What Could Cause the Next Recession

A “policy mistake” or other unforeseen provocation could kill the fragile recovery.

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If nothing terrible happens, the economy is likely to muddle along for a while, slowly gain momentum next year, and start to feel normal again by 2012 or 2013. By then, unemployment should be consistently improving, which will help revive the housing market and finally boost consumer spending.

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But with the economy growing at an anemic 2 percent or so, there's little margin for error, and the usual forces that bring a decisive end to recessions—like pent-up demand for housing or a spike in consumer spending—haven't materialized. That leaves the odds of a double-dip recession uncomfortably high. The Federal Reserve is sufficiently concerned that it's likely to start buying big pools of Treasury securities soon, the second dose of "quantitative easing" since 2009. If it works, injecting money into the economy will drive interest rates even lower, trigger a rally in stocks and bonds, boost exports by devaluing the dollar, and persuade companies to start spending nearly $2 trillion in cash that they're hoarding. But a year ago, most economists thought the Fed would be unwinding its extraordinary asset purchases by now, not adding to them. So predictions about the future of the economy carry less weight than ever.

The fragile recovery continues to spook investors, who worry that a relatively minor disruption might be all it takes to trigger a second bout of recession. Here are five of their biggest concerns:

A "policy mistake." If Republicans take over one or both houses of Congress in the midterm elections, as expected, it will probably spell an end to President Obama's reformist agenda. The conventional wisdom is that such a change would be good for businesses because they'd have less reason to worry about higher taxes or new regulations. But there are also many unknowns that would come with a split government and the gridlock it's likely to entail.

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If a new regime in Washington were to impose some kind of austerity program in order to tackle the national debt, it could shock markets that aren't expecting that to happen for a couple of years, at least. It would also shock investors if Congress were to let all the Bush tax cuts expire on schedule at the end of 2010, effectively raising everybody's taxes, since it's widely expected that a lame-duck Congress will temporarily extend those measure for most taxpayers, if not all. In fact, any kind of move that disrupted government spending, added unexpectedly to the debt or changed much at all could rattle investor confidence. The irony for Republicans who want to rewrite Washington's agenda is that a continuation of the status quo—including the full spendout of the 2009 stimulus funds—might be what the economy needs most.

Quantitative easing fails. The Fed faces the tricky task of convincing businesses and investors that it has powerful ammunition, without firing so much of it that it seems like a desperation move. Since late August, when Fed chairman Ben Bernanke first suggested that more easing was on the way, stocks have surged, based largely on the mere expectation of Fed action. The last round of easing triggered a huge stock market rally, since investors who sold securities to the Fed suddenly had money they needed to invest in something, and much of it went into stocks, pushing up prices. That's largely the point of quantitative easing—to compel investors to move their money out of safe, low-yielding investments into other securities that will do more to boost economic activity. Investors expect the same kind of rally this time, so they're already putting money into stocks and other assets, hoping to realize gains once the Fed program revs up.

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But the Fed hasn't yet said how much money it plans to inject into the economy, and if the Fed undershoots or overshoots or triggers an asset bubble or other unwelcome side effects, confidence will plummet. The Fed is the most powerful financial institution in the world, and investors have high expectations when the Fed acts. So it's not enough for the Fed to slightly improve economic conditions. Its moves must seem decisive, or they'll be considered a failure.

China dumps U.S. Treasuries. It's well-known that China is the biggest foreign holder of debt issued by the U.S. government. That serves the interests of both countries: It helps China keep its currency low, which makes its exports cheap, while helping the U.S. government run a deficit and keeping interest rates low here. If China were to abruptly dump significant amounts of treasuries, interest rates would spike and the U.S. government would have to pay more to borrow. That alone would probably trigger a recession. China would feel the pain too, since it's heavily dependent on exports to the United States, which would fall. So a provocative move by China seems unlikely.

Still, China has gradually reduced its holdings of U.S. treasuries over the last year, and tensions over interest rates and trade policy have been rising. Some members of Congress, for example, have called for tariffs on Chinese goods if China doesn't let its currency appreciate more. Some Chinese officials, meanwhile, have criticized profligate U.S. borrowing and hinted that China may permanently divest its U.S. holdings. Such rhetoric is nothing new, but if it turned into action it could easily destabilize the markets and send skittish investors back into their shells.

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An emerging-market bubble. Developing countries like China, India, and Brazil are recovering from the global recession much faster than mature economies like Europe and the United States. That's fueling a global recovery that's stronger than it would if the United States and Europe set the pace. But emerging markets often lack transparency, and investors worry about emerging market bubbles in real estate, infrastructure, and other types of assets. China gets particular attention because of an urban real estate boom that seems out of proportion to the needs or purchasing power of local citizens. A bust, coupled with major write-offs at Chinese banks, could suppress the whole Asian economy and force China into currency manipulation or other moves that would ripple throughout the world. The risks of emerging market problems have risen as investors have funneled more money into those economies, seeking higher returns that come from faster growth. Some worry it could be too much money.

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Other "sovereign" risks. The European Union has bailed out Greece for the time being, but there are still doubts about whether Ireland, Spain, Italy, and Portugal can pay off their medium- and long-term debts. A solvency problem in those countries would dwarf the trouble in Greece, and it's not clear whether Europe could muster a bailout that big. Even if there's no crisis, the amount of money required for debt service will impair those four economies for years and hold back the overall Eurozone economy. Recent history also shows that while all eyes are on a small set of countries, trouble could come from someplace else getting less attention right now. And the global shudder caused by the Greek crisis earlier this year—which effectively halted a worldwide stock-market rally—shows how even a small country can cause widespread economic damage. With so much that could go wrong, muddling through might not seem so bad.