Recessions are viewed as a natural part of the business cycle. Economic times are good, then bad, then good again. While there is a lot of truth to this simplified viewpoint, its logic largely depends on the reasons for the recession and how recessions generally evolve.
Here are two important concepts to keep in mind when thinking about how recessions evolve.
Malinvestment
The chief cause of many recessions is malinvestment, which is a fancy way of saying that a large section of the economy was put towards unproductive purposes. For example, let’s take the recession that began in 2000 after the dot com bubble collapsed. While the Internet is an amazing invention and propelled a lot of growth in the mid 90′s and last decade, the rush into internet businesses also led to a lot of failed ideas. While the Internet brought us Google and Amazon.com, it also brought many failed businesses like Webvan and the old pets.com. Many people invested a lot in these companies, which helped lead to the Nasdaq reaching an incredibly bubble high above 5000, but it subsequently collapsed, as these companies proved unprofitable since their products fundamentally did not add value to society.
The recession following the dot com bubble was a healthy one. We got our new invention, the Internet, which led to productivity gains. We over-estimated the gains to be made (and hence the profits) and invested too much into a lot of failed companies. This produced a recession, as these companies disappeared, along with the jobs they had created at the time. We let these compaines go out of business and allowed other businesses to pop up to take their place.
The recent recession is largely viewed as a result of malinvestment into housing. While everyone needs a roof over their head, far too many homes were built, and the housing and mortgage sector became far too large a part of the economy. However, unlike the dot com bubble, this recession didn’t merely see the housing industry shrink as a result. Due to an array of other factors, a domino effect occurred that nearly collapsed the entire economy (and still may!)
Credit
Malinvestment is a feature of recessions, but an over-extension of credit is a major cause as well. It is one thing to make a few bad investments (such as putting some money in Webvan). It is another thing to make bad investments and borrow a ton of money to make more of these bad investments. This exacerbates the problem.
When the bubble inevitably bursts, societies look to decrease leverage as soon as possible and pay back debt. Some are unable to and go bankrupt. This deleveraging cycle and cleaning out the excess is known as a ‘recession’ since economic activity is muted. People spend less and save more to get out of debt. This causes a temporary lull but allows society to move on from the past bust.