Top 5 Ways to Kill the U.S. Recovery

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Robert Galbraith / Reuters

They say heartbreak is optimism’s best cure. Not so in this economy. After a slew of painful economic data out over the past few weeks, it’s hard to find an economist who isn’t annoyingly upbeat.

Take the latest Wall Street Journal economic forecasting survey: Economists put the chances of a double-dip recession in the next year at a mere 16%. And a lot of them think U.S. growth will practically double in speed in this year’s second half. And yet, consumers are hurting, unemployment is up, and housing prices continue to fall. So what’s with all the freakish positivity?

Many bullish economists think a looming “dip” is merely a “blip” caused mostly by fleeting events. The crisis in Japan disrupted our supply of manufactured goods, pushing down retail sales. Trouble in the Middle East drove gas prices up, which kept consumers from buying other stuff.  But even if those headwinds pass, it doesn’t take complex math to suss out that we’re hardly in the clear. “When you’re highly leveraged and you’re already growing at a pretty tepid rate, it doesn’t take big shocks to fall into another recession,” says economist Carmen Reinhart of the Peterson Institute for International Economics, who researches the history of debt crises.  The mistake many economists make, she says, is comparing this recession to others in the recent past. “Using the U.S. business cycle since World War II is not the right comparison,” she says, and here’s one reason why: Household debt as a percentage of Americans’ incomes is now twice what it was at the bottom of the recession in 1982. That alone is reason enough to think we’re headed for a new kind of pain. (See “Is a Double Dip Becoming More Likely?”)

So just how likely is another big slump? Reinhart thinks we’ll probably just keep muddling along, which means a decade of “sideways movement in unemployment, some better months, some worse.” In other words, not good, but not a total disaster. And yet worst-case scenarios can’t be ignored. Here are the five trouble spots most likely to throw the recovery off:

An Oil Supply Squeeze

Skyrocketing energy prices have already squeezed the U.S. consumer. And while oil and gasoline prices have fallen in recent weeks, they’re still up sharply from the end of 2010. The high prices could be temporary. The Federal Reserve and other economists are betting that prices will fall once the slack of weaker consumer demand kicks in. But not if spats within OPEC cause an oil supply squeeze. Oil consuming countries have been pushing producers to pump more oil to make up for Libya’s halted supply, but talks last week between OPEC powers collapsed without a deal in a powwow the Saudi oil minister called “one of the worst meetings we ever had.” The world is facing a shortage of 2 million barrels a day in this year’s second half. If the wrangling continues and the gap isn’t filled, expect gas prices to continue to climb and the recovery to suffer a blow. (See Is OPEC Dead?)

The Eurozone Question

The eurozone’s latest fight over yet another Greek bailout isn’t just bad for Europe; it could stifle the global recovery. Under fire from irate German taxpayers, German officials favor scrapping the bailouts altogether and shifting the burden onto Greece and its bondholders. If Europe’s indecision leads to default (which could come as soon as September), bond yields elsewhere on the continent could skyrocket. A continued rise in oil prices might also set things off, making it harder for countries like Italy, Portugal, and Spain to pay their bills and keep lenders calm. (See Is Greece the Next Lehman?)

If that happens, Americans’ retirement accounts could feel the pinch. Many European companies are already struggling to attract investment and keep pace with the volatile euro. About 13 percent of U.S. mutual fund investments are in European stocks, and they’ll suffer if those companies are downgraded or become insolvent. Stocks of big U.S. companies also have skin in the game: Europe accounts for roughly 20 percent of their foreign profits.

Then there’s the matter of all that debt. At the end of 2009, Americans owned some $18 billion in government bonds from shaky European countries, which isn’t much. A bigger chunk belongs to U.S. banks, which hold roughly $170 billion. That’s still only a fraction of U.S. bank loans abroad, but these days a little exposure can result in a lot of problems. A chorus of financiers, including the European Central Bank and Jamie Dimon, head of JP Morgan Chase, have warned that, if indebted eurozone countries are forced to restructure their loans (meaning negotiating longer-term payments at lower interest rates), the result could be a run on banks holding that debt. Enter global financial crisis part two. Those days could be drawing near. As more signs of a global economic slowdown emerge, many economists think stagnant economies like Ireland, Greece, and Portugal won’t last long before they can no longer afford to pay down the interest on their loans, let alone the actual debt. And there’s only so much more bailouts can do before investors call it quits.

State and Local Debt Woes

U.S. states and cities are in a bad way. Revenues are dropping, underfunded public employee pension plans are growing, and cash-strapped residents are loathe to accept a tax hike.  The shortfall on state promises to retirees, according to the Pew Center on the States, totals $1.26 trillion, more than twice the debt load of crisis-torn Greece. Meanwhile, the White House’s $819 billion economic stimulus for states and cities is almost tapped, and investors are getting scared. Muni bond funds, which help cities raise money to fill in revenue gaps, have been bleeding cash for dozens of weeks in a row. If borrowing costs get too expensive for local issuers to afford, a wave of defaults could ignite calls for another big bailout and add fuel to the fire over our national debt. So far, only a fraction of muni issuers have actually defaulted. But even without a government bailout, local budget shortfalls could do the recovery in. Why? Because balancing local budgets requires painful cuts to local investment and government jobs, which adds to the drag on consumer demand.

Another Housing Slump

The housing market has already entered a double dip. The question is will it get worse. Prices have fallen some 33% since the housing crisis began in 2006. That’s more than the 31% fall during the housing slump of the Great Depression. And prices continue to tumble even though housing affordability is reaching historic highs. Why? Because as housing prices have continued to fall, so have American appetites for homebuying. More Americans are opting to rent, which is pushing up rental prices around the country. Already U.S. apartment rents have risen 5% in the past year. Many economists think rental prices relative to home prices will reach their highest level in decades this year and could continue rising for years to come.”One of the vanguards of economic recoveries is housing, and it’s still missing in action because there’s a tremendous overhang,” says Josh Feinman, global chief economist for DB Advisors. Falling housing values and higher rents could translate into even less U.S. spending, since roughly half of Americans’ wealth is tied up in their home. (See What U.S. Recovery? Five Destructive Myths) 

A Sharp Slowdown in Asia

The sputtering U.S. recovery is worrisome enough. But a looming slowdown in China, the world’s growth engine, is threatening to make things worse. Faced with rising inflation fueled by a frothy real estate market, Chinese authorities have been hiking interest rates and clamping down on credit, which has put the brakes on the country’s gangbuster growth. Some predict China’s economy will slow to a relative trot of 8.7% growth next year, down from 10.1% in 2010.

That spells trouble especially for countries that supply China’s export machine, like Thailand, Vietnam and Germany. American exports to China aren’t as big, but they still account for 4.5% of total U.S. exports and a much larger share of U.S. export growth. Falling demand from China could also lower commodity prices by creating a glut of materials like steel and hurting U.S. industries like farming and mining, which have been helping the recovery along.

And then there’s the issue of Japan. The tsunami has already cut into U.S. retail spending by depriving automakers of needed Japanese car parts. An even bigger risk looms if Japan, the second largest holder of U.S. Treasuries behind China, starts selling off Treasuries to fund its reconstruction needs. That would put upward pressure on interest rates just as the Fed is beginning to wind down its massive Treasury purchases, otherwise known as QE2. Because who’s going to buy U.S. Treasuries once Japan slows and the Fed steps away? As PIMCO’s Bill Gross put it: “Someone will buy them…the question really is, at what price?” Of course, investors tend to pile into Treasuries when times are tough, and that’s continued in this recession. But it’s anyone’s guess when that tide might finally turn.