Despite the revival of stocks in the past two years and recent optimistic economic data, the US economy remains so fragile that it could easily be driven into another recession. All it would take would be an outside shock – even a moderate one – and there are several candidates lining up.
Normally, the United States is resilient in the face of such shocks, especially when its economy is recovering. But this is no ordinary recovery. It's a two-tier phenomenon, with the fortunes of higher-income folks reviving swiftly while the rest of America is stuck in a slow deleveraging of household balance sheets that will take years to accomplish. This partial rebound makes the economy particularly vulnerable.
What shock could trigger another recession?
Japan: One candidate is the disruptive effects of the Japanese earthquake and tsunami, which may seriously disturb global supply and demand. Japan's trade and current account balances could be driven into negative territory by her need to increase imports to rebuild and curtail exports due to the destruction. Then, Japan would need to import capital and pay much more to finance her huge government debts.
Middle East: More immediate is the turmoil sweeping the Middle East and the roughly 20 percent surge in crude oil prices since mid-February. Concerns about oil supplies from Libya have been augmented by worries about the stability of Bahrain and the potential spillover effects on Saudi Arabia.
The effects of the oil-price surge were felt almost immediately as gas prices in the United States in mid-March were up nearly 30 percent from a year earlier. That price hike is, in effect, a new tax on consumers that they would normally spend elsewhere. Remember that the first oil crisis in 1973 and the second in 1979 were both associated with major recessions.
Housing: The third candidate is further decline in US house prices. Sales and prices remain weak, lending standards have tightened, and people are balking at buying big new assets that will be worth less in a year. Furthermore, the massive overhang of house inventories, the mortal enemy of prices, suggests another 20 percent fall in prices, resulting in a 43 percent peak-to-trough decline.
With that additional drop in prices, I estimate that about 40 percent of mortgages will be under water, up from 23 percent in the fourth quarter of 2010. The negative effects on consumer spending and the mortgage market are ominous.
China: A fourth possibility is a hard landing in China, which would burst the global commodity bubble. Its economy may look strong, but it's too dependent on exports – mostly to the US, where consumers are retrenching and buying less of everything. And China's policy tools to combat any economic slowdown are crude.
Europe: A fifth possible shock could be a fresh sovereign debt crisis in the eurozone. New debt troubles in Portugal and Spain, following the bailouts of Greece and Ireland last year, do not bode well. The vast political, cultural, fiscal, and other differences between the Teutonic North and the Club Med South and the vulnerability of the common currency could push out weaker members of the eurozone, followed by massive devaluations to make their economies competitive. The only serious alternative is continued bailouts by the stronger members, mainly Germany.
The potential for a shock from outside or from within looms.