The U.S. economy may be more vulnerable to a catastrophic event now than at any time in recent history. There are several things that could go wrong, and if they did, it could plunge us into a recession deeper than the one we just climbed out of. Here's a look at five indicators of economic risk and what we can do to guard against them.

Bank capital

Why it’s a problem: Without adequate capital reserves, banks are vulnerable to quick drops in the value of their assets, leaving them unable to make good on short-term loans.

How bad it could get: A Lehman Brothers repeat—cascading failures of banks or “shadow banks” in which borrowing and lending would grind to a halt.

What we can do about it: Strictly enforce capital requirements, with no loopholes, for banks and shadow banks alike.

 

Housing market

Why it’s a problem: Federal backstopping of home loans could be artificially propping up prices (which have fallen dramatically in the past three years) and encouraging overly risky lending.

How bad it could get: Another sharp drop in housing prices and a spike in foreclosures—like the recent housing crisis but starting from a lower peak.

What we can do about it: Further tighten lending requirements; phase out the government-backed mortgage system.

 

 

Climate change

Why it’s a problem: Greenhouse-gas emissions concentrating in the atmosphere are on pace to heat the planet, pushing up sea levels and likely increasing weather extremes such as droughts and floods. The results would wreak havoc on crops and water supplies, and force millions of people to migrate.

How bad it could get: Under a low-risk, high-impact scenario, the climate could change very rapidly, wiping out food supplies and creating a difficult-to-reverse warming cycle.

What we can do about it: Begin to price the climate-change effects of emissions, mostly by building those costs into the price of fossil fuels.

Oil prices

Why it’s a problem: Rising gasoline prices drain domestic consumption, weakening the economy; major oil-price increases have preceded every American recession except one since World War II.

How bad it could get: If Middle East protests spread to Saudi Arabia, oil could top $200 a barrel and gasoline could reach $6 a gallon, plunging the United States into deep recession.

What we can do about it: More aggressively seek alternatives to gasoline-powered transportation. Even dramatically ramping up domestic drilling would do little to shield the U.S. economy from $6-a-gallon gas.

Sovereign debt

Why it’s a problem: Large gaps between federal spending and revenues, in the recent past and projected over the coming decades, have all but eliminated fiscal policy as an option to lift America from another downturn.

How bad it could get: If debt levels rise unchecked and the economy suddenly weakens, U.S. borrowing costs could increase sharply, forcing lawmakers into painful austerity measures and triggering a prolonged recession.

What we can do about it: Reassure debt markets by taking credible steps to reduce fiscal deficits in the medium and long term.

Video by Theresa Poulson with photos by Getty Images

This article appears in the March 12, 2011, edition of National Journal.

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