What Causes An Economic Downturn

Economic Downturn - All You Need To Know

There are several causes of an economic downturn and they might have lingered for years before the effect showed on the economy or they might just have sprung up immediately. According to NBER (National Bureau of Economic Research), a recession is defined as a significant decline in activity spread across the economy. Sometimes, this decline in activity can last more than a few months and it is predominantly visible in wholesale-retail trade, real income, employment rates, and industrial production. 

What is an Economic Downturn?

An economic downturn is often caused by a series of events in the economy, such as a world event, a financial crisis, and disruptions to the chain of supply. An economic downturn can also be triggered after the economy has gone through a period of inflation. During the inflationary period and when inflation increases, the central bank of that economy raises the rates of interest to slow down the economy. The goal they all bear in mind is to bring down inflation. When higher interest rates prevail and go on for a long, there is a huge probability that economic downturns will increase and this will lead to decreased corporate spending, decreases consumer spending, fewer jobs, layoffs, and other effects that are usually found in a declining economy. 

As more and more consumers and companies become anxious about the economy, they cut back on spending and hold on to their money. Companies are then forced to lay off employees, limit losses, scale back production and also reallocate resources as the economic downturn intensifies and prevails. An economic downturn is marked by a decrease in the (GDP) gross domestic product and an increase in the rate of unemployment for two consecutive quarters. 

Economic Downturn Signs

There are two definitions of an economic downturn – the macroeconomic definition and the microeconomic definition. Let us take a look at them: 

  • For the standard macroeconomic definition of an economic downturn, there have to be two consecutive quarters of negative gross domestic product growth. When this happens, private firms and companies usually scale back their production level and also try to limit their exposure to risks. There is also bound to be a measurable decrease in investment and spending levels. Also, it is characterized by a natural declining pressure on prices. All these are part of the total demand slumps. Rises in unemployment rates and GDP declines also occur due to the fact that several companies lay off workers in a bid to reduce the costs they incur. 
  • For the standard microeconomic definition of an economic downturn, firms experience a decline in margins. Firms look to cut activities that are least efficient when revenue got from investments or sales declines. For instance, a firm might reduce the compensation of employees or stop producing low-margin products when there is an economic downturn. Also, it might want to obtain temporary interest relief by renegotiating with creditors. Unfortunately, the declining margins in the business may now force the firms to cut costs further by reducing employment and laying off staff. 

Now to the crux of the matter. What exactly causes an economic downturn? There is a wide range of factors that come into play in every economic downturn. From economic and psychological to financial. 

  • Financial – The expansion of money and credit supply in the economy by the banking sector and the Federal Reserve can lead to an economic downturn. Also, the overextension of credit and debit on marginal borrowers and risky loans can also be a factor. 
  • Psychological – This borders on the doom and gloom feeling that always follows a market crash, the excessive exuberance of investors, and the subjective expectations of consumers, businesses, and investors.
  • Economical – Beyond investor psychology and financial accounts, real changes in the fundamentals of the economy can play huge roles in an economic downturn. Disruptions in the chain of supply and the damage that they can incur are major factors. 

There are multiple causes of an economic downturn and high up on that list is higher interest rates. To avoid economic downturns, interest rates would have to reach a level where they can give a soft cushion for inflation.