At the start of 2020, I was getting an increasing number of inquiries about whether we were approaching a recession. I put together a series of posts on major macroeconomic indicators that both predict (leading) and confirm (lagging) when the business cycle turns. Very soon thereafter, came widespread Covid-19 quarantines and their rapid impact on the economy. For young families, many of whom have never experienced an economic recession before, I then explained what happens during a recession, which is a normal, recurring part of the economic cycle. Now, let’s put all those together and walk through what happens in a recession, by highlighting the realities of 5 major economic recessions of the last century.
What Happens In A Recession
Economic cycles typically follow a fairly consistent pattern, and recessions are just one part, and thankfully usually the shortest part, of the cycle. During a recession, we typically see declining consumer demand, leading to declines in production, and rapid increases in unemployment. What varies from recession to recession is what triggers the initial downturn, which then influences how our government and central bank respond and how quickly our economy recovers.
Related Post: What Happens During a Recession?
Two bits of good news?
- One, we have recovered from every economic recession in our nation’s history, and come back even stronger, reaching new levels of productivity and wealth.
- Two, as our economy has matured, and our government and the Federal Reserve have as well, recessions have become less frequent, shorter in duration, and less severe. We have just experienced the longest period of uninterrupted economic expansion in our nation’s history.
Since many of our memories are short, and we often tend to focus on the most recent history (many of you have asked about the 2008 Great Recession and if housing prices will collapse again). So I wanted to take a bit of a walkthrough recessions-past to talk about
- What triggered the recession
- What happened to major economic indicators (stock market, unemployment, CPI, & GNP/GDP)
- And most importantly, how we recovered
I will walk through the 2008 Great Recession and 2001 Dotcom Bubble, given their recency; the Great Depression that began in 1929 given its severity; the Stagflationary recession of the 1970s given its unique inflationary reaction; and the double dip recessions resulting from the Spanish Flu and end of WWI given it’s pandemic connection to current times.
What Happened in 2008 Great Recession
The Great Recession lasted 18 months. The economy peaked in December 2007 and did not begin to recover until June 2009. This was a financial crisis, that began with a subprime mortgage crisis that quickly consumed Wall Street, before also crippling Main Street.
The stock market fell more than 50%, the second-largest stock market decline, second only to the Great Depression, over the course of 18 months. Unemployment skyrocketed from 4.5% in the first half of 2007, to 10% in late 2009. We also experienced a period of price deflation as the air came out of the over-inflated housing bubble.
Subprime loans were loans granted to higher risk, poorer credit borrowers. Banks had been securitizing mortgages since the early 1980s. This process involves bundling numerous mortgages together and selling them off as bonds, removing the debt from the issuing bank’s balance sheets, and transferring the risk of loss to thousands of bondholders.
Over time, banks began securitizing less credit-worthy mortgages – subprime loans – and argued that bundled together there were far less risky than as individual credits. For years, the credit risk of these subprime loans was masked by a strong housing market. The ability for less credit-worthy individuals to buy houses further buoyed the market. It was all well and good as long as home prices continued to rise – they could sell their way out of a bad mortgage or the bank could foreclose and suffer no losses.
As outlined in Michael Lewis’ The Big Short (now also a feature film), a handful of savvy hedge fund investors began to question the math, credit ratings and credit-worthiness of these subprime securities. They made customized trades with banks, known as Credit Default Swaps (CDS), to bet that these bonds would default.
Then, banks began purchasing CDS as insurance against their own balance sheets – from each other, and major insurers, like AIG. The external pressure from investors eventually led credit rating agencies to drop credit ratings on subprime mortgage backed securities, triggering a massive liquidity event across Wall Street.
Lower credit ratings meant writing down mortgage backed securities banks still held on their balance sheets. It meant marking to market the credit default swap trades banks held and making margin payments on them. It also meant less credit available for issuing new mortgages to everyday people on Main Street.
The unraveling of mortgage-backed securities, the hundreds of billions in credit default swaps, and the deflation of the housing market as mortgage availability evaporated caused the recession.
Two major investment banks, who had been around for nearly a century or more, collapsed: Bear Stears (March 2008) and Lehman Brothers (September 2008). Countless others, deemed “too big to fail”, were bailed out by the Federal Reserve and the government.
As mortgage liquidity evaporated, homeowners could no longer sell their way out of homes they couldn’t afford. They couldn’t refinance to pull equity out of a home that appreciated – because now home prices were falling. This further impacted consumer demand.
How Did We Recover?
The Federal Reserve used expansionary monetary policy to drop the Fed’s target rate from 5.25% in September 2007 to 0% by the end of 2008. The Federal government passed a series of bills to stimulate the economy and support Wall Street. In February 2008, the Economic Stimulus Act issued taxpayer rebates of $600-$1,200.
While the Fed bailed out some major financial institutions earlier in the year, in October 2009, the US government funded $700 billion for Troubled Asset Relief Program (TARP) to purchase troubled assets, like downgraded mortgage backed securities and upside-down CDS trades, and even bought stock in struggling businesses, including 8 major banks, AIG, over 20 community banks and the Big Three auto manufacturers.
In 2009, the Treasury set aside TARP funds to help struggling homeowners refinance or restructure their mortgages. President Obama also passed a second stimulus package, totallying nearly $800 billion for tax cuts, infrastructure spending, schools, health care and green energy.
Lower interest rates, government spending and cleaning up America’s balance sheets – from Wall Street and across Main Street – restored consumer confidence and eventually the economy recovered.
What Happened in 2001 Dotcom Bubble
Like the 2008 Great Recession, the 2001 Dotcom Bubble was also a financial crisis. The late 1990s had been a boom time for technology stocks. Concerns over Y2K (the shift from 1900s to 2000s and how computers would handle it) and the growth of the internet spawned massive investment and new, internet-age companies.
Technology stocks drove excessive specutlation – both by professional investors and the public. Venture capital was easy to raise, and to cash out, they needed to take their investment public. Investment banks led IPOs, marketing internet companies who had yet to turn any profit based on the promises of future earnings driven by their growth in traffic and clicks.
The stock market fell nearly 50% from March 2000 to its bottom in October 2002. And most of the economic impact remained isolated to the stock market, with only minimal increases to unemployment and very little impact to GDP.
Eventually, the DotCom companies, with high cash burn rates and no sign of profits, started running out of their venture capital funds. The market also faced some additional negative impacts during this volatile period. First, the uncertainty created by the tragic events of 9/11, which led to the market closing for 4 days – only the third such closure in American history (early months of World War I and Great Depression in 1933 were other two). Second, there were also a series of accounting scandals at major corporations (WorldCom, Enron, Adelphia) that undermined investor trust.
How Did We Recover?
Much of the impact of the DotCom Bubble was isolated to the stock market, and most especially the tech inustry. Many DotCom’s had a culture of excess and burned through their venture capital funding quickly. As funding dried up, so did they – more than half were liquidated or consolidated.
Executives and investment banks involved in accounting fraud were jailed or levied with large fines by the SEC. GDP and employment were minimally impacted. And post 9/11, we saw our country rally and come together like never before.
What Happened in the Great Depression
Like the Dotcom Bubble, the Great Depression began after a period of stock market exuberance. During the Roaring Twenties, many fortunes were made in the stock market. Everyday people began investing, and many began to invest on ‘margin’ – a practice of borrowing funds to invest. Your returns are magnified if the market goes up, but you can be wiped out completely, if the market falls.
It began with a stock market crash. On October 28, 1929, now known as Black Tuesday, the stock market fell 13% in a single day, wiping out many margin investors in the process. The market would ultimately fall 86% from its peak in September 1929 to its trough in June 1932.
With many stock market fortunes wiped out, consumer confidence vanished. This reduced spending and subsequently slowed production leading to dramatic increases in unemployment, which reached as high as 20% by 1932.
There were also a series of banking panics, leading to a loss of confidence in the banking systems. The combination of the stock market collapse, as well as Great Britain’s move away from the gold standard and fears that America would follow, made depositors fear for the security of their money. A series of bank runs – when a large number of depositors all remove their deposits at the same time – led to hundreds of bank failures across the country.
The downturn was then made even worse by a drought. A prolonged period of recurring droughts hit American farmers in the 1930s, producing dust storms, and extended the economic crisis from the stock market across the country.
The downturn was prolonged by America’s strict adherence to the gold standard – every dollar printed had to be supported by gold held in the Federal Reserve – as well as President Hoover’s belief that the government should not directly intervene in the economy. The result was the worst economic downturn in the history of the industrialized world.
How Did We Recover?
America recovered from the Great Depression through massive, government-funded work programs designed to decrease unemployment, and an onslaught of regulations designed to protect Americans and restore confidence in the financial markets and banks.
In 1932, America elected Franklin D. Roosevelt to the first of four terms. He took immediate action. First, he announced a National Banking Holiday during which all banks were closed until they were determined to be solvent after federal inspection.
He began holding fireside chats over the radio to speak directly to the American people and restore their confidence. Under his administration the Glass-Steagall Act created the Federal Deposit Insurance Corporation (FDIC) to protect savings deposits. The Securities and Exchange Commission (SEC) was also created to regulate the stock market and trading of securities. He also repealed Prohibition.
New Deal legislation was passed in two waves. It created a series of government projects designed to put the American people back to work, including the Tennessee Valley Authority, Works Progress Administration, and it also gave birth to the Social Security Act, which provided unemployment, disability and pensions for retirement, and National Labor Relations Act, which gave private labor the right to colletively organize, both in 1935.
A second recession actually occurred in the latter half of the 1930s. Conservatives claim it was due to the New Deal’s hostility towards business, limiting their expansion. Others claim it is because FDR pulled back on government spending too soon, not wanting to run deficits.
Eventually, the start of World War II in the early 1940s fueled a sustained recovery.
What Happened in the Great Inflation of 1970s
Historically in a recession, unemployment rises, incomes fall and reduced demand puts downward pressure on prices, leading to deflation or at least lower levels of inflation. This is a Keynesian Economic theory that inversely links unemployment and inflation.
But in the 1970s something happened that defied all traditional Keynesian Economic theories.
Initially, much of the inflation during the 1970s was blamed on rising oil prices. But rising inflation began BEFORE the 1973 Oil Crisis. Milton Friedman, an American economist who won the Nobel Prize in 1976 for his work, eventually correctly diagnosed the real culprit – excess liquidity. Expansionary monetary policy was used in the late 1960s to chase lower levels of unemployment, but in the process, it created excess liquidity leading to price inflation. Basically, the Central Bank got it wrong for over a decade. In 1964, inflation was 1% and unemployment was 5%. By 1980, inflation was 14.5% and unemployment over 7.5%.
It has been referred to as “the greatest failure of American macroeconomic policy in the postwar period.” And Friedman’s work basically established modern monetary theory which the Fed has operated from ever since.
In 1971, President Nixon took a series of actions now referred to as The Nixon Shock in an attempt to counteract inflation. He instituted wage and price freezes and surcharges, or tariffs, on imports.
He also unilaterally terminated the Bretton Woods agreement which had created a fixed exchange rate for global currencies post-World War II. Foreign governments could exchange foreign currencies, like US dollars, for gold… however, during the 1960s, an oversupply of dollars led to the US not having enough gold to cover the volume of dollars in circulation combined with international money speculators that led to an overvaluation of the dollar. After several runs on the dollar (foreign holders trying to exchange dollars for gold), Nixon sought to protect the dollar and US gold reserves.
We spent our 10th anniversary at the Mount Washington Hotel, where the Bretton Woods agreement was first signed in 1944.
Then, in 1973, we suffered an Oil Crisis. Members of OPEC (Organization of the Petroleum Exporting Countries) formed an oil embargo targetting developed nations, inclding the US. From October 1973 to March 1974, the price of oil rose 400%. A second oil shock occurred in 1979, spawning another recession.
This combination of excess liquidity from expansionary monetary policy, severing the gold standard, and oil price shocks created an extended period we now refer to as stagflation: high inflation combined with high unemployment.
How Did We Recover?
In 1979, Paul Volcker became Chairman of the Federal Reserve Board. Under his leadership, the Fed set its sights on fighting inflation, even at the expense of disrupting economic activity. Instead of just using the federal funds rate, they sought to control the growth of the money supply to rein in inflation, by targeting reserve growth (what banks have to hold in the bank relative to total deposits). The goal was to restrain growth of the money supply to promote sustainable, long-term growth for the US economy.
Another recession in the early 1980s was the result, but by late 1982, both inflation and unemployment began a steady, continued decline. Volcker’s actions were controversial, and difficult to implement, causing more pain before they were effective. But they ultimately restored credibility in the Federal Reserve and established the low inflationary environment we have lived in for the last 40 years.
What Happened in Spanish Flu of 1918 / Post WWI Recessions
Last but not least, given our current pandemic, I wanted to talk about the double-dip recessions resulting from the last major global pandemic, the Spanish Flu which occurred in conjunction with the end of World War I.
Over time, recessions are common following periods of war: during wartimes, government spending is high, production levels ramp up to support the war effort, and all that comes to a screeching halt when the war is over. On top of that, you have thousands of soldiers returning home in need of employment. In 1918, this was compounded by a pandemic.
The Spanish Flu occurred in three waves over the Spring and Fall of 1918, and the Spring of 1919: first spreading among military camps and across Europe, then spreading again when soldiers returned home after the end of the war in late 1918. While data from the time period is less easy to come by, and at the time flu was not a notifiable illness, what data there is shows many states saw 3-6x the annual deaths from flu than in prior years. Globally, estimates are that 20-50 million people were killed, including 675,000 Americans, more than were even killed in the war.
I read Pandemic 1918 by Catharine Arnold over the last 2 weeks – to say it was eerie to read the events of 100 years ago every night before bed, only to have them echoed back to me in the news headlines the next morning would be an understatement:
On 1 October, elderly doctors were being called out of retirement, while medical students suddenly found themselves shouldering the responsibilities of veteran physicians, working fifteen-hour days.Pandemic 1918, by Catharine Arnold
My state of Connecticut set up a web portal to manage volunteer healthcare workers.
Essential services collapsed during the epidemic. Four hundred and eighty-seven police officers did not show up for work, while the Bureau of Child Hygiene was overwhelmed with hundreds of abandoned children. As they could not send the children to orphanages for fear of spreading the disease, they had to ask neighbours to take the children in. When 850 employees of the Pennsylvania Bell Telephone Company stayed away from work on 8 October, Bell was forced to take out a newspaper advertisement stating that the company could handle no ‘other than absolutely necessary calls compelled by the epidemic of by war necessity’.Pandemic 1918, by Catharine Arnold
To cope with the sheer number of dead, the authorities opened an emergency morgue at a cold-storage plant on 20th and Cambridge Streets. Another five makeshift moregues would be opened before the epidemic was over…
When the number of dead became so high that mere manpower was not enough, the Bureau of Highways lent a steam shovel to dig trenches in Potter’s Field for the burial of the poor and unknown…Pandemic 1918, by Catharine Arnold
In addition to all of the above, the Fed raised interest rates to combat inflation. Prices had soared during the war due to shortages, but rapid deflation began as European agriculture, sidelined during the war, came back online and supply chains were restored.
How Did We Recover?
At the time, science didn’t even have the capability to detect viruses, like influenza. So how did they combat it? Social distancing. Cities that took action and intervened early suffered far fewer losses, than cities like Philadelphia that allowed Armistice parades to proceed and faced weeks of illness and death after. Also, cities that lifted restrictions on public gatherings too quickly saw a rash of new cases and outbreaks again.
Then Commerce Secretary Herbert Hoover laid the groundwork for what eventually became our modern system of unemployment insurance in the early 1920s. An Emergency Tarriff was imposed in 1921 to protect domestic agriculture from foreign wheat, sugar, meat, wool and other agricultural products. This was further extended by the Fordney-McCumber Tariff of 1922, though it also adversely impacted exports as other countries reatliated. Income taxes were also reduced to stimulate the economy.
Ultimately, this double-dip recession gave way to a massive period of economic expansion: the Roaring 20s.
So, what happens in a recession?
The market starts to fall before anything else. In fact, the market spends more time in drawdowns than it does at new heights…
I shared the performance of the Dow, only because it has a longer history – but the S&P 500 data from 1927 produces similar results.
It takes months to recover, but often recovery begins before the recession officially ends, and it reaches new heights in the next economic recovery, producing long-term, positive returns.
Or for a closer look at historical performance – here’s a logrithmic version:
It is also evident when you look over the last 120 years, as our country matures, the Federal Reserve and the Federal government have become wiser and more effective in their response to recessions. Quick, decisive actions has led to fewer, shorter-lived downturns, and longer periods of expansion.
While to many Millennials the Great Recession and now may feel back to back, the current environment hitting just as you were getting back on your feet, the reality is economic cycles historically were far more frequent, volatile and destructive… but generations before us recovered and so will we. Learn from these experiences, vow to protect yourself, and be prepared to weather the next downturn.
If you’ve made it to the end, thank you for reading through this labor of love. I fully believe that knowledge is power, and we can learn a lot from history to shield us from making the same mistakes as the past.
To that end, coming up next? Track the progress of the current recession with me weekly with real-time data.
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