What Are the Causes of Economic Recession?
Over the last several years, there have been almost daily headlines announcing that the United States, and indeed a large part of the world, is in an economic recession. An economic recession is a measurable drop in economic activity that impacts the entire country. This can be determined by declines in Gross Domestic Product, real income, housing prices, employment and retail sales at the wholesale level. The causes of these drops are often cyclical in nature with one drop feeding off another. On top of that, investor paranoia in further declines will spur them to financial action that often results in more losses.
Economists have varying theories on the measurable causes of an economic recession because many of the factors can be psychological on the part of investors. However, there are some tangible causes of recession.
- Failure to raise interest rates when needed
- High interest rates
- Overspending
- Large losses in the business sector
Failure to Raise Interest Rates
Using the current recession as an example, we can examine how these factors contributed to the current situation. In the mid 2000’s, as the economy recovered from the failure of technology stocks in 2000-2001, the federal regulatory bodies were slow to raise interest rates as the economy began to expand. This led to many extremely low interest mortgage loans being made, often well in excess of the borrowers’ ability to afford or pay back.
High Interest Rates
A large number of these mortgage loans were variable interest rate loans. This meant that as rates began to rise beginning in 2006, many of the mortgagees found their mortgage payments increasing beyond their ability to pay. As interest rates rose higher, more and more foreclosures began to impact the housing market and in turn, the banks holding the mortgages.
Overspending
The booming housing and mortgage market mentioned above encouraged banks and investment and security firms to place tremendous sums of money in mortgages and mortgage related security products. This overspending and over reliance in one narrow area became evident as the interest rates rose.
Large Business Sector Losses
As housing prices were declining due to foreclosures, the banks began to lose money. Investment firms that had sold securities backed by the supposed high value of the now defaulted properties also began to lose money. As these facts were released to shareholders and traders, the psychological impact was to incite panic in large areas of the financial and investment sector that led to stock selloffs and further negative banking news. The aggregate effect was the failure of many smaller banks and even some large ones. Others survived only through government takeover and huge infusions of government money. The prime example of this was the literal takeover of ING by the federal government.
The Result: Economic Recession
As the housing markets and the banks declined, investors sought safety and security in less risky investment vehicles. Foreclosures and job losses further damaged the business climate in general. Companies and even state and local governments that had invested in mortgage securities found them at such losses that they could not pay pensions, meet salaries or fund local and state services. This led to a snowball effect of layoffs, hiring freezes and in some cases further bankruptcies among the invested companies. Nationwide unemployment reached the double digit mark and economic productivity declined across the nation. High unemployment is both a contributor to recession and an indicator its continuation.