Interview With Economist Ethan Harris: 50% Chance Greece Leaves Eurozone In 6 Months

by: Harlan Levy

Economist and author Ethan Harris is managing director and head of North America economics at Bank of America Merrill Lynch. Previously he worked at Lehman Brothers, where he was chief U.S. economist since 2003. Before that he worked at the Federal Reserve Bank of New York.

Harlan Levy: Do you see the worsening European debt situation spiraling out of control and seriously threatening the U.S. economy?

Ethan Harris: Clearly the European situation has taken a turn for the worse. The brief moment of stability that came from European Central Bank liquidity injections seems to be ending. We see about a 50% chance that Greece leaves the eurozone in the next six months. While Europe has been preparing for this event, if this should happen, clearly there could be unintended consequences, and it would put tremendous pressure on the rest of Europe.

However, our view is that even in this scenario, the European Central Bank would be very aggressive in stemming the contagion into the rest of the region. We would expect them to cut interest rates, buy peripheral bonds, and introduce a new bank lending program. We believe this would contain the damage and mean a small spillover into the U.S. and the rest of the world.

However, even with a European Central Bank rescue Europe faces a very daunting period ahead with a continuing recession, very tight credit, and continued mini-crises. Investors will have to keep an eye out for repeated risk flares from Europe.

H.L.: How do you rate the biggest headwinds facing the U.S. economy other than Europe, like the $1.2 trillion year-end budget cuts and the end of the Bush tax cuts?

E.H.: Clearly the big challenge in the U.S. in the year ahead is the massive fiscal cliff at year-end. Politicians have moved all the tough choices of the last three years to right after the election. This includes a wide range of tax increases and spending cuts. In total, the threatened austerity amounts to more than 4% of Gross Domestic Product. If the cliff is not modified or eliminated there's a high probability of a recession next year.

It's important to recognize that the cliff will be very hard to resolve in a completely benign manner. There will be tremendous pressure to implement at least some fiscal tightening. It's also important to recognize that the cliff will likely cause a slowdown in growth in the second half of this year. Faced with an uncertain large shock, businesses and households will tend to postpone spending decisions until after the cliff is resolved. We would expect big, hard-to-reverse spending decisions to be delayed. That would mean some slowing in business expansion plans and weakness in buying of large consumer durables like autos. People will decide to wait to see how the cliff is resolved before resuming their spending.

All of this could be avoided if politicians could get together and reach a bipartisan consensus to modify and reduce the potential shock to the economy, but in an election year, sensible fiscal planning is impossible.

H.L.: What kind of growth in the U.S. economy do you expect this year and next year?

E.H.: We think that the economy now has an underlying growth of about 2.5%. We're continuing to slowly recover from the banking and real estate crisis. However, the uncertainty being created by Washington and the likely fiscal austerity next year suggest to us that there will be another soft patch in the economy in the second half of this year and continuing into 2013. Over the four quarters surrounding the fiscal cliff we expect the economy to grow only at about a 1% to 1.5% rate.

H.L.: Is the housing market finally nearing a revival?

E.H.: We think housing is close to its bottom, but it's going to be a bumpy, long bottom. Some of the strength we've seen recently in housing was due to the incredibly mild winter weather. We still have a significant number of foreclosures to work through, and that will continue to put downward pressure on home prices and construction activity. There are pockets of strength in the multi-family area and in renovations, but in our view a real recovery in the single-family market is unlikely until the second half of next year.

H.L.: What are the prospects for the job market, with the low level of job creation and the still high level of jobless claims?

E.H.: Again the job market has had a mini-boom over the course of this winter. Some of that reflects a real improvement in the economy, but much of it is due to the mild winter. Looking ahead, with businesses becoming increasingly nervous about fiscal policy, we expect another slowdown in the job market in the second half of the year. Unfortunately, we're still in a two-steps-forward-one-step-back labor market.

H.L.: What do you see ahead for the stock market?

E.H.: The stock market on a longer-term basis has a number of things that are favorable. The corporate sector is in excellent health, earnings are high, and corporations with exposure to emerging markets benefit from their healthy economies.

However, we do see a rocky period ahead as the market comes to terms with the dangers of the fiscal cliff. In our view stocks do well when the focus is on corporate fundamentals, but when geopolitical or policy issues intervene, the market tends to do poorly. In the second half of the year we expect concerns about Washington to hurt an otherwise positive market backdrop. I think that some kind of correction is likely before year-end.

Disclosure: I am long AAPL.