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Impacts of a recession on a countrys economy

Although many people are afraid of the term "recession" for the bad consequences it carries, very few of them really do understand the true meaning of the term and its causes which might be avoided. Many economists have carried out researches aiming to find methods to deal with or find the true cause of recession and its impact which extends to every household. They all reached the conclusion that a recession is an inevitable process in the business cycle, and that sooner or later it will hit the economy (Samuelson, 2007: p66).

Conflicts between researches has risen as to what is directly or greatly affected by the recession and why. Some economists believe that recession hits certain industries like oil prices, housing market and credit problems as Samuelson mentioned (2007: p66) in turn, affecting the whole economy as they portray those industries as the main drivers for the economy. On the other hand, others argued that tourism industry and population levels are greatly affected by recessions, and that attention and efforts should be shifted towards them.

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Other economists focused on global financial crises that in turn hits a separate economy like Auerbach and Michael P. (2010: p1-6) even if it was performing well, but imports and exports facilitates recession to reach the economy. He then stressed the importance of understanding of the concept of "recession" through politics and academics to help avoid the consequences that come along with the recession.

According to some researches like Morse and Neil J. (2009:p98-101) blamed Securities, Exchange Commission and credit rating agencies for their actions that, from their point of view, directly caused a recession to hit the economy. All researches proved that none of them are wrong, and that effects of a recession extend to every aspect in an economy.

One reason why a recession usually causes loses after it, is because its unpredictable, it suddenly occurs. Economists reached a final conclusion and that is you can only watch for certain things to see if a possible recession may occur, but it's not reliable. The first thing they recommended to watch for is the drops in the stock markets, which usually occurs before a recession. Secondly, a 3 month unchanging unemployment rate or job losses is another worrying aspect.

Other institution like the National Bureau of Economic Research (NBER) takes a broader view of the economy to determine recessions. The method they adopt is based on measuring GDP overtime to draw the business cycle's peaks and troughs. GDP, real income, employment figures and volume of sales for retailers are all forecasted figures. Therefore, again can only predict if a recession may or may not hit, but its not 100% guaranteed (Flynn el al. 2008:p1-1).

2.1.1 Background and definitions:

Economists have defined recession in a set of ways according to the way each of them perceive its concept, causes and effects on the economy. However they all seem to agree on the broad definition of recession in macroeconomics "decline in a country's real gross domestic product (GDP) or negative real economic growth for two or more successive quarters of a year", so basically for half of the year or more. Others see it as the decline in the business activity including employment, investment and even corporate profits.

The National Bureau of Economic Research defined recession as the significant decline in economic activity spread across the economy , lasting more than a few months , normally visible in real gross domestic product(GDP), real income , employment, industrial production, and whole-sale retail sales (Flynn el al. 2008:p1-1).

The effect of the recession can normally be visible in real GDP, real income, employment, industrial production, and wholesale retail sales. That ties up with how a researcher said that when there is higher unemployment rates, weaker profits and more stress you should know that a recession has arrived as stated by Samuelson (2007: p66). Experts have stated that a recession starts when there is a slowdown in the positive growth of the economy.

2.1.2 Types of recession

There are four types of recession that an economy might face. The V-shaped, W-shaped, L-shaped and U-shaped. The names of the four types of recession were given due to the different ways an economy falls in to a recession and the different recovery periods from them. Each letter (W, U, L, and V) portrays the process of falling and recovering from a recession.

V-shaped: The economy falls into a sharp recession but is quick to recover. (the shape of the V shows, first, a sudden fall followed by a quick recovery) This type usually occurs when the economy is unstable with high interest rates and hyperinflation. Then when the economy become stable once more , inflation falls, interest rates declines and the economy then bounces right back-up(V)

W-shaped: (Double dipped recession), you have a sharp downturn followed by a temporary recovery. After this small recovery, the economy falls downwards again after which it finally recovers completely. This type is present in an economy depending on more than one market. The first market falls and recovers then its followed by another fall and recovery process of the other market.

L-shaped: A major threat to the whole world and it's the worst scenario that may occur which is a sharp downturn followed by several recessionary periods that may reach 10 consecutive years.

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U-shaped: Involves a prolonged period of recession, may reach 24 months, unlike V-shaped recessions, this type is not quick to end or in other words, recovery periods are longer.

2.1.3 Case studies of recessions in: USA

"Those who ignore history are condemned to repeat it". This is how George Santayana described the American situation when a fierce recession took place. Characterized by an increase in prices and banks suspending certain transactions fearful of insolvency, sending the economy in to a critical recession lasting for years (Auerbach el al. 2010:p1-6).

At the start of 2007, before the recession hits the US economy, some economists stated that it was just a matter of time before the next hit. They backed up their argument by stating that it's a normal phase in any business cycle and that people shouldn't be panicking about it as said by Samuelson (2007: p66). That ties up with how the business cycle consists of expansions occurring followed by general recessions as stated by (Flynn el al. 2008: p1-1)

On the other hand, others stated that warning signs started a year before the recession like Auerbach and Michael P. (2010:p1-6). In 2007, gross domestic product (GDP) slowed to 2.1% in the fourth quarter, business orders declined, employment fell, unemployment rose and housing prices fell by 10%. Sale of new or existing houses has fallen to 40%. New or existing houses are below their peak prices measured in January 2006, and therefore real estate prices were continuing to drop (Samuelson, 2007: p66).

Warning signs included the rising oil prices (reaching $100) a barrel due to the hurricane that hit Mexico as well as the possible Turkish war on Iraq. Also, the credit problems faced when lenders and investors suffered losses on mortgages (loans given to weaker borrowers) which made lending standards for other borrowers much harder or stricter. (Samuelson, (2007): p66) Described as "housing loans that are offered to the people with low incomes and/or poor credit" by Auerbach and Michael P. (2010:p1-6).

These warning signs can be tied up with what happened in Florida later on. Jobs have evaporated, population growth fell, and unemployment rate rising to 12%. Even the state budget was suffering from a deficit of $3.5 billion due to decreased revenues from property taxes. ((2010), Paradise foreclosed: p5-5) President Obama said a famous statement describing the situation at that time "This is the worst recession since the Great Depression." (March 2009)

With the unemployment rate rising, economists started comparing this recession with previous ones. The recession started exactly in December 2007 but had no immediate end in sight. This recession lasted for approximately 3 years, while the longest recession previously faced was only 17 months. Also, this recession had the highest rate of unemployment than any previous recession occurring in any year. The US government reported a loss of 325,000 jobs as employers were cutting labor which explains the rise in unemployment rates.

The debatable concept at that time was who to blame for the recession lasting that long and how to fix things. Policymakers were blamed for what the country was going through. They failed to increase spending to spark the economic growth or even carry out tax cuts to promote business capital investment, but there was already a budget deficit. ((2010), Paradise foreclosed: p5-5). The government at this point is asked not to interfere with the natural forces of the economy. Federal Reserve in the United States should lower the target Federal funds rate during recessions and other periods of lower growth. In fact this response has actually aided recent recessions.

Still, and even though the crises went global after shockwaves of what happened in the US economy affected other economies due to the bankruptcy of multinational companies, according to Auerbach and Michael P. (2010:p1-6). Others thought that this recession had a huge benefit, and that was lowering inflation rates in the economy. The recession "reverses the upward spiral of oil prices and triggers a faster--and healthier--drop in home prices"(Samuelson, 2007: p66).

2.2 Overview on the economy

Generally, the economy consists of individuals, governments, industries, factors of production and way of exchanging for buying goods or services. Interaction of these concepts and who owns the factors of production mainly decides the different types of economic systems that exist. "There are three major types of economic systems in the world today--market, planned and mixed" as stated by McGroarty.K (2010). Capitalism and socialism are equivalent meaning of market/free economy and planned economy.

2.2.1. Characteristics and types of the economy

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The economy consists of people, governments, industries and factors of production that is owned differently according to the type of economy in which they exist. (Market/free, mixed and planned.) Economies are mainly mixed but others might have characteristics that make them closer to either free or planned. Bearing in mind that there isn't any country which is purely free or purely planned.

Market economy: Economy featuring individuals who owns the factors of production while the state or the government plays a narrow role. The power driving the whole market is the consumer buying decision or supply and demand of products and services as stated by McGroarty.K (2010). Private ownership, free enterprise and little government intervention are the main characteristics making up free markets. However, the government plays an important role by providing the necessary infrastructure, security and defense. Also, and since the economy is driven by forces of supply and demand, the government supervises transactions and intervene if monopolies or market failures will occur. The United States, UK and Japan are all clear examples of market economies.

Planned economy: Also known as "command" or communism economy, government plays the main role by making all the major decisions for the country. Decisions involving what to produce, prices and distribution of goods and services are all made by the government. "The government owns and operates the factors of production." The debatable issue about planned economies is the efficiency of using the available resources. Some argue that it's very efficient since all resources are devoted to the production process only unlike the free market economy where available resources are distributed among other things like marketing or advertisement. On the other hand, other argues that it's a very slow process in terms of responding to consumer needs and demands, as stated by McGroarty.K (2010). The government in this type of economy is playing an active, leading role in the economy. That ties up with why the main goal of a planned economy is equal distribution of wealth. China and Cuba are clear examples of planned economies.

Mixed Economy: At type of economy having elements of both free and planned economies. Most economies are considered mixed with government regulation and supervision in areas along with flexibility for private owners in other areas. Mixed economies are the result when "a society looks to find balance when the people enjoy a wide range of social and political views" stated by McGroarty.K (2010) In other words, the private sector in this type owns many factors of production however; the government is the one directing the path of the whole economy by providing things like health and education.

2.2.2 The effect of the worldwide economic crisis

To clarify the different characteristics of economies, and how each one operates differently around the world, the worldwide financial crises that occurred recently, can give a brief explanation. How governments and economists in different economies used different policies and tools, to deal with or minimize the losses economies were suffering from.

The worldwide economic crises that happened in the late 2000 is considered the worst financial crisis since the great depression in the 1930's. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems. Economists tried to explain how a shortfall in the liquidity in the US banking system has collapsed large institutions around the globe.

Along with the liquidity problems, the US housing "bubble" and the rising "subprime" mortgages as banks started to give out more high-loans making them believe that they will be able to pay it back overlooking interest rates. This bad lending process, lending those who shouldn't have got loans in the first place, was the main cause of the problem. These loans all bundled up and turned into investments or securities to try to reduce the risk and encourage more investors to invest. However, the rising interest rate caused problems to the borrowers and house prices started to fall. Banks worried more about lending at this stage and interest rates raised to reflect the risks involved with lending at this stage. At the same time, there was an oversupply of homes coupled with the existing problems in the financing sector lead to the decline in the US economy.

Other factors pressured the problem and helped making it go global. The sharp rise in oil prices and other commodities caused inflation and causing central banks to maintain tight monetary policies. Losses now reached $650 billion dollars. Financial markets in the developed world have been adversely affected and growth in these economies has been weakened. Imports were the path for the financial crises to travel from the US and Europe to the rest of the world. Demand for imports declined therefore affecting market prices for such products.

Economists were afraid at that time that if the liquidity problems continue then there would be an extended recession. The output produced by labor declined at an annual rate of 6% and unemployment increased by 10%. The middle and lower classes of societies were greatly affected and the higher class wasn't that affected. Therefore, the gap between the social classes was widened, and distribution of wealth is an upcoming problem to the nations.

Major companies especially car manufacturers' declared bankruptcy throughout the disaster. There is a problem with the liquidity; consumers no longer think of buying cars or any other luxuries product instead, they worried about providing food to their families as prices went up. Therefore, sales for cars massively declined and losses for those companies are now unbearable. The first solution they tried was to dismiss labor from all around the world, multinational companies, to reduce costs. The government started injecting more money in the car industry but they were now facing another problem (unemployment) reaching very high rates each month.

Fearing of long-lasting global recession, governments finally started taking actions by systematically injecting capital and cutting interest rates to encourage borrowers to start paying banks that is heading towards bankruptcy. The US Federal reserve's was trying to expand the money supply to lower risks , since wages declined and unemployment increased which all reduced consumption. The central bank purchased US$2.5 trillion of government debt and private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The recession that began in December 2007 ended in June 2009.

2.2.3. A successful model of an efficient economy: Japan

Although it's the 3rd largest economy after the US and China, Japan's economy is considered the most efficient. Japan experienced rapid economic growth, which was referred to as the Japanese "post-war economic miracle". With average growth rates of 10% in the 1960s, 5% in the 1970s, and 4% in the 1980s, Japan was able to establish and maintain itself as the world's second largest economy from 1968 until 2010. It is a major producer and exporter of manufactured goods, including automobiles, electrical products, chemicals, and steel.

Japan is a capitalistic nation, an economy featuring individuals who owns the factors of production while the state or the government plays a narrow role. The power driving the whole market is the consumer buying decision or supply and demand of products and services as stated by McGroarty.K (2010). It's considered hard for other countries to reach the economic results Japan has reached because it has to do with their underlying cultures. Workers are extremely disciplined, displaying huge loyalty to their companies.

Japan's large supply of industrial leadership and technicians, well-educated and industrious work force, high savings and investment rates, and intensive promotion of industrial development and foreign trade produced a mature industrial economy. Japan has few natural resources, and trade helps it earn the foreign exchange needed to purchase raw materials for its economy.

Surplus funds for Investments is another success factor as private savings, which banks and other financial institutions in turn lend to expanding businesses , enhancing the economic growth. Japan's high savings rates enabled Japanese industries during the miracle years to obtain massive amounts of funds for expansion very cheaply.

Trade Union Structure/Industrial Relations

Japan has industrial rather than unions which means management negotiates with one rather than several labor unions. Also, lifetime employment in major industries, a seniority system where people are rewarded eventually if they remain with one company, and worker participation strategies all have contributed to increased harmony and productive Japanese work places. That ties up with what I've mentioned earlier about how Japanese workers are loyal to their workplaces.

Competition and Entrepreneurship

Even though the government played a larger role in the Japanese economy than was the case in the United States, domestic private competition in such industries as motorcycles, automobiles, and consumer electronics was fierce. Successful Japanese entrepreneurs in these, as well as other industries were able to build powerful companies that benefited the entire economy.

A Stable Political Situation

During the miracle years, the voters continued to elect members of one political party, the Liberal Democratic Party, thereby avoiding the political unrest that hurt the economies of other nations during this time.

Low Military Expenses

While Japan today has one of the largest armed forces in the world, because the U.S. viewed Japan as strategically important during the Cold War and thus shouldered a major portion of the costs of Japan's defense, Japan was freed from the burden of spending a large portion of its wealth on its military.

To conclude, the success of the Japanese economy in the period of the after war is undeniable. It has gone from almost nothing to a vast exporting market invading the international trade markets with its new technologies. Thus, the economy of the country soon became reckoned as one of the most powerful and successful in terms of competitiveness and welfare. Many people soon attributed Japan's success to a combination of factors:

Government-industry cooperation, a strong work ethic, mastery of high technology, and a comparatively small defense allocation (1% of GDP) have helped Japan advance with extraordinary pace to the rank of second most technologically powerful economy in the world after the US and third largest economy in the world. One characteristic of the economy is the working together of manufacturers, suppliers, and distributors in closely-knit groups called "keiretsu". A second basic feature has been the guarantee of lifetime employment for a substantial portion of the urban labor force.

Industry, the most important sector of the economy, is heavily dependent on imported raw materials and fuels. The much smaller agricultural sector is highly subsidized and protected, with crop yields among the highest in the world.

2.3 Effect of a recession on an economy

2.3.1. The effect of a recession on the individual's purchasing power

The relation between a recession and the purchasing power of individuals is indirect. That means if a recession affects employment levels for example then as a result, the purchasing power of consumers will be affected. In this section, we are going to analyze each effect of the recession has on every aspect of the economy and how it then reaches to the buying power of the consumers.

There is a general economic decline during recession. The economy has a tremendous setback. The purchase of the people comes down due to low salaries or lack of sufficient income. This results in slump in market with goods and services not being availed of by people. Production slows down and in turn prices go up. In fact during recession, many firms are forced to sell their products at throw-away prices and suffer from losses as a result.

Recession is something to be dreaded by producers as well as consumers. Both suffer during these hard times. Both need each other. In case, consumers do not have the purchasing power, then production suffers. Less production means fewer profits for producers who will find it difficult to run their business. The top four major impacts of recessions on an economy includes; slump in market, stock prices comes down, depression and national debts rising.

Firstly, slump in market due to slowdown of the economic cycle. Individuals are obsessed with the thought of a recession, panicking and controlling their expenditure for the disasters to come as mentioned by Samuelson (2007: p66). The purchasing power of individuals declines. That ties up with how shopkeepers in "Oviedo" mall in Florida mounted a campaign to revive the mall after witnessing a steep slowdown in consumers transactions. ((2010), Paradise foreclosed: p5-5)

Secondly, stock prices falling due to how investments are suffering. The industrial production is badly affected as investors avoid investing in companies that might suffer losses during recession. Bigger companies are able to withstand the setbacks but smaller companies have a tough time and some may end up closing down. Again the purchasing power of business owners is affected and the same applies to the investors who are afraid to contribute their capital in businesses, causing a general decline in the purchasing power (Auerbach el al. 2010:p1-6).

Thirdly depression, defined as a decline in GDP by 10% or one that lasts more than three years. (Diagnosing depression, 2009: p57-57) Negative trends are visible in the stock market and rapid unemployment is there. Companies need to be bailed out by the government. GDP falling means output decreasing and since depression lasts for a long time, eventually inflation arises. With the output declining and prices increasing the purchasing power of consumers falls dramatically.

Finally, rise in national debts suffers during a recession as an increase in national debts means less money can be spent by the government on development. Money gets diverted in bailing out companies rather than enhancing development of the economy as a whole which in turn affects purchasing power later on, as investment activities declines and unemployment levels increase and therefore many goods and services are out of their reach.

2.3.2. The effect of a recession on unemployment rates

A direct relation exists between a recession and unemployment rates in an economy. That ties up with how all characteristics of recession causes unemployment. Actually, effects of recession can be monitored through unemployment levels along with other things such as investments or even corporate profits.

As mentioned above, recession affects the purchasing power of individuals. That means that companies selling products suffers and ends up with a bad financial position. Their first way out is cutting the labor force and dismissing the unnecessary employees first as stated by Samuelson (2007:p66) Moreover, a recession doesn't help either those who were already unemployed and searching for a job before the recession takes place.

Companies which depend on banks for their operations and have problems meeting their obligations are the ones greatly affected by recession. As such they make drastic moves to save the business including cuts on their workforce as mentioned by Auerbach and Michael P. (2010:p1-6) On the other hand, there are businesses which express optimistic outlooks and have not been affected by the recession through expecting that they will be steady while survey states that 83 percent of agencies said their budgets have not been affected and they expect an increase in revenues this year.

The fact that a recession affects investments means job opportunities that might have been generated on the long run to solve unemployment levels no longer exists. The government now will have to worry not just about the current unemployed people but those who will graduate and will suffer to find a job. Less investments and rising prices for necessary things like oil and housing forces the economy as a whole to reduce spending and transactions and contributes to the unemployment problem. (Samuelson, 2007: p66)

It is therefore up to those concerned to make careful analysis of the situation and make whatever appropriate action they would make with regards the status of their workforce. It would also be very foolish to discourage people from applying for a job, or recommending hiring at this stage. There are still job opportunities waiting for those who are qualified. Unemployment is one of the worst effects of recession and government, with the help of the private sector should be able to come out with plans and actions to at least minimize unemployment.

2.3.3. Criticisms about the methods that deals with recessions

Before explaining how the adopted methods of dealing with the recession have been criticized, it's important to know the guidelines set and well known to every government as things to do when dealing with a recession. The first action is to increase spending by the government to enhance the economy and spark economic growth. This can be done through aiding major companies and spending more in markets. (Auerbach el al. 2010:p1-6).

Secondly, to encourage investments, tax cuts that will promote business capital investments. Hopefully investors might perceive this as a good opportunity as expenditure won't be that high. However, this shows how actions conflict as tax cuts means a possible budget deficit not making the government spend more to bail out companies. Banks or Federal Reserves in the US plays a crucial role by lowering rates during periods like recession. (Auerbach el al. 2010:p1-6).

The actions adopted by governments during a recession included increasing the injection of cash but it might have took them a while to do so because of the budget deficit that many of them suffer from. The US government is still blamed for allowing banks to give loans to those who are classified as "poor borrowers" and who won't be able to pay back the debt and just contributed to the "housing bubble" as stated by Morse and Neil J (2009: p98-101) So economists criticized lowering interest rates which caused irresponsible borrowing.

The SEC (Securities Exchange Commission) was trying to improve the problem but actually caused it to inflate by when they allowed the claim done by Freddie Mac and Fannie Mae who promised to compensate banks when anybody was unable to pay back a mortgage. This encouraged banks at that time, to give loans to poor borrowers who were very likely to default, which increased demand for houses, and inflated their price. To get money to give those loans, banks started selling bonds that were said to be "risk-free" since mortgages are guaranteed by Freddie Mac and banks use fancy financial engineering techniques. So when Freddie Mac and Fannie Mae ran out of money, those "risk-free" bonds became worthless. So lots of people lost money, and stopped spending therefore less spending, less economic activity and causing a recession. (Morse el al. 2009: p98-101)

Reference page:

Economics Principles and Practices Book

Money and Monetary Policies Book

Economic History Book


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