A recession is one or more consecutive years of negative real GDP growth. The opposite of recession is expansion.Business cycles are always present in market-oriented economies. Business cycles are important in determining the levels of recession in a country”s economy. It is defined as recurring chain of growth and recessions in the level of economic activity. It also means cyclical rise and fall in economic activity around a trend particularly its growth cycle, where the growth rates are high and level recessions are rare.
Business cycles in industrial countries after 1973 are characterized by lower growth rates and common level recessions. Business cycles in industrial countries from 1973 to 2000 have generally milder recessions and longer period of growth or expansions; synchronized recessions are a common feature of the international and historical experience; and investment is playing a larger role in recessions now than in the late nineteenth century.
Analysis indicates that investment contractions and stock price declines are more synchronized than recessions; that investment contractions make important contributions to recessions but upturns in consumption tend to drive recoveries; and that cycles in interest rates and output in G-7 countries are closely related.
There are four distinct periods of recession as indicated by the business cycles. These four are divided by major world events: the prewar period before World War I (1881-1913); the interwar period between the World Wars (1919-38); the Bretton Woods period between World War II and the productivity slowdown, the oil shocks, and the move to generalized floating of exchange rates in the early 1970s (1950-1972); and the post–Bretton Woods period (1973-2000).
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 internal recurring forces and external shocks. For instance, Keynesian economists and Real business cycle theorists may disagree on the causes of business cycle breakdown, but all would agree that purely external factors such as oil price, the weather, or a war could cause either temporary recession or economic growth.
Keynes pointed out that when interest rates get too low – below 2% – then people are not attracted to save money in the bank. Instead they hold money for other transactions. If there are no savings, banks could not extend loans, drying up savings and loans in the long run which would cause a business cycle to break down, according to Keynes.
Austrian school economists hold that it is an inflation of the money supply that causes modern recessions. They also see recessions as positive forces that naturally undo misallocation of resources during the boom or inflationary phase. Most monetarists believe that the cause of most recessions in the United States is mishandling of the money supply, while, a few believes that it is due to an extreme change in the structure of the economy.
The banking systems in forty or fifty countries such as Japan, Mexico, Finland, Sweden, South Korea, Thailand, Russia, and Brazil collapsed in one of three waves; the first wave began in 1982 in Mexico and many other developing countries, the second wave began in 1990 and included Japan and Sweden, and third wave began in 1997 and included Thailand and its neighbors in South Asia as well as Russia.
The combined loan losses of the banks in some of these countries comprised around thirty to forty percent of the annual government budgets in most of these countries.The differences of market exchange rates from real exchange rates for many of the emerging market countries have been much bigger because currencies depreciated greatly during financial crises.
The bubble in real estate and in stocks in Japan in the 1980s was the “mother of all asset price bubbles” as shown by both the increase in the ratio of household wealth to GDP and by the increase in the value of Tobin’s Q for publicly traded firms. The bubbles in real estate and stocks in Finland, Norway, and Sweden in the second half of the 1980s were the biggest these countries had experienced. The increases in the Q ratios in these countries though were smaller compared to the increase in the Q ratio in Japan at the same time.
There were bubbles in real estate and stocks in Thailand, Indonesia, Malaysia, and their neighboring countries in the first half of the 1990s. The United States experienced a bubble in stock prices that started a year or two before Greenspan’s made a remark about “irrational exuberance” and continued until 2000; the increase in the Q ratio was greater than in the 1920s.
The failures of national banking systems, the asset price bubbles, and the scope of overshooting and undershooting were all related. The failure of the banks and other financial institutions resulted from large losses to the borrowers in individual countries during the implosion of asset price bubbles or when their national currencies depreciated. In the pre-shock years these countries had experienced sustained inflows of savings from abroad that led to both the real appreciations of their currencies and to the increase in the prices of securities traded in the country; economic booms followed. The booms made the investor forgot how fragile and unsustainable the pattern of cash flows was.
As the influx of foreign saving mounted, the scope and extent of overshooting would most likely increase, and the countries acquired growing large trade deficits. The situation in terms of national income accounting identity is that domestic economies adopted to the increases in the influx of foreign savings by increase in domestic investment, decline in domestic saving, and an increase in their government’s fiscal deficit. Most countries experienced economic boom at the times when the inflow of foreign saving was improving and the government’s fiscal deficit often declined unless the inflow of foreign saving was an answer to the increase of government borrowing.
The adjustment to the increase in the inflow of foreign saving would result primarily in an increase in household consumption. Household wealth continued to improve for as long as the domestic savings would not decrease in order to equal the increase in the inflow of foreign saving. The economic boom would consequently lead to a noticeable increase in consumption spending which is brought about by the increase in household wealth.
The pattern of cash flows in the growth or expansion period is not likely to be continuous or sustainable; some of the borrowers obtained new loans to pay the interest on outstanding loans. To address the situation, some form of adjustment eventually would be necessary to reduce the rate of increase of indebtedness. That adjustment would affect or result in a decrease in the foreign exchange value of the country’s currency. During recession period, there was a reversal in the direction of the cross-border flow of saving and the currencies depreciated sharply and “undershot” the equilibrium value as the countries developed trade surpluses. The large depreciation of the currencies could trigger massive revaluation losses on loans.
The last thirty years saw the most tumultuous in international monetary history. More national banking systems collapsed in several different waves than at any other period. The deviations of market exchange rates from real exchange rates-the “overshooting” and “undershooting” and the fluctuating ratios of trade balances to the GDPs have been bigger than previous periods.
It also saw four major asset price bubbles; the “mother of all bubbles” was in Japan in the second half of the 1980s. These world events: failures of national banking systems, the large shifts in market exchange rates compared to the real exchange rates, the large fluctuations in flows of national saving across national boundaries, the bubbles in asset prices were methodically related to each other.
A marked increase in the cross-border flow of saving to a country would result in an increase in the price of that country’s currency in the foreign exchange market and could cause “overshooting” of its currency; the price of securities traded in that country also increased. The pattern of cash flows was non-sustainable but somehow this pattern was able to continue for a longer period. A shock will occur if there is reversal in the cross-border flow of capital and the price of that country’s currency in the foreign exchange market declined greatly and the price of securities traded in that country lessened. There is a close correlation between change in the value of a country’s currency in the foreign exchange market and the change in the value of the securities traded in that country. The adjustment process to inflows of foreign saving causes significant increases in the prices of domestic securities and leads to a prolonged economic expansion that could mask its non-sustainability. Thus, this resulted to cyclical modern world recessions.