The National Bureau of Economic Research tells us the recession is now over. In other words, the economy has simply ceased shrinking as this graph below illustrates. The economy has reached the bottom of the economic cycle and is entering the trough phase. From here it can go in one of three directions, sideways, up, or down. In the 1990‘s Japan’s economy remained in a trough and went sideways for a decade. This is not a desirable scenario and neither is reverting to further economic decline. In the 1930‘s the economy was in recovery until 1936-37 when it declined sharply and remained in decline until the start of World War II.

The third direction the economy can go in is an upward trend in growth and recovery. There is hope that the economy is showing signs of going in this direction. I had written in my last article that ideally what we wanted to see was a flat second and third quarter with an uptick coming in the fourth. This type of growth lays the groundwork for a sustained recovery.

Let’s look at some evidence that supports a recovery. The chart above represents leading economic indicators over the past three decades. The gray shaded areas depict recessions. As you can see, the indicators dipped more sharply than during the previous two recessions.

One of the standards for measuring whether an economy has exited a recession is the Durable Orders Index. The chart above illustrates the dip in durable orders that occurs during a recession. Retail sales have turned the corner away from negative territory and permits for new homes are beginning to turn positive. The National Association of Realtors said the number of signed contracts rose 6.1 percent in September to the highest level since December 2006 for an eighth straight monthly gain.

Lastly, the Gross Domestic Product or the sum of goods and services produced in our economy increased by 3.5% during the third quarter. In fact manufacturing activity grew in October at the fastest pace in more than three years.

Although these are all signs of an economic recovery this recovery has already been dubbed the “jobless recovery”. Unemployment continues to rise and at the writing of this article it sits at over 10%. We have an economy in which we do not produce anything and so it is going to be difficult to stimulate the job sector and create new jobs.

Few economists saw the real estate crash coming. Fred Foldvary, an advocate of the Eighteen Year Real Estate Cycle theory, had written about the impending implosion of the real estate market almost two years before it occurred. Most economists were trusting in Fed Chairman Alan Greenspan who continually dismissed talk of a housing bubble. When asked in 2004 about rapidly rising housing prices he said: “a national severe price distortion was most unlikely.” But lowering interest rates dramatically caused the economy to be flushed with cheap money in order to pull us out of the 2001 recession. In doing so, Greenspan only succeeded in creating a bubble in real estate values that would burst in 2007 and evaporate $13 trillion in wealth and over 6 million jobs in the process.

How we got here. Ever since Fed Chairman Paul Volker broke the back of inflation in the early 1980‘s the government has relied on the Federal Reserve and Monetary Policy to manage the economy. Here’s how monetary policy typically responds to recessionary pressures. When a recession begins, the Federal Reserve (Fed) responds by buying Treasury bills, which represent short-term government debt, from banks. This act in turn drives interest rates on government debt down, thereby driving other interest rates down as well creating a flush of cash in the economy, which then will generate investment thereby stimulating a recovery. During the recession of 1990-1992 the Fed drove short-term interest rates from 9 percent down to 3 percent. In 2001 it drove down rates from 6.5 percent to 1 percent. And it has tried to deal with the current recession by driving rates down from 5.25 percent to zero. There are several reasons why driving down interest rates has not generated the jump start that it has in prior years. First, banks are not loaning money to the same degree they were before the recession began. Many of the big banks have taken TARP funds and are using them as a source of investment capitol, trading derivatives and engaging in credit default swap schemes that got them into trouble before. Secondly, individuals and businesses do not have the capacity to take on additional debt. When credit was easy and interest rates low everybody borrowed and borrowed. American consumers are carrying a very heavy debt load right now. Third, we now have an economy in which we do not make anything. Our manufacturing capacity has been transferred overseas and the question economists have yet to find an answer to is “how do you stimulate an economy that doesn’t produce anything?”

How do we get out of the trough and enter the recovery phase? To answer that question we need to look at the last two major recessions. Recovery from the 1981-83 recession was led by a manufacturing boom in the micro computer and other small electronic device industry. At that time, Apple Computer, which developed the first commercial personal computer was making all of its computers at a plant in California that was highly automated and run by robots. Dell Computer, known then as PC LTD, was manufacturing all of its computers in Austin, Texas where Compaq, another early PC manufacturer, was also building computers. All of these companies now manufacture their computers in China. The dot com revolution ended the recession of 1990-1992 and pulled the economy out of the trough fueling the economic growth of the 1990’s. In every major recession since the Great Depression recovery occurred because of explosive growth in a new industry. Is there something on the horizon now that will pull this economy out of the trough and spur a new growth cycle? And the answer is that as long as our economy doesn’t make anything then it is going to be difficult to have the kind of recovery we’ve experienced out of the past three recessions. Frankly, with the limited manufacturing capacity we now have developing a new industry presents a serious challenge. However, one area does have potential and that is in the area of green or alternative energy. Investment into this area could spur a new cycle of economic growth while weening our economy off its dependence on middle eastern oil.

Although investment in a new industry, like alternative energy, could jump start the economy there remain significant obstacles that threaten to hamper a full recovery such as the failure to regulate and overhaul the financial sector, which remains on shaky ground after last year’s collapse. Credit default swaps and derivative sales are extremely complicated and many of the banks that have been dealing with them lack an understanding of how they work. Yet, the allure of making a fast buck is too powerful for them to pass up. Not surprisingly, banks remain unhealthy. There have been more bank failures in the 10 months of 2009 than there have been in the previous 10 years.

But the pink elephant in the room that nobody wants to talk about is the deficit. Since the recession began in 2007 domestic spending has risen 18% while revenues have declined to their lowest levels since the 1930’s.

The chart above tells the story. Although the deficit increased in real dollars between 1945 and 1981 it actually decreased as a percent of GDP. 1981 was the advent of Supply Side Economic Theory that has resulted in out of control deficit spending. Supply Siders like to say that deficits don’t matter as long as the ratio to the GDP is low. Although there is some merit to this statement, the chart above suggests Supply Side economic policy has actually contributed to the ratio of debt to GDP to become alarmingly high. Why should we be concerned about the ratio being so high? Oil, for the time being, is traded in dollars. The deficit has an adverse effect on the value of the dollar causing it to decline, which in turn causes Americans to pay more for oil. Oil prices have a multiplier effect and create inflation. Secondly, China and India have invested heavily in dollars and with the weakened dollar they are now dumping dollars for gold and Euros. China has been our banker buying government debt at low interest rates. Once they decide to cut off the cheap money, the government will then have to go back to borrowing on Wall Street where they will compete in the bond market thereby driving up interest rates and creating inflationary pressure in the economy.

Because of the enormous challenges facing the economy a recovery is going to be slow with unemployment likely remaining over the 5% threshold for the next several years and with interest rates rising.