What Would It Take to Start a U.S. Recession?

What Would It Take to Start a U.S. Recession?

In January, I predicted that 2015 would be a rough year for the markets, and it certainly has been so far. I also wrote that a recession looked likely within the coming two years, and there has been plenty of chatter about that possibility as well. But what would the trigger be, and would this recession look any different from those of the past?

The first question may seem tough to answer, given that the economy is growing and the unemployment rate continues to drop. Everything seems to be going well, so what could derail such a huge economy as the United States? Actually, a lot of things.

One is trouble in the financial markets — not the destructive, chaotic trouble of another subprime mortgage crisis, but the generic, mundane trouble that happens when big investors see losses in their portfolios.

There’s trouble brewing in East Asia, Brazil, and other emerging markets. The tremendous leverage built up in China’s stock market through its shadow banking industry has yet to unwind, and rolling corruption scandals in Brazil’s government and biggest companies have the South American giant teetering on the brink. And that’s assuming things stay relatively close to the status quo in North Africa, the Middle East, and Russia’s neighborhood.

Let’s say a collapse in the Ponzi scheme of China’s shadow banking — paying ever higher returns dependent on ever more money flowing into the market — forced Beijing to bail out banks and draw down its reserves of foreign currency. Investors worried about Chinese debt and financial stability could lead to a further sell-off in Chinese stock markets. And as they moved out of renminbi-denominated assets, they’d also push down the exchange rate, with its newly flexible trading rules, making imports more expensive for Chinese companies and households. As a result, the prospects of many businesses in Asia — which includes several countries dependent on exports to China — would dim as well. Markets would crash in those countries, and a full-on rout of emerging markets would be on.

But that wouldn’t be all. The Chinese economy would start to slow down as well. Local companies would be plagued by uncertainty, deterring new hiring and investment, and consumers would ramp up their saving for a potentially imminent rainy day rather than spending it now. Consequently, demand for the inputs China relies on would also ebb, sending energy and other commodity prices lower. High-yield credit markets, which typically finance the massive investments needed for new oil, gas, and mining development, would take another big hit.

Back in the United States, investors would be running for cover. They’d have to sell some of their assets in the local financial markets in order to cover their losses elsewhere. And American companies that earn profits around the world would see their expectations for future cash flows fall. The markets would tumble here, too, and that would chill the American economy just like China’s. The dent in Americans’ wealth from falling asset prices would dampen spending somewhat, but the effect on companies would likely be paralysis — no new hiring, no new investment.

This is what can happen in today’s interconnected global economy. Your local economy can be doing just fine, thank you very much, but havoc stirred up elsewhere can come and knock your block off.

Yet this sequence of events isn’t the only way a recession might start in the United States. Anything that causes enough uncertainty to make businesses think twice about new hiring or investment, and anything that could hurt their future profits enough to send their share prices into a tailspin, can be the trigger. Because America’s biggest companies now earn most of their profits overseas, that set of potential triggers is huge.

Moreover, at least one trigger could result in a totally different recession from those of recent decades. In the past, instability in the Middle East and subsequent increases in oil and gas prices would have been an unwelcome headwind for the American economy. Now, by contrast, higher oil and gas prices are a boon for the vast energy industry — and especially for companies and communities hit by the recent slump.

This is new. The United States has become such a well-synchronized economy that the effects of recessions and booms are often felt almost everywhere in similar ways, give or take a few months. But if oil prices rise again — and they probably will, as demand returns and companies are more wary of building supply — then some areas will be helped while others will simply suffer the hurt of higher costs for households and businesses alike.

The bifurcation makes Washington’s policy response to a recession much more difficult. Should officials try to stimulate the economy, even though some parts are booming? Or should they stand pat, even though some parts are in recession? It’s the same dilemma that has faced the European Central Bank for years now, and those years have not been kind.

The way to avoid this dilemma is to diversify the economies of the regions in question, so that they don’t depend solely on one unique source of growth. Yet that’s something that has to happen at the state and local level, rather than being led by those officials in Washington. It takes time, too. If the next recession is truly around the corner, will we be ready?

Jeremy Bales/Bloomberg via Getty Images