CMP Associates Regulation Blog: The Causes of the 2007 Credit/dollar Crisis, Financial Risk Aversion, Slow Growth and Global Inflation

The Causes of the 2007 Credit/dollar Crisis, Financial Risk Aversion, Slow Growth and Global Inflation

Carlos M. Pelaez

Executive Summary

I The Causes of the 2007 Credit/dollar Crisis

IA Securitization

IB Dealers

IC Financial Fragility

ID Monetary and Housing Policy

II Financial Risk Aversion

III Slow Growth

IV Global Inflation

V Valuation of Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

Executive Summary

The explanation of the credit/dollar crisis and resulting global recession is basically why and how a system of $12 trillion of securitized banking came under such stress. It is a “credit crisis” because credit is generated in the US mainly through securitized banking. A major part of credit is provided by commercial or consumer banks. The funds for the loans that are used by the bank customer do not always originate in deposits in the commercial bank. The loan is bundled with similar loans by credit rating, maturity and other common characteristics into a bond called “asset-backed security.” Securitized banking consists of converting credit into securities that are sold to generate the funds for credit. The payments on the loans provide the income of the asset-backed security. The types of loans include credit cards, automobile loans, student loans, home mortgage loans, commercial mortgage loans and so on. Investors buy this asset-backed security and obtain financing by pledging it as collateral in an overnight or short-dated transaction known as a “sale and repurchase agreement” or SRP. The investor promises to repurchase the asset-backed security at a prearranged price that includes an interest payment. The funds obtained from the SRP actually generate the fund used to provide credit to all types of borrowers.

Modern banking theory analyzes the transformation of illiquid assets into liquid demand deposits. The lending institution is fragile because perceptions that the value of the loans would not cover the value of deposits could trigger a run on the bank to transform the demand deposits into cash. A bank would become insolvent if an excessive volume of deposits sought conversion into cash. Banks have developed methods of evaluating business projects to be funded by the loans and systems to monitor the projects such that the funds are not used for other purposes that are unsound. Deposit insurance reduced the incentives to run on banks. Modern banking theory can be extended to analyze the liquidity transformation fragility of securitized banking.

Section I The Causes of the 2007 Credit/dollar Crisis provides the analysis of why and how the $12 trillion credit generating system of the US experienced a run on the liquidity created by SRPs. A relief rally in the week of Fri Jul 1 almost reversed the losses of the US stock market significantly because of the expectations of release of funds for Greece. Short-term indicators are showing slowing growth in the world economy probably now for the entire first half of the year. Real disposable income in the US stagnated in the first five months of 2011. Inflation is everywhere in the world economy with some deceleration at the margin.

I The Causes of the 2007 Credit/dollar Crisis. The definition of “banking panic” by Calomiris and Gorton (1991, 112) is:

“A banking panic occurs when bank debt holders at all or many banks in the banking system suddenly demand that banks convert their debt claims into cash (at par) to such an extent that the banks suspend convertibility of their debt into cash, or in the case of the United States, act collectively to avoid suspension of convertibility by issuing clearing-house loan certificates.”

The objective of this section is to probe into the causes of the credit/dollar crisis and global recession after 2007. Subsection IA Securitization considers the role in propagating the financial crisis by fracture of the system of financing securities collateralized by various types of assets in overnight or very short-term sale and repurchase agreements (SRP). Subsection IB reviews the analysis of the fragility of dealers intermediating securitizations, derivatives and related transactions. Subsection IC Financial Fragility discusses the theory of banking fragility because of the transformation of illiquid assets into liquid demand deposits and its applicability to the 2007 credit/dollar crisis. Subsection ID Monetary and Housing Policy focuses on monetary and housing policies as drivers of the financial crisis.

IIIA Securitization. Multiple contributions by Professors Gary Gorton and Andrew Metrick propose and analyze empirically that the credit/dollar crisis after 2007 occurred in the form of a “run” on the SRP or “repo” system (Gorton 2009AER, 2010FCIC, 2010SIH, SIFIH; Gorton and Metrick 2010H, 2010SB). There are important differences in the operations of “traditional banking” and “securitized banking.” The popular term for “securitized banking” is the “shadow banking system,” which in their important work Pozsar et al (2010, 4) argue “that it is an incorrect and perhaps pejorative name for such a large and important part of the financial system.” Gorton and Metrick (2010SB, Figure 1, 44) depict traditional banking as receiving cash in exchange for a certificate of savings insured by the FDIC (and in historical periods by clearing houses created by banks) with the cash being transferred to borrowers in exchange for a mortgage.

Most credit currently is provided by securitized banking without which the economy would probably not grow as rapidly as permitted by labor, capital, resources and technology. The bank is also an intermediary between investors (savers) and borrowers (debtors). Investors give cash to the bank in exchange for collateral, such as securities, that is not insured by the government (see Gorton and Metrick 2010, Figure 2, 45). The securities are “pledged” by the bank to the investors in guarantee of repayment of the cash. The bank in turn gives cash to direct lenders that provide it to homebuyers who pledge the home with a mortgage loan. The direct lenders receive the cash provided to the homebuyers by transferring the mortgage to the dealer bank. Mortgages of the similar maturity and credit quality are agglutinated or “bundled” into a residential mortgage-backed security (RMBS) and sold or “distributed” to investors in the market.

The part of securitization banking analyzed by Gorton and Metrick (2010SB, Figure 6, Securitization, 41) consists of the critical transactions that surfaced during the beginning of the credit/dollar crisis. Banks fund by receiving cash from investors in exchange for collateral that is not insured by the FDIC. With the mortgages received in exchange for the cash, the bank creates RMBS that in some cases are transferred to a special purpose vehicle, variously called structured investment vehicles (SIV) and conduits in Europe. The securities are divided in tranches with credit risk from AAA to investment grade BBB and an unrated equity tranche to which the manager of the securities allocates the first losses and when exhausted losses are allocated beginning with the lower-rated tranches until reaching AAA in ascending hierarchy of credit rating. The SIV is actually an off-balance sheet vehicle of a bank that provides its AAA rating to obtain lower-cost financing. The SIV generated cash by issuing asset-backed commercial paper (ABCP) with guarantees of the securities. The SIV financed the ABCP in the short-term SRP market, obtaining the funds to purchase the securities from the bank that in turn financed the direct lender and ultimately the homebuyer. The bank provided a desk letter of comfort that it would provide liquidity to the SIV in cases of failure to roll over or refinance SRPs to ensure AAA rating for the ABCP of the SIV that allowed low-cost SRP financing. The SIV then sold asset-backed securities (ABS) to investors with the securities bundled by the bank. The SIV also created collateralized debt obligations (CDO) with the same tranches from AAA to unrated equity layer and the same process of loss absorption beginning with the unrated equity layer and climbing in the rating ladder to the AAA tranche. The CDO is sold to investors. The purpose of the tranches is to create diverse products catering to the risk appetite of investors, with pension funds buying AAA tranches and hedge funds acquiring BBB. The tranches also include credit default swaps (CDS). This process of credit risk transfer was analyzed by the Joint Forum of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Supervisors (2004). Credit risk transfer consists of pulverizing credit in small transactions distributed to many investors in order to diminish concentrations of risk in large financial institutions that could cause systemic crises (see Pelaez and Pelaez, International Financial Architecture (2005), 134-54).

A basic assumption for the operational soundness of securitized banking and even traditional banking is the quality of credit instruments. A few hundred billion subprime mortgages broke a system of $12 trillion. Traditional banking panics analyzed by Calomiris and Gorton (1991) occurred by runs of depositors to convert their demand deposits into cash. The argument by Gordon and Metrick (2010H, 2010SB) is that the crisis of securitized banks of 2007 consisted of a run on the SRP market. The SRP provides short-term liquidity, much the same as the demand deposits and money market accounts of traditional banking. Imperfect information is pervasive in financial markets. The crisis started with defaults of subprime mortgages in 2007, culminating in Aug, which was the last time in which to reverse positions. Very few market players anticipated the debacle. Depositors withdrew cash from banks in historical US panics and again withdrew cash from the SRP market after 2007.

An important form of cash withdrawal is the haircut in SRPs. Gorton and Metrick (2010H, 2010SB) explain this mechanics. In the SRP, the investor buys assets from the bank at X dollars and the bank agrees to buy them back at Y dollars. The SRP rate is (Y – X)/X. If the price of repurchase by the bank from the investor were to be $100 and the price of sale from the bank to the investor were to be $98, the SRP rate would be ($100-$98)/$100 equal to 2 percent. Actual rates were quite low when there was plentiful confidence on the quality of collateral. Gorton and Metrick (2010H, 2010SB) compare the haircuts of SRPs with reserves of banks. Merton and Bodie (1992) provide critical analysis of financial guarantees that are ubiquitous and provide foundations for analysis of regulation (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b, 45-51). The haircut consists of a reduction in the price of the security to the value that is effectively financed. For example, if the price of the security is $100, the financing side of the SRP may accept to finance only, say, $95, such that the haircut, h, is defined as:

h= (Security Price – Price Financed)/(Security Price) = ($100-$95)100 = 5 percent (1)

Withdrawals of the SRP market occurred through the increase in haircuts, that is, the financing side of the SRP required higher haircuts to hedge against possible losses by the financing side of decline in the price of the security in the event of default of the agreement of repurchasing them by the financed side. The financing part has a financing need, F, which cannot be fully financed if haircuts increase, from say, h₂ to h₁, h₂ > h₁, such that the amount financed after the increase in haircut is lower

(h₂)F < (h₁)F (2)

Suppose the haircut increases from 5 percent in the example to 20 percent. Then there is an increasing funding need by the financed part of:

(0.05)$100 – (0.20)$100 = $95 - $80 = $15 (3)

In the case of subprime mortgages, Gorton and Metrick (2010H, 2010SB) find that the haircut went to 100 percent, that is, the market ceased to exist and no subprime mortgages were accepted as collateral in SRPs. Adrian and Shin (2009, Table 7, 7) provide IMF data showing major jumps in haircuts of securities from Apr 2009 to Aug 2009 ranging from 0.25 percent in Apr 2009 for US Treasuries to 3 percent in Aug 2009 with asset-backed securities jumping from 3-5 percent to 50-60 percent.

A critical issue in the analysis of the credit/dollar crisis is how subprime defaults of several hundred billion created such a debacle as measured by Brunnermier (2009) in the loss in equity markets of about $8 trillion between Oct 2007 and Oct 2008. Gorton and Metrick (2010H, 2010SB) and Brunnermeier and Pedersen (2009) analyze the impact of haircuts as a reduction of own capital required by positioning by dealers who have to reduce their exposures in all classes of securities. The result is fire sales at sharply declining prices as the buyers recognize the needs of the sellers. Falling prices reduce even further available capital and cause further increases in haircuts and fire sales. Gorton and Metrick (2010SB) find association between the three-month LIBOR-Overnight Index Swap (OIS) spread and the withdrawals from the SRP market. LIBOR is the rate paid in interbank unsecured loans at a rate measured by the British Bankers Association (BBA) (http://www.bba.org.uk/). The overnight indexed swap (OIS) is a swap paying the difference between a fixed rate and a flexible rate that is the geometric average in market days of the fed funds rate. The LIBOR-OIS spread measures the counterparty risk in transactions among banks because of the arbitrage in normal times of lending at three-month LIBOR and borrowing daily at the overnight fed funds rate (see Thornton 2009, Sengupta and Tam 2008). The LIBOR-OIS spread peaked at 364 basis points on Oct 10, 2008, being normally only around 10 basis points because of arbitrage (Gorton and Metrick 2010SB, 18). Counterparty risk fractured the SRP market because of fears holding the collateral securities of a failing dealer. Cochrane (2011Jan, 7) argues that instead of a flight to money, in the global recession:

“There is instead evidence for a broader ‘flight to quality,’ a flight to all government debt at the expense of private debt and goods and services.”

In an SRP market of $10 trillion, the increase in weighted average haircuts by 20 percents causes a funding gap of $2 trillion (Gorton and Matrick 2010SB, 4).

IB Dealers. Duffie (2010JEP) analyzes the operations of “dealer banks” and their failure mechanics that significantly differ from those of traditional banks, posing new policy challenges. Dealer banks are engaged in intermediating markets for securities and derivatives. As part of large, complex financial conglomerates the failure of dealer banks can have systemic repercussions, that is, other institutions and segments of financial markets may be affected. Dealer banks engage in four major types of financial operations. (1) Dealers banks are active in intermediating securities in primary markets by acquiring issues of securities and then distributing them to investors, sometimes in the capacity of underwriters. In secondary markets, dealer banks act as intermediaries by making markets with bid and ask prices. Intermediation of over-the-counter securities markets in multiple segments is dominated by dealer banks. Proprietary trading or taking exposures on the own capital of the firm is another activity. The SRP market is also actively intermediated by dealer banks. (2) Over-the-counter derivatives markets are quite deep. Dealer banks can have matched books in which they act as intermediaries on both sides, earning a spread, or they can engage in proprietary trading, taking exposures on views of the market. The largest volume in over-the-counter derivatives is in interest rates. The gross market value of over-the-counter derivatives in the second half of 2010 was $21,148 billion of which $14,608 billion in interest rate contracts, with interest rate swaps at $13,001 billion (BIS 2011May, 8). (3) Dealer banks also act as prime brokers to large investors and hedge funds and as asset managers for institutional investors and high net-worth individuals. Prime brokerage services include “management of securities holdings, clearing, cash-management services, securities lending, financing, and reporting (which may include risk measurement, tax accounting, and various other accounting services)” (Duffie 2010JEP, 58). The dealer bank is also major counterparty in over-the-counter derivatives transactions with its clients. (4) Dealer banks have also engaged in off-balance sheet transactions such as those using special purpose vehicles (SPV) explained in the prior subsection.

As in the analysis of Gorton and Metrick (2010H, 2010SB), the runs on dealers banks occur in the framework of Duffie (2010JEP) because of withdrawals of cash and securities from dealers banks in the fear of their failure. This is essentially the same mechanism of failure of banks without deposit insurance in historical periods of the US. Insured depositors in commercial banks have protection against default. The clients with exposure to dealer banks do not have default insurance and even when insurance is available such as in the form of collateral, clients do not desire involvement in the failure of the dealer bank because of the costs. Duffie (2010JEP) identifies four mechanisms of failure of dealer banks discussed in turn.

First, flight of short-term counterparty financing. Dealer banks can issue bonds and commercial paper but financing has turned increasingly to short-term SRPs. As discussed below in subsection ID Monetary and Housing Policy, low policy interest rates encouraged this shift to overnight SRPs. Duffie (2011JEP) finds that dealer banks were operating before the crisis with haircuts of only 2 percent and asset/capital ratios of 30. The distrust created by subprime mortgages spread through increasing haircuts and fire sales throughout all classes of securities as analyzed by Gorton and Metrick (2010H, 2010SB) and Brunnermeier and Pedersen (2009). Counterparty creditors withdraw SRP financing from dealer banks in order to avoid costly resolution and disposal of collateral in the event of failure of the financed dealer bank that is forced to generate cash by fire sales. Dealer banks face a run on SRP.

Second, contraction of prime brokerage business. Prime brokerage clients provide fee revenues to dealer banks. Cash and collateral of prime brokerage clients also provide financing to dealer banks (Duffie 2011JEP, 63-5). Hypothecation consists of the pledge of a security in guarantee of a financial transaction such as collateral securities in guarantee of SRP financing. Prime brokerage clients deposit cash and securities with their dealer banks. These very same cash and securities can be pledged again by the dealer banks to finance their own transactions in a practice known as “rehypothecation” (see Singh and Aitken 2010, 2009; Johnson 1997). There are limits in the US by SEC Rule 13c3-3 and Regulation T (SEC n.d. 137):

“The purpose of Rule 15c3-3 is to protect customer funds and securities held by the broker-dealer. Fully paid securities are securities that are purchased in transactions for which the customer has made full payment. Margin securities in a customer account are those securities with a market value equal to or less than 140 percent of the customer's debit balance (the amount the customer owes the broker-dealer for the purchase of the securities). Excess margin securities in a customer account are those securities with a market value greater than 140 percent of the customer's debit balance. An example of excess margin securities: A customer buys $80,000 worth of securities on 50 percent margin. The broker-dealer loans the customer $40,000 (debit balance). The amount of the customer margin securities that can be pledged as collateral for a bank loan is $56,000 (140 percent x $40,000 debit = $56,000 available as collateral). Because only $56,000 of the $80,000 of customer securities can be pledged to the bank, the remaining $24,000 of securities are excess margin securities that must be segregated and held in safekeeping by the broker-dealer.”

There is an important jurisdictional difference (Singh and Aitken 2010, 4): “in the United Kingdom, an unlimited amount of the customer’s assets can be rehypothecated and there are no customer protection rules.” There are also no similar restrictions of rehypothecation in Europe as in the US. Singh and Aitken (2010, 6) calculate that the “total collateral received that is permitted to be pledged/rehypothecated” fell for the seven largest US broker dealers from $4.5 trillion at the end of 2007 to $2.1 trillion at the end of 2009. As Adrian and Shin (2009, 8) find:

“The language of ‘liquidity’ suggests a stock of available funding in the financial system which is redistributed as needed. However, when liquidity dries up, it disappears altogether rather than being re-allocated elsewhere. When haircuts rise, all balance sheets shrink in unison, resulting in a generalized decline in the willingness to lend. In this sense, liquidity should be understood in terms of the growth of balance sheets (i.e. as a flow), rather than a stock.”

Singh and Aitken (2010, 7) propose that the size of securitized banking should be measured by adding SRPs of prime dealer banks, commercial paper of the financial sector and asset-backed commercial paper plus collateral received by dealer banks that can be pledged. The contraction of rehypothecated collateral during the financial crisis was an important source of stress for dealer banks.

Third, contraction of derivatives business. Counterparties suspecting insolvency of a dealer reduce their exposures of over-the-counter derivatives, accentuating the drain of cash of the dealer. Duffie (2011JPE, 65-7) finds four mechanisms of cash withdrawal: (1) increasing borrowing from the dealer; (2) entering in new trades that cause the dealer to disburse cash for a position in derivatives; (3) withdrawing cash from positions that have appreciated in favor of the counterparty; and (4) “novation,” by which a counterparty enters into a position with another dealer that offsets the position with the possibly insolvent dealer. For example, the counterparty that has bought protection on a borrower with a credit default swap provided by the insolvency suspect dealer engages another dealer to provide protection with a credit default swap. The new dealer buys protection from the suspect dealer and provides it to the counterparty, thus offsetting the position with the suspect dealer that achieves the objective of becoming insulated from default by the suspect dealer (Duffie 2011JPE, 65).

Fourth, loss of clearing bank overdraft. A dealer bank receives cash from multiple sources during the day and holds securities in the accounts with its clearing bank. The clearing bank provides the dealer with a “daylight overdraft” to settle payments concentrated at 10:00 A.M. The clearing bank expects that the overdraft would be met with other incoming cash in the dealer’s account. Duffie (2011JEP, 68) finds that Lehman Bros declared bankruptcy when the clearing bank refused to extend daylight overdrafts that made it impossible for Lehman to honor its obligations.

Title II of the Dodd-Frank Act provides “Orderly Liquidation Authority” of systemically important institutions (http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf). This means that regulators can “seize financial institutions that they deem to be systemically important” and that the firm can be liquidated by the FDIC (Bliss and Kauffman 2011). The intent of Dodd Frank is (http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf):

“To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services, and for other purposes.”

Orderly liquidation authority would eliminate bailouts and “too big to fail.” Bliss and Kauffman (2011, 13) conclude:

“We have argued that it is not clear that resolutions conducted under ORA [Orderly Resolution Authority] will be orderly. Constraining the solution to the liquidation will trigger adverse responses from other jurisdictions. Making decisions under time pressure and in a crisis are likely to lead to the FDIC assuming greater financial burdens than may be necessary under a different resolution regime. In the event this regime may prove so risky and potentially costly that regulators will be forced back on providing open firm assistance as they did during the recent financial crisis.”

An important issue is that SRPs and derivatives are protected by laws of insolvency resolution in the US and in most countries (Bliss and Kauffman 2006). Bankruptcy laws provide stay for creditors in enforcing their rights when the firm is in bankruptcy. There is exemption from this stay for derivatives and SRPs that can be netted or closed out. The intent of these exemptions was to prevent systemic risks in financial markets that could originate in derivatives and SRPs. According to Bliss and Kauffman (2006), this reasoning is unclear when considering the volumes and structure of derivative markets. Duffie (2011JEP, 70) concludes:

“The financial crisis has made clear the need to reconsider the systemic risks posed by the failure of dealer banks and has provided new insights into the mechanics by which they fail. The task of building new institutional mechanisms to address these failure mechanics is timely and urgent.”

IC Financial Fragility. There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.

In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection skills of the relationship banker convert an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.

Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by the financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.

The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):

“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”

ID Monetary and Housing Policy. Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:

“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”

Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.

In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):

“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”

The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. The Federal Home Loan Bank (FHLB) system was established by Congress in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly-owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.

According to Pinto (2008) in testimony to Congress:

“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”

Table 1 shows the euphoria of prices during the boom and the subsequent decline. House prices rose by 94.7 percent in the 10-city composite of the Case-Shiller home price index and 78.0 percent in the 20-city composite. Prices have fallen 32.4 percent since 2006 for the 10-city composite and by 32.7 percent for the 20-city composite.

Table 1, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Apr 2000 to Apr 2003	40.8	33.9
∆% Apr 2000 to Apr 2005	94.7	78.0
∆% Apr 2000 to Apr 2011	46.7	34.1
∆% Apr 2005 to Apr 2011	-24.7	-24.6
∆% Aug 2006 to Apr 2011	-32.4	-32.7
∆% Apr 2009 to Apr 2011	1.4	-0.3
∆% Apr 2010 to Apr 2011	-3.1	-3.9

Source: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:

“On the maturity date T, the firm must either pay the promised payment of B to the debtholders or else the current equity will be valueless. Clearly, if at time T, V(T) > B, the firm should pay the bondholders because the value of equity will be V(T) – B > 0 whereas if they do not, the value of equity would be zero. If V(T) ≤ B, then the firm will not make the payment and default the firm to the bondholders because otherwise the equity holders would have to pay in additional money and the (formal) value of equity prior to such payments would be (V(T)- B) < 0.”

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:

“The house market [in 2006] is probably operating with low historical levels of individual equity. There is an application of structural models [Duffie and Singleton 2003] to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown.”

There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Ingersoll 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.

The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (4)

Equation (4) shows that as r goes to zero, r →0, W grows without bound, W→∞.

Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of SIVs.

The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the structured investment vehicles (SIV) created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).

II Financial Risk Aversion. The past two months have been characterized by unusual financial turbulence. Table 2, updated with every comment in this blog, provides beginning values on Jun 27 and daily values throughout the week ending on Jul 1. All data are for New York time at 5 PM. The first three rows provide three key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. In a sign of significant relaxation of risk aversion, the dollar depreciated 2.3 percent relative to the euro, with flow of funds into risk financial assets. The dollar appreciated in the prior week by 0.8 percent relative to the euro with cumulative appreciation occurring mostly after Wed Jun 22 because of the fears of default in Greece with adverse repercussions in sovereign debts of other countries in Europe’s “periphery” as well as in “core countries” through exposures of banks. The week was characterized by major events such as two votes in the Greek parliament approving the austerity plan and its implementation required for release of the bailout tranche without which default could have been a possibility. The Japanese yen depreciated during the week finally reaching JPY 80.78/USD by Fri Jul 1, which is still quite strong as the currency is used as safe haven from world risks while fears of another Japanese and G7 intervention subsided. The Swiss franc depreciated 1.3 percent during the week, reaching CHF 0.8485/USD on Fri Jul 1, which could be a signal of relaxation of risk aversion by funds flowing back into risk positions after temporarily benefitting from safe haven in a strong deposit and investment market.

Table 2, Daily Valuation of Risk Financial Assets

	Jun 27	Jun 28	Jun 29	Jun 30	Jul 1
USD/ EUR	1.4281 -0.6%	1.4365 -1.2%	1.4433 -1.7%	1.4481 -2.1%	1.452 -2.3%
JPY/ USD	80.8780 -0.6%	81.113 -0.9%	80.7950 -0.5%	80.8015 -0.5%	80.78 -0.5%
CHF/ USD	0.8355 0.3%	0.8321 0.7%	0.8345 0.4%	0.8418 -0.5%	0.8485 -1.3%
10 Year T Note Yield	2.92	3.04	3.11	3.15	3.186
2 Year T Note Yield	0.39	0.48	0.46	0.45	0.479
10 Year German Bond Yield	2.89	2.93	2.98	3.02	3.03
DJIA	0.91% 0.91%	2.13% 1.21%	2.74% 0.60%	4.02% 1.25%	5.43% 1.36%
DJ Global	0.45% 0.45%	1.72% 1.27%	3.18% 1.43%	4.56% 1.34%	5.63% 1.02%
DAX	-0.19% -0.19%	0.69% 0.88%	2.43% 1.73%	3.58% 1.13%	4.19% 0.59%
DJ Asia Pacific	-1.01% -1.01%	-0.53% 0.49%	0.86% 1.39%	2.14%1.27%	2.56% 1.11%
WTI $/b	90.86 -0.29% -0.29%	92.910 1.95% 2.26%	95.070 4.32% 2.33%	94.860 4.09% -0.22%	94.700 3.92% -0.17%
Brent $/b	106.61 1.00% 1.00%	108.590 2.88% 1.86%	112.430 6.52% 3.54%	111.700 5.83% -0.65%	111.500 5.64% -0.18%
Gold $/ounce	1497.10 –0.39% -0.39%	1501.00 -0.13% 0.26%	1511.30 0.56% 0.69%	1498.70 -0.28% -0.83%	1486.50 -1.09% -0.81%

Note: For the exchange rates the percentage is the cumulative change since Fri the prior week; for the exchange rates appreciation is a positive percentage and depreciation a negative percentage; USD: US dollar; JPY: Japanese Yen; CHF: Swiss Franc; AUD: Australian dollar; B: barrel; for the four stock indexes and prices of oil and gold the upper line is the percentage change since the past week and the lower line the percentage change from the prior day;

Source: http://noir.bloomberg.com/intro_markets.html

http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

The three sovereign bond yields in Table 2 capture relaxation of risk aversion in the flight to risk financial assets and away from the safety of US Treasury securities and German securities. The 2-year US Treasury note is highly attractive because of minimal duration or sensitivity to price change and its yield continued declining for a sustained period to 0.338 percent per year on Fri Jun 24 but it rebounded to 0.479 percent by Fri Jul 1. Much the same is true of the 10-year Treasury note and the 10-year bond of the government of Germany, falling to 2.872 percent for the 10-year Treasury note and to 2.83 percent for the 10-year government bond of Germany in the week of Fri Jun 24 but jumping by Fri Jul 1 to 3.186 percent for the 10-year Treasury note and to 3.03 percent for the 10-year government bond of Germany. Section V Valuation of Risk Financial Assets provides more details and comparisons of performance in peaks and troughs.

The upper line in the stock indexes in Table 2 measures the percentage cumulative change since the closing level in the prior week on Jun 24 and the lower line measures the daily percentage change. There was a strong world equities rally in the week of Jul 1. The DJIA rallied during the week, accumulating gains of 5.4 percent. The DJ Global gained a strong 5.6 percent also with gains throughout the week. The performance of the DJ Asia Pacific was also excellent with a weekly gain of 2.56 percent. The German DAX equity index gained 4.2 percent in the week. The votes in the Greek parliament to approve and implement the austerity program and reassuring comments that funds would be released to avoid default were important events during the week.

The final block of Table 2 shows the strong performance of the oil indexes. Brent gained 5.6 percent in the week and WTI gained 3.9 percent. Increasing risk appetite appears to have stimulated the carry trade. Gold lost only 1.1 percent as world financial markets were more optimistic on taking risk.

Peter Spiegel and Alan Beattie writing on Jul 3 on “Europe agrees Greece aid payout” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a768c748-a526-11e0-8df9-00144feabdc0.html#axzz1R42X11O1) analyze the critical events on Greece during the week. European finance ministers meeting on Saturday agreed on the release of the tranche of €8.7 billion of the bailout package, which ensures that Greece will not default on maturing debt in the next few weeks. The Greek parliament had approved an austerity program of taxes, expenditures reductions and asset sales in value of €28 billion, which was a requirement for further assistance. The IMF announced that the passage of the Greek austerity program should permit its board to approve release of the tranche of the bailout package. European finance ministers remained undecided on the larger new program of €120 billion that would be required for Greece that cannot fund in international markets in 2012. The issue is the insistence of a group of members that the private sector participate in the bailout program of Greece. A decision has been postponed to a future meeting.

III Slow Growth. There are two types of very valuable information on income, consumption and prices in Table 3, showing monthly, and annual equivalent percentage changes, seasonally adjusted, of current dollar or nominal personal income (NPI), current dollars or nominal disposable personal income (NDPI), real or constant chained (2005) dollars DPI (RDPI), current dollars nominal personal consumption expenditures (NPCE) and constant or chained (2005) dollars PCE. First, the difference between NDPI and RDPI (NDPI/RDPI) and NPCE and RPCE (NPCE/RPCE) indicates inflation. Let the rate of inflation be π, the percentage change in nominal value NV and the change in real value rv. Then:

(1+π)(1+rv) = (1+NV)

Thus, if we know (1+NV) and (1+rv), simple rearrangement provides (1+π):

(1+π) = (1+NV)/(1+rv)

The growing gap between NDPI/RDPI and NPCE/RPCE is inflation and accelerating from the final quarter of 2010 to the first five months of 2011. The gap becomes more evident in the cumulative percentages Jan-May 2011 and IVQ2010 and their annual equivalents Jan-May 2011 A and IVQ2010 A. The gap of NDPI/RDPI in Jan-May 2011 in Table 3 is 3.9 percent (1.039/1.000), which is much higher than in IVQ2010 of 2.1 percent (1.037/1.016). The gap NPCE/RPCE in Jan-May 2011 in Table 3 is 4.3 percent (1.052/1.009), which is much higher than 1.9 percent (1.057/1.037) in IVQ2010. Inflation in the deflator of personal income and outlays is moving toward 4 percent per year. That is, the government is benefitting from a tax known as the inflation tax. By issuing money through its central bank the government buys goods and services. In a situation of sizeable deficits and inflation, the government gains by purchasing before effects of issuing money that causes increases in prices (see http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-monetary.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html Pelaez and Pelaez, International Financial Architecture (2005), 201-12). This is a hidden but actually felt contribution of monetary accommodation to financing bloated government expenditures. The new inflation tax argument is not by increases in inflation resulting from increasing monetary aggregates but by the rise in valuations of assets such as commodities induced through the carry trade of near zero interest rates. Second, while division in quarters is arbitrary, Table 3 shows reduction in the rates of growth of RDPI from 1.6 percent in IVQ2010 to 0 percent in Jan-May 2011 and of growth of RPCE from 3.7 percent in IVQ2010 to 0.9 percent in Jan-May 2011. There is no evidence of trend but rather the appearance of a slowing rate of growth that is captured by GDP growth of 1.9 percent in IQ2011 and economic indicators in the beginning of IIQ2011. There may have been a slowdown because of the interruption of the supply chain by the earthquake in Japan but the economy was already weak as shown by flat real disposable income.

Table 3, Percentage Change from Prior Month Seasonally Adjusted of Personal Income, Disposable Income and Personal Consumption Expenditures %

	NPI	NDPI	RDPI	NPCE	RPCE
2011
May	0.3	0.2	0.1	0.0	-0.1
Apr	0.3	0.2	-0.1	0.3	-0.1
Mar	0.4	0.4	0.0	0.6	0.2
Feb	0.4	0.3	-0.1	0.8	0.4
Jan	1.1	0.5	0.1	0.4	0.0
Jan-May 2011	2.5	1.4	0.0	2.1	0.4
Jan-May 2011 A	6.2	3.9	0.0	5.2	0.9
2010
Dec	0.4	0.4	0.2	0.4	0.1
Nov	0.2	0.2	0.1	0.3	0.3
Oct	0.4	0.3	0.1	0.7	0.5
IVQ10	1.0	0.9	0.4	1.4	0.9
IVQ010 A	4.1	3.7	1.6	5.7	3.7

Notes: NPI: current dollars personal income; NDPI: current dollars disposable personal income; RDPI: chained (2005) dollars DPI; NPCE: current dollars personal consumption expenditures; RPCE: chained (2005) dollars PCE; A: annual equivalent; IVQ2010: fourth quarter 2010; A: annual equivalent

Percentage change month to month seasonally adjusted

Source: http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0511.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pi0211.htm

Further information on income and consumption is provided by Table 4. The 12-month rates of increase of RDPI and RPCE in the past eight months do not show a trend of deterioration but rather very similar growth with the exception of 1.1 percent growth of RDPI in Apr 2011 and 0.6 percent in May 2011. Goods and especially durable goods have been driving growth of PCE as shown by the much higher 12-months rates of growth of real goods PCE (RPCEG) and durable goods real PCE (RPCEGD) than services real PCE (RPCES). The faster expansion of industry in the economy is derived from growth of consumption of goods and in particular of consumer durable goods while growth of consumption of services is much more moderate.

Table 4, Real Disposable Personal Income and Real Personal Consumption Expenditures Percentage Change from the Same Month a Year Earlier %

	RDPI	RPCE	RPCEG	RPCEGD	RPCES
2011
May	0.6	2.1	3.8	7.4	1.3
Apr	1.0	2.5	4.4	9.1	1.6
Mar	1.9	2.6	4.1	8.6	1.8
Feb	2.2	2.7	5.6	12.8	1.3
Jan	2.3	2.8	5.8	12.0	1.3
2010
Dec	2.0	2.6	5.5	10.6	1.2
Nov	2.3	2.7	5.4	10.0	1.4
Oct	2.4	2.5	6.0	12.2	0.9

Notes: RDPI: real disposable personal income; RPCE: real personal consumption expenditures (PCE); RPCEG: real PCE goods; RPCEGD: RPCEG durable goods; RPCES: RPCE services

Numbers are percentage changes from the same month a year earlier

Source: http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0511.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

The list of 25 purchasing managers’ indexes of Real Time Economics of the WSJ shows gains in the indexes only in three countries: Australia gaining 5.2 points to 52.9, Greece gaining 1.0 for slower contraction and the US increasing by 1.8 to 55.3 (http://blogs.wsj.com/economics/2011/07/01/world-wide-factory-activity-by-country-16/tab/interactive/). The JP Morgan Global Manufacturing PMI^TM fell from 53.0 in May to 52.3 in Jun, which is the weakest reading since Jul 2009 that was the first month of recovery. New orders fell from 51.9 in May to 50.9 in Jun and input prices declined from 66.7 in May to 60.8 in Jun (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/GLOBAL_Manufacturing_ENG_1107_PR.pdf). The final reading for the Markit Eurozone Manufacturing PMI^® for Jun is the lowest in 18 month with slowing growth throughout and contraction in Italy, Spain, Ireland and Greece (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/EZ_Manufacturing_ENG_1107_PR.pdf). The HSBC China Manufacturing PMI^TM compiled by Markit registered the first contraction of manufacturing output since Jul 2010 while prices increases slowed significantly (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/CN_Manufacturing_ENG_1107_PR.pdf). The Markit/CIPS Manufacturing PMI^TM for the UK declined from 52.0 in May to 51.3 in Jun for the lowest reading since Sep 2009 (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/UK_manufacturing_2011_07_01.pdf).

Table 5 shows growth of UK Gross Domestic product. First quarter, IQ2011, growth relative to IVQ2010 in the third column was 0.5 percent and growth from IQ2010 to IQ2011 was 1.6 percent. Internal demand measured by total consumption from gross fixed capital formation fell 0.9 percent in the quarter and grew 0.5 percent in IQ2011 relative to IQ2010, which is disappointing relative to growth of 2.7 percent in 2010 relative to 2009. The report of the Markit/CIPS Manufacturing PMI^TM registers slowing export sales related to weaker growth of the world economy with export sales of capital goods showing resilience (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/UK_manufacturing_2011_07_01.pdf).

Table 5, UK Gross Domestic Product (GDP) ∆%

	2010/2009	IQ2011/IV Q2010	IQ2011/ IQ2010
GDP	1.4	0.5	1.6
Household Consumption	0.9	-0.6	-0.5
Government Consumption	1.0	0.5	1.1
Gross Fixed Capital Formation	3.7	-2.0	-0.2
Total Consumption plus Gross Fixed Capital Formation	2.7	-0.9	0.5
Exports	5.2	2.4	2.3
Imports	8.8	-2.4	4.2

Source: http://www.statistics.gov.uk/pdfdir/qna0611.pdf

Percentage point contributions to GDP growth in France, shown in Table 6, also suggest weakness in internal demand and large contribution by inventory change. Net foreign trade deducted 0.4 percentage point in IQ2011. The French economy is also recovering slowly.

Table 6, France, Percentage Point Contributions to GDP Growth %

	2010	IQ2011
GDP	1.4	0.9
Internal Demand	0.8	0.6
Inventory Change	0.5	0.7
Net Foreign Trade	0.1	-0.4

Source: http://www.insee.fr/en/themes/theme.asp?theme=16&sous_theme=8

The Japanese economy continues to recover from the earthquake/tsunami of Mar. Table 7 provides 12-month rates of growth of sales. Retail sales dropped 8.3 percent in the 12 months ending in Mar as a result of the earthquake/tsunami and further fell by 4.8 percent in the 12 months ending in Apr. The fall in sales in the 12 months ending in May was only 1.3 percent, raising hopes for strong recovery.

Table 7, Japan, Wholesale and Retail Sales 12-Month ∆%

2011	Total	Wholesale	Retail
Jan	3.3	4.6	0.1
Feb	5.3	7.2	0.1
Mar	-1.3	1.2	-8.3
Apr	-2.6	-1.7	-4.8
May	1.3	2.3	-1.3

Source: http://www.meti.go.jp/english/statistics/tyo/syoudou/index.html

The impact of the earthquake/tsunami on industrial production in Japan was formidable, with a drop of 15.5 percent in Mar, shown in Table 8. Industry grew by 1.6 percent in Apr and then by 5.7 percent in May. The 12 months rates of growth improved from minus 13.1 percent in Mar and minus 13.6 percent in Apr to much lower minus 5.9 percent in May.

Table 8, Japan, Industrial Production

	∆% Month SA	∆% 12 Months NSA
Jan	0.0	4.6
Feb	1.8	2.9
Mar	-15.5	-13.1
Apr	1.6	-13.6
May	5.7	-5.9

Source: http://www.meti.go.jp/statistics/tyo/iip/result/pdf/press/h2a1005j.pdf

The Bank of Japan’s business sentiment Tankan survey is shown in Table 9 for Mar, Jun and the forecast. The manufacturing index for large enterprises fell from 6 in Mar, when the survey was almost completed before the earthquake/tsunami to minus 9 in Jun but has a stronger forecast for Sep of 2. The nonmanufacturing index for large enterprises fell from 3 in Mar to minus 5 in Jun but the forecast is milder at minus 2. The readings for medium and small enterprises are not as optimistic.

Table 9, Bank of Japan Tankan Survey

	Manufacturing	Nonmanufacturing
Mar 2011
Large Ent.	6	3
Medium Ent.	-4	-6
Small Ent.	-10	-19
Jun 2011
Large Ent.	-9	-5
Medium Ent.	-12	-17
Small Ent.	-21	-26
Forecast
Large Ent.	2	-2
Medium Ent.	-7	-16
Small Ent.	-15	-29

Ent. = enterprises

Source: http://www.boj.or.jp/en/statistics/tk/gaiyo/2011/tka1106.pdf

IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 10 updated with every post, provides the latest annual 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). CPI inflation stabilized in China at 5.3 percent in the 12 months ending in Apr relative to 5.4 percent in the 12 months ending in Mar. Food prices in China soared by 11.7 percent in Mar after 11.0 percent in Feb, 10.3 percent in Jan and 9.6 percent in Dec (http://www.ft.com/cms/s/0/69aa5fcc-670d-11e0-8d88-00144feab49a.html#axzz1J7CmnPhC). Food prices rose 11.5 percent in China in the 12 months ending in Apr relative to 11 percent in the first quarter of 2011 relative to 2010 as analyzed by Jamil Anderlini in the Financial Times (“China inflation edges lower to 5.3%” http://www.ft.com/cms/s/0/09a22246-7b75-11e0-ae56-00144feabdc0.html#axzz1LqpStZfj). Jamil Anderlini writing in the Financial Times (“Inflation in China hits 34-month high,” Jun 14 http://www.ft.com/intl/cms/s/0/dda66798-9630-11e0-8256-00144feab49a.html#axzz1P401vEUE) informs that food prices rose 11.7 percent in May 2011 relative to a year earlier, exceeding 11.5 percent in the 12 months ending in Apr. Jason Dean in the Wall Street Journal (“Chinese inflation speeds up,” WSJ Jun 14 http://professional.wsj.com/article/SB10001424052702303714704576382593374669206.html?mod=WSJPRO_hpp_LEFTTopStories) finds that CPI inflation of 5.5 percent in the 12 months ending in May 2011 is the highest rate since 6.3 percent in Jul 2008. Industrial output rose 13.3 percent in China in May 2011 relative to May 2010, almost equal to 13.4 percent in Apr while fixed investment rose 25.8 percent in the first five months of 2011 relative to the same period in 2010 compared with 25.4 percent in Jan-Apr. The money stock M2 rose 15.1 percent in May relative to a year earlier. New loans in local currency rose CNY (Chinese yuan) 740 billion in Apr (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aolyrQHuzo4o&pos=4) but new loans in local currency rose only CNY 551.6 billion in May 2011 relative to Apr 2010 (Jamil Anderlini writing in the Financial Times (“Inflation in China hits 34-month high,” Jun 14 http://www.ft.com/intl/cms/s/0/dda66798-9630-11e0-8256-00144feab49a.html#axzz1P401vEUE). The People’s Bank of China increased the reserve requirement by 0.5 percent to 21.5 percent effective Jun 20 (Bloomberg News, “China raises bank reserve requirements as inflation quickens,” http://noir.bloomberg.com/apps/news?pid=20601087&sid=aae70h91sWhY&pos=3). China has raised interest rates four times since Sep, raising the reserve requirements on banks and appreciating the CNY relative to the USD by 1.6 percent in 2011. Authorities in China are highly concerned about inflation because of its impact on social stability and fears of a forced landing of the economy.

Table 10, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	2.9	3.6	7.3	9.1
Japan	-0.7***	0.3	2.2	4.5
China	9.7	5.5	6.8
UK	1.8	4.5* RPI 5.2	5.3* output 15.7* input 10.9**	7.7
Euro Zone	2.5	2.7	6.7	9.9
Germany	4.8	2.4	6.4	6.0
France	2.2	2.2	6.4	9.5
Nether-lands	3.2	2.4	11.7	4.2
Finland	5.8	3.4	8.5	7.8
Belgium	3.0	3.1	10.6	7.3
Portugal	-0.7	3.7	6.5	12.4
Ireland	-1.0	1.2	5.0	14.0
Italy	1.0	3.0	5.5	8.1
Greece	-4.8	3.1	7.9	15.1
Spain	0.8	3.4	7.3	20.9

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

*Office for National Statistics

PPI http://www.statistics.gov.uk/pdfdir/ppi0611.pdf

CPI http://www.statistics.gov.uk/pdfdir/cpi0611.pdf

** Excluding food, beverage, tobacco and petroleum

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

***Change from IQ2011 relative to IQ2010 http://www.esri.cao.go.jp/jp/sna/sokuhou/kekka/gaiyou/main_1.pdf

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

Table 11 provides the forecasts of the Federal Reserve Board Members and Federal Reserve Bank Presidents for the FOMC meeting in Jun. Inflation by the price index of personal consumption expenditures (PCE) was forecast for 2011 in the Apr meeting of the FOMC between 2.1 to 2.8 percent. Table 11 shows that the interval has narrowed to PCE headline inflation of between 2.3 and 2.5 percent. The FOMC focuses on core PCE inflation, which excludes food and energy. The Apr forecast of core PCE inflation was an interval between 1.3 and 1.6 percent. Table 11 shows the revision of this forecast in Jun to a higher interval between 1.5 and 1.8 percent. The Statement of the FOMC meeting on Jun 22 analyzes inflation as follows (http://www.federalreserve.gov/newsevents/press/monetary/20110622a.htm):

“Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”

Table 11, Forecasts of PCE Inflation and Core PCE Inflation by the FOMC, %

	PCE Inflation	Core PCE Inflation
2011	2.3 to 2.5	1.5 to 1.8
2012	1.5 to 2.0	1.4 to 2.0
2013	1.5 to 2.0	1.4 to 2.0
Longer Run	1.7 to 2.0

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20110622.pdf

The 12-month rates of increase of PCE price indexes are shown in Table 12. These data are released at the end of the month while the CPI and PPI are released in mid month. Headline 12-month PCE inflation (PCE) has accelerated from slightly over 1 percent in the latter part of 2010 to 2.2 percent in Apr and 2.5 percent in May. Monetary policy uses PCE inflation excluding food and energy (PCEX) on the basis of research showing that current PCEX is a better indicator of headline PCE a year ahead than current headline PCE inflation. The explanation is that commodity price shocks are “mean reverting,” returning to their long-term means after spiking during shortages caused by climatic factors, geopolitical events and the like. Inflation of PCE goods (PCEG) has accelerated sharply reaching 4.6 percent in May, in spite of 12-month declining inflation of PCE durable goods (PCEG-D) while PCE services inflation (PCES) has remained around 1.3 to 1.5 percent. The last two columns of Table 12 show PCE food inflation (PCEF) and PCE energy inflation (PCEE) that have been rising sharply, especially for energy. Monetary policy expects these increases to revert with its indicator PCEX returning to levels that are acceptable for continuing monetary accommodation.

Table 12, Percentage Change in 12 Months of Prices of Personal Consumption Expenditures ∆%

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2011
May	2.5	4.6	-0.7	1.5	1.2	3.5	22.1
Apr	2.2	4.0	-1.1	1.4	1.1	3.2	19.6
Mar	1.9	3.0	-1.6	1.3	0.9	2.9	15.3
Feb	1.6	2.1	-1.4	1.3	0.9	2.4	11.1
Jan	1.2	1.2	-1.9	1.3	0.8	1.7	6.7
2010
Dec	1.1	1.0	-2.2	1.2	0.7	1.2	7.4
Nov	1.0	0.6	-2.0	1.3	0.8	1.3	4.0
Oct	1.2	0.8	-1.8	1.4	0.9	1.3	6.3
Sep	1.3	0.5	-1.4	1.7	1.1	1.3	4.2
Aug	1.4	0.6	-1.0	1.7	1.2	0.7	4.0

Notes: percentage changes in price index relative to the same month a year earlier of PCE: personal consumption expenditures; PCEG: PCE goods; PCEG-D: PCE durable goods; PCEX: PCE excluding food and energy; PCEF: PCE food; PCEE: PCE energy goods and services

Source: http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0511.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

The role of devil’s advocate is played by data in Table 13. Headline PCE inflation (PCE) has jumped to 1.6 percent cumulative in the first four months of 2011, which is equivalent to 3.9 percent annual, with PCEG jumping to 3.0 percent cumulative and 7.4 percent annual equivalent, PCEG-D rising 0.8 percent cumulative or 1.9 percent annual, and PCES rising to 0.9 percent cumulative and 2.2 percent annual. PCEX, used in monetary policy, rose to 1.1 percent cumulative or 2.7 percent annual. PCEF has increased by 3.0 percent cumulative, which is equivalent in a full year to 7.4 percent. PCEE has risen to 10.9 percent cumulative or 28.3 percent annual equivalent with decline by 1.2 percent in May.

Table 13, Monthly and Jan-May PCE Inflation and Annual Equivalent Jan-May 2011 and Sep-Dec 2010 ∆%

	PCE	PCEG	PCEG -D	PCES	PCEX	PCEF	PCEE
2011
Jan-May 2011	1.6	3.0	0.8	0.9	1.1	3.0	10.9
Jan-May 2011 AE	3.9	7.4	1.9	2.2	2.7	7.4	28.3
May	0.2	0.0	0.2	0.2	0.3	0.3	-1.2
Apr	0.3	0.6	0.3	0.2	0.2	0.4	2.3
Mar	0.4	0.8	0.0	0.2	0.2	0.8	3.7
Feb	0.4	0.8	0.2	0.2	0.2	0.8	3.5
Jan	0.3	0.8	0.1	0.1	0.2	0.7	2.3
Sep-Dec 2010	0.7	1.1	-0.9	0.9	0.1	0.5	7.9
Sep-Dec 2010 AE	2.1	3.3	-2.7	2.7	0.3	1.5	25.5
Dec	0.3	0.6	-0.3	0.1	0.0	0.1	4.1
Nov	0.1	0.0	-0.3	0.1	0.1	0.0	0.1
Oct	0.2	0.4	-0.2	0.1	0.0	0.1	2.7
Sep	0.1	0.1	-0.1	0.0	0.0	0.3	0.8

Notes:AE: annual equivalent; percentage changes in a month relative to the same month for the same symbols as in Table.

Source: http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0511.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0311.pdf

http://www.bea.gov/newsreleases/national/pi/2011/pdf/pi0411.pdf

Inflation in Japan in Table 14, measured by the CPI, is still quite low, 0.1 percent from Apr into May and 0.3 percent in May 2011 relative to May 2010. Excluding food and energy, CPI inflation rose 0.2 percent in May but declined 0.1 percent relative to a year earlier. The highest CPI inflation is in fuel, light and water charges, 0.7 percent in May and 3.2 percent relative to a year earlier.

Table 14, Japan CPI May 2011, ∆%

	May/Apr ∆%	Year ∆%
CPI	0.1	0.3
CPI excluding Fresh Food	0.1	0.6
CPI excluding Food and Energy	0.2	-0.1
CPI Goods	0.1	0.3
CPI Services	0.1	0.3
CPI Excluding Imputed Rent	0.0	0.3
CPI Fuel, Light, Water Charges	0.7	3.2
CPI Transport Communications	0.0	1.3
CPI Ku-area Tokyo	-0.1	-0.2
Fuel, Light, Water Charges Ku Area Tokyo	0.9	2.0

Source: http://www.stat.go.jp/english/data/cpi/1581.htm

The rate of unemployment in Japan decreased from 4.7 percent in Apr to 4.5 percent in May. Table 15 shows that the number of unemployed has fallen by 380,000 in the year ending in May 2011 or a decline of 11.5 percent. The number of employed is 60.19 million and has grown by 90 thousand in the year ending in May.

Table 15, Japan Employment Report May 2011

Unemployed	2.93 million
Change since last year	-380 thousand
Unemployment rate	4.5 percent
Employed	60.19 million
Change since last year	90 thousand

Source: http://www.stat.go.jp/english/data/roudou/154.htm

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart 1 for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart 1 cannot be explained without taking into account that the increase in the fed funds rate to 22 percent in 1981 in the Volcker Fed precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s; the loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:

“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”

Chart 1, Brazil, Phillips Circuit 1963-1987

©Carlos Manuel Pelaez, O cruzado e o austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

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/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html 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). Table 16 provides the change in GDP, CPI and the rate of unemployment from 1960 to 1990. There are three waves of inflation (1) in the second half of the 1960s; (2) from 1973 to 1975; and (3) from 1978 to 1981. In one of his multiple important contributions to understanding the Great Inflation, Meltzer (2005) distinguishes between one-time price jumps, such as by oil shocks, and a “maintained” inflation rate. Meltzer (2005) uses a dummy variable to extract the one-time oil price changes, resulting in a maintained inflation rate that was never higher than 8 to 10 percent in the 1970s. There is revealing analysis of the Great Inflation and its reversal by Meltzer (2005, 2010a, 2010b).

Table 16, 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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table 17 when monetary policy 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 17 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 monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). 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 while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table 17, 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.t

Table 18, 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 18. 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, subsequently by the tragic earthquake and tsunami in Japan and now again by the sovereign risk doubts in Europe. The yield of 3.186 percent at the close of market on Fr Jul 1, 2011, would be equivalent to price of 95.2281 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 5.9 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 credit issues. Important causes of the rise in yields shown in Table 18 are expectations of rising inflation and US government debt estimated to exceed 70 percent of GDP in 2012 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html), rising from 40.8 percent of GDP in 2008, 53.5 percent in 2009 (Table 2 in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html) and 69 percent in 2011. On Jun 15, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2849 billion, or $2.8 trillion, with portfolio of long-term securities of $2615 billion, or $2.6 trillion, consisting of $1524 billion Treasury nominal notes and bonds, $65 billion of notes and bonds inflation-indexed, $117 billion Federal agency debt securities and $909 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1619 billion or $1.6 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit of this trap created by the highest monetary policy accommodation in US history together with the highest deficits and debt in percent of GDP since World War II. Risk aversion from various sources, discussed in section I, has been affecting financial markets for several weeks. The risk is that in a reversal of risk aversion that has been typical in this cyclical expansion of the economy yields of Treasury securities may back up sharply.

Table 18, 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
04/15/11	3.411	93.3874	-7.8
04/22/11	3.402	93.4646	-7.7
04/29/11	3.290	94.3759	-6.8
05/06/11	3.147	95.5542	-5.6
05/13/11	3.173	95.3387	-5.8
05/20/11	3.146	95.5625	-5.6
05/27/11	3.068	96.2089	-4.9
06/03/11	2.990	96.8672	-4.3
06/10/11	2.973	97.0106	-4.2
06/17/11	2.937	97.3134	-3.9
06/24/11	2.872	97.8662	-3.3
07/01/11	3.186	95.2281	-5.9

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

V Valuation of Risk Financial Assets. 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). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

Table 19 shows the phenomenal impulse to valuations of risk financial assets originating in the initial shock of near zero interest rates in 2003-2004 with the fed funds rate at 1 percent, in fear of deflation that never materialized, and quantitative easing in the form of suspension of the auction of 30-year Treasury bonds to lower mortgage rates. World financial markets were dominated by monetary and housing policies in the US. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of the unconventional monetary policy encouraging carry trade from low US interest rates to long leveraged positions in commodities, exchange rates and other risk financial assets. The charts of risk financial assets show sharp increase in valuations leading to the financial crisis and then profound drops that are captured in Table 19 by percentage changes of peaks and troughs. The first round of quantitative easing and near zero interest rates depreciated the dollar relative to the euro by 39.3 percent between 2003 and 2008, with revaluation of the dollar by 25.1 percent from 2008 to 2010 in the flight to dollar-denominated assets in fear of world financial risks and then devaluation of the dollar by 19.0 percent by Fri Jun 24, 2011. Dollar devaluation is a major vehicle of monetary policy in reducing the output gap that is implemented in the probably erroneous belief that devaluation will not accelerate inflation. The last row of Table 19 shows CPI inflation in the US rising from 1.9 percent in 2003 to 4.1 percent in 2007 even as monetary policy increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006.

Table 19, 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	07/01 /2011
Rate	1.1423	1.5914	1.192	1.452
CNY/USD	01/03 2000	07/21 2005	7/15 2008	07/01 2011
Rate	8.2798	8.2765	6.8211	6.4650
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

Table 19A extracts four rows of Table 19 with the Dollar/Euro (USD/EUR) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table 21 below, the dollar has devalued again to USD 1.452/EUR or by 21.8 percent. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD until it revalued to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent and after fixing it again to the dollar, revalued to CNY 6.4650/USD on Fri Jul 1, 2011, or by an additional 5.2 percent, for cumulative revaluation of 21.9 percent.

Table 19A, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate

USD/EUR	6/26/03	7/14/08	6/07/10	07/01 /2011
Rate	1.1423	1.5914	1.192	1.452
CNY/USD	01/03 2000	07/21 2005	7/15 2008	07/01 2011
Rate	8.2798	8.2765	6.8211	6.4650

Source: Table 19.

Dollar devaluation did not eliminate the US current account deficit, which is projected by the International Monetary Fund (IMF) at 3.2 percent of GDP in 2011 and also in 2012, as shown in Table 20. Revaluation of the CNY has not reduced the current account surplus of China, which is projected by the IMF to increase from 5.7 percent of GDP in 2011 to 6.3 percent of GDP in 2012.

Table 20, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2011 Dollar GDP

	GDP $B	FD %GDP 2011	CAD %GDP 2011	Debt %GDP 2011	FD%GDP 2012	CAD%GDP 2012	Debt %GDP 2012
US	15227	-10.6	-3.2	64.8	-10.8	-3.2	72.4
Japan	5821	-9.9	2.3	127.8	-8.4	2.3	135.1
UK	2471	-8.6	-2.4	75.1	-6.9	-1.9	78.6
Euro	12939	-4.4	0.03	66.9	-3.6	0.05	68.2
Ger	3519	-2.3	5.1	54.7	-1.5	4.6	54.7
France	2751	-6.0	-2.8	77.9	-5.0	-2.7	79.9
Italy	2181	-4.3	-3.4	100.6	-3.5	-2.9	100.4
Can	1737	-4.6	-2.8	35.1	-2.8	-2.6	36.3
China	6516	-1.6	5.7	17.1	-0.9	6.3	16.3
Brazil	2090	-2.4	-2.6	39.9	-2.6	-2.9	39.4

Note: GER = Germany; Can = Canada; FD = fiscal deficit; CAD = current account deficit

Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx

There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table 19 above after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets with fluctuations provoked by events of risk aversion. Table 21, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough” and the sharp recovery after around Jul 2010 in the last column “∆% Trough to 07/01/11” with all risk financial assets in the range from 12.4 percent for European stocks to 31.0 percent for the US S&P 500. Japan has significantly improved performance rising 11.8 percent above the trough. The dollar devalued by 21.8 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 07/01/2011” shows the sharp rise of all risk financial assets in a relief rally for the avoidance of default in Greece. The Dow Global gained 3.3 percent with greater strength in the US and Europe. The DJ UBS Commodity Index gained 0.9 percent in the week. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with caution instead of more aggressive risk exposures but the week of Fr Jul 1 showed strong valuations of risk financial assets. There is a fundamental change in Table 21 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. That change is best perceived in the column “∆% Peak to 7/01/11” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event. Most financial risk assets had gained not only relative to the trough as shown in column “∆% Trough to 7/01/11” but also relative to the peak in column “∆% Peak to 7/01/11.” There are several indexes below the peak: NYSE Finance by 5.9 percent, Nikkei Average by 13.4 percent but mostly because of the earthquake/tsunami, Shanghai Composite by 12.8 percent and STOXX 50 by 4.8 percent. The gainers relative to the peak in Apr 2010 are: DAX by 17.2 percent, Asia Pacific by 6.2 percent, S&P 500 by 10.1 percent, DJIA by 12.3 percent, Dow Global by 3.3 percent and the DJ UBS Commodities Index by 8.2 percent. The factors of risk aversion have adversely affected the performance of financial risk assets. The performance relative to the peak in Apr is more important than the performance relative to the trough around early Jul because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Aggressive tightening of monetary policy to maintain the credibility of inflation not rising above 2 percent—in contrast with timid “measured” policy during the adjustment in Jun 2004 to Jun 2006 after the earlier round of near zero interest rates—may cause another credit/dollar crisis and stress on the overall world economy. The choices may prove tough and will magnify effects on financial variables because of the corner in which policy has been driven by aggressive impulses that have resulted in the fed funds rate of 0 to ¼ percent and holdings of long-term securities close to 30 percent of Treasury securities in circulation.

Table 21, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 7/ 01/11	∆% Week 7/ 01/11	∆% Trough to 7/ 01/11
DJIA	4/26/ 10	7/2/10	-13.6	12.3	5.4	29.9
S&P 500	4/23/ 10	7/20/ 10	-16.0	10.1	5.6	31.0
NYSE Finance	4/15/ 10	7/2/10	-20.3	-5.9	6.5	18.1
Dow Global	4/15/ 10	7/2/10	-18.4	3.3	5.6	26.6
Asia Pacific	4/15/ 10	7/2/10	-12.5	6.2	2.6	21.3
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-13.4	1.9	11.8
China Shang.	4/15/ 10	7/02 /10	-24.7	-12.8	0.5	15.8
STOXX 50	4/15/10	7/2/10	-15.3	-4.8	3.8	12.4
DAX	4/26/ 10	5/25/ 10	-10.5	17.2	4.2	30.8
Dollar Euro	11/25 2009	6/7 2010	21.2	4.0	-2.3	-21.8
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	8.2	0.9	26.5
10-Year Tre.	4/5/ 10	4/6/10	3.986	3.186

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 .

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. Table 22 shows a gain by Apr 29, 2011 in the DJIA of 14.3 percent and of the S&P 500 of 12.5 percent since Apr 26, 2010, around the time when sovereign risk issues in Europe began to be acknowledged in financial risk asset valuations. There were still fluctuations. Reversals of valuations are possible during aggressive changes in interest rate policy. The stock market of the US then entered a period of six consecutive weekly declines interrupted by a week of advance and then another decline in the week of Jun 24. In the week of May 6, return of risk aversion, resulted in moderation of the valuation of the DJIA to 12.8 percent and that of the S&P 500 to 10.6 percent. There was further loss of dynamism in the week of May 13 with the DJIA reducing its gain to 12.4 percent and the S&P 500 to 10.4 percent. Further declines lowered the gain to 11.7 percent in the DJIA and to 10.0 in the S&P 500 by Fri May 20. By Fri May 27 the gains were further reduced to 11.0 percent for the DJIA and 9.8 percent for the S&P 500. In the fifth consecutive week of declines in the week of Fri June 3, the DJIA fell 2.3 percent, reducing the cumulative gain to 8.4 percent, and the S&P 500 also lost 2.3 percent, resulting in cumulative gain of 7.3 percent. The DJIA lost another 1.6 percent and the S&P 500 also 2.2 percent in the week of Jun 10, reducing the cumulative gain to 6.7 percent for the DJIA and of 4.9 percent for the S&P 500. The DJIA gained 0.4 percent in the week of Jun 17, to break the round of six consecutive weekly declines, rising 7.1 percent relative to Apr 26, 2010, while the S&P moved sideways by 0.04 percent, with gain of 4.9 percent relative to Apr 26, 2010. In the week of Jun 24, the DJIA lost 0.6 percent and the S&P lost 0.2 percent. The DJIA had lost 6.8 percent between Apr 29 and Jun 10, 2011, and the S&P 500 lost 6.9 percent. The losses were almost gained back in the week of Jul 1 with the DJIA now gaining 12.3 percent and the S&P 500 10.5 percent. Both the DJIA and the S&P 500 are only 1.8 percent below the level of Apr 29.

Table 22, 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
Apr 15	-0.3	10.1	-0.6	8.9
Apr 22	1.3	11.6	1.3	10.3
Apr 29	2.4	14.3	1.9	12.5
May 6	-1.3	12.8	-1.7	10.6
May 13	-0.3	12.4	-0.2	10.4
May 20	-0.7	11.7	-0.3	10.0
May 27	-0.6	11.0	-0.2	9.8
Jun 3	-2.3	8.4	-2.3	7.3
Jun 10	-1.6	6.7	-2.2	4.9
Jun 17	0.4	7.1	0.04	4.9
Jun 24	-0.6	6.5	-0.2	4.6
Jul 1	5.4	12.3	5.6	10.5

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

Table 23, updated with every post, shows that exchange rate valuations affect a large variety of countries, in fact, almost the entire world, in magnitudes that cause major problems for domestic monetary policy and trade flows. Joe Leahy writing on Jul 1 from São Paulo on “Brazil fears economic fallout as real soars” published in the Financial Times (http://www.ft.com/intl/cms/s/0/8430cd36-a40c-11e0-8b4f-00144feabdc0.html#axzz1Qt9Zxqcy) informs that the Brazilian real traded at the strongest level relative to the dollar since floating in 1999 with the strong currency eroding the country’s competitiveness in industrial products. Dollar devaluation is expected to continue because of zero fed funds rate, expectations of rising inflation and the large budget deficit of the federal government (http://professional.wsj.com/article/SB10001424052748703907004576279321350926848.html?mod=WSJ_hp_LEFTWhatsNewsCollection) but with interruptions caused by risk aversion events.

Table 23, Exchange Rates

	Peak	Trough	∆% P/T	Jul 1, 2011	∆% T Jul 01 2011	∆% P Jul 01 2011
EUR USD	7/15 2008	6/7 2010		7/01 2011
Rate	1.59	1.192		1.452
∆%			-33.4		17.9	-9.5
JPY USD	8/18 2008	9/15 2010		7/01 2011
Rate	110.19	83.07		80.78
∆%			24.6		2.8	26.7
CHF USD	11/21 2008	12/8 2009		7/01 2011
Rate	1.225	1.025		0.8489
∆%			16.3		17.2	30.7
USD GBP	7/15 2008	1/2/ 2009		7/01 2011
Rate	2.006	1.388		1.607
∆%			-44.5		13.6	-24.8
USD AUD	7/15 2008	10/27 2008		7/01 2011
Rate	1.0215	1.6639		1.077
∆%			-62.9		44.2	9.1
ZAR USD	10/22 2008	8/15 2010		7/01 2011
Rate	11.578	7.238		6.72
∆%			37.5		7.2	41.9
SGD USD	3/3 2009	8/9 2010		7/01 2011
Rate	1.553	1.348		1.226
∆%			13.2		9.1	21.1
HKD USD	8/15 2008	12/14 2009		7/01 2011
Rate	7.813	7.752		7.781
∆%			0.8		-0.4	0.4
BRL USD	12/5 2008	4/30 2010		7/01 2011
Rate	2.43	1.737		1.558
∆%			28.5		10.3	35.9
CZK USD	2/13 2009	8/6 2010		7/01 2011
Rate	22.19	18.693		16.688
∆%			15.7		10.7	24.8
SEK USD	3/4 2009	8/9 2010		7/01 2011
Rate	9.313	7.108		6.261
∆%			23.7		11.9	32.8
CNY USD	7/20 2005	7/15 2008		7/01 2011
Rate	8.2765	6.8211		6.4650
∆%			17.6		5.2	21.9

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

VI Economic Indicators. The purchasing managers’ index of the Institute for Supply Management rose 1.8 percentage points from 53.5 in May to 55.3 in Jun and new orders gained 0.6 percentage point from 51.0 in May to 51.6 in Jun. The price segment fell 8.5 percentage points from 76.5 in May to 68.0 in Jun (http://ism.ws/ISMReport/MfgROB.cfm). The pending home sales index of the National Association of Realtors, reflecting contracts that may be closed in one or two months, rose 8.2 percent from Apr into May and is 13.4 percent higher than in May 2010 (http://www.realtor.org/press_room/news_releases/2011/06/pending_may).

The value of construction put in place in the US in seasonally adjusted annual equivalent rate fell 0.6 percent in May relative to Apr and residential construction fell 2.1 percent, as shown in Table 24.

Table 24, Value of Construction Put in Place in the United States

	May SAAR $ B	∆%
Total	753.5	-0.6
Residential	237.3	-2.1
Nonresidential	516.1	0.1
Total Private	477.2	-0.4
Total Public	276.3	-0.8

SAAR: seasonally adjusted annual rate; B: billions

Source: http://www.census.gov/const/C30/release.pdf

The value of construction put in place in the US, not seasonally adjusted, from Jan to May fell 6.3 percent in 2011 relative to 2010, as shown in Table 25. The contraction of construction has been quite profound: a fall in the first five months of the year in 2011 by 38.0 percent relative to 2006 and by 32.3 percent relative to 2005.

Table 25, Value of Construction Put in Place in the United States, Not Seasonally Adjusted, $ Billions and ∆%

Jan-May 2011 $ B	285.1
Jan-May 2010 $ B	304.4
∆% to 2011	-6.3
Jan-May 2006	460.1
∆% to 2011	-38.0
Jan-May 2005	421.1
∆% to 2011	-32.3

Source: http://www.census.gov/const/C30/release.pdf

http://www.census.gov/const/C30/pr200705.pdf

http://www.census.gov/const/C30/pr200605.pdf

The Energy Information Administration Weekly Petroleum Status Report is summarized in Table 26. Crude oil stocks fell to 359.5 million barrels in the week of Jun 24 from 363.8 million in the week of Jun 17 and are lower by 3.6 million barrels than in the week of Jun 25, 2010. The world crude oil price fell to $107.87/barrel in the week of Jun 24 from $113.55/barrel in the week of Jun 17, but is 43.7 percent higher than $75.09/barrel in the week of Jun 25, 2010. The price of regular motor gasoline of $3.574/gallon on Jun 24, 2011 was 29.6 percent higher than $2.757/gallon on Jun 28, 2010.

Table 26, Energy Information Administration Weekly Petroleum Status Report

	06/24/11	06/17/11	06/25/10
Crude Oil Stocks Million B	359.5	363.8	363.1
Crude Oil* Imports Thousand Barrels/Day	8,782	8,942	9,673
Motor Gasoline Million B	213.2	214.6	218.1
Distillate Fuel Oil Million B	142.3	142.0	156.4
World Crude Oil Price $/B	107.87	113.55	75.09
	06/27/11	06/20/11	06/28/10
Regular Motor Gasoline $/G	3.574	3.652	2.757

*Four weeks ending on the date

B: barrels; G: gallon

Source: http://www.eia.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf

Initial claims for unemployment insurance seasonally adjusted fell 1000 to reach 428,000 in the week of Jun 25 from 429,000 in the week of Jun 18, as shown in Table 27. Claims not seasonally adjusted rose 8998 to reach 403,284 in the week of Jun 25 from 394,286 in the week of Jun 18. The labor market is not showing improvement with claims around 400,000, seasonally adjusted or not.

Table 27, Initial Claims for Unemployment Insurance

	SA	NSA	4-week MA SA
Jun 25	428,000	403,284	426,750
Jun 18	429,000	394,286	426,250
Change	-1,000	8,998	500
Jun 11	420,000	400,608	426,250
Prior Year	472,000	444,712	468,250

Note: SA: seasonally adjusted; NSA: not seasonally adjusted; MA: moving average

Source: http://www.dol.gov/opa/media/press/eta/ui/current.htm

VII Interest Rates. It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table 28 provides inflation of the CPI. In Jan-May 2011, CPI inflation for all items seasonally adjusted was 4.9 percent in annual equivalent, that is, compounding inflation in the first five months and assuming it would be repeated during three consecutive four-month periods. In the 12 months ending in May, CPI inflation of all items not seasonally adjusted was 3.6 percent. The second raw provides the same measurements for the CPI of all items excluding food and energy: 2.4 percent annual equivalent in Jan-May and 1.5 percent in 12 months. Bloomberg provides the yield curve of US Treasury securities (http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/). The lowest yield is 0.02 percent for three months or virtually zero, 0.1 percent for six months, 0.19 percent for 12 months, 0.47 percent for two years, 0.82 percent for three years, 1.78 percent for five years, 2.53 percent for seven years and 3.18 percent for ten years. The Irving Fisher definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by Bloomberg, and the rate of inflation expected in the term of the security, which could behave as in Table 28. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

Negative real rates of interest distort calculations of risk and returns from capital budgeting by firms, through lending by financial intermediaries to decisions on savings, housing and purchases of households. Inflation on near zero interest rates misallocates resources away from their most productive uses and creates uncertainty of the future path of adjustment to higher interest rates that inhibit sound decisions.

Table 28, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent Jan-May 2011 ∆%

	∆% 12 Months May 2011/May 2010 NSA	∆% Annual Equivalent Jan-May 2011 SA
CPI All Items	3.6	4.9
CPI ex Food and Energy	1.5	2.4

Source: http://www.bls.gov/news.release/pdf/cpi.pdf

VII Conclusion. Section I The Causes of the 2007 Credit/dollar Crisis provides the analysis of why and how the $12 trillion credit generating system of the US experienced a run on the liquidity created by SRPs. A relief rally in the week of Fri Jul 1 almost reversed the losses of the US stock market significantly because of the expectations of release of funds for Greece. Short-term indicators are showing slowing growth in the world economy probably now for the entire first half of the year. Real disposable income in the US stagnated in the first five months of 2011. Inflation is everywhere in the world economy with some deceleration at the margin. (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)

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The Causes of the 2007 Credit/dollar Crisis, Financial Risk Aversion, Slow Growth and Global Inflation

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