5 Doomsday Scenarios for the U.S. Economy

Yahoo! Finance (Link) - The Atlantic - Derek Thompson, Daniel Indiviglio (September 4, 2010)

It�s been a brutal summer for the economy. The housing sector, like a balloon batted in the air one last time by the government credit, resumed its inevitable fall. Economic growth slowed to a lead-footed 1.6 percent, and job growth is even more anemic. Meanwhile, consumers are cranky, the trade gap is gaping.

Most signs point to a slow and steady recovery, but what if the pessimists are right, again? What if the United States isn�t in the slow-lane to recovery, but rather on the precipice of another decline -- a double dip?

To see where this re-recession might begin, my colleague Dan Indiviglio and I imagined five financial earthquakes, each with a single epicenter: housing, consumers, toxic assets, Europe, and the debt. The following five scenarios are listed in order of likelihood.

1. Housing�s Mini-Bubble Pops

Perhaps nothing poses as a big of a concern to the U.S. economy as its housing market. It�s unclear how the government�s efforts to stabilize the market through a buyer credit, ultra-low mortgage rates, and mortgage modification programs will pan out. Did it just create another mini-bubble that�s beginning to pop now that the support has been withdrawn?

Here�s the scenario. Weak home sales and continuing foreclosures result in climbing real estate inventory. This has two effects. First, it makes new homes even less attractive which further reduces construction jobs. Second, it puts downward pressure on home prices, which makes it harder for struggling homeowners to sell their home to avoid foreclosure and also keeps strategic default rates high, exacerbating the problem. Lower home values encourage Americans to save more and spend less, since their wealth is effectively reduced. The Dow drops and credit markets tighten even further, suffocating private investment just as homeowners bunker down and slash spending. Growth turns negative.

2. You Break the Economy

You, the American consumer, are reloading savings after a debt-fueled decade. But as any general will tell you, when an entire squad reloads at once, it leaves everybody vulnerable. It�s the same with the economy.

Here�s the scenario. Consumer sentiment continues to fall slowly, and spending turns negative again. Small businesses hold off to replenish their inventories or add new workers. Wages and hours freeze, and unemployment takes a leap toward 10 percent in October. Congress is paralyzed, because it�s only weeks away from the mid-terms. The stock market sees business revenue trending flat, joblessness rising and Congress doing nothing, and it sparks a 300-point sell-off. Americans frightful for their savings cut back spending even more the next month, and overall growth turns negative.

3. Toxic Assets Return

If you closely followed the bank bailout, then you know it wasn�t originally billed as simply throwing money at the banks. Instead, the Treasury intended to purchase the toxic assets from banks, which were the source of investors� uncertainty concerning bank stability. But the Treasury couldn�t figure out a way to do this quickly enough to make it effective. As a result, the banks were largely stuck with these bad assets. We just don�t know how bad, yet.

Here�s the scenario. The residential real estate market�s problems continue. Even once foreclosures begin to decline, we see waves of defaults, as modification program participants re-default at rates of 30% to 50%. Commercial mortgage-backed securities continue to deteriorate, as some businesses struggle with weak consumer demand. Home and commercial real estate values keep declining, and so do the value of the assets that back them. Banks with exposure to these toxic securities see another round of losses, and investors question their stability. The market plummets, credit freezes, and growth turns negative.

4. Europe Falls Apart

Europe seems to have avoided an all-out collapse of confidence in its ability to pay back its debt. But things can change, and fast fast. Indeed, the Greek debt crisis went from ignorable wire stories to front page news in a matter of days.

Here�s the scenario. Slow growth in weak Eurozone states like Greece, Spain, and Italy turns negative and spooks investors, who demand higher returns on government debt. Europe�s bond rates spike. Countries announce further austerity -- tax increases and spending cuts -- which strangles our biggest export market. The EU central bank responds by announcing a plan to write down troubled debt, which dings some Americans banks.

In a flight to quality debt, the dollar appreciates. This hurts our exports even more. As the trade deficit gapes open and manufacturing�s good run dead ends, the stock market plummets, taking household wealth down with it. Families looking to restore balance sheets cut back on spending, and the American producer loses the American consumer and the European buyer. Growth turns negative.

5. Debt Finally Catches Up to Us

Interest rates on U.S. debt are low today for one big reason. Investors trust the United States, at least more than they trust other countries. If the people giving us money suddenly have as little faith in America as Americans, that could change, and quickly.

Here�s the scenario. The IMF recently said the United States has a 25 percent chance of seeing dramatically higher interest rates in the near future. But the bond market can strike without warning, as it did in Europe earlier this year. If uncertainty with our political process gets reflected in our interest rate, we�ll have a harder time affording debt, 55% of which has to be rolled over in the next three years. Pension and mutual funds with government debt would be written down, causing Americans to save even more of their paychecks. We�d be left with two bad choices: tax cuts to juice consumption or tax hikes to please our lenders. But at that point, it would be too late to avoid a double dip.