The recent collapse in stock prices and Treasury yields in the U.S. was not related to any direct evidence that the U.S. economy was headed for a double-dip recession. It was mainly driven by fears of a European sovereign debt crisis that could potentially lead to a massive bank failure and a collapse of the Eurozone economy. With Europe already weak, a financial crash would likely bring the economy to its knees, and that in turn would be a serious drag on the U.S. economy. The chart above, which compares the S&P 500 index to its Eurozone counterpart, illustrates the dynamics. The recent Stoxx decline correlates highly (0.85) to the decline in the S&P 500, but the Stoxx index has fallen almost 20% more than the S&P 500 in the past six months. If investors are running scared here, they are in full-blown panic mode in Europe.
As the above chart shows, a Greek default/restructuring on its $500 billion of debt is a foregone conclusion; the only issue now is how serious the haircut will be. The likelihood of a Portuguese ($225 billion of debt) or Irish ($160 billion of debt) default/restructuring is less, but still a haircut of some magnitude is expected. The chances of an Italian default are not much higher than that of a BAA-rated company, but the size of Italian debt outstanding ($2.3 trillion) is what makes the market shudder. Pick even relatively small haircuts on the total debt of these four countries (just over $3 trillion) plus maybe Spain ($920 billion), and you quickly come up with losses that could wipe out the capital (about $600 billion) of Europe's 20 largest banks, which collectively own over $4 trillion of PIIGS debt. The numbers are scary indeed.
This chart of swap spreads offers some consolation. Eurozone swap spreads are quite high, signaling serious systemic risk and investor's attempts to avoid bank counterpart risk, but they are not catastrophically high like they were in late 2008. Plus, U.S. swap spreads remain at low, normal levels, which is a good indication that U.S. banks are almost entirely insulated from the consequences of a Eurozone sovereign debt default.
I refer back to a post I made a month ago, in which I argue that "most of the bad effects of too much debt have already happened." The money borrowed by Greece, Italy, et. al., has already been squandered on non-productive activities. Governments have misused scarce resources, and that is why their economies are relatively weak. Defaults don't necessarily lead to weaker economies, since debt is a zero-sum game: a restructuring of Greek debt means a loss for the holder of the debt, but a gain for the Greek government, since it is relieved of some of its debt burden. The Greek economy won't shrink just because it defaults; it is still full of people, offices, factories, and machinery that will go on producing. The worst thing about the threat of a default is that everyone wants to avoid taking the loss, and fear and panic can produce an economic slowdown—this is the phase Europe is in right now. The one good thing that will surely come from this is that governments will be forced to reform their spending habits. The era of Big Government is slowly drawing to a close.
Meanwhile, the 6% growth of real retail sales over the past year disproves any suggestion that the U.S. economy might be entering a double-dip recession.