More on the Dreaded Double Dip

Recent economic news has been discouraging. Growth is slowing in many developed countries, and experts warn that the world could slip into another recession, having never really recovered from the last one.

According to Mark Zandi, chief economist and cofounder of Moody’s Economy.com, the odds of a renewed recession over the next 12 months continue to be about one in three, but a continuing “crisis of confidence” could make matters worse.

“We’re suffering a loss of faith in the economy,” Zandi said in an interview with Knowledge@Wharton. “The collective psyche is on edge…. It really wouldn’t take much of a misstep or a shock to push us back under.”

In a report to Moody’s subscribers, Zandi wrote that Economy.com has reduced its forecast for real GDP growth in the U.S. to an annualized rate of 2% for the second half of 2011, and just over 3% in 2012. “A month ago, we projected GDP growth at 3.5% during the second half of this year and through 2012,” he said.

What has changed?

“A string of unfortunate shocks are to blame,” Zandi noted in the report. “Surging gasoline and food prices, and fallout from the Japanese quake hurt badly in the spring; more recently, the debt-ceiling drama, a revived European debt crisis and the Standard & Poor’s downgrade have been especially disconcerting. Confidence, already fragile after the nightmare of the Great Recession and Washington’s heated policy debates, was severely undermined. Stocks are nearing bear-market territory….. Prospects for GDP growth and job creation have diminished substantially since our last forecast.”

The irony, Zandi told Knowledge@Wharton, is that many economic gauges are more favorable than they typically are when a recession looms. Business balance sheets are very healthy, as many firms have paid down debt and locked in low interest rates. The ratio of businesses’ interest payments to cash flow “has never been lower.” Though many homeowners are struggling with mortgage debt, the overall portion of after-tax household income spent to remain current on loans is “falling fast” and could be at record low rates by early next year. Household liabilities have fallen by $1.2 trillion from their peak three years ago, a 10% drop.

(For another view of today’s unusual conditions, see this Wall Street Journal column co-authored by Wharton finance professor Jeremy J. Siegel.)

“The economy’s path depends on how swiftly and effectively policymakers act to shore up confidence,” Zandi wrote in his report to subscribers.

According to Zandi, the Federal Reserve should launch a third round of quantitative easing with an open-ended program of buying billions of dollars worth of Treasury securities every month until conditions improve. Washington also must avoid another debt-ceiling crisis, and needs to develop a long-term plan to reduce federal budget deficits, he added. That should include reform of entitlements and ways to increase tax revenues, largely by reducing tax credits and deductions. Even the cherished mortgage interest deduction should be trimmed, he noted.

“I think we are going to make our way through without a recession,” Zandi predicted during his interview. “The economy is going to gain traction through the rest of the year and into next year.”

But potential gains could be derailed, he cautioned, if a failure to address big underlying problems like sovereign debt in the U.S. and Europe further undermines consumer and business confidence. “A crisis of confidence,” Zandi said, “can become self-fulfilling.”

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