What is a recession?

WHAT IS RECESSION? I have been working since 1996 and have experienced "global recession" thrice since that time - three times too many to my liking :-) ! It first happened in 2001. The dot com boom in Bengaluru went bust and the one-liners started : B2B was no longer business-to-business ; it meant Back to Bangalore (as it was called then) ! B2C was no longer business-to-consumer ; it actually meant Back to Chennai ! There were stories of how dot com companies in Koramangala were affected and how those offices (in sheds, etc.) were now deserted. I had just joined a new job and was not affected personally, but it was still an uncomfortable feeling. Then there was a second recession in 2008, triggered by the sub-prime crisis in USA. In 2010, just as it appeared that the worst was over, we have the Eurozone crisis which threatens another recession, at least in Europe. In today's world, the interlinking between countries and groups is more, due to advances in transport and communication. Is it any wonder that we say that if China sneezes, the US catches a cold and also vice versa ? The Eurozone crisis has resulted in side effects for the rest of the world. All countries have trade links with each other. This is not a new phenomenon. The famed Silk Route was used around 300 A. D. Please visit http://www.cerritos.edu/jhaas/silk%20road%20project/silk_road.htm to learn more about the Silk Route. Thus, trade has been an integral part of human society from time immemorial. It is the Eurozone crisis that got me thinking : what is a recession ? Why does our Finance Minister say that the Eurozone crisis has affected our economy http://articles.economictimes.indiatimes.com/2012-05-22/news/31814454_1_eurozone-crisis-indian-economy-corporate-bond-market ? Is there (at least) some truth (5%? 2%? 0.1%?!) in what he says ? So, I searched for economic terms in Google to try and understand how economies work. What follows is my understanding of some economic concepts. To begin with: What is currency? From http://www.investopedia.com/terms/c/currency.asp, 'Currency' is a generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within an economy. Used as a medium of exchange for goods and services, currency is the basis for trade. The first form of currency was "bartering", where people exchanged goods. So, let us assume I had two pairs of gloves and was walking barefoot and you needed gloves while you had two pairs of shoes and were desperately searching for gloves (perhaps, you were a gardener desperate to handle thorny cactii immediately!) and neither of us had money. It would make sense to exchange my pair of gloves with the pair of shoes that you had - assuming that our hands and feet are roughly similar, so that we can use those respective items ! As kids, we used to do that commonly : the soft drink Gold Spot had characters of Jungle Book (Mowgli, Bhageera, etc.) and we would exchange the Gold Spot caps to get all characters for our personal collections. At work, I still see an extension of this form of bartering present, which also illustrates the concept of currency. If the guy in the canteen does not have change for Rs. 5, he gives us a scrap of paper that is worthless outside the canteen. But I know that if I go back to the canteen and give the scrap of paper, I get a cup of coffee or tea or badaam milk worth Rs. 5 ! Shopkeepers periodically give chocolates worth Re. 1 or Rs. 2. Currency is an extended version of bartering. The original concept was that the government kept gold equivalent to the currency coins and notes it produced. In practice, by the time the twentieth century dawned, there would not have been enough gold for all the currency that was in circulation in the world. Thus, the currency is more a matter of trust. http://www.phrases.org.uk/meanings/40500.html indicates how the phrase "good as gold" is linked to this historic meaning of the currency. http://inventors.about.com/od/mstartinventions/a/money.htm indicates that the "gold standard" was prevalent in the nineteenth and twentieth century. Later, it was a government decree that has provided currency notes and coins its value. Thus, each currency note or coin is, in a sense, guaranteed by the government, though it may be just paper ! This is why counterfeit money or fake currency is such a problem. Obviously, the government cannot "guarantee" such money. If that were possible, I would be happily printing my own Rs. 1000 notes ! Any way, currency evolved over many years and was used for trading. So, now if I wanted a pair of shoes and I had money (currency represents money which is my own loose definition about the difference between the two), I could give you the money. If you had a desperate need for gloves later on, you could give some of that money back to me to buy the pair of gloves. Thus, money and currency provided a means for trade, over the ages. This brings us to the "supply and demand" concept. Supply and demand is the foundation of a market economy. To me, it is about the value of a particular product or item. If I was walking barefoot and I knew that a stretch of hot burning road was ahead of me, I would want a pair of shoes badly. So, in that case, if I had enough money, I would be willing to pay extra ("premium") simply because of my need. If there were a 1000 other people in a similar situation as me, the shoe manufacturing industry (="you" !) would experience a big "demand". The implicit idea here is the value of a product. Circumstances determine the value of a product. A shoe would be worthless to me, if I knew I would always be walking on cool grass ! Otherwise, due to the demand, shoe production would also increase until an equilibrium between supply and demand is reached. The interesting part is that the equilibrium is rarely static. It appears that of the 1000 people, there are always some persons who want to walk on the hot burning road and need pairs of shoes desperately ! Now, I may have used rubber from trees to make the two pairs of gloves, while you may have used leather to create the two pairs of shoes. Both of us are producers and also consumers. If you know that I am willing to pay more for the pair of shoes, you end up with a profit. If there are only two of us, you could use the money to either show off or choose to invest in tools that would increase your profitability. If you do choose to show off, you may want to buy a dress, which means that the dressmaker may end up with a profit. Alternatively, you may want to buy the soft gloves that I have, which means that some of your profit also comes back to me ! Thus, it is all a cycle and ultimately it is Mother Earth who bears the brunt of our prosperity. Hopefully, if both of us are sensible, I will plant trees that will continue to give me rubber and you will rear cows that will give you leather. This is the concept of "sustainable development". Otherwise, we would be killing the proverbial hen that lays the golden eggs and both of us would be losers ! This is what is happening in trade, on a global scale also. Countries are producing goods and also services. India's expertise in medical knowledge and software is an example of services. Loosely, products can be felt (cars, computers) while services improve life or make life convenient (think of hotels, insurance, medical check ups, etc.). China produces manufactured goods like toys, textiles, etc. while America consumes such products. India has its software expertise that America again requires, along with European countries too. Thus, the supply and demand scenario plays itself out in a grand scale here. A government of a country has to manage its affairs (roads, law and order, etc.) for which it requires money. It gets this money through taxes (among other means). At an individual level, if you charge Rs. 100/- for the pair of shoes and I have only Rs. 80/-, I may borrow money or tell you that I will pay the remaining Rs. 20 later (next month). If I choose the first option of borrowing money and you trust me, I end up at an individual level with what would be called by governments as a "fiscal deficit". According to http://lexicon.ft.com/Term?term=fiscal-deficit/surplus, the amount by which government expenses exceed income is the fiscal deficit. I believe that most governments have such fiscal deficits. They make up the difference by issuing government securities. This is like a glorified version of an IOU ("I owe you") note which you may ask for, when I borrow money from you. http://www.businessdictionary.com/definition/government-securities.html defines government securities as bonds, notes, and other debt instruments sold by a government to finance its borrowings. These are generally long-term securities with the highest market ratings. The return from such securities is lower in terms of percentage but it is almost assured and risk is minimal. There are other types of deficits. If a country imports more than it exports, it incurs a trade deficit. In this case, the balance of trade for the country is negative. This means that the country cannot produce all that it requires. Now, to pay for the extra imports, the country requires money. Producers (other countries) can provide this money, which would have to be repaid. This is analogous to the situation where I ask you to give me Rs. 20 so that I can buy the Rs. 100 worth pair of shoes from you ! The catch is that in the next month, I would have to give you Rs. 25 (=25% interest) ! For a country, this situation leads to a current account deficit, which occurs when a country's government, businesses and individuals imports more goods, services and capital than it exports. In India today, the current account deficit is high. The supply and demand idea is another factor that is responsible for the high price of the dollar in rupee terms. Currently, in India, industries expected certain financial policies and decisions which have not been taken. Industrial production has declined and so the financial markets have reacted by reposing faith in the dollar. Since more dollars are being bought, the rupee is plunging and currently one dollar is worth around Rs. 55. Supply and demand played a role in the 1929 Great Depression. In the first world war, European countries went away from the gold standard while America continued to use it. So, a lot of gold was concentrated in the US at that time. After the first world war, Great Britain also returned to the gold standard and other European countries followed. The French currency franc was undervalued (it looks like the equilibrium was upset in a big way here) and so, French exports were less expensive. The French government and the Roosevelt government in USA made a couple of mistakes : France did not expand its money supply and the US raised its interest rates. These mistakes ultimately resulted in what we now know as the 1929 Great Depression. http://www.econlib.org/library/Enc/GreatDepression.html explains the situation in far greater detail. This brings me to the question I started this blog with : just what is a recession ? The answer as stated in http://www.businessdictionary.com/definition/recession.html is : a period of general economic decline, defined usually as a contraction in the GDP for six months (two consecutive quarters) or longer. Marked by high unemployment, stagnant wages, and fall in retail sales, a recession generally does not last longer than one year and is much milder than a depression. The causes of a recession are not specific. A prolonged recession is a depression, like the 1929 Great Depression. The first recession that I experienced was in 2001, as stated earlier. According to http://www.usatoday.com/money/economy/2003-07-17-recession_x.htm, the 2001 recession lasted 8 months. Possible causes of the reception are captured in the web site http://useconomy.about.com/od/grossdomesticproduct/a/cause_recession.htm : * Irrational exuberance (read: "hype") about tech companies was one factor. The Y2K threat had passed over and the dust had settled, so to speak. All the investment that went in to IT meant that there was an oversupply of hardware and software companies. The bubble burst in 2001. In India, Satyam purchased Indiaworld.com, a web site for a whopping Rs. 499 crores, which was unprecedented at that time. * High interest rates led to lesser money to invest in America. After 2001, there was a period of steady growth in Asian and African economies. China firmly established its position as the producer for the world. From 2003 to 2007, China recorded double digit growth in its GDP, increasing year-on-year, as seen in https://www.uschina.org/statistics/economy.html. Meanwhile, the US saw jobless growth, which was probably one indication of things to come. Probably, the people who had jobs earned more, since the GDP growth was significant in this time. The paper http://ftp.iza.org/dp4934.pdf has more information about the causes behind the 2008 recession. Due to the growth in wages in America, home loans were provided indiscriminately. This is the beginning of the "irrational exuberance" phase. The credit worthiness of the borrowers was not checked. Further, the lenders sold mortgaged property to other financial institutions. US government sponsored enterprises issued mortgage based securities. Further, these institutions transferred loans to structured investment vehicles (SIVs). SIVs were split into three types, which ultimately led to collateralized debt obligations (CDOs). Since the basis for these CDOs was suspect (indiscriminate loans), the situation eventually resulted in what is termed as the sub-prime crisis. The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. As a result, a significant rise in foreclosures led to the collapse of many lending institutions and hedge funds. The financial crisis in the mortgage industry also affected the global credit market resulting in higher interest rates and reduced availability of credit. So that was the story of the 2008 recession ! The world economy appeared to recovering by the end of 2009, but it was a false dawn. GDP growth can be seen at http://databank.worldbank.org/Data/Home.aspx after selecting "World" as a country and choosing years from 2000 to 2011. Few economists predicted a double dip recession in September 2011 as seen in http://www.thefiscaltimes.com/Articles/2011/09/02/AP-Economists-Predict-Second-Recession.aspx#page1, and that is indeed what has happened. The starting point for this recession is in the common European currency called the Euro. The Euro was created in January 2002. The countries in the European Union that use the euro are: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Euro area member states have a single currency, a common interest rate, and a common central bank (European System of Central Banks.) It is the largest monetary replacement the world has ever seen. The euro is administered by the European System of Central Banks (ESCB), which is comprised of the European Central Bank (ECB) and the Eurozone central banks. In the period from 2001 to 2007, a lot of money came into Europe from the developing nations. To get greater yield, few of the European countries chose risky options. In Ireland, it was property, while the money went into pay and pension benefits in Greece. Money from the richer European countries (Germany, France) flowed to the poorer ones (Greece, Portugal, etc.) Once the bubble burst in Ireland and Greece, Europe was in a dilemma. Should it fund Greece or should it cut spending ? Europe chose both options and cut spending, which are the "austerity measures" it has taken. The ECB increased interest rates in April 2012. Higher interest rates imply that there is lesser money circulation. The famous economist Paul Krugman feels that "austerity measures" was a mistake as seen in http://economictimes.indiatimes.com/features/investors-guide/austerity-for-all-formula-killing-the-euro-paul-krugman/articleshow/10971276.cms?curpg=1. From 2010 onwards, Greece was forced to adopt austerity measures, which its people resented. GDP growth plummeted in 2011 (-6.9%). In February 2012, the EU, IMF (International Monetary Fund) and ECB granted 130 billion Euro package, provided Greece agreed to additional austerity measures. This has led to discontent among the Greek people and also among Germans, since they feel that their money is unnecessarily being spent on an unworthy cause (Greece). Since Europe has its own house to put in order, this would affect its foreign trade. There would be lesser money that would go to other countries like India. Hence, Pranab Mukherjee stated that the Eurozone crisis has affected India also. So there is some truth in what Pranabda has said ! In the last couple of days I read a lot of useful web sites that explained to me what some economic terms mean. I have few inferences to make ! First, recession and expansion are a fact of life. These cycles keep happening. At an individual level, it is good to have savings. My analogy is that of strengthening a boat. A rough tide and strong winds would still cause the boat to sway, but if it is sound enough, it will stay afloat. Second, considering the supply and demand scenario, when people are selling, I should be buying and when they are buying, I should be selling. So, if I have enough savings, as discussed earlier, this woud be possible. This is what the oracle of Omaha, Warren Buffet says, as seen in http://www.investinganswers.com/education/famous-investors/50-warren-buffett-quotes-inspire-your-investing-2310: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." The other quotations are also worth studying in that web site. Third (this contradicts my second inference to some extent), excessive greed is bad. It can eat my savings in the times of irrational exuberance ! Fourth, for any country to prosper, we have to examine what value we can provide. In years to come, my prediction is that energy (electric power, solar power, alternative fuels for cars) and telemedicine (diagnosis using smartphones and apps) are areas that will become more important. In the end, I feel "value" is an important concept, even more than supply and demand. What I value defines what the world produces, whether it is in economic or even moral terms. So, if I want a super energy efficient car, this represents value in economic terms. What is also implicit in these values are moral values of equity and sustainability ("super fuel efficient"). Over the last 10 hours or so when I wrote this blog, my understanding of economics has improved. I feel pleased that I decided to write this blog. I am sure my understanding of some issues may be challenged. I would welcome any comments and discussion on the blog or via email or chat.