Nariman Behravesh is chief economist at consulting firm IHS Gobal Insight and is responsible for developing the economic outlook and risk analysis for the U.S., Europe, Japan, China, and other emerging markets.
Harlan Levy: In these times of major uncertainty, what are the possible long-term scenarios for the euro zone as it confronts the reality that its structure is fundamentally flawed?
Nariman Behravesh: We can consider three scenarios. The first, our baseline, is that Greece leaves sometime in the next year. And don't think the probability of a Greek exit depends on Sunday's Greek vote. Regardless of what coalition is brought together, the Greek situation is unsustainable, and Greece will leave sometime next year. But if the response by euro zone policy makers is very robust, and they do what everybody says they must in terms of closer integration, a fiscal union and a euro-wide banking union, then the contagion from Greece is limited.
That's the scenario in which Greece leaves. That would not do a lot of damage, especially to the United States.
The upside scenario is that Greece does not leave, and even without Greece leaving, Europeans enact bold policies, like a fiscal union and a unified banking system anyway. That would be a quite an upbeat outlook for Europe and good for the U.S. at some level.
A third scenario is one in which Greece leaves, and the policy response is not sufficient and is very weak. In that scenario, Europe would suffer a very deep recession; there would be full-blown banking crisis in Europe, and the U.S. would be hurt quite badly. This could be Europe's version of the Lehman crisis.
The most likely scenario is that Greece leaves sometime in the next year, and that's a wakeup call that triggers robust policies.
H.L: In a time when there's too little growth and too much debt, how much can the central banks do and for how long?
N.B.: I think the central banks still have a lot of arrows in their quiver. At a minimum they can keep buying government bonds and keep interest rates very low, and keep pumping money into the banking systems of whatever country we're talking about. In the end, it will be up to the central banks to save us from Armageddon as they did in 2008.
I don't buy this argument that the central banks are out of ammunition. That said, central bank actions will not solve the underlying structural problems.
H.L: Do you see a repeat of the last two years - the global economy just weakly muddling through in fits and starts for a few years?
N.B.: I think the global economy will continue to grow but very sluggishly in the coming two to three years, provided there's no blowup in Europe.
We know from history that in the wake of a financial crisis, as the deleveraging process gets going, then growth can be very weak. This is the situation we're in now.
H.L.: What are possible scenarios for the U.S. economy as it faces the year-end fiscal cliff -- the trillion dollars in defense, social programs, and Social Security cuts and the expiration of the Bush tax cuts?
N.B.: The fiscal cliff is clearly something we ought to worry about. But our best guess is that no one in Washington wants to be responsible for killing the economy. What that means is that the Bush tax cuts will be phased out over a number of years, probably, and the big spending cuts will be phased in over a number of years. The same thing with the Social Security tax cuts. They'll be phased out over a number of years.
The point here is that it's very unlikely that we'll fall off the fiscal cliff. Rather, we'll get to the bottom of the valley in a more gradual way, referring to lower deficit and debt levels.
H.L.: There's a lot of speculation over whether the Federal Reserve will opt for a third stimulus (another large purchase of various types of securities or bonds). What are the chances and what kinds of action might the Fed take?
N.B.: The Fed is going to keep its powder dry. They will not enact quantitative easing round three, unless there's a blow-up in Europe. However, we do expect in the next Fed meeting this week they will extend Operation Twist [a program in which the Fed changes the composition of its portfolio toward longer-term securities in order to keep long-term interest rates, and especially mortgage rates down.] By extending it they effectively won't be tightening monetary policy. If they were to let Twist expire, they would essentially be tightening monetary policy, and they don't want to do that, because the economy is quite fragile.
H.L.: With the world in turmoil and Congress in stalemate, how much can the stock market rally?
N.B.: I think the pressures on the stock market will be downward, so there's not a lot of upside to stock prices in this kind of environment. A lot depends on what happens in Europe. If they muddle along in Europe, U.S. companies can continue to do reasonably well in terms of earnings and stock prices. On the other hand, if Europe has a meltdown, then we would see stock prices across the board being hurt.
H.L.: What's ahead for jobs?
N.B.: One thing that's clear in the last month is that businesses have become quite a bit more cautious. This explains why employment growth is so weak. That caution will continue for some time until these clouds of uncertainty dissipate. In the process, companies will be very careful about spending and hiring.
H.L.: What do you think of the Republicans' solution to our economic problems: claiming that the government is spending huge amounts and needs a serious cutback and tax cuts for the wealthy?
N.B.: I think there's no question that there's a lot of wasteful government spending. Most sensible solutions about dealing with the U.S deficit and debt problems include spending cuts in most government categories, including entitlements, and tax increases not just on the rich but also on the middle class. This clearly is politically unpopular, and politicians on both sides in Washington seem unwilling to bring the bad news to the U.S. public.
Disclosure: I am long AAPL.