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Nariman Behravesh is chief economist at consulting firm IHS Gobal Insight. He directs Global Insight's forecasting process and is responsible for developing the economic outlook and risk analysis for the U.S., Europe, Japan, China, and other emerging markets.

HL: In light of those most criticalJuly job numbers – only 71,000 new private sector jobs -- anemic retail sales, unimpressive Gross Domestic Product growth, and an unabated flood of foreclosures, is the economy headed for a major slowdown in the second half of the year and beyond?

N.B.: The economy is headed for a major slowdown in the second half of the year. We will only be able to manage about 2 percent growth in the second half, and we need 3 percent growth to get the unemployment rate on a steady downward trend. So if we’re stuck at only 2 percent, what that means is that the unemployment rate will be stuck in the mid-nines – 9.6, 9.4, 9.5 -- for the balance of this year.

There are two things going on here. The first is that the big fiscal stimulus that we had is winding down. That is a bit of a headwind. The second is that some of the pop we had in growth, with fourth-quarter growth as high as 5 percent, some of that was from inventory building, and that cycle is over. So now we’re looking at the fundamentals: consumer spending and business spending. Here we’re beginning to observe super caution on the part of households and businesses. They’re saving a lot, and they’re being very, very careful in their spending. What we’ve got is an economy right now where we’re paradoxically saving too much almost.

H.L.: If we need around 125,000 new jobs a month just to keep up with population growth, when will job growth meet that need, if ever?

N.B.: Going forward in the early part of next year and certainly as the year progresses growth will gradually pick up steam. In the first half of next year we’ll get into that range where we’re matching population growth. The earliest it will happen will be the first quarter of 2011.

HL: If rising unemployment and shrinking consumer spending raise the risk of deflation, what are the chances we’ll have deflation and how bad could it be?

N.B.: Right now our assessment is that deflation in the sense that the consumer price index and the core CPI will move into negative territory has a 25 percent chance of happening. There’s enough growth right now and the Federal Reserve is worried enough about it and willing to do enough about it that it’s not the most likely scenario.

H.L.: Do we need a new round of better targeted federal stimulus spending to stave off deflation and help the economy?

N.B.: What’s needed in the aftermath of a financial crisis is a fairly long period of healing, deleveraging. That’s the healing process. That takes time. All were doing with these targeted stimulus programs is postponing that healing process. For example, we had stimulus tax incentives aimed at housing. They were temporary, and once they came off, home sales dropped again. The same thing with the “Cash for Clunkers” program. The same thing for the recent $26 billion grants to help state and local governments. That’s great, but the moment that stops, state and local governments are going to have lay off workers. Politically, it’s great, because the Democrats can say, “Oh, we did this and did that, and look what we’ve done for the economy.” But economically, all you’ve doing is postpone the adjustment process.

And of course there’s the issue of whether we can afford extra stimulus. Time may be the greatest healer of all. We’ve done a lot already. We need to wait.

H.L.: How long can the job cutting by the revenue-starved and deficit-plagued states continue without adequate federal help before it threatens the overall economy?

N.B.: Already it’s clearly a factor in the very sluggish job growth. It is a problem, and it is one of the problems that’s getting in the way. The feds can only do so much to help state and local governments, which will have to get their finances in order. It will take time. Hopefully they’ll do it in a way that’s not going to kill the recovery. I don’t think it will kill the recovery, but it certainly will make the recovery a sluggish one, and that’s what we’re seeing right now.

H.L.: Do you see the housing market improving any time soon, and how much is it affecting the economy?

N.B.: The housing market is clearly a factor in the economy. Housing is bouncing along the bottom – up, down, up, down – and there’s a healing process involved. There are still a lot of families under water in that their mortgages are a lot bigger than the value of their homes. That’s going to take time to work that out, and the good news is with prices down and mortgage rates way down, the incentives to buy a house are there, and the low interest rates are allowing at least some people to refinance and get out from under the burden of these mortgages.

So the housing market is getting a little in the way of the recovery. It’s not contributing to the recovery, but it’s hopefully not dragging it down by very much. Housing is still a fairly small chunk of the economy, and it’s not plummeting the way it was before, not really hitting lows, but it’s not adding to growth either. Normally you’d expect a rebound in housing in this phase of the recovery, but we’re not getting that.

H.L.: Is the stock market out of whack with economic reality?

N.B.: Not at all. The reason is simple, and it goes back to the financial health of corporations. Corporations are being so careful with their costs, slashing costs, and not rehiring very aggressively that earnings are looking very good. They have a lot of cash. Corporate cash flow as a share of GDP is up, so that sense the stock market is reacting to the financial condition of companies, and in that sense it’s not out of whack.

H.L.: Do you see continuing high volatility in stocks?

N.B.: There’s no question that we’re stuck in a volatile market, because the news on the economy will continue to be iffy. There will be some good news, some bad news, so we are in a period that could go on for six months and maybe even longer in which the market is going to bounce around quite a bit.

H.L.: Lastly, are tax hikes inevitable, and is it a good idea to let the Bush tax cuts for the wealthy expire?

N.B.: There’s no question in the medium to long term that a number of these tax cuts should be allowed to expire, but this is the worst possible time to do it, a time when the economy is slowing. So the policy advice that I and my colleagues and a number of other economists is giving is extend all of them for a couple of years and then let some of them phase out, say at the end of 2012, when we feel more confident about the recovery. Announce the phase out and announce a credible plan to reduce the deficit, but don’t do it now.

H.L.: Would you let just the tax cuts for the wealthy expire?

N.B.: Definitely those, but there may be other ones as well that one would want to consider. The truth that no politician wants to talk about is that to balance the budget everybody’s taxes are going to go up. The harsh truth is the way to get this deficit back down to manageable levels everybody’s taxes are going to have to go up, one way or another.

Frankly, if we’re talking about the deficit, both parties in Congress have acted irresponsibly. Nobody has made the tough calls. Nobody has shown any leadership. Certainly during the boom years the Republicans should have been much more careful in terms of spending and should have had more restraint. Spending got out of control. The Democrats, on the other hand, are going around saying that the way to solve this is to raise taxes on the rich.

The reality is that, depending on how you define the rich, the top 1 percent pay about 25 percent of the income taxes, and the top 10 percent pay about half the income taxes. How much more realistically are you going to raise taxes on the rich without potentially providing incentives for a lot of rich people to move their money offshore, to go somewhere else? The same thing happened in Britain in the 1960s and 1970s.

What we need, and here is where the Democrats and Republicans have not shown any leadership, is reforming Social Security, Medicare, and Medicaid. To get the costs there under control is crucial to getting our deficit under control in the next couple of decades. Nobody, not Bush, not Obama, not the Democrats, not the Republicans have dealt with this issue.

H.L.: How would you deal with that issue?

N.B.: There are lots and lots of potential solutions. One is to impose higher co-pays, based on income levels. You can provide incentives for people not to use taxpayer funds so freely for things like Medicare. I would strongly recommend you raise further the retirement age over time. There’s lots of ways you can control the costs of health care and the benefits you pay. You can use means testing for the benefits that are paid. For Medicare, if your IRS filings at age 70 are, say, $200,00 a year, shouldn’t you pay more than your fair share of healthcare costs? There should be a sliding scale for benefits paid based on income. These are things you can phase in over a 10- or 20-year period, not tomorrow.

The good news is that in 1983 the Social Security Commission chaired by Alan Greenspan put in places major fixes which helped. We still probably need to do a little more on Social Security, but we went a long way in fixing Social Security. Now we need to fix Medicare and Medicaid.

Frankly, if we’re talking about the deficit, both parties in Congress have acted irresponsibly. Nobody has made the tough calls. Nobody has shown any leadership. Certainly during the boom years the Republicans should have been much more careful in terms of spending and should have had more restraint. Spending got out of control. The Democrats, on the other hand, are going around saying that the way to solve this is to raise taxes on the rich.

The reality is that, depending on how you define the rich, the top 1 percent pay about 25 percent of the income taxes, and the top 10 percent pay about half the income taxes. How much more realistically are you going to raise taxes on the rich without potentially providing incentives for a lot of rich people to move their money offshore, to go somewhere else? The same thing happened in Britain in the 1960s and 1970s.

What we need, and here is where the Democrats and Republicans have not shown any leadership, is reforming Social Security, Medicare, and Medicaid. To get the costs there under control is crucial to getting our deficit under control in the next couple of decades. Nobody, not Bush, not Obama, not the Democrats, not the Republicans have dealt with this issue.

H.L.: How would you deal with that issue?

N.B.: There are lots and lots of potential solutions. One is to impose higher co-pays, based on income levels. You can provide incentives for people not to use taxpayer funds so freely for things like Medicare. I would strongly recommend you raise further the retirement age over time. There’s lots of ways you can control the costs of health care and the benefits you pay. You can use means testing for the benefits that are paid. For Medicare, if your IRS filings at age 70 are, say, $200,00 a year, shouldn’t you pay more than your fair share of healthcare costs? There should be a sliding scale for benefits paid based on income. These are things you can phase in over a 10- or 20-year period, not tomorrow.

The good news is that in 1983 the Social Security Commission chaired by Alan Greenspan put in places major fixes which helped. We still probably need to do a little more on Social Security, but we went a long way in fixing Social Security. Now we need to fix Medicare and Medicaid.

Disclosure: No positions

Source: Nariman Behravesh: Job Growth to Match Population Growth First Half of 2011