Intro: Recessions do not just fall out of the sky and it usually takes a long period of economic distortions to build up before they occur. Recessions are the painful healing process that forces businesses to shift production more in line with consumer demands and the availability of real savings.
Most economists find it impossible to forecast recessions and only seem to acknowledge them long after they begin. However, an understanding of how economic distortions build up, in combination with the use of financial market and other leading indicator, can make it significantly easier to predict turning points in the business cycle.
Recessions can result from external shocks such as a sharp deterioration in terms of trade (usually for countries that are particularly dependent on one particular commodity) or natural disasters. However, the most common reason is an unwinding of economic distortions that build up over time due to government or central bank policies that result in investment that is out of line with final consumer demands. The recession is actually the healing process whereby labour and capital shift away from unproductive industries towards more productive ones that are more in line with consumer demands.
Global Financial Crisis
For instance, in the case of the US financial crisis, years of low interest rates and policies to promote home ownership resulted in a housing construction boom. As prices rose, demand for houses increase, and so did production. At the same time, personal savings rates collapsed as rising paper wealth meant less perceived need to save.
When prices reached a peak and began to fall, demand for houses fell and the personal savings rate surged. Homebuilders and the related sectors saw major losses and construction crashed, while consumer focussed industries also suffered from a rise in the personal savings rate. The proximate causes were the fall in house prices and rise in the savings rate. However, these factors are not necessarily negative in their own right (higher savings allows for greater investment and lower house prices make them more affordable). The problem was that these events were merely triggers and the ultimate cause was the years of malinvestment into the property and consumer sectors thanks to excessively low interest rates and savings rates.
As workers were laid off in certain industries where they were not needed and slowly shifted towards more productive industries, the recovery began to take root. If a country has a free labour market and a high savings rate, recessions tend to be easy to bounce back from as labour can move to more productive areas relatively quickly, and there are ample resources available to be used to invest in new facilities. Stimulus efforts by governments or central banks may be successful in cushioning the downturn but this success will usually have the side effect of undermining a return to more productive growth, as we have seen since the financial crisis.
