As Credit Growth Slows, The First Recession Bell Tolls

May 24, 2017

As Credit Growth Slows, The First Recession Bell Tolls

  • The economy can only grow as fast as productivity in the long term.
  • U.S. real GDP growth has been around 2% in the last 8 years while productivity growth has lingered at 0.5%.
  • Therefore, 75% of economic growth is under the influence of credit. Credit expansion is slowing down and turning negative.


What do you do when your neighbor, that you know makes the same amount of money as you do, buys a Porsche, puts a big pool in their garden, remodels and refurnishes their house, and throws big parties to brag about it?

If you don’t know much about economics, you feel under pressure, your kids want you to do what your neighbor is doing and you don’t want to be the old Scrooge. At the next neighborhood party, you ask your neighbor how they afforded everything. They show you how simple it all is. All you need to do is go to the bank and take out a loan for this, use your credit card for that, lease this, invest in the stock market on margin because it only goes up, and you can have the great life too.

You go home, think about your neighbor’s advice, but you aren’t convinced because you still remember something you learned in school about how credit works, credit cycles, and consequential economic recessions. So, before going to the bank, you first want to see how much this economy is influenced by credit because history has shown, over and over again, how there is always a limit to credit expansion.

Let’s see where we are now in the credit cycle.

We Live In A Credit Economy

Let’s look at a few charts to understand how credit influences the economy.

Figure 1: Real U.S. GDP increased 17% in the last 8 years. Source: FRED.

17% GDP growth results in an average growth rate of 1.99% per year which is decent for a developed economy. However, an economy can only sustainably grow as fast as its productivity grows. The average productivity increase in the U.S. has been around 2% over the last 100 years, and GDP growth has been in line with productivity growth, albeit a bit more volatile.

Figure 2: The U.S. economy has grown as fast as its productivity. Source: Economic Principles.

Therefore, in order to know whether the annual 2% economic growth we enjoyed in the last 8 years is sustainable, we have to analyze productivity growth.

U.S. Total Factor Productivity, which accounts for effects in total output growth relative to the growth in traditionally measured inputs of labor and capital, grew 3% in the period from 2009 to 2014. This translates into 0.5% annually.

Figure 3: Total factor productivity in the U.S. Source: FRED.

What’s impactful from the figure above is that since the 2000s, productivity growth has been really slow.

If the economy doesn’t grow thanks to productivity growth, the only other option is to grow on credit. Consequently, credit expansion has been exploding.

Figure 4: The U.S. long term credit cycle has been expanding for more than 65 years. Source: FRED.

Apart from the long-term credit cycle, there are short term credit cycles that create recessions. Some say that we are close to the end of the long-term credit cycle which would lead us into a 1930-like depression, but this is a case where we simply don’t have enough input to create a rational opinion. What we’re going to focus on is the short-term credit cycle. If after blowing up it leads toward the deleveraging of the long-term credit cycle, we’re going to be at least partially prepared.

Where Are We In The Short-Term Cycle?

Checking where we are in the short-term credit cycle can help determine when the economy will enter into a recession. This isn’t an exact science, but it helps for the diversification of risk.

Whenever credit expansion starts to slow down, it signals that we’ll enter into a recession as soon as credit starts to contract.

Figure 5: Credit growth has already been slowing down for a year. Source: FRED.

Given the economy’s dependence on credit, a recession is clearly around the corner because banks have started to tighten their lending rules and interest rates are slowly increasing. On top of the huge credit expansion in the past years, credit is inevitably slowing down. A recession can be delayed with political or monetary actions, but it can’t be avoided as the economy can only grow as fast as economic productivity grows.

Going back to the scenario in our introduction, our neighbor has over-leveraged themselves and they will be forced to sit tight for a couple of years. Banks get wary of lending them more money as they might default on their loans. As they can’t get new loans, the credit expansion cycle is bound to end, the economy enters into a recession, and a deleveraging process starts. Usually the FED lowers interest rates to increase borrowing, but this will be difficult to do now as interest rates can’t go much lower.

Everything points toward a recession. The party can still go on for a while, but it’s bound to end at some point because credit is like alcohol, it makes you feel good for a while, but nobody wants to be next to you after a certain hour or the next day.

What Does This Mean For Investors?

Including cyclicality in one’s investment plans is a must for everyone. In an average recession, real economic activity declines 5% to 10%, the destruction of financial wealth is typically around 20%, while equity prices easily fall more than 50%. As ugly it can be to hear this, it’s the truth and somebody has to tell it.

There’s a way to prepare yourself for what’s going to happen. Keep reading Investiv Daily as tomorrow we’ll discuss what the best portfolio for the current economic environment is.


Cyclicality is something natural for the economy and for us. While things go well, we don’t think much about how sustainable it all is and instead take out as much credit as possible because we prefer to have something now rather than to wait for it a few years. However, when we take up all the loans we can take, the only way for us to borrow more is through increased income. The problem is that income is related to productivity, which has been increasing very slowly in the last two decades.

As soon as our neighbor, and many others like them, get under pressure and can’t afford to take new loans, the economy is bound to enter a deleveraging cycle. Banks increase lending criteria to lower the percentage of bad loans and the negative cycle begins. We’ve already seen declining car sales.

The problem is that many, including our neighbor, don’t see the cyclicality in the economy and investments. This is bound to end badly, as it did in 2001 and 2009. Be prepared.