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Where Do Recessions Come From?

11.20.2019

Recession. Even the word can be scary to some people. But what if the mystery was taken out of how recessions happen? The causes of a recession are easy to identify and are anything but random.

The Credit Cycle

Scenario:

A person makes $100,000 a year and needs a loan.

They approach a bank that loans them $10,000.

That money then goes into the economy and becomes someone else’s $110,000 income.

Then, the person who makes $110,000 a year and needs a loan.

They approach a bank that loans them $20,000.

That money then goes into the economy and becomes someone else’s $130,000 income.

Then the person who is making $130,000 a year needs a loan … you get the picture.

At some point, all of this borrowing and lending will hit a natural limit. That’s when the Federal Reserve steps in. The Federal Reserve tracks this cycle. It raises interest rates when they become too low, when people and banks are being too aggressive with borrowing and loaning, and when people are receiving loans who shouldn’t be.

Higher interest rates cause higher payments on debt that many people cannot afford. Banks will no longer give as many loans because people will no longer qualify at the higher interest rate. In a nutshell, higher interest rates mean that a much smaller pool of people can borrow money.

Being rejected for a loan is a big problem for people who now can’t borrow to refinance something that they already spent money on. In some cases, people will lose their homes, have to file for bankruptcy, etc. These people are no longer spending money and contributing to the economy on the same scale as they did in the past.

At this point, the cycle begins to go the other way: 

Someone’s $140,000 a year job disappears, and there’s only a $125,000 job to replace it. Then that job disappears, and there’s only a $110,000 job in its place, and so on.

People who lose their jobs and can’t find another one spend less money, which means someone else isn’t making their usual income. Eventually, they too may lose their job or go out of business. The cycle winds down until we end up in a recession

Recession and the Stock Market

A recession has a massive impact on the stock market. Why? A recession winds down both personal and corporate income.

When people are buying less, then there is less revenue in corporations that haven’t yet adjusted their cost structure. These corporations stop making money. Some even fail and go bankrupt.

When growth is once again under control, the Federal Reserve lowers interest rates. And the cycle starts over! 

What This Means For You

First, you can take comfort that Pinnacle Bank is a responsible and knowledgeable bank. We pride ourselves on the guidance we give to everyone who banks with us and encourage our patrons to make conscientious decisions with their money.

Finally, a recession can mean an opportunity to buy stock “on sale.” When the market rebounds, your investments will become profitable.

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