What is a Recession and how it happend?

Even though there are several definitions, I would make it simple by referring to NBER (National Bureau of Economic Research) which says that a contraction in US economy (Often measured using Real GDP) for at least two consecutive quarters in Recession. During dot-com bust in 2001-02, even though I was in B-school, I really missed the big point of why it happened and focus mostly on it's implications such as unemployment, corporate bankruptcies etc. Before looking at the core reasons, I would like to make it clear that there often are triggers such as 9/11 attack or collapse of Lehman and Bear Sterns which expedited a series of collapse leading to the slump in economy. However the question remains, how a few firms or a small percentage (close to 1%) of foreclosures can bring the entire economy down. Is it that the economy in general or for that matter the Finance or Real estate industry were surviving on a razor-thin margin and can fail in tandem like a house of cards following such events?

Certainly not! For example in spite of all the foreclosures, there are millions of house-owners who will continue to pay their mortgages in time and stay in their houses. The challenge comes from people's perception of where we are heading in the next couple of years and that sets the tone. As soon as bad news hits the newspaper, millions of customers start to postpone their economic activity fearing for the worst. Hence people buy old cars in stead of a new one, stay longer in the rental accommodations and cancel their trip to Cancun. This translates into a loss in business for car dealers, realtor's etc. who in turn get rid of some of their employees to continue their business profitably or at least to survive. Those who loose their job loose the buying power immediately; however many more start controlling their expenses to save for the bad days fearing that worst can happen to them. This is where the cascade starts and spread rapidly from Real estate to Finance, high-tech, airlines, tourism and other sectors. So the problem is not that of any real issue in the sense that US has not lost say 50% of it's production capacity in crude oil. This is more about perception of the consumers (And this is why the value of Consumer Confidence Index* is a very very important indicator) who can be citizens, companies themselves (B2B) or government who in their capacity as customers buy goods and services from the market. That is why US can get out of this recession through spending (to generate economic activity and keep the money moving). However this is counter-intuitive to both people and companies who can not afford to spend at the earlier rate at this time. Hence Government is the only party left to rescue this economy by dramatically increasing it's share of spending.

Now people must be saving more money which in turn should allow banks to boost their balance sheet and create incentives for them to lend; right! No, this does not happen. Because firms and individuals who loose business or loose job, immediately loose their purchasing power and start drawing from their reserves. Moreover banks become more circumspect about the ability of their consumers to pay back during this bad time and hence tighten their belt.

Comments are Welcome! I know there are thousands of articles on this very topic; my intention is to make it simple and intuitive for people outside the world of economics to understand the situation.

Note: Consumer Confidence Index can be found at Conference Board website.

Comments are welcome!
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