What's a recession, and how does it work?

Key takeaways

• A recession is an extended period of economic decline.
• In the US, the National Bureau of Economic Research (NBER) announces a recession's start and end.

Recessions are the normal part of the economic life cycle when things aren't going well. It's the opposite of economic expansion. While experiencing a recession may be unavoidable, understanding what they are and how they work can provide some perspective and help you prepare to weather the next one.

What is a recession?

A recession is a prolonged period of negative economic growth in a country. It's 1 of 4 phases in the endless economic circle of life, spanning from growth to peak to recession to trough (a.k.a. the bottom of the recession)—and back again. While it's frustrating that economic progress doesn't travel in a straight upward line, it is helpful to keep in mind that historically, periods of recession have occurred much less than periods of expansion and growth. And the US has recovered from every recession it's encountered in history.

In the US, the National Bureau of Economic Research (NBER)—a nonprofit, nonpartisan economic research organization—decides if we're in a recession by looking at signs of sustained economic decline across many parts of the economy. The data points it examines include real income, or individuals' purchasing power after considering inflation; employment levels; how much industrial producers output; how much wholesale retailers sell; and gross domestic product (GDP), or the value of all the goods and services produced during a time period.¹

The NBER usually requires that these data points fall for more than a few months to ensure it's not a short-term fluke, but this isn't always the case: The 2020 Covid-19 recession only lasted 2 months.

An important note: Recessions are different than bear markets, even though many people think they refer to the same thing. Recessions relate to a country's economy, while bear markets only refer to its stock market. While stock performance may fall the 20% or more necessary to enter into a bear market during a recession, there are instances when bear markets have not led to recessions.

What happens during a recession?

In a recession, the economy shrinks, which can lead to lower levels of employment, worsening corporate performance, deteriorating stock market results, and higher borrowing costs for both consumers and companies.

Many recession effects cause negative chain reactions. For example, when a recession looms, people may become more conservative with their spending. While this helps them feel more financially secure, it can negatively impact the businesses they usually support. This in turn causes layoffs, which decreases the amount of income others have to spend to grow the economy and may harm the company's performance in the stock market. This could cause even more people to rein in spending, continuing the negative cycle. In some extreme cases, this decrease in demand can also lead to deflation, or decreases in prices.

Recessions may correct themselves over time or be helped along by governmental intervention.

What causes a recession?

There is no single cause for every recession. But recessions are often the result of:

• Unexpected shocks to the world. Economies prefer predictability. When they're hit abruptly with wars, pandemics, or international financial collapses, the resulting instability and uncertainty can send companies and people into a panic. When they become more conservative about spending, the economy can contract, as seen in the short-lived 2020 COVID-19-induced recession.
• Asset bubbles bursting. When specific industries grow too quickly, their values may rise faster than is realistic or sustainable, creating what's called an asset bubble. This puts them in a position to burst if new money suddenly becomes unavailable or the overall economy changes, and they have no way to continue—or even simply maintain—their current level of expansion. When asset bubbles have grown large enough, as they did with dot-com-era tech companies or the 2007-2008 housing market, the bust can have far-reaching consequences, leading to a recession.
• Overheating economies. When the economy grows too quickly, businesses reach the maximum supply of resources available, from raw materials to the people they need to hire. This forces them to shell out more for the same goods and services, causing inflation. Rising prices and stiffer competition lead some businesses to struggle and fail, ringing alarm bells for investors who realize their expectations may have been too high. As they cut their losses by selling their investments, companies may undergo layoffs or freeze their hiring to remain profitable. This can compound quickly—as fewer people can work, there is less consumer demand, leading to even worse company performance and recession-level economic contractions.²

How long do recessions last?

Recessions have lasted an average of 11 months since 1945, but they can vary widely. The Great Recession of 2008-2009 latest 18 months, while the 2020 COVID-19 recession was just 2 months. Recessions occur on average about once every 5 years.³

Recession vs. depression

When talk of a recession starts, people almost inevitably become concerned we may be headed for another depression. Up until 1929, economists used "depression" to describe all prolonged periods of economic shrinking. But after the Great Depression's 43 months of economic decline, economists feared that using "depression" again would incite fear and panic and started using the milder term of "recession."⁴ These days, there is no clear definition of what would classify as a "depression," though it would likely have to be a severe recession lasting years.

The bottom line on recessions

It's very difficult to predict when a recession will occur, how long it may last, or its financial impacts. But there are steps you can take now (or anytime) to prepare for a recession, like adding to your emergency savings so you have a financial cushion and maintaining a professional network in the event you experience a job loss. It's also a good idea to develop a long-term investment strategy that you can stick with even when the economy and markets get bumpy.