The output of an economy usually increasesover time. However, growth in economic outputfluctuates, forming a ‘business cycle’ in whichthere are peaks and troughs in economic activity.In the trough of a business cycle, output growthcan be weak or negative. This usually results in joblosses and an increase in the unemployment rate.While there is no single definition of recession,it is generally agreed that a recession occurswhen there is a period of reduced output anda significant increase in the unemploymentrate. Views differ about how to best identifythis. Recessions inflict great hardship onhouseholds and businesses, and they can havelong-lasting effects on both society and theeconomy. Consequently, central banks and otherpolicymakers try to reduce the frequency andseverity of recessions. Monetary policy is one ofthe main tools used to do this. (See Explainer:Economic Growth and Explainer: What isMonetary Policy?).
This Explainer describes the nature of thebusiness cycle and discusses differentapproaches to identifying a recession. It alsosummarises some of the recessions that haveoccurred in Australia and the consequences ofrecessions.
What is the Business Cycle?
The business cycle refers to fluctuations ingrowth in economic output taking into accountthe steady growth in the ‘potential output’ ofthe economy. Output is defined as real grossdomestic product (GDP) and potential outputis the level of output that the economy canachieve when using all its resources – people,equipment, natural resources and technology –in a sustainable way, without putting excessiveupward pressure on prices in the economy.[1]
A business cycle has four main phases – expansion,peak, contraction and trough. In an expansion,households demand more goods and services,businesses hire more workers, and wages andprices typically increase. This phase ends witha peak in economic activity. In a contraction,households demand fewer goods and services,businesses reduce the number of workers theyemploy and growth in wages and prices slows. Thisphase ends with a trough in economic activity.
Importantly, business cycles can vary in length, ascan each phase of the cycle. In fact, the expansionphase usually lasts longer than the contractionphase. The length of the cycle will dependon a large number of factors, including policyresponses at different stages.
What is a Recession?
There is no single definition of recession, thoughdifferent descriptions of recession have commonfeatures involving economic output and labourmarket outcomes.
Indicated by weak output andrising unemployment rates
A recession can be defined as a sustained periodof weak or negative growth in real GDP (output)that is accompanied by a significant rise in theunemployment rate. Many other indicators ofeconomic activity are also weak during a recession.For instance, levels of household spending andinvestment by businesses are usually low. In addition,the numbers of households and businesses that areunable to pay back loans are unusually high, as isthe number of businesses that close down. Becausethese indicators are typically present when thereis a significant increase in the unemployment rate,the unemployment rate is considered a reliable andtimely summary indicator of a range of negativedevelopments in an economy.
Technical recession
The most common definition of recession used inthe media is a ‘technical recession’ in which therehave been two consecutive quarters of negativegrowth in real GDP. This definition often appears intextbooks and is widely used by journalists. On thisdefinition, Australia had not recorded a recessionfor 29 years since the recession of the early 1990s.This length of time since a technical recession isvery unusual compared with Australia's economichistory and the experience of most advancedeconomies, which typically record a recessionaround every seven to ten years on average.
There are, however, a number of shortcomings ofthis definition of recession:
- GDP growth can be weak – but not negative –and still be associated with significant increasesin the unemployment rate and hardship forhouseholds.
- Some components of GDP are volatile.Consequently, two consecutive quarters ofnegative growth in GDP can give a false signalabout the underlying pace of economic growth.
- Measurement of the components of GDPis subject to revision as more data becomeavailable. Consequently, a negative quarterlygrowth figure can be revised away or a positiveone can become negative, also increasingthe possibility of a false signal about theunderlying pace of economic growth.
Some commentators also consider alternativemeasures of economic output to assess periodswhere economic growth is easing or below trend.For example, some will focus on whether there havebeen two consecutive quarters of negative growth inGDP per person (or GDP per ‘capita’), which is a wayof excluding the contribution of population growthto economic activity. Other commentators focuson consecutive quarters of negative growth in GDPexcluding some volatile parts of the economy, suchas the farm sector, so as to avoid the effects of volatilemovements on the pattern of economic growth.
As identified by the NBER
The National Bureau of Economic Research (NBER)in the United States (a leading research institutionrecognised for its work on business cycles) takesa different approach to defining recessions. TheNBER defines a recession as a period between apeak and a trough in the business cycle wherethere is a significant decline in economic activityspread across the economy that can last from afew months to more than a year. While the NBERagrees that most recessions will, in fact, havetwo consecutive quarters of negative growthin real GDP, it says that this will not always beso. It highlights the conflicting signals that cansometimes arise from the different approaches tomeasuring GDP (see Explainer: Economic Growth)and so it considers a broad range of economicindicators in addition to GDP. However, thejudgements made by the NBER about whetherthe United States has recorded a recession are notusually arrived at quickly and it does not have areadily available formula for identifying recessionsthat can be applied to other economies.
Unemployment-based rules
Economists have also proposed definitions ofrecessions that rely only on the unemploymentrate. These rules typically signal a recession whenthe unemployment rate increases by more thana pre-specified amount. These unemployment-basedrules have the advantage of being simple,timely and not as susceptible to data revisionsas GDP-based measures. However, the mainlimitation of unemployment-based rules is thatthe unemployment rate might not always capturea deterioration in other economic indicators, suchas underemployment.
What is the DifferenceBetween Recession andDepression?
As with ‘recession’, there is no single definitionof a ‘depression’. However, a depression canbe thought of as a much bigger version of arecession, both in terms of scale and duration.Consequently, in a depression, there are periodsof falling output and high unemployment ratesthat persist for a number of years.
The scale and duration of a depression meansthat there are often negative economic outcomesthat are experienced in many countries aroundthe world, so some definitions of depression saythat it is a severe recession that occurs in one ormore economies.
When Have Recessions orDepressions Occurred inAustralia?
There are several episodes of very weak economicactivity in Australia that are recognised asrecessions or depressions by most economists.There are also some episodes of weak economicactivity where there is disagreement amongeconomists about whether these were recessions,in part because of the different definitions ofrecession that can be used.
Recessions
1974–1975: The mid-1970s recession followeda global oil price shock in which the world priceof oil roughly quadrupled. The increase in worldoil prices generated high rates of inflation whichwere made worse by domestic wage pressures.Significant increases in the costs of production,combined with reduced demand by othereconomies that were in recession, caused outputto contract and reduced Australian firms' abilityto employ workers. The unemployment raterose sharply from very low levels. Despite fallingoutput and rising unemployment, high rates ofinflation persisted – a situation called ‘stagflation’.(The unemployment rate peaked at 5½percentwhile inflation peaked at 18percent.)
1982–1983: Around the world, the high rates ofinflation that emerged during the 1970s hadbecome entrenched, with the inflationary effectsof higher oil prices reinforced by excessive growthof the money supply and expansionary fiscalpolicies. Given the costs of high inflation,[2] in theearly 1980s, central banks sought to reduceinflation through tighter monetary policy thatresulted in recession in a number of economies(especially the United States). In Australia, theeffects of tighter monetary policy and weakglobal demand were compounded by drought.With the breaking of the drought, a rapid economicrecovery followed, aided by the benefits of therecent floating of the Australian dollar and othereconomic reforms. (The unemployment ratepeaked at 10½percent).
1991–1992: The early 1990s recession mainlyresulted from Australia's efforts to address excessdomestic demand, curb speculative behaviourin commercial property markets and reduceinflation. Interest rates were increased to a veryhigh level because the transmission of tightermonetary policy took longer than expected toput downward pressure on demand and inflation.At the same time, countries in other parts of theword, in particular the United States, also enteredrecession, compounding the effect of tightermonetary policy in Australia. (The unemploymentrate peaked at just over 11percent.)
Depressions
The Great Depression of the 1930s: The GreatDepression is the most well-known economicdepression, owing to its depth and durationin economies around the world. It pre-datedmodern social security systems and its socialconsequences remain a defining example ofthe potential cost of economic policy failures.The Great Depression lasted from 1929 to 1931.The official Australian Year Book of 1933 recordsthat the unemployment rate reached 30 percent. This is the most widely reported figure andreflects unemployment rates among trade unionmembers; experts who have sought to constructhistorical economic statistics on a similar basisto contemporary statistics have estimated thatthe unemployment rate peaked at nearly 20 percent.[3] The social and economic consequencesof The Great Depression were severe, thoughAustralia was less affected than some othereconomies.
The Depression of the 1890s: Following along resource and property boom, foreigninvestors began winding back their activities andwithdrawing their funds from Australia. At thetime, Australia did not have its own currency,so the exchange rate could not depreciateto cushion the effects of this withdrawal. Thisoccurred alongside a collapse in wool prices.There was a ‘run’ on the banks in which manydepositors withdrew their deposits and Australiaexperienced its deepest financial crisis. Theresulting financial instability was associated witha deeper fall in production than in The GreatDepression and a higher rate of unemployment.The 1890s Depression had far-reachingconsequences for Australia, giving rise to theorganisation of labour, formation of the AustralianLabor Party and the achievement of Federation(with the scale of the crisis across the countrymaking clear the benefit of national government).
Other downturns
There have been a number of brief slowdowns ineconomic activity over the decades, most recentlyduring the global financial crisis (GFC), with theGFC resulting in significant negative shocks to theAustralian economy.
The global financial crisis (2008–2009):International financial markets and bankingsystems experienced a period of extreme stressand volatility in 2008 (see Explainer: The GlobalFinancial Crisis). The damage done to financialmarkets and the banking systems of many othercountries triggered large-scale losses of economicactivity and large increases in unemployment.For many countries, this was the most severerecession since The Great Depression. However,the Australian economy fared much better thanmost because it had a sound financial system, arelatively large exposure to the buoyant Chineseeconomy, and strong macroeconomic stimulus tocushion it from the global downturn. AustralianGDP only declined in one quarter, although theunemployment rate increased to close to 6 percent and the underemployment rate rose sharply.
COVID-19 pandemic
The COVID-19 pandemic caused large contractions in many economies, including Australia.Because management of the public health issue required the immediate suspension of manyeconomic activities, the economic effects of the pandemic have been notable for thespeed at which output fell and unemployment rates rose, as well as for the scale ofthese effects. For instance, in Australia GDP fell by 7 per cent in June quarter 2020,the largest quarterly decline for which records are available. The unemployment ratepeaked at close to 7½ per cent in mid-2020 and the underemployment rate also increasedsharply. Economic activity rebounded as COVID-19 restrictions were lifted andvaccination programs were rolled out, with households and businesses supported byhistorically large monetary and fiscal stimulus.
Can Recessions Have Long-termEffects?
The social and economic costs of recessions canbe large and persistent. The central bank andother economic policymakers seek to ensure theeconomy continues to grow at a sustainable rateto avoid any unnecessary slowdown in economicactivity. If a negative shock does occur that causesactivity to slow, policymakers will attempt tostimulate the economy to try to avoid a recessionand minimise the economic costs faced byhouseholds and businesses.
There can be long-term consequences from anincrease in unemployment and business failuresthat occur during recessions. Some people whobecome unemployed in recessions face long-termunemployment, even when normal rates ofeconomic growth resume.[4] This is because duringa recession their work skills may have reducedthrough lack of use, or because employersmay think that this has occurred. Long-termunemployment can also occur because arecession can speed up structural changes tothe way the economy works. Reflecting thesedevelopments, the unemployment rate aftereach recession tends to be higher than before theeconomy entered a recession and takes a longtime to decline.
The rise in unemployment that occurs duringa recession results in increased economichardship that is borne unequally across society(with different groups being affected indifferent recessions).[5] This, in turn, reduces theopportunities available to households directlyaffected by the recession and can have long-termeffects on their health, learning, achievementof qualifications and social mobility (that is, theability to improve their circ*mstances).
The business failures that occur during a recessionresult in a permanent loss of output by thesebusinesses and a destruction of productivecapacity. This is especially costly when businesseshad been innovative, had specialist knowledge, orformed a key part of a supply chain or network.
A recession can also have a longer-term impacton a nation's public debt as governmentsexperience a reduction in taxation revenue butneed to fund increased expenditure and transferpayments (through their efforts to stimulate theeconomy, provide social welfare and supportbusinesses).
Endnotes
[1]See Explainer: Economic Growth for an explanation of GDP, itsmeasurement and the difference between real and nominal GDP.
[2]See Explainer: Australia's Inflation Target for a discussion of thecosts of high inflation.
[3]Butlin M, R Dixon and P Lloyd (2014), ‘Statistical Appendix:Selected Data Series, 1800-2010’, in S Ville and G Withers (eds),The Economic History of Australia, Cambridge University Press,Cambridge, pp 555-594.
[4]For more details about the different types of unemploymentsee Explainer: Unemployment – Its Measurement and Types.
[5]In some recessions youth and those with less education havebeen more affected, while in other recessions people of primeworking age have been more affected (with the early 1980sand 1990s recessions in Australia having long lasting effectson prime working age males). The cause of the recession, itsduration and whether it accelerates structural change hasbearing on which groups are most affected by a recession.
