Causes of an Economic Recession

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Economic recessions can be caused by many different elements, including loss of consumer confidence, high interest rates, a stock market crash, and asset bubbles bursting. Most events that will cause the economy to slow down can also lead to a recession if left unchecked.

Key Takeaways

  • When consumer confidence slows, demand and economic growth slows, which can lead to a recession.
  • High interest rates or a lack of funds available to borrow can lead to a recession.
  • The 2008 recession was caused by a housing bubble and irresponsible lending practices.
  • The 2020 recession was caused by the COVID-19 pandemic, which forced many businesses to close or cut back in order to stop the spread of the virus.

Does GDP Indicate a Recession?

A decline in gross domestic product (GDP) growth is often listed as a cause of a recession, but it's more of a warning signal that a recession is already underway. The GDP is only reported after a quarter is over, so the recession would have probably already been underway for a couple months by the time the GDP turned negative.


Recessions have generally been defined as two or more successive quarters of GDP declines. However, the National Bureau of Economic Research (NBER), which is often used to date recessions, does not abide by that rule. Instead, NBER uses three different criteria—depth, diffusion, and duration.

Loss of Consumer Confidence

Loss of confidence in the economy prompts consumers to stop buying, which can lead to a vicious cycle. If the demand for goods and services is sufficiently reduced, that will then eventually reduce business profits and the need or financial capacity to hire more employees.

That means the economy will add fewer jobs, sales will continue to slow, and manufacturers will generally cut back production in response to the falling demand. Cutting back on production also means cutting back on jobs, which leads to a rising unemployment rate, which will then lead to people cutting back on their spending.

High Interest Rates

Higher interest rates make borrowing money more expensive, which discourages consumers and businesses from borrowing money in order to make purchases or investments. The reduced spending leads to a decreased demand in goods and services in the economy.

The decrease in demand and subsequent cutbacks on production then lead to businesses hiring fewer people. As spending in the economy goes down, inflation decreases. However, if high interest rates cause the economy to contract too much, that can lead to a recession.

A Stock Market Crash

If the stock market crashes, that can lead to a recession. As stock prices go down, investors often have less capital to invest in businesses. If businesses can't raise money for growth and operating costs, that can lead to layoffs or hiring freezes.

Some of the major stock market crashes in United States history immediately preceded a recession. These include the stock market crash of 1929, also known as "Black Tuesday", the 2008 financial crisis, and the short-term crash due to COVID-19.


Lawmakers can trigger a recession when they remove important safeguards. The seeds of the savings and loan crisis and the subsequent recession were planted in 1982 when the Garn-St. Germain Depository Institutions Act was passed. This and the Depository Institutions Deregulation and Monetary Control Act of 1980 removed loan-to-value ratio and interest rate cap restrictions for savings and loan associations.

The savings and loans crisis caused the 1990 recession. More than 1,000 banks, with total assets of $500 billion, failed as a result of land flips, questionable loans, and illegal activities. 

Postwar Recessions

Postwar recessions have happened frequently in U.S. history. There were recessions after World War II, the Korean War, the Vietnam War, and the Gulf War. The average growth following the Korean War, the Vietnam War, and the Gulf War went down 4.5%, and the average unemployment rate went up an average of 1%.

Credit Crunches

A credit crunch occurs when there is a sudden shortage of funds available to lend, which means there are fewer loans. For example, during the 2008 financial crisis, banks experienced huge losses because so many mortgages were defaulted on, and because they had bought bad mortgage debt. These losses meant that they were very reluctant to loan out money.

When lenders become more wary, interest rates rise, and there is less money available for businesses and consumers. That can lead to a recession.

When Asset Bubbles Burst

Asset bubbles occur when the prices of investments including gold, stocks, or housing become inflated beyond their sustainable value. The bubble itself sets the stage for a recession to occur when it bursts. The "dot com" stock bubble and the housing bubble came right before the recessions of 2001 and 2008.


Deflation reduces the value of goods and services being sold on the market, which encourages people to wait to buy until prices are lower. It is often associated with high interest rates, which can also cause people to wait to make purchases, since they cannot afford to take on debt at such high interest rates.

Deflation can also lead to an increase in unemployment, because companies need to cut costs. This can lead to a deflationary spiral, because unemployed people cannot typically spend money to help the economy grow.

The 2008 Recession

There was a housing bubble and little regulation in the early 2000s. Banks and lenders allowed consumers to take out mortgages they couldn't pay back. As a result, many buyers bought homes they couldn't afford. Many of these borrowers were victims of predatory lending practices.

Ultimately, these borrowers were forced to default on their loans. The foreclosures caused housing prices to plummet, and millions of Americans lost their homes.


The ability-to-repay rule requires mortgage lenders to make a good faith effort to determine whether borrowers can repay a loan. This rule was created after the 2008 financial crisis.

Financial institutions had also used these mortgages to create mortgage-backed securities, which is a type of bond or investment that is backed by the value of the mortgage. Derivatives using these mortgage securities were also created, These derivatives tracked the performance of mortgage securities. Credit default swaps were also issued by financial institutions to insure investors against MBS losses.

Eventually, the whole financial market was exposed to these securities in some way, which meant the whole financial market had some level of exposure to risky mortgages. Ultimately, many of the biggest financial institutions experienced huge losses on their mortgage-related assets.

The 2020 Recession

The U.S. economy contracted because of the COVID-19 shutdown in March of 2020. Real GDP declined 5.1% in the first quarter of 2020. The cause of the 2020 recession was a "black swan event" as the global COVID-19 pandemic required most businesses to shut down to avoid spreading the coronavirus.

It took 29 months for the U.S. jobs market to fully recover from the impact of COVID-19, which was faster than any other recession in the last 40 years.

Frequently Asked Questions (FAQs)

What causes interest rates to fall during a recession?

In some cases, interest rates fall during recessions, because central banks use monetary policy to encourage growth. A decrease in interest income is an incentive to invest rather than stash cash away in a bank account. In other cases, interest rates fall during a recession, because investors flock to the relative safety of bonds. That buying pressure can suppress interest rates.

How do governments try to encourage growth during a recession?

Monetary policy—such as cutting interest rates—is one way that governments try to encourage growth during a recession. Fiscal policy is another tool, such as cutting taxes to encourage consumer spending. Governments also spend taxpayer funds directly in the economy, such as by hiring workers for government projects or supplementing wages and benefits for low-income workers.

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