Recession or a new financial crisis?

Economists have been saying we might be facing a recession in the near future for months, and most see it starting early next year. It is debatable how it will present itself,, but the general consensus is that entering a period of contraction is almost inevitable.

Ironically, the Fed is slowing the economy after rescuing it from the last two recessions. The central bank helped expand lending by lowering interest rates to zero and increasing market liquidity by adding trillions of dollars of assets to its balance sheet. It is unraveling its balance sheet and has quickly raised interest rates from zero in March to between 4.25 percent and 4.5 percent this month.

But during the last two recessions, policymakers need not worry about high inflation eroding the purchasing power of consumers or businesses and seeping through the supply chain into the economy and raising wages.

The Fed is now seriously struggling with inflation. It predicts a further rate hike to around 5.1% early next year, and economists hope he can keep rates high to curb inflation.

These higher prices are already affecting the housing market, where home sales fell 35.4% year-over-year in November. The interest rate for a 30-year housing loan is nearly 7%. 

But is this a recession we can overcome? Or another financial crisis? What is the difference, if any, between the two?

The Financial Crisis: The Basics

During a financial crisis, asset prices fall sharply, businesses and consumers are unable to pay their debts, and financial institutions suffer from a lack of liquidity. A financial crisis is often associated with a bank panic, where investors sell their assets or withdraw money from their savings accounts, fearing that their value will decline if they stay with the financial institution.

Other situations that can be classified as a financial crisis include the bursting of a speculative financial bubble, a stock market crash, a sovereign debt or currency crisis. A financial crisis can be limited to banks or spread to a single economy, a regional economy or many economies around the world.

A financial crisis can take many forms, including a bank/credit run or a stock market crash, but it is different from the recession that often follows such a crisis.

An economic crisis can have different causes, ocurring when institutions or assets are overvalued – it can be exacerbated by irrational or herd behavior by investors. For example, a quick sale can lead to lower asset prices, causing people to divest their assets or withdraw large savings when there is talk of a bank failure.

A financial crisis can be divided into three phases, starting with the outbreak of the crisis. Financial systems often fail due to systemic and regulatory failures, poor institutional governance, etc. The next stage is the collapse of the financial system, where financial institutions, businesses and consumers are no longer able to meet their obligations. Eventually, the value of the assets will decrease and the total debt will increase.

The 2008 global financial crisis is one of the deepest crises in modern history and deserves special attention because its causes, consequences, responses and lessons are still relevant to today’s financial situation. The crisis was the result of a series of events, each with its own trigger, culminating in the near-collapse of the banking system.

What you need to know about the recession

Simultaneous or synchronized recessions have occurred several times in the past four decades in advanced economies – the mid-1970s, early 1980s, early 1990s and early 2000s —  and because the US has strong connections with the trade and finance of many other economies, most of these recessions are synchronized with the recessions that happened in the United States.

While US recessions have slowed over time, the recent global crisis has reversed the trend. The latest episode was one of the longest and deepest recessions since the Great Depression of the 1930s. It led to a sharp rise in unemployment – and a marked decline in output, consumption and investment.

We cannot say for sure what the official definition of recession is, but it is generally accepted that the term refers to a decline in economic activity. Very short periods of decline are not considered recessions. A recession could also be identified as two consecutive quarters of decline in a country’s real (inflation-adjusted) gross domestic product (GDP) — the value of all goods and services produced in the country. While this definition is a useful rule of thumb, it also has drawbacks.

While the economy may show signs of weakening months before a recession begins, it usually takes time to determine if a country is in a true recession.

There are several reasons for the recession. Some are related to sudden changes in the prices of inputs used in the production of goods and services. For example, a sharp increase in the oil price can be the harbinger of a recession.

Other recessions, like the one that started in 2007, have been caused by problems in the financial markets. A sharp rise in asset prices and rapid credit growth often go hand in hand with a rapid build-up of debt. As businesses and households become overburdened and struggle to service their debts, they reduce investment and consumption, which in turn leads to lower economic activity.

So… should we expect a recession or a financial crisis in the near future?

The answer is never as simple as you might think. One thing is clear, however: the idea that a rapid rise in interest rates could threaten financial stability is not new. In recent months, economists have often commented that it is surprising that the Fed has been able to raise rates so far and so quickly without major disruptions in markets accustomed to low borrowing costs.

Still, other experts said it was troubling that such serious problems could go undetected for so long at Silicon Valley Bank, the medium-sized California bank whose bankruptcy sparked the latest turmoil. This raises questions about other threats lurking, perhaps in less regulated areas of the financial industry, such as real estate or private equity.