Forget the Debt Ceiling -- Worry About the Economy

While the debt-ceiling debate grabs all the headlines, there's a potentially more troubling scenario developing for financial markets: a crumbling economy.

New reports revealing the economy nearly stalled out in the first half of the year have triggered renewed fears the U.S. could soon succumb to a second recession.

While views vary about the likelihood of a double-dip contraction, even the biggest bears were surprised when the Commerce Department on Friday took an axe to its first-quarter gross domestic product figure, saying the U.S. grew at an anemic 0.4% pace, down from 1.9% previously.

GDP last quarter rose just 1.3%, well shy of estimates of 1.8% growth.

The risk of a recession is much more heightened right now, Douglas Holtz-Eakin, the former director of the nonpartisan Congressional Budget Office, said in response to Fridays economic figures. The fact were still above water is good, but theres nothing pretty about this picture.

The 0.4% figure for the first quarter is dangerously close to the flat line and represents the worst growth since the apparent recovery began.

Alarmingly, consumer spending grew just 0.1% in the second quarter and durable goods orders, or big-ticket items like lawn mowers, declined 4.4% -- the steepest drop since late 2009. Government spending also fell for the third quarter in a row.

D.C. Drama Looms Over Forecast

Its important to note that recessions are declared by the National Bureau of Economic Research (with a significant lag) and are technically defined as two consecutive quarters of negative GDP, something that has not happened since 2008.

Slowdown fears swirled even before paralysis hit corporate America as Washington struggled this summer to reach a deal to raise the $14.29 trillion debt limit.

The deadlock threatens to wipe out the nations AAA credit rating and adds to the uncertainties blocking companies from spending on new products and personnel.

With growth rates this low, even a small negative impact resulting from failure to increase the debt ceiling and defaulting on our obligations could turn the economy back into a recession, Martin Regalia, the chief economist at the U.S. Chamber of Commerce, wrote in a statement urging Congress to raise the debt limit.

Still, most investors and political insiders expect the dramatics in Congress to result in a last-minute deal to raise the debt limit and avert a near-term crisis. (The AAA rating may be gone anyway, though). Many economists believe so long as a deal is reached, the U.S. will easily avoid a double-dip.

Just a Soft Patch?

Moodys Analytics is still calling for a second-half rebound, projecting GDP to rise between 3% and 3.5%.

We think this is a soft patch, we will get through it and we will see an acceleration of growth, said Gus Faucher, director of macroeconomics at Moodys Analytics, who sees a 25% chance of a double-dip recession.

Like other optimistic economists, Faucher believes most of the issues hitting the economy in the first half, such as high gas prices and supply disruptions in Japan due to the earthquake, will fade. For example, motor vehicle output shrank 4.7% last quarter.

The White House appears to be in this camp. When asked if the weak GDP data signal a double-dip risk, the administration said it expects the U.S. economy to keep growing. (Of course, the Bush Administration had a similar stance ahead of the 08 meltdown).

Dean Baker, co-director of the left-leaning Center for Economic Policy and Research, sees just a 10% chance of a double-dip recession. Its not because hes gung-ho on the economy, he just doesnt believe the problem areas like construction and consumption can perform much worse than they already are.

When you go through it sector by sector, its hard to see how you get a recession, apart from a financial panic about the debt ceiling, said Baker.

Historically Poor Recovery

Still, even optimists will concede the economy has failed to bounce back the way one would expect from a deep recession. After the other two deep downturns in the post-war period, the recessions in the mid 1970s and early 1980s, GDP jumped as much as 7% or 8%.

We can say that the current recovery is, nominally speaking, the worst of any recovery since the early 1920s, Dan Greenhaus, chief global strategist at BTIG, wrote in a note. That is truly both a historic and awful accomplishment and yet it underscores the size and scope of the issues facing the United States.

Thats part of the reason why Peter Kenny, managing director at Knight Capital Group, sees a greater than 50/50 chance the U.S. slips into another recession.

He called the 400,000 new initial jobless claims filed each week terrible and said the housing market remains at depressed levels, by any historical standard. Kenny added, There is very little appetite for risk and subsequently, for growth.

Wall Street appears to be taking note of the new double-dip fears as the Dow Jones Industrial Average was on pace late Friday afternoon for a sixth-straight day of losses. The blue chips have lost roughly 4.3% over that span, the worst six-day slump since mid-March.

Debating the D Word

James Rickards, co-head of Omniss threat finance and market intelligence practice, said the chances are extremely high the U.S. heads into a second recession. Thats because he believes the economy is actually in the midst of a depression that started in 2007 and will run until at least 2014.

I dont see this as a soft patch in a recovery. I think of 2010 as a strong patch in a depression, said Rickards, who noted that GDP briefly grew in the early 1930s before shrinking again later in the decade.

What were experiencing now is a desperate struggle to break out a of a debt death struggle, said Rickards, who called for eliminating corporate income taxes and slashing personal income taxes to avoid a disaster. In theory, no one was better prepared to avoid it than [Federal Reserve Chairman Ben] Bernanke. The irony is that he is being required to relive it.

The term depression is spelled out less clearly than recession, but it generally refers to a severe and prolonged period of high unemployment, a significant drop in business activity and falling prices.

Even Baker said the current conditions could eventually fit the bill of a depression, but he said he would hesitate to call it that because depression is not a well-defined concept.

While the economists debate the differences between recessions and depressions, Kenny said he will be closely watching the labor markets for clues as to whether or not a double-dip is in the cards.

If weekly jobless claims fail to ebb from their elevated levels, you can be sure we are heading into a recession, said Kenny. You will not have to wait for the next quarterly GDP report.  Youll know ahead of time.

Given the recent track record in Washington, Holtz-Eakin seemed to have little hope politicians will be able to turn the economy around.

Still, he hasnt jumped into the double-dip camp -- yet. Im enormously respectful of the power of the private sector and how resilient it is.