Interview With Nicholas Perna: Serious Recession If U.S. Goes Over Fiscal Cliff

Includes: ERO, EU
by: Harlan Levy

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: What does the second-quarter gross domestic product number tell you about the economy?

Nicholas Perna: The 1.5 percent GDP growth is slightly ahead of expectations, but the most important thing is that it's very puny. It comes after a mere 2 percent in the first quarter. So why are we so weak, and what is the significance of that weakness?

If you scan the line items of the spending components in the GDP, there was a small decline in consumer spending on durable goods, and that basically reflects that all of the increase in car sales occurred in the previous couple of quarters, and there was no further increase in the second quarter.

And the very interesting number is that total government spending was down, slightly at the federal level and more than 2 percent at the state and local level. The most unusual behavior of the GDP in this recovery has been this virtually unbroken string of the decline in state and local spending. This is austerity at work. This has real life consequences. It means we're stretching our teaching institutions, our fire and police, our infrastructure and road repair, and all that. In a sense what is happening in Europe is happening here, but not to the same degree.

As for the 1.5 percent, if we continue to grow at that rate as far as the eye can see, we'd never get the unemployment rate below 8 percent. Also, we'd be very hard-pressed to meet our pension obligations, fund retirements, because 1.5 percent real growth is consistent with very meager investment returns over the long run.

The other risk is that we're skating on thin ice, especially in this heat wave. When you're growing that slowly you have very little room for something to go wrong without pushing you into recession.

H.L.: Where do we go from here?

N.P.: We can eke out 2 percent GDP for the next four quarters. In order to start seeing unemployment rate declines brought by job growth as opposed to people dropping out of the workforce, we need at least 2.5 percent real GDP growth. Given all the negatives - the European situation and the fiscal asteroid - the reason I call the year-end fiscal cliff an asteroid is because we know exactly when it's going to collide - this gives us at least a 30 percent chance of a recession.

The good news is that these odds can decline fairly quickly if we see progress domestically and globally.

H.L.: What do you see happening with interest rates?

N.B.: The Fed Chairman has told us he's not going to raise short-term interest rates until 2014 at the earliest, assuming that the economy doesn't strengthen big-time. More problematic are long-term interest rates, because the Fed doesn't control them directly. It has to influence them through things like quantitative easing, the large-scale purchases of Treasury bonds and mortgage-backed securities.

It's possible that global capital markets could make long-term rates spike, but it's hard to see how that would happen in the U.S. over the coming year. I suppose, if we have a replay of the debt ceiling fiasco where we told the world that we would no longer honor our debts, we could have a spike, but I doubt that short of aberrant behavior like that any spike is imminent.

In fact there's a strong case for long-term rates to remain low for a while. Take a look at Japan. Think of it this way.

H.L.: Is there any risk of high inflation?

N.P.: The risk of a replay of the double-digit inflation in the 1970s is miniscule. With 2 percent GDP growth here and slow growth and declines elsewhere in the world, it's very difficult to see any substantial upward pressure on labor costs and even energy costs. I know food prices are rising, but they are only a small part of consumer spending. It's very important for people with low incomes, but it's hard to think of a situation where food prices would make much of an impact on overall inflation. Food in the consumer price index, including food at restaurants, is only 14 percent. Energy is 10 percent, so every 5 percent increase in food costs would add only about three quarters of a point to the CPI rise. And 5 percent, given much of the cost is labor, processing, energy, and distribution, a 5 percent increase would be a very large increase.

Can you do anything about it? Stockpile mayonnaise, which is heavily influence by soybean prices.

H.L.: Should banks and investment banks be separated?

N.P.: I'm not sure I know the answer to that. You're asking if we should go back to the 1930s legislation, the Glass-Steagall Act. I think it's worth looking at.

The big thing that's happened recently has to do with the role of proprietary trading at banks. That's large banks engaging in gambling using insured deposits. There may be some merit to what former Federal Reserve Chairman Paul Volcker has had to say, and there's a real issue as to how his proposed Volcker rule - which singles out bank trading desks which trade derivatives and securities for banks' accounts -- should be applied under the Dodd-Frank Act. There's nothing that precludes banks doing this for customers who want it done. But the real issue is should large financial institutions be allowed to trade on their own account.

A recent example is JPMorgan (NYSE:JPM) and its almost $6-billion loss. That may really have been proprietary trading as opposed to simply a hedging activity. And then there's the disclosures about Libor manipulations to enhance the profits from proprietary trading.

To me, the real question is whether Congress ought to look into the proper role of regulation under the current circumstances as opposed to Republican Ron Paul's latest efforts to audit the Federal Reserve. There's obviously a need for insightful regulation.

I'm not sure the answer is that banks and investment banks should be broken up, but I know the answer is not less regulation of things like proprietary trading.

H.L.: Do you believe that the euro zone will be maintained and become healthy without countries dropping out?

N.P.: Start from the premise that the euro was one of the biggest economic mistakes of the last 200 or 300 years. I have been saying that since Day One, because the very different countries that came into the union really didn't have the makings of a common currency zone. The architects looked to the U.S. as a model of a single-currency zone, but they didn't look close enough. We speak the same language. We're very mobile within our borders. We have a national fiscal authority, which is capable of taxing and spending. None of this is true in Europe. People barely move from Southern to Northern Italy. When was the last time you heard of large numbers of people moving from Italy to France?

Over the next couple of years, the euro authority will use every piece of chewing gum and baling wire to keep it together, because an exit by Greece in the next few months or year would probably be chaotic for the euro zone.

The odds are fairly good, however, that exit procedures will be developed for departures over the next few years. That would probably strengthen the euro currency and be a negative for Germany's export sector.

What you have is a struggle going on in Europe, and I'm not sure all the players are playing with a full deck. I'm not sure they really understand the consequences of some of their actions, especially this preoccupation with austerity. Austerity has produced little more than a deeper recession and a greater inability to pay debts. We've got this view that somehow austerity is what cures the problems of indebted nations. There's also this view among Germans, until recently, that the strength of their exports was solely the result of German manufacturing prowess. In fact, some of it was the result of countries like Greece weakening the euro, thereby benefiting Germany.

H.L.: We've got a similar theme going on here in the States, don't we?

N.D.: In the States we have a clash of ideology and politics. The ideology involves a debate over the appropriate role and size of government in the economy. Then we have the approaching November election. What we've got is a complete stalemate, but with potentially dire consequences. The simultaneous expiration of the Bush and Obama tax cuts as well as the $1.2 trillion defense and social program cuts all on Dec. 31. Given the current weakness of the economy this could result in a fairly serious recession, another man-made disaster. None of this has to be.

It's a tough call. To predict a policy response you have to be able to forecast what happens in the House of Representatives, the Senate, and the White House.

Disclosure: I am long AAPL.