What Caused the Recession?

We’ve been hearing this word a lot lately – recession. Nowadays, everyone is interested in the economy and how it is doing. The economic conditions had a lot to do with how the 2008 U.S. Elections played out – many people based their decision on which candidate would best deal with the current economic conditions.

We know that the stock market is down – we are now in a bear market situation. Layoffs will start happening in first quarter of 2009. But what exactly caused us to get to this point? What really caused the recession?

First off, let us define what recession means. According to the National Bureau of Economic Research (NBER), recession is a “significant decline in economic activity spread across the country, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

Recessions are cyclical in nature and are not caused just by the immediate events preceding it. In this case, what happened a few years back should also be taken in consideration. Recessions are also caused by irrational exuberance. Alan Greenspan coined this phrase when he was describing a stock market bubble. In layman terms, greed and frenzy over a certain industry causes investors to buy during bull markets.

Let’s look at how irrational exuberance contributed during the 2001 recession. Before the entry of the new millennium (2000), the Y2K scare caused investors and business people to invest and buy more in computer hardware and software to make their computers “Y2K compliant”. The stock prices of tech-oriented companies began to go up because of increased earnings and so investors started investing money in those companies. But eventually, in 2000, the revenues of computer companies fell back to normal – the stock market began a frenzied selling of stocks and that’s what happened in 2001 recession.

The 2001 recession has a hand in what economic conditions that we have today. The interest rates were slow to rise during the time that the market was picking up in 2004. This led people to buy more homes and get more mortgages because the interest rates were so low even when they could not afford it. Many started investing in real estate. When the interest rates were hiked, the housing prices fell and homeowners realized they bought homes they didn’t have the money for, so many foreclosed. Because the foreclosure rates were increasing rapidly, this caused alarm to the banks who bought mortgage-backed securities because losses would come soon.

Lending became tight and the stock market fell. This led to a credit crunch – meaning, there was an increase in costs for bank loans and a decrease in loan availability. The banks became apprehensive in loans because they wanted to protect their assets from toxic loans.

When this happened, banks and other financial institutions began defaulting because they were unable to their financial obligations. Thus we see what happened to Bear Stearns, AIG, Lehman, and other such banks and financial companies.

Being in recession, the next year is expected to bring layoffs and increased prices in commodities. Earnings and income are expected to decrease. Credit purchases are expected to increase.