Sorry Mr. Bernanke: There Will be a Double-Dip Recession

Despite what U.S. Federal Reserve Chairman Ben S. Bernanke said in his speech at the International Monetary Conference yesterday (Tuesday), it looks very much like we're headed for a double-dip recession.

Indeed, the economic reports of the last week or so demonstrate that the U.S. job machine was never really jump-started after the Great Recession of 2008-09.

The upshot: The U.S. economic recovery is stalling, and we're almost certainly looking at a double-dip downturn.

Recessions are always painful – and double-dip recessions are even more so.

And this second "dip" may be more of the same – a bloody economic downturn that leads into a feeble recovery with unemployment spiking to even higher levels than we're currently seeing.

But there's a slight chance that this double-dip recession could prove quite productive for the U.S economy.

Let me explain.

Anatomy of a Double-Dip Recession

That a "recession" of any kind could be productive might seem contradictory, but it's actually quite logical. That's not to say that we're ignoring the very real human toll – not at all.

But recessions can and do serve a productive purpose: An economic downturn can clean out the bad investments and misallocation of capital that tend to proliferate during boom periods, eradicating the "overhang" of surplus capacity across industries and set the stage for a more-vigorous – and ultimately healthy – recovery.

That opportunity for a healthy economic cleansing of precisely that type is especially apparent today. After the largesse of recent years – the subprime mortgage crisis, credit default swaps, mortgage-backed securities and the creation of far too much liquidity thanks to bailouts and easy monetary policy – there is a great mess that still needs to be cleaned up.

If we end up with a double-dip recession, the type of downturn – productive or unproductive – will depend upon the fiscal and monetary policies chosen. Unfortunately, if you're a wagering person, I'd have to say that the odds favor the wrong choices being made – resulting in an "unproductive" dip.

The Gloomy Scenario Bernanke Won't Acknowledge

The economy only added 54,000 new jobs in May – the lowest amount in eight months and only about a third of what was expected. That's pretty definitive proof that Washington's fiscal and monetary stimulus have not worked. (Not surprisingly, in his speech to the group of international bankers in Atlanta yesterday, Bernanke not only refused to acknowledge the likelihood of a double-dip recession – he even insisted that job growth will accelerate in the year's second half.)

Washington's fiscal stimulus – including the government dumping nearly $1 trillion into such unproductive pursuits as "new energy" projects and state employee labor union contracts – has generated massive budget deficits and given banks no incentive to play its key job-creation role by lending to small businesses.

Instead, the stimulus has provided temporary jobs with the government – and those jobs are now disappearing as Washington's money runs out.

Monetary stimulus has been more damaging. It has caused a worldwide commodities and energy bubble – which is single-handedly damaging the U.S. economy by making it more and more expensive for consumers to fill up their tanks. It is also likely to have contributed to the growing job-market malaise – and with good reason: Economic theory suggests that when capital is very cheap, businesses will use more capital at the expense of labor, reducing the demand for workers.

It is not surprising that the combination of extreme monetary and fiscal policies has now produced a downturn: The true costs of those policies was predestined to appear long after their benefits had disappeared.

But what happens now depends on how the authorities react to evidence of further economic weakness.

Why Pain Now is Better Than Pain Later

In the more likely scenario, the calls for another round of public spending "stimulus" will become deafening. Expect the same emotional call for a third round of Fed purchases of government bonds – aimed at holding down interest rates – to be created after the current round ends on June 30.

With this third round of quantitative easing – known as "QE3" – there may be a short-term boost to the economy. But the benefits will be very limited – and will be quickly overwhelmed by spiraling inflation as energy, commodities and other goods rise in price.

These price spikes will quickly suppress consumer spending, which accounts for about 70% of this country's economic output. That drop in spending will produce a further relapse in the U.S. economy – probably accompanied by a bursting of the bubble in commodities, energy, U.S. Treasury bonds and the stock markets.

Once that happens – Fed Chairman Bernanke's latest comments to the contrary – a double-dip recession is pretty much fait accompli. Rapid inflation will erode U.S. living standards, while low interest rates will cause the nation's already-pitiful savings rate to drop even more and capital to flee to Asia.

A recovery will eventually come, but that recovery will be one with much-lower living standards, and wage rates that are much more in line with those of emerging Asia.

Alternatively, it is possible that the politicians will come to an agreement about major spending cuts, while the Fed makes a frontal assault on the commodities/energy bubble by raising interest rates.

In the short run, this scenario will be much more painful, with a much higher human toll: The stock market will crash and a surge in real interest rates combined with the plunge in asset prices will prompt bankruptcies to spike.

However, the higher interest rates will raise domestic savings rates as well as the demand for labor. So when the recovery does come, it will be much healthier – marked by declining inflation, the elimination of the U.S. balance-of-payments deficit, and an unemployment decline as rapid as the one we saw back in 1983 (when job creation averaged 350,000 per month for the first two years of recovery).

With a rise in interest rates and a decline in public spending, a "double-dip recession" will be productive, returning the economy to a more-balanced track and wiping out much of the false investment of the successive bubbles. Unfortunately, given our current slate of policymakers, we are much more likely to get an unproductive double-dip, in which the economy's real problems are not addressed and unemployment fails to decline.

For investors, it is difficult to hedge against two such disparate potential scenarios as the "good" double-dip versus the "bad" double-dip. But here's the thing: T-bond yields have declined even further during the last month – even though inflation has increased. That means the market is betting on further Treasury bond purchases by the Bernanke-led Fed.

Since both "double-dip" scenarios include higher Treasury bond rates in the intermediate term – the one because of inflation and the other because of explicit rises in interest rates – taking a bearish position in U.S. Treasuries appears to be an excellent bet. To do so, you might consider the ProShares UltraShort Lehman 20+ Year Treasury Fund (NYSE: TBT), an exchange-traded fund (ETF) that takes a leveraged short position in long-term Treasury bond futures.

News and Related Story Links:

• MSNBC.com:
  May employment report shows pace of job growth weakening.
• Money Morning Special Report:
  Credit Default Swaps: A $50 Trillion Problem
• Investopedia:
  Double-Dip Recession.
• MarketWatch.com:
  
  Bernanke Sees Job-Growth Pickup in Year's Second Half.
• Investopedia:
  Real Interest Rates.
• MarketWatch.com:
  Text of U.S. Federal Reserve Chairman Ben S. Bernanke's Speech at the International Monetary Conference.

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