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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.

H.L.: The stock market seems to be saying that the economy is coming back and things look good. Are we out of the woods, or are investors deluded?

N.P.: I think there are things we need to worry about. First, the European debt situation and the other fragile countries. There has been progress vis-à-vis the Greeks, but we’re not out of the woods yet. A major problem is the threat of contagion. It’s a little like a new virus found in animals. Will it jump species? One set of risks is that it could weaken European banks which have lent a great deal of money to Greece, Portugal, Ireland, and Italy. The U.S. banks have not, but U.S. money market mutual funds have quite a bit of exposure to the European banks. That means they’re also exposed to the troubled countries, and we don’t know if that would also raise concerns about indebted states like Connecticut and California.

That’s one major cloud hanging over the horizon. The second major cloud of our own making is the debt ceiling fiasco. If the debt ceiling does not get increased soon, all sorts of financial chaos could break out, making the 2008 financial crisis look like a modest trial run or a modest summer squall. It’s almost impossible to fathom the results of a U.S. Treasury default. Anyone who says let’s not extend the debt ceiling and let the chips fall as they may are either incompetent, insane, or some of each. It’s that dangerous.

But there’s more. If the Democrats go along with the Republicans and extend the debt ceiling at the cost of large, near-term spending cuts, they will weaken a weak economy. It will provide a major drag on an already soft economy. The untested Pollyanna view that immediately reducing the deficit will unleash a torrent of optimism is unfounded and dangerous. There’s no evidence behind it.

Also, an important concern for the stock market should be a much slower growth in productivity than we’ve had in the last couple of years. This is going to make it harder to generate profits. On the plus side, it may make it more likely that more people will be hired.

H.L.: What would the Republicans’ plan of radical budget cutting with no revenue increases, no new taxes, and extending tax cuts for the rich do to the middle classes and the economy?

N.P.: Timing is everything, so if all these dramatic cuts occur quickly, then the economy could go into a tailspin, back into recession. What we seem to be learning from problems in countries like Greece and Ireland is that aggressive belt-tightening can be self-defeating in reducing deficits and can weaken the economy so much that deficits get larger. Belt-tightening in a weak economic context is like throwing people into debtor’s prison in Charles Dickens’ days. How do you pay your debts off when you’re in debtor’s prison.

Austerity has much more to do with ideology than sound economics.

H.L.: How bad is the continuing drain of job losses in spite of private job gains?

N.D.: What’s happened is that we’ve had some job gains over the last year, but what’s happened is that they’ve been stunted recently. Fed Chairman Ben Bernanke has said that the slowdown in jobs and other economic indicators is in part due to the Japanese earthquake and the rise in oil prices earlier this year, but the supply shortages seem to be abating, and there’s been a big drop in oil prices recently. Whether this is enough to goose up Gross Domestic Product growth remains to be seen. It’s also the ongoing drag on the economy from the downsizing of state and local governments and the ongoing malaise in housing.

H.L.: How is the housing market faring while it awaits a flood of foreclosures, and what will housing do to the economy?

N.P.: What’s unique in the current “recovery” is the failure of housing to lead us out of the recession. It comes as no surprise, given that housing was at the epicenter of the financial collapse. What is a surprise is that housing hasn’t shown signs of picking up. We had a couple of recent bright spots, including an increase in the Case-Shiller home price index, and I’m forecasting that there will be housing value and construction activity will increase as the year wears on and into next year.

But the big unknowns are the impact of further foreclosures and the possibility of higher interest rates somewhere along the way.

If the economy is able to grow around 3 percent, then housing will enjoy a modest recovery in prices, sales, and construction. My worry is that a slower GD will interact with housing, forcing prices down and even more people could end up under water, thereby increasing the volume of foreclosures. The potential is for weakness in one feeding on the other, back and forth, raising the possibility of a return to recession.

H.L.: Second-quarter earnings will now start coming out. What do you expect, and what will the earnings reveal?

N.P.: Corporate earnings have more than fully recovered from the recession. This is remarkable in light of the fact that the labor market has recovered very few of the jobs it lost in the recession. To say that the recession is over is true if you look at corporate earnings. On the other hand, the labor market has only regained about one in five of the 8.7 million jobs lost during the recession.

Looking ahead, the big increases in corporate earnings are behind us, because of the slowing of the extraordinary productivity growth two years ago, and productivity provides a huge offset to rising costs.

H.L.: You sound morose. Is there any good news?

N.P.: Actually, it’s that the agony doesn’t go on forever. We’ll know very soon about the European debt situation and the debt ceiling. So these uncertainties will be resolved quite soon. I think what’s going to happen will be that the debt ceiling crisis will be resolved without upsetting financial markets or depressing the economy in the near term. It’s in everybody’s interest to resolve the European debt situation. I think we should be able to get 3 percent growth in the second half of this year with oil prices staying on the low side and 3 percent next year.

Source: Interview With Economist Nick Perna: Not So Gloomy After All