5 Reasons a Double-Dip Recession Could Happen

The government can't prop up the economy forever.

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Most economists still think the odds of a relapse are low, but the listless economy is starting to resemble a moribund patient who doesn't respond to conventional treatment. The government has transfused trillions of dollars of aid into the economy, defibrillated the banking sector, subsidized housing for millions, and propped up other sectors, like autos. Yet hiring is far weaker than it should be, stocks have tumbled, consumers are depressed, and skeptics are predicting a dreaded double-dip recession. Here's why it could happen:

The stock market boom might have been artificial. After a steep plunge in 2008 and early 2009, stocks began an epic rebound in March 2009, rising about 83 percent over the next 13 months. In the traditional view, rising stocks are a leading indicator that ultimately helps pull the broader economy out of recession. So the rally seemed like a preview of a healthy recovery. But it's also possible that something else was going on. Beginning in March of last year, the Federal Reserve began an enormous program to buy mortgage-backed securities in order to help stabilize the housing market. The Fed ultimately injected about $1.2 trillion of capital into securities markets, which by some accounts is the largest "buy" program ever. The investors who sold the Fed all those mortgage-backed securities suddenly had cash they needed to invest in something else, and some of that money found its way to the stock market.

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The Fed stopped buying those securities in April of this year, the same month that the bull market ended. So by accident or not, the stock market rally tracked the Fed's MBS-purchase program almost perfectly. If it was the Fed's activity that stoked the market rally—and not an inherent improvement in the underlying economy—then sooner or later the markets will fall back to their "natural" levels and stay there until the real economy picks up steam. That may explain a big chunk of the 15 percent decline since April.

The housing market can't stand on its own. After a three-year skid, housing prices seemed to be bottoming out last fall. But those cheering a "recovery" overlooked the fact that government tax credits were fueling many purchases and that two insolvent government agencies—Fannie Mae and Freddie Mac—were responsible for the vast majority of new mortgages issued. Plus the Fed was helping push mortgage rates artificially low with its own mortgage purchases. Housing is a vital part of the economy, representing about one-sixth of all activity, yet it's being held together right now by the financial equivalent of duct tape.

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Nobody knows what the housing market would look like without all the government life support—but we got a recent, disturbing glimpse. Housing sales plummeted after the tax credit finally expired in April, and when demand falls, prices usually follow. So the housing bust seems likely to persist into a fourth or even fifth year, and if the government curtailed all of its subsidies, the bust might last a decade. It's hard to envision a robust recovery without a healthy housing market.

Consumers are broke. Income growth is weak—for those lucky enough to have an income—and household debt is still close to record levels, which doesn't leave consumers much money to fuel a recovery. As incomes stagnated over the last decade, consumers borrowed through their credit cards or home equity to support their spending habits. That kept the economy going. But now that home equity has plunged and banks have tightened credit—as they probably should have done 10 years ago—more consumers will have to save money before they spend it. It's a good habit to learn, but it's going to take time to pay down all that debt and rebuild wealth. Meanwhile, economists are wondering what might replace lost spending, which is what keeps the economy growing. For the past two years, it's been the government. That can't last.

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The stimulus is running out. Last year's $787 billion stimulus act wasn't popular, but we might actually miss it once it's gone. Among other things, that money prevented a lot of layoffs that would have sent the unemployment rate higher. Politicians dicker over how many jobs it saved, but if the economy doesn't get better soon we may get a better sense of that. State and local governments, for example, are poised to lay off thousands of teachers, firefighters, and other workers if tax revenues don't go up. They're begging the federal government for more aid, but this time the opposition in Congress is strong, since many legislators feel Washington can no longer afford to help. If states have to slash more services and raise taxes further, it will crimp consumers who are already under stress.

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Europe is a mess. Worries over Greece have cooled for now, but Europe's debt crisis remains a huge problem that could still derail world financial markets. Half a dozen European countries have problematic debt loads, and defaults or cut-rate refinancing could harm banks in stalwarts like Germany and France, which hold much of the debt. On top of that, several European countries, including the U.K., could slide back into recession, according to Moody's Economy.com. That doesn't mean the United States will follow, but it will dampen demand for U.S. exports and hold back American companies that operate in Europe. Maybe it's good news that we're better off than Europe. But not good enough.