A recession is a broad, sustained decline in economic activity—typically marked by falling GDP, rising unemployment, weaker consumer spending, and declining business investment. A common rule of thumb is two consecutive quarters of negative GDP growth.

Economists study recessions across fields like macroeconomics, and while no two recessions are identical, most are driven by a combination of recurring underlying forces.

Here are the main causes:

Tight monetary policy (rising interest rates)

One of the most common triggers is aggressive rate increases by a central bank such as the Reserve Bank of Australia.

Why it happens:

• Central banks raise rates to fight inflation

What it does:

• Makes borrowing more expensive
• Reduces household spending (especially mortgages)
• Discourages business investment

If rates rise too far or too fast:

• Demand drops sharply
• Businesses cut back
• Unemployment rises

This is often called a “policy-induced recession.”

Demand shocks (collapse in spending)

Recessions frequently occur when consumers and businesses suddenly stop spending.

Causes include:

• Loss of confidence
• Rising unemployment
• Falling asset prices (like housing or shares)

Since consumption is a major part of GDP:

• A drop in spending quickly spreads across the economy
• Businesses earn less → cut jobs → further reduces spending

This creates a negative feedback loop.

Financial crises and credit crunches

Problems in the financial system can trigger deep recessions.

What happens:

• Banks suffer losses (e.g., bad loans)
• Lending tightens or freezes
• Businesses and households can’t access credit

A classic example is the Global Financial Crisis.

Why it’s powerful:

• Modern economies rely heavily on credit
• When credit dries up, economic activity slows abruptly

Asset bubbles bursting

When prices of assets (like housing or stocks) rise far above their fundamentals, they can eventually collapse.

Examples:

• Housing bubbles
• Stock market bubbles

When they burst:

• Household wealth falls
• Confidence drops
• Spending declines

In housing-heavy economies (like Australia), this can be especially important because:

• Households feel poorer
• Construction activity slows
• Banks may face losses

External shocks

Some recessions are caused by unexpected events outside normal economic cycles.

Examples:

• Pandemics (e.g., COVID-19)
• Wars or geopolitical conflicts
• Natural disasters
• Sudden spikes in oil or commodity prices

These shocks can:

• Disrupt supply chains
• Reduce production
• Increase costs
• Cut global trade

Supply shocks (cost-driven recessions)

Not all recessions come from weak demand—some come from rising costs.

For example:

• Oil price spikes
• Supply chain disruptions
• Labour shortages

This leads to:

• Higher production costs
• Lower profit margins
• Reduced output and hiring

This combination of inflation + weak growth is often called “stagflation.”

High household or corporate debt

Excessive debt makes an economy fragile.

Why:

• Households must spend more on repayments
• Businesses become cautious
• Small shocks (like rate rises) have bigger effects

When debt levels are high:

• Even modest interest rate increases can sharply reduce spending
• Defaults can rise, stressing the financial system

Policy mistakes (beyond interest rates)

Governments and regulators can also contribute to recessions.

Examples:

• Cutting spending too quickly (austerity)
• Poorly timed tax increases
• Weak financial regulation leading to instability

Sometimes recessions happen not because of one bad decision, but because multiple policies interact poorly.

Global contagion

In a globalised world, recessions can spread between countries.

For example:

• A slowdown in major economies reduces export demand
• Financial market stress spreads internationally
• Capital flows reverse

Australia, being trade-dependent, is particularly exposed to:

• China’s economic cycle
• Global commodity demand

Psychological and expectation effects

Expectations themselves can cause or worsen recessions.

If people believe a recession is coming:

• Consumers cut spending
• Businesses delay investment
• Banks tighten lending

This is sometimes described as a self-fulfilling downturn.

Lauren Hua is a private client adviser at Fairmont Equities.

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