What causes recessions?

A few different resources explaining the various causes of recessions…

In 2019 I wrote a feature about firms and recessions, and I summed up the causes of recession this way:

Recessions… can be caused by economic shocks (such as a spike in oil prices), financial panics (like the one that preceded the Great Recession), rapid changes in economic expectations (the so-called “animal spirits” described by John Maynard Keynes; this is what caused the dot-com bubble to burst), or some combination of the three. Most firms suffer during a recession, primarily because demand (and revenue) falls and uncertainty about the future increases.

Here are the three categories that a Congressional Research Service report used in a 2019 brief on the causes of recessions:

Recessions can be caused by an overheated economy, in which demand outstrips supply, expanding past full employment and the maximum capacity of the nation’s resources. Overheating can be sustained temporarily, but eventually spending will fall in order for supply to catch up to demand. A classic overheating economy has two key characteristics—rising inflation and unemployment below its “natural” rate…

Asset Bubbles
The last two recessions were arguably caused by overheating of a different type. While neither featured a large increase in price inflation, both featured the rapid growth and subsequent bursting of asset bubbles. The 2001 recession was preceded by the “dot-com” stock bubble, and the 2007-2009 recession was preceded by the housing bubble…

Economic Shocks
They can also be triggered by negative, unexpected, external events, which economists refer to as “shocks” to the economy that disrupt the expansion…
A classic example of a shock is the oil shocks of the 1970s and 1980s.

Here is the IMF:

There are a variety of reasons recessions take place. Some are associated with sharp changes in the prices of the inputs used in producing goods and services. For example, a steep increase in oil prices can be a harbinger of a recession. As energy becomes expensive, it pushes up the overall price level, leading to a decline in aggregate demand. A recession can also be triggered by a country’s decision to reduce inflation by employing contractionary monetary or fiscal policies. When used excessively, such policies can lead to a decline in demand for goods and services, eventually resulting in a recession.

Other recessions, such as the one that began in 2007, are rooted in financial market problems. Sharp increases in asset prices and a speedy expansion of credit often coincide with rapid accumulation of debt. As corporations and households get overextended and face difficulties in meeting their debt obligations, they reduce investment and consumption, which in turn leads to a decrease in economic activity. Not all such credit booms end up in recessions, but when they do, these recessions are often more costly than others. Recessions can be the result of a decline in external demand, especially in countries with strong export sectors.

And here is a bit from David Moss’s A Concise Guide to Macroeconomics, 2nd edition:

Anything that causes labor, capital, or [total factor productivity] to fall could potentially cause a decline in output… A massive earthquake, for example, could reduce output by destroying vast amounts of physical capital. Similarly, a deadly epidemic could reduce output by decimating the labor force…

In some cases, however, output may decline sharply even in the absence of any earthquakes or epidemics… [He cites the Great Depression.] The British economist John Maynard Keynes claimed to have the answer… His key insight, implied by the phrase ‘immaterial devices of the mind’, was that the problem was mainly one of expectations and psychology. For some reason, people had gotten it into their heads that the economy was in trouble, and that belief rapidly became self-fulfilling…. Driven by nothing more than expectations, which Keynes would later refer to as ‘animal spirits,’ the economy had fallen into a vicious downward spiral…

Starting around the time of Keynes, therefore, economists began to realize that there was more to economic growth than just the supply side. Demand mattered a great deal as well, particularly since it could sometimes fall short. In fact, over roughly the next 40 years, it became an article of faith among leading economists and government officials that it was the government’s responsibility to ‘manage demand’ through fiscal and monetary policy.

p. 22-26

There’s one other bit of Moss’s book that’s worth mentioning here. It’s an incredibly slim volume and so he faces the question of how to organize such a brief survey of macroeconomics. He chose to use three overarching topics: Output, money, and expectations.

His whole discussion of recessions in the Output section, because a recession is a sustained decline in economic output. But you could break the causes of recessions into his three buckets: Output = shocks to labor, capital, or productivity. Money = financial crises or policy-induced shifts to interest rates or the money supply. Expectations = Shifts in collective psychology that lower demand.

With all this sketched out, one of my biggest questions is how to think about 2000. CRS buckets it with 2008 as the bursting of an “asset bubble.” That feels strange to me. It’s true that both involved financial markets and asset bubbles. But 2000 seemed like a shift in expectations, that then led to an asset bubble bursting and a fairly mild recession. In 2008, an asset bubble was part of the story. But the real story was a financial crisis sparked by opacity and complexity.

I think if I were writing a paragraph on the causes of recession today I’d go with four buckets:

  1. Economic shocks to productive capacity
  2. Policy-induced declines in demand (monetary or fiscal policy)
  3. Changes in expectations (“animal spirits”)
  4. Financial crises

You could think of 2000 as sort of straddling 3 and 4 whereas the global financial crisis was really all 4. The Covid recession was 1. And if we have a recession in the next year it’ll be firmly in 2. Honestly, 3 feels like the rarest one, but I think that’s because most of the time it overlaps with either 2 or 4. Shifts in investor sentiment span 3 and 4, depending on the type of investors and the type of asset. Shifts in demand now almost always relate to 2, since policymakers have internalized Keynes’ insight and actively manage it.

You could also try breaking it up into:

  1. Supply shocks
  2. Demand shocks (whether via policy or shifts in “animal spirits”)
  3. Financial crises

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