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Economist Fred Carstensen is a professor of finance and economics at the University of Connecticut and director of UConn's Center for Economic Analysis.

Harlan Levy: Weekly jobless claims hit 379,000, up 10,000 over the previous week, and looking at the four-week moving average, they were up 13,250, not a great trend. What's ahead for jobs?

Fred Carstensen: Obviously, the economy is growing at a very, very modest rate and is generating relatively weak job creation. The general pattern has been creating lower paying jobs, not higher paying jobs. The consequence is that even though we've had job growth, it has not translated into strong growth in demand. Unless and until we see strong growth in demand, the malaise that we have been experiencing will simply continue.

HL: Third-quarter Gross Domestic Product growth was strong. What do you make of that?

FC: It was fairly strong, but it was overwhelmingly a growth in inventory. That's very deceptive, because inventory is unsold goods. It was not a harbinger of strong economic recovery. It was, in fact, saying that the economy is continuing to struggle and continues to grow well below its historic average. Every notable economist has lowered GDP growth for the fourth quarter. We are now about 58 months into the recovery, which is by every metric the weakest economic recovery since World War II.

We have a long, long way to go. We're approaching five years into recovery, and five years is a pretty long time for economic expansion. I think we have to continue this expansion for another two years to get back to where we were.

The irony is that the Obama Administration focused its attention on health care reform and did not focus on the economic challenges when it first came into office when they had a Democratic majority in the Senate and the House. So the Democrats share a significant share of the blame because of their inaction.

When the Republicans took control of the House they made it worse. In the confrontations after 2010 there were enormous cuts in government programs, and we've had shrinkage in federal and local government, and we've laid off hundreds of thousands of teachers, firefighters, and police. By every aggregate measure, every level of government has contracted, and the critical public sector activities as well, whether in education, research, or infrastructure repair. They have fallen below what is essential if the U.S. is to restore its position in the global economy.

HL: What do you expect from manufacturing?

FC: In general, from the purchasing managers index and the various federal manufacturing surveys, we see that inflation extremely muted. In fact, we need higher inflation, which would induce businesses to stop sitting on their enormous accumulation of cash, because inflation imposes a penalty on holding cash, and it would induce them to find places to spend it.

Manufacturing has had very high productivity growth. As a consequence although manufacturing output has been growing, that does not translate into net new jobs. Manufacturing output needs to grow at more than 2.5 percent a year before it's going to have any direct impact on employment. So the relative health of the manufacturing sector is good, but doesn't really address the fundamental weaknesses in the overall economy.

HL: Where are stocks headed?

FC: Stocks are at historic highs, and I know that a lot of people insist that they're not overvalued. The conventional way of valuing stocks is the ratio of stock prices to profits, and profits are historically high, so the ratio looks reasonable.

But that's wrong for the following reasons: Profits are high because businesses are not investing. It's an accounting situation. Because they're not investing their costs have gone down dramatically. Those profits are coming at the expense of the kind of investments needed to sustain the long-term competitiveness of the businesses themselves.

When we return to a normal environment, corporate profits will shrink very significantly, not because businesses are making less money but because they will invest, and then the stock market will look significantly overvalued. That's why the stock market will decline in the next few years. And as the Federal Reserve's tapering of its monthly bond and equity purchases takes effect, interest rates on long-term bonds will rise, and that will pull money into bonds and away from the equity market. You're also lowering demand for equities at the same time. And when demand falls, typically stock prices fall. I would not be surprised to see a market contraction of 10 to 20 percent in the next two to four years. I just do not see a scenario where the market can sustain its current valuations.

HL: Is the surge in the housing market faltering?

FC: There's a lot of volatility, but the trend line has been good. Valuations have recovered. More and more people are coming out from being underwater. There's a lot of pent-up demand. Normally the fall is not a period where you have a lot of purchases. Normally it's spring and summer, so the fall period is not meaningful. But housing today may reflect confidence about going forward, because it has been enjoying over the long run a modest improvement.

However, consumer confidence remains quite weak, and we'll see how the Christmas season goes. The initial level of demand on Black Friday was not particularly good, so it still looks like the economy is continuing its very slow path to recovery.

HL: What do you think of the Federal Reserve's tapering its monthly purchases starting in January?

A: It's a very small surprise. The general feeling was that the Fed was not going to start tapering in February or March. Also, it's a modest taper, and it's going to be primarily focused on the part of quantitative easing of long-term federal debt. So it's a very cautious strategy to move away.

The Fed holds about $3.6 trillion in assets in its efforts to stimulate the economy, and tapering was something they had to begin doing. The fact that the Fed had to take these extraordinary measures in the first place underlies how irresponsible Congress has been in not shouldering its share of the burden for restoring the health of the national economy.

Fed Chairman Ben Bernanke in his testimony to Congress has been quite clear that Congress should have been doing much more to stimulate the economy. Fed policy was driven in large part by the failure of Congress to act. The mid-term election in 2010 was an unfortunate confluence of factors. You had the Obama Administration mishandling the financial crisis and there was enormous anger at government. And by all accounts the Republicans should have won the presidency in 2012, but they snatched defeat out of the hands of victory.

We're going to have an extremely interesting election next year.

HL: What do you think of the little budget deal, the first budget Congress passed in years?

FC: The budget deal will not necessarily avoid a catastrophic confrontation roughly in March over the debt limit. It's a process in which they have to pass the authorizations. So there's a lot that has to be done. That said, it's also the case that the best you can say for it is that it slows the rate of competitive decline in the U.S.

It does roll back some of the most disastrous aspects of the sequestration's across-the-board spending cuts. That really damaged and undercut strategically important investments in human capital, such as the funding of the National Science Foundation and the National Institutes of Health, the really core public sector investments. And it does nothing to address the dramatic decline in investments in physical infrastructure -- roads, highways, airports, and seaports.

It also failed to address the unemployment compensation situation. Almost 2 million people will lose their unemployment benefits in the next 12 months. That will measurably reduce aggregate demand for goods and services and, therefore, undermine the willingness of businesses both to hire new employees and to invest in capacity.

The budget deal, even though it reduces uncertainty, will actually lower American economic growth.

HL: What do you think of the extreme degree of income inequality?

FC: There are people who are now aware of the enormous inequality of income that has been developing over a long time. The average American household has a lower income than in 1997, and the average full-time male employee is earning in real terms the same wages he earned in 1973. As for how we restore a living wage and the rapidly contracting middle class in the U.S. you just can't say the market will sort it out.

The arguments are going to have to revolve around how America is going to restore its competitiveness, and that's not an easy issue to address, but people recognize that government has a role in how the market functions. I think that increasingly people who historically voted Republican are realizing that Republicans are making them lose their unemployment benefits and that the people they voted for are doing them a disservice. People are also becoming aware of the degree we are all interconnected and that a number of these programs are really important to the health of our communities.

HL: What do you think of the health care situation?

FC: In health care, the costs are literally killing us. We spend twice as much on health care as any other developed economies in the world, but in terms of health care outcome, we're behind more than dozen emerging economies. It is a stunning, phenomenal issue. We are literally killing our competitiveness with outrageously ineffective health care.

Obamacare is beginning the process of addressing that, but because of political compromises essential to getting it passed and deals with the insurance companies, the hospitals, and the pharmaceuticals, that meant not addressing the cost problem as effectively as you should, although, to some extent the law had to protect the economic interests of those groups. It's a good-faith effort, but we have a long way to go.

Now if Obamacare works, it will have addressed one of the huge issues: the large number of Americans who have no access to health care. And if in fact we are able to provide reasonably good access for virtually all Americans that will be a huge step forward for us as a country and for the economy, because a healthier population is a more competitive population.

Meanwhile one group says we have to do something, and the other group says no, we don't have to do anything. But not doing anything is unacceptable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Interview With Fred Carstensen: 2 Years To Full Recovery, Stocks To Correct 10-20% In 2-4 Years