Research Paper on Recession and the Current Economic Down Turn
Prepared By: Omar Alzarouni Prepared For: Dr. Anil Roy Dubey Date: 26 April 2009
Table of Content
Introduction..........................................................................................................................3 Recession Definition............................................................................................................4 Recession Vs Depression.....................................................................................................4 Depression Definition......................................................................................................4 The Difference ................................................................................................................4 Overall Impact of Recession................................................................................................5 The Impact of Recession on Businesses..........................................................................6 How Damaging Are Recessions ......................................................................................7 How to Survive in a Recession............................................................................................8 New Rules and Policies to Survive Recession...................................................................11 Problems the economy might face in recovering from a recession...................................11 Lessons gained from Recession.........................................................................................13 Conclusion ........................................................................................................................16
This report is discussing the recession and the current economy down turn. The report will go through and will cover the definition of recession and how a recession defers from a depression. Moreover; the report will talk about the impact of the recession and it affecting the business world. Furthermore, the report will discuss how to survive in recession. Another field to be discussed in the report is what a good investment in a recession and what are the new rules and policies introduced by world government to survive from the recession. Finally the report will discuss some examples of lessons learned from the recession.
The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) provides a better way to find out if there is a recession is taking place. This committee determines the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define a recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it is called an expansionary period. By this definition, the average recession lasts about a year. According to investopeda.com a recession refers to “Recession is a normal (albeit unpleasant) part of the business cycle; however, one-time crisis events can often trigger the onset of a recession. A recession generally lasts from six to 18 months, and interest rates usually fall in during these months to stimulate the economy by offering cheap rates at which to borrow money”.
Recession Vs Depression
In order to compare recession and depression, we must understand what does depression means.
Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was developed in this period to differentiate periods like the 1930s from smaller economic declines that occurred in 1910 and 1913. This leads to the simple definition of a depression as a recession that lasts longer and has a larger decline in business activity. The difference between the two terms is not very well understood for one simple reason: There is not a universally agreed upon definition. If you ask 100 different economists to define the terms recession and depression, you would get at least 100 different answers. I will try to summarize both terms and explain the differences between them in a way that almost all economists could agree with.
So how can we tell the difference between a recession and a depression? A good rule of thumb for determining the difference between a recession and a depression is to look at the changes in GNP. A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe. By this yardstick, the last depression in the United States was from May 1937 to June 1938, where real GDP declined by 18.2 percent. If we use this method then the Great
Depression of the 1930s can be seen as two separate events: an incredibly severe depression lasting from August 1929 to March 1933 where real GDP declined by almost 33 percent, a period of recovery, then another less severe depression of 1937-38. The United States hasn’t had anything even close to a depression in the post-war period. The worst recession in the last 60 years was from November 1973 to March 1975, where real GDP fell by 4.9 percent. Countries such as Finland and Indonesia have suffered depressions in recent memory using this definition. Now you should be able to determine the difference between a recession and a depression without resorting to the poor humor of the dismal scientists.
Overall Impact of Recession
The impact of the recession can be summarized as the following:
Rising Government Borrowing. A recession is bad news for the government budget. A recession leads to lower tax revenues (lower income tax and corporation tax revenues) and higher government spending on unemployment benefits. The UK is forecast to borrow £60 billion, a recession could make this borrowing even worse in 2009. This borrowing means higher taxes and higher interest payments in the future. Falling Share Prices. Generally a recession leads to lower profitability and lower dividends. Therefore, shares are less attractive. Note share prices often fall in anticipation of a recession. e.g. the recent falls in share prices are largely because the market expects a recession soon. During the actual recession, share prices often increase in anticipation of the economy recovering. Note also, falling share prices don't always mean a recession, falling share prices can occur for many other reasons. Lower Inflation. Typically a recession reduces demand and wage inflation. This should result in a lower inflation rate. However, this recession is complicated because of rising oil prices. Therefore, the forthcoming recession may actually occur simultaneously with higher inflation - a term known as stagflation. But, a recession will definitely reduce demand pull inflation pressures and encourages price wars on the high street as firms seek to retain consumers. Falling investment. Investment is much more volatile than economic growth. Even a slowdown in the growth rate (economy expanding at a slower rate) can lead to a significant fall in investment. Rising unemployment. This is the main concern over a recession. If output does fall, there is likely to be a fall in demand for labor. This problem is often
concentrated in those sectors most affected by the recession. For example, in the current climate, jobs related to finance and the housing market are more at risk than say the manufacturing sector. Often unemployment is a delayed factor) i.e. it takes time for unemployment to rise, but, even when the economy is recovering, it takes time for unemployment to fall.
The Impact of Recession on Businesses
1. A recession will make it difficult for new firms who have just entered the market. Most new firms have high set up costs; therefore, a downturn in the economy could make them close down. However, this does not mean that they are inefficient. It just means they are new and struggling to get established.. 2. Increased Monopoly Power. If a recession causes the smaller and newer firms to go out of business then the larger dominant firms will gain more monopoly power. In the long run this will lead to less choice and higher prices. This is a definite disadvantage of a recession. When the Chairman of Ryanair argued recessions would be a good thing, maybe he meant - a good thing for Ryanair, as it may involve new firms going out of business leaving him more market power. 3. Hysteresis. This is the argument that the past is a predictor for the future. Basically, if you have high unemployment, then it is more likely to have high unemployment in the future. If people are made unemployed in a recession, it may take a long time for them to find work again. When they are unemployed they lose skills, become demotivated and become less attractive to employers. Note after the recession of 1981, Unemployment remained stubbornly high in the UK, even into the boom years of the late 1980s 4. Fall in Productive Capacity. A recession can damage the productive capacity of an economy. Firms can go out of business and therefore shut down their resources. Furthermore in a recession, there will be a significant fall in investment; this can harm the long term development of an economy. 5. You don't need a recession to weed out inefficient firms. If markets are reasonably competitive, inefficient firms will be forced out of the market anyway. An economic decline in the United States is pretty much guaranteed to reduce the income of the business sector. The recent falls in the US stock markets are largely due to expectations of a future downturn in the economy. Lower growth leads to lower profits, therefore dividends decline and shares become less attractive. If the US enters into recession, firms will experience a decline in profitability. This is because:
1. Tendency for price wars to develop in a recession. Low sales encourage firms to cut prices 2. Falling sales will lead to lower revenues. Some firms will be affected more by the downturn. Firms producing luxury goods (Income elasticity of demand >1) will experience the biggest % fall in demand. This is likely to include manufacturers of luxury cars, 5 star hotels. Firms producing basic necessities will be more insulated from the effects of a recession.
How Damaging Are Recessions
Sometimes the media give the impression that a recession will lead to widespread economic disaster. It is easy to drag up memories of the Great Depression, the Jarrow Crusade, and unemployment rates of 30% +. This is made easier because the media highlight the bad news; the companies who go bankrupt, the people who are made unemployed, falling house prices. Negative news makes the most interesting headlines; the media won't start reporting "Big supermarkets doing OK - no job losses this year" I don't blame them for this, however, it is worth bearing in mind that for most people a recession might not actually change things very much. Most people will keep their jobs, most companies won't go bankrupt. For example, in the last recession, unemployment in the UK doubled from 1.5million (5%) to 3 million (10% of workforce). But, the majority of people still kept their jobs. People are more likely to be directly affected by rising costs of living. The rise in food and energy prices is hard to ignore; it is estimated that many consumers could be worse off this year because prices are rising faster than wages. This is what people will notice. Interestingly, many non-economists may confuse the concepts of recession and inflation. However, it is worth pointing out that although rising oil prices may help to cause a recession. A recession means real output or at least real output per capita falls. Of course, for those who are made unemployed in a recession, the effects are severe. Being made unemployed is one of the most stressful events in life, both economically and on an individual level. Surviving on unemployment benefits is no joke and the impact far greater than rising petrol prices The impact of a recession also depends on various factors such as: How Long does Recession Last? An important factor is how long and how deep the recession is. One of the notable features of the Great Depression was how long the mass unemployment existed. More recent recessions have been shorter in duration. Some sectors hit more than others. The impact of a recession is not equally distributed throughout the economy. A recession will usually affect some sectors much more than others. For example, in the present downturn, it is the construction sector which is particularly badly hit. This is for two reasons:
The collapse in house prices Construction investment tends to be more volatile than economic growth.
Some firms will be hit more than others. Early casualties of the current downturn are companies like Starbucks and Marks & Spencer. Both have businesses focused on luxury items. E.g. Starbucks coffee could be considered an expensive luxury; it is the kind of spending you can easily cut out. Other companies producing basic food items are barely touched by a recession. People do not stop buying grocery items in a recession; they just buy less luxury items like a takeaway Starbucks or Marks & Spencer organic salad. The important thing is that some firms will be hit much harder than others. If you're not in construction, real estate or producing luxury SUV cars, the impact of the forthcoming recession may feel more muted.
How to Survive in a Recession
With many predicting a recession in the US, the average consumer may be worrying how a recession might affect them and what they can do to insure against the negative effects of recession. These are some of the effects of recessions and how to deal with them. More difficult To Borrow. In a recession banks are less willing to lend. This is particularly a problem at the moment, because of the concurrent credit crises which is reducing the availability of loans.
Solution: Avoid taking on any unnecessary debts. The debts you have try to reduce and consolidate into a lower interest rates bearing account. On the positive side, in a recession interest rates are likely to be lower, meaning lower interest payments for mortgage holders.
Unemployment. This is the main concern over a recession. If output does fall, there is likely to be a fall in demand for labour. This problem is often concentrated in those sectors most affected by the recession. For example, in the current climate, jobs related to finance and the housing market are more at risk than say the manufacturing sector.
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Solution: If you fear unemployment, start thinking what you might do as an alternative. Is it viable to consider working on a second income, such as online business. Do you have unemployment insurance to cover mortgage payments? If not, it would be worth taking insurance out now. Don't panic. Firstly, the unemployment may not occur; there is nothing to be gained by worrying over what we have no control other. If are made unemployed, the best solution is to be flexible in looking for work. Consider new avenues and skills that you could learn. Also recessions will be
short lived; a period of temporary unemployment does not have to become permanent. Falling profitability of Business. If you are a small business owner the effects of a recession can be keenly felt. Lower profits could even threaten the survival of the business.
Solution: Look for ways to minimize costs without compromising the business. There are always ways to cut costs and increase inefficiency. Some economists even go so far as to say that recessions are a good thing because they force the economy to become more efficient. If your business is particularly affected by the downturn, look to see whether you can diversify to reflect the changing economic environment. For example, if you specialise in selling luxury goods with a high margin try including some new product lines which appeal to people's desire for frugality. A fall in profits is likely to be cyclical. therefore try to plan a financial plan to borrow at a low cost for the difficult years.
Falling Stock Market In a recession, stock markets are likely to fall as lower profits reduce dividend payments. Try to diversify your investment portfolio. In a recession, commodities such as gold often do well. Even in a recession, there can be good investment opportunities. Also bear in mind that stock markets can often be forward looking. For example, stock markets have fallen sharply since the start of the year in anticipation of a recession. When a recession comes, stock markets often don't fall any more. Consumer Confidence Often the worst aspect of a recession is the affect on consumer confidence and people's fear about the future. Bear in mind, the media often exaggerate the extent of a downturn in the economy. The media like to highlight sensationalist stories. However, it is often not as bad as it is made out to be. Keep a calm and detached attitude and just make the best of the current situation. Any other benefit Benefits of a recession?
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Lower interest rates. Good for borrowers Lower inflation rates. Good for savers Sometimes difficult times can force us to reevaluate our financial situation. It can make us look for new business avenues and new ways to cut costs and spending. Although it may be temporarily unpleasant, the important thing is not to panic but try to make the best of any situation we find ourselves in.
Good Investment for a Recession
With the problems in the credit markets and prospects of recession, a reader recently asked what would make a good investment in the current economic climate? I don’t know whether a penniless economist is the best person to advise about investing, however, these are some of the basic principles behind the different options for investment at the present moment. Housing Market The housing market has outperformed most other types of investment in recent years. I still remain a believe in the long term prospects of the housing market. However, for the next 1-2 years, I expect house prices to fall slightly. If you are thinking of investing for the next 10-20 years in the future, the shortage of supply relative to demand is likely to keep pushing prices higher. However, there is no harm in waiting for 12-18 months to see how much house prices fall. It may also become cheaper to borrow when the credit crunch ends Share Prices In a recession, firms make less profits, pay lower dividends and so share prices fall. The stock market may seem like a good place to avoid, especially given recent turbulence. However, it is my belief that the impact of a recession is already built into share prices. Sometimes share prices can actually rise in the period of a recession, because analysts are already looking forward to the recovery. Investing in the stock market has given pretty poor returns in the past few years, but, I think many shares now offer good value. Mineral Prices In a recession, people often resort to investing in solid products like silver and gold. It is seen as a safe alternative to market based share prices. The price of metals and other commodities are also being pushed higher by: 1. Depreciating dollar. Because of the dollar’s weakness, gold is becoming seen as an attractive alternative. As long as the US economy is suffering falling house prices a declining economy and low interest rates, the dollar will remain weak. This will make Gold attractive as an alternative 2. Rising Demand. Global growth, especially amongst the big two of China and India is causing rising demand for raw materials such as metals, gold and energy. There seems no let up in economic growth in India and China, however, the rising inflation rate indicates chance of boom and bust in China. Nevertheless mineral prices still offer chance for growth because of rising demand. Government Bonds Government bonds offer the chance to make a secure investment and stable interest rate. However, on long term bonds, the market price is inversely related to the market interest rate. If interest rates fall by more than market expectations then the price of bonds will rise. In the UK, this is a possibility, but there is a little prospect of dramatic
changes in prices, it is most likely that bonds will just offer secure but steady investment Any Currencies worth buying? Some are touting the Euro as an alternative to the dollar as the world’s most important currency. But, I would be wary of investing in the Euro as the Euro economy is doing pretty poorly. It could follow the US into recession and this would make the Euro look overvalued. If you fancy a gamble look for a currency like the Brazilian Real, which has done very well in the past 12 months (helped by G.Soros’s speculation).
New Rules and Policies to Survive Recession
Governments around the world especially the US government are seeking to introduce new policies and regulation in order to survive such recession and economy down turn in the present and the future. Some examples are mentioning below 1. Cutting Interest Rates. Recently, the Fed cut interest rates by 0.75% a big stimulus for consumer spending. Amongst other things, lower interest rates reduce mortgage interest payments, giving consumers more disposable income. - Fed Cut Interest rates by 0.75% 2. Freeze on Sub prime Mortgage Rates. There is a 5 year scheme to freeze sub prime rates, preventing house repossession. Effects of Freezing sub prime rates. 3. Tax Cuts. Cutting taxes increases consumer disposable income. But, will people spend if they are nervous about the future? Can tax cuts avoid a recession? 4. Increase in Government Spending. Higher government spending is another way to stimulate the economy. The US has not announced much in this area. They are hampered by budget deficit and preference for tax cuts. 5. Devaluation. The devaluation of the dollar is not particularly a policy, it is something that is just happening. However, the weaker dollar is boosting the US export sector and could help avoid recession. Effects of devaluing dollar.
Problems the economy might face in recovering from a recession
To recover from a recession there needs to be, either a rise in a Demand (AD), or a readjustment in prices and wages. Classical economists argue that a recession will only be temporary, because labor and product markets are flexible. However, Keynesians argue that wage and price rigidity can keep the economy below full capacity for a long time.
For example, to regain equilibrium it may be necessary to reduce prices and therefore reduce nominal wages by an equivalent amount. However, this may be difficult because trades unions will resist cuts in nominal wages, also firms would be unwilling to cut wages because it may lead to lower productivity amongst workers. 1. Low Consumer confidence. In a recession there will be rising unemployment and, therefore, a fall in consumer confidence. This will cause a rise in the savings ratio. In other words people will spend less of their disposable income and save more, leading to a bigger fall in AD. If confidence remains very low, for a long time, then it will be difficult for the government to increase AD. For example, if the government cut income taxes this would increase disposable income, but if confidence was low people would not be willing to spend any extra and the economy would remain in a recession. 2. Ineffectiveness of Monetary Policy. In a recession the Bank of England could cut interest rates to stimulate demand. Lower interest rates reduce the cost of borrowing, and therefore people should be more willing to spend and invest. However, monetary policy could be ineffective. Firstly, firms may be reluctant to invest, even though it is cheap to borrow, because they cannot see any increase in demand. If a country is a member of the EURO then it may be particularly difficult to increase AD in a recession. This is because interest rates will be set by the ECB and the country will have no control over interest rates. If the UK is in a recession and other countries in the Euro zone are growing too fast -interest rates may be too high 3. Effectiveness of Fiscal Policy. Keynesians argue that expansionary fiscal policy can be used to increase AD and get the economy out of a recession. However, there may be many problems of using fiscal policy to increase AD. Firstly there will be time lags. It takes time for the government to change its spending plans and once implemented it will take time for this spending plan to actually increase AD Also increasing AD may cause crowding out. This means that if the government increases its spending then it will lead to a corresponding fall in private sector spending. This is because the government borrows from the private sector to finance its spending. However, Keynesians reject this argument, they argue that the government will only be using previously unemployed resources therefore there will be no crowding out. 4. Deflation. If there is deflation this makes it difficult to increase demand. This is because people will not spend if they feel that prices will be cheaper in the future. Also monetary policy will become ineffective because interest rates cannot fall below 0%, therefore, with deflation real interest rates may remain high. E.g. Japan has
experienced deflation during the 1990s and this made it very difficult to increase AD and economic growth. 5. Hysteresis. This states that what has happened in the past will affect the future. For example if unemployment is high then it is likely to continue being high. If people are unemployed for a long time they become de-motivated and less employable, because they are now less skilled (less on the job training). Also, if productive capacity is not used for a long time then firms will shut factories down completely, causing a fall in a supply (AS). Therefore, in a prolonged recession there will be not just a fall in AD, there will also be a fall in AS, causing a permanent fall in the potential output of an economy. This occurred during the Great depression of the 1930s. 6. Supply side shocks. If there were a fall in AS, as well as AD, this would make the recession more severe for example, if there was a rapid rise in the oil price like in the 1970s then AS would shift to the left causing lower growth and higher inflation.
Lessons gained from Recession
Here are some lessons learned from the recession and the economic down turn
Realize we can't spend what we don't have; credit and credit cards are not the same as cash.
• Spend more time at home, we eat as a family, we are learning to spend time again with each other and talk to each other more. • Dinner out is now more a treat than a routine. • Dessert out is as much fun and more affordable than dinner out. • We do more family events using what we have; we look at photos, remember events and reconnect to our kids, parents, cousins and grandparents, and what to what they remember, share and think. • We use now more limited weekly food money on real food and have eliminated many of the snacks that are not good for us; we are starting to eat healthier. • We reconnected to our neighbors and learned to share our extra when they did not have enough; we are building our social networks face-to-face. • We hang up our clothes instead of leaving them on the floor or on the chair; we do less laundry, and we make things last.
• We waste less food, create less garbage and leave less of a footprint on the planet; we are more aware that supplies of things are limited - and once gone, they may be gone for good. • We are less fixated on whether we have the newest, shiniest, best or most expensive, in favor having the right things that keep people healthy and safe. • We drive our cars less, consume less gas and learn about the great things in our neighborhood; in the process we make our cars last a little longer. • We slow down on the road knowing that it conserves fuel and offers a view of some great things we generally didn't notice in our rush to get places. • We spend more time with each other; we rekindle friendships that evaporated when life became too busy to stay in touch. • We recycle more; go to garage sales, flea markets and thrift stores. Bohemian and trendy salvage styles are making a comeback. • We buy local produce that saves on fuel and gives us healthier things to eat. • We have learned to extend any meal by adding cans of things we had in the pantry; we invent new family recipes; we use what we have. • We borrow books and movies from the library instead of buying new ones. • We spend more time with crayons, glue, paper and a box to make great things and have a great time. • We are beginning to realize that a gift is truly based on the thought instead of the cash value - and that a flower picked or a handmade card delivered at the right moment creates the right memory. • We now turn lights off when we are not in a room, reduce the amount of heat or air conditioning and are still fine. • We live by the rule that for every bag that comes into the house, two must go - one to trash/recycle, one to the needy. • We now treat things with more respect - a person, book, toy, car or other important thing. • We give all of the clothes that don't fit or we can't use to organizations that ensure it gets distributed to those who use them.
• An afternoon out is now a walk around the neighborhood, time at a park or appreciating nature, architecture, a view or the weather; there doesn't have to be a purchase to make the afternoon valuable.
This report is discussed the recession and the current economy down turn. The report covered the definition of recession and how a recession defers from a depression. Moreover; the report talked about the impact of the recession and it affecting the business world. Furthermore, the report discussed how to survive in recession. Another discussion covered in the report is what a good investment in a recession and what are the new rules and policies introduced by world government to survive from the recession. Finally the report will discuss some examples of lessons learned from the recession.