Nicholas Perna Says Eurozone Won't Fail

by: Harlan Levy

Nicholas Perna is the economic adviser to Webster Financial Corp. and chief economist and managing director of the consulting firm Perna Associates. He is also a visiting lecturer at Yale University.

Harlan Levy is a business reporter and columnist at the Connecticut daily newspaper the Journal Inquirer.

H.L.: Is the bear back, or is the stock market oversold?

N.P.: There’s some evidence that it was oversold and had gotten ahead of itself. Stocks were up 60 percent in April over last April, and I think that had built into it high hopes for the recovery and little room for any anxiety. So what we’re getting is a moderate economic recovery in the U.S. and lots of externally generated anxiety, notably from Greece.

Even so, stocks are still 50 percent ahead of where they were a year ago. Tell me what’s going to happen with Greece, and I’ll tell you what will happen to stocks. What I mean is that the big worry for financial markets today is the fallout from indebted nations such as Greece. Is this another subprime crisis in the making? The Europeans have taken some big steps to avert such a crisis, but it ain’t over til it’s over, to quote Yogi Berra.

H.L.: What’s your analysis of the eurozone situation and the massive debts of European Union countries?

N.P.: I don’t think that the eurozone will fall apart. I think that’s a very remote possibility, mainly because if that were to happen, if Greece and some other countries withdrew from the eurozone, the results could be chaotic. You’d have major runs on vulnerable currencies, starting with the drachma, which Greece would reintroduce. Then the vultures would be circulating to see if Spain, Portugal, or Italy would have to also withdraw from the European Union.

There’s so much interconnectedness of financial systems, this would not only lead to a big big decline in the value of the bonds of indebted nations, but it would affect financial institutions throughout the world, and we could find ourselves back in the situation in 2008. Would this anxiety over government debt spread to California, New York, or Connecticut? We don’t know. There’s this possibility of contagion. Nobody can declare victory at this point.

H.L.: How will the eurozone crisis affect the U.S. economy and stock markets this year?

N.P.: From the standpoint of a strong dollar, which is the result of the uncertainty in Europe, it’s very good for Americans traveling in Europe this summer. However, the overall effects could be quite negative globally and for the U.S. If the dollar strengthens further it would weaken our exports to Europe. It also would reduce the value of profits repatriated by U.S. corporations from their European subsidiaries.

You can see how diminished earnings and diminished exports would not be good for the stock market. Plus, if large parts of Europe were to fall back into recession, this would also not be good for U.S. exports.

H.L.: What do you think of the financial reform package now in the works, and will whatever we end up with avoid future financial crises?

N.P.: The bill in Congress is a major step in the right direction, but I don’t think it would prevent another major crisis, but it would probably make it shorter and shallower. We don’t know what the final package will look like, but it does address issues of excessive leverage and the use of derivatives by trying to push much of derivatives trading onto exchanges rather than just between private parties in unregulated trading. Also it restrains how much financial institutions can borrow. One of the factors that made the recent crisis so deep and so pervasive was the excessive use of leveraging. When you leverage up to the hilt you can blow through your equity in a matter of hours or days.

H.L.: Shouldn’t there be regulation of credit default swaps?

N.P.: Yes. There should be strong regulation of these instruments of mass financial destruction, which were a major cause of the financial crisis. Basically they purported to provide insurance against declining securities values, but they couldn’t and didn’t. Regulation should make these more like insurance, which would mean they would have to be backed by reserves, and these weren’t. We, the taxpayers ended up holding the bag for AIG’s (NYSE:AIG) enormous crapshoot.

H.L.: Are job gains too disappointing not to paralyze the U.S. economy?

N.P.: I think the recent job gains have encouraged people. It looks like the recovery is underway. However, last week one of the factors that roiled the stock market was a surprising increase in applications for unemployment benefits, perhaps suggesting that future job gains could be disappointing. But one week’s worth of data doesn’t change the outlook, but it is something we must watch.

At the Connecticut level, the job gains have been surprisingly good at this point, including substantial job gains in each of the first four months of the year.

H.L.: How bad is the wave of foreclosures, and what are the main effects?

N.P.: Another thing that bothered markets last week was that foreclosures and delinquencies were at a very elevated level in the first quarter, but these are lagging indicators of economic activity, so if we continue to get job growth and house prices don’t fall a lot, foreclosures should be heading down by the end of the year, albeit unevenly.

H.L.: Is the Congress and the president doing too little to avoid us turning into Japan?

N.P.: I think there’s a real risk here and globally that we’ll do the right thing at the wrong time. The right thing is to bring budget deficits down. The wrong time is now. We have the beginnings of economic recovery here in the U.S. and in parts of Europe, and if you tighten fiscal or monetary policy too soon, you’re going to end up back in recession or going nowhere, a la Japan. Japan went nowhere for better than 10 years, because it generally was too restrictive with fiscal policy, relying too heavily on temporary measures, like temporary tax cuts. The other thing Japan did was not to focus the spending part on projects that had positive spillovers. They built highways to nowhere.

Here in the U.S., if we try to cut spending too fast and/or raise taxes too rapidly, we could drag ourselves back into recession. Does that mean we should ignore deficits? Of course not. Many economists suggest passing a credible long-term deficit reduction legislation for tax increases phased in three or four years out and spending cuts to be phased in at the same time, and these would be a very calming influence on global financial markets as well as a calming measure today.

Disclosure: No positions