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Nouriel Roubini Looks at Economic Downside Risks

The passage of payroll tax and unemployment insurance extensions means that fiscal policy will not contract starting at the end of the month. The modest recovery that we’re starting to see will not get pulled back, at least not yet.

But economist Nouriel Roubini, the so-called “Dr. Doom” who happened to be absolutely right about the recession in 2008, listed a number of reasons for pessimism about the economic outlook. These are largely global risks, but they would obviously have an impact here in the US. Roubini lists four possible downside risks for the year ahead.

First, the eurozone is in deep recession, especially in the periphery, but now also in the core economies, as the latest data show an output contraction in Germany and France. The credit crunch in the banking system is becoming more severe as banks deleverage by selling assets and rationing credit, exacerbating the downturn […]

Second, there is now evidence of weakening performance in China and the rest of Asia. In China, the economic slowdown under way is unmistakable. Export growth is down sharply, turning negative vis-à-vis the eurozone’s periphery. Import growth, a sign of future exports, has also fallen […]

Third, while U.S. data have been surprisingly encouraging, America’s growth momentum appears to be peaking. Fiscal tightening will escalate in 2012 and 2013, contributing to a slowdown, as will the expiration of tax benefits that boosted capital spending in 2011. Moreover, given continuing malaise in credit and housing markets, private consumption will remain subdued; indeed, two percentage points of the 2.8 percent expansion in the last quarter of 2011 reflected rising inventories rather than final sales. And, as for external demand, the generally strong dollar, together with the global and eurozone slowdown, will weaken U.S. exports, while still-elevated oil prices will increase the energy import bill, further impeding growth.

Finally, geopolitical risks in the Middle East are rising, owing to the possibility of an Israeli military response to Iran’s nuclear ambitions. While the risk of armed conflict remains low, the current war of words is escalating, as is the covert war in which Israel and the U.S. are engaged with Iran; and now Iran is lashing back with terrorist attacks against Israeli diplomats. With its back to the wall as sanctions bite, Iran could also react by sinking a few ships to block the Strait of Hormuz, or by unleashing its proxies in the region—the pro-Iranian Shiites in Iraq, Bahrain, Kuwait, and Saudi Arabia, as well as Hezbollah in Lebanon and Hamas in Gaza […] In other words, there are many things that could go wrong in the Middle East, any combination of which might stoke fear in markets and lead to much higher oil prices. Despite weak economic growth in advanced economies and a slowdown in many emerging markets, oil is already at around $100 per barrel. But the fear premium could push it significantly higher, with predictably negative effects on the global economy.

Europe is already in a recession, and that has impacted the Chinese economy. That softening in Europe and Asia may paradoxically help the US to a certain extent, though if the world slumps, the US is probably going to feel that headwind just a little bit.

The bigger issues are housing and oil prices. Roubini is absolutely right about fiscal tightening, but that doesn’t really start to take a bite until 2013. The housing malaise will continue to be a lead weight on the economy. There have been a few decent economic indicators here lately, with housing starts up and delinquencies at a three-year low. But I agree with Kathleen Madigan that analysts are making far more out of these gains than they should:

Housing has been down so long that any gain is welcome. But the 1.5% rise in January starts was less positive than meets the eye.

First, economists expected a bigger advance. After all, the mild weather should have allowed builders to break ground on many more projects than in a typical January. Economists at IHS Global Insight warn the building activity pulled forward into the tepid winter months could mean a payback in starts come the spring.

Second, the mix of projects suggests demand for new homes is coming from renters, not buyers. All the increase was in multifamily buildings. Single-family housing starts actually fell 1.0% last month.

Madigan goes on to say that mortgage purchase applications are down year-over-year, and that homebuilders are hoping for a very big summer without much to go on. And as for what the settlement on foreclosure fraud can do for this through debt forgiveness, you shouldn’t expect anything on that front for 6-9 months.

It’s possible that housing will bounce back as the economy does, as jobs are created and household formation goes up. But that brings us to the biggest downside risk on the horizon – oil prices, which have already risen enough to cause a spike in the Consumer Price Index. As the economy came back, oil demand was always going to rise, but as we learned this week, demand is at a 15-year low. The rise in prices has more to do with fears of instability in the Middle East, the shutdown of some refineries in the US, and over-speculation by Wall Street traders.

The expectations are that prices will top $4.00 a gallon nationally by Memorial Day, and could rise over $5.00 a gallon in some areas. This will eat away at the payroll tax savings and cause a sharp risk to the economy. Rising gas prices can at least be partially blamed for practically every recession of the last 40 years.

If over-speculation really does have a lot to do with the run-up in oil prices, for the sake of self-preservation, the Obama Administration had better get off its rear and have the CFTC crack down on the practice. The past couple months have raised the prospect that the President will cruise to re-election with a strong economy at his back. If high gas prices crush the recovery, it becomes a different ball game.

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David Dayen

David Dayen

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