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The Economy Might Be So Much Stronger Than You Think

The worst part about trying to study the economy is that no one really has any idea what's going on, ever. The metrics we have at our disposal are, at best, intelligent guesses, and flawed by theoretical error.

Late last year, I interviewed a great investor, Rob Arnott, who pointed out a flaw in the most popular economic metric, gross domestic product:

GDP is a terrible measure. It measures spending, not prosperity. So the family with the BMW, their GDP, GFP, Gross Family Product, just soared because they just spent money they didn't have. To the extent that we're engaged in deficit spending, we're spending money that we don't have. We're creating an illusion of prosperity that has consequences. That debt has to be paid back eventually and it leads to a lowering of future GDP in order to bolster current GDP, and puts us on a trajectory for really disappointing GDP growth in the coming decade.

This is smart. If the economy is fueled by rising debt, then growth today comes at the expense of tomorrow.

I asked Arnott which metrics he prefers. He responded:

I like looking at GDP net of new debt, because just as a family buying a car they can't afford makes them feel prosperous, it's phony prosperity. The same holds true for a nation that's on a consumer credit binge or that's on a government spending binge. You create phony GDP, which will disappear, and when it disappears, you feel the consequences.

Some would quibble that when the proceeds of debt are invested wisely -- a smart business expansion, or a new highway -- future growth prospects rise. But let's leave that aside for a moment and run with the idea that the best way to measure economic growth is GDP minus new debt.

Most, I think, would assume that doing so would make current GDP growth look worse than it's been reported. But it's actually the other way around. One of the most important statistics of the last five years is that total debt throughout the economy has declined in real terms (adjusted for inflation, the same way GDP is calculated). Yes, the federal government is running huge deficits. But consumers, businesses, banks, and local governments have been shedding an unprecedented amount of debt. Add it all up, and you get this:

Source: Federal Reserve, "Total Credit Market Debt Owed," adjusted by CPI All-Items. Y-Axis doesn't start at zero to better show change.

Since peaking in the first quarter of 2009, total debt throughout the economy has declined in real terms by $2.7 trillion, from $58 trillion to $55.3 trillion. GDP is currently $15.8 trillion, so the decline in real debt isn't insignificant. It's 17% of the economy over four years. To be logically consistent with Arnott's favorite metric, that amount should be added back in to today's GDP figures to get a true sense of growth.

There's some more quibbling to do here, since the decline in debt we're experiencing today is the flip side of an unsustainable debt boom last decade. We have to live below our means for as long as we lived above our means until a healthy balance is reached. And since we probably haven't reached that balance yet, adding the debt decline back into GDP masks a necessary adjustment. We are shedding debt because we need to be.

But these numbers highlight two important points.

One, it should be no surprise that the economy is in a funk. Growth isn't slow because we've lost our ability to innovate, or some vague reference to "uncertainty." It's slow because we're in the middle of the first debt deleveraging since the Great Depression. Just as a buildup of debt artificially juices the economy, working it off slows the economy down below its potential -- that was Arnott's entire point. "When it disappears, you feel the consequences," he said. That's us! Today! We're feeling the consequences! That's why we have 7.9% unemployment. It's actually amazing that we've been able to slowly grow the economy and bring down unemployment over the last four years all while deleveraging. Historically, debt deleveragings are characterized by economies collapsing into utter depression. We haven't. Hedge fund billionaire Ray Dalio says we're experiencing "the most beautiful deleveraging on record."

Two, the end of deleveraging could be a big boost to the economy, and will ultimately be how we get back to normal growth. Debt as a share of GDP has declined every year since 2008. If that metric simply went flat, economic growth would be about a percentage point higher per year than it currently is. The blog Calculated Risk has shown that if people weren't using their homes as ATMs last decade, the economy would have been in or near recession for most of the 2002-2006 period. As a corollary, if people weren't paying down as fast as they can today, we'd be closer to normal growth. The economy, in other words, might be stronger than you think. 

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  • Report this Comment On February 15, 2013, at 11:29 AM, Schneidku40 wrote:

    Very interesting article. Ever since the federal government went on their debt-fueled spending spree four years ago I've wondered how debt levels affect GDP (either artificially inflating it or lowering it).

    Since private sector debt has been going down, could this be part of the explanation of why inflation hasn't been an issue? All the talk of the fed printing money for the federal government that should be causing inflation, but no talk of how individual/company debt must be going down even faster than government debt is going up, according to your chart.

  • Report this Comment On February 15, 2013, at 11:32 AM, TMFMorgan wrote:

    ^ Yes. A lot of the deleveraging has been at the financial sector level, which helps explain why inflation hasn't taken off despite QE-infinity.

  • Report this Comment On February 15, 2013, at 1:33 PM, slpmn wrote:

    I like Arnott's notion. Basically, the debt fueled GDP growth of 2000-2007 borrowed from 2008-Present GDP growth. And you're right, it's actually really impressive that we've managed sluggish growth at all during a period of massive private deleveraging, because historically, those have been catastrophic.

    I would add that it's not by chance. The economy has been propped up by the dual forces of massive government deficit spending and the artifically low interest rates of the Ben Bernanke Fed. What remains to be seen, however, is the outcome. Does this have a happy ending or do we drown in debt and inflation? Are the government and Fed policies nuturing us back to health or prolonging and exacerbating the inevitable? Would it have been better to just "tear the band-aid off" in 2008?

    I'm pretty firmly in the camp that argues we're in a sustainable long term recovery.

  • Report this Comment On February 15, 2013, at 1:53 PM, mdk0611 wrote:

    How much of that post-2008 decline in debt is due to default and discharge? A very negative form of deleveraging. And with the rise in government debt, default (other than highly temporary) and discharge is almost inconceivable. Inflating their way out of it, on the other hand..........

  • Report this Comment On February 15, 2013, at 3:26 PM, TMFJCar wrote:


    Great article. It is simply foolish (small f) to compare today's GDP to housing boom GDP. Demand was pulled forward by borrowing on unsustainable "paper-gains" of an unchecked bubble.

    Fool On!


  • Report this Comment On February 15, 2013, at 6:05 PM, Landsman55 wrote:

    Another great Morgan Housel article. You would assume that "the most beautiful deleveraging ever" has been made possible by Ben Bernanke since his educated view is that central banks must be the mechanism of liquidity during a period of mass deleveraging.

    I guess the question that remains is, even though we have had net deleveraging since 2009 with central bank money printing, what is the effect on the economy when it is time for the Fed to bring its balance sheet back to a "normal", even assuming that inflation is necessarily an outcome and the Federal government must bring the bational debt back to some reasonable percentage of GDP.

    As an investor these issues concern me while at the same time I recognize that it may be useless to account for factors that are unknowable as to their outcome.

  • Report this Comment On February 15, 2013, at 6:07 PM, Landsman55 wrote:

    meant to write assuming inflation is NOT necessarily an outcome to my prior post

  • Report this Comment On February 15, 2013, at 6:42 PM, xetn wrote:

    I don't understand your numbers on debt. If you look at the US National Debt Clock, I don't see much debt going down.

    And it appears that the Federal Reserve is buying most if not all of the US debt by creating massive amounts of money out of thin air. How does that make things better? By their actions, it screws lenders (by getting paid back with cheaper dollars) and it screws savers because they get NO return.

    If you remove the "G" from GDP where is the economic growth?

  • Report this Comment On February 15, 2013, at 6:48 PM, Kiffit wrote:

    Still seems that there is an awful lot of deleveraging to do to get back to 2005 levels and a that the current trend line is flat, indicating perhaps it is stuck where it is.

  • Report this Comment On February 15, 2013, at 7:02 PM, TMFMorgan wrote:

    <<If you look at the US National Debt Clock, I don't see much debt going down.>>

    I'm clear about what figures I used here: It's Total Credit Market Debt Outstanding (the broadest figure of debt) adjusted for the CPI all items index.

    Two things about US Debt Clock: There is no way you can calculate debt movements down the hundredth of a second, so those are effectively made up numbers -- most credit figures are only updated every quarter. And whatever figures it's using are in nominal terms, not adjusted for inflation. If you're one of the people who think CPI under-reports inflation, then the real deleveraging we've experienced has been much greater than my chart shows. If you believe ShadowStats' rate of inflation, then we've deleveraged far past pre-2002 levels.

  • Report this Comment On February 16, 2013, at 12:38 AM, whereaminow wrote:


    You become a bigger State worshipper every day.

    This "deleveraging" is a fancy way of saying "intervention" in the market-clearing process. And like the Great Depression, it has served to hamper the necessary readjustments.

    I challenge not only you, but any of your readers to find one instance in American history with the following parameters:

    1. A bubble burst

    2. There was no intervention, either by a central bank or the government


    3. The resulting economic depression/recession lasted more than 2 years.

    You won't find one because in every instance in American history when the market was allowed to correct itself, it did so.

    So you can have your deleveraging. As xetn smartly noted, it's just the Fed assuming the debt, which ultimately lands right back on the shoulders of the tax payers.

    I'll take the market, which would have cleared out this mess in 18 months.

    Did you know that under the policy of laissez faire, unemployment was historically in the 2-3% range? Amazing right? Just imagine if it was the other way around. State worshippers like you would scream bloody murder.

    David in Liberty

  • Report this Comment On February 16, 2013, at 5:38 AM, Repurposed wrote:

    1. Good article. Good thoughts!

    2. "The Economy Might Be So Much Stronger Than You Think". That might be the only conclusion not sustained by data (don't you just love headline writers?). If non-intervention would have resulted in a recession from 2002-2006, what will the current deleveraging ultimately do? Lower margins? Higher taxes? Lower federal spending? More corporate jobs but lower productivity? None of these are good for the economy short term (5 years) unless you do believe that it IS time to pay the piper.

    3. I actually do agree that we don't have a bubble. But bloated isn't very good either for the economy or business. And that doesn't portend great results in the overall stock market -- here. And we likely won't be able to sell our way to prosperity through other economies who have similar trouble.

    4. Just as "shadow statistics" shows higher inflation, it misses unreported revenue and debt. Off the books cash-for-work still exists and family assistance I would venture is quite high. These delay retirement and impact savings. Plus, the boomers are retiring (that's me). As someone said, if you're going outside of "official" figures, I'd guess less deleveraging and more debt, not more.

    5. We are cursed to live in interesting times. Please do keep writing about them.

  • Report this Comment On February 16, 2013, at 11:38 AM, SPARTANBURG wrote:

    It seems that Mr. Bernacke sees the economy or estimates that the economy works as a seesaw. That is the more debt that the government incurs the more (in this instance) debt is retired by the private sector. I don't know if he and his team are that smart but he is now watching for a turning point where the private sector would be upping their debt load so he can bring the national debt to a more "normal" size. Of course since national debt and the size of the economy are living, breathing things errors could be made big time. A few variables that are certain are that we'll have more pensioners and higher health costs, need more guns to protect our interests and politicians will never change their ways of spending as much as they could get away with.

    Regardless, and despite my laissez faire character, I really liked the article and the notion that GDP net of new debt is a more real statistic. Absolutely loved it.

  • Report this Comment On February 16, 2013, at 1:48 PM, crca99 wrote:

    Five stars. GDP as spending and GDP minus new debt as concepts are new for me, and I think I understood. Shall we assemble Congress and try to teach them too?

  • Report this Comment On February 17, 2013, at 12:27 AM, 2motley4words wrote:

    Morgan, even when I'm not in complete agreement with your remarks (which occurs infrequently---and likely as not because I've had suffered a mental lapse), I find them to be provocative---in the positive sense of being thought-provoking---and therefore always worth reading. What I find equally impressive is the equanimity with which you reply to those ideologues whose (recurrent) cavils are based on an incomplete reading---or perhaps willful misreading---of your articles.

  • Report this Comment On February 17, 2013, at 4:54 AM, hbofbyu wrote:

    When I was small, my grandfather explained to me how the government went into his fields and shot his cows to help get us out of the depression (Agricultural Adjustment Act of 1933).

    Even a 5 year old mind understands the stupidity of such a thing.

    Before validating the genius of Bernanke keep in mind that government has been wrong about every major economic development of the past 20 years and rather than foresee the internet bubble, Greenspan helped fuel it. Rather than foresee the housing bubble, the Community Reinvestment Act and Fannie Mae and Freddie Mac ran wild. And we were told everything was fine and contained right before Lehman went bankrupt.

    We have too much toleration of, and even positive demand for, risky collectivist schemes, entitlement programs no one can pay for, protection from the rigors of market competition, and most of all the belief that if you make things complicated enough you will somehow get something for nothing (or at least keep the masses in the dark).

    We could be treading water for the next 10 years.

  • Report this Comment On February 17, 2013, at 9:48 AM, JeffParrel wrote:

    Great article.

    It is in a good agreement with the aqrticle published on December 27:

    We see also the incredible decline in housing inventory, which will help the market recover.

  • Report this Comment On February 18, 2013, at 5:11 AM, kyleleeh wrote:

    @David in Liberty

    In the last 100 years the great deppresion has been the ONLY recession that lasted more then 2 years. Even this last one was over in 18 months.

    But since you asked here you go:

    1815–21 depression:Shortly after the war ended on March 23, 1815, the United States entered a period of financial panic as bank notes rapidly depreciated because of inflation following the war. The 1815 panic was followed by several years of mild depression, and then a major financial crisis – the Panic of 1819, which featured widespread foreclosures, bank failures, unemployment, a collapse in real estate prices, and a slump in agriculture and manufacturing

    late 1839–late 1843 recession:This was one of the longest and deepest depressions. It was a period of pronounced deflation and massive default on debt. The Cleveland Trust Company Index showed the economy spent 68 months below its trend and only 9 months above it. The Index declined 34.3% during this depression.

    1882-85 recession:From 1879 to 1882, there had been a boom in railroad construction which came to an end, resulting in a decline in both railroad construction and in related industries, particularly iron and steel.

  • Report this Comment On February 18, 2013, at 1:33 PM, SkepikI wrote:

    ^ The reliability of economic statistics from the 19th century is substantially less reliable than those of the 21st century, which are not reliable at all. Its unfortunate, but they are the best "data" we have.... our biggest problem was and is the intervention of fumbling, blind giants at exactly the wrong time with less than perfect action. The amount of waste, fraud and counterproductive activity by our illustrious government has been the biggest anchor on recovery...billions set on fire would have been less damaging than billions in the hands of crooks, scamers, and wastrels. Albert Einstein said it well - "we cannot solve our significant problems at the same level of thinking we were at when we created these problems."

  • Report this Comment On February 18, 2013, at 1:37 PM, SkepikI wrote:

    Morgan: A very good think piece, but I have to note that your first two lines are the best summary of economic truth I've seen in recent times. I'd like to quote it from time to time?

  • Report this Comment On February 18, 2013, at 4:51 PM, ynotc wrote:

    While you are correct that we could have gone into free fall with deleveraging it would be over much quicker.

    Government deficit spending caused a much slower deleveraging. The result is that the public stiill has to pay more debt down via taxes but they did not get direct where that money was spent.

    The net result is that we still owe money

  • Report this Comment On February 18, 2013, at 6:22 PM, CMFTomBooker wrote:

    "The worst part about trying to study the economy is that no one really has any idea what's going on, ever. The metrics we have at our disposal are, at best, intelligent guesses, and flawed by theoretical error."

    That doesn't mean many won't continue to believe they can figure what is going on. In fact, many believe they can predict the future based on current metrics and data. While their track record has proven them to be incapable of seeing the present, let alone the future.

    The State of the Economy has become like the Existential tree falling in the forest.

    Is the de-leveraging and its consequences part and parcel of the Economy, or some distinction apart from it?

    The "Tell it" opening was sufficient. There was no necessity for us all to go forward and prove it. ;)

    Which includes my witless commentary.

  • Report this Comment On February 18, 2013, at 10:47 PM, whereaminow wrote:


    The Panic of 1819. You proved my point. But you should dig a little deeper. The Panic of 1819 was preceded by the creation of the Second Bank of the United States, which was set up to create money out of thin air to lend to the government to pay for the War of 1812.

    The Second Bank created a paper money bubble that drove up real estate prices (sound familiar), which collapsed in 1819. There was no government intervention and the economy recovered in 18 months.

    Murray Rothbard is considered by all economists, mainstream or not, to be the pre-eminent scholar on the Panic of 1819. Check out his book, which can be found free here:

    (He's considered that because as he liked to joke, he's the only one to write a book about it. =D)

    late 1839–late 1843 recession

    Another interesting episode. It coincided with the end of the Second Bank of the United States, whose charter expired in 1836.

    From 1832-1837 the money supply increased by a whopping 61%!!!!

    The resulting deflation of 1839-1843 was entirely predictable. But simply because prices were falling (deflation) does not mean that the period was entirely a depression.

    Most economists believe deflation and depression are linked, even though the most encompassing empirical study ever conducted showed no link between the two (

    Now, think about this.

    From 1839-1843, the money supply contracted 34 percent. Wholesale prices collapsed 42 percent.

    According to mainstream economic theory, America should have NEVER recovered, since there was no central bank and no intervention.

    But it turns out, things were not nearly as bad as such indicators would make us believe (see Peter Temin's research on the period).

    Why? Because deflation != depression.

    What else? 1873 Long Depression? Myth. Brief recession followed by the longest period of expansion in American history.

    1857? 6 months

    1920? 18 months

    We could go on.

    David in Liberty

  • Report this Comment On February 22, 2013, at 7:56 PM, ChrisBern wrote:

    I think this was an interesting article. That said, the easiest way to tell how strong this recovery is would be for the Fed to discontinue buying $85B in bonds every month and for the Federal gov't to discontinue its $100B per month deficit spending.

    Anyone care to wager on how many days (hours?) it would take for the economy to fall into recession (depression?) under that experiment?

    THAT, my friends, is the easiest way to tell how "strong" the economy is right now.

  • Report this Comment On March 21, 2013, at 2:11 PM, C0ncernedCit wrote:

    Interesting that your summary is basically that once we stop deleveraging at such a fast pace, that we will start growing the economy at a more healthy rate. The problem is that based on your chart, deleveraging did stop after the first quarter of 2011. While private sector deleveraging continues, our government is running $800B deficits. If the private sector slowed or stopped delveraging, GDP may grow faster, but so would debt.

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