The Budget Quagmire, Fed Commodities Stimulus, World Inflation and European Sovereign Risk

 

The Budget Quagmire, Fed Commodities Stimulus, World Inflation and European Sovereign Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011

Executive Summary

I The Budget Quagmire

IA The National Commission

IB White House Budget

IC House Budget Committee

ID Summary

II Fed Commodities Stimulus

III World Inflation

IV European Sovereign Risk

V Economic Indicators

VI Interest Rates

VII Conclusions

References

Executive Summary

The objective of this comment is to analyze in Section I the budget quagmire of the US. Outlays jumped from 21.0 percent of GDP in 2008 to 24.7 percent of GDP in 2009. The deficits from 2009 to 2012 exceed $1 trillion every year, accumulating to $5452 billion or about 36 percent of estimated GDP for 2011. Solutions for the budget quagmire of the US focus on reducing the ratio of outlays to GDP toward 20 percent with the objective of reducing the deficit which would slow the growth of government debt that will exceed 70 percent of GDP next year. The US has not been successful in obtaining tax revenue in excess of 20 percent of GDP. The fiscal effort requires attaining primary balance or fiscal expenditures less revenue net of interest payments. A critical restriction of the US is that mandatory expenditures of the US government are $2194 billion or 57.5 percent of total outlays and 14.5 percent of GDP with Social Security, Medicare and Medicaid accounting for $1506 billion or 39.4 percent of total outlays and 9.9 percent of GDP. Discretionary expenditures are $1416 billion or 37.1 percent of total outlays, but non-security discretionary expenditures are only $507 billion or 13.3 percent of total outlays. The text below analyzes the Congressional Budget Office (CBO) baseline budget for the next ten years, the proposal of the National Commission on Fiscal Reform and Responsibility (NCFRR), the White House budget (WHB) proposal and the House Budget Committee (HBC) proposal, using the CBO baseline budget and other CBO research for comparison. Another restriction is the that there are between 24 and 30 million people in job stress in the US and multiple vulnerable populations depending on the social safety net. The avoidance of government shutdown at the last second brings promises that agreements can be reached but also illustrates the significant divide. The US needs a gradual approach of restraining growth of discretionary spending to the level before the recession plus accumulated inflation and holding its nominal growth below GDP growth could reduce outlays as percent of GDP to what they were before the crisis or 19.5 percent of GDP in 2007. There are various proposals along these lines such as by Becker, Schultz and Taylor (2011Apr4), the NCFRR and HBC. A gradual approach must be credible in the sense that the belief by economic agents that it will not be abandoned encourages confidence that can induce investment and hiring. The gradual approach must also be transparent with communications of the intentions and measures. Gradual approaches are difficult to design and implement. The alternative is an abrupt break such as a risk premium in yields of US government debt. The shock treatment in such a situation could prove devastating for economic activity and employment. A comprehensive, inclusive and productive program of restoring fiscal soundness can induce the confidence required in promoting economic growth and full employment.

Section II of the comment addresses the critical issue of whether Fed policy of zero interest rates induces increases in commodity prices that may cause inflation with sharp increases in yields of Treasury securities and costs of borrowing. Inflation everywhere in the world economy is analyzed in Section III in terms of the risks it poses. Sovereign risk issues and new stress tests of European banks are analyzed in section IV. Economic indicators discussed in section V show continuing growth of the economy. Section VI considers interest rates and Section VI concludes.

I The Budget Quagmire. According to the CBO (2011BEOJ, 4):

“The deficits that will accumulate under current law will push federal debt held by the public to significantly higher levels. Just two years ago, debt held by the public was less than $6 trillion, or about 40 percent of GDP; at the end of fiscal year 2010, such debt was roughly $9 trillion, or 62 percent of GDP, and by the end of 2021, it is projected to climb to $18 trillion, or 77 percent of GDP. With such a large increase in debt, plus an expected increase in interest rates as the economic recovery strengthens, interest payments on the debt are poised to skyrocket over the next decade. CBO projects that the government’s annual spending on net interest will more than double between 2011 and 2021 as a share of GDP, increasing from 1.5 percent to 3.3 percent.”

Table 1 provides the budget outlook of the CBO (2011BEOJ, 2011PBM) for 2011 to 2021. Two critical issues relating to the budget quagmire of the US are revealed by these projections: (1) the ratio of outlays to GDP is projected at 24.1 percent of GDP in 2011 and at 23.5 percent for 2012 to 2021; and (2) the debt/GDP ratio remains above 70 percent after 2012 and is projected at 75.6 percent in 2021. Revenue in the projections of the CBO (2011BEOJ, 2; 2011PBM, 20) is 19.9 percent of GDP, facing the historical ceiling of 20 percent. Adjustment would require reduction of expenditures or outlays closer to 20 percent to eliminate permanent deficits. The rise of the debt/GDP ratio poses doubts of whether yields of US Treasury securities could incorporate a risk premium to reflect increasing difficulty in placing new debt to finance the deficits and refinance existing debt.

Table 1, CBO Budget Outlook 2011-2021

	Out $B	Out %GDP	Deficit $B	Deficit %GDP	Debt	Debt %GDP
2010	3,456	23.8	1,294	8.9	9,019	62.1
2011	3,629	24.1	1,399	9.3	10,363	68.9
2012	3,639	23.2	1,081	6.9	11,516	73.4
2013	3,779	23.0	692	4.2	12,311	75.1
2014	3,954	22.9	513	3.0	12,919	74.9
2015	4,180	23.0	538	3.0	13,554	74.5
2016	4,460	23.3	635	3.3	14,282	74.6
2017	4,661	23.3	590	2.9	14,964	74.7
2018	4,856	23.2	585	2.8	15,640	74.7
2019	5,148	23.6	665	3.0	16,393	75.0
2020	5,412	23.7	710	3.1	17,192	75.3
2021	5,680	23.9	729	3.1	18,008	75.6
2012 to 2021	45,770	23.3	6,737	3.4

Note: Out = outlays

Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/SummaryforWeb.pdf

http://www.cbo.gov/ftpdocs/121xx/doc12103/2011-03-18-APB-PreliminaryReport.pdf

 

Table 2 provides a brief window of 2008 to 2012 of CBO data and the White House budget for 2012 (WHB) (http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf). Outlays jumped from 21.0 percent of GDP in 2008 to 24.7 percent of GDP in 2009. The deficit from 2009 to 2012 exceeds $1 trillion every year, accumulating to $5452 billion or about 36 percent of estimated GDP for 2011. Solutions for the budget quagmire of the US focus on reducing the ratio of outlays to GDP toward 20 percent to reduce the deficit and slow the growth of government debt.

Table 2, Budget of the US Government, $ Billion and % GDP

	2008	2009	2010	2011	2012
Revenue $B	2524	2105	2163	2174	2627
% GDP	17.7	14.8	14.9	14.4	16.6
Outlays $B	2983	3518	3456	3819	3729
% GDP	21.0	24.7	23.8	25.3	23.6
Deficit $B	459	1413	1293	1645	1101
% GDP	3.2	9.9	8.9	10.9	7.0
Debt $B	5803	7543	9019	10856	11881
% GDP	40.8	53.2	62.2	72.0	75.1
GDP $ Trillion	14.2	14.1	14.5	15.1	15.8

Source: 2008: http://www.cbo.gov/ftpdocs/102xx/doc10296/06-16-AnalysisPresBudget_forWeb.pdf

2010 to 2012: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf  Page 171 Table S-1

The fiscal situation of the US is even more complex because of the structure of outlays for 2011 shown in Table 3. Mandatory expenditures are 57.5 percent of total outlays and 14.5 percent of GDP. Discretionary expenditures are 37.1 percent of total outlays but $908 billion are security expenditures out of total discretionary of $1416 billion. An even more important constraint is that the expenditures for Social Security, Medicare and Medicaid are $1506 billion equivalent to 9.9 percent of GDP and 39.4 percent of total outlays. The Sep 2010 projections of the Centers for Medicare and Medicaid (CMS) estimate 2011 Federal expenditures on health, including CHIP (Children’s Health Insurance Program) of $989.6 billion (http://www.cms.gov/NationalHealthExpendData/downloads/NHEProjections2009to2019.pdf).

Table 3, Outlays of 2011 in the White House Budget Proposal in $ Billions and Percents of GDP and Total Outlays

	2011
Discretionary	1416
Percent of GDP	9.4
Percent of Total Outlays	37.1
Security	908
Non-security	507
Mandatory	2194
Percent of GDP	14.5
Percent of Total Outlays	57.5
Social Security	742
Medicare	488
Medicaid	276
Subtotal	1506
Percent of GDP	9.9
Percent of Total       Outlays	39.4
Net Interest and Disaster	209
Total Outlays	3819
Percent of GDP	25.3
GDP	15,080

Source: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf   Page 173, Table S-3.

Note: there are discrepancies between outlays and receipts and the deficit between Table S-1 used for Table 1 in this writing and Table S-4 used for Table 2 in this writing.

Three subsections below consider alternative paths for US budgets and a fourth summarizes: IA National Commission on Fiscal Responsibility and Reform (NCFRR), IB White House Budget (WHB), IC House Budget Committee (HBC) budget and ID Summary.

IA National Commission on Fiscal Responsibility and Reform (NCFRR). The plan of the NCFRR (http://www.fiscalcommission.gov/) in Table 4 would reduce outlays as percent of GDP from 23.8 percent in 2010 and 24.4 percent in 2011 to 21.8 percent in 2020 with the deficit as percent of GDP falling from 9.15 percent in 2010 to 1.2 percent in 2020. The debt/GDP ratio would peak at 71.5 in 2013, declining to percent in 2020. The cumulative outlays of the US in 2011-2020 would reach $42,144 billion, or $42.1 trillion, which would “achieve nearly $4 trillion in deficit reduction through 2020, more than any effort in the nation’s history” (NCFRR 2011MT, 14). The plan would also “cap revenue at 21 percent of GDP and get spending below 22 percent and eventually to 21 percent” (Ibid, 14).

Table 4, The National Commission (NCFRR) Plan

	Outlays $B	Outlays % GDP	Deficit $B	Deficit % GDP	Debt $B	Debt %GDP
2010	3,485	23.8	1,342	9.15	9,031	61.6
2011	3,703	24.4	1,192	7.9	10,133	66.9
2012	3,671	23.3	949	6.0	11,200	71.0
2013	3,691	22.1	646	3.9	11,952	71.5
2014	3,842	21.6	455	2.6	12,497	70.4
2015	4,024	21.6	421	2.3	13,004	69.8
2016	4,276	21.9	432	2.2	13,522	69.3
2017	4,450	21.8	372	1.8	13,987	68.6
2018	4,597	21.6	294	1.4	14,380	67.5
2019	4,839	21.8	298	1.3	14,779	66.6
2020	5,052	21.8	279	1.2	15,164	65.5
2011-2020	42,144	22.1	5,338	2.8

Source: http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf

There are six areas of action in the NCFRR plans. (1) Reduction of discretionary spending has multiple recommendations with an important one being a discretionary spending cap until 2020 that would be restrained in 2012 to be equal or lower than spending in 2011 and then returning to the 2008 level in real terms by 2013, growing thereafter at half the projected rate of inflation until 2020. (2) Fundamental tax reform would be enacted by 2012 with the objective of lowering rates, broadening the base, reducing deficits and simplifying the code. (3) Lowering expenditures on health care would be required to slow their growth below that of the economy. (4) Although various other mandatory programs account for only one fifth of the budget and do not drive the deficit/debt, the NCRFF plan finds the need to include them in the correction of the fiscal affairs of the US. (5) The NCFRR affirms that Social Security is “the keystone of the American safety net” that “must be protected,” proposing “a balanced plan that eliminates the 75-year Social Security shortfall and puts the program on a sustainable path” (NCFRR 2010MT, 48). (6) The final component of the NCFRR plan consists of reform of the budget process.

IB White House Budget. The overall goal of the White House budget (WHB) consists of improving the competitiveness of the US globally by investing “in the engines of competitiveness and job creation: education, innovation and infrastructure” (Executive Office of the President EOP 2011WHB, 19). The approach of the WHB in attaining the overall goal consists of three broad components with multiple subcomponents. First, there are measures of restoring fiscal discipline: (i) freezing for five years non-security discretionary spending; (ii) freezing for two years federal civilian worker pay; (iii) elimination or consolidation of programs; (iii) development of new discipline in defense expenditures; (iv) providing higher returns from mineral development; (v) elimination of earmarks; and (vi) receiving repayment of assistance to financial institutions. Second, there are measures to enhance long-term fiscal soundness: (i) reduction of future liabilities; (ii) continuing efforts of retraining growth of health care expenditures; (iii) beginning tax reform; and (iv) strengthening Social Security. Third, there are measures to enhance government effectiveness and efficiency: (i) reduction of improper payments; (ii) eliminating excessive, underutilized federal property; (iii) reorganization of government; (iv) reduction of administrative overhead; (v) increasing competition in grant programs; (vi) improvement of program evaluation; (vii) reform of information technology procurement and use; and (viii) improvement in priority goals.

The CBO (2011PBM) analyzes the WHB (EOP 2011WHB) using its own economic assumptions and estimation methods, instead of those used in elaborating the WHB, and also relying on the estimates of the Joint Committee on Taxation (JCT 2011Mar17). The CBO (2011PBM, 1-2, 15) finds that the enactment of all the proposals in EOP (2011WHB) would increase the baseline deficit of the CBO by $26 billion, resulting in a deficit in 2011 of $1.43 trillion, equivalent to 9.5 percent of CBO’s estimated GDP of $15,034 billion (CBO 2011PBM, 16). There is greater confidence on the nearby estimate than in those ten years in the future. The CBO (2011PBM) estimates that the WHB deficit would fall to $1.2 trillion in 2012, or 7.4 percent of GDP, as shown in Table 5 (column “WHB deficit %GDP”), which is $83 billion lower than the CBO baseline estimate that is equivalent to 6.9 percent of GDP. As shown in Table 5, the WHB deficit declines in percentage of GDP throughout the ten-year period, reaching 4.9 percent in 2021 but by much less than the CBO baseline estimate that falls to 3.1 percent in 2021. The last row of Table 5 shows the CBO baseline deficit as percent of GDP in 2012 to 2021 at 3.4 percent of GDP and that of the WHB at 4.8 percent. The CBO baseline deficit in 2012 to 2021 is $6737 billion, or $6.7 trillion, which is lower by $2733 billion, or $2.7 trillion, than the WHB deficit in that period of $9470 billion, or $9.5 trillion, as calculated by the CBO (2011PBM, 15). The CBO calculates that $2.2 trillion of this difference of $2.7 trillion between the WHB and the CBO baseline estimate originates in policy proposals and $0.5 trillion in interest payments originating in increasing borrowing. Debt held by the public would increase under the WHB as calculated by the CBO (2011PBM, 16) from $10,389 billion in 2011, or 69.1 percent of GDP of $15,035 billion, to $20,806 billion in 2021, or 87.4 percent of GDP of $23,810 billion. The debt of $20,806 in the WHB would exceed the baseline CBO debt of $18,008 billion by $2798 billion. The debt as percent of GDP of 87.4 percent in 2021 in the WHB would exceed the 75.6 percent of the CBO baseline estimate by 11.8 percentage points.

Table 5, CBO Budget and White House Budget (WHB) Deficit and Debt as Percent of GDP

	CBO Deficit %GDP	CBO Debt %GDP	WHB Deficit %GDP	WHB Debt %GDP
2011	9.3	68.9	9.5	69.1
2012	6.9	73.4	7.4	74.3
2013	4.2	75.1	5.5	77.2
2014	3.0	74.9	4.4	78.3
2015	3.0	74.5	4.1	78.9
2016	3.3	74.6	4.4	79.9
2017	2.9	74.7	4.3	81.1
2018	2.8	74.7	4.3	82.4
2019	3.0	75.0	4.7	84.0
2020	3.1	75.3	4.8	85.7
2021	3.1	75.6	4.9	87.4
2012-2021	3.4		4.8

Source: http://www.cbo.gov/ftpdocs/121xx/doc12103/2011-03-18-APB-PreliminaryReport.pdf

Table 6 shows that outlays in the CBO baseline estimate and in the WHB under the assumptions and methods of the CBO are quite similar in dollar values and as percent of GDP. For the entire period 2011-2021 the outlays of the CBO of $45,770 billion, or 23.3 percent of GDP, differ by only $402 billion from those of the WHB of $46,172 billion, or 23.5 percent of GDP. According to the CBO (2011PBM, 2), average outlays in the US have been 20.8 percent in over 40 years. The difference in deficits of $2.7 trillion is explained by the CB0 (2011PBM, 2) by the reduction of revenue in the WHB in every year of the decade, accumulating to a reduction of 6 percent of government revenue in the period of 2012-2021. Total revenues still increase relative to GDP from 16.2 percent in 2012 to 19.3 percent in 2021 (Ibid, 2, 16) such that “the 19.3 percent figure is 1.5 percentage points below CBO’s baseline projection for 2021 but 1.3 percentage points above the ratio of revenues to GDP seen over the past 40 years” (Ibid, 2). The reduction of revenues in the WHB over the CBO baseline in each year of the period 2012 to 2021 increases deficits, raising the costs of interest payments on the debt and thus yearly outlays: “net interest payments would nearly quadruple in nominal dollars (without an adjustment for inflation) over the 2012-2021 period and would increase from 1.7 percent of GDP to 3.9 percent” (Ibid, 2). The CBO (2011PBM, 2-3) explains the revenue measures as follows:

“Of the various initiatives that the President is proposing, tax provisions would have by far the largest budgetary impact. The 2010 tax act (officially the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Public Law 111-312) extended through December 2012 many of the tax reductions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The President proposes to extend those reductions permanently, with some modifications, and to permanently index for inflation the amounts of income exempt from the alternative minimum tax (AMT), starting at their 2011 levels. In addition, the President proposes that, beginning in January 2013, estate and gift taxes return permanently to the rates and exemption levels that were in effect in calendar year 2009. Those policies would reduce tax revenues and boost outlays for refundable tax credits by a total of more than $3.0 trillion over the next decade relative to the amounts projected in CBO’s baseline.4 That total exceeds the $2.7 trillion net increase in the deficit over the next 10 years that would result from the President’s budget as a whole; the President’s other proposals would reduce the deficit, on balance, over 10 years.”

Some of those proposals would increase outlays relative to the baseline CBO estimate, such as the freezing of Medicare payment rates for physicians that would increase outlays by $0.3 trillion in 2012-2021 compared with sharp reductions under current law that would deprive care for Medicare recipients, while others would reduce outlays relative to baseline, such as the reduction of $0.9 trillion in defense outlays relative to the projection of the CBO baseline.

Table 6, CBO Outlays and White House Budget (WHB) Outlays

	CBO Outlays $B	CBO Outlays %GDP	WHB Outlays $B	WHB Outlays $B
2011	3,629	24.1	3,655	24.3
2012	3,639	23.2	3,708	23.6
2013	3,779	23.0	3,800	23.2
2014	3,954	22.9	3,976	23.0
2015	4,180	23.0	4,191	23.0
2016	4,460	23.3	4,476	23.4
2017	4,661	23.3	4,687	23.4
2018	4,856	23.2	4,896	23.4
2019	5,148	23.6	5,200	23.8
2020	5,412	22.7	5,483	24.0
2021	5,680	23.9	5,756	24.2
2011-2021	45,770	23.3	46,172	23.5

Note: http://www.cbo.gov/ftpdocs/121xx/doc12103/2011-03-18-APB-PreliminaryReport.pdf

IC House Budget Committee. The budget proposal for 2012 of the Chairman of the House Budget Committee (HBC 2011PP) is shown in Table 7 together with the WHB proposal in its original version (EOP 2011WHB). The CBO has not furnished yet estimates of the HBC (2011PP) in accordance with CBO assumptions and estimating techniques. An important difference is in the total outlays for 2011-2021 of $49,772 for the WHB relative to $43,576 for the HBC or difference of $6196 billion, or $6.2 trillion. The total WHB outlays in 2012-2021 of $45,952 billion exceed the HBC outlays of $39,958 billion by $5994 billion, or $5.9 trillion. Although the WHB revenue is stronger by $3,876 billion, $38,746 less $34,870, the WHB deficit of $7205 billion is higher than the HBC deficit of $5088 billion by $2177 billion. The lower deficit is sufficient to bring HBC outlays below 20 percent of GDP in 2018-2021, closer to the 40-year average. The revenue difference between the WHB and the HBC is the result of the elimination of $800 billion of taxes created with the health reform of 2010 and other taxes of total reduction by $1.5 trillion proposed in the WHB. An important feature of the HBC proposal is that the primary deficit, or fiscal deficit without interest payments, reaches balance in 2015. The HBC (2011PP, 2) finds that nondefense discretionary spending rose by 24 percent since Jan 2009 or 84 percent when adding stimulus funds; the budget of the environmental protection agency (EPA) has increased by 36 percent in two years. A major proposal of HBC (2011PP, 29) is to reduce nondefense discretionary spending “below 2008 levels and hold this category of spending to a five-year freeze.” Comparison of the two proposals would be significantly improved by the availability of HBC (2011PP) estimated conforming to CBO assumptions and estimating techniques.

Table 7, White House Budget (WHB) and House Budget Committee (HBC) Budget

	WHB Outlays $B	WHB Outlays % GDP	HBC Outlays $B	HBC Outlays % GDP
2011	3,819	25.3	3,618	24.1
2012	3,729	23.6	3,529	22.5
2013	3,771	22.5	3,559	21.7
2014	3,977	22.4	3,586	20.8
2015	4,190	22.3	3,671	20.2
2016	4,468	22.6	3,858	20.2
2017	4,669	22.5	3,998	20.0
2018	4,876	22.5	4,123	19.7
2019	5,154	22.8	4,352	19.9
2020	5,422	23.0	4,544	19.9
2021	5,697	23.1	4,739	19.9
Total 2011-2021	49,772	Average 22.9	43,576	Average 20.8
Total 2012-2021	45,952		39,958	20.5
Average % Increase per Year	4.1			2.7
	WHB Outlays $B	WHB Revenue $B	HBC Outlays $B	HBC Revenue
2012 to 2021	45,952	38,746	39,958	34,870
	WHB Deficit $B	WHB Deficit %GDP	HBC Deficit $B	HBC Deficit %GDP
2012 to 2021	7,205	3.7	5,088	2.7

Sources: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf

http://budget.house.gov/UploadedFiles/PathToProsperityFY2012.pdf

Debt held by the public rises in the WHB proposal from $9,019 billion in 2011 to $18,967 in 2021, or from 72 percent of GDP to 77 percent in 2021 (http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf 171, Table S-1). In the HBC (2011PP, 62) proposal debt held by the public rises from $10,351 billion in 2011 to $16,071 billion in 2021, or from 68.8 percent of GDP to 67.5 percent of GDP. Table 8 provides the deficit and debt as percent of GDP of the WHB and HBC proposals in 2011-2021. A critical effort appears to be reduction of the outlays/GDP ratio below 20 percent and attaining a primary balance in the federal budget as soon as feasible. Other sources on the HBC proposal include Ryan (2011WSJ), CBO (2011BPR) and Heritage Center (2011Apr5). The CBO (2011SRO) is very useful.

Table 8, White House Budget (WHB) and House Budget Committee (HBC) Deficit and Debt as Percent of GDP

	WHB Deficit % GDP	WHB Debt % GDP	HBC Deficit % GDP	HBC Debt % GDP
2011	10.9	72.0	9.2	68.8
2012	7.0	75.1	6.3	72.8
2013	4.6	76.3	4.3	74.5
2014	3.6	76.3	2.9	74.2
2015	3.1	75.9	2.4	73.2
2016	2.4	75.1	2.5	72.5
2017	2.2	74.3	2.0	71.7
2018	1.9	73.5	1.8	70.7
2019	2.0	72.8	1.9	69.8
2020	2.0	72.1	1.8	68.7
2021	1.9	71.3	1.6	67.5
Average	4.2	74.1	2.7	71.6

Sources: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/tables.pdf

http://budget.house.gov/UploadedFiles/PathToProsperityFY2012.pdf

ID Summary. The required strategy consists of economic growth, full employment and deficit reduction without inflation, as proposed by Becker, Schultz and Taylor (2011Apr4). There are two ingredients in this budget strategy to attain credibility and transparency: (1) restraining discretionary spending before it becomes the norm in government agencies; and (2) implementing a trajectory of growth of government expenditures for 2012 and future years that balances spending with tax revenue as generated by the current tax code until there is sound reform of corporate and individual taxes. There must be communication of the strategy as friendly to growth and employment creation to induce investment and hiring decisions. The example by Becker, Schultz and Taylor (2011Apr4) is the increase of nondefense discretionary appropriations from $378.4 billion in 2007 to $460.1 billion in 2010 or by 22 percent. The House budget plan (HR1) proposed holding nondefense discretionary spending at $394.5 billion, or 4 percent above the 2008 level, which would be sufficient to compensate for inflation over the three years. The CBO is quoted by Becker, Schultz and Taylor (2011Apr4) as estimating that HR1 would reduce outlays by only $19 billion in 2011, reducing outlays to 24 percent of GDP relative to 24.1 percent currently. The path of fiscal adjustment following yearly adjustments similar to this one would attain in 2021 the outlays/GDP ratio of 19.5 of 2007. A key characteristic of the path is growth of nominal federal outlays at 2.7 percent per year from 2010 to 2021 while nominal GDP grows at 4.6 percent per year.

Gradual fiscal adjustment requires long-term commitment such that expectations of its reversal do not induce adverse decisions on investment and hiring that frustrate the economic growth and employment creation required for increasing revenue, as in Kydland and Prescott (1977). The last-hour avoidance of government shutdown shows the feasibility of reaching agreements in a divided Congress. NCFRR (2010MT, 12) poses an important guiding principle: “We must ensure that our nation has a robust, affordable, fair, and sustainable safety net.” This is critical at a time when there are 24 to 30 million people in job stress (http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html), placing substantial pressure on the social and health care safety net. Another recession ahead in 2011-2021, as it has been common in history, could create a bump in fiscal adjustment. Gradual fiscal adjustments are difficult to implement and abrupt solutions in a debt crisis have even stronger economic and social repercussions. Constructive, inclusive analysis and debate of fiscal issues and economic alternatives could help place the US in the path of prosperity.

II Fed Commodity Stimulus. The possible relation between commodity prices and quantitative easing is analyzed by Glick and Leduc (2011CP). In theory, the interaction of demand and supply factors determines commodity prices. An example of supply factors is erratic changes in climatic conditions. There is a lag of at least three years between planting the coffee tree and obtaining the first crop. The historical coffee producing region of Brazil in São Paulo state suffered frosts that spoiled the crop, causing sharp increases in prices which stimulated new planting that with a lag resulted in production when demand could not support higher prices (see the classic theoretical and econometric analysis by Delfim Netto 1959; on the coffee support program see also Pelaez, 1971). An example of demand factors is growth of world demand as reflected in world industrial production that shows high association with the rise in commodity prices as argued by Glick and Leduc (2011CP). High growth rates in emerging economies such as China, India and Brazil caused increases in demand for commodities that pulled upward their prices. Glick and Leduc (2011CP) argue that monetary policy can also induce increases in commodity prices through four channels: (1) reduction in the stock of securities in classes of maturities targeted by policy in the imperfect asset substitution model of Tobin (1969) that raise prices of financial assets or equivalently lower their yields with reductions in the costs of investment and consumption, resulting in increase in aggregate demand pulling upward commodity prices; (2) reduction of the interest cost of carry of stocks of commodities that raise demand and prices; (3) devaluation of the dollar by easy monetary policy would reduce relative prices of commodities to investors in other currencies, raising demand and prices of commodities; and (4) commodity prices respond more rapidly than other prices such that higher expectations of inflation are reflected more quickly in commodity prices. Glick and Leduc (2011CP) observe the yen/dollar rate and prices of energy and industrial metals in the Goldman Sachs Commodities Index (http://www2.goldmansachs.com/services/securities/products/sp-gsci-commodity-index/index.html) in the two rounds of quantitative easing by the Fed, finding declines in the first round and hardly any change during the second round.

Monetary policy before and during the credit/dollar crisis and global recession and currently is characterized by McKinnon (2011INF, 2011CWI) as the “bubble economy” created by near zero interest rates. There were two shocks of near zero interest rates identified by McKinnon:

1.“Greenspan-Bernanke Interest Rate Shock of 2003-2004”. On the basis of fear of deflation that never materialized (Bernanke 2002FD), the Federal Open Market Committee (FOMC) lowered the fed funds rate target to 1 percent on Jun 25, 2003 (http://federalreserve.gov/boarddocs/press/monetary/2003/20030625/default.htm) and left it at that level until Jun 30, 2004 (http://federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) when it began to raise it by 17 consecutive increments of 25 basis points in FOMC meetings to reach 5.25 percent on Jun 29, 2006 (http://federalreserve.gov/newsevents/press/monetary/20060629a.htm). There was an initial form of quantitative easing in the suspension of the auction of 30-year bonds by Treasury with the objective of increasing prices of mortgage-backed securities that was equivalent to reducing mortgage rates. McKinnon (20011INF, 2011CWI) explains that the 1 percent target of fed funds rates caused a carry trade from these low rates to two classes of risk assets: (i) auction-traded assets such as commodities soared in value after 2003 and the dollar collapsed in value; and (ii) US home prices increased by over 50 percent from the beginning of 2003 to mid 2006 with a building boom that spread to countries such as the UK, Spain and Ireland. The origin of the credit/dollar crisis is explained by McKinnon (2011CWI, 2) as: “the residue of bad debts, particularly ongoing mortgage defaults, led to the banking crisis and global downturn of 2008 into 2009—all too painfully known.” The now available transcripts of the FOMC meeting on Jun 29, 30, 2005, discussing a presentation on housing, reveal the comments by the Vice-Chairman of the FOMC, Timothy Geithner: “It’s worth noting, though, that these risks—from a cliff in housing prices to a sharp increase in household savings, to a larger and more sustained oil shocks, to less favorable future productivity outcomes, to a sharp increase in risk premia or to declines in asset prices—in general are risks that we can’t really mitigate substantially ex ante through monetary policy” (FOMC 2005JM, 138; see also FOMC 2005PM). Participants of the FOMC meetings in 2005 interviewed by Bloomberg find that the Fed fueled the housing boom by the slow and predictable interest rate policy that added the term “measured” to the FOMC statements as the form of reducing policy accommodation in small increments (FOMC 2005JM, 124, 155, 159, 170; see http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aMsKd2nN3.sY). At the meeting of the FOMC on Jun 29/30, 2005, the FRBSF economist John C. Williams, now president of the FRBSF, estimated with unusual anticipation that the decline of house prices by 20 percent from those prevailing at that time would “reduce household wealth by $3.6 trillion (30% of current GDP)”(FOMC 2005PM, 26). The carry trade of “buying” money at near zero riskless interest rates and shorting the dollar to invest or take long risk positions caused a gigantic valuation of risk financial assets and real estate that is shown in Table 9. McKinnon (20011CWI, 2011INF) also observes the rapid depreciation of the dollar after 2003 that is now shown in Table 9 from $1.1423 on Jun 26, 2003 (using Federal Reserve data) to $1.5914 on Jul 14, 2008 (using WSJ data confirmed by Federal Reserve data) for a cumulative devaluation of 39.3 percent. The last row shows the rise of Dec to Dec consumer price inflation (CPI) rising from 1.9 percent in 2003 to 3.4 percent in 2005 and 4.1 percent in 2007. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).

Table 9, Volatility of Assets

DJIA	10/08/02-10/01/07	10/01/07-3/4/09	3/4/09- 4/6/10
∆%	87.8	-51.2	60.3
NYSE Financial	1/15/04- 6/13/07	6/13/07- 3/4/09	3/4/09- 4/16/07
∆%	42.3	-75.9	121.1
Shanghai Composite	6/10/05- 10/15/07	10/15/07- 10/30/08	10/30/08- 7/30/09
∆%	444.2	-70.8	85.3
STOXX EUROPE 50	3/10/03- 7/25/07	7/25/07- 3/9/09	3/9/09- 4/21/10
∆%	93.5	-57.9	64.3
UBS Com.	1/23/02- 7/1/08	7/1/08- 2/23/09	2/23/09- 1/6/10
∆%	165.5	-56.4	41.4
10-Year Treasury	6/10/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
USD/EUR	6/26/03	7/14/08	6/07/10	04/8 /2011
Rate	1.1423	1.5914	1.192	1.448
CNY/USD	01/03 2000	07/21 2005	7/15 2008	04/8 /2011
Rate	8.2798	8.2765	6.8211	6.5375
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203
	2003	2005	2007	2010
CPI	1.9	3.4	4.1	1.5

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm

http://markets.ft.com/ft/markets/currencies.asp

2. “Bernanke Shock.” McKinnon (2011CWI, 1) finds policy in this shock as: “the Fed has set U.S. short-term interest rates at essentially zero since Sep 2008 followed in 2010 by QEs 1&2 [quantitative easing 1, Dec 2008 to Mar 2009, and 2, after Nov 3] to drive down long rates.” The result of monetary policy (Ibid, 1) is that: “just in 2010 alone, all items in The Economist’s dollar commodity price index rose 33.5 percent, while the industrial raw materials component soared a remarkable 37.4 percent.” Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.” There are two problems with this analysis of quantitative easing: (i) the general equilibrium model of Tobin (1969) as extended by Andrés et al (2004) consists of a set of j = 1,2,∙∙∙m portfolio balance equations for i = 1,2,∙∙∙n capital assets, A_ij = f(r, x), where r is the 1xn vector of rates of return (interest plus capital gains) r_i and x the vector of other relevant variables (Tobin 1969, 5). Fed policy chooses only three of n capital assets that can be stimulated by Fed policy: (a) long-term securities that are close substitutes of securitization of loans to lower their rates and stimulate investment and consumption of aggregate demand; (b) the US stock market to increase perceived wealth of households in the effort to increase consumption and home buying and construction; and (c) devaluation of the dollar to improve the trade account in the effort to grow the economy by net exports. In practice, the Fed cannot anticipate the carry trade from zero interest rates to the other n-3 capital assets, or actually to the entire n capital assets, including multiple risk financial assets such as auction-traded commodities, currencies and foreign stocks; and (ii) world markets for financial assets have been shocked by bouts of risk aversion resulting from sovereign risk issues in Europe; increase of inflation in China prompting tight monetary policies that can reduce growth of the Chinese economy, affecting world financial markets, Asian economies and the world economy; and uncertainties about growth in the US in an expansion phase characterized by legislative restructurings, implementation of intrusive regulation, record peacetime deficits/government debt and increasing expectations of taxation and sharp increases in interest rates rising from zero. The Japan earthquake/tsunami and events in the Middle East have caused other shocks of risk aversion. Zero interest rates constitute a necessary condition for higher valuations of capital assets especially risk financial assets in an upward trend, in what McKinnon calls the “Bernanke shock,” but with sharp fluctuations originating in the shocks in Europe, China, Middle East, Japan and the US. A sufficient condition for the “trend is your friend” stimulus to carry trade from zero interest rates to risk financial asset valuations is subdued risk aversion from the shocks in Europe, China, Middle East, Japan and the US. Investors have learned from the losses of the credit/dollar crisis or by avoiding the losses and are more cautious than before, implementing strategies of buying and rapidly realizing profits. Table 10, updated with every comment of this blog, illustrates the carry trade, which is now trading more opportunistically on a learning curve far ahead of that of the Fed. The trend observed by McKinnon resulted in a rise of valuations of risk financial assets that reached a peak in the second half of Apr. Sovereign risk issues in Europe caused significant risk aversion that lasted until early Jul, which is shown in the fourth column of Table 10, “∆% to Trough,” in sharp declines of all risk financial assets, most of which are in the n-3 segment not mentioned in policy analysis by the Fed and are traded in auction markets such as global stocks, commodities and currencies. The appreciation of the dollar by 21.2 percent shows the flight into temporary safety of dollar assets that caused a collapse of long-term yields of dollar-denominated securities such as Treasury notes and bonds. The final column, “∆% Trough to 4/8/11,” shows the trend of carry trade from zero interest rates in the US to long leveraged positions in risk financial assets all of which soared in valuations except for devaluation of the dollar by 21.5 percent after subdued sovereign risks in Europe. The highest appreciation is 40.2 percent by commodities with 2.3 percent in the week ending on Apr 8 in large part because of the widening differential of European interest rates relative to the zero fed funds policy of the Fed after the increase in interest rates on Apr 7 by the European Central Bank (http://www.ft.com/cms/s/0/f7f4c48a-6081-11e0-9fcb-00144feab49a.html#axzz1IOUUtVjP http://professional.wsj.com/article/SB10001424052748704013604576249232475850752.html?mod=WSJPRO_hpp_LEFTTopStories).

Table 10, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 4/ 8/11	∆% Week 4/ 8/11	∆% Trough to 4/ 8/11
DJIA	4/26/ 10	7/2/10	-13.6	10.5	0.03	27.8
S&P 500	4/23/ 10	7/20/ 10	-16.0	9.1	-0.3	29.9
NYSE Finance	4/15/ 10	7/2/10	-20.3	-2.3	0.2	22.6
Dow Global	4/15/ 10	7/2/10	-18.4	5.9	0.6	29.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	6.7	0.9	21.8
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-14.3	0.6	10.7
China Shang.	4/15/ 10	7/02 /10	-24.7	-4.3	2.1	27.2
STOXX 50	4/15/10	7/2/10	-15.3	-2.4	0.9	15.3
DAX	4/26/ 10	5/25/ 10	-10.5	13.9	0.5	27.2
Dollar Euro	11/25 2009	6/7 2010	21.2	4.3	-1.7	-21.5
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	19.9	2.3	40.2
10-Year Tre.	4/5/ 10	4/6/10	3.986	3.576

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

Source: http://online.wsj.com/mdc/page/marketsdata.html.

Table 11, updated with every comment, shows the percentage changes of the DJIA and S&P 500 since Apr 26 with much less dynamism than from their troughs as shown in Table 10. The carry trade from zero interest rates to risk financial assets is not on a friendly trend, as desired by traders, but subject to fluctuations of risks in Europe, Asia and the United States that originated in the adjustment policies to the global recession. Events in the Middle East and Japan have introduced additional risk aversion episodes.

Table 11, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from earlier date	∆% DJIA from Apr 26	∆% S&P 500 from earlier date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8
Jan 7	0.8	4.2	1.1	4.9
Jan 14	0.9	5.2	1.7	6.7
Jan 21	0.7	5.9	-0.8	5.9
Jan 28	-0.4	5.5	-0.5	5.3
Feb 4	2.3	7.9	2.7	8.1
Feb 11	1.5	9.5	1.4	9.7
Feb 18	0.9	10.6	1.0	10.8
Feb 25	-2.1	8.3	-1.7	8.9
Mar 4	0.3	8.6	0.1	9.0
Mar 11	-1.0	7.5	-1.3	7.6
Mar 18	-1.5	5.8	-1.9	5.5
Mar 25	3.1	9.1	2.7	8.4
Apr 1	1.3	10.5	1.4	9.9
Apr 8	0.03	10.5	-0.3	9.6

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004

Table 12, which is updated with every post, shows in the last three rows the Chinese yuan (CNY) to US dollar (USD) exchange rate or number of CNY required to buy one USD. China fixed the rate at around 8.2765 CNY/USD for a long period until Aug 2005. That rate afforded a competitive edge to Chinese products in world markets and in competition of internally-produced goods with foreign-produced imports. China then strengthened the yuan by 17.6 percent until Jul 2008 when it fixed it to the dollar in an effort to prevent the erosion of its competitiveness in world markets and at home to protect the economy from the global recession. China resumed the revaluation of the yuan in 2010, with revaluation by 4.2 percent by Apr 8, 2011 and cumulative by 21.0 percent. Table 12 shows the sharp appreciation relative to the dollar of most currencies in the world, which is far higher than the Fed’s objective of attaining by quantitative easing “a moderate change in the foreign exchange value of the dollar that provides support to net exports,” as revealed for the first time by Yellen (2011AS, 6). Bernanke (2002FD) states:

“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Many countries have complained that Fed “nonconventional policy” of near zero interest rates and quantitative easing is designed to cause, or at least results in, competitive devaluation of the dollar that would export US unemployment to other countries. A widening differential between interest rates in the euro area and the US could further devalue the dollar, inducing carry trade from near zero interest rates in the US to risk financial assets. The Executive Board of the International Monetary Fund (IMF) has endorsed (http://www.imf.org/external/pubs/ft/survey/so/2011/NEW040511B.htm) research of the staff (Ostry et al 2010). The objective is developing “a pragmatic, experience-based approach to help countries manage large capital inflows. Until last year, capital controls were not seen as part of the policy toolkit, now they are” (http://www.imf.org/external/pubs/ft/survey/so/2011/NEW040511B.htm). The IMF has released new research on this initiative (IMF 2011CIFeb14. Ostry et al. 2011). The approach is designed to help countries “weigh the benefits,” choosing from a “menu of policy options” and engage in
“capital flow management measures,” consisting of “taxes, prudential measures and capital controls” (Ibid). Capital inflows are typically beneficial but can cause sharp appreciation of currencies and vulnerabilities such as excessive asset valuations, growth of credit and the risk of sudden stops and reversals of inflows. The main principles for structuring a framework are, according to the IMF (http://www.imf.org/external/pubs/ft/survey/so/2011/NEW040511B.htm): (1) no program is ideal for all countries at all times; (2) structural reforms are advisable; (3) controls should not substitute sound macroeconomic policies; (4) capital controls are part of the instruments of adjustment; (5) capital flow policies should address the concerns of stabilization and adjustment with withdrawal after risks are subdued; and (6) countries should be mindful of others so not to affect the financial stability and growth prospects of other countries. As shown in Table 12, the Brazilian real (BRL) appreciated from 2.43 BRL/USD on Dec 5, 2008 to 1.737 BRL/USD on Apr 30, 2010, or by 28.5 percent, and to 1.569 BRL/USD on Apr 8, 2011, for 35.4 percent appreciation since Dec 5, 2008. Brazil introduced on Apr 6, 2011 the fourth capital control measure since Oct 2010 in the form of extending a 6 percent tax on foreign-currency loans to longer-dated instruments, blaming the zero interest rate of the US for the capital inflows that have caused the BRL’s appreciation. Brazil’s exports have become uncompetitive internationally relative to exports of other countries and domestic production is also suffering from cheaper imports (http://professional.wsj.com/article/SB10001424052748704101604576247301829769410.html?mod=WSJPRO_hps_MIDDLEThirdNews). The BRL appreciates through the carry trade induced by zero interest rates into risk financial assets such as commodities, currencies and emerging stocks. As it is happening with the euro, currencies of countries increasing interest rates because of concerns of inflation are appreciating because of the widening differential with the zero interest rate of the Fed.

Table 12, Exchange Rates

	Peak	Trough	∆% P/T	Apr 1 2011	∆T  Apr 8 2011	∆% P Apr 8  2011
EUR USD	7/15 2008	6/7 2010		4/8 2011
Rate	1.59	1.192		1.448
∆%			-33.4		17.7	-9.8
JPY USD	8/18 2008	9/15 2010		4/8 2011
Rate	110.19	83.07		84.74
∆%			24.6		2.0	23.1
CHF USD	11/21 2008	12/8 2009		4/8 2011
Rate	1.225	1.025		0.911
∆%			16.3		11.1	25.6
USD GBP	7/15 2008	1/2/ 2009		4/8 2011
Rate	2.006	1.388		1.638
∆%			-44.5		15.3	-22.5
USD AUD	7/15 2008	10/27 2008		4/8 2011
Rate	1.0215	1.6639		1.057
∆%			-62.9		43.1	7.4
ZAR USD	10/22 2008	8/15 2010		4/8 2011
Rate	11.578	7.238		6.632
∆%			37.5		8.4	42.7
SGD USD	3/3 2009	8/9 2010		4/8 2011
Rate	1.553	1.348		1.257
∆%			13.2		6.7	19.1
HKD USD	8/15 2008	12/14 2009		4/8 2011
Rate	7.813	7.752		7.771
∆%			0.8		-0.2	0.5
BRL USD	12/5 2008	4/30 2010		4/8 2011
Rate	2.43	1.737		1.569
∆%			28.5		9.7	35.4
CZK USD	2/13 2009	8/6 2010		4/8 2011
Rate	22.19	18.693		16.834
∆%			15.7		9.9	24.1
SEK USD	3/4 2009	8/9 2010		4/8 2011
Rate	9.313	7.108		6.201
∆%			23.7		12.8	33.4
CNY USD	7/20 2005	7/15 2008		4/8 2011
Rate	8.2765	6.8211		6.5375
∆%			17.6		4.2	21.0

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; CNY: Chinese yuan; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm

http://markets.ft.com/ft/markets/currencies.asp

III World Inflation. The Fed released the minutes of the meeting of the Federal Open Market Committee (FOMC 2011Mar15M) on Mar 15, 2011. There are two apparent issues that are considered in turn as revealed by the minutes (FOMC (2011Mar15M, 7).

First, temporary inflation. Increases in commodity prices have spread to overall or headline inflation. However, commodity price shocks, even in major jumps, have not caused increases in overall inflation in the US in recent periods. Energy inputs are of relatively inferior magnitude such that increases in their costs do not affect overall prices. Costs per unit of work fell in recent years because increases in productivity exceeded wage increases. Core inflation, excluding energy and food, remains subdued, even if it has bottomed. Resource slack with stable expectations of inflation suggests that overall inflation continues subdued.

Second, inflation doubts. Effects of increases of commodity prices on headline inflation could result in increasing inflation expectations. Significant increases in inflation expectations over the long term could induce excessive increases in salaries and inflation. The view of the FOMC (2011Mar15M, 7) is:

“Participants expected that the boost to headline inflation from recent increases in energy and other commodity prices would be transitory and that underlying inflation trends would be little affected as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. However, a significant increase in longer-term inflation expectations could contribute to excessive wage and price inflation, which would be costly to eradicate. Accordingly, participants considered it important to pay close attention to the evolution not only of headline and core inflation but also of inflation expectations.

In this regard, participants observed that measures of longer-term inflation compensation derived from financial instruments had remained stable of late, suggesting that longer-term inflation expectations had not changed appreciably, although measures of one year inflation compensation had risen notably. Survey based measures of inflation expectations also indicated that longer-term expected inflation had risen much less than near-term inflation expectations.”

There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 13, updated with every post, provides the latest yearly data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (http://www.ft.com/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1G67TzFqs). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration. The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings; (2) the tradeoff of growth and inflation in China; (3) slow growth (see http://cmpassocregulationblog.blogspot.com/2011_03_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/02/mediocre-growth-raw-materials-shock-and.html) and continuing job stress of 24 to 30 million people in the US (http://cmpassocregulationblog.blogspot.com/2011/04/twenty-four-to-thirty-million-in-job_03.html http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the earthquake and tsunami affecting Japan that is having repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) the geopolitical events in the Middle East.

Table 13, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	2.9	2.1	5.6	8.8
Japan	2.5	0.0	1.7	4.6
China	9.8	4.9	7.2
UK	1.5	4.4* RPI 5.5	5.4* output 14.6* input 9.9**	8.0
Euro Zone	2.0	2.6	6.6	9.9
Germany	4.0	2.1	6.3	6.3
France	1.5	1.8	6.3	9.6
Nether-lands	2.4	2.0	10.3	4.3
Finland	5.0	3.5	7.7	8.0
Belgium	1.8	3.5	10.2	7.6
Portugal	1.2	3.5	6.4	11.1
Ireland	-1.0	2.2	3.9	14.9
Italy	1.5	2.5	5.7	8.4
Greece	-6.6	4.2	8.0	12.4
Spain	0.6	3.4	7.6	20.5

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

*Mar Office for National Statistics

PPI http://www.statistics.gov.uk/pdfdir/ppi0411.pdf

CPI http://www.statistics.gov.uk/pdfdir/cpi0311.pdf

** Feb EUROSTAT http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-04042011-AP/EN/4-04042011-AP-EN.PDF

Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html

DeLong (1997, 247-8) shows that the 1970s were the only peacetime period of inflation in the US without parallel in the prior century. The price level in the US drifted upward since 1896 with jumps resulting from the two world wars: “on this scale, the inflation of the 1970s was as large an increase in the price level relative to drift as either of this century’s major wars” (DeLong, 1997, 248). Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). As DeLong (1997) shows, the Great Inflation began in the mid 1960s, well before the oil shocks of the 1970s (see also the comment to DeLong 1997 by Taylor 1997, 276-7). A counterfactual of the 1970s immediately rises out of Table 14. What would have been the Great Inflation if the Federal Reserve would have lowered interest rates to zero in 1961, in fear of deflation because of 0.7 percent CPI inflation, and purchased the equivalent of 30 percent of the Treasury debt in long-term securities, subsequently engaging in quantitative easing II in 1964 after CPI inflation of 1.0 percent? The counterfactual would not be complete without including the equivalent of $5.4 trillion fiscal deficits, as between 2009 and 2012, with the government debt/GDP ratio rising from 40.8 percent to 75.1 percent from 2008 to 2012, as in the current WHB proposal (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html).

Table 14, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1960-1982

	∆% GDP	∆% CPI	UNE
1960	2.5	1.4	6.6
1961	2.3	0.7	6.0
1962	6.1	1.3	5.5
1963	4.4	1.6	5.5
1964	5.8	1.0	5.0
1965	6.4	1.9	4.0
1966	6.5	3.5	3.8
1967	2.5	3.0	3.8
1968	4.8	4.7	3.4
1969	3.1	6.2	3.5
1970	0.2	5.6	6.1
1971	3.4	3.3	6.0
1972	5.3	3.4	5.2
1973	5.8	8.7	4.9
1974	-0.6	12.3	7.2
1975	-0.2	6.9	8.2
1976	5.4	4.9	7.8
1977	4.6	6.7	6.4
1978	5.6	9.0	6.0
1979	3.1	13.3	6.0
1980	-0.3	12.5	7.2
1981	2.5	8.9	8.5
1982	-1.9	3.8	10.8
1983	4,5	3.8	8.3
1984	7.2	3.9	7.3
1985	4.1	3.8	7.0
1986	3.5	1.1	6.6
1987	3.2	4.4	5.7
1988	4.1	4.4	5,3
1989	3.6	4.6	5.4
1990	1.9	6.1	6.3

Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment; CPI and UNE are at year end instead of average to obtain a complete series

Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2009&LastYear=2010&3Place=N&Update=Update&JavaBox=no

http://www.bls.gov/web/empsit/cpseea01.htm

http://data.bls.gov/pdq/SurveyOutputServlet

The impact of stagflation on financial markets could cause high risks of another financial crisis because of the zero short-term fed funds rate and low yields of long-term Treasury securities. The pressure on interest rates rising from zero is heightened by the large-scale purchases of long-term securities by the Fed that may have to unwind the position in rising inflation and/or pay higher interest on excess reserves of banks held at the Fed, thus raising borrowing costs throughout the economy. On Apr 6, the line “Reserve Bank credit” in the Fed balance sheet was $2632 billion, or $2.6 trillion, with portfolio of long-term securities of $2401 billion, or $2.4 trillion, consisting of $1273 billion of nominal Treasury notes and bonds, $59 billion of inflation-indexed notes and bonds, $132 billion of federal agency securities and $937 billion of mortgage-backed securities; “reserve balances with Federal Reserve Banks” stood at $1502 billion, or $1.5 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). Table 15, updated with every blog comment, provides in the second column the yield at the close of market of the 10-year Treasury note on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the 10-year note current at the time of the second round of quantitative easing after Nov 3, 2010 and the final column “∆% 11/04/10” calculates the percentage change of the price on the date relative to that of 101.2573 at the close of market on Nov 4, 2010, one day after the decision on quantitative easing by the Fed on Nov 3, 2010. Prices with the new coupon of 3.63 percent in recent auctions (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2011/2011.htm) are not comparable to prices in Table 15. The highest yield in the decade was 5.510 percent on May 1, 2001 that would result in a loss of principal of 22.9 percent relative to the price on Nov 4. The Fed has created a “duration trap” of bond prices. Duration is the percentage change in bond price resulting from a percentage change in yield or what economists call the yield elasticity of bond price. Duration is higher the lower the bond coupon and yield, all other things constant. This means that the price loss in a yield rise from low coupons and yields is much higher than with high coupons and yields. Intuitively, the higher coupon payments offset part of the price loss. Prices/yields of Treasury securities were affected by the combination of Fed purchases for its program of quantitative easing and also by the flight to dollar-denominated assets because of geopolitical risks in the Middle East and subsequently by the tragic earthquake and tsunami in Japan. The yield of 3.576 percent at the close of market on Apr 8, 2011, would be equivalent to price of 92.0635 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 9.1 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing. If inflation accelerates, yields of Treasury securities may rise sharply. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed, the tragic earthquake and tsunami affecting Japan and recurring fears on European sovereign issues. Important causes of the rise in yields shown in Table 15 are expectations of rising inflation and US government debt estimated to reach 75 percent in 2012 in the WHB in Table 2 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html). There is no simple exit of this trap created by the highest monetary policy accommodation in US history.

Table 15, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note

Date	Yield	Price	∆% 11/04/10
05/01/01	5.510	78.0582	-22.9
06/10/03	3.112	95.8452	-5.3
06/12/07	5.297	79.4747	-21.5
12/19/08	2.213	104.4981	3.2
12/31/08	2.240	103.4295	2.1
03/19/09	2.605	100.1748	-1.1
06/09/09	3.862	89.8257	-11.3
10/07/09	3.182	95.2643	-5.9
11/27/09	3.197	95.1403	-6.0
12/31/09	3.835	90.0347	-11.1
02/09/10	3.646	91.5239	-9.6
03/04/10	3.605	91.8384	-9.3
04/05/10	3.986	88.8726	-12.2
08/31/10	2.473	101.3338	0.08
10/07/10	2.385	102.1224	0.8
10/28/10	2.658	99.7119	-1.5
11/04/10	2.481	101.2573	-
11/15/10	2.964	97.0867	-4.1
11/26/10	2.869	97.8932	-3.3
12/03/10	3.007	96.7241	-4.5
12/10/10	3.324	94.0982	-7.1
12/15/10	3.517	92.5427	-8.6
12/17/10	3.338	93.9842	-7.2
12/23/10	3.397	93.5051	-7.7
12/31/10	3.228	94.3923	-6.7
01/07/11	3.322	94.1146	-7.1
01/14/11	3.323	94.1064	-7.1
01/21/11	3.414	93.4687	-7.7
01/28/11	3.323	94.1064	-7.1
02/04/11	3.640	91.750	-9.4
02/11/11	3.643	91.5319	-9.6
02/18/11	3.582	92.0157	-9.1
02/25/11	3.414	93.3676	-7.8
03/04/11	3.494	92.7235	-8.4
03/11/11	3.401	93.4727	-7.7
03/18/11	3.273	94.5115	-6.7
03/25/11	3.435	93.1935	-7.9
04/01/11	3.445	93.1129	-8.0
04/08/11	3.576	92.0635	-9.1

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates and the coupon of 2.625% on 11/04/10

Source:

http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020

The baseline monetary policy rule considered by Clarida, Galí and Gertler (CGG) in the analysis of the Great Inflation is a simple linear equation:

r*_t = r* + β(inflation gap) + γ(output gap) (1)

Where r*_t is the Fed’s target rate for the fed funds rate in period t, r* is the desired nominal rate corresponding to both inflation and output being at their target levels (CGG 2000, 150), (inflation gap) is the deviation of actual inflation from target inflation and (output gap) is the percentage difference between actual GDP and its target. The rule is forward looking because the two gaps are relative to future desired levels. The Federal Reserve of the Great Inflation virtually ignored the inflation gap, setting negligible β, with generous accommodation to tighten the output gap in the form of relatively high and positive γ. The result was major increases of both the inflation gap and output gap, manifested in high inflation rates and equally high unemployment rates. Something similar is occurring currently with the obsession of the Fed with the output gap while deflation is assumed requiring negligible β and even higher γ.

Fed policy is designed to increase inflation by increasing commodity prices and devaluing the dollar, which is not very different from the hypothesis of creating an “inflation surprise.” The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983, 592, equation 1) is:

U_t = Uⁿ_t – α(π_t – π^e) α > 0 (2)

Where U_t is the rate of unemployment at current time t, Uⁿ_t is the natural rate of unemployment, π_t is the current rate of inflation and π^e is the expected rate of inflation by economic agents based on current information. Equation (1) expresses unemployment net of the natural rate of unemployment as a decreasing function of the gap between actual and expected rates of inflation. The system is completed by a social objective function, W, depending on inflation, π, and unemployment, U:

W = W(π_t, U_t) (3)

The policymaker maximizes the preferences of the public, (3), subject to the constraint of the tradeoff of inflation and unemployment, (2). The total differential of W set equal to zero provides an indifference map in the Cartesian plane with ordered pairs (π_t, U_t - Uⁿ) such that the consistent equilibrium is found at the tangency of an indifference curve and the Phillips curve in (2). The indifference curves are concave to the origin. The consistent policy is not optimal. Policymakers without discretionary powers following a rule of price stability would attain equilibrium with unemployment not higher than with the consistent policy. The optimal outcome is obtained by the rule of price stability, or zero inflation, and not more unemployment than under the consistent policy with nonzero inflation and the same unemployment. The “inflation surprise” consists of pursuing an inflation rate that is higher than that expected by economic agents that lowers the difference between the actual and natural unemployment rate by the term – α(π_t – π^e) (Barro and Gordon 1983). The US risks repeating the Great Inflation and Unemployment of the 1970s (http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html).

Equation (1) gives the false impression that the Fed has the “science,” measurements and forecasting to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table 16 when the Fed pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table 16 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without Fed tightening because of the long lag in effect of monetary policy on inflation. The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery and creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether exotic policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability. A glance at Table 14 shows CPI inflation of 0.7 percent in 1961, creating a counterfactual of what would have been the Great Inflation if the Fed had set the policy rate at zero and purchased a third of the outstanding Treasury debt. The symmetric inflation target of “a little less than 2 percent,” or an infinitesimal neighborhood of 2, is an extremely dangerous misplaced analogy with the Great Depression that may bring the economy closer to the relevant historical event of the Great Inflation of the 1970s and the Great Bond Crash of 1994.

Table 16, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

1994	FF	30Y	30P	10Y	10P	MOR	CPI
Jan	3.00	6.29	100	5.75	100	7.06	2.52
Feb	3.25	6.49	97.37	5.97	98.36	7.15	2.51
Mar	3.50	6.91	92.19	6.48	94.69	7.68	2.51
Apr	3.75	7.27	88.10	6.97	91.32	8.32	2.36
May	4.25	7.41	86.59	7.18	88.93	8.60	2.29
Jun	4.25	7.40	86.69	7.10	90.45	8.40	2.49
Jul	4.25	7.58	84.81	7.30	89.14	8.61	2.77
Aug	4.75	7.49	85.74	7.24	89.53	8.51	2.69
Sep	4.75	7.71	83.49	7.46	88.10	8.64	2.96
Oct	4.75	7.94	81.23	7.74	86.33	8.93	2.61
Nov	5.50	8.08	79.90	7.96	84.96	9.17	2.67
Dec	6.00	7.87	81.91	7.81	85.89	9.20	2.67

Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months

Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

IV European Sovereign Risk. In the midst of efforts to reduce deficits and contain government debt, shown in Table 17, Portugal is requesting assistance from the European Union that would be processed through the European Financial Stability Facility (EFSF) (http://www.efsf.europa.eu/about/index.htm http://professional.wsj.com/article/SB10001424052748704101604576246294138576346.html?mod=WSJPRO_hpp_LEFTTopStories). The bailout cost is estimated at around €80 billion (http://www.ft.com/cms/s/0/fed76674-610b-11e0-8899-00144feab49a.html#axzz1J7CmnPhC). Portugal requested assistance from the European Union and the IMF on Apr 7. European Union finance ministers meeting on Apr 8 authorized the European Commission to develop an assistance program together with the European Central Bank and the International Monetary Fund (IMF). It is expected that Portugal will be requested to engage in enhanced austerity measures, including possibly privatization (http://www.ft.com/cms/s/0/82842b42-62b0-11e0-93b8-00144feab49a.html#axzz1J7CmnPhC). An important issue is that the Prime Minister of Portugal resigned after failing to obtain approval of austerity measures from parliament. The negotiations are being initiated with the current administration but the program will be implemented by the new administration to be elected on Jun 5.

Table 17, Portugal, Government Deficit and Debt as Percent of GDP

	Deficit	Debt
2007	-3.1	68.3
2008	-3.5	71.6
2009	-10.0	82.9
2010	-8.6	92.4
2011	-4.6	97.3

Source: http://www.ine.pt/xportal/xmain?xpid=INE&xpgid=ine_destaques&DESTAQUESdest_boui=107694003&DESTAQUESmodo=2

An important issue in European sovereign risk is that exposures of banks in countries without sovereign risks to countries with heightened sovereign risks may spread the crisis from highly indebted countries to others through bank exposures. Thus, the European Union stress tests are being coordinated by the European Banking Authority (EBA) to strengthen their rigor and validity of results. On Apr 8, the EBA announced a benchmark Core Tier (CT1) capital definition and 5 percent requirement (http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-announces-the-benchmark-to-be-used-in-the-.aspx). Tier 1 capital in the Basel capital accords consists of stockholder’s equity plus retained earnings, being considered the strongest source of capital that can withstand losses and deductions during periods of stress (see Pelaez and Pelaez, International Financial Architecture (2005), 239-299, Globalization and the State, Vol. II (2008b), 114-48, Government Intervention in Globalization (2008c), 145-54, Financial Regulation after the Global Recession (2009a), 52-6, Regulation of Banks and Finance (2009b), 60-70). The EBA announced a definition to be used exclusively for the purposes of the stress tests with specific criteria that will be used by all banks in the European Union. The basis of the EBA definition is existing European Union legislation (European Parliament and Council 2006Jun14). The objective of the definition is to find a uniform CT1 criterion for all the countries. The EBA definition (http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-announces-the-benchmark-to-be-used-in-the-.aspx): “takes the existing EU [European Union] definition of Tier 1 net of deductions of participations in financial institutions and it strips out hybrid instruments including existing preference shares. It recognizes existing government support measures, which will be identified separately in the results.” The EBA criteria emphasize the need that all capital be immediately available to face contingencies in periods of stress. Transparency is assured by requiring that stress tests “include full disclosure of all capital elements included in CT1 and their evolution since December 2010, under both the baseline and the adverse scenarios” (Ibid). The requirement of 5 percent of CT1 relative to risk-weighted assets is not a legal requirement but “the EBA expects any bank failing to meet the benchmark, or showing specific weakness in the stress test, to agree with the relevant supervisory authority to appropriate remedial measures and execute them in due time” (Ibid). The sample of banks to be stress-tested consists of 90 banks, with many that were not tested in 2010 and all tested in 2010 except when they have disappeared. The sample for the 2011 stress tests includes “more than 65 percent of banking assets in the European Union and more than half of the banking assets in all individual EU countries” (Ibid).

The stress tests for this year include an event of contraction of 0.5 percent in the economy of the euro area and a decline of 15 percent in European equities. Other scenarios consist of the effects on assets held in bank trading books of a principal loss of 3.5 percent in German bonds with 10 year maturity and of 7.6 percent on UK debt (http://noir.bloomberg.com/apps/news?pid=20601087&sid=acTf3TnjU.aI&pos=3). The tests also simulate the impact of an increase of 75 basis points on yields of Europe’s sovereign bonds and of an increase by 125 basis points of interbank financing rates. The scenarios do not include default of sovereign debt (http://www.ft.com/cms/s/0/d5f9926c-61ca-11e0-88f7-00144feab49a.html#axzz1IOUUtVjP). The disclosures of the EBA are intended to mitigate the differences in capital definitions among the diverse members of the European Union but there are also differences in the calculation of risk-weighted assets (http://professional.wsj.com/article/SB10001424052748704503104576250540103406106.html?mod=WSJPRO_hps_LEFTWhatsNews).

V Economic Indicators. The economy continues to expand; inflation is showing in double-digit nominal increases in yearly sales; the US is not experiencing difficulties in importing oil; total consumer credit is increasing with declines in revolving credit and increases in nonrevolving credit; initial jobless claims continue to decline; and the volume of retail sales in Europe is showing significant disparities among members of the euro area. The non-manufacturing index (NMI) of the Institute for Supply Management (ISM) fell 2.5 points from 59.7 in Feb to 57.3 in Mar (http://ism.ws/ISMReport/NonMfgROB.cfm). The major problem was the fall of 7.2 points in the segment of business activity/production from 66.9 in Feb to 57.3 in Mar. New orders were practically unchanged with a fall of 0.3 from 64.4 in Feb to 64.1 in Mar. The segment of prices fell 1.2 points from 73.3 in Feb to 72.1 in Mar. The market reacted adversely but the NMI continues to show expansion. The Fed reported that total consumer credit rose by $7.6 billion, reaching $2419.6 billion in Feb relative to $2412.0 billion in Jan. Revolving credit fell again to $794.0 billion in Feb from $796.7 billion in Jan or by $2.7 billion. Nonrevolving credit rose from $1614.2 billion in Jan to $1625.5 billion in Feb or by $10.3 billion. Total consumer credit grew at the annual rate of 3.75 percent in Feb; revolving credit fell at the annual rate of 4 percent; and nonrevolving credit grew at the annual rate of 7.74 percent (http://www.federalreserve.gov/releases/g19/current/g19.htm). Sales of manufacturers’ branches, adjusted for seasonal variation but not for price changes, fell 0,8 percent in Feb 2011 relative to Jan 2011 but were higher by 13.7 percent relative to Feb 2010; sales of durable goods in Feb fell 0.8 percent relative to Jan but were higher by 12.5 percent relative to Feb 2010; sales of nondurable goods fell 0.4 percent in Feb relative to Jan but were higher by 14.7 percent relative to Feb 2010 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf). Nominal sales of manufacturers rising by double digits relative to a year ago are reflecting price increases originating in the rise of costs of raw materials and inputs. In the week of Apr 1, US commercial crude oil inventories, excluding the Strategic Petroleum Reserve, were 357.7 million barrels, for a weekly increase of 2 million barrels; US crude oil imports were on average 9 million barrel per day with a four-week average of 8.9 million (http://www.eia.doe.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf). The US is not experiencing difficulties in importing oil. Initial jobless claims seasonally adjusted fell 10,000 in the week of Apr 2 to 382,000 from 392,000 a week earlier. Initial unemployment claims not seasonally adjusted fell 6790 to 350,667 in the week of Apr 2 from 357, 457 in the prior week and are substantially lower than 421,130 a year earlier. The four-week moving average of initial claims seasonally adjusted fell 5750 to 389,500 in the week of Apr 2 from 395,250 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The volume of retail trade in both the euro area and the European Union fell 0.1 percent in Feb 2011 relative to Jan 2011. In the 12 months from Feb 2010 to Feb 2011, the retail sales index grew 0.1 percent in the euro area and by 0.9 percent in the European Union. There is significant variation in the volume of retail trade among countries. In the 12 months ending in Feb 2011 the volume of retail trade rose 1.1 percent in Germany and 3.9 percent in France but fell 5.6 percent in Spain, 4.5 percent in Portugal and 3.0 percent in Ireland (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-05042011-AP/EN/4-05042011-AP-EN.PDF).

VI Interest Rates. The 10-year Treasury note was traded on Apr 8 at 3.58 percent, which is higher than 3.44 percent a week earlier and 3.37 percent a month earlier. The 10-year government bond of Germany was traded at 3.48 percent for negative spread of only 10 basis points relative to the comparable Treasury security (http://markets.ft.com/markets/bonds.asp?ftauth=1302438769493). Yields of government bonds are rising in multiple markets. The 10-year Treasury note with coupon of 3.63 percent and maturity in 02/21 traded at yield of 3.58 percent or comparable price of 100.41 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-080411). This price is not comparable to that in Table 15, which is for a note with coupon of 2.625 percent and maturity in exactly ten years for purposes of comparison with earlier yields.

VII Conclusion. The US is facing the toughest fiscal adjustment since World War II. Reducing outlays to 20 percent or less of GDP and attaining as soon as possible primary balance or fiscal balance less interest payments constitute essential ingredients of gradual adjustment. The gradual approach requires credibility and transparency, that is, it must create the expectations that it will not be abandoned. The alternative is an abrupt reduction of expenditures in the future with devastating impact on economic activity and employment. Future growth and hiring require avoiding such as an abrupt break. The Fed must also begin to return monetary policy to normal conditions to avoid the distortions of risk/return decisions by zero interest rates and minimize the risk of repeating the 1970’s Great Inflation and Unemployment. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

References

Andrés, Javier, J. David López-Salido and Edward Nelson. 2004. Tobin’s imperfect asset substitution in optimizing equilibrium. Journal of Money, Credit and Banking 36 (4, Aug): 665-90.

Barro, Robert J. and David B. Gordon. 1983b. A positive theory of monetary policy in a natural rate model. Journal of Political Economy 91 (4, Aug): 589-610.

Becker, Gary S., George P. Schultz and John B. Taylor. 2011Apr4. Time for a budget game-changer. Wall Street Journal, Apr 4 http://professional.wsj.com/article/SB10001424052748704471904576231010618488684.html

Bernanke, Ben S. 2002FD. Deflation: making sure “it” doesn’t happen here. Washington DC, National Economists Club, Nov 21 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Bernanke, Ben S. 2010WP. What the Fed did and why: supporting the recovery and sustaining price stability. Washington Post, Nov 4. http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372_pf.html

CBO. 2011BEOJ. The budget and economic outlook: fiscal years 2011 to 2021. Washington, DC: CBO Jan http://www.cbo.gov/ftpdocs/120xx/doc12039/SummaryforWeb.pdf

CBO. 2011PBM. Preliminary analysis of the President’s budget for 2012. Washington, DC: CBO Mar 18 http://www.cbo.gov/ftpdocs/121xx/doc12103/2011-03-18-APB-PreliminaryReport.pdf

CBO. 2011SRO. Reducing the deficit: spending and revenue options. CBO: Washington, DC, Mar http://www.cbo.gov/ftpdocs/120xx/doc12085/03-10-ReducingTheDeficit.pdf

CBO. 2011BPR. Long-term analysis of a budget proposal by Chairman Ryan. Washington, DC: CBO, Apr 5 http://www.cbo.gov/ftpdocs/121xx/doc12128/04-05-Ryan_Letter.pdf

Clarida, Richard, Jordi Galí and Mark Gertler. 2000. Monetary policy rules and macroeconomic stability: evidence and some theory. Quarterly Journal of Economics 115 (1, Feb): 147-80.

Delfim Netto, Antonio. 1959. O problema do café no Brasil. São Paulo: Faculdade de Ciências Econômicas e Administrativas, Universidade de São Paulo. In Carlos Manuel Peláez, ed. Ensaios sobre café de desenvolvimento econômico. Traduções de Magnólia M. Pelaez. Rio de Janeiro: Instituto Brasileiro do Café e Fundação Getúlio Vargas, 1973.

De Long, J. Bradford. 1997. America’s peacetime inflation: the 1970s. In Christina D. Romer and David H. Romer, eds. Reducing inflation: motivation and strategy. Chicago: University of Chicago Press, 1997.

European Parliament and Council. 2006Jun14. Directive 2006/48/EC of the European Parliament and of the Council. Brussels, Jun 14 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2006L0048:20100330:EN:PDF

Executive Office of the President of the United States (EOP). 2011WHB. Fiscal year 2012 budget of the US government. Washington DC: Office of Management and Budget http://www.whitehouse.gov/sites/default/files/omb/budget/fy2012/assets/budget.pdf

Friedman, Milton. 1968. The role of monetary policy. American Economic Review 58 (1, Mar): 1-17.

FOMC. 2005JM. Meeting of the Federal Open Market Committee on June 29, 30, 2005. Washington, Federal Reserve System, Jun 29, 30 http://www.federalreserve.gov/monetarypolicy/files/FOMC20050630meeting.pdf

FOMC. 2005PM. Appendix 1: materials used by Messrs. Gallin, Lehnert, Peach, Rudebusch and Williams. Washington, Federal Reserve System, Jun 29, 30 http://www.federalreserve.gov/monetarypolicy/files/FOMC20050630material.pdf

FOMC. 2011Mar15M. Minutes of the Federal Open Market Committee March 15, 2011. Washington, DC, FOMC, Apr 5 http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20110315.pdf

Glick, Reuven and Sylvain Leduc. 2011CP. Are large-scale purchases fueling the rise in commodity prices? Federal Reserve Bank of San Francisco Economic Letter, 2011-10, Apr 4 http://www.frbsf.org/publications/economics/letter/2011/el2011-10.html

Heritage Center for Data Analysis. 2011Apr5. Economic analysis of the house budget resolution. Washington, DC, Heritage Foundation http://budget.house.gov/UploadedFiles/heritageanalysis452011.pdf

House Budget Committee (HBC). 2011PP. The path to prosperity. Fiscal year 2012 budget resolution. Washington, DC: House Committee on the Budget http://budget.house.gov/UploadedFiles/PathToProsperityFY2012.pdf

IMF. 2011CIFeb14. Recent experiences in managing capital inflows—cross-cutting themes and possible policy framework. Washington, DC, IMF Strategy, Policy and Review Department, Feb 14 http://www.imf.org/external/np/pp/eng/2011/021411a.pdf

Joint Committee on Taxation (JCT). 2011Mar17. Estimated budget effects of the revenue provisions contained in the President’s fiscal year 2012 budget proposal [1]. Washington, DC, JCT, http://www.jct.gov/publications.html?func=startdown&id=3773

Kydland, Finn E. and Edward C. Prescott. 1977. Rules rather than discretion: the inconsistency of optimal plans. Journal of Political Economy 85 (3, Jun): 473-92.

McKinnon, Ronald I. 2011CWI. The Fed on the cusp of worldwide inflation. Stanford, CA, Jan 4 http://www.stanford.edu/~mckinnon/papers/fed_on_cusp_worldwide_inflation.pdf

McKinnon, Ronald I. 2011INF. The latest American export: inflation. Wall Street Journal, Jan 18 http://professional.wsj.com/article/SB10001424052748704405704576064252782421930.html?mod=WSJPRO_hpp_sections_opinion

National Commission on Fiscal Responsibility and Reform (NCFRR). 2010MT. The moment of truth. Washington: White House, Dec 2010. http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf

Ostry, Jonathan et al. 2010. Capital inflows: the role of controls. Washington, DC, IMF Staff Position Note SPN/10/04, Feb 19 http://www.imf.org/external/pubs/ft/spn/2010/spn1004.pdf

Ostry, Jonathan et al. 2011. Managing capital inflows: what tools to use? Washington, DC, IMF Discussion Note SDN/11/06, Apr 5 http://www.imf.org/external/pubs/ft/sdn/2011/sdn1106.pdf

Pelaez, Carlos M. and Carlos A. Pelaez. 2007. The Global Recession Risk. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2008a. Globalization and the State: Vol. I. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.

Pelaez, Carlos M. and Carlos A. Pelaez. 2008c. Government Intervention in Globalization. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

Peláez, Carlos Manuel. 1971. Análise econômica do programa brasileiro de sustentação do café, 1906-1945: teoria, política e medição. Revista Brasileira de Economia 25 (4, out/dez): 5-211. In Carlos Manuel Peláez, ed. Ensaios sobre café de desenvolvimento econômico. Traduções de Magnólia M. Pelaez. Rio de Janeiro: Instituto Brasileiro do Café e Fundação Getúlio Vargas, 1973.

Phelps, Edmund S. 1968. Money-wage dynamics and labor-market equilibrium. Journal of Political Economy 76 (4, 2, Jul-Aug): 678-711.

Ryan, Paul D. 2011WSJA. The GOP path to prosperity. Wall Street Journal, Apr 5 http://professional.wsj.com/article/SB10001424052748703806304576242612172357504.html?mg=reno-wsj

Taylor, John B. 1997. Comment. In Chrstina Romer and David Romer, eds. Reducing inflation: motivation and strategy. Chicago: University of Chicago Press.

Tobin, James. 1969. A general equilibrium approach to monetary theory. Journal of Money Credit and Banking 1 (1, Feb): 15-29.

Yellen, Janet L. 2011AS. The Federal’s Reserve’s asset purchase program. Denver, Colorado, Allied Social Science Association Annual Meeting, Jan 8 http://federalreserve.gov/newsevents/speech/yellen20110108a.pdf

© Carlos M. Pelaez, 2010, 2011