What is a Recession, Exactly?

A concept image illustrates the concept of a recession, with a downward-trending graph on a background of charts and financial indicators.

Recessions are an unfortunate fact of life. These economic downturns happen occasionally, and the broad economic factors that cause them are outside of any single person’s control.

While no one can prevent a recession, it is possible to:

  • Build a better understanding of what a recession is in the economy and how they’re caused
  • Learn about potential signs that a recession may be approaching
  • Plan for a recession, with the goal of increasing your personal financial security

Let’s take a closer look at recessions. We’ll review what happens when there is a recession, warning signs, and more. Then, we’ll focus on how to adjust and adapt personal finances and investments before and during a recession.

What Does A Recession Mean? Defining Recessions

We would like to offer a concise and precise definition of a recession, but regrettably, pinning down an all-encompassing description of what constitutes a recession can be somewhat elusive. A standard dictionary entry defines a recession as “a period characterized by a temporary economic downturn, marked by a reduction in economic activity and industrial production, typically discernible through two consecutive quarters of declining GDP growth.” However, it’s worth noting that even the White House acknowledges the absence of an officially established definition.

More authoritative economic sources, such as the International Monetary Fund (IMF), are quick to point out that “there is no official definition of a recession.” A lot of economic research has been done by the National Bureau of Economic Research (NBER), and they add a quantitative measure to the definition by stating that a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months.” In their economic research, the National Bureau of Economic Research Business Cycle Committee concluded that the decline in economic output must be “significant.”

Now, we need to define “significant” to have an accurate definition. You can see how this rabbit hole can suck us down. Since there is no official, universally complete definition – and we don’t want to go down the rabbit hole of defining every word used in the description – we’re left with having to use a commonsense understanding.

That means to understand if we’re in an economic recession, we should look at what’s happening in the economy. What effects or economic indicators can we observe broadly, nationally, or internationally? Since most of the definitions of recession describe a decline in economic activity, that’s one of the key things that can be observed. We can debate whether it’s “significant” or how long it lasts, but the reality is a recession means economic activity has decreased.

Declines in economic activity usually occur in multiple areas of the economy. Companies’ sales go down as consumer spending decreases and the number of items they sell decreases. Sometimes, that means they’ll offer sales to encourage people to buy. Unexplained sales might be a good economic indicators of slow economic growth.

You’ll often read in the newspaper or online that production is down (fewer cars or refrigerators were sold last week or month). Some of this may be seasonal – you expect fewer houses to be started in the middle of the winter than you do in the spring – but if we see that production and consumer confidence are dropping across multiple industries at the same time while unexplained discounts are being offered, then there might be a recession brewing.  

At the international level, the amount of imports and exports decreases during a recession. Sadly, too many economists look at the difference between imports and exports to give them insights. We don’t believe that is an important factor. If you look at the combination of how much every country exports plus how much every country imports, you have a very good sense of total international economic activity. In a recession, you’d expect this total to decrease because total economic activity is decreasing.

On the personal level, wages tend to decrease and the unemployment rate increases in recessions. As various companies across the economy experience reduced sales and, therefore, produce fewer items, they generally cut back on the number of hours they employ their workers or they cut back on the number of workers they use.

What Causes A Recession?

Economic recessions have different causes, and it’s helpful to understand why they start. In general, an economic recession is usually caused by extraneous events. Extraneous events include war, high taxes, and excess regulation. Most businesses want to grow and will only cut back production or employment if they have to. Their fiduciary goal is to use their stockholders’ money to earn as much as they can legally and ethically.

Regulations and taxes impose burdens on that process. Some amount of taxation and regulation is a normal course of business and already factored into decisions about how much to produce and how many people to employ. But if excess taxes or regulations are suddenly imposed, profits may be squeezed to the point where it no longer makes sense to produce or employ as many people. Interest rate increases are also an extraneous event that can cause recessions.

Wars are in a very special category. Wars are extraneous events, and they tend to have widespread effects. Not all wars lead to recessions. The nature and breadth of the war is the critical factor. Wars that destroy large sections of a country’s industrial production, factories, or farmland will clearly reduce economic activity and thus lead to a recession, if not worse.

However, we do not believe that the war in Ukraine created a recession. As sad and difficult as this is for Ukrainians, worldwide economic damage was limited because other countries could replace what Ukraine originally exported. Overall, there was not a significant decline in economic activity spread across the world.

Supply chain disruptions typically do not cause recessions; supply chain disruptions are typically limited to one or a handful of industries. The Covid shutdown is an example of a supply chain disruption which did cause a small recession. The Covid response caused the largest work stoppage the world had experienced. It was uncharted territory. It covered almost every industry in almost every country. Fortunately, the shutdown was short lived, and the recession was very mild. Although worldwide supply chains struggled to get back up to pre-pandemic levels.

A great example of a recession is the “Great Recession” which occurred between 2008 and 2009. Regulations from the Federal Reserve Bank and other government financial institutions encouraged banks to loosen their mortgage lending standards. Banks ultimately made loans to people who could not afford those loans. Then, the government bought those loans from the banks and resold them in packages to many other banks in the U.S. and worldwide.

Barron’s Magazine broke the story, forcing the Federal Housing Agency to step in and take over Fannie Mae, which in turn called into question the solvency of banks that owned pieces of these bad loans. In turn, these banks had to dramatically reduce their lending, which restricted the ability of firms worldwide to obtain financing. Without financing, economic activity shrank and quickly turned into a severe recession.

Similarly, the oil crisis of the mid-1970s created a financial crisis. The oil-exporting nations (OPEC) suddenly decided to exercise their government-supported monopoly power to restrict the oil supply. The world economy is heavily dependent on energy, and when the supply of energy decreased, economic activity decreased, oil prices skyrocketed, and a long recession started. Eventually, other sources of oil were developed, supply improved, oil prices went down, and the economy began the road to recovery.

How Does A Recession Interfere With Your Financial Plan?

Recessions are “disruptors.” We tend to use this word to describe how technological innovations “disrupt” old industries or old ways of doing things. Amazon.com disrupted the way we used to buy stuff at the neighborhood store; the way we used to communicate with each other over landlines was disrupted by cell phones.

These are good examples of disruption in the sense that the way we used to do something was replaced by another – and, in almost all cases, a more efficient and productive – way of doing things.  

Recessionary disruptions are not good because there is no replacement. Economic activity is not being changed or replaced; it’s being decreased. Companies decrease production, employers decrease wages and hours, consumers reduce purchases, and the negative effects like job losses and higher unemployment rates cascade through the economy.  

Financial plans count on certain things continuing in the future; they are based on assumptions, hopefully, realistic assumptions. A solid financial or retirement plan will include realistic assumptions about how much you make, how much discretionary cash flow you have, what you can save for the future, what you’ll be able to earn on your retirement accounts, and then, ultimately, what you’ll have available at retirement to sustain your retirement years. Even if those assumptions are rock solid, they depend on your ability to do them.

Recessions typically impact all of these assumptions. To greater or lesser degrees, depending on where you work, how much you save, and how you’ve structured your retirement accounts, a recession will impact your financial plan. You may not be able to make as much during the recession as you projected, you may not be able to contribute as much to your retirement plan, and your investments may not earn what you assumed they would make.

If your financial plan does not have enough margin for error and/or if the recession lasts longer than you’ve anticipated in the financial plan, then your planned retirement may be in jeopardy. It’s absolutely crucial that you avoid running out of money in retirement.

Does that mean you won’t be able to retire at all? Hopefully, if you’ve done the planning well, the answer is no; your retirement may be delayed a bit, but you should be able to retire. A great retirement plan will have built-in contingencies that allow you to change directions and still stay on track to enjoy your retirement dreams.

How Can You Prepare For And Navigate A Recession?

As you’ve probably guessed, the secret to preparing and navigating a recession is to develop a great financial plan. Assumptions need to be realistic, as we wrote above, but there are other critical components to a great financial plan that allow you to prepare for a severe recession.

You need to have an accurate and detailed understanding of your current situation. The values of your assets, the amount of your liabilities, your living expenses, etc., all need to reflect reality. They cannot be back-of-the-napkin guesstimates. If you don’t know where you are, you cannot develop an accurate map to get you where you want to be. After all, a great financial plan is a map showing you how to reach your desired financial destination.  

You also need to have enough margin for error so the plan works when it meets reality. If you assume you can contribute $50K each year to your retirement plan, and the reality is – because of a blown radiator or roof repair – you cannot contribute at all, then your plan is doomed.

On the other hand, if you have been conservative in your assumptions and your actual retirement contribution can be larger, then even the unexpected roof repair would still let you make the $50K contribution. The point is not to have your estimates so tight that the slightest hiccup (and there are always hiccups) sets you back.

It’s also vital to have the ability to properly understand how you can achieve a target average annual return on your investments. Of course, that means you have to establish a target return in the first place. We are constantly amazed at the number of new clients who come to us with no target at all; they’re content to let their investments sit there – for better or worse. The better course of action is to work out what return is needed to accomplish your retirement goals, how the portfolio should be structured to achieve that target, and then build in enough time to weather the inevitable setbacks, financial market volatility, and recessions which are inevitable.

The final preparation piece is to develop contingencies. We call these “what-if” scenarios. After we develop a great financial plan, we look at different potential interruptions and plan ahead of time what we will do to overcome them. What if your personal income decreases? Where can you cut back expenses? What if you get laid off? What emergency funds do you need to give you time to find the next job? Are your emergency savings safe from the recession? How much unemployment insurance is available for you? Do you have excessive debt? Can you service your existing debt and keep your credit score intact?  

There are many scenarios, and no two clients are susceptible to the same potential interruptions. You need to determine which potential interruptions are the worst in your specific situation and then develop contingency plans for each. 

A Harvard Business Review article focused on how only a minority of companies were able to thrive – not just survive – a recessionary economic cycle. The key lesson for business managers applies equally to individuals. Only “9% of companies flourished”, and “the difference maker was preparation.” Your great financial plan is your preparation. Make sure you have one by working with a financial advisor who knows how to build one.

Navigating the inevitable recession – or recessions if you’re young enough – which you will encounter is one of the easiest things to do if you have developed a great financial plan, implemented it, and followed it. Excellent financial planning contains the steps to take during an economic downturn. Your margin for error helps to soften the blow and buy time. The investment plan tells you how to rebalance your portfolio during a recession, but this can be emotionally tough.

Your investment plan tells you how much to hold in stocks and bonds to achieve your target return. When a recession hits, stock values will inevitably decrease. As that happens, you will have less in stocks as a percentage than you need. This is the time to buy stocks to return to the right percentage. When the stock market craters and stocks are losing value, and the media is telling you the sky is falling, that can be a difficult time to buy stocks. But investing in the stock market is exactly the right thing to do.

Are You Ready Or Do You Need Help?

Whether you have a retirement plan or not, we’d love to hear from you. Of course, you need a great retirement plan, and we can build that with you and help you implement and maintain it. But even if you have a retirement plan, we’re happy to give you a second opinion.

One of the worst things you could do is have a plan that you think is great but is mediocre or terrible. Having a plan should give you confidence, which is good if well-placed. Confidence in the wrong plan means you’re putting your head in the sand and hoping for the best.   

We’d love to hear from you to discuss where we fit in helping you prepare for and thrive through a recession. We offer 100% objective advice and have helped hundreds of clients achieve their retirement goals and, yes, even thrive through a recession. If you’d like to begin a conversation, please use the button below to schedule a complimentary introductory appointment.  

Greg Welborn is a Principal at First Financial Consulting. He works with individuals and privately-owned businesses on financial planning issues including investment, retirement, and tax planning, among others.

Greg Welborn is a Principal at First Financial Consulting. He works with individuals and privately-owned businesses on financial planning issues including investment, retirement, and tax planning, among others.

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