What happens in a recession, and how can you prepare?

The period from 2007 to 2009 is now known as the “Great Recession.” During this time period, the stock market crashed, millions lost their jobs, housing prices dropped off a cliff, and the financial situation of most households in the U.S. got much worse.

The next recession may not be so intense. In fact, many recessions are mild compared to what we saw in 2007-2009.  But another recession is almost certain to happen at some point — we just don’t know when. Recessions are a normal part of the economic cycle, but they can certainly disrupt our lives and our finances.

What happens in a recession? And how might you prepare for a potential recession?

What is a recession?

The simplest definition of a recession comes from the National Bureau of Economic Research:

“[A recession is] a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”

Economic activity refers to everything involving an exchange of money. That could be a consumer buying something, a business paying an employee, a firm investing in a new project, or even an investor buying a rental property.

So, a recession is when economic activity slows down — for at least a few months.

Some define a recession as a decline in economic activity (measured by gross national product or gross domestic product) that lasts at least 2 consecutive quarters (or six months). But even this definition is widely debated!

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In short, a recession is when economic activity declines for a period of more than a few months.

Is a recession coming in 2023 or 2024?

There’s been a lot of talk in the news about a potential 2023 recession. Is it going to happen?

The truth is that nobody knows for sure. Economists are roughly split on the matter, with 53% of surveyed economists putting the odds of a recession in the next 12 months at 50% or less.

Some warning signs are certainly there: Inflation is rampant, the housing market is slowing, and interest rate increases are putting a strain on industrial production and corporate investment. We’ve also seen mass layoffs, particularly in the tech industry.

We don’t know for sure whether a slowdown will happen. However, the current economic situation certainly warrants some caution. It’s a great time to learn more about recessions and how to prepare.

What happens in a recession?

During a recession, economic activity declines and the economy as a whole contracts. Economists measure economic activity in a number of ways. Typically, here’s what happens during a recession:

• A drop in gross domestic product (GDP), which is the total monetary value of all goods and services produced in the U.S. in a given year

• An increase in the unemployment rate

• A decrease in household income/earnings

• A decrease in corporate earnings/profits

• Slowing industrial production

• A drop in consumer spending/retail sales

• A decrease in asset prices (stocks, real estate, etc.)

Put simply, everything slows down during a recession. Less money changes hands, consumer demand drops, household incomes decline, asset prices decline, and the entire economy slows down.

Of course, the extent of a recession can vary a lot. A mild recession might just mean that businesses invest a little less, households cut back on spending a bit, and a handful of industries have layoffs. But a more significant recession can cause a huge drop in real GDP, mass layoffs, a stock market crash, and other major economic disruptions.

When a recession occurs, the government will typically respond by shifting monetary policy via the Federal Reserve (the Fed) or via new legislation from Congress. While recessions are normal, the government often steps in to soften the blow. 

For instance, they may cut interest rates to encourage businesses and individuals to borrow and spend more money, or they may boost unemployment insurance programs to keep more money in people’s pockets after job losses (as they did in the brief 2020 recession).

The U.S. economy is massive (the biggest in the world, in fact!) and economic recessions are complex. There’s a lot of stuff going on behind the scenes — but for everyday people, what should be done to prepare?

How to prepare for a recession

We don’t know for sure whether or not a recession is coming. But it never hurts to be prepared — and really, most of the tips below will help your finances even if economic growth continues.

Here are some things to consider tackling now to prepare for a potential recession.

Build an emergency fund.

An emergency fund is a chunk of change set aside for — you guessed it — emergencies! This money could be used for an expected expense, like a car repair, but it could also be used to replace lost income should someone in your household lose their job.

Experts recommend having three to six months of basic expenses saved in an emergency fund. If that’s not possible, aim to save as much as you can — and park your funds in a savings account so you can earn some compound interest.

Assess your financial situation.

It’s wise to take a bird’s eye view of your entire financial situation. This is a good practice for general financial wellbeing, but it’s particularly important if a recession may be on the horizon.

During this process, you can take a look at your monthly spending, total income from all your income sources, and the progress you’re making toward your financial goals (both short-term goals like building an emergency fund and long-term goals like saving for retirement).

If you have kids, now is a good time to include them in family financial discussions — and to help them get a handle on their own money management. Greenlight is an all-in-one money app for teens and kids that helps them and parents work together to learn money management skills by saving, spending, investing, budgeting, and more. 

Make a contingency plan.

Once you have a handle on your current financial situation, you can start planning for future variables. What happens if you lose your job? How long could you make ends meet with your savings alone or with income from other household members?

During this stage, it’s also wise to make two budgets: a standard budget and a “bare bones” budget. The latter should be only the bare minimums that you need to get by. It’s helpful to know your base expenses, because if you do face a job loss, you’ll want to cut back on all your optional spending categories. And knowing what those categories are — and how much of your normal budget they account for — is quite useful!

Involve the whole household.

Money can feel like a highly individual thing — but if you share a home with other people, it’s a good idea to include them in your financial plans. Whether that’s chatting with your partner, your kids, or even your roommates, it’s wise to have everyone on the same page, particularly when you’re preparing for a potential economic downturn.

If you have children, this is a good time to start talking about money at home. Studies have shown that children from homes that discuss money openly have better financial outcomes in young adulthood. Plus, if a recession does occur, you may have to make some changes in your spending patterns — and giving your kids a heads up doesn’t hurt.

Tip for parents: Greenlight is a money app for kids and teens that helps teach financial literacy and money management skills. Kids and parents can work together to start saving, managing money, and even investing for the future.

Reconsider your financial priorities.

We all have various financial goals. Maybe you’re focused on paying off debt or saving for retirement. Maybe you’re just hoping to break out of the paycheck-to-paycheck cycle and have a little financial cushion.

Whatever your goals may be, this is a wise time to reassess and plan out your future priorities. For instance, saving for retirement is a worthy goal — but if you don’t yet have an emergency fund, you might want to shift a bit of your monthly savings toward short-term savings.

Don’t make any major investment changes.

When a recession strikes, the stock market often takes a downturn. This can be short term or evolve into what’s known as a “bear market” (when a stock market index falls by 20% or more).

If you have investments, you might think it’s a good idea to sell them or to shift into less volatile asset classes. While this is a logical line of thinking, the unfortunate reality is that it’s really difficult to predict what the stock market will do or when a recession might occur.

Ultimately, investment decisions should be made mindfully and carefully — and fit into your long-term plans. Try not to let short-term market fluctuations affect your long-term financial goals! If you want personalized advice, it’s a good idea to consult with a fiduciary financial advisor.

Be prepared for an economic downturn

During a recession, economic activity slows, which can lead to job losses, declining asset prices, reduced spending, and more. Recessions are normal, and occur often — but we simply don’t know when the next recession will happen. With that said, it’s a good time to assess your financial situation and prepare for any potential bumps in the road.

To learn more about personal finance topics, read through the Greenlight blog. And for your kids, try Level Up, the financial literacy game for kids and teens — with a best-in-class curriculum, educational challenges, and rewards that keep them coming back to learn more.