What is the Definition of a Recession? A Comprehensive Guide

The global economy is in constant motion, generally trending upwards over time. However, this growth is not always linear. It ebbs and flows, creating a ‘business cycle’ characterized by peaks and troughs in economic activity. When the economy enters a trough, growth can stagnate or even contract, leading to job losses and increased unemployment. This downturn is often referred to as a recession. But What Is The Definition Of A Recession precisely?

While there’s no universally agreed-upon definition, the consensus is that a recession signifies a period of declining economic output coupled with a significant surge in unemployment. However, the specifics of identifying a recession remain a subject of debate among economists and policymakers. Recessions are more than just abstract economic events; they inflict real hardship on individuals, families, and businesses. The repercussions can extend far beyond the immediate downturn, leaving lasting scars on society and the economy. Therefore, central banks and governments worldwide prioritize mitigating the frequency and severity of recessions, primarily through monetary policy and other economic interventions.

This article will delve into the intricacies of the business cycle and explore various definitions of a recession. We will examine different approaches to identifying these economic downturns, providing a comprehensive understanding of this critical economic phenomenon.

Decoding the Business Cycle

To understand a recession, it’s essential to first grasp the concept of the business cycle. The business cycle describes the recurring fluctuations in the growth rate of economic output, considered against the backdrop of the economy’s ‘potential output’ growth. Economic output is typically measured as real Gross Domestic Product (GDP), while potential output represents the maximum level of output an economy can sustainably produce when all its resources – labor, capital, natural resources, and technology – are fully utilized without triggering inflationary pressures. ¹

A business cycle is typically characterized by four distinct phases: expansion, peak, contraction, and trough.

Expansion: During an expansionary phase, the economy experiences robust growth. Households increase their demand for goods and services, businesses expand operations and hire more workers, and wages and prices tend to rise. This phase culminates in a peak of economic activity.
Peak: The peak represents the highest point of economic activity in the business cycle. After the peak, the economy begins to slow down.
Contraction: A contraction, often referred to as a recession, is a period of economic decline. Household demand for goods and services weakens, businesses reduce investment and lay off workers, and growth in wages and prices decelerates.
Trough: The trough marks the lowest point of economic activity in the business cycle. After the trough, the economy begins to recover and enter a new expansionary phase.

It’s important to note that business cycles are not uniform. They vary in length and intensity, and each phase can also differ in duration. Expansions generally tend to last longer than contractions. The overall length and characteristics of a business cycle are influenced by a multitude of factors, including government policies and global economic conditions.

Defining a Recession: Exploring Various Perspectives

As mentioned earlier, there isn’t one single, universally accepted definition of a recession. However, common threads run through most descriptions, primarily focusing on economic output and labor market conditions.

Core Elements: Weak Output and Rising Unemployment Rates

At its heart, a recession can be defined as a sustained period of weak or negative growth in real GDP, accompanied by a significant and widespread increase in the unemployment rate. This definition emphasizes two critical components:

Weak or Negative GDP Growth: A decline in real GDP signifies that the economy is producing fewer goods and services. This can be due to decreased consumer spending, reduced business investment, or a fall in exports.
Significant Rise in Unemployment: As economic activity slows, businesses often reduce their workforce, leading to job losses and a higher unemployment rate. This indicates that a larger proportion of the labor force is actively seeking employment but unable to find it.

Beyond these core indicators, recessions are typically associated with a range of other economic weaknesses. Household spending and business investment tend to decline. Loan defaults by households and businesses rise, reflecting financial strain. Business closures become more frequent as companies struggle to survive the economic downturn. The unemployment rate is often seen as a particularly reliable and timely indicator because it reflects a broad spectrum of negative economic developments.

Technical Recession: Two Consecutive Quarters of Negative GDP Growth

One of the most frequently cited definitions of recession, particularly in the media, is that of a “technical recession.” This definition states that a recession occurs when an economy experiences negative real GDP growth for two consecutive quarters (a quarter being a three-month period). This definition is straightforward, easily quantifiable, and widely used in textbooks and by journalists for its simplicity.

However, the “technical recession” definition has limitations:

Weak Growth vs. Negative Growth: GDP growth can be weak, hovering just above zero, without technically being negative. Such periods can still be associated with rising unemployment and significant economic hardship, which the technical definition might overlook.
GDP Volatility: GDP figures, especially quarterly data, can be volatile and subject to revisions as more complete data becomes available. Two consecutive quarters of negative GDP growth might be a statistical anomaly or later revised away, giving a false signal of a recession. Conversely, a true recession might be underestimated if initial data is revised upwards later.
Data Revisions: The components of GDP are constantly being measured and refined. Initial GDP growth figures are often revised as more comprehensive data becomes available. This means that a preliminary negative quarterly growth figure could be revised to positive, or vice versa, potentially leading to incorrect recession classifications based on the “technical recession” rule.

To address some of these shortcomings, some economists and analysts consider alternative measures of economic output. For example, some focus on GDP per capita (GDP per person) to exclude the impact of population growth on overall GDP figures. Consecutive quarters of negative GDP per capita growth might offer a more nuanced view of economic stagnation or decline in living standards. Others might look at GDP excluding volatile sectors like agriculture to smooth out fluctuations caused by factors such as weather patterns, providing a clearer picture of underlying economic trends.

As Identified by the NBER: A Broader Approach

The National Bureau of Economic Research (NBER) in the United States, a highly respected research institution renowned for its work on business cycles, adopts a more comprehensive and nuanced approach to defining recessions. The NBER defines a recession as:

“a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

This definition emphasizes several key aspects:

Significant Decline: The economic downturn must be substantial and not just a minor slowdown.
Spread Across the Economy: The decline must be broad-based, affecting various sectors and industries, not localized to a specific area.
Lasting More Than a Few Months: The downturn must be persistent, not a fleeting dip in economic activity.
Multiple Indicators: The NBER considers a range of economic indicators beyond just GDP, including real income, employment, industrial production, and sales. This holistic approach aims to capture a more complete picture of the economy’s health.

While the NBER acknowledges that most recessions will indeed exhibit two consecutive quarters of negative real GDP growth, it emphasizes that this is not a rigid requirement. They prioritize a comprehensive assessment of various economic indicators to determine whether a recession has occurred. However, the NBER’s recession dating process is not formulaic or automated. It involves careful analysis and judgment by a committee of experts, and their official recession declarations often come with a significant time lag. Furthermore, the NBER’s definition and methodology are primarily tailored to the US economy and may not be directly transferable to other economies without careful consideration of country-specific factors.

Unemployment-Based Rules: A Focus on Labor Markets

Some economists propose definitions of recession that rely solely on unemployment rate metrics. These rules typically signal a recession when the unemployment rate increases by more than a predetermined threshold within a specific timeframe.

Unemployment-based rules have certain advantages:

Simplicity: They are easy to understand and apply.
Timeliness: Unemployment data is usually released more promptly than GDP figures, providing a more timely recession signal.
Less Susceptible to Revisions: Unemployment data is generally less subject to revisions compared to GDP data, making these rules potentially more stable.

However, unemployment-based rules also have limitations:

Incomplete Picture: Focusing solely on unemployment might overlook deteriorations in other crucial economic indicators, such as underemployment (people working part-time who desire full-time work) or declining business investment.
Lagging Indicator: The unemployment rate is often considered a lagging indicator, meaning it tends to rise after a recession has already begun. Relying solely on unemployment might delay recession recognition.

What is the Difference Between Recession and Depression?

While the term “recession” is frequently discussed, “depression” represents a far more severe economic downturn. Similar to “recession,” there is no single, precise definition of a depression. However, a depression is generally understood as a much more profound and prolonged version of a recession, both in terms of scale and duration.

In a depression, the economy experiences a drastic and sustained decline in output, accompanied by extremely high unemployment rates that persist for several years. The economic and social consequences of a depression are far more devastating than those of a typical recession.

Depressions often have global ramifications, affecting multiple countries simultaneously. Some definitions of depression emphasize its international scope, describing it as a severe recession that engulfs one or more major economies and has widespread global repercussions.

Historical Recessions: Lessons from the Past

Examining historical recessions provides valuable insights into the causes, characteristics, and consequences of economic downturns. Australia, like many other economies, has experienced periods of weak economic activity that are recognized as recessions or depressions.

Recessions in Australia

1974–1975 Recession: This recession was triggered by a global oil price shock, where oil prices quadrupled. This surge in energy costs fueled high inflation, exacerbated by domestic wage pressures. Rising production costs and reduced global demand from recession-hit economies led to output contraction and job losses in Australia. The economy experienced “stagflation” – a combination of falling output and rising unemployment alongside high inflation. (Unemployment peaked at 5.5%, inflation at 18%).
1982–1983 Recession: Globally, high inflation from the 1970s became entrenched, driven by oil price shocks, excessive money supply growth, and expansionary fiscal policies. Central banks, prioritizing inflation control, tightened monetary policy, triggering recessions in many economies, including the US. In Australia, tighter monetary policy and weak global demand were compounded by a severe drought. A rapid economic recovery followed the breaking of the drought, aided by the floating of the Australian dollar and economic reforms. (Unemployment peaked at 10.5%).
1991–1992 Recession: This recession primarily stemmed from Australia’s efforts to curb excessive domestic demand, speculative activity in commercial property, and high inflation. Interest rates were raised significantly, but the impact of tighter monetary policy on demand and inflation was slower than anticipated. Simultaneous recessions in other countries, particularly the US, amplified the downturn in Australia. (Unemployment peaked just over 11%).

Depressions in Australia

The Great Depression of the 1930s: The Great Depression remains the most infamous economic depression due to its global severity and prolonged duration. It predated modern social safety nets, and its social consequences underscore the potential costs of economic policy failures. In Australia, the Great Depression lasted from 1929 to 1931. Unemployment reached an estimated peak of 20-30%. The social and economic consequences were profound, although Australia was less severely impacted than some other nations.
The Depression of the 1890s: Following a prolonged boom in resources and property, foreign investors reduced their activity and withdrew funds from Australia. Australia, lacking its own currency at the time, couldn’t devalue its exchange rate to cushion the blow. This coincided with a collapse in wool prices. A “run” on banks ensued as depositors withdrew funds, triggering a deep financial crisis. This financial instability led to an even sharper fall in production than during the Great Depression and higher unemployment. The 1890s Depression had lasting impacts, contributing to the rise of organized labor, the formation of the Australian Labor Party, and the eventual Federation of Australia.

Other Downturns in Australia

The Global Financial Crisis (GFC) 2008–2009: The GFC triggered extreme stress and volatility in global financial markets. While many countries experienced severe recessions, Australia fared relatively well due to a sound financial system, strong trade ties with China, and effective macroeconomic stimulus measures. Australia experienced only one quarter of GDP decline, although unemployment and underemployment did rise.
COVID-19 Pandemic (2020): The COVID-19 pandemic caused unprecedented economic contractions globally. Lockdowns and business closures to manage public health led to a rapid and sharp economic downturn. Australia’s GDP fell by 7% in the June quarter of 2020, the largest recorded quarterly decline. Unemployment peaked at nearly 7.5%. However, strong monetary and fiscal stimulus, coupled with the easing of restrictions and vaccine rollout, facilitated a subsequent economic rebound.

Can Recessions Have Long-Term Effects?

The costs of recessions extend beyond the immediate economic contraction. Recessions can have significant and persistent long-term consequences for both individuals and the economy as a whole. Central banks and policymakers actively strive to maintain sustainable economic growth and mitigate economic downturns to avoid these lasting negative effects.

One of the most concerning long-term impacts is on unemployment. Individuals who lose their jobs during recessions may face prolonged unemployment, even after the economy recovers. Skills can become outdated, and employers might be hesitant to hire those with long unemployment gaps. Recessions can also accelerate structural changes in the economy, leading to job displacement in certain sectors. Consequently, unemployment rates after recessions often remain higher than pre-recession levels and take considerable time to decline.

Recessions exacerbate economic hardship, disproportionately affecting vulnerable segments of society. This can lead to reduced opportunities, impacting health, education, skill development, and social mobility for affected individuals and families.

Business failures during recessions also represent a permanent loss of productive capacity. The closure of innovative businesses, those with specialized knowledge, or those crucial to supply chains can hinder long-term economic growth and dynamism.

Furthermore, recessions can increase a nation’s public debt. Governments often experience reduced tax revenue due to lower economic activity while simultaneously increasing spending on social welfare programs and economic stimulus measures. This can lead to a longer-term burden of public debt.

Conclusion

What is the definition of a recession? As we’ve explored, defining a recession is not a simple task. While the “technical recession” definition of two consecutive quarters of negative GDP growth is widely used, it has limitations. Broader definitions, like that of the NBER, consider a wider array of economic indicators to capture a more comprehensive picture of economic downturns. Ultimately, regardless of the specific definition employed, recessions represent periods of significant economic contraction, rising unemployment, and widespread economic hardship. Understanding the nuances of recession definitions, their causes, and their long-term effects is crucial for policymakers, businesses, and individuals alike to navigate these challenging economic periods and work towards building a more resilient and stable economic future.

Footnotes

¹ For more on potential output, see Explainer: Economic Growth

² For more on the costs of high inflation, see Explainer: What is Monetary Policy?

³ See Butlin, N.G. 1969, Australian Domestic Product, Investment and Foreign Borrowing 1861–1938/39, Cambridge University Press, Cambridge.

⁴ See Explainer: The Phillips Curve

⁵ See Saunders, P, J Chalmers and M Bradford (2020), ‘Inequality in Australia during the COVID-19 pandemic’, Reports and Issues Papers, No 2020/07, Social Policy Research Centre, UNSW Sydney.