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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.

Harlan Levy: Is the wild volatility of the stock market accurately reflecting how bad the world economy is or is it a bit hysterical and a product of manipulation?

N.P.: There are two thing going on: This is an attempt on the part of markets to zero in on a very uncertain environment. Is the economy slowing down, and if so, how much? Are we going to get hurt by what’s going on in Europe, and if so how much?

And the whole thing with the debt ceiling: Congress just postponed certainty and prolonged the uncertainty. We don’t know any more now than before the debt ceiling resolution, except that we’re not going to default: Well, big deal.

We still don’t know what’s going to happen with spending and when these cuts are going to hit.

As far as manipulation goes, I think that flash trading (high-frequency traders using lightning-quick computers to execute millions of orders a second, often issuing and immediately canceling orders) is a very dangerous and counter-productive activity. These guys claim that they increase liquidity: Yes, for each other, and they exaggerate swings, making it harder for the market to settle in on what it should be settling in on. They make tons of money on these swings by exaggerating this volatility. It’s uncalled for, and it should be regulated heavily.

Then there’s the uncertainty about economic policy. What is it that Federal Reserve Chairman Ben Bernanke can do or can’t do? He can’t lower short-term interest rates. They’re already at zero.

I have a proposal: Perna’s Reverse Toaster Program: When you go to the bank to make a deposit you have to give the bank a toaster, like a negative interest rate. But there’s no way to effectively have negative interest rates for any extended period of time. In a very short run depositors will pay for the safety, liquidity, and depository insurance, but the point is that short-term rates are as low as they can possibly go.

H.L.: So what can Bernanke do?

N.P.: All that’s left is some form of quantitative easing, which means that the Fed buys longer-maturity Treasurys to drive down long-term interest rates. But this is very controversial. It involves enlarging the Fed’s balance sheet, which is very distasteful to certain small-government types.

As for fiscal policy, it’s growing abundantly clear that the economy needs a short-term shot in the arm — like extending the payroll tax holiday and extended unemployment benefits, both of which are set to expire in December.

But the same types who oppose enlarging the Fed balance sheet are also opposed to anything that enlarges the deficit … except tax cuts.

What Obama could have done is basically just use the controversial Constitutional provision that would have allowed him to raise the debt ceiling himself. It’s not clear that he would have been able to get additional stimulus out of that, but he might have avoided what could end up being some near-term budget cuts that may be hurtful.

H.L.: What do you think of Standard & Poor’s’ downgrade of U.S. debt?

N.P.: I thought the responses to the downgrade were way out of proportion to its significance. In fact, what’s happened recently is that the decline in the stock market and the rise in Treasury bond prices prove that people like U.S. Treasurys. The stock market has lost 1,600 points in the last two weeks, while the Treasury bond has gone from 2.8 percent down to 2.2 percent. People like and trust Treasurys much more than they like Standard & Poor’s.

What these wild gyrations do is that they themselves lead to increased perceptions of equity risk, and people require a bigger premium to hold equities rather than stocks.

H.L.: Are we in for a long period of below-average growth and high unemployment?

N.P.: Sorry to say the answer is yes. We’re lucky if we escape recession this year. The odds of recession have risen significantly, and we probably will, but cross your fingers.

There are two reasons why we’re in for a slow and agonizing return to normal. One is that Congress has a totally inept fiscal policy in place. What Congress is trying to do is replay the recession of 1937/398, which I find amazing given that for several years we have been warning that that was a possibility. They just won’t listen.

Except for a handful of demonstrators, the vast majority of the U.S. population is not in favor of cutting entitlement programs to balance the budget. What people want is jobs right now. They don’t want ideology, and all they’re getting is ideology. Try eating ideology.

The other problem we’ve got is that even under the best circumstances, research shows that it takes a long time to recover from financial debacles. That’s because there’s a lot of credit damage that takes place that has to be healed

— people over their head with mortgages — and that takes a long time to heal. But it would take a lot less time with appropriate macro-economic policies.

This is going to make for a very interesting election year in 2012 with an unemployment rate hovering around 9 percent.

H.L.: How much does Congress’s deadlock affect the U.S. economy?

N.P.: Originally when the House changed hands in 2010, the glib consensus was that deadlock could be good, because this keeps Congress from damage, but they’ve shown that they can do an awful lot of damage.

H.L.: Is the $1.2 trillion deficit reduction agreement and another $1.2 trillion or more to go into effect next year enough to right the economy?

N.P.: It’s hard to think in deficit terms. We’ve got a number of other issues out there, including a couple of wars. The appropriate way to look at what’s needed is to look at total fiscal stimulus provided by the government sector. That includes state and local sectors, which are big sources of negative stimulus right now. You can’t just look at the federal budget deficit. You need to look at the combined economic impact of all levels of government.

What’s happened is that cutbacks at the state and local level, have offset much of the stimulus enacted at the federal level.

H.L.: When Congress considers tax reform, will corporate lobbyists accept drastic cuts to programs they care about (like defense) or an end to loopholes that benefit their clients?

N.P.: Here’s what I think will happen: The 12-member committee (six Republicans and six Democrats charged with coming up with more deficit cuts) won’t be able to reach agreement, so the automatic cuts of $1.2 trillion will come into play on entitlements and defense. I don’t know what that means for lobbyists, but they will have their work cut out for them.

If I’m right, the lobbyists will be fighting for their lives on defense cuts, and then who knows? It may well be that the cuts turn out to be so hurtful that taxes will have to go back on the table before the committee’s Nov. 23 deadline or even after they start implementing the cuts. There’s nothing that says they can’t go back and change it.

One of the things that is a sleeper but probably has the greatest chance of getting through is reducing corporate loopholes, practically all of which are indefensible. When push comes to shove, those things might get pushed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Economist Nick Perna: 'The Odds of Recession Have Risen Significantly'