Interview With Nicholas Perna: Fiscal Cliff Will End Up A Fiscal Pothole In 2013

Includes: DIA, QQQ, SPY
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 do the third-quarter Gross Domestic Product growth numbers indicate for the rest of this year and next year?

Nicholas Perna: Two percent, which was slightly better than the expected 1.8 percent is the difference between crummy and very crummy. It's better than the 1.3 percent growth in the second quarter. But no matter how you slice it, it's slow and too slow to be sustainable.

One of the bright lights was the pickup in contribution from new-home building. This could be a positive for the future if it's not offset by the fiscal cliff or the European problems.

To restore jobs, to get incomes growing, we really need the economy to grow more like 3.5 percent for the next several years. Then it could settle down to 2.5 percent once we're at reasonably full employment.

H.L.: Is there anything surprising in the most recent jobs data?

N.P.: What we had was a very modest increase in payroll jobs, a little over 100,000 for September, but we had a sizable decline in September's unemployment rate brought about by an outsized gain in jobs - over 800,000 gained - as measured by the household survey, which is the basis for the jobless rate.

Very promptly there ensued a series of very irresponsible statements by people who should know better - including Jack Welch, who said that the increase had to have been distorted in favor of Obama. This is totally irresponsible. I think Jack should apologize for saying something for which he had no evidence whatsoever. I know these numbers very well. I've been working with these numbers for over 40 years, and the probability that the White House could change the numbers in its favor is as close to zero as anything you'll ever find in life.

What really happened is that a survey known for its volatility was volatile. What we've got is an unemployment rate of about 8 percent, which is still much too high, given that it reflects a great deal of hardship and very slow economic growth. If you don't feel sorry for the unemployed, maybe you should ask why the stock market has done so poorly in recent days.

H.L.: Is the stock market's volatility and its backsliding just a reflection of poor U.S. growth?

N.P.: It's a reflection of poor U.S. and European growth and prospects for more of the same. A slow-growth syndrome not only puts the lid on stock prices but has recently been responsible for commodity prices' slide, particularly oil.

H.L.: What's the latest status of housing?

N.P.: What we're seeing is that we are bouncing off the bottom in terms of home-building activity and house prices, but we're so far below where we were four or five years ago that this is just the beginning of a very long climb. Having said this, with a little luck housing will become a driver of economic growth over the next couple years. Without a lot of other headwinds like the fiscal cliff, I could confidently say it would be a major driver in late 2013. But the headwinds will dampen the contribution of housing until 2014.

The same is true of automobiles. There is a lot of potential for higher auto sales in the U.S. as a result of the need to replace the aging fleet of cars. Without headwinds it would have a major effect soon in early 2013. With headwinds, it could postpone it a year.

H.L.: What do you think of the fiscal cliff and worsening European economies?

N.P.: The fiscal cliff has an easy solution. The European situation doesn't. Both are serious.

The expiration of the Bush tax cuts, the Social Security payroll tax cut, the extension of unemployment benefits, in addition to the $1.2 trillion in defense and other cuts mandated by Congress last year amount to something like 3.5 percent of GDP. If they all hit, they could push the economy back into recession at a time when we haven't recovered from the last one.

The good news - I think it's good news - is that what happens is entirely in the hands of Washington. Congress and the White House have it within their powers to alleviate the threat of the fiscal cliff. The problem is we don't know whether they'll drag it out or be ready for compromises.

I think there will be some substantial alleviation of the fiscal cliff, but I'm afraid there will still be some significant fiscal drag next year if, for example, the Social Security payroll tax cut and the expiration of the extension of jobless benefits happen but are not offset by other tax cuts.

The most likely outcome is we'll have a fiscal pothole instead of a fiscal cliff.

H.L.: What do you see in Europe?

N.B.: The European leadership is beginning to understand that austerity programs simply don't work in a recessionary environment. They just make the recession worse. The Europeans are realizing that they need to have growth, so we're seeing a major turnabout under the leadership of the European Central Bank leader Mario Draghi, who, not coincidentally is an MIT Ph.D. cut from the same cloth as Federal Reserve Chairman Ben Bernanke. However, he's much more constrained by the ECB mandates than Bernanke. Bernanke has been able to implement very large scale quantitative easing, and even though the U.S. economy is growing slowly, it's doing better than Europe - and New Jersey - with the embrace of austerity.

Keep your fingers crossed that Greece doesn't collapse, because I'd worry then about contagion for other vulnerable countries like Portugal, Spain, and Italy.

H.L.: What do you think of Fed policy?

N.P.: This December will mark the fourth anniversary of the Federal Reserve's pushing the Fed funds rates to zero. Bernanke has pledged that it will remain close to that until at least the middle of 2015. This is conditional on the economy needing that kind of stimulation. If it does a lot better, he doesn't have to deliver on that promise.

More problematic is the charting the future of long-term interest rates. I agree with Bernanke that his forays into quantitative easing and the like have significantly reduced long-term interest rates from where they otherwise would be. What will happen to them is a question. Now you could think of horror stories where Congress decides not to extend the debt ceiling and we default, which drives U.S. interest rates way up so that they begin to look a little like Greece's. While that's scary, it's very unlikely, because that would be suicidal.

But what's more likely is a gradual uptrend in long-term rates caused by an improving economy. How much? Maybe three-quarters of a point next year and another three-quarters of a point in 2014. This would be the result of both increased private credit demands and the eventual unwinding of the Fed's quantitative easing program.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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