Double-Dip Recession More Likely

Last Updated Jun 7, 2010 2:29 PM EDT

While it's rare for the US to experience a double-dip recession, it's more likely than it's been in prior recessions.

Now when I say a double-dip is more likely, that doesn't mean it'll happen. In fact, I certainly hope it doesn't happen. It just means you need to think about how your financial life is positioned to deal with it if it does. This sort of thinking is all part of learning how to manage global risks in your own financial life.

First, for this type of analysis, forget about the economic forecasts from people on Wall Street. They've been wrong so many times their forecasting ability just isn't credible. And by the way, it never has been. Economists are generally correct as long as the direction of the economy isn't changing. But they rarely catch the inflection points, which is what matters.

Moreover, the data they're looking at isn't as helpful as it has been in prior recessions because we have so many government programs skewing the data. So let's look at the two overriding themes that may spell trouble for the longer term economy: government debt and government intervention.

Government Debt. We just have too much government debt domestically and internationally. And it's rising at record pace. If we continue at this rate, the breaking point might be a year, two or five years down the line, but it's coming. You can't escape the math.

And the solution is either massive inflation to reduce the costs of paying back the debt, or severe austerity measures to cut spending and collect more taxes to pay off our creditors. Both of these scenarios will likely cause a recession.

Consider this simple number for our national debt. Once the ratio of the nation's debt to GDP reaches 1 to 1 (and it's getting there), we are then in a financial position similar to a family that has a $500,000 mortgage but only $100,000 of household income; not good. Here's why.

  • Our federal tax collections average about 20% of GDP, and that has been true over long-term cycles. Those tax collections are the government's income. So once your national debt reaches 100% of GDP, you now have a national debt to income ratio of 5 to 1, which is basically unsustainable.
  • At that level, a huge percentage of whatever income the government collects in taxes must go to simply paying interest on past debts.
  • Again, here's why. Assume our national debt carries an interest rate of 4%. Well, if your debt is 100% of GDP, and the interest payments are 4%, then that means 4% of GDP goes to paying interest (which doesn't even include paying back the principal).
  • Since taxes are 20% of GDP, the 4% that must go to interest represents 20% of the government's total income. And if interest rates went to 5%, then 25% of our income goes to just paying interest. So far, the US has been lucky as interest rates have remained low. But that probably won't continue forever.
  • And if we ever decide to pay back the debt, then even more of our tax revenue will be consumed by old debts. Those payments crowd out other more productive uses of money. We're all just working and paying taxes to pay off these old bills, instead of investing in new opportunities.
Government Intervention. Now, in a normal recession, the odds are we could grow our way out of the problem. That would be similar to our family with the $500,000 mortgage where mom or dad gets lucky with a nice raise, and now they make $150,000. The bigger income makes it easier to pay back the debts.

But this isn't a normal recession. Our recovery is heavily dependent on government actions, not the actions of private business owners. And this is because of the huge role the federal government continues to take in every aspect of the economy.

Congress people aren't good at business. They're good at politics. You can be quite sure that whatever they come up with will be more complicated, costly and filled with so many loopholes for special interest that it further suffocates the economy's ability to recover.

  • Just look at the financial reform bill where they want to exempt car dealers from the regulations that apply to other lenders. Why? Because Congress is knee-deep in it with the auto industry and knows that tougher lending rules will restrict car sales. This is just one example of the tens of thousands of exemptions we'll see in all of this new business regulation, from health care, to financial services, employment, automobiles, taxes and energy, just to name a few. As the government's role increases, more businesses will lobby for more exceptions, and a toxic mix of money and politics will rule the economy.
Here's another good example of politics trumping business needs. In the recent jobs bill being debated in the House, $1 billion is allocated to summer jobs for youth and $0.5 billion is allocated to small business loans. So teenagers would get twice as much money for summer jobs than would go to business owners who have their personal assets on the line and who are the main source of job growth for the economy. I'm not saying we don't need to keep kids busy this summer, but they shouldn't be getting more help than small business owners.

What's even more ridiculous is that the bill is $190 billion and only $0.5 billion appears to be going to small business assistance. The main problem in the economy is the restriction of credit to private business owners, and little is being done to address that issue. These are some ugly truths about Congressional spending, and it'll have a real impact on the economy's ability to recover.

Bottom line. The government's involvement in a crisis is a matter of degree, and they may be overstepping their bounds. As politics starts to dominate the allocation of resources in multiple industries, a double-dip becomes more likely.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.