Recession Totally Explained

In macroeconomics, a recession is a decline in any country's Gross Domestic Product (GDP), or negative real economic growth, for two or more successive quarters of a year. However, this definition isn't universally accepted. The National Bureau of Economic Research defines a recession more ambiguously as "a significant decline in economic activity spread across the economy, lasting more than a few months." A recession may involve simultaneous declines in coincident measures of overall economic activity such as employment, investment, and corporate profits. Recessions may be associated with falling prices (deflation), or, alternatively, sharply rising prices (inflation) in a process known as stagflation. A severe or long recession is referred to as an economic depression. A devastating breakdown of an economy is called economic collapse. Newspaper columnist Sidney J. Harris amusingly distinguished terms this way: a recession is when you lose your job; a depression is when I lose mine.
Market-oriented economies are characterized by economic cycles, but actual recessions (declines in economic activity) don't always result. There is much debate as to whether government intervention smooths the cycle (see Keynesianism), exaggerates it (see Real business cycle theory), or even creates it (see monetarism).

Causes of recessions

The precise causes of recession are the subject of fierce debate among academics and policy makers although most would agree that recessions are caused by some combination of endogenous cyclical forces and exogenous shocks. For example, Keynesian economists and Real business cycle theorists would all disagree about the precise cause of the business cycle breakdown, but most would agree that purely exogenous factors like the price of oil, weather conditions, or a war could by themselves cause a temporary recession, or, conversely, short term economic growth. Keynes himself, however, pointed out that when interest rates get too little -- below about 2% -- than people no longer have an incentive to save, preferring to hold money for what he called transactions demands. If there are no savings, banks get no money with which to make loans, and it's is drying up of savings -- and loans -- that caused the regular business cycle to break down, according to Keynes. Austrian school economists hold that it's an inflation of the money supply that causes modern recessions and that recessions are positive forces in-so-much that they're the market's natural mechanism of undoing the misallocation of resources present during the boom or inflationary phase. Most monetarists believe that the cause of most recessions in the United States is this mishandling of the money supply, while extreme changes in the structure of the economy are responsible for very few.
The Great Depression
Prior to the Great Depression, speculative investing in the stock market occurred, which created artificially high stock prices. Shares were also used as a partial collateral for loans to buy more stocks (ie. buying stocks on margins as little as 10%). When share prices plummeted, people who had bought on margin were forced to pay their 90% loans used to buy their stocks; to pay their loans, they sold stocks, driving prices down still further in a vicious domino effect. Financial institutions -- banks, etc. -- collapsed, triggering a monetary crisis.
   This analysis has been sharply disputed by monetarist economists such as Milton Friedman (dubbing the Great Depression the Great Contraction) who wrote that the Great Depression would have been merely a "garden-variety recession" if it weren't for the response of the Federal Reserve to the following runs on the banks and that most investments were made unsound by the effects of a massive deflation, the increase in real interest rates and decline of real personal and business incomes. This led to the famous run on the banks, in which massive withdrawals of bank deposits led some banks to collapse, confirming investors' fears and inspiring more withdrawals. From the beginning to end, it has been calculated that the money supply declined by one third thus forcing down production while prices adjusted.
   John Maynard Keynes, a famous British economist, believed that the classical business cycle theory broke down when interest rates went below to about 2%. People then had no incentive to save money, because they earned so little interest. This meant that banks didn't receive money with which they could make loans. The lack of loan money disrupted business, according to Keynes. Keynes also had written a book -- The Economic Consequences of the Peace -- saying that the World War I Allies demanded far too much in reparations from Germany, etc., and that this demand for reparations was at least in part to blame for the lack of trade and economic collapse.
   Other people often blame very high tariffs -- the Smoot-Hawley tariffs, which actually are still in effect -- as a cause of the depression. Each country enacted high protectionist tariffs to make imports very expensive; but because all countries did this, that led to a breakdown in international trade. Because trading is good in economics -- people don't trade unless there's a benefit to each side -- a breakdown in trading is bad in economic terms.
   To date no repetitions of the Great Depression have happened in the industrial world. However, many Latin American countries suffered a severe economic slump coupled with high inflation in the 1980s, Japan suffered from a depression during the 1990s, and the former Communist states of central and eastern Europe also fell into an economic depression during the transition to capitalist economies. Additionally, the term "depression" may be used to describe the situation of many poorer countries in the Third World (although in many cases these countries never achieved sustained economic development in the first place).

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