Understanding the Odds of a Double-Dip Recession

We should first define what a double dip recession is. For purposes of this article, we shall adopt the most common definition utilized by economists -- and one which also happens to make common sense: A double dip recession is an occurrence whereby the US economy enters into a recession within a period less than 12 months following the end of the previous recession.

According to the National Bureau of Economic Research (NBER), the most authoritative source of information regarding business cycles, there have been 33 recessions registered in the US since 1854. Over this entire time frame, there have been only three recorded instances of a double-dip recession by this standard definition. The first one was in 1913, the second in 1920, and the third in 1981.

(Note: If we make the definition of a double-dip more expansive, including all recessions within 18 months of the end of the previous recession, the number of occurrences of double-dips rises only slightly to five.)

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How Likely Is a Double-Dip in 2010?

It's likely that the NBER will declare that the recession that began in December of 2007 ended in July of 2009. If that's the case, the economy will have to begin to contract by July of 2010 in order for a double-dip to occur. Even under the more expansive definition of a double-dip, a contraction would have to begin by January of 2011.

Independent support is plentiful for the notion that it's highly unlikely that a double-dip recession could arise from endogenous forces in 2010. For example, the NY Fed Model (based on Treasury yield curves) and the Leading Economic Index (LEI) -- both of which have a very good track record -- are signaling that the risk of a double-dip recession is close to 0%

In my view, the only credible threat to the US recovery in 2010 would be a major exogenous shock. What sort of exogenous shocks would be capable of provoking a reversal of positive economic momentum coming out of a trough?

An abrupt ramping up of interest rates such as that which caused the 1981 double-dip would be an example of such an exogenous shock. However, such a scenario in 2010 is fairly unlikely due to the absence of the type of inflationary momentum that existed in 1981.

A more credible exogenous threat, in my view, would be a spike in fuel prices caused by military conflict in the Middle East. Another, less likely, exogenous shock could come in the form of contagion from financial crises emanating from Europe due to sovereign risk re-ratings. Another, also unlikely, possibility might be a confidence-destroying terrorist attack. Finally, a dramatic domestic unraveling of President Obama’s credibility and effectiveness as a leader could potentially zap overall confidence in the US amongst domestic and foreign consumers and investors.

Currently, I'd place the combined odds of a double-dip recession prior to December 2010 at less than 25%. I'd characterize this level of risk as low, albeit substantial. Structural vulnerabilities due to endogenous factors play an integral part of this risk assessment. However, it's my view that the risk of a double-dip in 2010 is probably less than 5% without a major exogenous catalyst.

http://www.minyanville.com/articles/Kostohryz/index/a/26285