What Actually Causes a Recession?

Conventional wisdom in the aftermath of the Great Recession seems to be that the massive amounts of money pumped into the economy by various central banks — including the Fed — saved the world from global collapse. However, few can articulate why the recession occurred, although the subprime mortgage market certainly had an impact. This was just one factor, though.

Artificially Inflated Money Supply

Money flows, and the faster it flows, the better the economy. But when you artificially increase the money supply through long lines of credit, it creates a glut. When people jump on that credit but cannot pay it back, the supplier of that credit loses out, as do customers.

If this happens to one consumer, the effect is negligible from an economic standpoint,  so even if an entire bank goes under, the economy can typically absorb that shock. But when this economic pumping occurs across millions of lines of credit, it creates the conditions that were seen prior to the recession.

Real Wealth

Artificially inflating the money supply essentially means ignoring the presence of real wealth: assets that can be used to recover lines of credit if they go under. In addition, real wealth also includes activities vital in a service-industry-heavy economy that contribute to economic activity. All of these have measurable economic value.

Fractional Lending

Banks operate on the principle of fractional lending where small reserves are held to cover potential losses, and they assume that most people will pay the bank back. The current regulations require U.S. banks to hold significantly higher reserves (total reserves have had a threefold increase) compared to 2001, but they still accept substantial risk using this system, particularly if there’s a run on the bank.

This means that fractional lending can be a significant contributing factor in a bank’s failure if investor or consumer confidence in a banking institution falls and the bank cannot replenish its money supply fast enough. Again, if this happens across multiple banks, the money supply dries up rapidly, causing a significant decrease in lending. This then forces a recession as the overall money supply dries up, compelling some businesses to hold off on expansion plans fueled by the supply of easy credit and others to lose the credit lines they need to survive on a day-to-day basis. This effect led to 170,000 fewer small businesses in 2010 compared to 2008.

Once stagnation sets in as a result of a reduction of credit, fewer entities qualify for credit, particularly as individuals are forced to dip into savings due to decreased company spending — fewer deposits are available and less money is flowing to the banks. This means that there is less money for wage rises, yet inflation still increases in response to global pressures. As banks are forced to call in loans in response to this pressure, even less credit results. Central banks aim to control and stabilize the economy by raising and lowering interest rates and by pumping in more money to make the economy withdraw from its need for easy credit, yet this creates uncertainty.

Wise Investments

When there are times of uncertainty, gold rises to the fore. It’s the preferred standard of many banks, as it helps to hedge against unexpected shocks. In addition, it helps individual portfolios weather crises, and it retains value well. Consider it an essential part of your portfolio to help you prepare for inevitable drops in the market.