recessions.

• Asset bubbles: A recession is widespread—not a decline in a specific sector or industry. Sometimes when one type of asset bubble bursts, however, it can have a cascading effect that causes a recession. Such was the case when the housing market collapsed in 2007 and led to the Great Recession.
• Economic shocks: A large enough external factor, such as an economic crisis in another country or a global pandemic, can also trigger a recession. The most recent recession, according to NBER, occurred from February 2020 to April 2020 as the COVID-19 pandemic threw the global economy for a loop.
• Overheating: High inflation and low unemployment can cause an economy to grow too fast, or overheat. When there isn't much room to grow, the economy winds up shrinking instead.

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

Unlike with a recession, there's no formal definition or committee that declares a depression. However, the general understanding is that a depression is a more extreme or long-lasting recession. There's also only been one depression in the modern U.S., the Great Depression, which lasted from 1929 into World War II.

One potential difference between the two is that a recession is only the period in which the economy shrinks—it ends when the economy starts to expand again. But because depressions can cause so much hardship, a depressionary period may continue even if the economy has started to expand.

How Long Does a Recession Last?

A recession is the period between a peak in economic activity and a trough—the drop from a high point to the lowest point, according to the NBER. Conversely, the normal or expansionary period occurs from the trough to the next peak. Sometimes it can take a while to determine when those peaks and troughs occurred, and it's not uncommon for the committee to take several months (sometimes over a year) to declare that there was a recession.

The recession of early 2020 started when economic activity reached a peak in February 2020 and then contracted to a low point in April 2020—it was only two months long. But the committee didn't come to that conclusion until July 2021, some 15 months later.

The NBER's chart of business cycle expansion and contraction shows how recessions have played out since 1857 and how long each cycle lasted. On average, the last 10 recessions lasted about 10 months.

How Can a Recession Affect You?

A recession can affect you in different ways depending on what causes the recession and how it impacts various parts of the economy.

Layoffs and Hiring Pauses

Companies generally pause hiring and lay people off as the economy shrinks and their profits decline or disappear. Even if you still have your job, fear of losing your job and limited opportunities could keep you from asking for a raise or looking for a better job elsewhere.

Rising Prices and a Decline in Stock Values

At the same time, inflation may lead to rising prices, and stock values may drop. Unfortunately, if you've lost your job or need extra money, this also means that you may be forced to sell investments when they're down in order to free up cash.

Changes to Credit Offerings

Lenders may offer fewer products or have more stringent requirements if they're worried about borrowers' ability to afford payments. They may also be more likely to offer hardship plans, however, which can help account holders avoid missing payments.

Interest Rate Fluctuations

The Federal Reserve also tends to lower rates during a recession to try and spur growth. To help fight inflation and prevent economic overheating, however, the Fed might increase interest rates, which can lead to higher credit card bills and make borrowing more expensive.

While the above are examples of how a recession can negatively impact your finances, recessions don't affect everyone equally. If you have a stable income and aren't worried about taking out a loan right now, you might benefit because you can invest more money while the markets are down.

How to Prepare for a Recession

While you always want to be ready for unexpected setbacks, a recession can have a large and prolonged impact on your finances. Here are a few steps you can take to prepare.

• Create or review your budget. A budget can help you track your spending and reveal places where you might be able to save. You don't necessarily have to limit your spending now, but it's good to know how much you can reduce your spending if you need to cut back in the future.
• Keep extra cash on hand. Having a flush emergency fund, and possibly increasing how much you keep in your emergency fund, could give you more options if you lose a job or need extra cash fast.
• Review your debt. Make a list of all your debts as well as their balances, minimum payments and interest rates. You may want to pay down or off some high-rate debts to free up extra money in your monthly budget. However, you'll also want to have a plan for which debts you'll focus on if you have to pick and choose.
• Diversify your income. Consider how you might be able to diversify your income so you don't rely completely on your current jobs. If you have time, you might want to start making extra money and building additional income streams.

Good Credit Gives You Options

Having a good credit score can help you qualify for more and better types of financial products, and it can be especially helpful when interest rates are high and lenders tighten their belts. It can also take a long time to build good credit. Find out where you're at by checking your free credit score and reviewing the factors that are most helping and hurting your score. Then, learn about what affects your score and what you can do to improve your score.