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22 - What Causes Recessions?
Now that we know about the economic cycle, inflation and deflation; it’s time to take a look at what actually causes recession. There are many different causes of a recession but there are also a few things that will happen over and over again no matter how the recession manifests its ugly head. This makes it worth taking the time to go over these reasons now.
In this Article:
- Interest Rates
- Decreasing Export Demand
- Trade Wars
- Asset Bubbles
- Example of when a Central Bank Fails
The first thing that can cause a recession is the impact of rising interest rates that are conducted by the central bank. Yep, you read that right. The central bank can literally be the cause a recession. But let’s be fair because they can also be the reason for an expansion as well.
If the economy gets too strong then inflation can get out of control so the central bank needs to keep a close eye on this and step in to make changes to the interest rate when it is appropriate to do so. They do this by raising interest rates and trying to balance interest rates with economic growth so that the economy doesn’t grow too quickly or get out of control.
It really is a balancing act for the central bank of anticipating and then reacting to economic developments as they unfold. This isn’t an easy job to do because many economies are huge and have an enormous amount of moving parts.
Another cause of recessions can happen when businesses build up too much inventory. This is mainly due to an overly optimistic view of the economy by individual companies. This causes manufacturers to produce way more goods than the economy or exporters can naturally support. Basically, too much supply and not enough demand is what happens here.
It could also be that demand for certain key products naturally dropped over time. This happens all the time in various industries and segments of economies. An example that we are seeing a lot of these days is when new technology replaces older technology.
Think about how VCR’s were replaced by DVD’s, then DVD’s were replaced by Blue Rays, now Blue Rays are pretty much being replaced by streaming television and movie services such as Netflix. This is possible because internet speeds are so fast these days.
The demand would naturally drop for the old technology in these cases. If the old technology was widely used it could hurt many manufacturers that were slow to adapt to the new technology. This is especially true if the new technology is being imported from a different country which now puts new cost pressures on domestic companies.
When the production buildup occurs manufacturers then cut production to bring it back in line with what the market can support at the particular time. This then lowers employment and consequently the income levels of the nation’s citizens. This then spreads to other sectors throughout the economy and likely results in an overall slowdown.
Decreasing Export Demand
A major decrease in exports can be a common reason to cause a recession. This is especially true for nations that rely heavily on selling and exporting their products abroad. If exporters are losing money then this has a negative impact on the country’s income or tax base, and therefore, its ability to grow.
For example, in 2008 one of the major causes of recession in Germany and Japan was the significant drop in exports that occurred due to the financial crisis spreading around the world. The rest of the world simply could not afford to buy German and Japanese products as much as they were used to.
Sometimes countries can get into trade wars. For example, this could mean that country A refuses to buy goods from country B for whatever reason. The reason could be because of a changing political environment such as a new leader of the country (think Donald Trump here). If country B is heavily reliant on exporting to country A then this can really hurt the economy of country B.
Sometimes one country might decide to put some kind of tax or tariff on goods imported from other countries. If the other countries are heavily reliant on importing to the country that just put the tax or tariffs then these other countries can really suffer as a result of their exporting companies losing money. If companies are losing money than they are obviously not contributing to taxes which will really hurt the GDP of the particular nation.
There is another cause of recessions that happens from time to time that is not only incredibly interesting and but is definitely something that you need to be aware of. What we are referring to is asset bubbles.
We will devote an entire lesson on asset bubbles in the next article. For now we just wanted to make you aware that asset bubbles can definitely be a major cause of recessions.
Hyperinflation is not just a cause of recessions but can lead to outright depressions within countries. Many times if hyperinflation gets too out of control then a country might have to just completely fold and start over. This is important enough that we will include a separate lesson on it coming up after we talk about asset bubbles.
Example of when a Central Bank Fails
Up to this point we have kind of been making the central seem like they get this balancing act of inflation and economic expansion perfect all the time….. They definitely do not! Let’s look at a quick example of when a central bank totally blew it and failed to meet its legal mandate to their country.
In 1982 the Federal Reserve in the U.S. caused a major recession because they decided to hike interest rates wayyyyy too quickly in order to combat inflation that was allowed to get out of control. In recent years inflation had skyrocketed higher than 13% per year!
Now, maybe 13% would be ok if we were talking about a micro emerging economy but the United States was and still is the largest economy on planet earth. Going from 5% to 13% overnight is a major shock to such a large economy.
This meant that regional banks had no choice but to pump mortgage rates up to as much as 22% per year because their cost of borrowing money just went up massively. This was a time when almost all mortgages were variable rate mortgages which meant that the rate would change with the central bank rate (sometimes referred to as prime rate) plus the regional banks rate for taking the risk on the loan.
How long do you think most people can afford to pay 20% for their mortgages before they default? For most people the answer is not too long! 22% seems crazy when we are so used to unbelievably low interest rates since the great recession of 2007-2008.
Many economists say that the Fed waited far too long to act and combat the rising inflation and were the sole reason for the recession. It’s pretty hard to imagine any other reason, they simply pooched it!
As you can see, there can be many reasons for a recession and many common causes that we should always be on the lookout for so that we can position ourselves to profit as early as possible. These are all good things to have in mind when you start to notice subtle shifts in the economy.
There is another cause of recessions that happens from time to time that is not only incredibly interesting and but is definitely something that you need to be aware of. What we are referring to is asset bubbles. We will devote an entire lesson to these next.