Economic recessions are caused by a decline in GDP growth, which is itself caused by a slowdown in manufacturing orders, falling housing prices and sales, and a drop-off in business investment. The result of this slowdown is falling employment, and rising unemployment, which causes a slowdown in retail sales. This creates a downward spiral in manufacturing and increased layoffs. A stock market decline, known as a bear market, can either be a result of a recession but is often a cause itself.
But what usually causes the slowdown in the first place? Each recession has its own specific causes, but all of them are usually preceded by a period of irrational exuberance. This is part of the expansion phase of the business cycle.
Cause of 2008 RecessionIrrational exuberance in the housing market led many people to buy houses they couldn't afford, because everyone thought housing prices could only go up. In 2006, the bubble burst as housing prices started to decline. This caught many homeowners off guard, who had taken loans with little money down. As they realized they would lose money by selling the house for less than their mortgage, they foreclosed. An escalating foreclosure rate panicked many banks and hedge funds, who had bought mortgage-backed securities on the secondary market and now realized they were facing huge losses.
By August 2007, banks became afraid to lend to each other because they didn't want these toxic loans as collateral. This led to the $700 billion bailout, and bankruptcies or government nationalization of Bear Stearns, AIG, Fannie Mae, Freddie Mac, IndyMac Bank, and Washington Mutual. By December 2008, employment was declining faster than in the 2001 recession.
In 2009, the government launched the economic stimulus plan. It was designed to spend $185 billion in 2009. And in fact, it halted a four-quarter decline in GDP by Q3 of that year, thus ending the recession. However, unemployment continued to rise to 10%, and many business leaders still expected a W-shaped recession by the end of 2010. High unemployment rates still persisted into 2011.
What Caused the Recession of 2001?The recession of 2001 was caused by irrational exuberance in high tech. In 1999, there was a economic boom in computer and software sales caused by the Y2K scare. Many companies and individuals bought new computer systems to make sure their software was Y2K compliant. This meant that the operating code would be able to understand the difference between 2000 and 1900, since many fields within that code only had two spaces, not the four needed to fully differentiate the two dates. As a result, the stock price of many high tech companies started to increase. This led to a lot of investors' money going to any kind of high tech company, whether they were showing profits or not. The exuberance for dot.com companies became irrational.
It became apparent in January 2000 that computer orders were going to decline, since the shelf life of most computers is about two years, and companies had just bought all the equipment they would need. This led to a stock-market sell-off in March 2000. As stock prices declined, so did the value of the dot.com companies, and many went bankrupt.
High Interest Rates Usually Cause RecessionHigh interest rates are also a cause of recession. That's because it limits liquidity, or the amount of money available to invest. In spite of the stock market decline in March 2000, the Federal Reserve continued raising interest rates to a high of 6.25% in May 2000. The Fed didn't start lowering rates until January 2001, and lowered them about 1/2 point each month, resting at 1.75% in December 2001. This kept interest rates high when the economy needed low rates for cheap business loans and mortgages.
One of the causes of the 2008 recession was that the Fed was also slow to raise interest rates when the economy started to boom again in 2004. Low interest rates in 2004 and 2005 helped created the housing bubble. Irrational exuberance set in again as many investors took advantage of low rates to buy homes just to resell. Others bought homes they couldn't afford thanks to interest-only loans.
What will cause the next recession? It's hard to say exactly where it would occur, but you can bet it will be some combination of low interest rates, irrational exuberance on the part of investors, and high interest rates that pop the bubble, lead to panic and cause a recession.