Cause of recession debated among macroeconomists

Not all recessions and recoveries are equal. A downturn can be as mild as the one from July 1990 to March 1991 when GDP fell by 1.3%. It can also be severe like the most recent one where GDP fell by 5.1% from peak to trough. In addition, recoveries can be anemic or robust. For example, GDP grew almost 14% in the two years following the 1981-82 recession, while it has only grown 5% in the two years since the end of the last recession.

What exactly causes a recession is a matter of intense debate among macroeconomists. It is likely that there are many causes.

Keynesian theories focus on the role that consumer confidence plays in recessions. When consumers begin to feel pessimistic about the future, they will save more and spend less. This leads to a decrease in demand for goods and services. If the prices of goods are slow to adjust, this will, in turn, lead to a surplus of production and firms will begin to lay off workers.

New classical economic theories point to the role of technology. When there is a drop in productivity, firms will be unable to produce as many goods as they could previously. The drop in worker productivity leads firms to lay off workers and to a recession. New classical economists realize that technology rarely decreases, but they point out that energy price increases and tax hikes are often identical in terms of their effects on firms.

Financial crises can also cause recession if they have a major impact on the banking sector. When banks are in financial trouble they are reluctant to lend to businesses, and many sectors of the economy rely on bank lending to cover up front costs.

Our most recent recession was caused primarily by the subprime mortgage financial crisis. The anemic recovery, however, is likely due to other causes.

One facet of recent recoveries has been the slow rebound in employment. This is especially true of the past two years. A great deal of this is due to government policy. Increases in personal and corporate income taxes are very similar to drops in technology from the point of view of firms hiring workers.

Expectations of increased taxes act as a powerful disincentive to businesses. Since most business operators dislike dealing with uncertainty concerning the future business environment, even uncertainty about whether taxes will go up or not, can act as a drag on the economy. The expectation of increased government regulation can also mimic a productivity drop. When particular methods of production are banned or made more costly, this forces firms to adopt different production techniques that are likely less efficient (else the firm would already be using them).