Why This Recovery Seems So Painful

NEW YORK ( Real Money -- When policymakers consider their options in trying to ramp up economic growth and, in turn, bringing down unemployment, the forces of nature -- or, at least, economics -- seem conspired against them. They might as well try to outlaw bad weather. The fundamental problem with the Great Recession and the following anemic recovery is that this period is different from what we've experienced since World War II. The primary factor is the role of credit. Leverage, as it is known, can work both ways: It can either magnify economic growth on the way up or magnify contraction on the way down.

You've probably already heard that recessions associated with excess leverage and ensuing credit busts are often worse than are more "normal" recessions, and that the former enjoy less robust recoveries than do the latter. However, there is another factor to consider. Regarding the strong economic expansions to which we've become accustomed, the reason for such recoveries has been the rapid growth of credit that began several decades ago. In other words, we're using the wrong benchmark in comparing ourselves with where we should be. So not only is the U.S. recovery weaker than average, but we'd become accustomed to economic growth that had been above average. That has made this recovery seem especially painful.

The San Francisco Fed did some research into the role of credit in economic cycles ( PDF), examining 14 countries over 140 years. The researchers determined that, when leverage is above average, economic expansions last about one and a half years longer and that the cumulative increase in output is 4% higher. More recently, though -- after World War II -- the differences became even more pronounced. On average, high-leverage expansions have resulted in 38% accumulated gains in output, compared with 28% for low-leverage expansions. They've lasted 9.7 years and produced average annual rates of growth of 3.4%, compared with 8.9 years' duration and 2.4% growth rates for low-leverage expansions.

Starting in the early 1980s, the growth of credit products took off -- and so did economic growth. After the two recessions of the early 1980s, the rest of the decade boomed and so did the next one, punctuated only by a relatively mild downturn in the early 1990s. In real terms, economic growth averaged 3.7% from 1983 to 2000. During that period, total domestic non-financial-sector debt increased from 152% of U.S. gross domestic product to 183%. In other words, debt grew by an annualized 1.1 percentage point more than did GDP -- a 1.3 to 1 ratio.

From 2000 through 2006, GDP averaged a 2.5% annual growth rate in real terms. Total domestic debt outside the financial space rose from 183% to 232% of the GDP. In this period, debt grew by an annualized 3 percentage points more than did the GDP, a ratio of 2.2 to 1.

From 2007 to the present, debt levels further increased from 232% of GDP to 254%. GDP averaged 0.6% growth in real terms, and total debt climbed by an annualized 1.8 percentage points more than did the GDP, or a 4-to-1 ratio. (Most of this debt increase was at the federal government level.)

(These data are from the Bureau of Economic Analysis for GDP and the St. Louis Fed for debt levels, and the debt levels include government debt at all levels of government, as well as private debt levels outside the financial sector. Remember that debt for a financial firm, such as a bank, includes deposits like savings accounts and CDs, and their inclusion can give a misleading understanding of the total indebtedness of the country when included in these debt totals, since those deposits are then lent out.)

Clearly, the economy has relied extensively on the growth of credit since the 1980s in fueling the growth rate we had enjoyed. We can surmise that credit growth was partly responsible for economic growth during this period, as annual household income growth has fallen in real terms over time. Instead of consumption growth being financed by income growth, as it had been in the past, it was financed through increased debt. During the housing boom, we saw explosive growth of mortgage debt -- and, since the recession, government debt has thus far taken the lead role in fueling the recovery.

Now, the focus in Washington is on cutting the deficit -- not expanding it -- and households are limiting their growth of credit products while banks focus on better-credit-risk customers. As a result, total debt growth of the economy, across all sectors, is likely to be constrained. As it seems to have taken an increasing amount of debt to fund each dollar in further GDP growth during these successive time periods, I wonder how we can expect economic growth to be robust from here, given that this process is now running partly in reverse.

The San Francisco Fed does indeed note that economic growth is likely to be weaker than what we'd have expected from historical experience. The researchers conclude, "Consequently, economic forecasts should take into account the effects of the recent financial crisis. Compared with the average U.S. post-World War II recession, the forecast for real GDP should be lowered 0.6-0.8 percentage point in 2012, 0.5-0.7 percentage point in 2013, finally returning almost to normal by 2014. Similarly, inflation forecasts should be revised down between two-thirds and a full percentage point over the next three years."

There you have it.
Gene Balas has 20 years experience in investment management and is a Chartered Financial Analyst. He most recently was director of investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop the appropriate investment strategy. Prior to GFAM, Balas was director of investment management and guidance at Merrill Lynch, where he advised pension funds, endowments and foundations as to appropriate investment strategy. Balas received a bachelor's degree in business administration in finance from the University of Houston and a Master of Business Administration degree from Columbia Business School.

To contact Gene, please email gene.balas@thestreet.com.