What causes an economic recession?

Despite simmering fears about an impending recession this summer, the U.S. economic expansion, the longest on record, is chugging along toward its twelfth year.

The labor market is booming — job creation is solid with a robust 225,000 added in January and unemployment is near a half-century low — and the economy is growing at a slow but steady pace, with the nation expanding by 2.3 percent in 2019.

But growth can’t last forever, and eventually, something will kill it.

Recessions, or periods when employment, GDP growth, income, employment and retail sales stutter, are part of the economic cycle, although they’re notoriously difficult to predict. The longer an expansion lasts, the more likely it will fall victim to a slowdown.

Here are three most frequent causes for historical recessions based on past economic slowdowns, according to a 2019 paper published by Marc Labonte, a specialist in macroeconomic policy at the Congressional Research Service.

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Overheating: An economy that’s overheating, meaning demand outpaces supply, has two key characteristics — rising inflation and unemployment below its “natural” rate, which causes growth to occur at an unsustainable rate. Although it can be sustained temporarily, spending will eventually fall in order for supply to catch up to demand.

Almost every recession since World War II has featured a run-up in inflation before the recession began. The largest was the eight percentage point increase in inflation before the 1980 recession. The Federal Reserve’s preferred level of inflation is 2 percent; it’s currently at 1.6 percent.

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Unemployment, which fell to 5 percent or lower before all but two recession since World War II, is near a half-century low at 3.6 percent.

Asset bubble: The previous two recessions were likely caused by a different type of overheating, known as an “asset bubble.” Although neither featured a large increase in price inflation, both featured the rapid growth and subsequent bursting of asset bubbles. The 2001 recession was preceded by the dot-com bubble burst, and the 2007-2009 recession was preceded by the housing bubble.

Asset bubbles develop when the economy is thriving and investors in a particular asset purchase large quantities of that asset on the belief that it will sell for a higher price. But if those asset prices plummet, and if enough people had significant exposure to that asset, it could drain the value of people across the country.

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Recent market volatility, combined with record highs for the three major indexes, has raised questions about whether the economy is currently in a bubble.

“Unfortunately, it is difficult to accurately identify bubbles and to predict when they will cause problems for the broader economy,” Labonte wrote. “Because stock prices are volatile, large increases and declines over, say, 12-month periods are not uncommon.”

Economic shocks: Recessions aren’t always caused by some type of overheating. Negative, unexpected, external events, referred to as “shocks” by economists, have the power to disrupt growth.

One classic example is the oil shocks of the 1970s and 1980s, which meant those recessions weirdly featured high inflation as well as high unemployment. For instance, in 1979, oil output dropped by about 4 percent as a result of the Iranian Revolution, resulting in mass panic, which then drove prices higher. The price of crude oil more than doubled to $39.50 per barrel. The shock pushed the U.S. and other countries into a recession.

Shocks could also stem from an economic crisis abroad, although few are large enough to truly dent U.S. growth.

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