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Adolfo Laurenti Is Deputy Chief Economist at Chicago-based financial services firm Mesirow Financial. Previously he was an associate economist at LaSalle Bank/ABNAmro.

Harlan Levy: How much of an impact will the Libor scandal - banks falsifying the rates (called "Libor") they pay to borrow from other banks. The Libor rate affects borrowing rates for consumers and companies worldwide - have on the global economy and stock markets?

Adolfo Laurenti: In terms of direct impact to the economy, I think it will be very small. It's an important rate but, to be fair, market practitioners were well aware of the shortcomings of Libor as an economic indicator. The problem is that the Libor scandal undermines confidence in the markets, and that will be a long-term problem. It will add uncertainty. People will be less certain about entering into various contracts, and the broader public will be more hostile to financial markets in general and baking in particular.

H.L.: How many banks do you think were involved and have things been corrected?

A.L.: I don't know how many banks. I think part of the problem is that this was not an observable quantity. It was the banks reporting what prices they were facing. So the old system was not transparent. And that's where the
confidence issue came up.

H.L.: What will be done to change things?

A.L: I think the Federal Reserve will help to make the whole process more transparent probably with the help of the regulators who are already operating in those banks and will supervise the reporting of Libor.

H.L.: What's the status of the European debt problems and will the euro zone slowly sink?

A.L.: No. I am surprised by the lack of understanding that the survives in the market, especially in the U.S. and the U.K.. There is no doom in the euro zone if you understand the issues at stake, the big economic problems, and the way the governments are approaching them. I think it's extremely unlikely that the euro will fail, and it's more than likely that it will survive.

H.L.: How long might it take to fix the euro zone, and what will be the impact in the meantime?

A.L.: It will take a long time. I'm optimistic about the survival but not optimistic about the timing. Meanwhile, we continue to see incremental efforts by European countries to march toward greater integration and to fix their debt and deficit problems, an ongoing process, which, by its very nature, is going to take time.

H.L.: Several analysts think Greece will drop out of the euro zone. Do you agree?

A.L.: It's possible Greece may consider it, but even then it's not really likely. Greek public opinion is strongly in favor of staying with the euro. Even the Greek government understands this.

H.L.: German politicians say they are unwilling to accept the reality that Germany must provide most of the money to solve the crisis and have continued to insist on severe austerity measures in Greece, which many Greeks resist, threatening a Greek withdrawal. But isn't Germany just posturing, since it would gain a major advantage in spite of footing most of the bill?

A.L.: The German government understands the importance of keeping Greece in the euro zone. So, overall, the most likely scenario is for Greece not dropping out.

People do not understand the size of the problem. Germany is a very large economy on the global scale. Greece is a very, very small country. Germans may protest the ineptitude of the Greek politicians, but if you look at the size of the country, it's not a big problem.

On the flip side, Germany has a very large export sector. I would argue that most of the growth in Germany is coming from exports, and I just don't buy one story that Germany would leave the euro zone and move to a smaller union with stronger countries like the Netherlands. But the resulting currency would be significantly higher in value, and because of that they would lose a lot of market share. So it's not in Germany's best interest to do that. The story that Germany would be willing to kick out Greece just defies economic logic.

H.L.: Is the approaching fiscal cliff - the automatic trillion dollar cuts in defense and social programs at Dec. 31 - and our divided Congress's failure to do anything about it already having a growing negative effect on businesses and the economy?

A.L.: Yes. We know these cuts will be coming. It's disingenuous to think that businesses will not take action ahead of time to avoid bearing the brunt in January. Businesses are already making contingency plans, and some of the current economic weakness reflects those contingency plans already being implemented.

H.L.: Do you think the Republicans and Democrats are seriously hurting the economy in refusing to compromise and fix our problems?

A.L.: My feeling is politics should always be the art of compromise. You need to come to a point of balance. I understand the disappointment because the two parties are unwilling to make that effort.

On the other side, I also feel that many of the problems have been accumulating over the years, and you do not fix these things with compromise. You fix them by coming up with comprehensive, long-term plans which in the short term involve the very large deficit, the result of the stimulus of the last few years. And we have long-term challenges from entitlement programs like Social Security. We need a comprehensive plan on both. We need to be realistic about the size of the challenge.

The Republican party must understand that there is no solution without increasing tax revenues, which does not mean increasing tax rate but does mean that somebody will have to pay more taxes.

On the other side, the Democrats must understand that the defense of government spending to the level we got over the last few years is not sustainable. Government must go on a diet. So, while I disagree with both parties for their unwillingness to compromise, I'm not sympathetic to either party on the grounds that the positions they are holding are not sustainable.

H.L.: Is there any hope for housing, a basis for our economy, to recover soon?

A.L.: The issue is being realistic. The housing market will eventually come back. The problem is our expectations and how long it will take. I am becoming more confident that maybe we have a bottom in housing , but I don't think we will get back to the home prices, home sales, and home building that we were used to 10 years ago when we were getting into the boom.

We have to understand that attitudes toward housing have changed, and procedures to apply for mortgages have changes. So the new equilibrium will be at a much lower level than it was 10 years ago. When we will get back to new sustainable levels they will not be where they used to be at the time of the boom. For people to expect homes to increase in value 10 percent a year won't happen.

H.L.: So where is the economy going?

A.L.: I don't see much to be excited about this year or next year unfortunately. The very best will be a case of muddling through with a lot of uncertainty coming from the political elections, the fiscal cliff, and the elections in Europe. I do not expect much excitement for the next 18 months, but I hope by the end of 2013 we will be feeling a little more comfortable, that the uncertainty will dissipate, and that the economy by the end of 2013 will be on a sounder footing.

Growth this year will be closer to 1 percent or 1.5 percent, and by the end of 2013 we may be back to 2.5 percent or 2.7 percent.

H.L.: So are we entering another recession?

A.L.: I do not see a recession, but the risk of recession is increasing, because this is a very weak economy. The weaker the economy, the easier it is to suffer from some external shock, whether it's Europe or the mismanagement of the fiscal cliff, and the easier it is for us to take some blow and feel some pain.

H.L.: What do you think of the stock market and where it's headed?

A.L.: I think the correction we had in June was an overreaction. I like to think in terms of fundamentals, and fundamentals suggest that overall profits will be around 4 percent. My take is that profits of 7 or 8 percent is too optimistic at this point. I don't think the stock market will be flat, but when we were up by 15 percent in May, that was an overstretch. Because of the overall uncertainty there will be a lot of volatility. The real challenge is not for day traders. It's for people in 401(k)s who are retiring. If they suffer stock losses they may not have the time it takes to recover.

Source: Interview With Adolfo Laurenti: Germany Would Lose Too Much Export Market Share To Let Greece, Others Leave Euro