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. 

The article The Economy Might Be So Much Stronger Than You Think originally appeared on Fool.com.

Morgan Housel doesn't own shares in any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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