CMP Associates Regulation Blog: Debt and Financial Risk Aversion and Reinhart and Rogoff on Debt and Growth

Debt and Financial Risk Aversion and Reinhart and Rogoff on Debt and Growth

Carlos M. Pelaez

Executive Summary

I Financial Risk Aversion

IA Financial Risk Aversion

IB European Sovereign Risk

II United States

IIA Debt

IIB Growth and Employment

IIC Reinhart and Rogoff on Debt and Growth

IID Brazil

III Anniversary of Dodd-Frank

IV Global Inflation

V Valuation of Risk Financial Assets

VI Economic Indicators

VII Interest Rates

VIII Conclusion

References

Executive Summary

A monumental effort of data gathering, calculation and analysis by Carmen M. Reinhart and Kenneth Rogoff is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time periods:

“Our results incorporate data on 44 countries spanning about 200 years. Taken together, the data incorporate over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements and historic circumstances. We also employ more recent data on external debt, including debt owed by government and by private entities.”

Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the United States: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90.

For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).

An important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):

“The ignorance, of course, stems from the belief that financial crises happen to other people at other time in other places. Outside a small number of experts, few people fully appreciate the universality of financial crises. The arrogance is of those who believe they have figured out how to do things better and smarter so that the boom can long continue without a crisis.”

There is sober warning by Reinhart and Rogoff (2011CEPR, 42) on the basis of the momentous effort of their scholarly data gathering, calculation and analysis:

“Despite considerable deleveraging by the private financial sector, total debt remains near its historic high in 2008. Total public sector debt during the first quarter of 2010 is 117 percent of GDP. It has only been higher during a one-year sting at 119 percent in 1945. Perhaps soaring US debt levels will not prove to be a drag on growth in the decades to come. However, if history is any guide, that is a risky proposition and over-reliance on US exceptionalism may only be one more example of the “This Time is Different” syndrome.”

As both sides of the Atlantic economy maneuver around defaults the experience on debt and growth deserves significant emphasis in research and policy. The world economy is slowing with high levels of unemployment in advanced economies. Countries do not grow themselves out of unsustainable debts but rather through de facto defaults by means of financial repression and in some cases through inflation. This time is not different.

I Financial Risk Aversion. World financial markets continue to experience significant turbulence resulting from European sovereign risk exposures. Subsection IA Financial Risk Aversion provides data and analysis during the week of daily valuations of financial risk assets. Subsection IB European Sovereign Risk considers the new bailout package for Greece.

IA Financial Risk Aversion. The past three months have been characterized by unusual financial turbulence. Table 1, updated with every comment in this blog, provides beginning values on Jul 18 and daily values throughout the week ending on Jul 22. 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. The week was dominated by the new program for Greece considered below in Subsection IB European Sovereign Risk. In a sign of relaxing financial risk aversion, the dollar depreciated 1.5 percent relative to the euro by Jul 22, with inflows of funds from risk financial assets. The dollar appreciated in the prior week by 0.7 percent relative to the euro because of renewed fears of default in Greece that could have adverse repercussions on sovereign debts of other countries in Europe’s “periphery” as well as in “core countries” through exposures of banks. A combination of renewed fears of default, downgrade of Ireland, rise in bond spreads and declining bank stocks in Italy, the weak employment report of the US and alerts on downgrading of US debt in case of failure of increase of the federal debt limit were important factors of risk aversion in the prior week of Jul 15 but markets recovered with the expectation and then statement by the Council of the European Union (2011Jul21) announcing formally the Greek program. The Japanese yen appreciated by 0.8 percent during the week reaching JPY 78.52/USD by Fr Jul 22, which is 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 traded at CHF 0.816/USD on Fri Jul 22 exactly at the same strong level traded on Fri Jul 15, which reflects risk aversion by funds flowing away from risk positions to temporarily benefitting from safe haven in a strong deposit and investment market.

Table 1, Daily Valuation of Risk Financial Assets

	Jul 18	Jul 19	Jul 20	Jul 21	Jul 22
USD/ EUR 1.4157	1.4110 0.3% 0.3%	1.4143 0.1% -0.2%	1.4214 -0.4% -0.5%	1.4404 -1.7% -1.3%	1.4363 -1.5% 0.3%
JPY/ USD 79.13	79.042 0.1% 0.1%	79.2348 -0.1% -0.2%	78.7655 0.5% 0.6%	79.3650 -0.3% -0.8%	78.52 0.8% 1.1%
CHF/ USD 0.816	0.8173 -0.7% -0.7%	0.8243 -1.6% -0.9%	0.8198 -1.0% 0.5%	0.8143 -0.3% 0.7%	0.816 0.0% 0.2%
10 Year T Note Yield	2.92	2.87	2.94	3.01	2.964
2 Year T Note Yield	0.36	0.37	0.37	0.40	0.392
10 Year German Bond Yield	2.65	2.68	2.77	2.88	2.83
DJIA 12479.73	-0.8% -0.8%	0.9% 1.6%	0.7% -0.1%	1.9% 1.2%	1.6% -0.3%
DJ Global 2095.71	-1.3% -1.3%	-0.01% -1.4%	0.8% 0.8%	2.3% 1.5%	2.8% 0.5%
DAX 7220.12	-1.6% -1.6%	-0.4% 1.2%	-0.02% 0.4%	0.9% 0.9%	1.5% 0.5%
DJ Asia Pacific 1394.39	-0.4% -0.4%	-0.2% 0.1%	0.8% 1.1%	1.1% 0.2%	2.4% 1.3%
WTI $/b 97.43	95.990 -1.5% -1.5%	97.650 0.2% 1.7%	98.400 0.9% 0.8%	99.25 1.9% 0.9%	99.73 2.4% 0.5%
Brent $/b 117.66	116.25 -1.2% -1.2%	117.18 -0.4% 0.8%	118.130 0.4% 0.8%	117.94 0.2% -0.2%	118.470 0.7% 0.4%
Gold $/ounce 1594.20	1606.40 0.8% 0.8%	1587.50 -0.4% -1.2%	1600.30 0.4% 0.8%	1590.50 -0.2% -0.6%	1602.90 0.5% 0.8%

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://www.bloomberg.com/markets/

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

The three sovereign bond yields in Table 1 capture renewed risk aversion in the flight away from risk financial assets toward 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 fluctuating in a tight low range between 0.36 and 0.40 percent, trading at 0.392 percent on Fri Jul 22. There is generalized expectation in financial markets, shown by normal bid/coverage ratios in the auctions of three, ten and thirty year US Treasury bonds and the yields in Table 1, that there will not be default of US debt because of political failure to raise the debt limit. Much the same is true of the 10-year Treasury note and the 10-year bond of the government of Germany, trading at 2.964 percent for the 10-year Treasury note and to 2.83 percent for the 10-year government bond of Germany by Fri Jul 22 because of outflows to risk financial assets with hopes on the new program on Greece and longer maturities and lower rates for programs of Ireland and Portugal. Market can still become volatile under perceptions of challenges in the sovereign rescue program of Europe and/or failure to raise the debt limit. Section IV Valuation of Risk Financial Assets provides more details and comparisons of performance in peaks and troughs.

The upper row in the stock indexes in Table 1 measures the percentage cumulative change to Jul 22 since the closing level in the prior week on Jul 15 and the lower row measures the daily percentage change. Performance of equities markets significantly improved after the announcement of the new program for Greece. The DJ Global index rose 2.8 percent in the week, mostly on Apr 21 with the announcement of the Greek program. All four indexes in Table 1 registered gains concentrated on Apr 21 and with delay in Asian markets when they opened the following day.

The final block of Table 1 shows upward performance of oil and gold futures. Brent gained only 0.7 percent in the week but WTI gained 2.4 percent and is now around $100/barrel. Increasing risk appetite appears to have stimulated the carry trade. Gold gained 0.5 percent by Fri Jul 22 with some investors believing gold can hedge reversal of optimism on the program for Greece and resolution of the impasse on the US debt limit.

IB European Sovereign Risk. The Council of the European Union (2011Jul21), hereafter CEU, announced important measures in the effort to contain and resolve the sovereign debt crisis in Europe. These measures are as follows:

· Greece adjustment program. The CEU welcomes the legislative measures approved by the Greek Parliament on stabilization of public finance and reform of the economy, including privatization. The CEU finds that the measures are necessary for sustainable growth in Greece and is aware of the sacrifices of the population in the effort to attain future stability and welfare

· Official financing to Greece. The new program for Greece has contributions from the European Union, IMF and the private sector in the estimated amount of €109 billion. The European Financial Stability Facility (EFSF http://www.efsf.europa.eu/about/index.htm) will be the vehicle for financing of the next disbursement by the European Union

· Lending conditions: maturities. The maturity of EFSF loans to Greece will be extended as feasible from 7.5 years in current conditions “to a minimum of 15 years and up to 30 years with a grace period of 10 years.” The CEU also extended the maturities of existing loans to Greece

· Lending conditions: interest rates. The CEU decided to lower EFSF lending rates to approximately 3.5 percent, which is the rate for the balance of payments facility but “without going below the EFSF funding cost”

· Monitoring. The program for Greece will continue to be monitored with regular assessments by the European Commission, European Central Bank and the IMF with “appropriate incentives to implement the programme”

· Task force. The CEU welcomes the proposal by the European Commission of creating a task force “which will work with the Greek authorities to target the structural funds on competitiveness and growth, job creation and training.” Member states of the euro area and the European Commission “will immediately mobilize all resources necessary in order to provide exception technical assistance to help Greece implement its reforms”

· Private financial sector participation. There is a critical difference here with the earlier program as stated by the Council of the European Union (2011Jul21, 2): “the financial sector has indicated its willingness to support Greece on a voluntary basis through a menu of options strengthening overall sustainability. The net contribution of the private sector is estimated at 37 billion euro. Credit enhancement will be provided to underpin the quality of collateral so as to allow its continued use for access to Eurosystem liquidity operations by Greek banks. We will provide adequate resources to recapitalize Greek banks if needed.” Footnote 1 to this paragraph also in page 2 of Council of the European Union (2011Jul21) on the €35 billion states on that number: “taking into account the cost of credit enhancement for the period 2011-2014. In addition, a debt buy back programme will contribute to 12.6 billion euro, bringing the total to 50 billion euro. For the period 2011-2019, the total net contribution of the private sector involvement is estimated at 106 billion euro.” The CEU justifies the participation of the private sector on the grounds that the “Greece requires an exceptional and unique solution”

· Conditionality. IMF programs work on the basis of “conditionality” (see Pelaez and Pelaez, International Financial Architecture (2005), 160-2; see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 119-23). The Council of the European Union (2011Jul21, 3) increased the “flexibility linked to conditionality” of the EFSF and its future successor after mid 2013 the European Stabilization Mechanism (ESM) in three forms: (1) action on the basis of a precautionary program; (2) recapitalization of financial institutions will be through loans to governments, including countries outside programs; and (3) “intervene in the secondary markets on the basis of an ECB analysis recognizing the existence of exceptional financial market circumstances and risks to financial stability and on the basis of a decision by mutual agreement of the EFSF/ESM Member States, to avoid contagion.” The EFSF and its successor ESM are authorized, on the basis of analysis by the ECB, to buy and sell sovereign bonds in secondary markets under “exceptional financial market circumstances.” Collateral will be posted as required to prevent risk to euro area member states from their guarantees provided to bond issues by the EFSF

· Other countries at risk. The CEU will continue to assist other countries, such as Ireland and Portugal, until they can fund again in international financial markets on the condition that “they successfully implement” their individual programs. The lending rates and maturities by the EFSF agreed for Greece are also extended to Portugal and Ireland.

· Fiscal targets and macroeconomic imbalances. All members of the euro area will comply with their fiscal targets and with the exception of countries under a program will reduce their deficits to less than 3 percent of GDP by 2013. Countries will provide “backstops to banks as appropriate” in accordance with the results of stress tests, meaning that bank with deficiencies will be recapitalized

The Institute of International Finance (IIF 2011Jul21, 1) provides the form of participation of the private sector. Existing government bonds of Greece will be exchanged “into a combination of four instruments together with the Greek Debt Buyback Facility.” The four instruments are (IIF 2011Jul 21, 1):

1. “A Par Bond Exchange into a 30 year instrument

2. A Par Bond offer involving rolling-over maturing Greek government bonds into 30 year instruments

3. A Discount Bond Exchange into a 30 year instrument

4. A Discount Bond Exchange via an insurance mechanism into a 15 year instrument”

Zero-coupon bonds rated AAA with 30-year maturities will be used to collateralize the principal of all four instruments or in the case of instrument 2 coverage of the principal with a 40 percent tranche-based insurance. The servicing risk is entirely Greek risk. The instruments will be selected with weights of 25 percent. Pricing of the instruments will be designed to result in a net present value loss of 21 percent on the basis of a discount rate of 9 percent. The term sheet accompanying IIF (2011Jul21) provides for terms “comparable to those of the official sector.” Rates are graduated in order to facilitate the process of regaining access by Greece to international financial markets. In the example provided by the IIF (2011Jul21): “the coupon on the Par Bond will be 4% during the first five years, 4.5% during the next five years and 5% for years 2011-2030.” Assuming the target rate of participation by the private sector of 90 percent, the contribution by the private sector to financing Greece will amount exchanging maturing securities of €54 billion between the middle of 2011 and the middle of 2014 and €135 billion from the middle of 2011 to the end of 2020. The average maturity of Greece’s debt will increase from the average of 6 years to 11 years. A number of private sector financial institutions already agreed to participate in the program.

Fitch ratings (2011Jul21) finds that the commitments at the summit of leaders of the European Union on July 21 is “an important and positive step toward securing financial stability in the euro zone.” The pressure on sovereign ratings in the euro zone is relieved by stronger policy on Greece. There is still vulnerability to financial market turbulence until return of widespread and sustained economic growth in the region together with reduction of large government budget deficits and reforms required for long-term growth. The positive signs found by Fitch (2011Jul22) are: (1) enhanced flexibility in operating the ESF and later of its successor ESM; (2) increase in the net lending facility to €440 billion that can meet ample needs; (3) new lending program of €109 billion to Greece with longer maturities and lower rates; and (4) private sector participation. Fitch (2011Jul22) finds that the IIF (2011Jul21) proposal results in a loss of 20 percent of net present value to banks and other investors in sovereign debt of Greece. “Fitch’s coercive debt exchange criteria” applies to an exchange that results in terms for holders of the debt that are worse than in the contractual conditions of existing debt, constituting default. Following its rating approach to sovereign debt exchange, Fitch will classify Greek sovereign debt into “restricted default,” assigning ratings of default to Greek sovereign bonds as of the date of closing of the debt exchange. New “post-default” ratings will be assigned to Greek government bonds at the time of issue of new bonds to participating holders of Greek debt. Fitch (2011Jul21) anticipates that the new ratings are likely to be “low speculative grade.” The extension of maturity and interest rate reductions to Ireland and Portugal is positive for their sovereign credit ratings. Fitch (2011Jul22) will continue to analyze the ratings of Ireland and Portugal on the basis of progress in economic recovery and attaining sustainable fiscal adjustment.

Charles Forelle and Marcus Walker, writing on Jul 23 on “Europe debt plan relieves pressure,” published by the Wall Street Journal Europe Business News (http://professional.wsj.com/article/SB10001424053111903554904576461371571916918.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze the new program of the CEU. The bond exchange program of €135 billion together with the debt buyback program will reduce Greece’s debt of €350 billion by €26 billion, or 7.4 percent. The exchange of half of the €135 billion of holdings of Greek sovereign bonds at discount of 20 percent will reduce Greece’s debt by €13.5 billion [0.20(€135/2) = €13.5]. The package of €109 billion provides that €35 billion will be used as collateral required for AAA-rating in issuing bonds by the EFSF guaranteed by the sovereigns of the euro zone. The package also provides the use of €20 billion from the €109 billion in purchasing discounted Greek debt that will result in reduction of debt by €12.6 billion. The total debt reduction of €26 billion is the sum of €13.5 billion from the bond exchange and €12.6 billion from the buyback.

David Enrich, writing on Jul 23 on “Slim fallout seen for Europe banks” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111903554904576462323145520168.html?mod=WSJPRO_hps_MIDDLEFifthNews) reveals Wall Street Journal analysis of European bank-stress tests in their relation to the Greek bailout program. The disclosures by the 90 large European banks with the results of the stress tests permit calculation of losses in the bond exchange program ranging from €7 billion to €14 billion, around $10 billion to $20 billion. Of the potential losses of €13.99 billion, in the higher estimate, Greece’s banks account for €9.043 billion, or 64.6 percent. Enrich explains that the losses from the bond exchange, of 10 percent to 20 percent depending on the method used for calculating discounts, are relatively mild in comparison with the market discounts of 50 percent or more equivalent to market trading prices. The impact on Greek banks originates in the holdings by six Greek banks of €43 billion of Greek debt maturing in the next 10 years, which would result in losses exceeding over €9 billion, according to Wall Street Journal analysis provided by Enrich. Losses to French banks may total €1.4 billion and those of German banks may be €843 billion. Discounts on debt maturing beyond 2020 may result in higher losses for French and German banks.

There are euro zone countries that are relatively sound in terms of fiscal situations and financial variables, especially spreads of sovereign bonds and government debts and deficits, such as France and Germany. Three euro zone countries have engaged in bailouts within the mechanism created by the European Union, IMF and European Central Banks: Portugal, Ireland and Greece. The combined GDPs of Portugal, Ireland and Greece add to $739 billion, which represents only 6.1 percent of the euro zone GDP of $12,192.8 billion, shown in Table 2. The problem is in the exposure of European banks to the bailed out countries and of banks worldwide to the bailed out countries and to the European banks. These exposures are much more important in relative terms of propagating financial stress than the combined GDP of the bailed out countries. The turmoil during the past two weeks manifested in the form of increases in the sovereign bond spreads and declines in the stock markets and bank stocks of Spain and Italy. The addition of the GDP of Spain and Italy to the bailed-out countries totals $4204 billion, which is equivalent to 34.5 percent of euro zone GDP. David Cottle writing on Jul 12 on “Italy fears rattle Europe’s markets” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303812104576441302547119220.html?mod=WSJPRO_hpp_LEFTTopStories) informs that Italy’s “total capital market debt” is €1598 billion, approximately $2.2 trillion, which is the largest in the euro zone and the third largest in the world after the US and Japan. There is a cushion in that only €88 billion mature in 2011 and €190 billion mature in 2012. Perhaps the major source of concern for propagation of turbulence in Italy is that French banks had $392.6 billion in Italian government and private debt at the end of 2010, according to Bank for International Settlements (BIS) data, as informed by Fabio Benedetti-Valentini, writing on Jul 12, 2011, on “French banks face greatest Italian risk” published by Bloomberg (http://www.bloomberg.com/news/2011-07-12/france-s-bnp-credit-agricole-on-frontline-with-italian-risk.html).

Table 2, World and Selected Regional and Country GDP and Fiscal Situation

	GDP USD 2010 USD Billions	Primary Net Lending Borrowing % GDP 2010	General Government Net Debt % GDP 2010
World	57,920.3
Euro Zone	12,192.8	-3.6	64.3
Portugal	229.3	-4.6	79.1
Ireland	204.3	-29.7	69.4
Greece	305.4	-3.2	142.0
Spain	1,409.9	-7.8	48.8
Major Advanced Economies G7	31,891.5	-6.9	74.4
United States	14,657.8	-10.6	64.8
UK	2,247.5	-8.6	69.4
Germany	3,315.6	-3.3	53.8
France	2,582.5	-7.7	74.6
Japan	5,458.9	-9.5	117.5
Canada	1,574.1	-5.5	32.2
Italy	2,055.1	-4.6	99.6
China	5,878.3	-2.6	17.7

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

The Markit Flash Eurozone PMI^® for Jul is suggesting stagnation of growth of the euro zone (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/EZ_Flash_ENG_1108_PR.pdf). The composite output index fell from 53.3 in Jun to 50.8 in July, suggesting flat growth, in the weakest performance in 23 months. The services business activity index fell from 53.7 in Jun to 51.4 in Jul for the weakest performance in 22 months. The manufacturing PMI output index declined from 52.5 in Jun to a two-year low of 49.5 in Jul.

II United States. This section provides data and analysis of the most critical issues of United States risk: the size of the debt and low growth resulting in a fractured job market. Subsection IIA Debt considers the debt of the US and the difficulties it can create. Subsection IIB Growth and Employment provides key data and analysis of US economic growth and employment with some additional indicators released during the week. IIC Reinhart and Rogoff on Debt and Growth reviews the momentous contribution of Carmen M. Reinhart and Kenneth S. Rogoff on the relation of debt and economic growth based on a huge sample of several centuries across many countries. Subsection IID Brazil provides an analysis of debt, money, income and prices in nineteenth-century Brazil that is related to the findings of Reinhart and Rogoff.

IIA Debt. There are two issues with the debt of the US: (1) the possibility of a point of explosion that would force sudden adjustment that could occur in the form of sharp increases in taxes, draconian cuts in expenditures, increases in taxes, dollar devaluation and low rates of economic growth with resulting unemployment; or (2) less disorderly adjustment that would still result in low rates of economic growth and permanent high levels of unemployment. An alternative scenario of the CBO (2011LTBO) provides measurements of the impact of adjustment of high debt levels.

Table 3 provides fiscal projections under an alternative fiscal scenario, which is based on the following assumptions (CBO 2011LTBO, 2):

“The alternative fiscal scenario embodies several changes to current law that would continue certain tax and spending policies that people have grown accustomed to (because the policies are in place now or have been in place recently). Versions of some of the changes assumed in the scenario—such as those related to the tax cuts originally enacted in 2001, the AMT, certain other tax provisions, and Medicare’s payments to physicians—have regularly been enacted in the past and are widely expected to be made in some form over the next few years. After 2021, the alternative fiscal scenario also incorporates modifications to several provisions of current law that might be difficult to sustain for a long period. Thus, the scenario includes changes to certain restraints on the growth of spending for Medicare and to indexing provisions that would slow the growth of federal subsidies for health insurance coverage. In addition, the scenario includes unspecified changes in tax law that would keep revenues constant as a share of GDP after 2021.”

Table 3, CBO Long-term Budget Outlook Alternative Fiscal Scenario, % of GDP

	2011	2021	2035
Spending	24.1	25.9	33.9
Primary	22.7	21.5	25.0
SS	4.8	5.3	6.1
Medicare	3.7	4.3	6.7
Medicaid	1.9	2.8	3.7
Other	12.3	9.1	8.5
Interest	1.4	4.4	8.9
Revenues	14.8	18.4	18.4
Deficit	-9.3	-7.5	-15.5
Primary	-7.9	-3.1	-6.6
Debt	69	101	187

Primary spending is spending other than interest payments. Primary deficit or surplus is revenue less primary spending.

Source: http://www.cbo.gov/ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf

An important distinguishing characteristic of the alternative fiscal scenario in Table 3 is the much sharper increase in debt held by the public from 69 percent of GDP in 2011 to 101 percent of GDP in 2021 and 187 percent of GDP in 2035. Accordingly, interest payments on the debt jump from 1.4 percent of GDP in 2011 to 8.9 percent of GDP in 2035. In contrast with the extended-baseline scenario, the alternative fiscal scenario fixes revenue as percent of GDP at 18.4 percent after 2035.

Fiscal projections by the CBO incorporate a host of assumptions on demographic variables, such as the rate of growth and consumption of the US population, economic variables, interest rates, labor market factors, real GDP and earnings per worker. The CBO (2011LTBO) analyzes how the performance of the economy would be affected by an increase in debt held by the public over 76 percent of GDP, which is used as benchmark economic conditions. The CBO uses a Solow-type model in measuring effects on the economy of fiscal policies under the two scenarios (after Solow 1956, 1989; see Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 11-16)). The method is discussed in CBO (2011PBB, Appendix A, 31-7). The calculations by the CBO (2011LTBO, 28-31) are shown in Table 4. The impact is much softer on GDP than on GNP because “the change in GDP does not reflect the increased future outflow of profits and interest generated by the additional capital inflow” (CBO 2011LTBO, 28). The striking result in Table 4 is the sharp reduction of GNP by 2035 of 6.7 percentage points to 17.6 percentage points over what it would be under the benchmark debt level of 76 percent and of GDP from 2.4 percentage points to 9.9 percentage points.

Table 4, Effects on GNP and GDP of Fiscal Policies in CBO’s Scenarios in Percentage Difference from Benchmark Level

	2025	2035
Extended Baseline
GNP	-0.2 to –0.4	-0.5 to –1.6
GDP	(-0.05 to 0.05 to –0,2	-0.2 to –1.3
Alternative Fiscal
GNP	-2.2 to –5.7	-6.8 to –17.6
GDP	-0.4 to –3.1	-2.4 to –9.9

Source: http://www.cbo.gov/ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf

IIB Growth and Employment. Taylor (2011Jul21), in an article for the Wall Street Journal, compares average annual equivalent growth after the recession of 2007-2009 of only 2.8 percent with 7.1 percent after the comparably strong recent recession of 1981-1982. Growth has not been mediocre but stalled since the beginning of the current expansion phase. There were 144 million people with jobs in the US in 2006 compared with only 140 million in Jun 2011 (see Table 2 in http://cmpassocregulationblog.blogspot.com/2011/07/twenty-five-to-thirty-million.html). Some common explanations for the current slump are not valid. Negative effects of weak housing currently are inferior compared with negative exports in the 1980s that gave the pejorative name of “rust belt” to the US industrial corridor. Growth originates in aggregate demand consisting of investment and consumption. Taylor (2011Jul21) finds that real GDP growth currently is 60 to 70 percent lower than in the recovery of the 1980s, which is also the case of consumption and investment. Another common misperception is that there has been a systemic financial crisis with many ignoring the debt crisis of 1982 when US money-center banks had more than 40 percent of their capital in loans to emerging countries in default or near default. Several countries that had borrowed for financing balance of payments deficits declared moratoriums on their foreign debts, impairing balance sheets of money-center banks (see, for example, in vast literature, Krugman 1994). The increase in interest rates to deal with stagflation caught the banking industry with short-dated funding and long-term fixed-rate assets. In a parallel of what could happen when monetary policy abandons its near zero interest rates, 1150 US commercial banks, close to 8 percent of the industry, failed, almost twice the number of banks that failed since establishment of the FDIC in 1934 until 1983 (Benston and Kaufman 1997, 139; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7). More than 900 savings and loans associations, equivalent to around 25 percent of the industry, had to be closed, merged or placed in conservatorship (Ibid). Taxpayer funds in the value of $150 billion were used in the resolution of failed savings and loans institutions. In terms of relative dimensions, $150 billion was equivalent to 2.6 percent of GDP of $5800 billion in 1990 and 3.6 percent of GDP of $4217 billion in 1985 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1980&LastYear=1990&3Place=N&Update=Update&JavaBox=no). The equivalent in terms of 2.6 to 3.6 percent of US GDP in 2010 of $14,657 billion would be $381 billion to $528 billion (data from Ibid). Wide swings in interest rates resulting from aggressive monetary policy can wreck the balance sheets of families, financial institutions and companies while posing another recession risk. While it is true that monetary policy can increase interest rates instantaneously, the increase from zero percent toward much higher levels to contain inflation can have devastating effects on the world economy.

The NBER dates another recession in 1980 that lasted about half a year. If the two recessions from IQ1980s to IIIQ1980 and IIIQ1981 to IVQ1982 are combined, the impact on lost GDP is comparable to the revised 4.1 percent drop of the recession from IVQ2007 to IIQ2009. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. Table 5 provides the BEA quarterly growth rates of GDP in SA yearly equivalents for the recessions of 1981-1982 and 2007 to 2009. There were four quarters of contraction in 1981-1982 ranging in rate from -1.5 percent to -6.4 percent and five quarters of contraction in 2007-2009 ranging in rate from -0.7 percent to -6.8 percent. The striking difference is that in the first seven quarters of expansion from IQ1983 to IIIQ1984, shown in Table 5 in relief, GDP grew at the high quarterly percentage growth rate of 5.1, 9.3, 8.1, 8.5, 7.1, 3.9 and 3.3 while the percentage growth rate in the first seven quarters from IIIQ2009 to IQ2011, shown in relief in Table 5, was mediocre: 1.6, 5.0, 3.7, 1.7, 2.6, 3.1 and 1.8. The data in Table 5 incorporate the third estimate of IQ2011 by the BEA, with the growth of GDP at 1.9 percent. Inventory change contributed to initial growth but was rapidly replaced by growth in investment and demand in 1983. The key difference may be found in the negative incentive to business and household investment and business hiring from the structural shock to business models resulting from legislative restructurings and regulation with alleged benefits in the long-term but adverse short-term growth and jobs effects.

Table 5, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Q	1981	1982	1983	1984	2008	2009	2010
I	8.6	-6.4	5.1	7.1	-0.7	-4.9	3.7
II	-3.2	2.2	9.3	3.9	0.6	-0.7	1.7
III	4.9	-1.5	8.1	3.3	-4.0	1.6	2.6
IV	-4.9	0.3	8.5	5.4	-6.8	5.0	3.1
				1985			2011
I				3.8			1.9
II				3.4
III				6.4
IV				3.1

Source:

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp1q11_2nd.pdf

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr

http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp4q10_3rd.pdf

The highest average yearly percentage of unemployed to the labor force since 1940 was 14.6 percent in 1940 followed by 9.9 percent in 1941, 8.5 percent in 1975, 9.7 percent in 1982 and 9.6 percent in 1983 (ftp://ftp.bls.gov/pub/special.requests/lf/aa2006/pdf/cpsaat1.pdf). The rate of unemployment remained at high levels in the 1930s, rising from 3.2 percent in 1929 to 22.9 percent in 1932 in one estimate and 23.6 percent in another with real wages increasing by 16.4 percent (Margo 1993, 43; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 214-5). There are alternative estimates of 17.2 percent or 9.5 percent for 1940 with real wages increasing by 44 percent. Employment declined sharply during the 1930s. The number of hours worked remained 29 percent in 1939 below the level of 1929 (Cole and Ohanian 1999). Private hours worked fell in 1939 to 25 percent of the level in 1929. The policy of encouraging collusion through the National Industrial Recovery Act (NIRA), to maintain high prices, together with the National Labor Relations Act (NLRA), to maintain high wages, prevented the US economy from recovering employment levels until Roosevelt abandoned these policies toward the end of the 1930s (for review of the literature analyzing the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217).

The Bureau of Labor Statistics (BLS) makes yearly revisions of its establishment survey (Harris 2011BA):

“With the release of data for January 2011, the Bureau of Labor Statistics (BLS) introduced its annual revision of national estimates of employment, hours, and earnings from the Current Employment Statistics (CES) monthly survey of nonfarm establishments. Each year, the CES survey realigns its sample-based estimates to incorporate universe counts of employment—a process known as benchmarking. Comprehensive counts of employment, or benchmarks, are derived primarily from unemployment insurance (UI) tax reports that nearly all employers are required to file with State Workforce Agencies.”

The number of not seasonally adjusted total private jobs in the US in Dec 2010 is 108.464 million, declining to 106.079 million in Jan 2011, or by 2.385 million, because of the adjustment of a different benchmark and not actual job losses. The not seasonally adjusted number of total private jobs in Dec 1984 is 80.250 million, declining to 78.704 million in Jan 1985, or by 1.546 million for the similar adjustment. Table 6 attempts to measure job losses and gains in the recessions and expansions of 1981-1985 and 2007-2011. The final ten rows provide job creation from May 1983 to May 1984 and from May 2010 to May 2011, that is, at equivalent stages of the recovery from two comparable strong recessions. The row “Change ∆%” for May 1983 to May 1984 shows an increase of total nonfarm jobs by 4.9 percent and of 5.9 percent for total private jobs. The row “Change ∆%” for May 2010 to May 2011 shows an increase of total nonfarm jobs by 0.7 percent and of 1.7 percent for total private jobs. The last two rows of Table 6 provide a calculation of the number of jobs that would have been created from May 2010 to May 2011 if the rate of job creation had been the same as from May 1983 to May 1984. If total nonfarm jobs had grown between May 2010 and May 2011 by 4.9 percent, as between May 1983 and May 1984, 6.409 million jobs would have been created in the past 12 months for a difference of 5.457 million more total nonfarm jobs relative to 0.952 million jobs actually created. If total private jobs had grown between May 2010 and May 2011 by 5.9 percent as between May 1983 and May 1984, 6.337 million private jobs would have been created for a difference of 4.539 million more total private jobs relative to 1.798 million jobs actually created.

Table 6, Total Nonfarm and Total Private Jobs Destroyed and Subsequently Created in Two Recessions IIIQ1981-IVQ1982 and IVQ2007-IIQ2009, Thousands and Percent

	Total Nonfarm Jobs	Total Private Jobs
06/1981 #	92,288	75,969
11/1982 #	89,482	73,260
Change #	-2,806	-2,709
Change ∆%	-3.0	-3.6
12/1982 #	89,383	73,185
05/1984 #	94,471	78,049
Change #	5,088	4,864
Change ∆%	5.7	6.6
11/2007 #	139,090	116,291
05/2009 #	131,626	108,601
Change %	-7,464	-7,690
Change ∆%	-5.4	-6.6
12/2009 #	130,178	107,338
05/2011 #	131,753	108,494
Change #	1,575	1,156
Change ∆%	1.2	1.1
05/1983 #	90,005	73,667
05/1984 #	94,471	78,049
Change #	4,466	4,382
Change ∆%	4.9	5.9
05/2010 #	130,801	107,405
05/2011 #	131,753	109,203
Change #	952	1,798
Change ∆%	0.7	1.7
Change # by ∆% as in 05/1984 to 05/1985	6,409*	6,337**
Difference in Jobs that Would Have Been Created	5,457 = 6,409-952	4,539 = 6,337-1,798

*[(130,801x1.049)-130,801] = 6,409 thousand

**[(107,405)x1.059 – 107,405] = 6,337 thousand

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

The large number of unemployed in the US remains virtually static with slight improvement in some regions and divisions, nearly the same situation in others and even worsening in some, as revealed by the Bureau of Labor Statistics (BLS) data in Table 7. Using the rate of participation in the labor force of 2006, the number of unemployed could be as high as 18.413 million because as many as 4.004 million could have desisted from seeking a job in the belief that there is none really available for them. The number of part-time for economic reasons who would like to work but cannot find a job is 8.600 million and those marginally attached to the labor force are 2.680 million. The total number of people in job stress is the sum of the 18.413 million effectively unemployed plus the 8.600 million involuntarily in part-time jobs and the 2.680 million marginally attached to the labor force for total 29.693 in job stress (http://cmpassocregulationblog.blogspot.com/2011/07/twenty-five-to-thirty-million.html). Sara Murray and Phil Izzo, writing on Jul 22 on “Job search stretches past a year for millions” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111904233404576460171662228698.html?mod=WSJPRO_hpp_LEFTTopStories) inform that the current recovery is the one with highest number of people in long periods of unemployment since the 1940s. There are 4.4 million people, about 30 percent of the unemployed, in the data for Jun 2011 who have been unemployed for more than a year, which is slightly higher than 29 percent in Jun 2010. Conor Dougherty, writing on Jul 21 on “Layoffs deepen gloom” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111903461104576458322987900468.html?mod=WSJPRO_hpp_LEFTTopStories) finds that US companies are laying off workers at the fastest rate in about a year.

Table 7, Unemployed and Unemployment Rate by Census Region and Division NSA, Thousands and %

	UNE Jun 2010	UNE Jun 2011	UNE as Percent of Labor Force	UNE as Percent of Labor Force
NE	2,449.3	2,338.2	8.6	8.3
New England	659.3	617.7	8.4	7.9
Middle Atlantic	1,790.0	1,720.4	8.7	8.4
South	5,213.2	5,258.7	9.4	9.4
South Atlantic	2,914.8	2,873.9	9.9	9.7
East South Central	862.1	912.0	10.0	10.3
West South Central	1,436.3	1,472.8	8.2	8.4
Midwest	3,293.2	3,006.6	9.5	8.7
East North Central	2,496.1	2,329.5	10.5	9.5
West North Central	797.1	767.1	7.2	6.9
West	3,911.1	3,805.5	10.9	10.7
Mountain	1,076.4	1,032.0	9.7	9.3
Pacific	2,834.7	2,773.5	11.5	11.3

UNE: number unemployed in thousands; NE: Northeast

Source:

http://www.bls.gov/news.release/pdf/laus.pdf

The weekly earnings report of the BLS states (http://www.bls.gov/news.release/pdf/wkyeng.pdf):

“Median weekly earnings of the nation’s 100.6 million full-time wage and salary workers were $753 in the second quarter of 2011 (not seasonally adjusted), the US Bureau of Labor Statistics reported today. This was 1.8 percent higher than a year earlier, compared with a gain of 3.4 percent in the Consumer Price Index for All Urban Consumers (CPI-U) over the same period.”

Those working full-time are experiencing another drama in the form of decreases in real wages and salaries. Median wages and salaries of US workers in current dollars increased from $740 per week in IIQ2010 to $753 in IIQ2011 or an increase of 1.8 percent, as shown in Table 8. Adjusting for inflation, median wages and salaries of US workers fell by 1.8 percent.

Table 8, Median Usual Weekly Earnings of Full-Time Wage and Salary Workers NSA, Current Dollars and Constant (1982-84) Dollars

	IIQ2010	IIQ2011	∆%
Current Dollars	740	753	1.8
Constant 1982-84 Dollars	340	334	-1.8

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

IIC Reinhart and Rogoff on Debt and Growth. A monumental effort of data gathering, calculation and analysis by Carmen M. Reinhart and Kenneth Rogoff is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). This section reviews some selective earlier literature and then focuses on the contribution on debt and growth by Reinhart and Rogoff.

The liberalization of financial markets in the second globalization after the 1980s following the second industrial revolution after the late 1970s resulted in “twin crises” of both the domestic banking sector and the balance of payments (Kaminsky and Reinhart 1999; see Pelaez and Pelaez, International Financial Architecture (2005), 219-29; The Global Recession Risk (2007), 147-87; Globalization and the State Vol. II (2009b), 102-13). Kaminsky and Reinhart (1999, 474, 477) use a sample of 76 currency crises and 26 banking crises, including the Asian Crisis of 1997, which contains 18 twin crises of both the domestic financial sector and the balance of payments in the period from 1980 to 1995 and one in the 1970s. This research suggests that banking problems precede problems in the balance of payments. A “vicious spiral” is triggered by the effects of the currency crash on the domestic financial sector. A substantive characteristic of twin crises is that the domestic financial crisis magnifies the output and employment losses of the currency crash.

Dornbusch, Goldfajn and Valdés (1995, 270) quote a banker’s adage of what kills in asset flights: “it is not the speed that kills, it is the sudden stop.” An important assumption in this model is inertial inflation, which means that prices are downwardly rigid, such that policy should not overvalue exchange rates because of future pains of contraction of output and employment during the need to devalue during financial crises. Calvo and Reinhart (2000) elaborated sudden stops questioning traditional theory that there are limited effects on output and employment by attaining external balance with devaluation (see Pelaez and Pelaez, The Global Recession Risk (2007), 147-54 with reference to the literature).

Debt intolerance is defined by Reinhart and Rogoff (2010FCDC, 9) as “the extreme duress many emerging markets experience at debt levels that would seem quite manageable by advanced country standards.” The long-term average debt/GDP ratio explains a country’s debt intolerance together with other explanatory variables such as debt/exports ratios, history of debt and past experience with macroeconomic stability, as analyzed by Reinhart, Rogoff and Savastano (2003). Debt hardship recurs in the form of “serial default” which “refers to countries which experience multiple sovereign defaults (on external or domestic public or publicly-guaranteed debt—or both” (Reinhart and Rogoff 2010FCDC, 9). A third important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):

There are multiple important contributions in the research of Reinhart and Rogoff of which four are discussed in turn: dynamics of debt cycles, relation of debt and economic growth, role of domestic debt and application to current conditions.

First, dynamics of debt cycles. The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time:

The concept of public debt is gross central government debt and does not include government guarantees. The dataset includes commonly neglected domestic government debt issued by the government under its national legal jurisdiction. Total external debt “includes the external debts of all branches of government as well as private debt that is issued by domestic private entities under a foreign jurisdiction” (Reinhart and Rogoff 2010GTD, 1).

There are four critical results provided by Reinhart and Rogoff (2010FCDC, 2011CEPR). (1) Domestic banking crises are preceded by booms of borrowing from domestic banks and foreign sources, with government contributing to the booms; banking crises in major financial centers also associate with domestic banking crises in other countries. (2) Sovereign debt crises are preceded by banking crises both in the national banking system and in major international financial centers. (3) Acceleration of public borrowing precedes sovereign debt crises; crises also reveal openly previously unnoticed high increases in domestic public debt and in private debt that is eventually absorbed into public debt. (4) Shortly before the debt crisis with the peak of private and public borrowing, including cases of high inflation and hyperinflation, the structure of debt concentrates on short maturities.

Reinhart and Rogoff (2010FCDC, 2011CEPR) provide a highly valuable analytical description of the global debt cycles, financial crises and sovereign debt crises based on the chartbook of Reinhart (2010CB), which provides charts, data and sources for each individual country in the sample. The analysis provides global perspectives supplemented with key representative discussion of individual countries. An important econometric result is that VAR tests that are not dependent on the sample period or estimation strategy show “that systemic banking crises in major financial centers help explain domestic banking crises and domestic banking crises help explain sovereign default” (Reinhart and Rogoff 2010FCDC, 37). Domestic banking crises are a significant predictor of debt crises. The probability of default depends significantly on the occurrence of a banking crisis.

Second, relation of debt and economic growth. Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the US: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90. In the case of the 24 emerging market economies (Reinhart and Rogoff 2010GTD, 4):

“For 1900-2009, median and average GDP growth hovers around 4-4.5 percent for levels of debt below 90 percent of GDP, but median growth falls markedly to 2.9 percent for high debt (above 90 percent); the decline is even greater for the average growth rate, which falls to 1 percent. The similarities with advanced economies end there, as higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

Third, role of domestic debt. Another important contribution by Reinhart and Rogoff (2011EJ, 319) is “a vast trove of historical time-series data on domestic public debt for 64 countries ranging back to 1914”. Domestic debt has not been used in analysis of sovereign defaults because of the focus on external debt. There are three key findings in the analysis of domestic debt data. (1) The relative size of the debt is quite large being on average two-thirds of public debt in the sample of 64 countries; domestic debts were valued at market interest rates with the exception of the period of financial repression after World War II. (2) Fiscal stress is high when accounting for domestic debt, explaining the defaults of countries at what appeared low levels of external debt. (3) Inflation higher than the optimum required for purposes of seigniorage (see http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-monetary.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html http://cmpassocregulationblog.blogspot.com/2011/05/mediocre-growth-world-inflation.html) could have an explanation on the high levels of domestic debt; Reinhart and Rogoff (2011EJ) find cases of high inflation and hyperinflation in which domestic debt was equal and in some cases higher than base money.

Fourth, application to current conditions. For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).

Reinhart and Sbrancia (2011LD) analyze exhaustively the liquidation of public debt by inflation and financial repression. Market participants in Argentina in the 1980s referred to a form of financial repression as liquation of debt in an allusion of liquid debt becoming ether. Classic works in financial repression include Giovannini and Melo (1993), McKinnon (1973) and Shaw (1973). Financial repression has existed in all countries. The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession (2009a), 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. The rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes (Friedman 1970). Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman (1970, 26-7) predicted the future as revealing as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.” There is this same risk in Dodd-Frank.

Typical restrictions in the postwar period until the 1970s consisted of interest rate ceilings, similar to Regulation Q, on deposit rates and even sometimes in loan rates and volumes. Onerous reserve requirements were imposed on bank liabilities together with restrictions on bank liquidity. Direct lending channeled resources to activities of interest in economic policy. Even capital requirements were applied to restrict banking activities. Price and quantitative restrictions are not effective without parallel constraints of flows of international capital to prevent financial intermediaries to engage in capital flight to compensate for the restrictions (see Giovannini and Melo 1993). In the analysis of Giovanni and Melo (1993), the base of the tax for government revenue from financial repression is central-government debt. The revenue is estimated as the multiple of the spread of domestic and international interest rates multiplied by the stock of domestic government liabilities. There were significant differences among countries engaged in financial repression but the non-weighted average was 2 percent of GDP and 9 percent of government revenue less revenue from financial repression (see more references in Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 81-6).

There is sober warning by Reinhart and Rogoff (2011CEPR, 42) on the basis of the momentous effort of their scholarly data gathering, calculation and analysis:

IID. Brazil. Reinhart and Rogoff (2010FCDC, 1) argue in favor of applying economic theory and measurement to long-term series:

“The economics profession has an unfortunate tendency to view recent experience in the narrow window provided by standard datasets. It is particularly distressing that so many cross-country analyses of financial crisis are based on debt and default data going back only to 1980, when the underlying cycles can be half centuries and more, not just thirty years.”

In the “big picture” analysis of their data in Figure 2 covering sovereign external default cycles from 1800 to 2009, Reinhart and Rogoff (2010FCDC, 10) find that:

“Aside from the current lull, there are long periods where a high percentage of all countries are in a state of default or restructuring. Indeed, there are five pronounced peaks or default cycles in the figure. The first is during the Napoleonic War. The second runs from the 1820s through the late 1840s, when, at times, nearly half the countries in the world were in default (including all of Latin America).”

The reader would be intrigued by Figure 5 in Reinhart and Rogoff (2010FCDC, 15) in which Brazil is classified in external default for seven years between 1828 and 1834 but not again until 64 years later in 1989, above the 50 years of incidence for serial default. This void has been filled in scholarly research on nineteenth-century Brazil by William R. Summerhill, Jr. (2007SC, 2007IR). There are important conclusions by Summerhill on the exceptional sample of institutional change or actually lack of change, public finance and financial repression in Brazil between 1822 an 1899, combining tools of economics, political science and history. During seven continuous decades, Brazil did not miss a single interest payment with government borrowing without repudiation of debt or default. What is really surprising is that Brazil borrowed by means of long-term bonds and even more surprising interest rates fell over time. The external debt of Brazil in 1870 was ₤41,275,961 and the domestic debt in the internal market was ₤25,708,711, or 62.3 percent of the total (Summerhill 2007IR, 73).

The experience of Brazil differed from that of Latin America (Summerhill 2007IR). During the six decades when Brazil borrowed without difficulty, Latin American countries becoming independent after 1820 engaged in total defaults, suffering hardship in borrowing abroad. The countries that borrowed again fell again in default during the nineteenth century. Venezuela defaulted in four occasions. Mexico defaulted in 1827, rescheduling its debt eight different times and servicing the debt sporadically. About 44 percent of Latin America’s sovereign debt was in default in 1855 and approximately 86 percent of total government loans defaulted in London originated in Spanish American borrowing countries.

External economies of commitment to secure private rights in sovereign credit would encourage development of private financial institutions, as postulated in classic work by North and Weingast (1989), Summerhill 2007IR, 22). This is how banking institutions critical to the Industrial Revolution were developed in England (Cameron 1972). The obstacle in Brazil found by Summerhill (2007IR) is that sovereign debt credibility was combined with financial repression. There was a break in Brazil of the chain of effects from protecting public borrowing, as in North and Weingast (1989), to development of private financial institutions. According to Pelaez 1976, 283) following Cameron:

“The banking law of 1860 placed severe restrictions on two basic modern economic institutions—the corporation and the commercial bank. The growth of the volume of bank credit was one of the most significant factors of financial intermediation and economic growth in the major trading countries of the gold standard group. But Brazil placed strong restrictions on the development of banking and intermediation functions, preventing the channeling of coffee savings into domestic industry at an earlier date.”

Brazil actually abandoned the gold standard during multiple financial crises in the nineteenth century, as it should have to protect domestic economic activity. Pelaez (1975, 447) finds similar experience in the first half of nineteenth-century Brazil:

“Brazil’s experience is particularly interesting in that in the period 1808-1851 there were three types of monetary systems. Between 1808 and 1829, there was only one government-related Bank of Brazil, enjoying a perfect monopoly of banking services. No new banks were established in the 1830s after the liquidation of the Bank of Brazil in 1829. During the coffee boom in the late 1830s and 1840s, a system of banks of issue, patterned after similar institutions in the industrial countries, supplied the financial services required in the first stage of modernization of the export economy.”

Monetary and fiscal policy coordination has occurred in multiple historical episodes. Reinhart and Rogoff (2010GTD, 4), as quoted above, mention fiscal dominance as a possibility in explaining high domestic debts throughout historical periods. Table B provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. Chart 1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in nineteenth-century England, and accelerated to 27.1 percent per year in 1945-1970. The even more surprising experience of Brazil is the high rates of growth of base money in an economy with few banks mostly under government tutelage and rent seeking with sovereign credibility in borrowing not only abroad but also in the internal market without major disruptions during seven decades. Pelaez and Suzigan (1981) analyze the multiple domestic financial crises that occurred in Brazil in 1857, 1864, 1875 and 1889 when news arrived in a ship about financial distress in major financial centers that disrupted the rudimentary domestic financial system. Brazil protected its internal economy by depreciating away from gold standard parity (Pelaez 1976), which was also the way in which it escaped the worst of the Great Depression by abandoning the gold standard and devaluing early (Pelaez, 1968, 1972).

Table B, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)

	M1	M2	Y	y	y/N	P
1861-1970	9.3	6.2	10.2	4.6	2.4	5.8
1861-1900	5.4	5.9	5.9	4.4	2.6	1.6
1861-1913	4.7	4.7	5.3	4.4	2.4	0.1
1861-1929	5.5	5.6	6.4	4.3	2.3	2.1
1900-1970	13.9	13.9	15.2	4.9	2.6	10.3
1900-1929	8.9	8.9	10.8	4.2	2.1	6.6
1900-1945	8.6	9.1	9.2	4.3	2.2	4.9
1920-1970	17.8	17.3	19.4	5.3	2.8	14.1
1920-1945	8.3	8.7	7.5	4.3	2.2	3.2
1920-1929	5.4	6.9	11.1	5.3	3.3	5.8
1929-1939	8.9	8.1	11.7	6.3	4.1	5.4
1945-1970	30.3	29.2	33.2	6.1	3.1	27.1

Note: growth rates are obtained by regressions of the natural logarithms on time.

Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.

Chart 1, Brazil, Money, Income and Prices 1861-1970.

Source: © Carlos Manuel Pelaez and Wilson Suzigan. 1981. História Monetária do Brasil Segunda Edição. Coleção Temas Brasileiros. Brasília: Universidade de Brasília, 21.

III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. The JP Morgan Global PMI, compiled by Markit, provides an important reading of the world economy, analyzed by Markit’s Chief Economist Chris Williamson (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/global_economy_11_07_07.pdf). The JP Morgan Global PMI, compiled by Markit, registered the weakest quarter of private sector output growth in manufacturing and services since IIIQ2009, when the world economy began recovering, falling from 52.7 in May to 52.2 in Jun. Japan recovered sharply from the Mar earthquake/tsunami but the JP Morgan Global PMI compiled by Markit shows that the index is significantly lower in Jun than in May, being consistent with world GDP growth at the low annual rate of 2 percent. Japan’s sharp recovery has been compensated in the index by weak IIQ2011 growth in the US, with Jun being at the lowest in 22 months, and similar weakness in the euro zone and the UK. Growth has also weakened in the BRIC countries of Brazil, Russia, India and China. The JP Morgan Global PMI compiled by Markit shows that world manufacturing exports have nearly stagnated with the worst performance since Jul 2009. The softness of the economy is worldwide and persistent.

Table 9 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). The flash HSBC Manufacturing PMI^™ for China declined from 50.1 in Jun to 48.9 in Jul, with the sharpest deterioration of manufacturing since Mar 2009 (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/CN_NOTE_21_07_11.pdf http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/CN_Manufacturing_ENG_1108_PR_FLASH.pdf). China’s rate of growth of industrial production rose from 13.3 percent in May to 15.1 percent in Jun. The rate could decline to about 10 percent as suggested by the flash PMI. Both official data and the PMI have tracked slowing export growth in China that peaked in early 2010 (http://www.markit.com/assets/en/docs/commentary/markit-economics/2011/jul/CN_NOTE_21_07_11.pdf). Economic conditions have worsened for smaller companies relative to larger ones. Aaron Back and Jason Dean writing on Jul 9, 2011 on “China price watchers predict another peak” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304793504576433443699064616.html?mod=WSJ_hp_LEFTWhatsNewsCollection) inform that China’s CPI inflation jumped to 6.4 per cent in Jun relative to a year earlier, much higher than 5.5 percent in May but many economists believe that inflation could decline in the second half of the year. Comparisons with high rates of CPI inflation late in 2010 will likely result in lower 12 months rates of inflation later in 2011. Jamil Anderlini writing on Jul 9, 2011, on “China inflation hits three-year high” published by the Financial Times (http://www.ft.com/intl/cms/s/0/693daad2-aa1d-11e0-958c-00144feabdc0.html#axzz1Repz5K5o) informs that food prices increased 14.4 percent in the 12 months ending in Jun. Core non-food prices increased 3 percent in the 12 months ending in Jun, which is the highest rate in five years, suggesting inflation is spreading in the economy. Headline CPI inflation rose 0.3 percent in Jun relative to May but prices excluding food were stable, which could signal decelerating inflation. Aaron Back writing on Jul 6, 2011 on “China raises interest rates” published by the Wall Street Journal Asia Business (http://professional.wsj.com/article/SB10001424052702303544604576429393824293666.html?mod=WSJ_hp_LEFTWhatsNewsCollection) informs that the People’s Bank of China raised the one-year lending rate from 6.31 percent to 6.56 percent and the one-year deposit rate to 3.5 percent from 3.25 percent. This was the fifth increase in interest rates in 2010 and 2011. The People’s Bank of China has raised the reserve requirements of banks six times in 2011. The concern with inflation in China is that it could be a factor in a “hard landing” of the economy with growth lower than 7 percent. The lending rate may not be negative in real terms if during the next 12 months inflation falls below the yearly rate of 6.5 percent. An issue is China is the use of generous credit growth to prevent the impact of the global recession on China. Deposit rates of 3.5 percent are likely to be lower than forward inflation, stimulating the purchase of speculative assets such as housing and also goods that may rise more than expected inflation. Martin Vaughan writing on July 5, 2011 on “Moody’s warns on China debt” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304803104576427062691548064.html?mod=WSJ_hp_LEFTWhatsNewsCollection) informs of the warning by Moody’s Investors Service that China’s National Audit Office (NAO) understated CNY 3.5 trillion or $541 billion of bank loans to local governments. That portion of loans has poor documentation and highest exposure to delinquencies. NAO has concluded that banks have lent CNY 8.5 trillion to local government. A critical issue in China is the percentage of those loans that could become nonperforming and the impact that could occur on bank capital and solvency. The report by Moody’s Investors Service “estimates that the Chinese banking system’s economic nonperforming loans could reach between 8% and 12% of total loans, compared to 5% to 8% in the agency’s base case, and 10% to 18% in its stress case” (http://www.moodys.com/research/Moodys-Scale-of-problem-loans-to-Chinese-local-governments-greater?lang=en&cy=global&docid=PR_222068). A hard landing in China could have adverse repercussions in the regional economy of Asia and throughout the world’s financial markets and economy. The combination of a hard landing in China with sovereign risk difficulties in Europe and further slowing of the US economy could have strong, unpredictable effects. Jamil Anderlini writing from Shanghai on Jul 10, 2011 on “Trade data show China economy slowing” published by the Financial Times (http://www.ft.com/intl/cms/s/0/eeedc000-aabc-11e0-b4d8-00144feabdc0.html#axzz1Repz5K5o) informs that Chinese imports grew at 19.3 percent in June 2011 relative to Jun 2010, which is significantly below the 12-month rate of 28.4 percent in May. China’s industrial activity appears to be decelerating as suggested by lower imports of commodities such as crude oil, aluminum and iron ore, all falling in the 12 months ending in Jun 2011. China’s imports of crude oil fell 11.5 percent in Jun 2011 relative to Jun 2010 and copper imports grew in Jun but were lower than a year earlier. China’s exports grew 17.9 percent in Jun from a year earlier to a monthly record of $162 billion. The trade surplus of China in Jun of $22.3 billion was higher than $13 billion in May and may reignite the complaints about China’s exchange rate policy. Simon Rabinovitch writing on Jul 12 on “China’s foreign reserves climb by $153 billion” published by the Financial Times (http://www.ft.com/intl/cms/s/0/13c382e6-ac59-11e0-bac9-00144feabdc0.html#axzz1Repz5K5o) informs that China’s foreign reserves rose by $153 billion in IIQ2011 after increasing $197 billion in IQ2011, reaching $3197 billion, which is around 50 percent of GDP and three times higher than reserves by any other country. The trade surplus contributed $47 billion of the increase of reserves of $153 billion in IIQ2011 with the remainder originating mostly in investment inflows and interest earnings. Aaron Back writing on Jul 13 on “China growth suggests tightening ahead” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304223804576443493415667206.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyzes new data on China showing fast expansion of the economy that could signal further tightening measures. China’s GDP grew at 9.5 percent in IIQ2011, which is lower than 9.7 percent in IQ2011. Most countries report GDP growth as seasonally adjusted quarterly rates converted in annual equivalent. The adjustment of Chinese data for seasonality in annual equivalent results in GDP growth of 9.1 in IIQ2011 compared with 8.7 percent growth in IQ2011. The growth rate of GDP of China in IIQ2011 increased slightly to 2.2 percent in that quarter. Industrial production rose to the 12-month rate in Jun of 15.1 percent, which is higher than 13.3 percent in May. Real estate investment in Jan-Jun 2011 rose to CNY 2.625 trillion, equivalent to about $405 billion, which is higher by 32.9 percent relative to Jan-Jun 2010. Sales of commercial and residential property sales in Jan-Jun 2011 rose 24.1 percent relative to 2010, which is higher than 18.1 percent in Jan-May.

Table 9, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	2.9	3.6	7.0	9.2
Japan	-0.7***	0.3	2.5	4.5
China	9.5	6.4	6.8
UK	1.8	4.5* RPI 5.2	5.7* output 17.0* input 12.8**	7.7
Euro Zone	2.5	2.7	6.2	9.9
Germany	4.8	2.4	6.1	6.0
France	2.2	2.3	6.0	9.5
Nether-lands	3.2	2.5	10.7	4.2
Finland	5.8	3.4	8.0	7.8
Belgium	3.0	3.4	9.7	7.3
Portugal	-0.7	3.3	5.9	12.4
Ireland	-1.0	1.2	5.3	14.0
Italy	1.0	3.0	4.8	8.1
Greece	-4.8	3.1	7.2	15.1
Spain	0.8	3.0	6.7	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/ppi0711.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 10 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 12 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 10 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 10, 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

Germany’s producer price inflation in Table 11 shows a pattern similar to inflation in other countries. The sharp acceleration in Jan-Apr was arrested by the decline in commodity prices in May that spilled over into Jun. The 12-month rate of producer price inflation in Germany peaked at 6.4 percent in 2011, much higher than 5.3 percent in Dec 2010 but declined to 5.6 percent in the 12 months ending in Jun. Much the same happened with monthly inflation that spiked 1.2 percent in Jan and 1.0 percent in Apr but was nil in May and rose by only 0.1 percent in Jun. The annual equivalent rate of inflation in Jan-Jun is 7.0 percent.

Table 11, Germany, Producer Price Index ∆%

	Month	12 Months
Jun	0.1	5.6
May	± 0.0	6.1
Apr	1.0	6.4
Mar	0.4	6.2
Feb	0.7	6.4
Jan	1.2	5.7
AE ∆%	7.0
Dec 2010	0.7	5.3

AE: annual equivalent

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/DE/Presse/pm/2011/07/PD11__271__61241,templateId=renderPrint.psml

Industrial new orders exhibit significant volatility because of the transportation components with high-price items. Table 12 shows these fluctuations in industrial new orders for the euro area. The 12 month rates of growth of double digits reflect price changes instead of only volumes

Table 12, Euro Area Industrial New Orders ∆%

	Month	12 Months
May 2011	3.6	15.5
Apr	-0.1	10.3
Mar	0.4	14.9
Feb	0.3	21.1
Jan	1.9	21.2
Dec 2010	1.1	18.3

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-22072011-BP/EN/4-22072011-BP-EN.PDF

Growth of euro zone construction output has been weak with significant fluctuations as shown in Table 13. There were only two positive growth rates on a monthly basis in Jan of 4.0 percent and in Apr of 1.2 percent. The 12-months rates of increase have been negative for three consecutive months Mar-May.

Table 13, Euro Zone Construction Output ∆%

	Month	12 Months
May 2011	-1.1	-1.9
Apr	1.2	-1.3
Mar	-0.2	-5.1
Feb	-0.6	3.5
Jan	4.0	-4.0
Dec 2010	-2.6	-13.8

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-19072011-AP/EN/4-19072011-AP-EN.PDF

Japan continues to make significant progress is recovering the economy from the earthquake/tsunami of Mar 11. The all industry index of Japan in Table 14 combines services and output indexes in what is an approximation of GDP. The earthquake/tsunami caused a monthly decline of the all industry index of 6.4 percent in Mar and contraction of 4.5 percent in the 12 months ending in Mar. The monthly rates of growth in Apr of 1.4 percent and May of 2.0 percent confirm the V-shaped recovery of the economy of Japan. The 12-months rates of contraction of the all industry index have fallen from minus 4.5 percent in Mar to minus 1.5 percent in May.

Table 14, Japan All Industry Index

	Month SA	12 Months NSA
May	2.0	-1.5
Apr	1.4	-4.2
Mar	-6.4	-4.5
Feb	0.9	2.0
Jan	-0.5	1.4
AE ∆%
Dec 2010	0.1	2.1

Source: http://www.meti.go.jp/statistics/tyo/zenkatu/result-2/pdf/hv37913_201105j.pdf

The volume of retail sales has been weak and fluctuating in the UK, as shown in Table 15. Dec volume of retail sales fell 1.0 percent and declined 0.1 percent in 12 months. Monthly changes in Jan-Jun 2011 have exhibited two negative changes and one nil change. The annual equivalent rate in Jan-Jun is 1.7 percent. The 12-month rate for Jun is only 0.4 percent.

Table 15, UK, Volume of Retail Sales

	Month SA	12 Months
Jun	0.7	0.4
May	-1.3	-0.3
Apr	1.2	3.8
Mar	-	-0.6
Feb	-1.1	0.7
Jan	1.4	4.8
AE ∆%	1.7
Dec 2010	-1.0	-0.1

Source: http://www.statistics.gov.uk/pdfdir/rs0711.pdf

Retail sales in Italy are also quite weak, as shown in Table 16. Growth of retail sales from Apr 2011 into May 2011 is minus 0.1 percent. The change in the quarter of Mar to May 2011 relative to the quarter of Dec 2010 to Feb 2011 is minus 0.1 percent. The 12 month rate of change of retail sales in May is minus 0.6 percent. The austerity program of Italy in attempting to erase the deficit by 2014 is more painful without growing revenues that are constrained by weak economic growth, as in most advanced economies.

Table 16, Italy, Retail Sales

	Retail Sales ∆%
May 2011/Apr 2011	-0.1
Mar-May 2011/Dec 2010-Feb 2011	-0.1
May 2011/May 2010	-0.6

http://www.istat.it/salastampa/comunicati/in_calendario/commdett/20110722_00/testointegrale20110722.pdf

The Business Outlook Survey of the Federal Reserve Bank of Philadelphia in Table 17 continues to show moderation in current prices paid and received shown in the first block of data. Expectations for the next six months in the second block of numbers show anticipations of price increases in the survey of Jul relative to that of Jun, with the index of prices paid, or costs of inputs, rising from 27.5 in May to 38.7 in Jul. Expectations for the next six months in prices received or sales prices also trend upward with the index rising from 2.5 in Jun to 8.3 in Jul.

Table 17, FRB of Philadelphia Business Outlook Survey, Prices Paid and Prices Received, SA

	Increase	No Change	Decrease	Index
Current
Prices Paid
Jul	32.6	59.9	7.5	25.1
Jun	36.6	49.6	9.8	26.8
May	56.3	35.6	8.0	48.3
Prices Received
Jul	17.7	65.1	16.6	1.1
Jun	16.8	66.5	12.4	4.4
May	19.7	76.2	2.9	16.8
Six Months
Prices Paid
Jul	44.6	43.4	5.9	38.7
Jun	40.4	40.0	12.9	27.5
May	59.1	33.1	6.7	52.4
Prices Received
Jul	22.5	61.4	14.2	8.3
Jun	19.3	56.0	16.7	2.5
May	34.9	53.2	7.6	27.3

Source: http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0711.pdf

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 2 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 the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that 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. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

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 2, 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 18 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 18, 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 19 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 19 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 19, 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 20, 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 20. 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 2.964 percent at the close of market on Fr Jul 22, 2011, would be equivalent to price of 97.0847 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 4.1 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing. If inflation accelerates, yields of Treasury securities may rise sharply. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed, the tragic earthquake and tsunami affecting Japan and recurring fears on European sovereign credit issues. Important causes of the rise in yields shown in Table 20 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 Jul 13, 2011, the line “Reserve Bank credit” in the Fed balance sheet stood at $2855 billion, or $2.9 trillion, with portfolio of long-term securities of $2625 billion, or $2.6 trillion, consisting of $1541 billion Treasury nominal notes and bonds, $66 billion of notes and bonds inflation-indexed, $114 billion Federal agency debt securities and $904 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1625 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 20, 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
07/08/11	3.022	96.5957	-4.6
07/15/11	2.905	97.5851	-3.6
07/22/11	2.964	97.0847	-4.1

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

Source:

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

IV 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/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html 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 21 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 21 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 20.5 percent by Fri Jul 22, 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 21 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 21, 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	07/22 /2011
Rate	1.1423	1.5914	1.192	1.436
CNY/USD	01/03 2000	07/21 2005	7/15 2008	07/22 2011
Rate	8.2798	8.2765	6.8211	6.4474
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 21A extracts four rows of Table 21 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 23 below, the dollar has devalued again to USD 1.436/EUR or by 20.5 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 6.4474/USD on Fri Jul 22, 2011, or by an additional 5.5 percent, for cumulative revaluation of 22.1 percent.

Table 21A, 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	07/22 /2011
Rate	1.1423	1.5914	1.192	1.436
CNY/USD	01/03 2000	07/21 2005	7/15 2008	07/22 2011
Rate	8.2798	8.2765	6.8211	6.4474

Source: Table 21.

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 22. 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 22, 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 21 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 23, 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 07/22/11” with all risk financial assets in the range from 11.6 percent for the European stocks index STOXX 50 to 33.3 percent for the DJ UBS Commodity Index. Japan has significantly improved performance rising 14.8 percent above the trough. The Nikkei Average closed at 10,132.11 on Fri Jul 22, only 1.2 percent below 10,254.43 on Mar 11 on the date of the earthquake and 10.1 percent above the lowest Fri closing on Mar 18 of 9206.75. The dollar depreciated by 20.5 percent and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 07/22/2011” shows positive performance of all financial assets but one. The Dow Global gained 2.8 percent with gains in all stock indexes in Table 23 with the exception of loss of 1.8 percent in the Shanghai Composite. The Nikkei Average rose 1.6 percent, DJIA rose 1.6 percent and S&P increased 2.2 percent. The STOXX 50 of Europe rose 1.9 percent and DAX of Germany gained 1.5 percent. There are still high uncertainties on European sovereign risks, US debt and China’s growth and inflation tradeoff. The DJ UBS Commodity Index gained 0.4 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. There is a fundamental change in Table 23 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 7/22/11” 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 7/22/11” but also relative to the peak in column “∆% Peak to 7/22/11.” There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 7.7 percent, Nikkei Average by 11.1 percent, Shanghai Composite by 12.5 percent and STOXX 50 by 5.5 percent. The gainers relative to the peak in Apr 2010 are: DAX by 15.7 percent, Asia Pacific by 9.2 percent, S&P 500 by 10.5 percent, DJIA by 11.4 percent, Dow Global by only 0.4 percent and the DJ UBS Commodities Index by 13.2 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 23, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 7/ 22/11	∆% Week 7/ 22/11	∆% Trough to 7/ 22/11
DJIA	4/26/ 10	7/2/10	-13.6	13.2	1.6	30.9
S&P 500	4/23/ 10	7/20/ 10	-16.0	10.5	2.2	31.5
NYSE Finance	4/15/ 10	7/2/10	-20.3	-7.7	3.3	15.9
Dow Global	4/15/ 10	7/2/10	-18.4	3.2	2.8	26.5
Asia Pacific	4/15/ 10	7/2/10	-12.5	9.2	2.4	24.8
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-11.1	1.6	14.8
China Shang.	4/15/ 10	7/02 /10	-24.7	-12.5	-1.8	16.3
STOXX 50	4/15/10	7/2/10	-15.3	-5.5	1.9	11.6
DAX	4/26/ 10	5/25/ 10	-10.5	15.7	1.5	29.2
Dollar Euro	11/25 2009	6/7 2010	21.2	5.1	-1.4	-20.5
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	13.9	0.4	33.3
10-Year Tre.	4/5/ 10	4/6/10	3.986	2.964

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 24 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 and other market events. 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 gaining 12.3 percent and the S&P 500 10.5 percent. There were gains of 0.6 percent for the DJIA and 0.3 percent in the week of Jul 8 even with turmoil around sovereign risk issues in Europe and an abnormally weak employment situation report released on Fri Jul 8. The DJIA closed on Fri Jul 8 only 1.2 percent lower than the closing on Fri Apr 29 and the S&P 500 closed only 1.5 percent below the level of Apr 29. Continuing risk aversion as a result of sovereign risk uncertainty in Europe influenced the loss of 1.4 percent by the DJIA in the week of Jul 15, reducing the cumulative gain to 11.4 percent and much sharper loss by the S&P 500 of 2.1 percent with reduction of the cumulative gain by 8.6 percent. Improved risk moods as a result of the program for Greece raised the valuation of the DJIA to 13.2 percent on Jul 22 and that of the S&P 500 to 10.9 percent.

Table 24, 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
Jul 8	0.6	12.9	0.3	10.9
Jul 15	-1.4	11.4	-2.1	8.6
Jul 22	1.6	13.2	2.2	10.9

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

Table 25, 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 25, Exchange Rates

	Peak	Trough	∆% P/T	Jul 22, 2011	∆% T Jul 22 2011	∆% P Jul 22 2011
EUR USD	7/15 2008	6/7 2010		7/22 2011
Rate	1.59	1.192		1.436
∆%			-33.4		16.9	-10.7
JPY USD	8/18 2008	9/15 2010		7/22 2011
Rate	110.19	83.07		78.52
∆%			24.6		5.5	28.7
CHF USD	11/21 2008	12/8 2009		7/22 2011
Rate	1.225	1.025		0.816
∆%			16.3		20.4	33.4
USD GBP	7/15 2008	1/2/ 2009		7/22 2011
Rate	2.006	1.388		1.63
∆%			-44.5		14.8	-23.1
USD AUD	7/15 2008	10/27 2008		7/22 2011
Rate	1.0215	1.6639		1.085
∆%			-62.9		44.6	9.8
ZAR USD	10/22 2008	8/15 2010		7/22 2011
Rate	11.578	7.238		6.767
∆%			37.5		6.5	41.5
SGD USD	3/3 2009	8/9 2010		7/22 2011
Rate	1.553	1.348		1.21
∆%			13.2		10.2	22.1
HKD USD	8/15 2008	12/14 2009		7/22 2011
Rate	7.813	7.752		7.791
∆%			0.8		-0.5	0.3
BRL USD	12/5 2008	4/30 2010		7/22 2011
Rate	2.43	1.737		1.553
∆%			28.5		10.6	36.1
CZK USD	2/13 2009	8/6 2010		7/22 2011
Rate	22.19	18.693		16.952
∆%			15.7		9.3	23.6
SEK USD	3/4 2009	8/9 2010		7/22 2011
Rate	9.313	7.108		6.331
∆%			23.7		10.9	32.0
CNY USD	7/20 2005	7/15 2008		7/22 2011
Rate	8.2765	6.8211		6.4474
∆%			17.6		5.5	22.1

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

V Economic Indicators. The Business Outlook Survey of the Federal Reserve Bank of Philadelphia in Table 26 provides strengthening of activity from Jun into Jul. The general index rose minus 7.7 to positive 3.2, reversing the first negative reading in Jun since Sep 2010. New orders also rose from minus 7.6 to barely positive 0.1. Number of employees rose from 4.1 to 8.9 but the average employee workweek fell from 1.9 to minus 5.4. The optimistic portion of the report is in excellent readings of improving expectations for the next six months, all significantly higher.

Table 26, FRB of Philadelphia Business Outlook Survey Diffusion Index SA

	Jun	Jul
Current Jun/May
General Index	-7.7	3.2
New Orders	-7.6	0.1
Shipments	4.0	4.3
Unfilled Orders	-16.3	-16.3
Number Employees	4.1	8.9
Average Employee Workweek	1.9	-5.4
Expectation Six Months
General Index	2.5	23.7
New Orders	7.9	27.8
Shipments	6.6	23.0
Unfilled Orders	-9.6	2.9
Number Employees	5.5	10.1
Average Employee Workweek	-1.6	4.1

Sources: http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0711.pdf

http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2011/bos0611.pdf

The residential construction report of the US Bureau of the Census in Table 27 shows monthly improvement. Housing starts seasonally adjusted at an annual rate rose by 14.6 percent in Jun 2011 relative to May. Housing permits increased 2.5 percent in Jun 2011 relative to May after jumping 8.2 percent from Apr into May.

Table 27, Housing Starts and Permits Seasonally Adjusted Annual Equivalent Rates, Thousands of Units, %

	Housing Starts	Housing Permits
Jun 2011	629	624
May 2011	549	609
∆% Jun/May 2011	14.6	2.5
Apr 2011	549	563
∆% May/Apr 2011	0.0	8.2

Source: http://www.census.gov/const/newresconst.pdf

Housing starts, not seasonally adjusted, rose 5.4 percent in Jan-Jun 2011 relative to Jan-Jun 2010 and new permits fell 5.9 percent, as shown in Table 28. Housing starts fell 68.9 percent in Jan-Jun 2011 relative to the same period in 2006 and 70.1 percent relative to the same period in 2005. New permits fell 71.5 percent relative to Jan-Jun 2006 and 72.6 percent relative to Jan-Jun 2005. The National Association of Realtors informs that existing home sales, consisting of completed sales of single family homes, condominiums and co-ops, fell 0.8 percent seasonally adjusted in Jun relative to May and are 8.3 percent lower than the level in Jun 2010, which was the deadline for the home buyer tax credit (http://www.realtor.org/press_room/news_releases/2011/07/existing_slip).

Table 28, Housing Starts and New Permits, Thousands of Units, NSA, and %

	Housing Starts	New Permits
Jan-Jun 2011	306.3	295.4
Jan-Jun 2010	290.7	314.2
∆%/ Jan-Jun 2011	5.4	-5.9
Jan-Jun 2006	984.9	1036.9
∆%/Jan-Jun 2011	-68.9	-71.5
Jan-Jun 2005	1023.6	1079.1
∆%/ Jan-Jun 2011	-70.1	-72.6

Source: http://www.census.gov/const/newresconst.pdf

http://www.census.gov/const/newresconst_200706.pdf

http://www.census.gov/const/newresconst_200606.pdf

Treasury’s international capital report in Table 29 shows net foreign purchases of long-term securities decreasing from $30.6 billion in Apr 2011 to 23.6 billion in May. Net foreign purchases of US long-term securities remained stable with $44.6 billion in May almost the same as $44.8 billion in Apr with the private portion increasing from $14.7 billion in Apr to $21.4 billion in May. Official purchases, including foreign central banks, fell from $30.1 billion in Apr to $23.2 billion in May, consisting mostly of a decrease in Treasury purchases from $28.1 billion in Apr to $23.2 billion in May. An interesting change is in B with net US purchases of LT foreign securities increasing from $14.2 billion in Apr to $21 billion in May. Purchases of foreign bonds rose from $1.3 billion in Apr to $14.6 billion in May while purchases of equities declined from $12.9 billion in Apr to $6.4 billion in May. Various factors could be at work here. US investors may be seeking higher yields in foreign bonds or may be reducing exposures to foreign stock markets with the renewed risk aversion originating in European sovereign risks.

Table 29, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Apr 2011	May 2011
A Foreign Purchases less Sales of US LT Securities	44.8	44.6
Private	14.7	21.4
Treasury	-4.8	16.4
Agency	5.7	-8.9
Official	30.1	23.2
Treasury	28.1	21.5
Agency	1.8	0.7
B Net US Purchases of LT Foreign Securities	-14.2 Foreign: Bonds – 1.3 Equities -12.9	-21.0 Foreign: Bonds -14.6 Equities - 6.4
C Net Foreign Purchases of US LT Securities	30.6	23.6

C = A + B

Source: http://www.treasury.gov/press-center/press-releases/Pages/tg1244.aspx

The combination of current account deficits and government deficits will require much stronger foreign financing. The main doubt is whether expectations of continuing devaluation of the dollar and increases in government debt will reach a point of satiation of US securities at which a discount premium on US government debt may force abrupt fiscal and external adjustment. The fiscal theory of the price level also argues that inflation would rise. High economic growth over more than a century and relatively sound fiscal management has allowed the US to avoid distrust of its debt obligations. There is no past experience of debt disruption but current circumstances are worrisome. Table 30 provides the major holders of US Treasury securities in May 2011 and Dec 2010. The UK, Japan, oil exporting countries and Brazil increased their holdings of US Treasury securities. There may be a limit as to how much US Treasury debt foreign holders may desire.

Table 30, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	May 2011	Dec 2010
China	1159.8	1160.1
Japan	912.4	882.3
United Kingdom	346.5	271.6
Oil Exporters	229.8	211.9
Brazil	211.4	186.1
Taiwan	153.4	155.1
Caribbean Banking Centers	148.3	168.1
Hong Kong	121.9	134.2
Russia	115.2	151.0
Switzerland	108.2	107.0

Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

Commercial stocks of crude oil in the US fell 3.8 million from 355.5 million on Jul 8 to 351.7 million on Jul 15, as shown in Table 31. The explanation is in the line on crude oil refineries input that rose from 15,265 barrels per day in the four weeks ending on Jul 8 to 15,350 barrels per day in the four weeks ending on Jul 15. Capacity utilization in refineries is at a high 88.7 percent. The increase in input in refineries occurred at the same time as an increase in average crude oil imports to 9,234 barrels per day in the four weeks ending on Jul 15 from 9,185 barrels per day in the four weeks ending on Jul 8. There is worrisome decline in motor gasoline supplied and distillate fuel oil supplied. Higher production in refineries with lower use resulted in increases in the stock of gasoline by 0.8 million barrels and of distillate fuel oil by 3.5 million barrels. Table 31 suggests important analysis: higher prices of refined products, such as gasoline and fuel oil, together with weak economy resulted in decline in the supply of gasoline and fuel oil. The international price of oil rose 40.0 percent and gasoline at the pump by 35.3 percent, relative to the same period in 2010. Supply of gasoline in the market fell 2.2 percent, from 9,347 thousand barrels per day in 2010 to 9,154 thousand barrels per day in 2011. The weak economy and higher prices may have contributed to the decline in consumption.

Table 31, Energy Information Administration Weekly Petroleum Status Report

Four Weeks Ending Thousand Barrels/Day	07/15/11	07/08/11	07/16/10
Crude Oil Refineries Input	15,350	15,265	15,237
Refinery Capacity Utilization %	88.7	88.4	90.0
Motor Gasoline Production	9,192	9,266	9,391
Distillate Fuel Oil Production	4,470	4,405	4,425
Crude Oil Imports	9,234	9,185	9,505
Motor Gasoline Supplied	9,154	9,226	9,357
Distillate Fuel Oil Supplied	9,154	9,228	9,357
	07/15/11	07/08/11	07/16/10
Crude Oil Stocks Million B	351.7	355.5	353.5
Motor Gasoline Million B	212.5	211.7	222.2
Distillate Fuel Oil Million B	148.5	145.0	166.6
World Crude Oil Price $/B	113.51	109.56	73.49
	07/18/11	07/11/11	07/19/10
Regular Motor Gasoline $/G	3.682	3.641	2.722

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 rose 10,000 to reach 418,000 in the week of Jul 16 from 408,000 in the week of Jul 9, as shown in Table 32. Claims not seasonally adjusted, or the actual estimate, fell 9,022 to reach 464,865 in the week of Jul 16 from 473,887 in the week of Jul 9. The labor market is not showing improvement with claims around 400,000, seasonally adjusted or not.

Table 32, Initial Claims for Unemployment Insurance

	SA	NSA	4-week MA SA
Jul 16	418,000	464,865	421,250
Jul 9	408,000	473,887	424,000
Change	+10,000	-9,022	-2,750
Jul 2	427,000	425,640	427,000
Prior Year	466,000	502,065	459,500

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

Source: http://www.istat.it/salastampa/comunicati/in_calendario/precon/20110714_00/testointegrale20110714.pdf

VI Interest Rates. VI 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 33 provides inflation of the CPI. In Jan-Jun 2011, CPI inflation for all items seasonally adjusted was 3.7 percent in annual equivalent, that is, compounding inflation in the first six months and assuming it would be repeated during the second half of 2011. In the 12 months ending in Jun, CPI inflation of all items not seasonally adjusted was 3.6 percent. The second row provides the same measurements for the CPI of all items excluding food and energy: 2.6 percent annual equivalent in Jan-May and 1.6 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 0.03 percent for three months or virtually zero, 0.08 percent for six months, 0.17 percent for 12 months, 0.40 percent for two years, 0.68 percent for three years, 1.52 percent for five years, 2.26 percent for seven years, 3.0 percent for ten years and 4.31 percent for 30 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 33. 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 33, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent Jan-May 2011 ∆%

	∆% 12 Months Jun 2011/Jun 2010 NSA	∆% Annual Equivalent Jan-Jun 2011 SA
CPI All Items	3.6	3.7
CPI ex Food and Energy	1.6	2.6

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

VII Conclusion. The US labor market is fractured in a slowing world economy in an environment of multiple financial vulnerabilities

(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 ).

VII Conclusion. The US labor market is fractured in a slowing world economy in an environment of multiple financial vulnerabilities

(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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Sunday, July 24, 2011

Debt and Financial Risk Aversion and Reinhart and Rogoff on Debt and Growth

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