As a small business owner, you may hear economists warn businesses of a "looming recession". But what exactly does a recession mean and why should you care about it? In this article, we'll explain what a recession is and its potential impact on your small business.
A recession is an economic phenomenon in which the economy experiences a decline in output, employment, and income. From 1945 to 2009, the average length of a recession was 11 months. However, it is important to highlight that recessions are a normal part of what we call the "business cycle"—a cycle of contraction and expansion in a country's economy. Don't worry, we'll discuss the business cycle later in this article. For now, a recession happens when a country's economy is contracting.
The National Bureau of Economic Research (NBER) is responsible for declaring a recession. However, it only declares recessions after they have ended. This is because they must review all data before all members of the Business Cycle Dating Committee come to an agreement on whether what constitutes a recession has occurred. Only then can they make the declaration.
This results in situations where we could be in a recession and not even know it. As a business owner, you need to be keen on picking up on the signs that we're in or entering a recession and should be looking for ways to prepare for an economic downturn.
Given that the NBER only officially declares an economic recession once it ends, it's hard to gauge whether we're in or approaching a recession. Unfortunately, there is no single method or metric that predicts when and how a recession will begin. Thus, economists track multiple variables that are widely recognized predictors of a potential recession when they occur simultaneously.
Real Gross Domestic Product (GDP) is the general metric for identifying a recession. This is because real GDP measures the total output of American companies and people making it a great metric to assess the country's overall business activity. Also, the impacts of inflation are adjusted for when calculating real GDP, hence the term "real."
Traditionally, the rule of thumb is a recession starts when the real GDP growth rate is negative for two consecutive quarters or longer. However, it does have two main limitations. It takes a long time for real GDP numbers to be confirmed meaning a recession is predicted too late for business owners to prepare for. Additionally, the metric is an estimate and an adjustment to that estimate can change the prediction from it being a recession to being business as usual.
Due to the limitations of real GDP, the NBER uses monthly statistics to be able to predict a recession in a timelier manner as the statistics below provide a more up-to-date estimate of economic growth.
An economic recession brings with it a lack of job security, an increased cost of living, and uncertainty for small business' income. The average recession lasts ten months, and during this time individuals and businesses alike will experience significant impacts on their day-to-day lives.
Though the NBER does not declare a recession until it's over, there are signs you can look out for and steps you can take to protect yourself, and your business from uncertain economic times.
If you want to know whether the economy is in a recession, keep an eye on these characteristics:
In addition to the metrics above tracked by the NBER, the following warning signs can give you more time to figure out how to prepare for a recession before it happens:
Image courtesy of Corporate Finance Institute
The difference between a moderate and a deep recession (also commonly referred to as a depression) is the level of which the GDP drops. For example, a moderate recession is more common, and usually prompts GPD to drop 2%.
With only a handful of what is considered a depression in recent history, there is no formal definition of the event—but they are commonly referred to when a prolonged recession has the GDP drop beyond 10%. The last deep recession occurred in the 1930s and was known as The Great Depression.
The Great Depression took place during the 1930s and would last for a total of four long years. During this time the GDP dropped a total of 30%. This long and deep recession followed up the conclusion of the roaring twenties—where the economy was booming after the end of World War I, and the New York Stock Exchange was on the rise. When spending escalated and the stock market crashed—October 9, 1929 would mark the beginning of the greatest recession in history.
From 2008-2009, The Great Recession would prompt a 8.5% drop in GDP, and an unemployment rate of 10%. This recession was triggered by a housing crisis and would last a total of two years—causing a worldwide financial crisis and the deepest recession the US had experienced since World War II.
The most recent, and likely the most familiar is the Global Pandemic Recession. Lasting from February to April, 2020, this recession was recorded as the shortest in U.S. history—but relevant enough to be mentioned here today.
During these two short months, the GDP had the steepest decline since the World War II Recession, and resulted in fast, and extreme reactions from the federal government to correct itself. Interest rates were cut to zero, and special loans were released to support individuals and small businesses who were feeling the effects of the recession.
You might be wondering, what does a recession mean for me?
During a recession, customers may frequently put off payments longer than usual due to their personal cash constraints. This could be for many reasons, including untimely lay-offs, increase in prices, rise in interest rates and unpredictability in the stock market.
Individuals who are usually customers to small businesses such as yours, are now in saving mode—relying on their emergency funds, cutting back their spend on luxury items and postponing larger purchases. Not only do these decisions affect the lifestyle of the individual consumer, but also their local economy, and the businesses they're cutting from their budget.
One of the most common effects of a recession for all businesses is reduced cash flow. However, unlike bigger corporations, small businesses have less access to cash resources, making managing cash flow extremely important during an economic downturn.
During an economic recession, small businesses become even more dependent on customer spending habits. They are more likely to spend money as it is received which makes the timeliness of customer payments pivotal in keeping the business afloat. This creates a domino effect of late payments to vendors or manufacturers, which slows down all operations of the business. Because there is even less financing available during a recession, it is difficult for small businesses to borrow their way out of this.
Another universal experience for businesses during an economic downturn is a decline in sales. When customers experience cash constraints, they're more likely to put that money towards essential items and save elsewhere. Lesser customer spending directly translates to a decline in revenue for businesses.
Both reduced revenue and access to financing mean that businesses will have less cash available to keep their doors open. This leads to a domino effect on other aspects of the business such as less marketing spending and reduced employee budget.
As mentioned, a recession is a normal, although unpleasant, part of the business cycle. So what exactly is the business cycle?
The business cycle is a concept that explains how an economy continues to swing between expanding and deflating phases. When expanding, growth is experienced by the country's economy. During this phase, the country's output, income, employment, and retail sales are all increasing. When this is happening, lenders in the country will encourage consumers and businesses to take on more debt by gradually making borrowing money less difficult and expensive.
As debt becomes more easily accessible, the prices of assets start to increase. This may create an illusion of growth through "asset bubbles"—rapidly increasing value that's unsustainable. As this continues to happen, economic expansion eventually stalls. As things start to slow, loans and credit become less affordable, business slows, and the stock market takes a hit. This is when a recession hits the economy.
Though it isn't ideal for business, a recession necessarily occurs as a part of the natural fluctuation of the business cycle—and serves as a motivation to regulate the market and set the foundation for economic growth.
There are simple steps you can take to ensure your small business thrives under any economic circumstances. But first, it's important to understand where your business is at right now and where your spending is ineffective—so you can feel confident knowing you have a sound financial plan. If you're looking for a good place to start, head over to the Bench Blog to read collection of financial resources.
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