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It might be time to talk double-dip recession

June 8, 2011, 1:00 PM UTC

In normal times, the default setting for the U.S. economy is ‘expand.’ But these aren’t normal times.

Last year I dropped by a birthday party for Nouriel Roubini (a.k.a. “Dr. Doom”), the New York University economist who shot to fame after predicting, in 2006, a housing and credit bust. Somebody brought out a cake. On top of it was a big frosted “W,” representing the double-dip recession that Roubini had been trumpeting since the summer of 2009, when the recovery had hardly begun. Beaming, he blew out the candles and poured champagne. But as the global rebound proved more durable than he (and others) expected, Roubini backtracked. Last August he put the probability of a double dip at 40%, which meant it no longer qualified as a genuine prediction. Going into this year, he said the U.S. economy would expand by close to 3%. And Roubini wasn’t alone. The economics group at Goldman Sachs, which had been notably bearish, reversed course and said GDP would rise by 4% in 2011.

As if on cue, the economy took a downward lurch. In the first quarter, GDP expanded at a rate of just 1.8%, and house prices fell. Recently factory output has slipped. Yes, there are conflicting signals. Employers still appear to be creating jobs — 54,000 in May. Consumer spending, which makes up two-thirds of overall spending, has held up. But could the doomsters end up being proved right after all?

It isn’t out of the question. The default state of the economy is expansion. America boasts a growing population, flexible goods and labor markets, a sprawling financial system that provides more than ample credit, and policymakers who habitually react to bad news by turning on the monetary and fiscal taps. In the absence of a major shock — the Fed raising interest rates sharply, the bursting of an asset price bubble — this commitment to growth ensures that GDP generally keeps rising.

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But these aren’t normal times. Consumers are still heavily in debt and are worried about the future; businesses remain reluctant to invest; banks are nervous about lending; states are laying off workers by the tens of thousands. In such circumstances it is conceivable that small shocks could tip the economy back toward recession. Take the rise in gas prices to $4 a gallon (closer to $5 in my forecourt), which acts like a tax increase. Higher gas prices, if sustained, could knock a full percentage point off economic growth over the next year.

Falling house prices and the possibility of a big slowdown in China, the locomotive of the world economy, are other worries, as is the possibility of the European debt crisis spiraling out of control. But my biggest concern is the coming reversal in U.S. policy, which the markets are probably underestimating. Since the fall of 2008, policymakers at the Fed, at the White House, and on Capitol Hill have had but one aim: heading off an economic disaster and ensuring a recovery. Now other concerns are starting to predominate: the deficit, the dollar, and inflation. As Congress shifts from passing stimulus programs to cutting spending and the Fed abandons quantitative easing — pumping extra money into the financial system — critics of these emergency policies may discover why they were so necessary. (For another view, see “Taking a Stand on Bonds.”) Absent the federal government acting as the buyer of last resort, businesses will be even more reliant on exports. And without the Fed stoking the markets, Wall Street could be facing more tough times.

Is the private sector ready to stand on its own two feet? We are about to find out. Roubini, perhaps realizing that he hopped off the double-dip train early, appears about ready to clamber back on board. Speaking at a hedge fund conference in early May, he trimmed his 2011 growth forecast to less than 2% and said unemployment could head back up to 10%. “Things,” he declared, “are going to be much more difficult than they have been so far.”

–John Cassidy is a Fortune contributor and a New Yorker staff writer.