“A soft landing is impossible. The economy is going to go into a recession fast. You’re going to see the economy just screech to a halt. That’s what the Fed needs to do to get inflation down.” ~ Mike Novogratz, Galaxy Digital CEO
The causes of recessions can vary greatly, according to the FinTech company Sofi. Generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers. The recession that occurred in 2020 could be considered an outlier, as it was mainly sparked by an external global health event rather than internal economic causes.
The mechanics behind a typical recession work like this: consumers lose confidence and stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing, and a continued decline in consumer spending.
According to SoFi, here are some common causes of recessions:
1. High Interest Rates
High interest rates make borrowing money more expensive, limiting the amount of money available to spend and invest. In the past, the Federal Reserve has raised interest rates to protect the value of the dollar or prevent the economy from overheating, which has, at times, resulted in a recession.
For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation.” To fight it, the Fed raised interest rates throughout the decade, which created the recessions between 1980 and 1982.
2. Falling Housing Prices
If housing demand falls, so does the value of people’s homes. Homeowners may no longer be able to tap their house’s equity. As a result, homeowners may have less money in their pockets to spend, reducing consumption in the economy.
3. Stock Market Crash
A stock market crash occurs when a stock market index drops severely. If it falls by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession since individual investors’ net worth declines, causing them to reduce spending because of a negative wealth effect. It can also cut into confidence among businesses, causing them to spend and hire less.
As stock prices drop, businesses may also face less access to capital and may produce less. They may have to lay off workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.
4. Reduction in Real Wages
Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.
When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, leading to less spending and economic slowdown.
5. Bursting Bubbles
Asset bubbles are to blame for some of the most significant recessions in U.S. history, including the stock market bubble in the 1920s, the tech bubble in the 1990s, and the housing bubble in the 2000s.
An asset bubble occurs when the price of an asset, such as stock, bonds, commodities, and real estate, quickly rises without actual value in the asset to justify the rise.
As prices rise, new investors jump in, hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts — for example, if demand runs out — the market can collapse, eventually leading to recession.
6. Deflation
Deflation is a widespread drop in prices, which an oversupply of goods and services can cause. This oversupply can result in consumers and businesses saving money rather than spending it. This is because consumers and businesses would rather wait to purchase goods and services that may be lower in price in the future. As demand falls and people spend less, a recession can follow due to the contraction in consumption and economic activity.
How Do Recessions Affect You?
Businesses may have fewer customers when the economy begins to slow down because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.
As more people lose their jobs, they have less to spend on discretionary items, which means fewer sales and lower revenue for businesses. Individuals who can keep their jobs may choose to save their money rather than spend it, leading to less revenue for businesses.
Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.
When consumer spending declines, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.
Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus to boost employment and spending. “It’s hard to not underestimate the huge impact that the response to COVID-19 had on all assets. We pumped so much liquidity into the markets it was crazy, we had never seen anything like it. We were throwing trillions of dollars around like matchsticks,” said Mike Novogratz, Galaxy Digital CEO.
Central banks, like the Federal Reserve, can provide monetary policy stimulus. The Fed can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.
Source: https://www.sofi.com/learn/content/what-is-a-recession/