Mediocre Economic Growth, Financial Repression, IMF Forecast, World Financial Turbulence and World Economic Slowdown: Part I

 

Mediocre Economic Growth, Financial Repression, IMF Forecast, World Financial Turbulence and World Economic Slowdown

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I Mediocre Economic Growth

II Financial Repression

IIA Views of the Economy and Interest Rates

IIB Financial Repression

III World Financial Turbulence

IIIA Financial Risks

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

IIID Appendix on European Central Bank Large Scale Lender of Last Resort

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV IMF Forecast

V Global Inflation

VI World Economic Slowdown

VIA United States

VIB Japan

VIC China

VID Euro Area

VIE Germany

VIF France

VIG Italy

VIH United Kingdom

VII Valuation of Risk Financial Assets

VIII Economic Indicators

IX Interest Rates

X Conclusion

References

Appendix I The Great Inflation

Executive Summary

ESI Mediocre Economic Growth. In the four quarters of 2011, US real GDP grew at the seasonally-adjusted annual equivalent rates of 0.4 percent in the first quarter of 2011 (IQ2011), 1.3 percent in IIQ2011, 1.8 percent in IIIQ2011 and 2.8 percent in IVQ2011. The annual equivalent rate of growth of GDP for 2011 is 1.6 percent, obtained as follows. Discounting 0.4 percent to one quarter is 0.1 percent; discounting 1.3 percent to one quarter is 0.32 percent; discounting 1.8 percent to one quarter is 0.45 percent; and discounting 2.8 percent to one quarter is 0.69. Real GDP growth in the four quarters of 2011 accumulated to 1.6 percent {[(1.001 x 1.0032 x 1.0045 x 1.0069)-1]100 = 1.6%}. This is equivalent to growth from IVQ2010 to IVQ2011 obtained by dividing the seasonally-annual rate (SAAR) of IVQ2011 of $13,422.4 billion by the SAAR of IV2011 of $13,216.9 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1) and expressing as percentage {[($13,422.4/$13,216.1)-1]100 = 1.6%}. The US economy is still close to a standstill especially considering the GDP report in detail. The Bureau of Economic Analysis (BEA) of the US Department of Commerce released on Fri Jan 27, 2012, the first estimate of GDP for IVQ2011 at 2.8 percent seasonally-adjusted annual rate (SAAR) (http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf). Inventory accumulation contributed 1.94 percentage points to the SAAR of GDP growth of 2.8 percent in IVQ2011 with weak gross domestic investment of only 0.41 percentage points net of inventory accumulation. Personal consumptions expenditures (PCE) contributed 1.44 percentage points partly because of reduction of savings. There is no aggregate internal demand of consumption and investment to sustain growth.

Characteristics of the four cyclical contractions are provided in Table ES-1 with the first column showing the number of quarters of contraction; the second column the cumulative percentage contraction; and the final column the average quarterly rate of contraction in annual equivalent rate. There were two contractions from IQ1980 to IIIQ1980 and from IIIQ1981 to IVQ1982 separated by three quarters of expansion. The drop of output combining the declines in these two contractions is 4.8 percent, which is almost equal to the decline of 5.1 percent in the contraction from IVQ2007 to IIQ2009. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.7 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

Table ES-1, US, Number of Quarters, Cumulative Percentage Contraction and Average Percentage Annual Equivalent Rate in Cyclical Contractions 

	Number of Quarters	Cumulative Percentage Contraction	Average Percentage Annual Equivalent Rate
IIQ1953 to IIQ1954	4	-2.5	-0.63
IIIQ1957 to IIQ1958	3	-3.1	-9.0
IQ1980 to IIIQ1980	2	-2.2	-1.1
IIIQ1981 to IVQ1982	4	-2.7	-0.67
IVQ2007 to IIQ2009	6	-5.1	-0.87

Source: Business Cycle Reference Dates: http://www.nber.org/cycles/cyclesmain.html

Data: http://www.bea.gov/iTable/index_nipa.cfm

Table ES-2 shows the extraordinary contrast between the mediocre average annual equivalent growth rate of 2.4 percent of the US economy in the ten quarters of the current cyclical expansion from IIIQ2009 to IVQ2011 and the average of 6.2 percent in the four earlier cyclical expansions. The BEA data for the four quarters of 2011 show the economy in standstill with annual growth of 1.6 percent. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent

Table ES-2, US, Number of Quarters, Cumulative Growth and Average Annual Equivalent Growth Rate in Cyclical Expansions

	Number of Quarters	Cumulative Growth ∆%	Average Annual Equivalent Growth Rate
IIIQ 1954 to IQ1957	11	12.6	4.4
IIQ1958 to IIQ1959	5	10.2	8.1
IIQ1975 to IVQ1976	8	9.5	4.6
IQ1983 to IV1985	13	19.6	5.7
Average Four Above Expansions			6.2
IIIQ2009 to IVQ2011	10	6.2	2.4

Source: http://www.bea.gov/iTable/index_nipa.cfm

Chart ES-1 shows US real quarterly GDP growth from 1980 to 1989. The economy contracted during the recession and then expanded vigorously throughout the 1980s, rapidly eliminating the unemployment caused by the contraction.

Chart ES-1, US, Real GDP, 1980-1989

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ES-2 shows the entirely different situation of real quarterly GDP in the US between 2007 and 2011. The economy has underperformed during the first ten quarters of expansion for the first time in the comparable contractions since the 1950s. The US economy is now in a perilous standstill.

Chart ES-2, US, Real GDP, 2007-2011

Source: http://www.bea.gov/iTable/index_nipa.cfm

As shown in Tables ES-1 and ES-2 above the loss of real GDP in the US during the contraction was 5.1 percent but the gain in the cyclical expansion has been only 6.2 percent (last row in Table ES-2). As a result, the level of real GDP in IVQ2011 with the first estimate is only higher by 0.7 percent than the level of real GDP in IVQ2007. Table ES-3 provides in the second column real GDP in billions of chained 2005 dollars. The third column provides the percentage change of the quarter relative to IVQ2007; the fourth column provides the percentage change relative to the prior quarter; and the final fifth column provides the percentage change relative to the same quarter a year earlier. The contraction actually concentrated in two quarters: decline of 2.3 percent in IVQ2008 relative to the prior quarter and decline of 1.7 percent in IQ2009 relative to IVQ2008. The combined fall of GDP in IVQ2008 and IQ2009 was 4.0 percent (1.023 x 1.017). Those two quarters coincided with the worst effects of the financial crisis. GDP fell 0.2 percent in IIQ2009 but grew 0.4 percent in IIIQ2009, which is the beginning of recovery in the cyclical dates of the NBER. Most of the recovery occurred in three successive quarters from IVQ2009 to IIQ2010 of equal growth at 0.9 percent for cumulative growth in those three quarters of 2.7 percent. The economy lost momentum already in IIIQ2010 and IVQ2010 growing at 0.6 percent in each quarter, or annual equivalent 2.4 per cent combining the two quarters in annual equivalent rate {(1.006 x 1.006)²}. The economy then stalled during the first half of 2011 with growth of 0.1 percent in IQ2011 and 0.33 percent in IIQ2011 for combined annual equivalent rate of 0.86 percent {(1.001 x 1.0033)²}. The economy grew 0.045 percent in IIIQ2011 for annual equivalent growth of 1.12 percent in the first three quarters {(1.001 x 1.0033 x 1.0045)^4/3}. Growth picked up in IVQ2011 with 0.69 percent relative to IIIQ2011. Growth in a quarter relative to a year earlier in Table ES-3 slows from over 3 percent during three consecutive quarters from IIQ2010 to IVQ2010 to 2.2 percent in IQ2011, 1.6 percent in IIQ2011, 1.5 percent in IIIQ2011 and 1.6 percent in IVQ2011. The revision of the seasonally-adjusted annual rate in IIQ2011 from 1.0 percent to 1.3 percent merely increases growth in IIQ2011 relative to IQ2011 from 0.25 percent to 0.33 percent. There is stronger quarterly growth in IIIQ2011 of 0.45 percent even with the downward revision of the third estimate. Growth in IIQ2011 relative to IIQ2010 and in IIIQ2011 relative to IIIQ2010 remains at the mediocre rates of 1.6 percent and 1.5 percent, respectively, with 1.6 percent in IVQ2011. As shown in the full text, growth of 0.7 percent in IVQ2011 was driven by inventory accumulation. The critical question for which there is not yet definitive solution is whether what lies ahead is continuing growth recession with the economy crawling and unemployment/underemployment at extremely high levels or another contraction or conventional recession. Forecasts of various sources continued to maintain high growth in the second half of 2011 without taking into consideration the continuous slowing of the economy in late 2010 and the first half of 2011. The sovereign debt crisis is one of the common sources of doubts on the rate and direction of economic growth in the US but there is weak internal demand in the US.

Table ES-3, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%

	Real GDP, Billions Chained 2005 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	13,326.0	NA	NA	2.2
IQ2008	13,266.8	-0.4	-0.4	1.6
IIQ2008	13,310.5	-0.1	0.3	1.0
IIIQ2008	13,186.9	-1.0	-0.9	-0.6
IVQ2008	12,883.5	-3.3	-2.3	-3.3
IQ2009	12,663.2	-4.9	-1.7	-4.5
IIQ2009	12,641.3	-5.1	-0.2	-5.0
IIIQ2009	12,694.5	-4.7	0.4	-3.7
IV2009	12,813.5	-3.8	0.9	-0.5
IQ2010	12,937.7	-2.9	0.9	2.2
IIQ2010	13,058.5	-1.8	0.9	3.3
IIIQ2010	13,139.6	-1.4	0.6	3.5
IVQ2010	13,216.1	-0.8	0.6	3.1
IQ2011	13,227.9	-0.7	0.1	2.2
IIQ2011	13,271.8	-0.4	0.33	1.6
IIIQ2011	13,331.6	0.04	0.5	1.5
IV2011	13,422.4	0.7	0.7	1.6

Source: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1

ESII Falling Real Disposable Income and Repression of Savings. Chart ES-3 of the Bureau of Economic Analysis (BEA) of the US Department of Commerce provides percentage changes in a quarter relative to the same quarter a year earlier of real disposable income (personal income less taxes adjusted for inflation) from 1980 to 2011. Real disposable income recovered sharply from the contraction in 2008 but has fallen sharply until becoming negative again in IVQ2011.

Chart ES-3, US, Percentage Change of Real Disposable Income in a Quarter Relative to the Same Quarter a Year Earlier

Source: Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ES-4 of the Bureau of Economic Analysis (BEA) provides quarterly savings as percent of disposable income or the US savings rate from 1980 to 2011. There was a long-term downward sloping trend from 12 percent in the early 1980s to less than 2 percent in 2005-2006. The savings rate then rose during the contraction and also in the expansion. In 2011 the savings rate declined as consumption is financed with savings in part because of the disincentive or frustration of receiving a few pennies for every $10,000 of deposits in a bank. The objective of monetary policy is to reduce borrowing rates to induce consumption but it has collateral disincentive of reducing savings. The zero interest rate of monetary policy is a tax on saving. This tax is highly regressive, meaning that it affects the most people with lower income or wealth and retirees. The long-term decline of savings rates in the US has created a dependence on foreign savings to finance the deficits in the federal budget and the balance of payments.

Chart ES-4, US, Savings as Percentage of Disposable Personal Income

Source: Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

ES-III IMF Forecast. The International Monetary Fund (IMF) has revised its World Economic Outlook (WEO) to an environment of lower growth (IMF 2012WEOJan24):

“The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated. Global output is projected to expand by 3¼ percent in 2012—a downward revision of about ¾ percentage point relative to the September 2011 World Economic Outlook (WEO).”

The IMF (2012WEOJan24) projects growth of world output of 3.8 percent in 2011 and 3.3 percent in 2012 after 5.2 percent in 2010. Advanced economies would grow at only 1.6 percent in 2011, 1.2 percent in 2012 and 3.9 percent in 2013 after growing at 3.2 percent in 2010. Emerging and developing economies would drive the world economy, growing at 6.2 percent in 2011, 5.4 percent in 2012 and 5.9 percent in 2012 after growing at 7.3 percent in 2010. The IMF is forecasting deceleration of the world economy.

World economic slowing would be the consequence of the mild recession in the euro area in 2012 caused by “the rise in sovereign yields, the effects of bank deleveraging on the real economy and the impact of additional fiscal consolidation” (IMF 2012WEOJan24). After growing at 1.9 percent in 2010 and 1.6 percent in 2010, the economy of the euro area would contract by 0.5 percent in 2012 and grow at 0.8 percent in 2013. The United States would grow at 1.8 percent in both 2011 and 2012 and at 2.2 percent in 2013. The IMF (2012WEO Jan24) projects slow growth in 2012 of Germany at 0.3 percent and of France at 0.2 percent while Italy contracts 2.2 percent and Spain contracts 1.7 percent. While Germany would grow at 1.5 percent in 2013 and France at 1.0 percent, Italy would contract 0.6 percent and Spain 0.3 percent.

The IMF (2012WEOJan24) also projects a downside scenario, in which the critical risk “is intensification of the adverse feedback loops between sovereign and bank funding pressures in the euro area, resulting in much larger and more protracted bank deleveraging and sizable contractions in credit and output.” In this scenario, there is contraction of private investment by an extra 1.75 percentage points in relation to the projections of the WEO with euro area output contracting 4 percent relative to the base WEO projection. The environment could be complicated by failure in medium-term fiscal consolidation in the United States and Japan.

There is significant deceleration in world trade volume in the projections of the IMF (2012WEOJan24). Growth of the volume of world trade in goods and services decelerates from 12.7 percent in 2010 to 6.9 percent in 2011, 3.8 percent in 2012 and 5.4 percent in 2013. Under these projections there would be significant pressure in economies in stress such as Japan and Italy that require trade for growth. Even the stronger German economy is dependent on foreign trade. There is sharp deceleration of growth of exports of advanced economies from 12.2 percent in 2010 to 2.4 percent in 2012. Growth of exports of emerging and developing economies falls from 13.8 percent in 2010 to 6.1 percent in 2012. Another cause of concern in that oil prices in the projections fall only 4.9 percent in 2012, remaining at relatively high levels.

I Mediocre Economic Growth. In the four quarters of 2011, US real GDP grew at the seasonally-adjusted annual equivalent rates of 0.4 percent in the first quarter of 2011 (IQ2011), 1.3 percent in IIQ2011, 1.8 percent in IIIQ2011 and 2.8 percent in IVQ2011. The annual equivalent rate of growth of GDP for 2011 is 1.6 percent, obtained as follows. Discounting 0.4 percent to one quarter is 0.1 percent; discounting 1.3 percent to one quarter is 0.32 percent; discounting 1.8 percent to one quarter is 0.45 percent; and discounting 2.8 percent to one quarter is 0.69. Real GDP growth in the four quarters of 2011 accumulated to 1.6 percent {[(1.001 x 1.0032 x 1.0045 x 1.0069)-1]100 = 1.6%}. This is equivalent to growth from IVQ2010 to IVQ2011 obtained by dividing the seasonally-annual rate (SAAR) of IVQ2011 of $13,422.4 billion by the SAAR of IV2011 of $13,216.9 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1) and expressing as percentage {[($13,422.4/$13,216.1)-1]100 = 1.6%}. The US economy is still close to a standstill especially considering the GDP report in detail. The Bureau of Economic Analysis (BEA) of the US Department of Commerce released on Fri Jan 27, 2012, the first estimate of GDP for IVQ2011 at 2.8 percent seasonally-adjusted annual rate (SAAR) (http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf). The objective of this section is analyzing US economic growth. There is initial brief discussion of the concept of “slow-growth recession” followed by comparison of the current growth experience of the US with earlier expansions after past deep contractions and consideration of performance in 2011.

The concept of growth recession was popular during the stagflation from the late 1960s to the early 1980s. The economy of the US underperformed with several recession episodes in “stop and go” fashion of economic activity while the rate of inflation rose to the highest in a peacetime period (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-monetary.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html). A growth recession could be defined as a period in which economic growth is insufficient to move the economy toward full employment of humans, equipment and other productive resources. The US is experiencing a dramatic slow growth recession with 29.6 million people in job stress, consisting of an effective number of unemployed of 18.6 million, 8.4 million employed part-time because they cannot find full employment and 2.5 million marginally attached to the labor force (see Table I-4 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html). The discussion of the growth recession issue in the 1970s by two recognized economists of the twentieth century, James Tobin and Paul A. Samuelson, is worth recalling.

In analysis of the design of monetary policy in 1974, Tobin (1974, 219) finds that the forecast of the President’s Council of Economic Advisers (CEA) was also the target such that monetary policy would have to be designed and implemented to attain that target. The concern was with maintaining full employment as provided in the Employment Law of 1946 (http://www.law.cornell.edu/uscode/15/1021.html http://uscode.house.gov/download/pls/15C21.txt http://www.eric.ed.gov/PDFS/ED164974.pdf) see http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html), which also created the CEA. Tobin (1974, 219) describes the forecast/target of the CEA for 1974:

“The expected and approved path appears to be quarter-to-quarter rates of growth of real gross national product in 1974 of roughly -0.5, 0.1, and 1 percent, with unemployment rising to about 5.6 percent in the second quarter and remaining there the rest of the year. The rate of price inflation would fall shortly in the second quarter, but rise slightly toward the end of the year.”

Referring to monetary policy design, Tobin (1974, 221) states: “if interest rates remain stable or rise during the current (growth) recession and recovery, this will be a unique episode in business cycle annals.” Subpar economic growth is often called a “growth recession.” The critically important concept is that economic growth is not sufficient to move the economy toward full employment, creating the social and economic adverse outcome of idle capacity and unemployed and underemployed workers, much the same as currently.

The unexpected incidence of inflation surprises during growth recessions is considered by Samuelson (1974, 76):

“Indeed, if there were in Las Vegas or New York a continuous casino on the money GNP of 1974’s fourth quarter, it would be absurd to think that the best economic forecasters could improve upon the guess posted there. Whatever knowledge and analytical skill they possess would already have been fed into the bidding. It is a manifest contradiction to think that most economists can be expected to do better than their own best performance. I am saying that the best forecasters have been poor in predicting the general price level’s movements and level even a year ahead. By Valentine’s Day 1973 the best forecasters were beginning to talk of the growth recession that we now know did set in at the end of the first quarter. Aside from their end-of-1972 forecasts, the fashionable crowd has little to blame itself for when it comes to their 1973 real GNP projections. But, of course, they did not foresee the upward surge of food and decontrolled industrial prices. This has been a recurring pattern: surprise during the event at the virulence of inflation, wisdom after the event in demonstrating that it did, after all, fit with past patterns of experience.”

Economists are known for their forecasts being second only to those of astrologers. Accurate forecasts are typically realized for the wrong reasons. In contrast with meteorologists, economists do not even agree on what happened. There is not even agreement on what caused the global recession and why the economy has reached a perilous standstill.

Historical parallels are instructive but have all the limitations of empirical research in economics. The more instructive comparisons are not with the Great Depression of the 1930s but rather with the recessions in the 1950s, 1970s and 1980s. The growth rates and job creation in the expansion of the economy away from recession are subpar in the current expansion compared to others in the past. Four recessions are initially considered, following the reference dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles/cyclesmain.html ): IIQ1953-IIQ1954, IIIQ1957-IIQ1958, IIIQ1973-IQ1975 and IQ1980-IIIQ1980. The data for the earlier contractions illustrate that the growth rate and job creation in the current expansion are inferior. The sharp contractions of the 1950s and 1970s are considered in Table I-1, showing the Bureau of Economic Analysis (BEA) quarter-to-quarter, seasonally adjusted (SA), yearly-equivalent growth rates of GDP. The recovery from the recession of 1953 consisted of four consecutive quarters of high percentage growth rates from IIIQ1954 to IIIQ1955: 4.6, 8.3, 12.0, 6.8 and 5.4. The recession of 1957 was followed by four consecutive high percentage growth rates from IIIQ1958 to IIQ1959: 9.7, 9.7, 8.3 and 10.5. The recession of 1973-1975 was followed by high percentage growth rates from IIQ1975 to IIQ1976: 6.9, 5.3, 9.4 and 3.0. The disaster of the Great Inflation and Unemployment of the 1970, which made stagflation notorious, is even better in growth rates during the expansion phase from contractions in comparison than the current slow-growth recession.   

Table I-1, US, Quarterly Growth Rates of GDP, % Annual Equivalent SA

	IQ	IIQ	IIIQ	IVQ
1953	7.7	3.1	-2.4	-6.2
1954	-1.9	0.5	4.6	8.3
1955	12.0	6.8	5.4	2.3
1957	2.5	-1.0	3.9	-4.1
1958	-10.4	2.5	9.7	9.7
1959	8.3	10.5	-0.5	1.4
1973	10.6	4.7	-2.1/	3.9
1974	3.5	1.0	-3.9	6.9
1975	-4.8	3.1	6.9	5.3
1976	9.4	3.0	2.0	2.9
1979	0.7	0.4	2.9	1.1
1980	1.3	-7.9	-0.7	7.6

Source: http://www.bea.gov/iTable/index_nipa.cfm

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 of lost GDP of 4.8 percent is more comparable to the latest revised 5.1 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. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.5 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). Table I-2 provides the Bureau of Economic Analysis (BEA) quarterly growth rates of GDP in SA yearly equivalents for the recessions of 1981-1982 and 2007 to 2009, using the latest major revision published on Jul 29, 2011 (http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp2q11_adv.pdf) and the first estimate of IVQ2011 released on Jan 27, 2012 (http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf). 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 -8.9 percent. The striking difference is that in the first ten quarters of expansion from IQ1983 to IIIQ1985, shown in Table 2 in relief, GDP grew at the high quarterly percentage growth rates of 5.1, 9.3, 8.1, 8.5, 7.1, 3.9, 3.3, 5.4, 3.8 and 6.4 while the percentage growth rates in the first ten quarters of expansion from IIIQ2009 to IVQ2011, shown in relief in Table I-2, were mediocre: 1.7, 3.8, 3.9, 3.8, 2.5, 2.3, 0.4, 1.3, 1.8 and 2.8. Asterisks denote the estimates that have been revised by the BEA. During the four quarters of 2011 GDP has been growing at annual equivalent rates of 0.4 percent in IQ2011, 1.3 percent in IIQ2011, 1.8 percent in IIIQ2011 and 2.8 percent in IVQ2011 in what can be considered as a slow growth recession because of the 29.6 million in job stress (http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html). Inventory change contributed to initial growth but was rapidly replaced by growth in investment and demand in 1983.

Table I-2, US, 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	-1.8*	-6.7*	3.9*
II	-3.2	2.2	9.3	3.9	1.3*	-0.7	3.8*
III	4.9	-1.5	8.1	3.3	-3.7*	1.7	2.5*
IV	-4.9	0.3	8.5	5.4	-8.9*	3.8*	2.3*
				1985			2011
I				3.8			0.4
II				3.4			1.3
III				6.4			1.8
IV				3.1			2.8

Source: http://www.bea.gov/iTable/index_nipa.cfm

Chart I-1 provides strong growth of real quarterly GDP in the US between 1947 and 1999. There is an evident acceleration of the rate of GDP growth in the 1990s as shown by a much sharper slope of the growth curve. Cobet and Wilson (2002) define labor productivity as the value of manufacturing output produced per unit of labor input used (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). Between 1950 and 2000, labor productivity in the US grew less rapidly than in Germany and Japan. The major part of the increase in productivity in Germany and Japan occurred between 1950 and 1973 while the rate of productivity growth in the US was relatively subdued in several periods. While Germany and Japan reached their highest growth rates of productivity before 1973, the US accelerated its rate of productivity growth in the second half of the 1990s. Between 1950 and 2000, the rate of productivity growth in the US of 2.9 percent per year was much lower than 6.3 percent in Japan and 4.7 percent in Germany. Between 1995 and 2000, the rate of productivity growth of the US of 4.6 percent exceeded that of Japan of 3.9 percent and the rate of Germany of 2.6 percent.

Chart I-1, US, Real GDP 1947-1999

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-2 provides the growth of real quarterly GDP in the US between 1947 an 2011, using the new estimate for 2011 GDP. The drop of output in the recession from IVQ2007 to IIQ2009 has been followed by anemic recovery and a standstill that can lead to growth recession, or low rates of economic growth, but perhaps even another contraction or conventional recession.

Chart I-2, US, Real GDP 1947-2011

Source:

US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-3 provides real GDP percentage change on the quarter a year earlier for 1983-1984. The objective is simply to compare expansion in two recoveries from sharp contractions as shown in Table I-2. Growth rates in the early phase of the recovery in 1983 and 1984 were very high, which is the opportunity to reduce unemployment that has characterized cyclical expansion in the postwar US economy.

Chart I-3, Real GDP Percentage Change on Quarter a Year Earlier 1983-1984

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

In contrast, growth rates in the comparable first nine months of expansion in 2009 and 2011 in Chart I-4 have been mediocre. As a result, growth has not provided the exit from unemployment and underemployment as in other cyclical expansions in the postwar period. Growth rates did not rise in V shape as in earlier expansions and then declined close to the standstill of growth recessions.

Chart I-4, US, Real GDP Percentage Change on Quarter a Year Earlier 2009-2011

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table I-3 provides the change in real GDP in the United States in the 1930s, 1980s and 2000s. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.7 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). Data are available for the 1930s only on a yearly basis. US GDP fell 4.8 percent in the two recessions from IQ1980 to IIIQ1980 and from III1981 to IVQ1981 to IVQ1982 and 5.1 percent cumulatively in the recession from IVQ2007 to IIQ2009. It is instructive to compare the first two years of the expansions in the 1980s and the current expansion. GDP grew at 4.5 percent in 1983 and 7.2 percent in 1984 while GDP grew at 3.0 percent in 2010 and 1.7 percent in 2011. GDP grew at 4.1 percent in 1985 and 3.5 percent in 1986 while the forecasts of participants of the Federal Open Market Committee (FOMC) are 2.2 to 2.7 percent in 2012 and 2.8 to 3.2 percent in 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

Table I-3, US, Percentage Change of GDP in the 1930s, 1980s and 2000s, ∆%

Year	GDP ∆%	Year	GDP ∆%	Year	GDP ∆%
1930	-8.6	1980	-0.3	2000	4.1
1931	-6.5	1981	2.5	2001	1.1
1932	-13.1	1982	-1.9	2002	1.8
1933	-1.3	1983	4.5	2003	2.5
1934	10.9	1984	7.2	2004	3.5
1935	8.9	1985	4.1	2005	3.1
1936	13.1	1986	3.5	2006	2.7
1937	5.1	1987	3.2	2007	1.9
1938	-3.4	1988	4.1	2008	-0.3
1930	8.1	1989	3.6	2009	-3.5
1940	8.8	1990	1.9	2010	3.0
1941	17.1	1991	-0.2	2011	1.7

Source: http://www.bea.gov/iTable/index_nipa.cfm

Chart I-5 provides percentage change of GDP in the US during the 1930s. There is vast literature analyzing the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance (2009) 198-217). Cole and Ohanian (1999) find that US real per capita output in 1939 remained 11 percent lower than in 1929 while the typical expansion of real per capita output in the US is 31 percent. Private hours worked in the US were 25 percent lower in 1939 than in 1929.

Chart I-5, US, Percentage Change of GDP in the 1930s

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

In contrast, Chart I-6 shows rapid recovery from the recessions in the 1980s. High growth rates in the initial quarters of expansion eliminated the unemployment and underemployment created during the contraction. The economy then returned to grow at the trend of expansion, interrupted by another contraction in 1991.

Chart I-6, US, Percentage Change of GDP in the 1980s

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-7 provides the rates of growth during the 2000s. Growth rates in the initial eleven quarters of expansion have been relatively lower than during recessions after World War II. As a result, unemployment and underemployment continue at the rate of 18.6 percent of the US labor force (Table I-4 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html).

Chart I-7, US, Percentage Change of GDP in the 2000s

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Characteristics of the four cyclical contractions are provided in Table I-4 with the first column showing the number of quarters of contraction; the second column the cumulative percentage contraction; and the final column the average quarterly rate of contraction in annual equivalent rate. There were two contractions from IQ1980 to IIIQ1980 and from IIIQ1981 to IVQ1982 separated by three quarters of expansion. The drop of output combining the declines in these two contractions is 4.8 percent, which is almost equal to the decline of 5.1 percent in the contraction from IVQ2007 to IIQ2009. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.7 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

Table I-4, US, Number of Quarters, Cumulative Percentage Contraction and Average Percentage Annual Equivalent Rate in Cyclical Contractions 

	Number of Quarters	Cumulative Percentage Contraction	Average Percentage Annual Equivalent Rate
IIQ1953 to IIQ1954	4	-2.5	-0.63
IIIQ1957 to IIQ1958	3	-3.1	-9.0
IQ1980 to IIIQ1980	2	-2.2	-1.1
IIIQ1981 to IVQ1982	4	-2.7	-0.67
IVQ2007 to IIQ2009	6	-5.1	-0.87

Source: Business Cycle Reference Dates: http://www.nber.org/cycles/cyclesmain.html

Data: http://www.bea.gov/iTable/index_nipa.cfm

Table I-5 shows the extraordinary contrast between the mediocre average annual equivalent growth rate of 2.4 percent of the US economy in the ten quarters of the current cyclical expansion from IIIQ2009 to IVQ2011 and the average of 6.2 percent in the four earlier cyclical expansions. The BEA data for the four quarters of 2011 show the economy in standstill with annual growth of 1.6 percent. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent

Table I-5, US, Number of Quarters, Cumulative Growth and Average Annual Equivalent Growth Rate in Cyclical Expansions

	Number of Quarters	Cumulative Growth ∆%	Average Annual Equivalent Growth Rate
IIIQ 1954 to IQ1957	11	12.6	4.4
IIQ1958 to IIQ1959	5	10.2	8.1
IIQ1975 to IVQ1976	8	9.5	4.6
IQ1983 to IV1985	13	19.6	5.7
Average Four Above Expansions			6.2
IIIQ2009 to IVQ2011	10	6.2	2.4

Source: http://www.bea.gov/iTable/index_nipa.cfm

Chart I-8 shows US real quarterly GDP growth from 1980 to 1989. The economy contracted during the recession and then expanded vigorously throughout the 1980s, rapidly eliminating the unemployment caused by the contraction.

Chart I-8, US, Real GDP, 1980-1989

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-9 shows the entirely different situation of real quarterly GDP in the US between 2007 and 2011. The economy has underperformed during the first ten quarters of expansion for the first time in the comparable contractions since the 1950s. The US economy is now in a perilous standstill.

Chart I-9, US, Real GDP, 2007-2011

Source: http://www.bea.gov/iTable/index_nipa.cfm

As shown in Tables I-4 and I-5 above the loss of real GDP in the US during the contraction was 5.1 percent but the gain in the cyclical expansion has been only 6.2 percent (last row in Table I-4). As a result, the level of real GDP in IVQ2011 with the first estimate is only higher by 0.7 percent than the level of real GDP in IVQ2007. Table I-6 provides in the second column real GDP in billions of chained 2005 dollars. The third column provides the percentage change of the quarter relative to IVQ2007; the fourth column provides the percentage change relative to the prior quarter; and the final fifth column provides the percentage change relative to the same quarter a year earlier. The contraction actually concentrated in two quarters: decline of 2.3 percent in IVQ2008 relative to the prior quarter and decline of 1.7 percent in IQ2009 relative to IVQ2008. The combined fall of GDP in IVQ2008 and IQ2009 was 4.0 percent (1.023 x 1.017). Those two quarters coincided with the worst effects of the financial crisis. GDP fell 0.2 percent in IIQ2009 but grew 0.4 percent in IIIQ2009, which is the beginning of recovery in the cyclical dates of the NBER. Most of the recovery occurred in three successive quarters from IVQ2009 to IIQ2010 of equal growth at 0.9 percent for cumulative growth in those three quarters of 2.7 percent. The economy lost momentum already in IIIQ2010 and IVQ2010 growing at 0.6 percent in each quarter, or annual equivalent 2.4 per cent combining the two quarters in annual equivalent rate {(1.006 x 1.006)²}. The economy then stalled during the first half of 2011 with growth of 0.1 percent in IQ2011 and 0.33 percent in IIQ2011 for combined annual equivalent rate of 0.86 percent {(1.001 x 1.0033)²}. The economy grew 0.045 percent in IIIQ2011 for annual equivalent growth of 1.12 percent in the first three quarters {(1.001 x 1.0033 x 1.0045)^4/3}. Growth picked up in IVQ2011 with 0.69 percent relative to IIIQ2011. Growth in a quarter relative to a year earlier in Table I-6 slows from over 3 percent during three consecutive quarters from IIQ2010 to IVQ2010 to 2.2 percent in IQ2011, 1.6 percent in IIQ2011, 1.5 percent in IIIQ2011 and 1.6 percent in IVQ2011. The revision of the seasonally-adjusted annual rate in IIQ2011 from 1.0 percent to 1.3 percent merely increases growth in IIQ2011 relative to IQ2011 from 0.25 percent to 0.33 percent. There is stronger quarterly growth in IIIQ2011 of 0.45 percent even with the downward revision of the third estimate. Growth in IIQ2011 relative to IIQ2010 and in IIIQ2011 relative to IIIQ2010 remains at the mediocre rates of 1.6 percent and 1.5 percent, respectively, with 1.6 percent in IVQ2011. As shown below, growth of 0.7 percent in IVQ2011 was driven by inventory accumulation. The critical question for which there is not yet definitive solution is whether what lies ahead is continuing growth recession with the economy crawling and unemployment/underemployment at extremely high levels or another contraction or conventional recession. Forecasts of various sources continued to maintain high growth in the second half of 2011 without taking into consideration the continuous slowing of the economy in late 2010 and the first half of 2011. The sovereign debt crisis is one of the common sources of doubts on the rate and direction of economic growth in the US but there is weak internal demand in the US.

Table I-6, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%

	Real GDP, Billions Chained 2005 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	13,326.0	NA	NA	2.2
IQ2008	13,266.8	-0.4	-0.4	1.6
IIQ2008	13,310.5	-0.1	0.3	1.0
IIIQ2008	13,186.9	-1.0	-0.9	-0.6
IVQ2008	12,883.5	-3.3	-2.3	-3.3
IQ2009	12,663.2	-4.9	-1.7	-4.5
IIQ2009	12,641.3	-5.1	-0.2	-5.0
IIIQ2009	12,694.5	-4.7	0.4	-3.7
IV2009	12,813.5	-3.8	0.9	-0.5
IQ2010	12,937.7	-2.9	0.9	2.2
IIQ2010	13,058.5	-1.8	0.9	3.3
IIIQ2010	13,139.6	-1.4	0.6	3.5
IVQ2010	13,216.1	-0.8	0.6	3.1
IQ2011	13,227.9	-0.7	0.1	2.2
IIQ2011	13,271.8	-0.4	0.33	1.6
IIIQ2011	13,331.6	0.04	0.5	1.5
IV2011	13,422.4	0.7	0.7	1.6

Source: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1

Chart I-10 provides the percentage change of real GDP from the same quarter a year earlier from 1980 to 1989. There were two contractions almost in succession in 1980 and from 1981 to 1983. The expansion was marked by initial high rates of growth as in other recession in the postwar US period during which employment lost in the contraction was recovered. Growth rates continued to be high after the initial phase of expansion.

Chart I-10, Percentage Change of Real Gross Domestic Product from Quarter a Year Earlier 1980-1989

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

The experience of recovery after 2009 is not as complete as during the 1980s. Chart I-11 shows the much lower rates of growth in the early phase of the current expansion and how they have sharply declined from an early peak.

Chart I-11, Percentage Change of Real Gross Domestic Product from Quarter a Year Earlier 2007-2011

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-12 provides growth rates from a quarter relative to the prior quarter during the 1980s. There is the same strong initial growth followed by a long period of sustained growth.

Chart I-12, Percentage Change of Real Gross Domestic Product from Prior Quarter 1980-1989

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-13 provides growth rates in a quarter relative to the prior quarter from 2007 to 2011. Growth in the current expansion after IIIQ2009 has not been as strong as in other postwar cyclical expansions.

Chart I-13, Percentage Change of Real Gross Domestic Product from Prior Quarter 2007-2011

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

The revised estimates and earlier estimates from IQ2008 to IQ2011 in seasonally adjusted annual equivalent rates are shown in Table I-7. The strongest revision is for IVQ2008 for which the contraction of GDP is revised from minus 6.8 percent to minus 8.9 percent. IQ2009 is also revised from contraction of minus 4.9 percent to minus 6.7 percent. There is only minor revision in IIIQ2008 of the contraction of minus 4.0 percent to minus 3.7 percent. Growth of 5.0 percent in IV2009 is revised to 3.8 percent but growth in IIQ2010 is upwardly revised to 3.8 percent. The revisions do not alter the conclusion that the current expansion is much weaker than historical sharp contractions since the 1950s and is now changing into slow growth recession with higher risks of contraction.

Table I-7, US, Quarterly Growth Rates of GDP, % Annual Equivalent SA, Revised and Earlier Estimates

Quarters	Revised Estimate	Earlier Estimate
2008
I	-1.8	-0.7
II	1.3	0.6
III	-3.7	-4.0
IV	-8.9	-6.8
2009
I	-6.7	-4.9
II	-0.7	-0.7
III	1.7	1.6
IV	3.8	5.0
2010
I	3.9	3.7
II	3.8	1.7
III	2.5	2.6
IV	2.3	3.1
2011
I	0.4	1.9

Source: http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp2q11_adv.pdf

Contributions to the rate of growth of GDP in percentage points (PP) are provided in Table I-8. Aggregate demand, personal consumption expenditures (PCE) and gross private domestic investment (GDI) were much stronger during the expansion phase in IQ1983 to IIQ1984 than in IIIQ2009 to IVQ2011. Growth of GDP in IVQ2011 at 2.8 percent at seasonally-adjusted annual rate (SAAR) consisted of positive contributions of 1.45 percentage points of personal consumption expenditures (PCE) + 2.35 percentage points of gross domestic investment (GDI) but with the bulk originating in inventory change of 1.94 percentage points (∆ PI) minus 0.11 percentage points of net exports (net trade or exports less imports) minus 0.93 percentage points of government consumption expenditures and gross investment (GOV). Real disposable fell 0.1 percent in IVQ2011 relative to a year earlier but families still consumed by drawing down savings as percent of personal income from 5.2 in IVQ2010 to 3.7 in IVQ2011.

Table I-8, US, Contributions to the Rate of Growth of GDP in Percentage Points

	GDP	PCE	GDI	∆ PI	Trade	GOV
2011
I	0.4	1.47	0.47	0.32	-0.34	-1.23
II	1.3	0.49	0.79	-0.28	0.24	-0.18
III	1.8	1.24	0.17	-1.35	0.43	-0.02
IV	2.8	1.45	2.35	1.94	-0.11	-0.93
2010
I	3.9	1.92	3.25	3.10	-0.97	-0.26
II	3.8	2.05	2.92	0.79	-1.94	0.77
III	2.5	1.85	1.14	0.86	-0.68	0.20
IV	2.3	2.48	-0.91	-1.79	1.37	-0.58
2009
I	-6.7	-1.02	-7.76	-2.66	2.44	-0.33
II	-0.7	-1.28	-2.84	-0.58	2.21	1.21
III	1.7	1.66	0.35	0.21	-0.59	0.28
IV	3.8	0.33	3.51	3.93	0.15	-0.18
1982
I	-6.4	1.62	-7.50	-5.47	-0.49	-0.03
II	-2.2	0.90	-0.05	2.35	0.84	0.50
III	-1.5	1.92	-0.72	1.15	-3.31	0.57
IV	0.3	4.64	-5.66	-5.48	-0.10	1.44
1983
I	5.1	2.54	2.20	0.94	-0.30	0.63
II	9.3	5.22	5.87	3.51	-2.54	0.75
III	8.1	4.66	4.30	0.60	-2.32	1.48
IV	8.5	4.20	6.84	3.09	-1.17	-1.35
1984
I	8.0	2.35	7.15	5.07	-2.37	0.86
II	7.1	3.75	2.44	-0.30	-0.89	1.79
III	3.9	2.02	-0.89	0.21	-0.36	0.62
IV	3.3	3.38	1.79	-2.50	-0.58	1.75
1985
I	3.8	4.34	-2.38	-2.94	0.91	0.95

Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment; – is negative and no sign positive

GDP: percent change at annual rate; percentage points at annual rates

Source: http://www.bea.gov/iTable/index_nipa.cfm

The Bureau of Economic Analysis (BEA) (http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf 1) explains growth of GDP in IVQ2011 in terms of positive growth contributions shown in Table I-9:

· Private inventory investment of 1.94 percentage points

· Personal consumption expenditures (PCE) growing at 2.0 percent with consumption of durable goods growing at 14.8 percent

· Exports growing at 4.7 percent

· Nonresidential fixed investment (NRFI) growing at 1.7 percent

· Residential fixed investment (RFI) growing at 10.9 percent

There were negative contributions:

· Federal government spending (Federal GOV) declining at 7.3 percent

· State and local government spending (State/Local GOV) falling at 2.6 percent

· Imports, which are deduction from growth, growing at 4.4 percent

The BEA explains acceleration in real GDP in IVQ2011 by:

· Increase in private inventory investment from minus 1.35 percentage points in IIIQ2011 to 1.94 percentage points in IVQ2011

· Increase in growth of personal consumption expenditures (PCE) from 1.8 percent in IIIQ2011 to 2.8 percent in IVQ2011

· Higher growth of residential fixed investment (RFI) from 1.3 percent in IIIQ2011 to 10.9 percent in IVQ2011

There were several negative contributions to the acceleration of growth of GDP from 1.8 percent in IIIQ2011 to 2.8 percent in IVQ2011:

· Deceleration in nonresidential fixed investment (NRFI) from growth of 15.7 percent in IIIQ2011 to 1.7 percent in IVQ2011

· Increase in the rate of decline of government expenditure from minus 0.1 percent in IIIQ2011 to minus 4.6 percent in IVQ2011

· Acceleration of the rate of growth of imports from 1.2 percent in IIIQ2011 to 4.4 percent in IV2011 as import growth deducts from GDP growth

· Higher rate of decline of state/local government spending from 1.6 percent in IIIQ2011 to 2.6 percent in IVQ2011

Table I-9, US, Percentage Seasonally Adjusted Annual Equivalent Quarterly Rates of Increase, %

	IVQ 2010	IQ     2011	II Q  2011	IIIQ  2011	IVQ 2011
GDP	2.3	0.4	1.3	1.8	2.8
PCE	3.6	2.1	0.7	1.7	2.0
Durable Goods	17.2	11.7	-5.3	5.7	14.8
NRFI	8.7	2.1	10.3	15.7	1.7
RFI	2.5	-2.4	4.2	1.3	10.9
Exports	7.8	7.9	3.6	4.7	4.7
Imports	-2.3	8.3	1.4	1.2	4.4
GOV	-2.8	-5.9	-0.9	-0.1	-4.6
Federal GOV	-3.0	-9.4	1.9	2.1	-7.3
State/Local GOV	-2.7	-3.4	-2.8	-1.6	-2.6
∆ PI (PP)	-1.79	0.32	-0.28	-1.35	1.94
Final Sales of Domestic Product	4.2	0.0	1.6	3.2	0.8
Gross Domestic Purchases	0.9	0.7	1.0	1.3	2.8
Prices Gross Domestic Purchases	2.1	4.0	3.3	2.0	0.8
Prices of GDP	1.9	2.5	2.5	2.6	0.4
Prices of GDP Excluding Food and Energy	1.3	2.5	2.7	1.8	0.9
Prices of PCE	1.9	3.9	3.3	2.3	0.7
Prices of PCE Excluding Food and Energy	0.7	1.6	2.3	2.1	1.1
Prices of Market Based PCE	1.8	4.0	3.5	2.6	0.7
Prices of Market Based PCE Excluding Food and Energy	0.3	1.3	2.4	2.3	1.2
Real Disposable Personal Income*	3.5	2.6	1.1	0.1	-0.1
Personal Savings As % Disposable Income	5.2	5.0	4.8	3.9	3.7

Note: PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment; GOV: government consumption expenditures and gross investment; ∆ PI: change in

private inventories; GDP - ∆ PI: final sales of domestic product; PP: percentage points; Personal savings rate: savings as percent of disposable income

*Percent change from quarter one year ago

Source: http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf

Growth of final sales of domestic product at seasonally-adjusted annual equivalent rate (SAAR) fell from 3.2 percent in IIIQ2011 to 0.8 percent in IIIQ2011. Price indicators of GDP and gross domestic purchases decelerated into IVQ2011. Prices of PCE excluding food and energy, which is the inflation indicator of monetary policy, fell from change of 2.1 percent in IIIQ2011 to 1.1 percent in IVQ2011. Similar behavior is observed for the other market-based price indexes. The final two rows of Table I-9 show decline of real disposable income in IVQ2011 relative to IVQ2010 and reduction of personal savings as percent of disposable income from 4.8 percent in IIQ2011 to 3.9 percent in IIIQ2011 and 3.7 percent in IVQ2011. Families interrupted saving and consumed in what could not be considered sustained driver of economic growth.

Percentage shares of GDP are shown in Table I-10. PCE is equivalent to 70.6 percent of GDP and is under pressure with decline of real disposable income, high levels of unemployment and underemployment and higher savings rates than before the global recession. Gross private domestic investment is also growing slowly even with about two trillions of dollars in cash holdings by companies. In a slowing world economy, it may prove more difficult to grow exports faster than imports to generate higher growth. Bouts of risk aversion revalue the dollar relative to most currencies in the world as investors increase their holdings of dollar-denominated assets.

Table I-10, US, Percentage Shares of GDP, %

	IVQ2010
GDP	100.0
PCE	70.6
Goods	23.6
Services	47.0
Gross Private Domestic Investment	12.3
Fixed Investment	12.1
NRFI	9.8
RFI	2.2
Change in Private       Inventories	0.3
Net Exports of Goods and Services	-3.4
Exports	13.1
Imports	16.5
Government	20.5
Federal	8.4
State and Local	12.1

PCE: personal consumption expenditures; NRFI: nonresidential fixed investment; RFI: residential fixed investment

Source: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1

Table I-11 shows percentage point (PP) contributions to the annual levels of GDP growth in the earlier recessions 1958-1959, 1975-1976, 1982-1983 and 2009, 2010 and 2011. The data incorporate the new revisions released by the BEA on Jul 29, 2011 and the preliminary estimate of 2011 GDP released on Jan 27, 2012. The most striking contrast is in the rates of growth of annual GDP in the expansion phases of 7.2 percent in 1959, 4.5 percent in 1983 followed by 7.2 percent in 1984 and 4.1 percent in 1985 but only 3.0 percent in 2010 after six consecutive quarters of growth and 1.7 percent in 2011 after ten consecutive quarters of expansion. Annual levels also show much stronger growth of PCEs in the expansions after the earlier contractions than in the expansion after the global recession. Gross domestic investment was much stronger in the earlier expansions than in 2010 and 2011.

Table I-11, US, Percentage Point Contributions to the Annual Growth Rate of GDP

	GDP	PCE	GDI	∆ PI	Trade	GOV
1958	-0.9	0.54	-1.25	-0.18	-0.89	0.70
1959	7.2	3.61	2.80	0.86	0.00	0.76
1975	-0.2	1.40	-2.98	-1.27	0.89	0.48
1976	5.4	3.51	2.84	1.41	-1.08	0.10
1982	-1.9	0.86	-2.55	-1.34	-0.60	0.35
1983	4.5	3.65	-1.45	0.29	-1.35	0.76
1984	7.2	3.43	4.63	1.95	-1.58	0.70
1985	4.1	3.32	-0.17	-1.06	-0.42	1.41
2009	-3.5	-1.32	-3.61	-0.84	1.11	0.34
2010	3.0	1.44	1.96	1.64	-0.51	0.14
2011	1.7	1.53	0.58	-0.20	0.05	-0.45

Source: http://www.bea.gov/iTable/index_nipa.cfm

Table I-12 provides more detail of the contributions to growth of GDP from 2009 to 2011 using annual-level data. PCEs contributed 1.44 PPs to GDP growth in 2010 of which 0.99 percentage points (PP) in goods and 0.46 PP in services. GDI deducted 3.61 PPs of GDP growth in 2009 of which -2.77 PPs by fixed investment and -0.84 PPs of inventory change (∆PI) and added 1.96 PPs to gross domestic investment (GDI) in 2010 of which 0.32 PPs of fixed investment and 1.64 PPs of inventory accumulation (∆PI). Trade, or exports of goods and services net of imports, contributed 1.11 PPs in 2009 of which exports deducted 1.18 PPs and imports added 2.29 PPs. In 2010, trade deducted 0.51 PPs with exports contributing 1.31 PPs and imports deducting 1.82 PPs. In 2009, government added 0.34 PP of which 0.45 PPs by the federal government and -0.11 PPs by state and local government; in 2010, government added 0.14 PPs of which 0.37 PPs by the federal government with state and local government deducting 0.23 PPs. The final column of Table I-12 provides the preliminary estimate for 2011. There is not much difference in PCE with 1.53 PPs of contribution in 2011 after 1.44 PPs in 2010. The breakdown into goods and services is similar. Gross private domestic investment contributed 1.96 PPs in 2010 with 1.64 PPs originating in accumulation of private inventories but the contribution of gross private domestic investment was only 0.58 PPs in 2011. Net exports of goods and services contributed marginally in 2011 with 0.05 PPs. Government deducted 0.45 PPs in 2011. The expansion since IIIQ2009 has been characterized by weak contributions of aggregate demand, which is the sum of personal consumption expenditures plus gross private domestic investment. The US did not recover strongly from the global recessions as typical in past cyclical expansions. Recovery tends to be more sluggish as the expansion matures. At the margin in IVQ2011 the acceleration of expansion was driven by inventory accumulation instead of aggregate demand of consumption and investment.

Table I-12, US, Contributions to Growth of Gross Domestic Product in Percentage Points

	2009	2010	2011
GDP Growth ∆%	-3.5	3.0	1.7
Personal Consumption Expenditures (PCE)	-1.32	1.44	1.53
Goods	-0.69	0.99	0.87
Durable	-0.41	0.53	0.60
Nondurable	-0.28	0.46	0.28
Services	-0.63	0.46	0.66
Gross Private Domestic Investment (GPDI)	-3.61	1.96	0.58
Fixed Investment	-2.77	0.32	0.79
Nonresidential	-2.05	0.42	0.82
Structures	-0.85	-0.51	0.11
Equipment, software	-1.20	0.93	0.71
Residential	-0.72	-0.11	-0.03
Change Private Inventories	-0.84	1.64	-0.20
Net Exports of Goods and Services	1.11	-0.51	0.05
Exports	-1.18	1.31	0.88
Goods	-1.04	1.12	0.68
Services	-0.13	0.19	0.20
Imports	2.29	-1.82	-0.82
Goods	2.19	-1.74	-0.79
Services	0.10	-0.08	-0.03
Government Consumption Expenditures and Gross Investment	0.34	0.14	-0.45
Federal	0.45	0.37	-0.17
National Defense	0.30	0.18	-0.13
Nondefense	0.16	0.19	-0.03
State and Local	-0.11	-0.23	-0.28

Source: Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

II Financial Repression. This section provides analysis of financial repression in US financial markets. Subsection IIA Views of the Economy and Interest Rates analyzes the economic projections and interest rate views of participants in the Federal Open Market Committee (FOMC) that are used in monetary policy decisions. Subsection IIB Repression of Savings provides analysis of financial repression.

IA Views of the Economy and Interest Rates. In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.

The statement of the FOMC at the conclusion of its meeting on Jan 25, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm):

“Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.  In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates 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 at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. ”

There are several important issues in this statement.

1. Mandate. The FOMC 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”

2. Extending Average Maturity of Holdings of Securities. The statement of Jan 25, 2012, invokes the mandate that inflation is subdued but employment below maximum such that further accommodation is required. Accommodation consists of low interest rates. The new “Operation Twist” (http://cmpassocregulationblog.blogspot.com/2011_09_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html) or restructuring the portfolio of securities of the Fed by selling short-dated securities and buying long-term securities has the objective of reducing long-term interest rates. Lower interest rates would stimulate consumption and investment, or aggregate demand, increasing the rate of economic growth and thus reducing stress in job markets.

3. Target of Fed Funds Rate. The FOMC continues to maintain the target of fed funds rate at 0 to ¼ percent.

4. Advance Guidance. The FOMC increases transparency by advising on the expectation of the future path of fed funds rate. This guidance is the view that conditions such as “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 at least through late 2014.”

5. Monitoring and Policy Focus. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.”

These policy statements are carefully crafted to express the intentions of the FOMC. The main objective of the statements is to communicate as clearly and firmly as possible the intentions of the FOMC to fulfill its dual mandate. During periods of low inflation and high unemployment and underemployment such as currently the FOMC may be more biased toward measures that stimulate the economy to reduce underutilization of workers and other productive resources. The FOMC also is vigilant about inflation and ready to change policy in the effort to attain its dual mandate.

The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table II-1. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2011 is analyzed in the current post of this blog in section I. The Bureau of Economic Analysis (BEA) provides the GDP report with the second estimate for IVQ2011 to be released on Feb 29 and the third estimate on Mar 29 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/national/index.htm#personal), which is analyzed in this blog as soon as available. The next report will be released at 8:30 AM on Jan 30, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog. The report for February will be released on Feb 3, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jan 25 and the second row “Nov PR” the projection of the Nov meeting. There are three major changes in the view.

1. Growth “GDP ∆.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun to 2.5 to 2.9 percent in Nov and now to 2.2 to 2.7 percent at the Jan 25 meeting.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun to 8.5 to 8.7 percent in Nov but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun to virtually the same of 1.4 to 2.0 percent in Nov but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun of 1.4 to 2.0 percent and the Nov projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting.

Table II-1, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, January 2012 and November 2011

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012  Nov PR	2.2 to 2.7 2.5 to 2.9	8.2 to 8.5 8.5 to 8.7	1.4 to 1.8 1.4 to 2.0	1.5 to 1.8 1.5 to 2.0
2013  Nov PR	2.8 to 3.2 3.0 to 3.5	7.4 to 8.1 7.8 to 8.2	1.4 to 2.0 1.5 to 2.0	1.5 to 2.0 1.4 to 1.9
2014  Nov PR	3.3 to 4.0 3.0 to 3.9	6.7 to 7.6 6.8 to 7.7	1.6 to 2.0 1.5 to 2.0	1.6 to 2.0 1.5 to 2.0
Longer Run	2.3 to 2.6 2.4 to 2.7	5.2 to 6.0 5.2 to 6.0	2.0 1.7 to 2.0
Range
2012 Nov PR	2.1 to 3.0 2.3 to 3.5	7.8 to 8.6 8.1 to 8.9	1.3 to 2.5 1.4 to 2.8	1.3 to 2.0 1.3 to 2.1
2013 Nov PR	2.4 to 3.8 2.7 to 4.0	7.0 to 8.2 7.5 to 8.4	1.4 to 2.3 1.4 to 2.5	1.4 to 2.0 1.4 to 2.1
2014 Nov PR	2.8 to 4.3 2.7 to 4.5	6.3 to 7.7 6.5 to 8.0	1.5 to 2.1 1.5 to 2.4	1.4 to 2.0 1.4 to 2.2
Longer Run	2.2 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.0	2.0 1.5 to 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):

“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary.  However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; 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). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table II-2 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. The table is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). There are 14 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 11 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and two participants expecting rates from 1 to 1.5 percent but only 4 with rates exceeding 2.5 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.

Table II-2, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

	0 to 0.25	0.5 to 1.0	1.0 to 1.5	1.75 to 2.0	2.5 to 2.75	3.75 to 4.5
2012	14	1	2
2013	11	4		2
2014	6	5	2		4
Longer Run						17

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Additional information is provided in Table II-3 with the number of participants expecting increasing interest rates in the years from 2012 to 2016. It is evident from Table II-3 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table II-1.

Table II-3, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2012	3
2013	3
2014	5
2015	4
2016	2

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

An intriguing question by a member of the press at the meeting of release of projections and views of fed funds rates on Jan 25, 2012, was why the FOMC does not use immediately all of its resources to prevent economic conditions as weak as those expected to prevail in 2014. A partial answer is that the FOMC has already deployed massive doses of policy. Lack of further improvement could illustrate limitations of monetary policy as well as the lack of complementary policies such as fiscal stimulus. There are other approaches of generating incentives for private initiative that could promote consumption, investment, growth and employment.

An old advice of business economists recommends: “Do not forecast but if you must forecast then forecast often.” The FOMC actually forecasts infrequently or at least reveals forecasts that are revised with long lags. Indicators followed by the comments in this blog do show strengthening growth from 0.8 percent at annual equivalent for the first half of 2011 to 1.1 percent for the first three quarters of 2011 and now 1.6 percent cumulative for 2011 as a whole. Recent recovery has been driven by decline in the savings rate from 5.2 percent in IVQ2010 to 3.7 percent in IVQ2011 while real disposable income has fallen 0.1 percent. Labor markets continue to be fractured with unemployment or underemployment of 29.6 million, weak hiring and falling real wages. Inflation has been moving on waves with fluctuations in more recent months relative to moderation in May-Jul (http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states.html). The translation of current trends or appearance of trends into forecasts with statistical predictive value is very difficult or nearly impossible. FOMC policy in the statement is to increase economic growth to reduce the rate of unemployment in accordance with its statutory dual mandate (http://www.federalreserve.gov/aboutthefed/mission.htm):

“The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

Today, the Federal Reserve's duties fall into four general areas:

· 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

· supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers

· maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

· providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system”

The key phrase in this mission is: “influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”

The Board of Governors of the Federal Reserve and the Federal Reserve Banks has competence at the frontiers of knowledge to develop optimum projections based on the state of the art. The need for projections originates in the belief in lags in effect of monetary policy based on technical research (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Innovative research by Romer and Romer (2004, 1081) concludes:

“Estimates of the effects of policy using the new shock series indicates that monetary policy has large and statistically significant effects on real output. In our baseline specification, a shock of one percentage point starts to reduce industrial production after five months, with a maximum fall of 4.3 percent after two years. The peak effect is highly statistically significant. For prices, we find that the one-percentage point shock has little effect for almost two years, but then lowers the inflation rate by 2 to 3 percentage points. As a result, the price level is about 6 percent lower after four years. This estimate is overwhelmingly significant. The most important uncertainty concerns the lag in the impact of policy on prices: in some specifications, the price level begins falling within six months after the policy shock, while in others it is unchanged for as much as 22 months.”

In short, a monetary policy impulse implemented currently has effects in the future. Thus, monetary policy has to anticipate economic conditions in the future to determine doses and timing of policy impulses. Policy is actually based on “projections” such as those in Table II-1 (on central banking see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 69-90, Regulation of Banks of Finance (2009b), 99-116). Bernanke (2003, 9) and Bernanke and Mishkin (1997, 106) characterize “inflation targeting” as “constrained discretion.” The constrained part means that the central bank is under the constraint of maintaining inflation at the desired level of 2.0 percent per year. The “discretion” part means that the central bank is concerned with maintaining output at the level that results in full employment. Central banks anchor inflation expectations at 2.0 percent by means of credible policy measures, that is, economic agents believe that central banks will take all required measures to prevent inflation from deviating from the goal of 2.0 percent. That credibility was lost during the stagflation of the 1960s and 1970s, which was an episode known as the Great Inflation and Unemployment (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011_05_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation). A more general and practical approach is analyzed by Svensson (2003, 429) in which central banks consider specific objectives, target levels, available information and “judgment.” Svensson (2003, 466) finds that actual practice consists of targeting forecasts of inflation. In fact, central banks also target output gaps. Policy is designed to attain the inflation forecast on the basis of existing technical knowledge, empirical information and judgment with minimization of the changes in the output gap. There is as much imprecision and resulting uncertainty in this process as in managing risk exposures by finance professionals on the basis of risk management techniques, existing information and “market sentiment.” In fact, Greenspan (2004, 36-7) has compared central banking to financial risk management (see Pelaez and Pelaez, The Global Recession Risk (2007), 212-14):

“The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision making.”

Monetary policy is not superior in technique to “proprietary trading” by financial institutions but may actually be more difficult in implementation because of the complexity of knowledge of the entire economy with all of its institutions, including those engaged in trading. Traders can constantly observe changes in conditions that allow them to reverse risk exposures immediately or use loss limit rules. Traders also work in structures with tight chain of command. Rogue traders do cause major problems but infrequently. In contrast, central banks cannot reverse instantaneously the effects of policies because of the long and uncertain lags in effects of monetary policy. Central banks act in delegation of duties by the principals in Congress and the administration who also act in delegation of the ultimate principal consisting of electors. There is long delay in action of the electors in correcting policy errors.

It is instructive to consider the latest available full transcript of the meeting of the Federal Open Market Committee (FOMC) on Dec 2006 (FOMC 2006Dec12 at http://www.federalreserve.gov/monetarypolicy/files/FOMC20061212meeting.pdf). There was no anticipation of the global recession beginning in IVQ2007 with cumulative decline of output of 5.2 percent by IIQ2009 and legacy of 29 million people unemployed or underemployed but rather an optimistic assessment of the economy. The Vice Chairman of the FOMC Timothy Geithner outlined the forecast of the Federal Reserve Bank of New York that he presided (Ibid 56, 57 http://www.federalreserve.gov/monetarypolicy/files/FOMC20061212meeting.pdf):

“Our forecast hasn’t changed much since the last meeting. We still expect growth to move back to potential in the first half of next year and to stay in the vicinity of potential, which we think is around 3 percent, over the forecast period. The risks to the forecast may have shifted somewhat in the direction of less upside risk to inflation and more downside risk to growth. But to us, the current weakness in the economy still seems principally to stem from the direct effects of the slowdown in housing on construction activity and related parts of the manufacturing sector as well as from the reduction in automobile and auto-related production. As things now stand, the softer-than-expected recent numbers don’t argue, in our view, for a substantial reassessment of the risks in the outlook. Surveys of business sentiment outside the manufacturing sector still seem consistent with reasonable growth going forward. A slowdown of investment in equipment and software doesn’t seem to be particularly troubling to us at this point. Consumer spending seems to be growing at a fairly good pace. Employment growth, of course, is still quite solid, and growth outside the United States still looks pretty good.”

The Chairman of the Board of Governors of the Federal Reserve and of the FOMC Ben S. Bernanke expressed the following view of the economy (Ibid 79 http://www.federalreserve.gov/monetarypolicy/files/FOMC20061212meeting.pdf):

“Looking forward, again to compliment the staff, I think most people around the table accepted the general contour of the Greenbook forecast—that is, moderate growth perhaps below potential for the next few quarters but returning to potential growth later next year, with risks to the upside as well as to the downside. So far there is little evidence of spillover into consumption in particular, although obviously we have to keep an eye on that. There are a number of strong underlying conditions, including supportive financial conditions, strong profits, and a strong international economy, which are providing a cushion to the economy. At the same time, like many members of the Committee, I see a very strong labor market and a very strong services sector plus a very strong nonmanufacturing ISM, which, though it includes construction, was nevertheless still very strong. One begins to wonder a bit about the measurement of the services sector—whether or not we are understating growth and productivity in that sector. That’s a question we’ll need to continue to consider. So like most people around the table, I think that a soft landing with growth a bit below potential in the short run looks like the most likely scenario. I expect the unemployment rate to increase gradually but income growth and other factors to be sufficient to keep consumption above 2 percent, which is essentially what we need to keep the economy growing. Again, I see the risks going in both directions. A couple of other factors are like that, which I just would like to bring to your attention. One has to do with the very strong presumption we seem to have now that demand for housing has stabilized. That may be the case, but I would point out that we have seen a very sharp decline in mortgage rates. People may have a sort of mean-reverting model of mortgage rates in their minds. It could be they are looking at this as an opportunity to jump in and buy while the financial conditions are favorable. So even if rates stay low, we face some risk of a decline in demand. The counter argument to that, which I should bring up, is that if people thought that prices were going to fall much more, then they would be very reluctant to buy. That’s evidence for stabilization of demand. Another point to make about housing is that, even when starts stabilize, there are going to be ongoing effects on GDP and employment. On the GDP side, it takes about six months on average to complete residential structures. Therefore, even when starts stabilize, we’re going to continue to see declines in the contribution of residential construction to GDP.”

IIB Repression of Savings. McKinnon (1973) and Shaw (1974) argue that legal restrictions on financial institutions can be detrimental to economic development. “Financial repression” is the term used in the economic literature for these restrictions (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). Interest rate ceilings on deposits and loans have been commonly used. Prohibition of payment of interest on demand deposits and ceilings on interest rates on time deposits were imposed by the Banking Act of 1933. These measures were justified by arguments that the banking panic of the 1930s was caused by competitive rates on bank deposits that led banks to engage in high-risk loans (Friedman, 1970, 18; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 74-5). The objective of policy was to prevent unsound loans in banks. Savings and loan institutions complained of unfair competition from commercial banks that led to continuing controls with the objective of directing savings toward residential construction. Friedman (1970, 15) argues that controls were passive during periods when rates implied on demand deposit were zero or lower and when Regulation Q ceilings on time deposits were above market rates on time deposits. The Great Inflation or stagflation of the 1960s and 1970s changed the relevance of Regulation Q.

Most regulatory actions trigger compensatory measures by the private sector that result in outcomes that are different from those intended by regulation (Kydland and Prescott 1977). Banks offered services to their customers and loans at rates lower than market rates to compensate for the prohibition to pay interest on demand deposits (Friedman 1970, 24). The prohibition of interest on demand deposits was eventually lifted in recent times. In the second half of the 1960s, already in the beginning of the Great Inflation (DeLong 1997), market rates rose above the ceilings of Regulation Q because of higher inflation. Nobody desires savings allocated to time or savings deposits that pay less than expected inflation. This is a fact currently with zero interest rates and consumer price inflation of 3.0 percent in the 12 months ending in Dec (http://www.bls.gov/cpi/). Funding problems motivated compensatory measures by banks. Money-center banks invented the large certificate of deposit (CD) to accommodate increasing volumes of loan demand by customers. As Friedman (1970, 25) finds:

“Large negotiable CD’s were particularly hard hit by the interest rate ceiling because they are deposits of financially sophisticated individuals and institutions who have many alternatives. As already noted, they declined from a peak of $24 billion in mid-December, 1968, to less than $12 billion in early October, 1969.”

Banks created different liabilities to compensate for the decline in CDs. As Friedman (1970, 25; 1969) explains:

“The most important single replacement was almost surely ‘liabilities of US banks to foreign branches.’ Prevented from paying a market interest rate on liabilities of home offices in the United States (except to foreign official institutions that are exempt from Regulation Q), the major US banks discovered that they could do so by using the Euro-dollar market. Their European branches could accept time deposits, either on book account or as negotiable CD’s at whatever rate was required to attract them and match them on the asset side of their balance sheet with ‘due from head office.’ The head office could substitute the liability ‘due to foreign branches’ for the liability ‘due on CDs.”

Friedman (1970, 26-7) predicted the future:

“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.”

In short, Depression regulation exported the US financial system to London and offshore centers. What is vividly relevant currently from this experience is the argument by Friedman (1970, 27) that the controls affected the most people with lower incomes and wealth who were forced into accepting controlled-rates on their savings that were lower than those that would be obtained under freer markets. As Friedman (1970, 27) argues:

“These are the people who have the fewest alternative ways to invest their limited assets and are least sophisticated about the alternatives.”

Chart II-1 of the Bureau of Economic Analysis (BEA) of the US Department of Commerce provides percentage changes in a quarter relative to the same quarter a year earlier of real disposable income (personal income less taxes adjusted for inflation) from 1980 to 2011. Real disposable income recovered sharply from the contraction in 2008 but has fallen sharply until becoming negative again in IVQ2011.

Chart II-I, US, Percentage Change of Real Disposable Income in a Quarter Relative to the Same Quarter a Year Earlier

Source: Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart II-2 of the Bureau of Economic Analysis (BEA) provides quarterly savings as percent of disposable income or the US savings rate from 1980 to 2011. There was a long-term downward sloping trend from 12 percent in the early 1980s to less than 2 percent in 2005-2006. The savings rate then rose during the contraction and also in the expansion. In 2011 the savings rate declined as consumption is financed with savings in part because of the disincentive or frustration of receiving a few pennies for every $10,000 of deposits in a bank. The objective of monetary policy is to reduce borrowing rates to induce consumption but it has collateral disincentive of reducing savings. The zero interest rate of monetary policy is a tax on saving. This tax is highly regressive, meaning that it affects the most people with lower income or wealth and retirees. The long-term decline of savings rates in the US has created a dependence on foreign savings to finance the deficits in the federal budget and the balance of payments.

Chart II-2, US, Savings as Percentage of Disposable Personal Income

Source: Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment; and (3) the outcome of the sovereign debt crisis in Europe. This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. There are various appendixes at the end of this section for convenience of reference of material related to the euro area debt crisis. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank. Appendix IIID Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis.

IIIA Financial Risks. The past half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr Jan 20 and daily values throughout the week ending on Fri Jan 27 of several financial assets. Section VII Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Jan 20 and the percentage change in that prior week below the label of the financial risk asset. The first five asset rows provide five 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. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. The most important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact.

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.293/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 20, depreciating to USD 1.3029/EUR on Mon Jan 23, or by 0.8 percent. The dollar depreciated because more dollars, $1.3029, were required on Jan 23 to buy one euro than $1.293 on Jan 20. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3029/EUR on Jan 23; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Jan 20, to the last business day of the current week, in this case Fri Jan 27, such as depreciation by 2.2 percent to USD 1.322/EUR by Jan 27; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (negative sign) by 2.2 percent from the rate of USD 1.293/EUR on Fri Jan 20 to the rate of USD 1.322/EUR on Fri Jan 27 {[(1.322/1.293) – 1]100 = 2.2% and depreciated by 0.9 percent from the rate of USD 1.3102 on Thu Jan 26 to USD 1.322/EUR on Fri Jan 27 {[(1.322/1.3102) -1]100 = 0.9%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets.

III-I, Weekly Financial Risk Assets Jan 23 to Jan 27, 2012

Fri Jan 20, 2012	Mon 23	Tue 24	Wed 25	Thu 26	Fr 27
USD/EUR 1.293 -2.0%	1.3029 -0.8% -0.8%	1.3025 -0.7% 0.0%	1.3108 -1.4% -0.6%	1.3102 -1.3% 0.0%	1.322 -2.2% -0.9%
JPY/  USD 76.9563 0.0%	76.9770 0.0% 0.0%	77.721 -1.0% -1.0%	77.7265 -1.0% 0.0%	77.4342 -0.6% 0.4%	76.68 0.4% 1.0%
CHF/  USD 0.9341 2.2%	0.9270 0.8% 0.8%	0.9284 0.6% -0.2%	0.9217 1.3% 0.7%	0.9207 1.4% 0.1%	0.919 1.6% 0.2%
CHF/ EUR 1.2083 -0.1%	1.2078 0.0% 0.0%	1.2092 -0.1% -0.1%	1.2081 0.0% 0.1%	1.2064 0.1% 0.1%	1.2064 0.1% 0.0%
USD/  AUD 1.048 0.9542 1.5%	1.0534 0.9493 0.5% 0.5%	1.0476 0.9546 0.0% -0.6%	1.0598 0.9436 1.1% 1.1%	1.0619 0.9417 1.3% 0.2%	1.066 0.9381 1.7% 0.4%
10 Year  T Note 2.026	2.06	2.05	2.00	1.94	1.893
2 Year     Note 0.242	0.24	0.23	0.22	0.21	0.215
German Bond 2Y 0.21 10Y 1.93	2Y 0.20 10Y 1.97	2Y 0.22 10Y 1.99	2Y 0.19 10Y 1.94	2Y 0.18 10Y 1.87	2Y 0.19 10Y 1.86
DJIA 12720.48 2.4%	12708.82 -0.1% -0.1%	12675.75 -0.4% -0.3%	12758.85 0.3% 0.7%	12734.63 0.1% -0.2%	12660.46 -0.5% -0.6%
DJ Global 1908.00 3.6%	1917.16 0.5% 0.5%	1906.84 -0.1% -0.5%	1914.27 0.3% 0.4%	1930.53 1.2% 0.9%	1928.27 1.1% -0.1%
DJ Asia Pacific 1231.88 3.1%	1235.07 0.3% 0.3%	1230.43 -0.1 -0.4%	1237.98 0.5% 0.6%	1250.25 1.5% 1.0%	1255.99 1.9% 0.5%
Nikkei 8766.36 3.1%	8765.90 0.0% 0.0%	8785.33 0.2% 0.2%	8883.69 1.3% 1.1%	8849.47 0.9% -0.4%	8841.22 0.9% -0.1%
Shanghai 2319.12 3.3%	2319.12 closed 1.0%	2319.12 closed 1.0%	2319.12 closed 1.0%	2319.12 closed 1.0%	2319.12 closed 1.0%
DAX 6404.39 4.3%	6436.62 0.5% 0.5%	6419.22 0.2% -0.3%	6421.85 0.3% 0.0%	6539.85 2.1% 1.8%	6511.98 1.7% -0.4%
DJ UBS Comm. 141.24 0.5%	143.5 1.6%	143.99 1.9% 0.3%	145.60 3.1% 1.1%	146.25 3.5% 0.4%	146.62 3.8% 0.3%
WTI $ B 98.46 -0.8%	99.82 1.4% 1.4%	99.16 0.7% -0.7%	99.79 1.3% 0.6%	99.89 1.4% 0.1%	99.56 1.1% -0.3%
Brent    $/B 110.21 -0.8%	110.84 0.6% 0.6%	110.28 0.1% -0.5%	110.47 0.2% 0.2%	111.08 0.8% 0.6%	111.51 1.2% 0.4%
Gold  $/OZ 1666.5 1.6%	1677.5 0.7% 0.7%	1665.3 -0.1% -0.7%	1714.3 2.9% 2.9%	1724.7 3.5% 0.6%	1740.9 4.5% 0.9%

Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss

Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce

Sources: http://www.bloomberg.com/markets/

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

Table III-1 shows mixed results in valuations of risk financial assets in the week of Jan 23-27. Risk aversion returned in earlier weeks because of the uncertainties on rapidly moving political development in Greece, Italy, Spain and perhaps even in France and Germany. Most currency movements in Table III-1 reflect alternating bouts of risk aversion because of continuing doubts on the success of the new agreement on Europe reached in the week of Dec 9. Risk aversion is observed in foreign exchange markets with daily trading of $4 trillion. The dollar had fluctuated in a tight range with hardly any changes but depreciated after advanced guidance by the Federal Open Market Committee (FOMC) that fed funds rates may remain at 0 to ¼ percent until the latter part of 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). The JPY depreciated initially during the week but ended 0.4 percent stronger. IIIB Appendix on Safe Haven Currencies analyzes the burden on the Japanese economy of yen appreciation. The Swiss franc appreciated 1.6 percent relative to the dollar, in response to the advanced guidance of permanently low fed funds rates, and appreciated 0.1 percent relative to the euro. The Australian dollar appreciated to USD 1.066/AUD on Jan 27 for cumulative appreciated of 1.7 percent relative to USD 1.048/AUD on Jan 20.

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing aversion is captured by decrease of the yield of the 10-year Treasury note from 2.326 percent on Oct 28 to 1.964 percent on Fri Nov 25, 2.065 on Dec 9 and collapse to 1.847 percent by Fr Dec 16. The yield of the 10-year Treasury rose from 1.81 percent on Mon Dec 19 to 2.027 percent on Fri Dec 23, falling to 1.871 percent on Fri Dec 30 and increasing to 1.957 percent on Jan 6 but falling again to 1.869 on Jan 13. More relaxed risk aversion is shown in the increase of the yield of the 10-year Treasury to 2.026 percent on Fri Jan 20 but renewed aversion with decline to 1.893 percent on Jan 27, as shown in Table III-1. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.0 percent in the 12 months ending in Dec (http://www.bls.gov/cpi/ http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with stable low yield of 0.226 percent on Dec 16 but rising to 0.28 percent on Dec 23 and then falling to 0.239 percent on Fri Dec 30, increasing to 0.256 on Fri Jan 6 but falling to 0.225 on Jan 13. The yield of the two-year Treasury rose to 0.242 percent on Fri Jan 20 in an environment of more relaxed risk aversion but fell to 0.215 on Fri Jan 27 in another shock of aversion, as shown in Table III-1. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities.

A similar risk aversion phenomenon occurred in Germany. The estimate of euro zone CPI inflation is at 2.7 percent for the 12 months ending in Dec (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17012012-AP/EN/2-17012012-AP-EN.PDF) but the yield of the two-year German government bond fell from 0.32 percent on Dec 9 to 0.22 percent on Dec 16, virtually equal to the yield of the two-year Treasury note of the US and settled at 0.23 percent on Fri Dec 23, collapsing to 0.14 percent on Fri Dec 30 and rising to 0.17 percent on Jan 6 and 0.15 percent on Jan 13. The yield of the two-year government bond of Germany increased to 0.21 percent in an environment of marginally more relaxed risk aversion on Jan 20 but fell to 0.19 percent on Jan 27, as shown in Table III-1. The yield of the ten-year German government bond has also collapsed from 2.15 percent on Dec 9 to 1.85 percent on Dec 16, rising to 1.96 percent on Dec 23, falling to 1.83 percent on Dec 30, which was virtually equal to the yield of 1.871 percent of the US ten-year Treasury note. The ten-year government bond of Germany traded at 1.85 percent on Jan 6 and at 1.77 percent on Jan 13, increasing to 1.93 percent on Jan 20 but falling to 1.86 percent on Jan 27, as shown in Table III-1. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds.

There was strong performance of equity indexes in Table III-1 during the week of Jan 27. Germany’s Dax rose 4.3 percent. DJIA gained 1.7 percent in the week of Fri Jan 27. Dow Global increased 1.1 percent in the week of Jan 27. Japan’s Nikkei Average increased 0.9 percent. Dow Asia Pacific rose 1.9 percent. The DJIA fell 0.6 percent on Fri Jan 27, causing decline of 0.5 percent in the week as financial markets analyzed weakness in the GDP report.

Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities were strong in the week of Jan 27. The DJ UBS Commodities Index increased 3.8 percent. WTI gained 1.1 percent and Brent also increased 1.2 percent. Gold gained 4.5 percent.

Improving equity markets and strength of the euro appear related to developments in sovereign debt negotiations and markets. Alkman Granitsas and Costas Paris, writing on Jan 29, 2012, on “Greek debt deal, new loan agreement to finish next week,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204573704577189021923288392.html?mod=WSJPRO_hpp_LEFTTopStories), inform that Greece and its private creditors were near finishing a deal of writing off €100 billion, about $132 billion, of Greece’s debt depending on the conversations between Greece, the euro area and the IMF on the new bailout. An agreement had been reached in Oct 2011 for a new package of fresh money in the amount of €130 billion to fill needs through 2015 but was contingent on haircuts reducing Greece’s debt from 160 percent of GDP to 120 percent of GDP. The new bailout would be required to prevent default by Greece of €14.4 billion maturing on Mar 20, 2012. There has been increasing improvement of sovereign bond yields. Italy’s ten-year bond yield fell from over 6.30 percent on Jan 20, 2012 to slightly above 5.90 percent on Jan 27. Spain’s ten-year bond yield fell from slightly above 5.50 percent on Jan 20 to just below 5 percent on Jan 27.

An important difference, according to Beim (2011Oct9), between large-scale buying of bonds by the central bank between the Federal Reserve of the US and the European Central Bank (ECB) is that the Fed and most banks do not buy local and state government obligations with lower creditworthiness. The European Monetary Union (EMU) that created the euro and the ECB did not include common fiscal policy and affairs. Thus, EMU cannot issue its own treasury obligations. The line “Reserve bank credit” in the Fed balance sheet for Jan 25, 2012, is $2902 billion of which $2570 billion consisting of $1565 billion US Treasury notes and bonds, $68 billion inflation-indexed bonds and notes, $101 billion Federal agency debt securities and $836 billion mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed has been careful in avoiding credit risk in its portfolio of securities. The 11 exceptional liquidity facilities of several trillion dollars created during the financial crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62) have not resulted in any losses. The Fed has used unconventional monetary policy without credit risk as in classical central banking.

Beim (2011Oct9, 6) argues:

“In short, the ECB system holds more than €1 trillion of debt of the banks and governments of the 17 member states. The state-by-state composition of this debt is not disclosed, but the events of the past year suggest that a disproportionate fraction of these assets are likely obligations of stressed countries. If a significant fraction of the €1 trillion were to be restructured at 40-60% discounts, the ECB would have a massive problem: who would bail out the ECB?

This is surely why the ECB has been so shrill in its antagonism to the slightest mention of default and restructuring. They need to maintain the illusion of risk-free sovereign debt because confidence in the euro itself is built upon it.”

Table III-2 provides the consolidated financial statement of the Eurosystem on Dec 31, 2010 and Dec 28, 2011. Memo items provide the sum of lines 5, “lending to euro area credit institutions related to monetary policy operations denominated in euro,” and 7, “securities of euro area residents denominated in euro,” which has increased from €1,004,174 million on Dec 31, 2010 to €1,489,759 million on Dec 28, 2011. This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF. There is a recurring issue of whether the ECB should accept a haircut on its portfolio of Greek bonds of €40 billion acquired at discounts from face value. An article on “Haircut for the ECB? Not so fast,” published by the Wall Street Journal on Jan 28, 2012 (http://blogs.wsj.com/davos/2012/01/28/haircut-for-the-ecb-not-so-fast/), informs of the remarks by Mark Carney, Governor of the Bank of Canada and President of the Financial Stability Board (FSB) (http://www.financialstabilityboard.org/about/overview.htm), expressing what appears to be correct doctrine that there could conceivably be haircuts for official debt but that such a decision should be taken by governments and not by central banks.

Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011
1 Gold and other Receivables	367,402	419,822
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629
8 General Government Debt Denominated in Euro	34,954	33,928
9 Other Assets	278,719	336,574
TOTAL ASSETS	2,004, 432	2,733,235
Memo Items
Sum of 5 and  7	1,004,174	1,489,759
Capital and Reserves	78,143	81,481

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common currency prevents Italy from devaluation to parity or the exchange rate that would permit export growth to promote internal economic activity that generates fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 43.6 percent of the total. Exports to non-European Union area are growing at 15.2 percent in the 12 months ending in Nov while those to EMU are growing at 9.6 percent.

Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12 Months ∆%

	Exports % Share	∆% Jan-Nov 2011/ Jan-Nov 2010	Imports % Share	Imports ∆% Jan-Nov 2011/ Jan-Nov 2010
EU	57.3	9.5	54.8	6.9
EMU 17	43.6	9.6	44.6	6.4
France	11.6	11.9	8.8	4.2
Germany	13.0	13.2	16.1	6.4
Spain	5.8	2.3	4.6	8.1
UK	5.2	-1.0	2.7	9.4
Non EU	42.7	15.2	45.2	15.1
Europe non EU	12.0	24.4	10.3	20.2
USA	6.0	11.9	3.0	18.5
China	2.6	16.5	7.8	5.3
OPEC	5.3	-1.3	9.5	-0.4
Total	100.0	11.9	100.0	10.6

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Source: http://www.istat.it/it/archivio/50960

Growth rates of Italy’s trade and major products are provided in Table III-4 for the period Jan-Nov 2011 relative to Jan-Nov 2010. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 6.4 percent. Capital goods exports increased 11.1 percent relative to a year earlier and intermediate products by 14.4 percent.

Table III-4, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Jan-Nov 2011/ Jan-Nov 2010	Imports Share %	Imports ∆% Jan-Nov 2011/ Jan-Nov 2010
Consumer Goods	29.5	9.4	25.3	8.0
Durable	6.3	4.7	3.5	-6.4
Non Durable	23.2	10.6	21.8	10.3
Capital Goods	32.4	11.1	22.4	1.3
Inter- mediate Goods	33.5	14.4	33.9	13.9
Energy	4.6	16.1	18.4	19.6
Total ex Energy	95.4	11.7	81.6	8.6
Total	100.0	11.9	100.0	10.6

Source: http://www.istat.it/it/archivio/50960

Table III-5 provides Italy’s trade balance by product categories in Nov and Jan-Nov 2011. Italy’s trade balance excluding energy is a surplus of €30,523 in Jan-Nov 2011 but the energy trade balance is a deficit of €56,301 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.

Table III-5, Italy, Trade Balance by Product Categories, € Millions

	Nov 2011	Jan-Nov 2011
Consumer Goods	877	7,361
Durable	876	9,256
Nondurable	1	-1,896
Capital Goods	3,075	33,579
Intermediate Goods	78	-10,417
Energy	-5,610	-56,301
Total ex Energy	4,030	30,523
Total	-1,581	-25,778

Source: http://www.istat.it/it/archivio/50960

Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.

IIIB Appendix on Safe Haven Currencies. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation but also remained relatively unchanged. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.

1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent. The pain of Japan from dollar devaluation continues as illustrated by Table VI-6 in Section VII Valuation of Risk Financial Assets: The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 78.08/USD on Dec 23, 2011, for cumulative appreciation of 29.1 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Dec 23, 2011 (JPY 78.08) was 6.0 percent.

2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.

There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. The JPY was virtually unchanged in the week of Dec 16 with depreciation of 0.1 percent but depreciated by 0.5 percent in the week of Dec 23, appreciating by 1.5 percent in the week of Dec 30. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:

· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.

· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”

Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc remained unchanged relative to the USD in the week of Dec 23 and appreciated 0.2 percent in the week of Dec 30 relative to the USD and 0.5 percent relative to the euro, as shown in Table II-1. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.5 percent in the week of Fr Dec 16 after no change in the week of Dec 9. In the week of Dec 23, the Australian dollar appreciated 1.9 percent, appreciating another 0.5 percent in the week of Dec 30 as shown in Table II-1. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).

IIIC Appendix on Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.

1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.

i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with adjustment of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.

ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.

2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.

i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.

ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in Mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Matthew Dalton and Matina Stevis, writing on Dec 20, 2011, on “Euro Zone Agrees to New IMF Loans,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204791104577107974167166272.html?mod=WSJPRO_hps_MIDDLESecondNews), inform that at a meeting on Dec 20, finance ministers of the euro-zone developed plans to contribute €150 billion in bilateral loans to the IMF as provided in the agreement of Dec 9. Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).

3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.

IIID Appendix on European Central Bank Large Scale Lender of Last Resort. European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”

An important statement of Draghi (2011Dec15) focuses on the role of central banking: “You all know that the statutes of the ECB inherited this important principle and that central bank independence and the credible pursuit of price stability go hand in hand.”

Draghi (2011Dec19) explains measures to ensure “access to funding markets” by euro zone banks:

§ “We have decided on three-year refinancing operations to support the supply of credit to the euro area economy. These measures address the risk that persistent financial markets tensions could affect the capacity of euro area banks to obtain refinancing over longer horizons.

§ Earlier, in October, the Governing Council had already decided to have two more refinancing operations with a maturity of around one year.

§ Also, it was announced then that in all refinancing operations until at least the first half of 2012 all liquidity demand by banks would be fully allotted at fixed rate.

§ Funding via the covered bonds market was also facilitated by the ECB deciding in October to introduce a new Covered Bond Purchase Programme of €40 billion.

§ Funding in US dollar is facilitated by lowering the pricing on the temporary US dollar liquidity swap arrangements.”

Lionel Barber and Ralph Atkins interviewed Mario Draghi on Dec 14 with the transcript published in the Financial Times on Dec 18 (http://www.ft.com/intl/cms/s/0/25d553ec-2972-11e1-a066-00144feabdc0.html#axzz1gzoHXOj6) as “FT interview transcript: Mario Draghi.” A critical question in the interview is if the new measures are a European version of quantitative easing. Draghi analyzes the difference between the measures of the European Central Bank (ECB) and quantitative easing such as in Japan, US and UK:

1. The measures are termed “non-standard” instead of “unconventional.” While quantitative easing attempts to lower the yield of targeted maturities, the three-year facility operates through the “bank channel.” Quantitative easing would not be feasible because the ECB is statutorily prohibited of funding central governments. The ECB would comply with its mandate of medium-term price stability.

2. There is a critical difference in the two programs. Quantitative easing has been used as a form of financial repression known as “directed lending.” For example, the purchase of mortgage-backed securities more recently or the suspension of the auctions of 30-year bonds in response to the contraction early in the 2000s has the clear objective of directing spending to housing. The ECB gives the banks entire discretion on how to use the funding within their risk/return decisions, which could include purchase of government bonds.

The question on the similarity of the ECB three-year lending facility and quantitative easing is quite valid. Tracy Alloway, writing on Oct 10, 2011, on “Investors worry over cheap ECB money side effects,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d2f87d16-f339-11e0-8383-00144feab49a.html#axzz1hAqMH1vn), analyzes the use of earlier long-term refinancing operations (LTRO) of the ECB. LTROs by the ECB in Jun, Sep and Dec 2009 lent €614 billion at 1 percent. Alloway quotes estimates of Deutsche Bank that banks used €442billion to acquire assets with higher yields. Carry trades developed from LTRO funds at 1 percent into liquid investments at a higher yield to earn highly profitable spreads. Alloway quotes estimates of Morgan Stanley that European debt of GIIPS (Greece, Ireland, Italy, Portugal and Spain) in European bank balance sheets is €700 billion. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. Three such LTROs could add to $1.9 trillion, which is not far from the value of quantitative easing in the US of $2.5 trillion. Fairless and Cottle find that there could be renewed hopes that banks could use the LTROs to support euro zone bond markets. It is possible that there could be official moral suasion by governments on banks to increase their holdings of government bonds or at least not to sell existing holdings. Banks are not free to choose assets in evaluation of risk and returns. Floods of cheap money at 1 percent per year induce carry trades to high-risk assets and not necessarily financing of growth with borrowing and lending decisions constrained by shocks of confidence.

The LTROs of the ECB are not very different from the liquidity facilities of the Fed during the financial crisis. Kohn (2009Sep10) finds that the trillions of dollars in facilities provided by the Fed (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-64, Regulation of Banks and Finance (2009b), 224-7) could fall under normal principles of “lender of last resort” of central banks:

“The liquidity measures we took during the financial crisis, although unprecedented in their details, were generally consistent with Bagehot's principles and aimed at short-circuiting these feedback loops. The Federal Reserve lends only against collateral that meets specific quality requirements, and it applies haircuts where appropriate. Beyond the collateral, in many cases we also have recourse to the borrowing institution for repayment. In the case of the TALF, we are backstopped by the Treasury. In addition, the terms and conditions of most of our facilities are designed to be unattractive under normal market conditions, thus preserving borrowers' incentives to obtain funds in the market when markets are operating normally. Apart from a very small number of exceptions involving systemically important institutions, such features have limited the extent to which the Federal Reserve has taken on credit risk, and the overall credit risk involved in our lending during the crisis has been small.

In Ricardo's view, if the collateral had really been good, private institutions would have lent against it. However, as has been recognized since Bagehot, private lenders, acting to protect themselves, typically severely curtail lending during a financial crisis, irrespective of the quality of the available collateral. The central bank--because it is not liquidity constrained and has the infrastructure in place to make loans against a variety of collateral--is well positioned to make those loans in the interest of financial stability, and can make them without taking on significant credit risk, as long as its lending is secured by sound collateral. A key function of the central bank is to lend in such circumstances to contain the crisis and mitigate its effects on the economy.”

The Bagehot (1873) principle is that central banks should provide a safety net, lending to temporarily illiquid but solvent banks and not to insolvent banks (see Cline 2001, 2002; Pelaez and Pelaez, International Financial Architecture (2005), 175-8). Kohn (2009Apr18) characterizes “quantitative easing” as “large scale purchases of assets:”

“Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt. We initially announced our intention to undertake large-scale asset purchases last November, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. These purchases are intended to reduce intermediate- and longer-term interest rates on mortgages and other credit to households and businesses; those rates influence decisions about investments in long-lived assets like houses, consumer durable goods, and business capital. In ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. However, the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates. These preferences are likely to be especially strong in current circumstances, so that long-term asset prices rise and yields fall as the Federal Reserve acquires a significant portion of the outstanding stock of securities held by the public.”

Non-standard ECB policy and unconventional Fed policy have a common link in the scale of implementation or policy doses. Direct lending by the central bank to banks is the function “large scale lender of last resort.” If there is moral suasion by governments to coerce banks into increasing their holdings of government bonds, the correct term would be financial repression.

An important additional measure discussed by Draghi (2011Nov19) is relaxation on the collateral pledged by banks in LTROs:

“Some banks’ access to refinancing operations may be restricted by lack of eligible collateral. To overcome this, a temporary expansion of the list of collateral has been decided. Furthermore, the ECB intends to enhance the use of bank loans as collateral in Eurosystem operations. These measures should support bank lending, by increasing the amount of assets on euro area banks’ balance sheets that can be used to obtain central bank refinancing.”

There are collateral concerns about European banks. David Enrich and Sara Schaefer Muñoz, writing on Dec 28, on “European bank worry: collateral,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203899504577126430202451796.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the strain on bank funding from a squeeze in the availability of high-quality collateral as guarantee in funding. High-quality collateral includes government bonds and investment-grade non-government debt. There could be difficulties in funding for a bank without sufficient available high-quality collateral to offer in guarantee of loans. It is difficult to assess from bank balance sheets the availability of sufficient collateral to support bank funding requirements. There has been erosion in the quality of collateral as a result of the debt crisis and further erosion could occur. Perceptions of counterparty risk among financial institutions worsened the credit/dollar crisis of 2007 to 2009. The banking theory of Diamond and Rajan (2000, 2001a, 2001b) and the model of Diamond Dybvig (1983, 1986) provide the analysis of bank functions that explains the credit crisis of 2007 to 2008 (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7, 48-52, Regulation of Banks and Finance (2009b), 52-66, 217-24). In fact, Rajan (2005, 339-41) anticipated the role of low interest rates in causing a hunt for yields in multiple financial markets from hedge funds to emerging markets and that low interest rates foster illiquidity. Rajan (2005, 341) argued:

“The point, therefore, is that common factors such as low interest rates—potentially caused by accommodative monetary policy—can engender excessive tolerance for risk on both sides of financial transactions.”

A critical function of banks consists of providing transformation services that convert illiquid risky loans and investment that the bank monitors into immediate liquidity such as unmonitored demand deposits. Credit in financial markets consists of the transformation of asset-backed securities (SRP) constructed with monitoring by financial institutions into unmonitored immediate liquidity by sale and repurchase agreements (SRP). In the financial crisis financial institutions distrusted the quality of their own balance sheets and those of their counterparties in SRPs. The financing counterparty distrusted that the financed counterparty would not repurchase the assets pledged in the SRP that could collapse in value below the financing provided. A critical problem was the unwillingness of banks to lend to each other in unsecured short-term loans. Emse Bartha, writing on Dec 28, on “Deposits at ECB hit high,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577125913779446088.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that banks deposited €453.034 billion, or $589.72 billion, at the ECB on Dec 28, which is a record high in two consecutive days. The deposit facility is typically used by banks when they do prefer not to extend unsecured loans to other banks. In addition, banks borrowed €6.225 billion from the overnight facility on Dec 28, when in normal times only a few hundred million euro are borrowed. The collateral issues and the possible increase in counterparty risk occurred a week after large-scale lender of last resort by the ECB in the value of €489 billion in the prior week. The ECB may need to extend its lender of last resort operations.

The financial reform of the United States around the proposal of a national bank by Alexander Hamilton (1780) to develop the money economy with specialization away from the barter economy is credited with creating the financial system that brought prosperity over a long period (see Pelaez 2008). Continuing growth and prosperity together with sound financial management earned the US dollar the role as reserve currency and the AAA rating of its Treasury securities. McKinnon (2011Dec18) analyzes the resolution of the European debt crisis by comparison with the reform of Alexander Hamilton. Northern states of the US had financed the revolutionary war with the issue of paper notes that were at risk of default by 1890. Alexander Hamilton proposed the purchase of the states’ paper notes by the Federal government without haircuts. McKinnon (2011Dec18) describes the conflicts before passing the assumption bill in 1790 for federal absorption of the debts of states. Other elements in the Hamilton reform consisted of creation of a market for US Treasury bonds by their use as paid-in capital in the First Bank of the United States. McKinnon (2011Dec18) finds growth of intermediation in the US by the branching of the First Bank of the United States throughout several states, accepting deposits to provide commercial short-term credit. The reform consolidated the union of states, fiscal credibility for the union and financial intermediation required for growth. The reform also introduced low tariffs and an excise tax on whisky to service the interest on the federal debt. Trade relations among members of the euro zone are highly important to economic activity. There are two lessons drawn by McKinnon (2011Dec18) from the experience of Hamilton for the euro zone currently. (1) The reform of Hamilton included new taxes for the assumption of debts of states with concrete provisions for their credibility. (2) Commercial lending was consolidated with a trusted bank both for accepting private deposits and for commercial lending, creating the structure of financial intermediation required for growth.

IIIE Appendix Euro Zone Survival Risk. Markets have been dominated by rating actions of Standard & Poor’s Ratings Services (S&PRS) (2012Jan13) on 16 members of the European Monetary Union (EMU) or eurozone. The actions by S&PRS (2012Jan13) are of several types:

1. Downgrades by two notches of long-term credit ratings of Cyprus (from BBB/Watch/NegA-3+ to BB+/Neg/B), Italy (from A/Watch Neg/A-1 to BBB+/Neg/A-2), Portugal (from BBB-/Watch Neg/A-3 to BB/Neg/B) and Spain (from AA-/Watch Neg/A-1+ to A/Neg/A-1).

2. Downgrades by one notch of long-term credit ratings of Austria (from AAA/Watch Neg/A-1+ to AA+/Neg/A-1+), France (from AAA/Watch Neg/A-1+ to AA+/Neg A-1+), Malta (from A/Watch, Neg/A-1 to A-/Neg/A-2), Slovakia (from A+/Watch Neg/A-1 to A/Stable/A-1) and Slovenia (AA-/Watch Neg/A-1+ to A+/Neg/A-1).

3. Affirmation of long-term ratings of Belgium (AA/Neg/A-1+), Estonia (AA-/Neg/A-1+), Finland (AAA/Neg/A-1+), Germany (AAA/Stable/A-1+), Ireland (BBB+/Neg/A-2), Luxembourg (AAA/Neg/A-1+) and the Netherlands (AAA/Neg/A-1+) with removal from CreditWatch.

4. Negative outlook on the long-term credit ratings of Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain, meaning that S&PRS (2012Jan13) finds that the ratings of these sovereigns have a chance of at least 1-to-3 of downgrades in 2012 or 2013.

S&PRS (2012Jan13) finds that measures by European policymakers may not be sufficient to contain sovereign risks in the eurozone. The sources of stress according to S&PRS (2012Jan13) are:

1. Worsening credit environment

2. Increases in risk premiums for many eurozone borrowers

3. Simultaneous attempts at reducing debts by both eurozone governments and households

4. More limited perspectives of economic growth

5. Deepening and protracted division among Europe’s policymakers in agreeing to approaches to resolve the European debt crisis

There is now only one major country in the eurozone with AAA rating of its long-term debt by S&PRS (2012Jan13): Germany. IIIE Appendix Euro Zone Survival Risk analyzes the hurdle of financial bailouts of euro area members by the strength of the credit of Germany alone. The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is abouy $3531.6 billion. There is some simple “unpleasant bond arithmetic.” Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is about $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. Debt as percent of Germany’s GDP would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Charles Forelle, writing on Jan 14, 2012, on “Downgrade hurts euro rescue fund,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204409004577159210191567778.html), analyzes the impact of the downgrades on the European Financial Stability Facility (EFSF). The EFSF is a special purpose vehicle that has not capital but can raise funds to be used in bailouts by issuing AAA-rated debt. S&P may cut the rating of the EFSF to the new lowest rating of the six countries with AAA rating, which are now down to four with the downgrades of France and Austria. The other rating agencies Moody’s and Fitch have not taken similar action. On Jan, S&PRS (2012Jan16) did cut the long-term credit rating of the EFSF to AA+ and affirmed the short-term credit rating at A-+. The decision is derived from the reduction in credit rating of the countries guaranteeing the EFSF. In the view of S&PRS (2012Jan16), there are not sufficient credit enhancements after the reduction in the creditworthiness of the countries guaranteeing the EFSF. The decision could be reversed if credit enhancements were provided.

The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.

Bond auctions are also critical in episodes of risk aversion. David Oakley, writing on Jan 3, 2012, on “Sovereign issues draw euro to crunch point,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/63b9d7ca-2bfa-11e1-98bc-00144feabdc0.html#axzz1iLNRyEbs), estimates total euro area sovereign issues in 2012 at €794 billion, much higher than the long-term average of €670 billion. Oakley finds that the sovereign issues are: Italy €220 billion, France €197 billion, Germany €178 billion and Spain €81 billion. Bond auctions will test the resilience of the euro. Victor Mallet and Robin Wigglesworth, writing on Jan 12, 2012, on “Spain and Italy raise €22bn in debt sales,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/e22c4e28-3d05-11e1-ae07-00144feabdc0.html#axzz1j4euflAi), analyze debt auctions during the week. Spain placed €10 billion of new bonds with maturities in 2015 and 2016, which was twice the maximum planned for the auction. Italy placed €8.5 billion of one-year bills at average yield of 2.735 percent, which was less than one-half of the yield of 5.95 percent a month before. Italy also placed €3.5 billion of 136-day bills at 1.64 percent. There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20.

A combination of strong economic data in China analyzed in subsection VC and the realization of the widely expected downgrade could explain the strength of the European sovereign debt market. Emese Bartha, Art Patnaude and Nick Cawley, writing on January 17, 2012, on “European T-bills see solid demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204555904577166363369792848.html?mod=WSJPRO_hpp_LEFTTopStories), analyze successful auctions treasury bills by Spain and Greece. A day after the downgrade, the EFSF found strong demand on Jan 17 for its six-month debt auction at the yield of 0.2664 percent, which is about the same as sovereign bills of France with the same maturity.

There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20. Paul Dobson, Emma Charlton and Lucy Meakin, writing on Jan 20, 2012, on “Bonds show return of crisis once ECB loans expire,” published in Bloomberg (http://www.bloomberg.com/news/2012-01-20/bonds-show-return-of-crisis-once-ecb-loans-expire-euro-credit.html), analyze sovereign debt and analysis of market participants. Large-scale lending of last resort by the European Central Bank, considered in IIID Appendix on European Central Bank Large Scale Lender of Last Resort, provided ample liquidity in the euro zone for banks to borrow at 1 percent and lend at higher rates, including to government. Dobson, Charlton and Meakin trace the faster decline of yields of short-term sovereign debt relative to decline of yields of long-term sovereign debt. The significant fall of the spread of short relative to long yields could signal concern about the resolution of the sovereign debt while expanding lender of last resort operations have moderated relative short-term sovereign yields. Normal conditions would be attained if there is definitive resolution of long-term sovereign debt that would require fiscal consolidation in an environment of economic growth.

Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.

Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent (see Table III-1). There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table III-6 is constructed with IMF World Economic Outlook database for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.

Table III-6, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2010 USD Billions	Primary Net Lending Borrowing % GDP 2010	General Government Net Debt % GDP 2010
World	62,911.2
Euro Zone	12,167.8	-3.6	65.9
Portugal	229.2	-6.3	88.7
Ireland	206.9	-28.9	78.0
Greece	305.4	-4.9	142.8
Spain	1,409.9	-7.8	48.8
Major Advanced Economies G7	31,716.9	-6.5	76.5
United States	14,526.6	-8.4	68.3
UK	2,250.2	-7.7	67.7
Germany	3,286.5	-1.2	57.6
France	2,562.7	-4.9	76.5
Japan	5,458.8	-8.1	117.2
Canada	1,577.0	-4.9	32.2
Italy	2,055.1	-0.3	99.4
China	5,878.3	-2.3	33.8*
Cyprus	23.2	-5.3	61.6

*Gross Debt

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

The data in Table III-6 are used for some very simple calculations in Table III-7. The column “Net Debt USD Billions” in Table III-7 is generated by applying the percentage in Table III-6 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-5. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

Table III-7, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,018.6
B Germany	1,893.0		$7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1%
C France	1,960.5
B+C	3,853.5	GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3%
D Italy	2,042.8
E Spain	688.0
F Portugal	203.3
G Greece	436.1
H Ireland	161.4
Subtotal D+E+F+G+H	3,531.6

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

There is extremely important information in Table III-8 for the current sovereign risk crisis in the euro zone. Table III-8 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Nov. German exports to other European Union members are 59.0 percent of total exports in Nov and 59.5 percent in Jan-Nov. Exports to the euro area are 39.7 percent in Nov and 39.9 percent in Jan-Nov. Exports to third countries are only 40.9 percent of the total in Nov and 40.5 percent in Jan-Nov. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone.

Table III-8, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Nov 2011 € Billions	12 Months ∆%	Jan-Nov 2011 € Billions	Jan-Nov 2011/ Jan-Nov 2010 ∆%
Total Exports	94.9	8.3	976.0	12.1
A. EU Members	56.0 % 59.0	8.4	580.9 % 59.5	11.1
Euro Area	37.7 % 39.7	7.7	389.7 % 39.9	9.9
Non-euro Area	18.3 % 19.3	9.8	191.2 % 19.6	13.7
B. Third Countries	38.9 % 40.9	8.2	395.1 % 40.5	13.5
Total Imports	78.7	6.7	829.6	13.9
C. EU Members	50.6 % 64.3	10.6	526.7 % 63.5	14.7
Euro Area	35.1 % 44.6	8.8	369.4 % 44.5	13.8
Non-euro Area	15.5 % 19.7	15.1	157.3 % 18.9	17.0
D. Third Countries	28.0 % 35.6	0.2	302.9 % 36.5	12.4

Notes: Total Exports = A+B; Total Imports = C+D

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/01/PE12__006__51,templateId=renderPrint.psml

IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.

First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:

D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)

Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,

{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:

N(t+1) = (1+n)N(t), n>-1 (2)

The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:

B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)

On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.

Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:

(M_t + B_t)/P_t = E_t∫(1/R_{t, t+τ})s_t+τdτ (4)

Equation (4) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_{t, t+τ}, of the future primary surpluses s_t+τ, which are equal to T_t+τ – G_t+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post R_{t, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (5)

Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):

“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”

An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.

There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:

(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress

(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality

(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.

IV. IMF Forecast. The IMF revised its three reports on monitoring the world economy, finance and fiscal affairs. These three reports are discussed in turn.

1 World Economic Outlook. The International Monetary Fund (IMF) has revised its World Economic Outlook (WEO) to an environment of lower growth (IMF 2012WEOJan24):

“The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated. Global output is projected to expand by 3¼ percent in 2012—a downward revision of about ¾ percentage point relative to the September 2011 World Economic Outlook (WEO).”

The IMF (2012WEOJan24) projects growth of world output of 3.8 percent in 2011 and 3.3 percent in 2012 after 5.2 percent in 2010. Advanced economies would grow at only 1.6 percent in 2011, 1.2 percent in 2012 and 3.9 percent in 2013 after growing at 3.2 percent in 2010. Emerging and developing economies would drive the world economy, growing at 6.2 percent in 2011, 5.4 percent in 2012 and 5.9 percent in 2012 after growing at 7.3 percent in 2010. The IMF is forecasting deceleration of the world economy.

World economic slowing would be the consequence of the mild recession in the euro area in 2012 caused by “the rise in sovereign yields, the effects of bank deleveraging on the real economy and the impact of additional fiscal consolidation” (IMF 2012WEOJan24). After growing at 1.9 percent in 2010 and 1.6 percent in 2010, the economy of the euro area would contract by 0.5 percent in 2012 and grow at 0.8 percent in 2013. The United States would grow at 1.8 percent in both 2011 and 2012 and at 2.2 percent in 2013. The IMF (2012WEO Jan24) projects slow growth in 2012 of Germany at 0.3 percent and of France at 0.2 percent while Italy contracts 2.2 percent and Spain contracts 1.7 percent. While Germany would grow at 1.5 percent in 2013 and France at 1.0 percent, Italy would contract 0.6 percent and Spain 0.3 percent.

The IMF (2012WEOJan24) also projects a downside scenario, in which the critical risk “is intensification of the adverse feedback loops between sovereign and bank funding pressures in the euro area, resulting in much larger and more protracted bank deleveraging and sizable contractions in credit and output.” In this scenario, there is contraction of private investment by an extra 1.75 percentage points in relation to the projections of the WEO with euro area output contracting 4 percent relative to the base WEO projection. The environment could be complicated by failure in medium-term fiscal consolidation in the United States and Japan.

There is significant deceleration in world trade volume in the projections of the IMF (2012WEOJan24). Growth of the volume of world trade in goods and services decelerates from 12.7 percent in 2010 to 6.9 percent in 2011, 3.8 percent in 2012 and 5.4 percent in 2013. Under these projections there would be significant pressure in economies in stress such as Japan and Italy that require trade for growth. Even the stronger German economy is dependent on foreign trade. There is sharp deceleration of growth of exports of advanced economies from 12.2 percent in 2010 to 2.4 percent in 2012. Growth of exports of emerging and developing economies falls from 13.8 percent in 2010 to 6.1 percent in 2012. Another cause of concern in that oil prices in the projections fall only 4.9 percent in 2012, remaining at relatively high levels.

2 Global Financial Stability Report. The IMF (2012GFSRJan24) finds significant risks to global financial stability. At year-end 2011, “more than two-thirds of the euro area sovereign debt had credit default swap (CDS) spreads of over 200 basis points” (IMF2012GFSRJan24, 1, Figure 1, 2). Banks can engage in two types of deleveraging with different consequences. Deleveraging consists of reducing assets to attain a more manageable balance sheet. First, there can be favorable development such as disposing assets acquired before the financial crisis that would strengthen balance sheets. Another favorable deleveraging could be in the form of selling asset management subsidiaries to banks with stronger balance sheet. Second, unfavorable deleveraging would consist of reduction of bank credit by not refinancing maturing loans and tightening conditions for new loans. Unfavorable deleveraging would reduce credit required for maintaining the existing level of economic activity and could cause lower growth and even economic contraction. There could be spillover effects throughout the world economy.

The European sovereign debt crisis is a continuing pressure on unfavorable deleveraging. Resolution of the European debt crisis would withdraw most of the pressure on bank deleveraging. The European Central Bank (ECB) has implemented measures to alleviate funding conditions of banks. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. There is a new LTRO in Feb. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6).

The IMF (2012GSFRJan24) finds the need for regulatory action on deleveraging:

A “macroprudential gatekeeper” is needed to assure deleveraging plans are consistent with sustaining the flow of credit to support economic activity and to avoid a downward spiral in asset prices.”

3 Fiscal Monitor. The IMF (2012FMJan24) measures fiscal deficits in two forms: (i) percent of actual GDP; and (ii) cyclically-adjusted or as percent of potential GDP. Fiscal affairs differ significantly throughout the world suggesting different paths of adjustment. The overall fiscal balance of the world has declined from 6.7 percent of world output in 2009 to estimated 5.5 percent in 2010 and projected 4.5 percent in 2011 and 4.1 percent in 2012. As percent of potential output, or cyclically adjusted, the world fiscal deficit has declined from 4.6 percent in 2009 to projected 3.0 percent in 2012.

Fiscal consolidation in the view of the IMF (2012FMJan24) differs significantly among regions and countries. The main principle is that fiscal consolidation in economies with weakening conditions should consist of credible medium-term adjustment instead of excessive current measures. The IMF (2012FMJan24) proposes the following principle for fiscal consolidation:

“In the near term, sufficient fiscal adjustment is in train in most advanced economies, and they should allow the automatic stabilizers to operate freely, so long as solvency concerns allow and financing for higher deficits can be realized. Among those countries, those with very low interest rates or other factors that create adequate fiscal space, including some in the euro area, should reconsider the pace of near-term fiscal consolidation. However, implementation of credible medium-term debt reduction plans remains a priority, as high debt levels make these countries vulnerable should interest rates increase. For the United States, such a plan should feature measures that contain entitlement spending and raise revenues. In Japan, an adjustment path that allows debt ratios to begin declining by the middle of this decade is called for.”

V Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table V-1 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 (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section  as soon as available, following Table IV-1. Data for other countries in Table V-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section VI World Economic Slowdown following with individual country and regional data tables.

Table V-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	1.6	3.0	5.7	8.6
Japan	-0.7	-0.2	1.3	4.5
China	8.9	4.1	1.7
UK	0.8	4.2* RPI 4.8	4.8* output 8.7* input 6.9**	8.4
Euro Zone	1.4	2.7	5.3	10.3
Germany	3.0	2.8	5.2	5.5
France	1.6	2.7	5.6	9.8
Nether-lands	1.1	2.7	6.7	4.9
Finland	2.7	3.2	5.8	7.4
Belgium	1.8	3.7	5.7	7.2
Portugal	-1.7	3.8	5.2	13.2
Ireland	NA	1.7	3.8	14.6
Italy	NA	3.7	4.5	8.6
Greece	-5.2	2.8	7.2	18.8
Spain	0.8	2.9	6.3	22.9

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.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/stb-producer-price-index---december-2011.html

CPI http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2011/index.html

**Excluding food, beverage, tobacco and petroleum

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

Table V-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IVQ2011 relative to IVQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf). Japan’s GDP fell 0.7 percent in IIIQ2011 relative to IIIQ2010 and contracted 1.7 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 5.6 percent in IIIQ2011 (http://www.esri.cao.go.jp/jp/sna/sokuhou/kekka/gaiyou/main_1.pdf); the UK grew at 0.8 percent in IVQ2011 relative to IVQ2010 and GDP fell 0.2 percent in IVQ2011 relative to IIIQ2011 (http://www.ons.gov.uk/ons/rel/gva/gross-domestic-product--preliminary-estimate/q4-2011/stb-q4-2011.html); and the Euro Zone grew at 1.4 percent in IIIQ2011 relative to IIIQ2010 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06122011-AP/EN/2-06122011-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.6 percent in the US but 18.6 percent for unemployment/underemployment (see Table I-4 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html), 4.5 percent for Japan, 8.4 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in subsection VH http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states_22.html) and 10.3 percent in the Euro Zone. Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 3.0 percent in the US, minus 0.2 percent for Japan, 2.7 percent for the Euro Zone and 4.2 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states.html) (2) the tradeoff of growth and inflation in China; (3) slow growth by repression of savings with de facto interest rate controls (http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable.html), weak hiring (http://cmpassocregulationblog.blogspot.com/2012/01/recovery-without-hiring-united-states.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (see Section I Thirty Million Unemployed or Underemployed in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see II Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) the geopolitical events in the Middle East

Unconventional monetary policy of zero interest rates and quantitative easing has been used in Japan and now also in the US. Table V-2 provides the consumer price index of Japan, with inflation of minus 0.2 percent in 12 months ending in Dec, 0.0 percent NSA (not-seasonally-adjusted) and 0.1 percent SA (seasonally-adjusted). There is deflation in most of the 12-month rates in 2011 with the exception of Jul and Aug both with 0.2 percent and stability in Sep. There are eight years of deflation and one of zero inflation in the 12-month rate of inflation in Dec from 1995 to 2010. This experience is entirely different from that of the US that shows long-term inflation. It is difficult to justify unconventional monetary policy because of risks of deflation similar to those experienced in Japan.

Table V-2, Japan, Consumer Price Index, All Items ∆%

	∆% Month   SA	∆% Month  NSA	∆% 12 Months NSA
Dec 2011	0.1	0.0	-0.2
Nov	-0.1	-0.6	-0.5
Oct	0.0	0.1	-0.2
Sep	-0.1	0.0	0.0
Aug	-0.2	0.1	0.2
Jul	0.3	0.0	0.2
Jun	-0.1	-0.2	-0.4
May	-0.1	0.0	-0.4
Apr	-0.1	0.1	-0.4
Mar	0.0	0.3	-0.5
Feb	0.1	0.0	-0.5
Jan	0.0	-0.1	-0.6
Dec 2010	-0.2	–0.3	0.0
Dec 2009			-1.7
Dec 2008			0.4
Dec 2007			0.7
Dec 2006			0.3
Dec 2005			-0.1
Dec 2004			0.2
Dec 2003			-0.4
Dec 2002			-0.3
Dec 2001			-1.2
Dec 2000			-0.2
Dec 1999			-1.1
Dec 1998			0.6
Dec 1997			1.8
Dec 1996			0.6
Dec 1995			-0.3
Dec 1994			0.7
Dec 1993			1.0
Dec 1992			1.2
Dec 1991			2.7
Dec 1990			3.8

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

http://www.e-stat.go.jp/SG1/estat/ListE.do?lid=000001085751

Unconventional monetary policy of zero interest rates and large-scale purchases of long-term securities for the balance sheet of the central bank is proposed to prevent deflation. The data of CPI inflation of all goods and CPI inflation excluding food and energy for the past six decades show only one negative change by 0.4 percent in the CPI all goods annual index in 2009 but not one year of negative annual yearly change in the CPI excluding food and energy measuring annual inflation (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html). Zero interest rates and quantitative easing are designed to lower costs of borrowing for investment and consumption, increase stock market valuations and devalue the dollar. In practice, the carry trade is from zero interest rates to a large variety of risk financial assets including commodities. Resulting commodity price inflation squeezes family budgets and deteriorates the terms of trade with negative effects on aggregate demand and employment. Excessive valuations of risk financial assets eventually result in crashes of financial markets with possible adverse effects on economic activity and employment.

Producer price inflation history in the past five decades does not provide evidence of deflation. The finished core PPI does not register even one single year of decline. The headline PPI experienced only six isolated cases of decline (http://cmpassocregulationblog.blogspot.com/2011/08/world-financial-turbulence-global.html):

-0.3 percent in 1963,

-1.4 percent in 1986,

-0.8 percent in 1986,

-0.8 percent in 1998,

-1.3 percent in 2001

-2.6 percent in 2009.

Deflation should show persistent cases of decline of prices and not isolated events. Fear of deflation in the US has caused a distraction of monetary policy. Symmetric inflation targets around 2 percent in the presence of multiple lags in effect of monetary policy and imperfect knowledge and forecasting are mostly unfeasible and likely to cause price and financial instability instead of desired price and financial stability.

Chart V-1 provides the consumer price index NSA from 1960 to 2011. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart V-1, US, Consumer Price Index, All Items, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart V-2 provides 12-month percentage changes of the consumer price index from 1960 to 2011. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart V-2, US, Consumer Price Index, All Items, NSA, 12- Month Percentage Change 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart V-3 provides the consumer price index excluding food and energy from 1960 to 2011. There is long-term inflation in the US without episodes of deflation.

Chart V-3, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart V-4 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2011. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

Chart V-4, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

More detail on the consumer price index of Japan in Nov is shown in Table IV-3. Inflation in the 12 months ending in Dec has been driven by items rich in commodities such as 5.2 percent in fuel, light and water charges with monthly increase of 0.2 percent in the month of Dec. There is similar behavior in the preliminary estimate for Jan for the Ku Area of Tokyo with monthly inflation of fuel, light and water charges of -0.2 percent but 6.9 percent in 12 months. There is inflation in some of the items in the consumer price index with increases in Dec of: 0.3 percent in transport and communications (1.5 percent in 12 months) and 0.2 percent in fuel, light and water charges. There is mild deflation in the CPI excluding food, alcoholic beverages and energy with minus 0.1 percent in Dec and minus 1.1 percent in 12 months. The CPI goods fell 0.1 percent in Dec and 0.4 percent in 12 months. The CPI excluding imputed rent increased 0.1 percent in Dec but fell 0.2 percent in 12 months.

Table V-3, Japan, Consumer Price Index, ∆%

2011	Dec/Nov ∆%	Year ∆%
CPI All Items	0.0	-0.2
CPI Excluding Fresh Food	0.0	-0.1
CPI Excluding Food, Alcoholic Beverages and Energy	-0.1	-1.1
CPI Goods	-0.1	-0.4
CPI Services	0.1	0.0
CPI Excluding Imputed Rent	0.1	-0.2
CPI Fuel, Light, Water Charges	0.2	5.2
CPI Transport Communications	0.3	1.5
CPI Ku-Area Tokyo All Items	-0.3	-0.3
Fuel, Light, Water Charges Ku Area Tokyo	-0.2	6.9

Note: Ku-area Tokyo CPI data preliminary for Jan 2012

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

 

© Carlos M. Pelaez, 2010, 2011, 2012