What Causes an Economic Recession?

Britain's population had been using bronze as a trade currency and for millennia to make tools, jewelry, and other objects. However, that started to change around 800 BCE as the price of bronze fell, leading to social unrest and an economic crisis—what we would now refer to as a recession. There has been much debate among economists over the years about what causes recessions, and for good reason. A recession can range in severity from a brief downturn with local effects that lasts months to a protracted downturn with global effects that lasts years.

The fact that so many different factors affect an economy's health and it is challenging to identify specific causes further complicates the situation. So it's helpful to start with the big picture: recessions happen when the balance between supply and demand is negatively disrupted. A mismatch exists between the quantity of goods consumers want to purchase, the quantity of goods and services producers can supply, and the cost of the goods and services sold, which leads to a decline in the economy. Interest rates and inflation rates both reflect how supply and demand are balanced in an economy. When goods and services become more expensive, inflation occurs. The value of money declines, to put it another way. Inflation, however, need not always be a bad thing. In fact, it is believed that a low inflation rate stimulates the economy.

High inflation, however, can harm an economy and eventually trigger a recession if it is not accompanied by high demand. Meanwhile, interest rates represent the price that people and businesses pay when they take on debt. The rate is typically a percentage that borrowers pay annually to creditors until the loan is repaid. Low interest rates allow businesses to borrow more money, which they can then use to fund more projects. While this is going on, high interest rates raise the cost of goods for both consumers and producers, slowing down economic growth. The most obvious causes of inflation and interest rate fluctuations are shocks like natural disaster, war, and geopolitical factors. However, what actually drives these fluctuations is less clear. For instance, an earthquake can demolish the infrastructure required for the production of valuable goods like oil. This discourages demand and might even trigger a recession by forcing the supply side of the economy to raise prices for goods that use oil.

Some recessions do happen when the economy is doing well—possibly even because of it. Some economists think that a market's expansion can occasionally result in business activity that is too high to sustain. For instance, businesses and consumers might take on more debt under the theory that the expansion of the economy will enable them to manage the increased burden. They might accumulate more debt than they can handle, however, if the economy doesn't expand as quickly as anticipated. They'll have to divert funds from other uses, which will decrease business activity, to pay it off. A recession may be influenced psychologically as well. If recession anxiety discourages people from investing and spending, it could become a self-fulfilling prophecy. To prepare for the anticipated drop in demand, producers may reduce operating costs as a response. Cost reductions eventually cause wages to decline, which causes demand to decline even further, which can set off a vicious cycle. Even measures intended to avert recessions may have an impact. Governments and central banks may print money, increase spending, and lower interest rates when times are hard. It is possible for smaller lenders to reduce their interest rates in turn, effectively lowering the cost of debt to encourage spending.

But in order to stop too much inflation, these policies must eventually be changed because they are unsustainable. If people rely too heavily on low-cost debt and government stimulus, that could trigger a recession. The adoption of iron contributed to a revolution in agriculture and food production, which ultimately brought an end to the Bronze recession in Britain. Because of the complexity of today's markets, it is much harder to navigate recessions. However, each recession generates fresh information that can be used to better predict and prepare for future recessions.