It has become commonplace to read that some economist believes the US economy is heading towards a recession, another believes it could be a depression (he must be crazy), while still others believe the US economy is still growing nicely and will continue to expand because… well, because… because the government statistics say so.

Last week we saw that the US economy has been contracting since 2000, and contracted 4.16% in the second quarter of 2008 compared to the second quarter of 2007. The Bureau of Economic Analysis (BEA) may not want to label it a recession just yet, but that does not change the fact that the US economy is in serious decline. Perhaps it’s not possible, after all, to get wealthy by spending borrowed money.

A recession is colloquially defined as two consecutive quarters of economic contraction. Based on that definition and the real (AMS adjusted) GDP data I published last week there is no doubt that the US is in recession: its economy has been contracting every year since 2000. Colloquially, a depression is four consecutive quarters of negative economic growth, which means the US is actually not in a recession, but a depression.

Recessions and depressions are the troughs of a business cycle, whereas economic expansions are the opposite -- the peaks of the business cycle. Central bankers are fixated on eliminating the business cycle; unfortunately, that is even less likely than peace in the Middle East. The business cycle is a product of human psychology and unless we all somehow morph into Vulcans, the business cycle is here to stay.

Real wealth creation results from the judicial employment of savings -- not debt-financed consumption. When savings are deployed to acquire, develop, invent or build means of production there is a chance that economic expansion will follow. However, this allocation of capital has to be demand driven, otherwise the savings will be squandered on production capacity for which there is no market. When capital is intelligently employed it can result in an increase in productivity, which means an increase in the production of goods and services relative to the population. An increase in productivity raises the real value of labor, reduces the real cost of goods and services and therefore increases discretionary income and prosperity.

Human nature, unfortunately, often compels us to extrapolate the immediate past too far into the future. An increase in economic activity and prosperity can lead to over-optimism that results in superfluous production capacity and excess inventory. When businesses realize they have produced too much they start cutting down: layoffs, an increase in unemployment and increased competition to get rid of inventory by lowering prices are the result. Consumers recognize that job creation has fallen and become more conservative, spending less and saving more. Their reduced consumption puts the brakes on economic growth and their increased savings set the stage for the next expansion phase when those savings will again be gainfully employed. So we move from phases of expansion to contraction and back to expansion again. It is a natural, self-correcting cycle that works best when left alone.

When a contraction occurs due to the build-up of excess inventory the ensuing economic trough is usually short, lasting only a few quarters, and typically not very severe. These are recessions and they are necessary to work off excess inventory so that expansion can resume once again.

Economic depressions are a different beast altogether. When an economic expansion runs too far, and instead of merely building up excess inventory, savings are used to build excess production capacity, it takes more than a few quarters to work off the excess. Such economic expansions are most often debt financed and go hand-in-hand with an increase in financial speculation.

Bankers are seldom innocent during these events. An economic expansion benefits everyone, including bankers, who benefit from the increased demand for the savings entrusted to them. Instead of letting a normal economic slowdown work itself out (recession) bankers demand that their central bank “do something” at the first sign of economic weakness. In response, the central bank may try to stimulate the economy by making money more readily available using one of many tools it has at its disposal. The increased availability of money results in additional investment in production capacity and increased consumer spending, and everyone is happy.

However this cannot, and will not last. Production capacity will reach a point when there is no further economic benefit to investing in even more capacity, and the investment stops, then job creation stops and consumer spending stops, and everything goes into reverse. The trigger for the reversal is rarely predictable but when the expansion phase turns into a contraction it takes far more than a few quarters to get rid of the excesses.

Working off excess inventory doesn’t take very long; working off excess production capacity takes quite a while, often several years, and that is the difference between a recession and a depression.

It is often the case that a depression won’t be over until a considerable amount of assets change ownership. People who over-expanded are often forced to sell assets at a fraction of their cost and the new owners of those assets therefore have lower cost bases that more accurately reflect those assets’ real economic value. This is why over-extended economic expansions destroy savings. But after a depression has cleansed the economy of excesses and forced us to consider acting rationally again, as opposed to emotionally, the stage is set for an economic expansion to take hold.

Now think back to the 1990s. Greenspan furiously (and foolishly) forestalled one potential economic downturn after another, creating the stock market bubble and the Internet-, or Tech-Bubble. Massive amounts of savings were invested in production capacity that I doubt is profitable yet.

Economic growth had already started decelerating in 1994, but the increase in consumer spending and speculation on the stock market masked the economic downturn and gave people a false sense of prosperity. When the Tech-Bubble finally burst in 1999 the economy started contracting and has not had a single year of expansion since then (see last week’s article). Yet in spite of this, the Federal Reserve Bank pulled out all the stops to try and prevent people from saving and entice them to keep spending. And spend they did, but it didn’t help. The US economy has been contracting every year since 2000 yet most people didn’t notice as they were too busy taking on more debt to sustain their consumption and expenses.

Considering the debt that has accumulated in the market and the excess production capacity that is now unproductive, it is clear that the United States is indeed, already, in a depression. The only question is how long it will last.