What is an Economic Recession?

//What is an Economic Recession?
What is an Economic Recession? 2017-10-04T06:45:36+00:00

Definition: An economic recession is a significant decline in economic activity, real GPD, real income, employment, industrial production, and sales following a decline in the aggregate demand for at least two quarters.

What Does Economic Recession Mean?

What is the definition of economic recession? When the government imposes higher interest rates, the cost of money rises, thus lowering consumer and government borrowing. Consumer confidence is declining, thus lowering the demand for goods and services. Furthermore, the financing of business operation becomes harder through borrowing, and firms have to lay off their workforce, thus increasing unemployment.

Normally, the recession follows the downward phase of an economy, with stagnation or decline in the investment, reduction of income, and increase of unemployment. From the downward phase the economy either enters a recession, or it resumes to the expansion phase.

Let’s look at an example.

Example

The subprime mortgage crisis of 2008 is one of the major economic recessions after the crash of 1929. The bursting of the real estate bubble in the summer of 2006 originally led to the bankruptcy of a large number of floating rate mortgages, and then moved to the market of corporate subordinated bonds issued to finance securitized mortgages. The outcome was a wave of collapses, mergers, and nationalizations after September 2008.

Through securitization, commercial and savings banks were moving their mortgage liabilities to the balance sheets of intermediary financial institutions. For instance, a mortgage of $1,200 was replaced by an equivalent amount provided by the intermediary financial institution and the bank was using the money to issue new mortgages, which in turn were also moved to the balance sheet of the intermediary financial institution and so on. In that way, the liabilities to equity ratio increased exponentially to 50 over 1 as opposed to 9 over 1, which is the norm for the banks.

Furthermore, the intermediary financial institutions were financing corporate bonds issued by investment banks that managed to convince the bond rating agencies to rate with AAA and AA corporate subordinated bonds that had securitized loans as collateral. To protect against bond default, institutional investors bought credit default swaps (CDs) issued by the AIG insurance company.

The consequences of the subprime crisis are mainly attributed to the size of the mortgage loans market, $12 trillion, out of which 75% were scrutinized. In August 2008, about 10% of the mortgage loans were past due or auctioned. Therefore, the crisis was immediately moved to the financial markets of other countries, causing a dramatic decline of 40 to 70%.

Summary Definition

Define Economic Recession: Economic recession means a consistent decrease in GDP and employment over a period of at least six months.