Are Economic Recessions Inevitable?

Key Takeaways

Modern, capitalist economies exhibit readily observable cycles of booming growth followed by periods of recession and eventual recovery.
Many people have come to assume that these cycles are more or less inevitable.
Understanding what causes recessions is the key to knowing whether they are inevitable.
Numerous explanations for recessions have been proposed, focusing on different factors in the economy.
The most powerful and comprehensive of these theories implies that while recessions are not logically inevitable, they are here to stay, given current economic circumstances.

What Are Recessions?

“Recession” is the term given to an economic period marked by negative real growth, declining output, depressed prices, and rising unemployment, which often follows a period of notably strong economic growth as measured by these same variables. Recessions are characterized by an unusual, simultaneous, and large grouping of business errors, which some economists call “malinvestments.”

Faced with financial loss and declining margins, businesses scale back production or fail entirely, and business managers (or the new owners) reallocate resources tied up in the failed projects to different uses. During the period of transition, some of these resources will need to be repriced (in terms of goods prices, asset values, or in the case of labor, wages), and some will remain idle for some time until a new use is found. As this process proceeds, the economy recovers.

The National Bureau of Economic Research (NBER) determined that February 2020 was officially the peak and end of economic expansion that started following the Great Recession, as the U.S. economy contracted in the wake of the COVID-19 pandemic.

Causes of Recessions

The key issue as to whether this process of growth-recession-recovery is inevitable is: What causes the cluster of business errors to occur? Why can businesses not continue to grow and asset prices continue to rise indefinitely? Economists have developed numerous explanations for these clusters of business failures over the years.

Some rely on psychological factors. These explanations point out that people can be prone to excessive optimism and confidence or pessimism and fear, leading to the propagation and collapse of market bubbles and persistent deficiencies of aggregate demand.

Some of this can even be reproduced experimentally through simulations or experiments on a very limited scale. Such theories are popular, but in general fail to actually explain how a large-scale cluster of business errors can occur across markets and asset classes in an entire economy, as happens during a recession.

Others point to economic shocks, which are random events such as wars or epidemics, that can negatively affect production, consumer demand, or the costs of key goods and commodities in an economy. These kinds of things can certainly hurt businesses across an economy all at once.

However, they fail to explain why recessions seem to occur with such regularity or why they consistently follow periods of notably strong growth. After all, economic shocks are by nature random events. There is no particular reason for random shocks to follow patterns like these, which are easily observed. Random negative shocks may be inevitable, but that doesn’t show why the observed boom-and-bust patterns in the economy should be inevitable.

Still others explain the recurrent cycle of growth and recession in the economy in purely financial terms. These often involve errors by the central bank or monetary authority that supplies money to the economy. Maybe too much new money leads to excessive inflation, but too little may lead to tightening credit conditions and defaults leading to debt deflation, and this is why we have recessions.

Many different explanations for recessions have been advanced by economists, and many of them may have at least a kernel of truth.

Each of these types of explanations for the cycle of growth and recession that can be seen over the decades seems to have some power and perhaps some bit of truth. But none of them really shows that recessions are inevitable, or that a cycle of expansion and contraction in the economy should really exist at all.

These theories fail to explain why monetary authorities should err so greatly and with such apparent regularity as to cause a readily visible cycle of boom and bust in the economy. Essentially these theories simplify the question from “Why do clusters of severe business errors occur?” to “Why should severe clusters of central bank errors occur with such regularity?”

Alternative Explanation

Another alternative explanation for recessions comes from Austrian Business Cycle Theory (ABCT). This theory takes a deeper look at many of the factors discussed above. It focuses on how central banking and monetary policy interact with real economic events and the psychology and incentives faced by investors, producers, and consumers in the economy. By looking at how all these things relate to each other, we can get a more complete view of how business cycles work and whether they are inevitable.

In ABCT, the key cause of recessions is the creation of new money in the form of loans and corresponding deposits by the banking system, known as fiduciary media of exchange. Banks, and especially central banks, do this not out of an error in calculating the correct monetary policy, but because it is their essential business model. This sets in motion a series of investments in the economy by distorting the incentives of investors, consumers, and savers in favor of debt-financed investment and consumption and a simultaneous decrease in savings.

The expansion of credit in the banking system sets in motion the cycle of boom and inevitable bust.

This creates a temporary illusion of a strong economy as prices and spending across the economy rise—but because the plans of investors, consumers, and savers are fundamentally in conflict, this illusion cannot last. Business investment projects previously expected to be profitable under the illusion of distorted incentives and the optimistic exuberance of the boom are eventually revealed to be a cluster of errors.

Often, this revelation of the cluster of errors may be triggered in part by some random economic shock, but not necessarily. The conflicts that arise as investors, consumers, and savers try to increase both present and future consumption while decreasing savings often take the form of real constraints and bottlenecks in supply chains that may resemble random economic shocks, though they are nonetheless systematically caused by the initial overissuance of new money and credit. These lead to business failures, rising unemployment, debt deflation, and all the economic pain of a recession.

Recessions Are (Probably) Inevitable

In the end, once the process of the artificial boom in the economy by the issuance of credit is set in motion, then the ensuing bust and recession are indeed inevitable. But this does not mean that recessions are always and generally inevitable, other than after episodes of inappropriate creation of money and credit. Recessions are not logically inevitable in any economy, but are contingent upon the monetary practices and institutions that a society adopts.

For the time being, given existing monetary institutions, recessions are inevitable.

However, for better or for worse, all modern, capitalist economies include banking systems based on fractional reserve lending coordinated by central banks that routinely and continuously issue new fiduciary media into the economy. As long as this is the case, then the cycles of boom and bust that we regularly experience, as described by ABCT, will unfortunately be inevitable. Given the ubiquity and entrenched position of the current monetary arrangements, for now, recessions are just part and parcel of how our economy works.

Why Are There Always Booms and Busts in the Economy?

There are natural tendencies for the economy to experience booms and busts due to the way that modern capitalism functions. During periods of growth and expansion, firms may begin overproducing goods, increasing aggregate supply relative to actual demand. Banks, likewise, may overextend credit to borrowers who might have gotten in over their heads. This leads to businesses going bankrupt and/or having to sell assets at low prices to raise cash to pay their debts.

As prices fall across the board in response to excess supply or excessive debts in the business sector, this sets off a chain reaction throughout the economy as producers cut back production in the face of falling prices, leading to layoffs and more bankruptcies. Eventually, the economy contracts back to something closer to a normal level of production and employment.

What Causes a Recession?

A recession occurs when economic output declines from one period to the next, but recessions can be caused by several factors affecting the economy.

Sometimes a downturn can be triggered by a financial crisis or a large fall in asset prices such as housing or other investments. Other times, it can be due to a structural change such as a shift in the composition of an economy from producing goods toward producing services or vice versa. Another cause can be a natural event like an earthquake or a drought that causes a decline in the production of key goods and services.

How Do Central Banks and Governments Fight Recessions?

While recessions may be somewhat natural in terms of macroeconomic cycles, governments and central banks can and do intervene to both lessen the severity and duration of an economic downturn. Central banks like the Federal Reserve can enact an accommodative monetary policy, such as lowering interest rates to make it easier to borrow for consumption and investment. The government can also enact expansionary fiscal policy such as lowering taxes and increasing federal spending to spur aggregate demand.

The Bottom Line

Recessions, or economic contractions, are likely a function of the usual operations of a modern capitalistic economy. Unfortunately, recessions can lead to high levels of unemployment, lower asset prices, investment losses, and firms going out of business. But they also show us something very important about how modern economies work—namely that unchecked growth and credit expansion funded by banks is unsustainable when it occurs without regard for fundamental constraints on the supply of goods and services.

Ultimately, this illustrates the potential need for policies that promote long-term economic stability rather than short-term growth. Otherwise, we likely will continue to see a predictable pattern of economic booms followed by the inevitable busts, at least until people begin to question whether it is economically wise to continue with such economic practices.