Recovery without Hiring, United States Trade, Euro Zone Survival Risk and World Economic Slowdown: Part I

 

Recovery without Hiring, United States Trade, Euro Zone Survival Risk and World Economic Slowdown

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I Recovery without Hiring

IA Hiring Collapse

IB Labor Underutilization

II United States Trade

IIA Trade Account

IIB Import and Export Prices

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 Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendix I The Great Inflation

Executive Summary

An important characteristic of the current fractured labor market of the US is the closing of the avenue for exiting unemployment and underemployment normally available through dynamic hiring. Another avenue that is closed is the opportunity for advancement in moving to new jobs that pay better salaries and benefits again because of the collapse of hiring in the United States. Those who are unemployed or underemployed cannot find a new job even accepting lower wages and no benefits. The employed cannot escape declining inflation-adjusted earnings because there is no hiring.

Total nonfarm hiring (HNF), total private hiring (HP) and their respective rates are provided for the month of Nov in the years from 2001 to 2011 in Table ES1. Hiring numbers are in thousands. There is some recovery in HNF from 3431 (or 3.4 million) in Nov 2009 to 3485 in Nov 2010 and 3708 in Nov 2011 for cumulative gain of 8.1 percent. HP rose from 3238 in Nov 2009 to 3500 in Nov 2011 for cumulative gain of 8.1 percent. HNF has fallen from 4911 in Nov 2006 to 3708 in Nov 2011 or by 24.5 percent. HP has fallen from 4645 in Nov 2005 to 3500 in Nov 2011 or by 24.7 percent. The labor market continues to be fractured, failing to provide an opportunity to exit from unemployment/underemployment or to find an opportunity for advancement away from declining inflation-adjusted earnings.

Table ES1, US, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment Not Seasonally Adjusted

	HNF	Rate RNF	HP	Rate HP
2001 Nov	4364	3.3	4101	3.7
2002 Nov	4331	3.3	4028	3.7
2003 Nov	4158	3.2	3926	3.6
2004 Nov	4648	3.5	4373	3.9
2005 Nov	4700	3.5	4435	3.9
2006 Nov	4911	3.6	4645	4.0
2007 Nov	4587	3.3	4335	3.7
2008 Nov	3347	2.5	3156	2.8
2009 Nov	3431	2.6	3238	3.0
2010 Nov	3485	2.7	3290	3.0
2011 Nov	3708	2.8	3500	3.2

Source:  US Bureau of Labor Statistics

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

Chart ES1 provides total nonfarm hiring on a monthly basis from 2001 to 2011. Hiring rebounded in early 2010 but then fell and stabilized at a lower level than the early peak in 2010. Nonfarm hiring fell again in Oct as shown in Chart ES1 with SA monthly data. The number of seasonally-adjusted hires in Sep was 4150 thousand, falling to 4042 thousand in Oct or by 2.6 percent but increasing to 4149 in Nov or by 2.6 percent. The number of hires not seasonally adjusted was 4396 in Sep, falling to 4057 in Oct or by 7.7 percent and falling to 3708 in Nov or by 8.6 percent. The number of nonfarm hiring not seasonally adjusted fell by 15.7 percent from Sep to Nov.

Chart ES1, US, Total Nonfarm Hiring (HNF), 2001-2011 Month SA

Source: US Bureau of Labor Statistics

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

There is only milder improvement in total private hiring shown in Chart ES2. HP rose in 2010 followed by stability and renewed increase in 2011. The number of private hiring seasonally adjusted fell from 3885 thousand in Sep to 3785 in Oct or by 2.6 percent and increased to 3865 in Nov or by 2.1 percent. The number of private hiring not seasonally adjusted fell from 4027 thousand in Sep to 3816 in Oct or by -5.2 percent, falling to 3500 in Nov or by 8.3 percent for cumulative decline of 13.1 percent from Sep to Nov.

Chart ES2, US, Total Private Hiring Month SA 2011-2011

Source: US Bureau of Labor Statistics

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

There are seasonal doubts on the employment reports for Nov and Dec. The number employed part-time for economic reasons because they could not find full-time employment fell from 9.270 million in Sep 2011 to 8.098 million in Dec 2011, seasonally adjusted, or decline of 1.172 million in just three months, as shown in Table ES2. The number employed full-time increased from 112.479 million in Sep 2011 to 113.765 million in Dec 2011 or 1.286 million. The number of employed part-time for economic reasons actually increased without seasonal adjustment from 8.271 million in Nov 2011 to 8.428 million in Dec 2011 or by 157,000. The number employed full time without seasonal adjustment fell from 113.138 million in Nov 2011 to 113.050 million in Dec 2011 or by 88,000.

Table ES2, US, Employed Part-time for Economic Reasons, Thousands, and Full-time, Millions

	Part-time Thousands	Full-time Millions
Seasonally Adjusted
Dec 2011	8,098	113.765
Nov 2011	8,469	113.212
Oct 2011	8,790	112.841
Sep 2011	9,270	112.479
Aug 2011	8,787	112.406
Not Seasonally Adjusted
Dec 2011	8,428	113.050
Nov 2011	8,271	113.138
Dec 2010	9,205	111.207

Source: US Bureau of Labor Statistics

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

I Recovery without Hiring. There are two subsections. IA Hiring Collapse provides the data and analysis on the weakness of hiring in the US economy. IB Labor Underutilization provides the measures of labor underutilization of the Bureau of Labor Statistics.

IA Hiring Collapse. An important characteristic of the current fractured labor market of the US is the closing of the avenue for exiting unemployment and underemployment normally available through dynamic hiring. Another avenue that is closed is the opportunity for advancement in moving to new jobs that pay better salaries and benefits again because of the collapse of hiring in the United States. Those who are unemployed or underemployed cannot find a new job even accepting lower wages and no benefits. The employed cannot escape declining inflation-adjusted earnings because there is no hiring. The objective of this section is to analyze hiring and labor underutilization in the United States.

An appropriate measure of job stress is considered by Blanchard and Katz (1997, 53):

“The right measure of the state of the labor market is the exit rate from unemployment, defined as the number of hires divided by the number unemployed, rather than the unemployment rate itself. What matters to the unemployed is not how many of them there are, but how many of them there are in relation to the number of hires by firms.”

The natural rate of unemployment and the similar NAIRU are quite difficult to estimate in practice (Ibid; see Ball and Mankiw 2002).

The Bureau of Labor Statistics (BLS) created the Job Openings and Labor Turnover Survey (JOLTS) with the purpose that (http://www.bls.gov/jlt/jltover.htm#purpose):

“These data serve as demand-side indicators of labor shortages at the national level. Prior to JOLTS, there was no economic indicator of the unmet demand for labor with which to assess the presence or extent of labor shortages in the United States. The availability of unfilled jobs—the jobs opening rate—is an important measure of tightness of job markets, parallel to existing measures of unemployment.”

The BLS collects data from about 16,000 US business establishments in nonagricultural industries through the 50 states and DC. The data are released monthly and constitute an important complement to other data provided by the BLS.

Hiring in the nonfarm sector (HNF) has declined from 64.9 million in 2006 to 47.2 million in 2010 or by 17.7 million while hiring in the private sector (HP) has declined from 60.4 million in 2006 to 43.3 million in 2010 or by 17.1 million, as shown in Table I-1. The ratio of nonfarm hiring to unemployment (RNF) has fallen from 47.7 in 2006 to 36.4 in 2010 and in the private sector (RHP) from 52.9 in 2006 to 40.3 in 2010 (http://cmpassocregulationblog.blogspot.com/2011/03/slow-growth-inflation-unemployment-and.html). 

Table I-1, US, Annual Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US and Percentage of Total Employment

	HNF	Rate RNF	HP	Rate HP
2001	63,766	48.4	59,374	53.6
2002	59,797	45.9	55,665	51.1
2003	57,787	44.5	54,082	49.9
2004	61,624	46.9	57,534	52.4
2005	64,498	48.2	60,444	54.0
2006	64,870	47.7	60,419	52.9
2007	63,326	46.0	58,760	50.9
2008	53,986	39.5	50,286	44.0
2009	45,372	34.7	41,966	38.8
2010	47,234	36.4	43,299	40.3

Source: http://www.bls.gov/jlt/data.htm

Chart I-1 provides the yearly levels of total nonfarm hiring (NFH) in Table I-1. The fall of hiring during the contraction of 2007 to 2009 was much stronger than in the shallow contraction of 2001 with GDP contraction of only 0.4 percent from Mar 2001 (IQ2001) to Dec 2011 (IVQ 2001) compared with 5.1 percent contraction in the much longer recession from Dec 2007 (IVQ2007) to Jun 2009 (IIQ2009) (http://www.nber.org/cycles/cyclesmain.html).

Chart I-1, US, Total Nonfarm Hiring (HNF), Yearly, 2001-2010

Source: US Bureau of Labor Statistics

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

Chart I-2 shows the ratio or rate of nonfarm hiring to unemployment (RNF) that also fell much more in the recession of 2007 to 2009 than in the shallow recession of 2001.

Chart I-2, US, Rate Total Nonfarm Hiring (HNF), Yearly, 2001-2010

Source: US Bureau of Labor Statistics

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

Total nonfarm hiring (HNF) yearly percentage changes are provided in Table I-2. There were much milder declines in 2002 of 6.2 percent and 3.4 percent in 2003 followed by strong rebounds of 6.6 percent in 2004 and 4.7 percent in 2005. In contrast, the contractions of nonfarm hiring in the recession after 2007 were much sharper in percentage points: 2.4 in 2007, 14.7 in 2008 and 16 percent in 2009. On a yearly basis, nonfarm hiring grew 4.1 percent in 2010 relative to 2009.

Table I-2, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2010

Year	Annual
2002	-6.2
2003	-3.4
2004	6.6
2005	4.7
2006	0.6
2007	-2.4
2008	-14.7
2009	-16.0
2010	4.1

Source: US Bureau of Labor Statistics

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

Chart I-3 plots yearly percentage changes of nonfarm hiring. Percentage declines after 2007 were quite sharp.

Chart I-3, US, Annual Total Nonfarm Hiring (HNF), Yearly Percentage Change, 2001-2010

Source: US Bureau of Labor Statistics

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

Total private hiring (HP) yearly data are provided in Chart I-4. There has been sharp contraction of total private hiring in the US and only mild recovery in 2010.

Chart I-4, US, Total Private Hiring, Yearly, 2001-2010

Source:

US Bureau of Labor Statistics

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

Chart I-5 plots the rate of total private hiring relative to unemployment (RHP). The rate collapsed during the global recession after 2007.

Chart I-5, US, Rate Total Private Hiring, Yearly, 2001-2010

Source:

US Bureau of Labor Statistics

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

Total nonfarm hiring (HNF), total private hiring (HP) and their respective rates are provided for the month of Nov in the years from 2001 to 2011 in Table I-3. Hiring numbers are in thousands. There is some recovery in HNF from 3431 (or 3.4 million) in Nov 2009 to 3485 in Nov 2010 and 3708 in Nov 2011 for cumulative gain of 8.1 percent. HP rose from 3238 in Nov 2009 to 3500 in Nov 2011 for cumulative gain of 8.1 percent. HNF has fallen from 4911 in Nov 2006 to 3708 in Nov 2011 or by 24.5 percent. HP has fallen from 4645 in Nov 2005 to 3500 in Nov 2011 or by 24.7 percent. The labor market continues to be fractured, failing to provide an opportunity to exit from unemployment/underemployment or to find an opportunity for advancement away from declining inflation-adjusted earnings.

Table I-3, US, Total Nonfarm Hiring (HNF) and Total Private Hiring (HP) in the US in Thousands and in Percentage of Total Employment Not Seasonally Adjusted

	HNF	Rate RNF	HP	Rate HP
2001 Nov	4364	3.3	4101	3.7
2002 Nov	4331	3.3	4028	3.7
2003 Nov	4158	3.2	3926	3.6
2004 Nov	4648	3.5	4373	3.9
2005 Nov	4700	3.5	4435	3.9
2006 Nov	4911	3.6	4645	4.0
2007 Nov	4587	3.3	4335	3.7
2008 Nov	3347	2.5	3156	2.8
2009 Nov	3431	2.6	3238	3.0
2010 Nov	3485	2.7	3290	3.0
2011 Nov	3708	2.8	3500	3.2

Source:  US Bureau of Labor Statistics

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

Chart I-6 provides total nonfarm hiring on a monthly basis from 2001 to 2011. Hiring rebounded in early 2010 but then fell and stabilized at a lower level than the early peak in 2010. Nonfarm hiring fell again in Oct as shown in Chart I-6 with SA monthly data. The number of seasonally-adjusted hires in Sep was 4150 thousand, falling to 4042 thousand in Oct or by 2.6 percent but increasing to 4149 in Nov or by 2.6 percent. The number of hires not seasonally adjusted was 4396 in Sep, falling to 4057 in Oct or by 7.7 percent and falling to 3708 in Nov or by 8.6 percent. The number of nonfarm hiring not seasonally adjusted fell by 15.7 percent from Sep to Nov.

Chart I-6, US, Total Nonfarm Hiring (HNF), 2001-2011 Month SA

Source: US Bureau of Labor Statistics

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

Similar behavior occurs in the rate of nonfarm hiring plot in Chart I-7. Recovery in early 2010 was followed by decline and stabilization at a lower level but with decrease in monthly SA estimates from 3.2 in Sep 2011 to 3.1 in 2011 and stability at 3.2 in Nov. The rate not seasonally adjusted fell from 3.5 in Aug to 2.8 in Nov.

Chart I-7, US, Rate Total Nonfarm Hiring, Month SA 2001-2011

Source: US Bureau of Labor Statistics

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

There is only milder improvement in total private hiring shown in Chart I-8. HP rose in 2010 followed by stability and renewed increase in 2011. The number of private hiring seasonally adjusted fell from 3885 thousand in Sep to 3785 in Oct or by 2.6 percent and increased to 3865 in Nov or by 2.1 percent. The number of private hiring not seasonally adjusted fell from 4027 thousand in Sep to 3816 in Oct or by -5.2 percent, falling to 3500 in Nov or by 8.3 percent for cumulative decline of 13.1 percent from Sep to Nov.

Chart I-8, US, Total Private Hiring Month SA 2011-2011

Source: US Bureau of Labor Statistics

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

Chart I-9 shows similar behavior in the rate of private hiring. The rate in 2011 in monthly SA data has not risen significantly above the peak in 2010. The rate seasonally adjusted fell from 3.6 in Sep to 3.5 in Nov. The rate not seasonally adjusted fell from 3.7 in Sep to 3.2 in Nov.

Chart I-9, US, Rate Total Private Hiring Month SA 2011-2011

Source: US Bureau of Labor Statistics

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

The JOLTS report of the Bureau of Labor Statistics also provides total nonfarm job openings (TNF JOB), TNF JOB rate and TNF LD (layoffs and discharges) shown in Table I-4 for the month of Nov from 2001 to 2011. The final column provides TNF LD for the years from 2001 to 2010. Nonfarm job openings fell from a peak of 4133 in Nov 2006 to 2811 in Nov 2011 or by 31.9 percent while the rate dropped from 2.9 to 2.1. Nonfarm layoffs and discharges (TNF LD) rose from 1624 in Nov 2005 to 2176 in Nov 2008 or by 33.9 percent. The yearly data show layoffs and discharges rising from 21.5 million in 2006 to 26.3 million in 2009 or by 22.3 percent.

Table I-4, US, Job Openings and Total Separations, Thousands NSA

	TNF JOB	TNF JOB Rate	TNF LD SA	TNF LD Year
Nov 2001	3261	2.4	2097	24351
Nov 2002	3245	2.4	1837	23325
Nov 2003	2963	2.2	1798	23959
Nov 2004	3703	2.3	1847	23389
Nov 2005	3974	2.8	1624	22774
Nov 2006	4133	2.9	1840	21468
Nov 2007	3988	2.8	1938	22577
Nov 2008	2740	2.0	2176	23737
Nov 2009	2038	1.5	1907	26318
Nov 2010	2666	2.0	1755	21243
Nov 2011	2811	2.1	1726

Notes: TNF JOB: Total Nonfarm Job Openings; LD: Layoffs and Discharges

Source: US Bureau of Labor Statistics

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

Chart I-10 shows monthly job openings rising from the trough in 2009 to a high in the beginning of 2010. Job openings then stabilized into 2011 but have surpassed the peak of 2010 with 3161 seasonally adjusted in Nov relative to 2966 in Nov 2010 but fell from 3377 in Sep 2011 to 3161 in Nov or 6.4 percent. The high of job openings not seasonally adjusted in 2010 was 3295 in Apr 2010 that was surpassed by 3454 in Aug 2011. The level of hires not seasonally adjusted fell to 2811 in Nov 2011 or by 18.6 percent relative to Aug 2011.

Chart I-10, US Job Openings, Thousands NSA, 2001-2011

Source: US Bureau of Labor Statistics

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

The rate of job openings in Chart I-11 shows similar behavior. The rate not seasonally adjusted rose from the high of 2.3 in Apr 2010 to 2.5 in Sep 2011 but fell back to 2.3 in Nov 2011. The rate not seasonally adjusted rose from 2.3 in Jul 2010 to 2.6 in Sep 2011 and fell further to 2.1 in Nov 2011.

Chart I-11, US, Rate of Job Openings, Thousands NSA, 2001-2011

Source: US Bureau of Labor Statistics

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

Total separations are shown in Chart I-12. Separations are much lower in 2010 than before the global recession.

Chart I-12, US, Total Separations, Month SA, 2001-2011

Source: US Bureau of Labor Statistics

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

Yearly total separations are shown in Chart I-13. Separations are much lower in 2010 than before the global recession.

Chart I-13, US, Total Separations, Yearly, 2001-2010

Source: US Bureau of Labor Statistics

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

Table I-5 provides total nonfarm total separations from 2001 to 2010. Separations fell from 62.7 million in 2006 to 46.3 million in 2010 or by 16.4 million.

Table I-5, US, Total Nonfarm Total Separations, Thousands, 2001-2010

Year	Annual
2001	65610
2002	60412
2003	57847
2004	59666
2005	62107
2006	62699
2007	62173
2008	57525
2009	50544
2010	46347

Source: US Bureau of Labor Statistics

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

Monthly data of layoffs and discharges reach a peak in early 2009, as shown in Chart I-14. Layoffs and discharges dropped sharply with the recovery of the economy in 2010 and 2011 once employers reduced their job count to what was required for cost reductions and loss of business.

Chart I-14, US, Total Nonfarm Layoffs and Discharges, Monthly SA, 2011-2011

Source: US Bureau of Labor Statistics

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

Layoffs and discharges in Chart I-15 rose sharply to a peak in 2009. There was pronounced drop into 2010.

Chart I-15, US, Total Nonfarm Layoffs and Discharges, Yearly, 2001-2010

Source: US Bureau of Labor Statistics

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

Table I-6 provides annual nonfarm layoffs and discharges from 2001 to 2010. Layoffs and discharges peaked at 26.3 million in 2009 and then fell to 21.2 million in 2010, by 5.1 million, or 19.4 percent.

Table I-6, US, Total Nonfarm Layoffs and Discharges, 2001-2010

Year	Annual
2001	24351
2002	23325
2003	23959
2004	23389
2005	22774
2006	21468
2007	22577
2008	23737
2009	26318
2010	21243

Source: US Bureau of Labor Statistics

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

IB Labor Underutilization. The Bureau of Labor Statistics also provides alternative measures of labor underutilization shown in Table I-7. The most comprehensive measure is U6 that consists of total unemployed plus total employed part time for economic reasons plus all marginally attached workers as percent of the labor force. U6 not seasonally annualized has risen from 5.6 percent in 2006 to 15.2 in Dec 2011.

Table I-7, US, Alternative Measures of Labor Underutilization %

	U1	U2	U3	U4	U5	U6
Dec 2011 NSA	4.8	5.0	8.3	8.8	9.8	15.2
Nov     2011 NSA	4.9	4.7	8.2	8.9	9.7	15.0
Oct      2011 NSA	5.0	4.8	8.5	9.1	10.0	15.3
Sep      2011 NSA	5.2	5.0	8.8	9.4	10.2	15.7
Dec     2010 NSA	5.4	5.9	9.1	9.9	10.9	16.6
2010	5.7	6.0	9.6	10.3	11.1	16.7
2009	4.7	5.9	9.3	9.7	10.5	16.2
2008	2.1	3.1	5.8	6.1	6.8	10.5
2007	1.5	2.3	4.6	4.9	5.5	8.3
2006	1.5	2.2	4.6	4.9	5.5	5.6

Note: LF: labor force; U1, persons unemployed 15 weeks % LF; U2, job losers and persons who completed temporary jobs %LF; U3, total unemployed % LF; U4, total unemployed plus discouraged workers, plus all other marginally attached workers; % LF plus discouraged workers; U5, total unemployed, plus discouraged workers, plus all other marginally attached workers % LF plus all marginally attached workers; U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers

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

Monthly seasonally adjusted measures of labor underutilization are provided in Table I-8. U6 climbed from 15.8 percent in May 2011 to 16.0 percent in Oct 2011 and then fell to 15.6 in Nov 2011 and 15.2 percent in Dec 2011. Unemployment is an inaccurate measure of the stress in US job markets. A different calculation in this blog is provided by using the participation rate in the labor force before the global recession. This calculation shows 29.6 million in job stress of unemployment/underemployment in Dec 2011, not seasonally adjusted, corresponding to 18.6 percent of the labor force (http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html Table 4). The decline of U6 is driven by an inexplicable decline in the employed part-time for economic reasons from 9.270 million in Sep 2011 to 8.098 million in Dec 2011, raising seasonality and sampling issues (see Table I-3 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html). Employed part-time for economic reasons actually rose from 8.271 million in Nov 2011 to 8.428 million in Dec 2011 (see Table 4 in http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html).

Table I-8, US, Alternative Measures of Labor Underutilization SA %

	Dec    2011	Nov 2011	Oct 2011	Sep 2011	Aug  2011	Jul 2011	Jun 2011	May 2011
U1	5.0	5.0	5.1	5.3	5.3	5.3	5.3	5.3
U2	4.9	4.9	5.1	5.2	5.3	5.4	5.4	5.4
U3	8.5	8.7	8.9	9.0	9.1	9.1	9.2	9.1
U4	9.1	9.3	9.5	9.6	9.6	9.8	9.8	9.5
U5	10.0	10.2	10.4	10.5	10.6	10.7	10.7	10.3
U6	15.2	15.6	16.0	16.4	16.2	16.1	16.2	15.8

Note: LF: labor force; U1, persons unemployed 15 weeks % LF; U2, job losers and persons who completed temporary jobs %LF; U3, total unemployed % LF; U4, total unemployed plus discouraged workers, plus all other marginally attached workers; % LF plus discouraged workers; U5, total unemployed, plus discouraged workers, plus all other marginally attached workers % LF plus all marginally attached workers; U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers

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

Chart I-16 provides U6 on a monthly basis from 2001 to 2011. There was a steep climb from 2007 into 2009 and then this measure of unemployment and underemployment stabilized at that high level.

Chart I-16, US, U6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons % LF plus all marginally attached workers as % of Labor Force, Month, SA, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart I-17 provides the number employed part-time for economic reasons or who cannot find full-time employment. There are sharp declines at the end of 2009, 2010 and 2011.

Chart I-17, US, Working Part-time for Economic Reasons

Thousands, Month SA 2001-2011

Sources: US Bureau of Labor Statistics

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

There are seasonal and sampling doubts on the employment reports for Nov and Dec. The number employed part-time for economic reasons because they could not find full-time employment fell from 9.270 million in Sep 2011 to 8.098 million in Dec 2011, seasonally adjusted, or decline of 1.172 million in just three months, as shown in Table I-9. The number employed full-time increased from 112.479 million in Sep 2011 to 113.765 million in Dec 2011 or 1.286 million. The number of employed part-time for economic reasons actually increased without seasonal adjustment from 8.271 million in Nov 2011 to 8.428 million in Dec 2011 or by 157,000. The number employed full time without seasonal adjustment fell from 113.138 million in Nov 2011 to 113.050 million in Dec 2011 or by 88,000.

Table I-9, US, Employed Part-time for Economic Reasons, Thousands, and Full-time, Millions

	Part-time Thousands	Full-time Millions
Seasonally Adjusted
Dec 2011	8,098	113.765
Nov 2011	8,469	113.212
Oct 2011	8,790	112.841
Sep 2011	9,270	112.479
Aug 2011	8,787	112.406
Not Seasonally Adjusted
Dec 2011	8,428	113.050
Nov 2011	8,271	113.138
Dec 2010	9,205	111.207

Source: US Bureau of Labor Statistics

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

People lose their marketable job skills after prolonged unemployment and find increasing difficulty in finding another job. Chart I-18 shows the sharp rise in unemployed over 27 weeks and stabilization at an extremely high level.

Chart I-18, US, Number Unemployed for 27 Weeks or Over, Thousands SA Month 2001-2011

Sources: http://www.bls.gov/cps/data.htm

Another segment of U6 consists of people marginally attached to the labor force who continue to seek employment but less frequently on the frustration there may not be a job for them. Chart I-19 shows the sharp rise in people marginally attached to the labor force after 2007 and subsequent stabilization.

Chart I-19, US, Marginally Attached to the Labor Force, SA Month 2001-2011

Sources: US Bureau of Labor Statistics

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

II United States Trade. IIA Trade Account provides data and analysis of the US trade balance. Data and analysis of prices of imports and exports are provided in IIB Import and Export Prices.

IIA Trade Account. Table II-1 provides the trade balance of the US and monthly growth of exports and imports. The US trade balance deteriorated sharply in Nov with growth of imports by 1.3 percent and decline of exports by 0.9 percent, resulting in a deficit of $47,752 million, which is the highest since $52,104 million in Jun. There was mild improvement in the balance of international trade in goods and services of the US from Jul to Oct, declining from deficit of $50,540 million in May and $52,104 million in Jun to deficit of $43,271 million in Oct, as shown in Table II-1. In the months of Jun to Nov, exports increased 3.4 percent, at the annual equivalent rate of 8.3 percent, while imports increased 0.8 percent, at the annual equivalent rate of 1.9 percent. The trade balance deteriorated from cumulative deficit of $459,573 million in Jan-Nov 2010 to deficit of $512,781 million in Jan-Nov 2011. The trade deficit for 2011 would reach $560,533 million if the deficit in Dec were equal to the Nov deficit of $47,752 million. The most recent estimate of the US current account deficit by the Bureau of Economic Analysis of the US Department of Commerce is for IIQ2011 (http://www.bea.gov/scb/pdf/2011/10%20October/1011_itaq%20text.pdf 1):

“The US current account deficit—a net measure of transactions between the United States and the rest of the world in goods, services, income, and unilateral current transfers—decreased to $118 billion (preliminary) in the second quarter of 2011 from $119.6 billion (revised) in the first quarter. The deficit decreased to 3.1 percent of current-dollar gross domestic product (GDP) from 3.2 percent in the first quarter. The decrease in the deficit was more than accounted for by increases in the surpluses on income and on services. These increases were partly offset by an increase in the deficit on goods and an increase in net unilateral current transfers.”

In IVQ2010, “the deficit decreased to 3.0 percent of current-dollar GDP from 3.4 percent, the first decrease after five straight quarterly increases” (http://www.bea.gov/scb/pdf/2011/04%20April/0411_itaq-text.pdf 1). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The current account deficit reached 6.1 percent of GDP in 2006. The external imbalance of the US measured by the current account deficit must be financed with foreign borrowings. The US borrows heavily from other countries. China is the largest holder of US Treasury securities with $1134.1 billion in Oct 2011, slightly lower than $1160.1 billion in Dec 2010. Japan increased its holdings from $882.3 billion in Dec 2010 to $979.0 billion in Oct. The United Kingdom reduced its holdings at $408.1 billion in Oct relative to $421.6 billion in Sep but much higher than $270.4 billion in Dec. Treasury will release Nov data next week.

Table II-1, US, Trade Balance of Goods and Services Seasonally Adjusted Millions of Dollars and ∆%  

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Nov 2011	-47,752	177,838	-0.9	225,591	1.3
Oct	-43,271	179,373	-0.7	222,644	-0.9
Sep	-44,170	180,619	1.4	224,789	0.6
Aug	-45,341	178,042	0.1	223,383	-0.2
Jul	-46,069	177,811	3.5	223,880	0.0
Jun	-52,104	171,794	-2.2	223,898	-1.1
May	-50,540	175,734	-0.3	226,275	2.9
Apr	-43,561	176,306	1.3	219,867	-0.2
Mar	-46,397	173,981	4.9	220,378	4.2
Feb	-45,718	165,727	-1.3	211,444	-1.9
Jan	-47,858	167,849	2.3	215,707	5.5
Dec 2010	-40,454	164,006	1.7	204,459	2.2
Jan-Nov 2011	-512,781	1,925,076		2,437,857
Jan-Nov 2010	-459,573	1,673,571		2,133,144

Note: Trade Balance of Goods and Services = Exports of Goods and Services less Imports of Goods and Services. Trade balance may not add exactly because of errors of rounding.

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

Chart II-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit fell during the economic contraction after 2007 but has grown again during the expansion. There has been slight improvement at the margin from Jul to Oct but new increase in the gap in Nov as both exports and imports stagnate in value. Weaker world and internal demand and moderating commodity price increases explain the flattening curves of exports and imports in Chart II-1.

Chart II-1, US Balance, Exports and Imports of Goods and Services $ Billions

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr042.html

The balance of international trade in goods of the US seasonally-adjusted is shown in Table II-2. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The balance in international trade of goods deteriorated sharply from $591.5 billion in Jan-Nov 2010 to $676.3 billion in Jan-Nov 2011. Deterioration occurred both in the petroleum balance, exports less imports of petroleum, as well as in the non-petroleum balance, exports less imports of non-petroleum goods. Exports rose 17.0 percent with non-petroleum exports growing 14.1 percent. Total imports rose 16.1 percent with petroleum imports increasing 31.4 percent and non-petroleum imports increasing 12.6 percent.

Table II-2, US, International Trade in Goods Balance, Exports and Imports $ Millions and ∆% SA

	Jan-Nov  2011	Jan-Nov 2010	∆%
Total Balance	-676,282	-591,458
Petroleum	-298,461	-240,879
Non Petroleum	-367,955	-340,693
Total Exports	1,371,935	1,172,384	17.0
Petroleum	102,647	64,370	59.5
Non Petroleum	1,253,025	1,098,520	14.1
Total Imports	2,048,217	1,763,842	16.1
Petroleum	401,108	305,249	31.4
Non Petroleum	1,620,979	1,439,213	12.6

Details may not add because of rounding and seasonal adjustment

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

US exports and imports of goods not seasonally adjusted in Jan-Oct 2010 and Jan-Oct 2011 are shown in Table II-3. The rate of growth of exports was 17.1 percent, which is slightly higher than 16.1 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that rose 20.6 percent and of mineral fuels that increased 59.8 percent both because of higher prices of raw materials and commodities. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose only 11.8 percent while imports rose 12.2 percent. Significant part of the US trade imbalance originates in imports of mineral fuels growing by 28.9 percent and crude oil increasing 29.9 percent. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in deterioration of the terms of trade of the US, export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates.

Table II-3, US, Exports and Imports of Goods, Not Seasonally Adjusted Millions of Dollars and %

	Jan- Nov 2011 $ Millions	Jan-Nov 2010 $ Millions	∆%
Exports	1,370,337	1,170,255	17.1
Manufactured	889,296	795,446	11.8
Agricultural Commodities	124,550	103,241	20.6
Mineral Fuels	115,519	72,278	59.8
Crude Oil	1,299	1,317	-1.4
Imports	2,049,779	1,766,273	16.1
Manufactured	1,475,015	1,314,160	12.2
Agricultural Commodities	90,676	74,689	21.4
Mineral Fuels	417,548	323,861	28.9
Crude Oil	307,528	236,828	29.9

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

Chart II-2 provides prices of total US imports 2001-2011. Prices fell during the contraction of 2001. Import price inflation accelerated after unconventional monetary policy of near zero interest rates in 2003-2004 and quantitative easing by withdrawing supply with the suspension of 30-Treasury auctions. Slow pace of adjusting fed funds rates from 1 percent by increments of 25 basis points in 17 consecutive meetings of the Federal Open Market Committee (FOMC) between Jun 2004 and Jun 2006 continued to give impetus to carry trades. The reduction of fed funds rates toward zero in 2008 fueled a spectacular hunt for yields that caused commodity price inflation in the middle of a global recession. After risk aversion in 2009 because of the announcement of TARP (Troubled Asset Relief Program) creating anxiety on “toxic assets” in bank balance sheets (see Cochrane and Zingales 2009), prices collapsed after unwinding carry trades. Renewed price increases returned with zero interest rates and quantitative easing. Monetary policy impulses in massive doses have driven inflation and valuation of risk financial assets in wide fluctuations over a decade.

Chart II-2, US, Prices of Total US Imports 2001=100, 2001-2011

Source: http://www.bls.gov/mxp/data.htm

Chart II-3 provides prices of US imports from 1982 to 2011. There is no similar episode to that of the increase of commodity prices in 2008 during a protracted and deep global recession with subsequent collapse during a flight into government obligations. Trade prices have been driven by carry trades created by unconventional monetary policy in the past decade.

Chart II-3, US, Prices of Total US Imports, 2001=100, 1982-2011

Source: http://www.bls.gov/mxp/data.htm

Chart II-4 provides 12-month percentage changes of US total imports from 1982 to 2011. There have not been wide consecutive oscillations as the ones during the global recession of IVQ2007 to IIQ2009.

Chart II-4, US, Prices of Total US Imports, 12-Month Percentage Changes, 1982-2011

Source: http://www.bls.gov/mxp/data.htm

Chart II-5 provides the index of US export prices from 2001 to 2011. Import and export prices have been driven by impulses of unconventional monetary policy in massive doses. The most recent segment in Chart II-5 shows declining trend resulting from a combination of the world economic slowdown and the decline of commodity prices as carry trade exposures are unwound because of risk aversion to the sovereign debt crisis in Europe.

Chart II-5, US, Prices of Total US Exports, 2001=100, 2001-2011

Source: http://www.bls.gov/mxp/data.htm

Chart II-6 provides prices of US total exports from 1982 to 2011. The rise before the global recession from 2003 to 2008, driven by carry trades, is also unique in the series.

Chart II-6, US, Prices of Total US Exports, 2001=100, 1982-2011

Source: http://www.bls.gov/mxp/data.htm

Chart II-7 provides 12-month percentage changes of total US exports from 1982 to 2011. The uniqueness of the oscillations around the global recession of IVQ2007 to IIQ2009 is clearly revealed.

Chart II-7, US, Prices of Total US Exports, 12-Month Percentage Changes, 1982-2011

Source: http://www.bls.gov/mxp/data.htm

Twelve-month percentage rates of change of US prices of exports and imports are provided in Table II-4. Import prices have been driven since 2003 by unconventional monetary policy of near zero interest rates influencing commodity prices according to moods of risk aversion. In a global recession without risk aversion until the panic of Sep 2008 with flight to government obligations, import prices rose 10.6 percent in the twelve months ending in Nov 2007 and fell 10.1 percent when risk aversion developed in 2008 until mid 2009. Import prices rose again sharply in 2009 by 8.6 percent and in 2011 until May in the presence of zero interest rates with relaxed mood of risk aversion. There is similar behavior of prices of imports ex fuels, exports and exports ex agricultural goods but less pronounced than for commodity-rich prices dominated by carry trades from zero interest rates.

Table II-4, US, Twelve-Month Percentage Rates of Change of Prices of Exports and Imports

	Imports	Imports Ex Fuels	Exports	Exports Non-Ag
Dec 2011	8.5	3.4	3.6	4.0
Dec 2010	5.3	3.0	6.5	5.1
Dec 2009	8.6	0.3	3.4	2.9
Dec 2008	-10.1	1.2	-2.9	-2.2
Dec 2007	10.6	3.1	6.0	4.5
Dec 2006	2.5	2.9	4.5	3.7
Dec 2005	8.0	1.1	2.8	2.6
Dec 2004	6.7	3.0	4.0	5.0
Dec 2003	2.4	1.0	2.2	1.3
Dec 2002	4.2	NA	1.0	0.4
Dec 2001	-9.1	NA	-2.5	-2.5

Source: http://www.bls.gov/mxp/data.htm#

Chart II-8 shows the US monthly import price index of all commodities excluding fuels from 2001 to 2011. All curves of nominal values follow the same behavior under the influence of unconventional monetary policy. Zero interest rates without risk aversion result in jumps of nominal values and zero interest rates while under strong risk aversion there are declines of nominal values.

Chart II-8, US, Import Price Index All Commodities Excluding Fuels, 2001=100, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart II-9 provides 12-month percentage changes of the US import price index excluding fuels between 2001 and 2011. There is the same behavior of carry trades driving up without risk aversion and down with risk aversion prices of raw materials, commodities and food in international trade during the global recession of IVQ2007 to IIQ2009 and in previous and subsequent periods.

Chart II-9, US, Import Price Index All Commodities Excluding Fuels, 12-Month Percentage Changes, 2002-2011

Source: US Bureau of Labor Statistics

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

Chart II-10 provides the monthly US import price index ex petroleum from 2001 to 2011. Prices including or excluding commodities follow the same fluctuations and trends originating in impulses of unconventional monetary policy of zero interest rates.

Chart II-10, US, Import Price Index ex Petroleum, 2001=100, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart II-11 provides the US import price index ex petroleum from 1982 to 2011. There is the same hump in 2008 caused by carry trades from zero interest rates to prices of commodities and raw materials.

Chart II-11, US, Import Price Index ex Petroleum, 2001=100, 1982-2011

Source: US Bureau of Labor Statistics

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

Chart II-12 provides 12-month percentage changes of the import price index ex petroleum from 1986 to 2011. The oscillations caused by the carry trade in increasing prices of commodities and raw materials without risk aversion and subsequently decreasing them during risk aversion are quite unique.

Chart II-12, US, Import Price Index ex Petroleum, 12-Month Percentage Changes, 1986-2011

Source: US Bureau of Labor Statistics

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

Chart II-13 of the US Energy Information Administration provides the price of the crude oil futures contract from 1985 to 2011. There is the same hump in 2008 as in all charts caused by the common factor of carry trades from zero interest rates to commodity futures positions with risk appetite and subsequent decline when carry trades were unwound during shocks of risk aversion.

Chart II-13, US, Crude Oil Futures Contract

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D

The price index of US imports of petroleum and petroleum products in shown in Chart II-14. There is similar behavior of the curves all driven by the same impulses of monetary policy.

Chart II-14, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart II-15 provides the price index of petroleum and petroleum products from 1982 to 2011. The rise in prices during the global recession in 2008 and the decline after the flight to government obligations is unique in the history of the series. Increases in prices of trade in petroleum and petroleum products were induces by carry trades and declines by unwinding carry trades in flight to government obligations.

Chart II-15, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 1982-2011

Source: US Bureau of Labor Statistics

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

Chart II-16 provides 12-month percentage changes of the price index of US imports of petroleum and petroleum products from 1982 to 2011. There were wider oscillations in this index from 1999 to 2001 (see Barsky and Killian 2004 for an explanation).

Chart II-16, US, Import Price Index of Petroleum and Petroleum Products, 12-Month Percentage Changes, 1982-2011

Source: US Bureau of Labor Statistics

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

The price index of US exports of agricultural commodities is in Chart II-17 from 2001 to 2011. There are similar fluctuations and trends as in all other price index originating in unconventional monetary policy repeated over a decade. The most recent segment in 2011 has declining trend in a new flight from risk resulting from the sovereign debt crisis in Europe.

Chart II-17, US, Exports Price Index of Agricultural Commodities, 2001=100, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart II-18 provides the price index of US exports of agricultural commodities from 1982 to 2011. The increase in 2008 in the middle of deep, protracted contraction was induced by unconventional monetary policy. The decline from 2008 into 2009 was caused by unwinding carry trades in a flight to government obligations. The increase into 2011 and current pause were also induced by unconventional monetary policy in waves of increases during relaxed risk aversion and declines during unwinding of positions because of aversion to financial risk.

Chart II-18, US, Exports Price Index of Agricultural Commodities, 2001=100, 1982-2011

Source: US Bureau of Labor Statistics

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

Chart II-19 provides 12-month percentage changes of the index of US exports of agricultural commodities from 1986 to 2011. The wide swings in 2008, 2009 and 2011 are only explained by unconventional monetary policy inducing carry trades from zero interest rates to commodity futures and reversals during risk aversion.

Chart II-19, US, Exports Price Index of Agricultural Commodities, 12-Month Percentage Changes, 1986-2011

Source: US Bureau of Labor Statistics

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

Chart II-20 shows the export price index of nonagricultural commodities from 2001 to 2011. Unconventional monetary policy of zero interest rates drove price behavior during the past decade. Policy has been based on the myth of stimulating the economy by climbing the negative slope of an imaginary short-term Phillips curve.

Chart II-20, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 2001-2011

Source: US Bureau of Labor Statistics

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

Chart II-21 provides a longer perspective of the price index of US nonagricultural commodities from 1982 to 2011. Increases and decreases around the global contraction after 2007 were caused by carry trade induced by unconventional monetary policy.

Chart II-21, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 1982-2011

Source: US Bureau of Labor Statistics

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

Finally, Chart II-22 provides 12-month percentage changes of the price index of US exports of nonagricultural commodities from 1986 to 2011. The wide swings before, during and after the global recession beginning in 2007 were caused by carry trades induced by unconventional monetary policy.

Chart II-22, US, Exports Price Index of Nonagricultural Commodities, 12-Month Percentage Changes, 1986-2011

Source: US Bureau of Labor Statistics

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

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 four months have been characterized by financial turbulence, attaining unusual magnitude in the past few weeks. Table III-1, updated with every comment in this blog, provides beginning values on Fr Jan 6 and daily values throughout the week ending on Fri Jan 13 of several financial assets. Section VI 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 6 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 1.2720/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 6, depreciating to USD 1.2766/EUR on Mon Jan 9, or by 0.4 percent. The dollar depreciated because more dollars, $1.2766, were required on Jan 9 to buy one euro than $1.2720 on Jan 6. 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 1.2766/EUR on Jan 9; 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 6, to the last business day of the current week, in this case Fri Jan 13, such as appreciation by 0.3 percent to USD 1.268/EUR by Jan 13; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (positive sign) by 0.3 percent from the rate of USD 1.2720/EUR on Fri Jan 6 to the rate of USD 1.268/EUR on Fri Jan 13 {[(1.268/1.2720) – 1]100 = -0.3%} and appreciated by 1.1 percent from the rate of USD 1.2826 on Thu Jan 13 to USD 1.268/EUR on Fri Jan 13 {[(1.268/1.2826) -1]100 = -1.1%}. 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 yield 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 9 to Jan 13, 2012

Fri Jan 6, 2012	Mon 9	Tue 10	Wed 11	Thu 12	Fri 13
USD/EUR 1.2720 1.7%	1.2766 -0.4% -0.4%	1.2774 -0.4% -0.1%	1.2705 0.1% 0.5%	1.2826 -0.8% -0.9%	1.268 0.3% 1.1%
JPY/  USD 76.96 -0.1%	76.8298 0.2% 0.2%	76.8378 0.2% 0.0%	76.8878 0.1% -0.1%	76.7510 0.3% 0.2%	76.952 0.0% -0.3%
CHF/  USD 0.956 -2.2%	0.9496 0.7% 0.7%	0.9493 0.7% 0.0%	0.9543 0.2% -0.5%	0.9439 1.3% 1.1%	0.9555 0.1% -1.2%
CHF/ EUR 1.2150 0.0%	1.2123 0.2% 0.2%	1.2126 0.2% 0.0%	1.2125 0.2% 0.0%	1.2106 0.4% 0.2%	1.2076 0.6% 0.2%
USD/  AUD 1.022 0.9785 0.2%	1.0239 0.9767 0.2% 0.2%	1.0311 0.9698 0.9% 0.7%	1.0310 0.9699 0.9% 0.0%	1.0340 0.9671 1.2% 0.3%	1.0321 0.9689 1.0% -0.2%
10 Year  T Note 1.957	1.95	1.97	1.91	1.92	1.869
2 Year     T Note 0.256	0.24	0.24	0.23	0.23	0.225
German Bond 2Y 0.17 10Y 1.85	2Y 0.14 10Y 1.85	2Y 0.17 10Y 1.88	2Y 014 10Y 1.81	2Y 0.16 10Y 1.84	2Y 0.15 10Y 1.77
DJIA 12359.92 1.2%	12392.69 0.3% 0.3%	12462.47 0.8% 0.6%	12449.45 0.7% -0.1%	12471.02 0.9% 0.2%	12422.06 0.5% -0.4%
DJ Global 1812.76 0.6%	1815.86 0.2% 0.2%	1841.43 1.6% 1.4%	1843.59 1.7% 0.1%	1850.33 2.1% 0.4%	1841.21 1.6% -0.5%
DJ Asia Pacific 1168.32 0.5%	1171.18 0.2% 0.2%	1186.13 1.5% 1.3%	1188.69 1.7% 0.2%	1187.34 1.6% -0.1%	1194.65 2.3% 0.6%
Nikkei 8390.35 -0.8% -1.2%	8390.35 -1.2% -1.2%	8422.26 0.4% 0.4%	8447.88 0.7% 0.3%	8385.59 -0.1% -0.7%	8500.02 1.3% 1.4%
Shanghai 2163.39 -1.6%	2225.89 2.9% 2.9%	2285.74 5.6% 2.7%	2276.05 5.2% -0.4%	2275.01 5.2% -0.1%	2244.58 3.8% -1.3%
DAX 6057.92 2.7%	6017.23 -0.7% -0.7%	6162.98 1.7% 2.4%	6152.34 1.6% -0.2%	6179.21 2.0 0.4%	6143.08 1.4% -0.6%
DJ UBS Comm. 142.55 1.3%	143.08 0.4% 0.4%	144.21 1.2% 0.8%	143.17 0.4% -0.7%	141.61 -0.7% -1.1%	140.51 -1.4% -0.8%
WTI $ B 101.76 2.8%	101.41 -0.3% -0.3%	102.17 0.4% 0.7%	101.04 -0.7% -1.1%	99.15 -2.6% -1.9%	99.26 -2.5% 0.1%
Brent    $/B 113.40 5.5%	112.37 -0.9% -0.9%	113.24 -0.1% 0.8%	112.58 -0.7% -0.6%	110.88 -2.2% -1.5%	111.14 -2.0% 0.2%
Gold  $/OZ 1617.5 3.4%	1611.6 -0.4% -0.4%	1632.4 0.9% 1.3%	1642.2 1.5% 0.6%	1650.9 2.1% 0.5%	1639.6 1.4% -0.7%

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

The week has 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 environments

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.

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 7.26 percent on Jan 9 to 6.74 percent on Jan 13 and the yield of Spain’s 10-year bond fell from 5.59 percent on Jan 9 to 5.24 percent on Jan 13.

Table III-1 shows mixed results in valuations of risk financial assets in the week of Jan 9. 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 muted 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 probably best observed in foreign exchange markets with daily trading of $4 trillion instead of in relatively thin equity markets during year-end holidays. The dollar has fluctuated in a tight range with hardly any changes except for appreciation of the Swiss franc by 0.6 percent relative to the euro and appreciation by 1.0 percent of the Australian dollar relative to the US dollar. The USD was relatively unchanged during the week relative to the EUR, JPY and CHF.

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing risk 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, as shown in Table III-1. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.4 percent in the 12 months ending in Nov (http://www.bls.gov/cpi/). 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, 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 2.8 percent for the 12 months ending in Dec (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-04012012-AP/EN/2-04012012-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 in Jan 13, as shown in Table III-1. The yield of the 10-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 10-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, 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 mixed performance of equity indexes in Table III-1 during the week of Jan 6. Germany’s Dax rose 2.7 percent. DJIA gained 1.2 percent in the week of Fri Jan 6. Dow Global increased 1.4 percent in the week of Jan 13. China’s Shanghai Composite jumped 3.8 percent in the week with an increase of 5.6 percent in Jan 9 and Jan 10 after release of inflation data that may signal renewed fiscal and monetary stimulus to support Chinese economic growth. Japan’s Nikkei Average dropped increased 1.3 percent. Dow Asia Pacific rose 2.3 percent and the Global Dow gained 1.6 percent. The DJIA increased 0.5 percent during the week.

Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities fell in the week of Jan 13. The DJ UBS Commodities Index dropped 1.4 percent. WTI lost 2.5 percent and Brent fell 2.0 percent. Gold gained 1.4 percent. Confrontation with Iran may be influencing oil and commodity prices.

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 VI 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. 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 II-2 is constructed with current 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-2, 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 II-2 are used for some very simple calculations in Table III-3. The column “Net Debt USD Billions” in Table II-3 is generated by applying the percentage in Table III-2 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-3. 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-3, 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-4 for the current sovereign risk crisis in the euro zone. Table III-4 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-4, 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.

III Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table III-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 IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.

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

	GDP	CPI	PPI	UNE
US	1.5	3.4	5.7	8.6
Japan	-0.7	-0.5	1.7	4.5
China	9.1	4.1	1.7
UK	0.5	4.8* RPI 5.2	4.8* output 8.7* input 6.9**	8.3
Euro Zone	1.4	2.8	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/november-2011/index.html

**Excluding food, beverage, tobacco and petroleum

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

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.5 percent in IIIQ2011 relative to IIIQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2011/pdf/gdp3q11_3rd.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 and see historical data in IIIB at http://cmpassocregulationblog.blogspot.com/2011/12/euro-zone-survival-risk-world-financial_11.html); the UK grew at 0.5 percent in IIIQ2011 relative to IIIQ2010 and 0.6 percent in IIIQ2011 relative to IIQ2011 (http://www.ons.gov.uk/ons/rel/naa2/quarterly-national-accounts/q3-2011/index.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, 8.3 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_1721.html) and 10.3 percent in the Euro Zone. Twelve months rates of inflation have been quite high, even when some are moderating at the margin: 3.4 percent in the US, minus 0.2 percent for Japan, 2.8 percent for the Euro Zone and 4.8 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/thirty-million-unemployed-or.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/2011/12/recovery-without-hiring-world-inflation_20.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.

The Federal Open Market Committee (FOMC) did not change the course of monetary policy at its meeting on Dec 13 with the following statement (http://www.federalreserve.gov/newsevents/press/monetary/20111213a.htm):

“Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, 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 continues to expect a moderate pace of economic growth over coming quarters 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 inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today 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.

The Committee also decided 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 mid-2013.

The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”

There were no changes of direction in the meeting of the Federal Open Market Committee (FOMC) from Nov 1 to Nov 2, 2011. The FOMC released the statement as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111102a.htm):

“For immediate release

Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today 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.

The Committee also decided 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 mid-2013.

The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.”

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 IV-2. It is instructive to focus on 2012, as 2011 is gone, 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. The first row for each year shows the projection introduced after the meeting of Nov 2 and the second row “Jun PR” the projection of the Jun 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.

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.

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.

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.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, November 2011

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2011 Jun PR	1.6 – 1.7 2.7 – 2.9	9.0 – 9.1 8.6 – 8.9	2.7 – 2.9 2.3 – 2.5	1.8 – 1.9 1.5 – 1.8
2012 Jun PR	2.5 – 2.9 3.3 – 3.7	8.5 – 8.7 7.8 – 8.2	1.4 – 2.0 1.5 – 2.0	1.5 – 2.0 1.4 – 2.0
2013 Jun PR	3.0 – 3.5 3.5 – 4.2	7.8 – 8.2 7.0 – 7.5	1.5 – 2.0 1.5 – 2.0	1.4 – 1.9 1.4 – 2.0
2014 Jun PR	3.0 – 3.9 NA	6.8 – 7.7 NA	1.5 – 2.0 NA	1.5 – 2.0 NA
Longer Run	2.4 – 2.7 2.5 – 2.8	5.2 – 6.0 5.2 – 5.6	1.7 – 2.0 1.7 – 2.0
Range
2011 Jun PR	1.6 – 1.8 2.5 – 3.0	8.9 – 9.1 8.4 – 9.1	2.5 – 3.3 2.1 – 3.5	1.7 – 2.0 1.5 – 2.3
2012 Jun PR	2.3 – 3.5 2.2 – 4.0	8.1 – 8.9 7.5 – 8.7	1.4 – 2.8 1.2 – 2.8	1.3 – 2.1 1.2 – 2.5
2013 Jun PR	2.7 – 4.0 3.0 – 4.5	7.5 – 8.4 6.5 – 8.3	1.4 – 2.5 1.3 – 2.5	1.4 – 2.1 1.3 – 2.5
2014 Jun PR	2.7 – 4.5 NA	6.5 – 8.0 NA	1.5 – 2.4 NA	1.4 – 2.2 NA
Longer Run	2.2 – 3.0 2.4 – 3.0	5.0 – 6.0 5.0 – 6.0	1.5 – 2.0 1.5 – 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20111102.pdf

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 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 1.22 percent for the first three quarters of 2011 (http://cmpassocregulationblog.blogspot.com/2011/12/slow-growth-falling-real-disposable.html). Recent recovery has been driven by decline in the savings rate from 5.2 percent in Dec 2010 to 3.5 percent in Nov 2011 while real disposable income has fallen. Labor markets continue to be fractured with unemployment or underemployment of 29 million, weak hiring and falling real wages. Inflation has been moving on waves with acceleration in more recent months relative to moderation in May-Jul (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.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 14 (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 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.”

China is experiencing similar inflation behavior as the advanced economies, as shown in Table IV-3. Dec inflation of the price indexes for industry is minus 0.3 percent but 12 months inflation is still 1.7 percent and inflation in Jan/Dec 2011 relative to the same period in 2010 is 6.0 percent. There were no drivers of inflation in Oct with all components in Table IV-3 falling on a monthly basis in row “Month Dec ∆%,” which is also the case for Nov producer prices. This is the case of prices of raw materials which fell 0.5 percent in Dec after increasing 2.5 percent in 12 months and 9.2 percent in 2011 relative to a year earlier. Mining and quarrying prices rose 0.7 percent in Dec after increasing 9.4 percent in 12 months and 15.4 percent in 2011 relative to a year earlier. Prices of the various categories of inputs in the purchaser price index also fell in Dec after also falling in Nov and Oct.

Table IV-3, China, Price Indexes for Industry ∆%

	Month    Dec ∆%	12 Months Dec ∆%	Year 2011 ∆%
I Producer Price Indexes	-0.3	1.7	6.0
Means of Production	-0.4	1.4	6.6
Mining & Quarrying	0.7	9.4	15.4
Raw Materials	-0.5	2.9	9.2
Processing	-0.5	0.0	4.6
Consumer Goods	-0.1	2.5	4.2
Food	-0.1	4.3	7.4
Clothing	0.3	3.6	4.2
Daily Use Articles	-0.2	2.1	4.0
Durable Consumer Goods	-0.2	-0.5	-0.6
II Purchaser Price Indexes	-0.4	3.5	9.1
Nonferrous Metals	-1.4	0.6	12.1
Fuel and Power	0.6	8.4	10.8
Ferrous Metals	-1.2	1.4	9.4
Raw Chemical Materials	-1.3	1.4	10.4

Source: National Bureau of Statistics of China http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778770.htm

Producer price inflation in China was -0.3 percent in Dec and 1.7 percent in 12 months, as shown in Table IV-4. In the six months Jul-Dec 2011 annual equivalent inflation is minus 3.9 percent. In contrast, in the first half of the year annual equivalent inflation was 20.4 percent. Inflation has fallen at the margin in China. Inflation worldwide is driven by inflation waves that abate during heightened risk aversion but is driven upward by the carry trade from zero interest rates to positions in commodity futures as analyzed in a past comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/12/recovery-without-hiring-world-inflation_20.html), which will be updated in the comment of next week.

Table IV-4, China, Month and 12 Months Rate of Change of Producer Price Index, ∆%

	12 Month ∆%	Month ∆%
Dec	1.7	-0.3
Nov	2.7	-0.7
Oct	5.0	-0.7
Sep	6.5	0.0
Aug	7.3	0.1
Jul	7.5	0.0
AE ∆% Jul-Dec		-3.9
Jun	7.1	0.0
May	6.8	0.3
Apr	6.8	0.5
Mar	7.3	0.6
Feb	7.2	0.8
Jan	6.6	0.9
AE ∆% Jan-Jun		20.4
Dec 2010	5.9	0.7

AE: Annual Equivalent

Source: National Bureau of Statistics of China

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778770.htm

Chart IV-1 of the National Bureau of Statistics of China provides monthly and 12 months rates of inflation of the price indexes for the industrial sector. Negative monthly rates in Oct, Nov and Dec pulled down the 12 months rates to 5.0 percent in Oct, 2.7 percent in Nov and 1.7 percent in Dec. At the margin since Jun inflation had been almost zero to Sep and fell 0.7 percent in Oct, another 0.7 percent in Nov and 0.3 percent in Dec.

Chart IV-1, China, Producer Prices for the Industrial Sector Month and 12 months ∆%

Source: National Bureau of Statistics of China

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778770.htm

China is highly conscious of food price inflation because of its high weight in the basket of consumption of the population. Consumer price inflation in China in Dec was 0.3 percent, 4.1 percent in 12 months and 5.5 percent 2011 relative to 2010, as shown in Table IV-5. By far the highest increase occurred in food with increase of 1.2 percent in Dec and increase of 9.1 percent in the 12 months ending in Dec and 11.8 percent in 2011 relative to a year earlier. Another area of concern is housing minus 0.2 percent in Dec but 2.1 percent in 12 months and 5.3 percent in 2011 relative to a year earlier. Prices of services fell 0.2 percent in Dec but rose 2.0 percent in 12 months and 3.5 percent in 2011 relative to a year earlier. In contrast with producer prices, there were increases in several components.

Table IV-5, China, Consumer Price Index

2011	Dec   Month   ∆%	Dec 12 Month  ∆%	Year 2011   ∆%
Consumer Prices	0.3	4.1	5.4
Urban	0.3	4.1	5.3
Rural	0.3	4.1	5.8
Food	1.2	9.1	11.8
Non-food	-0.1	1.9	2.6
Consumer Goods	0.5	4.9	6.2
Services	-0.2	2.0	3.5
Commodity Categories:
Food	1.2	9.1	11.8
Tobacco, Liquor	0.3	3.9	2.8
Clothing	0.4	3.8	2.1
Household	0.0	2.5	2.4
Healthcare & Personal Articles	-0.1	2.8	3.4
Transportation & Communication	-0.1	0.3	0.5
Recreation, Education, Culture & Services	-0.3	0.1	0.4
Residence	-0.2	2.1	5.3

Source: National Bureau of Statistics of China

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778750.htm

Month and 12 months rates of change of consumer prices are provided in Table IV-6. In contrast with producer prices, the annual equivalent rate of consumer price inflation rose from 2.0 percent in Apr to Jun to 4.3 percent in Jul to Oct and 3.0 percent in Jul-Dec. At the marginal monthly level, consumer prices are increasing at a relatively high rate of 3.0 percent even if lower than 8.3 percent in annual equivalent in Jan-Mar. Inflation waves accelerate in carry trades from zero interest rates to commodity futures positions when risk aversion diminishes.

Table IV-6, China, Month and 12 Months Rates of Change of Consumer Price Index ∆%

	Month ∆%	12 Month ∆%
Dec 2011	0.3	4.1
Nov	-0.2	4.2
Oct	0.1	5.5
Sep	0.5	6.1
Aug	0.3	6.2
Jul	0.5	6.5
AE ∆% Jul to Dec	3.0
Jun	0.3	6.4
May	0.1	5.5
Apr	0.1	5.3
AE ∆% Apr to Jun	2.0	2.0
Mar	-0.2	5.4
Feb	1.2	4.9
Jan	1.0	4.9
AE ∆% Jan to Mar	8.3
Dec 2010	0.5	4.6

AE: Annual Equivalent

Source: National Bureau of Statistics of China

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778750.htm

Chart IV-2 of the National Bureau of Statistics of China provides monthly and 12 months rates of consumer price inflation. In contrast with producer prices, consumer prices had not moderated at the monthly marginal rates. Consumer prices fell 0.2 percent in Nov after increasing only 0.1 percent in Oct but increased 0.3 percent in Dec.

Chart IV-2, China, Consumer Prices ∆% Month and 12 Months Aug 2010 to Aug 2011

Source: National Bureau of Statistics of China

http://www.stats.gov.cn/enGliSH/newsandcomingevents/t20120112_402778750.htm

The Statistiche Bundesamt Deutschland or Federal Statistical Agency of Germany estimates preliminarily that the consumer price index of Germany rose 2.3 percent in 2011 in relation to 2010. The preliminary estimate of the consumer price index in Dec is now confirmed as an increase of 2.1 percent relative to Dec 2010. CPI inflation in Dec is confirmed at 0.7 percent “mainly due to seasonal factors” (http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2011/12/PE11__487__611,templateId=renderPrint.psml). Consumer price inflation in Germany in Nov was flat and 2.4 percent in 12 months, as shown in Table IV-7. Most inflation in Germany in 2011 has concentrated in three months: 0.4 percent in Jul, 0.5 percent in Mar and 0.5 percent in Feb. A quarter composed of those three months repeated for an entire year would result in annual equivalent inflation of 5.8 percent. Annual equivalent inflation in the quarter Jul-Nov was at the annual equivalent rate of 1.2 percent, which is lower than the 12-month rate of 2.4 percent in Nov. Annual equivalent inflation in Jul-Dec using the confirmed estimate is 2.4 percent.

Table IV-7, Germany, Consumer Price Index ∆%

	12 Months ∆%	Month ∆%
Dec 2011	2.1	0.7
Nov	2.4	0.0
Oct	2.5	0.0
Sep	2.6	0.1
Aug	2.4	0.0
Jul	2.4	0.4
AE ∆% Jul-Dec		2.4
Jun	2.3	0.1
May	2.3	0.0
AE ∆% May-Jun		0.6
Apr	2.4	0.2
Mar	2.1	0.5
Feb	2.1	0.5
Jan	2.0	-0.4
AE ∆% Jan-Apr		2.4
Dec 2010	1.7	1.0
Nov	1.5	0.1
Oct	1.3	0.1
Sep	1.3	-0.1
Aug	1.0	0.0
Annual Average ∆%
2011	2.3
2010	1.1
2009	0.4
2008	2.6

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/01/PE12__011__611,templateId=renderPrint.psml

Chart IV-3, of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index of Germany from 2003 to 2011. There is an evident acceleration in the form of sharper slope in the first months of 2011 and then a flattening in more recent months with renewed strength in Dec. If risk aversion declines, new carry trades from zero interest rates to commodity futures could again result in higher inflation.

Chart IV-3, Germany, Consumer Price Index, Unadjusted, 2005=100

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/Content/Statistics/TimeSeries/EconomicIndicators/KeyIndicators/ConsumerPrices/liste__vpi,templateId=renderPrint.psml

Chart IV-4 of the Statistiche Bundesamt Deutschland, or Federal Statistical Agency of Germany, provides the unadjusted consumer price index of Germany and trend from 2007 to 2011. Inflation moderated during the global recession but regained the sharper slope with the new carry trades from zero interest rates to commodity futures beginning in 2010.

Chart IV-4, Germany, Consumer Price Index, Unadjusted and Trend, 2005=100

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/Content/Statistics/TimeSeries/EconomicIndicators/Prices/Content100/kpre510graf0.psml

Table IV-8 provides the monthly and 12 months rate of inflation for segments of the consumer price index. Inflation excluding energy was flat in Nov and rose 1.4 percent in 12 months. Excluding household energy inflation was 0.8 percent in Dec and rose 1.3 percent in 12 months. High increases in Germany’s consumer prices in Dec were 1.7 percent in services and 0.6 percent in food. Heating oil that rose 18.2 percent in 12 months and 24.5 percent in the yearly average fell 3.0 percent in Dec.

Table IV-8, Germany, Consumer Price Index ∆%

Dec 2011	Weight	∆% 2010 Annual Average	12 Months ∆%	Month   ∆%
Total	1,000.00	2.3	2.1	0.7
Excluding heating oil and motor fuels	955.42	1.7	1.7	0.9
Excluding household energy	940.18	1.8	1.5	0.7
Excluding Energy	904.81	1.3	1.3	0.8
Total Goods	493.00	3.3	3.0	-0.2
Nondurable Consumer Goods	305.11	4.7	4.0	-0.1
Medium-Term Life Consumer Goods	95.24	1.4	1.5	-0.9
Durable Consumer Goods	92.65	-0.1	-0.1	-0.1
Services	507.00	1.3	1.3	1.7
Energy Components
Motor Fuels	35.37	11.0	5.2	-1.6
Household Energy	59.82	9.5	9.6	-0.3
Heating Oil	9.21	24.5	18.2	-3.0
Food	89.99	2.5	2.0	0.6

Source: Statistiche Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/01/PE12__011__611,templateId=renderPrint.psml

Table IV-9 provides monthly and 12 months consumer price inflation in France. There are the same three waves as in inflation worldwide. In the first wave, annual equivalent inflation in Jan-Apr was 4.3 percent driven by the carry trade from zero interest rates to commodity futures positions in an environment of risk appetite. In the second wave, risk aversion caused the reversal of carry trades into commodity futures, resulting in the fall of the annual equivalent inflation rate to minus 1.2 percent in May-Jul. In the third wave, annual equivalent inflation rose to 3.4 percent in Aug-Dec with alternations of risk aversion and risk appetite.

Table IV-9, France, Consumer Price Index, Month and 12 Months ∆%

	Month	12 Months
Dec 2011	0.4	2.5
Nov	0.3	2.5
Oct	0.3	2.4
Sep	-0.1	2.2
Aug	0.5	2.2
AE ∆% Aug-Dec	3.4
Jul	-0.5	1.9
Jun	0.1	2.1
May	0.1	2.0
AE ∆% May-Jul	-1.2
Apr	0.3	2.1
Mar	0.8	2.0
Feb	0.5	1.6
Jan	-0.2	1.8
AE ∆% Jan-Apr	4.3
Dec 2010	0.4	1.8
Nov	0.1	1.6
Oct	0.1	1.6
Sep	-0.1	1.5
Aug	0.2	1.4
Jul	-0.3	1.7
Jun	0.0	1.5
May	0.1	1.6
Apr	0.3	1.7
Mar	0.5	1.6
Feb	0.6	1.3
Jan	-0.3	1.1

AE: Annual Equivalent

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112

Table IV-10 provides the estimates of inflation by the Institut National de la Statistique et des Études Économiques for the years from 1999 to 2010. Inflation has been relatively moderate in France. The rise of inflation to 2.8 percent in 2008 was caused by the commodity price shock as investment funds shifted from other risk financial assets into carry trades driven by interest rates falling toward zero.

Table IV-10, France, Consumer Price Index Year ∆%

Year	∆%
2010	1.5
2009	0.1
2008	2.8
2007	1.5
2006	1.6
2005	1.8
2004	2.1
2003	2.1
2002	1.9
2001	1.7
2000	1.7
1999	0.5

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112

Chart IV-5 of the Institut National de la Statistique et des Études Économiques of France shows headline and core consumption price inflation of France. Inflation rose during the commodity price shock of unconventional monetary policy. Risk aversion in late 2008 and beginning of 2009 caused collapse of valuation of commodity futures with resulting decline in inflation. Unconventional monetary policy with alternations of risk aversion resulted in higher inflation in France that stabilized in recent months until the increase of 0.3 percent in both Oct and Nov and 0.4 percent in Dec.

Chart IV-5, France, Consumer Price Index (IPC) and Core Consumer Price Index (ISJ) 12 Months Rates of Change

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120112

Inflation in the UK is somewhat higher than in many advanced economies, deserving more detailed analysis. Table IV-11 provides 12-month percentage changes of UK output prices for all manufactured products, excluding food, beverage and petroleum and excluding duty. The 12 months rates rose significantly in 2011 in all three categories, reaching 6.3 percent for all manufactured products in Sep 2011 but declining to 5.7 percent in Oct, 5.4 percent in Nov and 4.8 percent in Dec. Output price inflation is highly sensitive to commodity prices as shown by the increase by 6.7 percent in 2008 when oil prices rose over $140/barrel even in the midst of a global recession driven by the carry trade from zero interest rates to oil futures. The mirage episode of false deflation in 2001 and 2002 is also captured by the output prices for the UK, which was originated in decline of commodity prices but was used as an argument for the unconventional monetary policy of zero interest rates and quantitative easing during the past decade.

Table IV-11, UK Output Prices 12 Months ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
Dec 2011	4.8	3.0	4.8
Nov	5.4	3.1	5.6
Oct	5.7	3.3	5.9
Sep	6.3	3.7	6.4
Aug	6.0	3.5	6.2
Jul	6.1	3.4	6.2
Jun	5.8	3.2	5.9
May	5.4	3.4	5.5
Apr	5.6	3.6	5.8
Mar	5.6	3.1	5.5
Feb	5.3	3.1	5.2
Jan	5.0	3.3	5.0
Dec 2010	4.2	2.7	4.0
Year ∆%		Ex Food
2010	4.2	3.0	3.9
2009	1.6	2.5	0.9
2008	6.7	3.7	6.7
2007	2.3	1.4	2.1
2006	2.0	1.5	2.0
2005	1.9	1.0	1.9
2004	1.0	-0.3	0.6
2003	0.6	0.1	0.5
2002	-0.1	-0.4	-0.3
2001	-0.3	-0.6	-1.1
2000	1.4	-0.5	0.8
1999	0.6	-0.9	-0.3

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html

Monthly and annual equivalent rates of change of output prices are shown in Table IV-12. There has been significant deceleration of output price inflation from an annual equivalent rate of 12.0 percent in Jan-Apr to 1.5 percent annual equivalent in May-Dec. As in the euro zone producer price index, there was monthly inflation in all three measurements of UK’s output prices. An important characteristic is that output prices excluding food, beverage and petroleum decelerated from an annual equivalent rate of change of 6.5 percent in Jan-Apr to 1.4 percent in May-Nov. Another important characteristic is that prices in all three measurements rose in each and every month of 2011 with the exception of the decline by 0.1 percent in Oct, Nov and Dec for the index excluding food, beverage and petroleum and decreases in all three indexes in Dec. Data in the tables include all revisions.

Table IV-12, UK Output Prices Month ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
Dec 2011	-0.2	-0.1	-0.2
Nov	0.2	-0.1	0.2
Oct	0.0	-0.1	0.1
Sep	0.3	0.3	0.2
Aug	0.0	0.1	0.1
Jul	0.3	0.4	0.3
Jun	0.2	0.2	0.2
May	0.2	0.2	0.2
May-Dec ∆% AE	1.5	1.4	1.7
Apr	1.1	0.8	0.9
Mar	1.1	0.5	1.1
Feb	0.5	0.0	0.5
Jan	1.1	0.8	1.1
Jan-Apr ∆% AE	12.0	6.5	7.1
Dec 2010	0.5	0.0	0.6

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html

Input prices in the UK have been more dynamic than output prices, as shown by Table IV-13. The 12 months rates of increase of input prices, even excluding food, tobacco, beverages and petroleum, are very high, reaching 18.0 percent in Sep 2011 for materials and fuels purchased and 13.2 percent excluding food, beverages and petroleum. Inflation in 12 months of materials and fuels purchased moderated to 8.7 percent in Dec 2011 and 6.9 percent excluding food, tobacco, beverages and petroleum. There is only comparable experience with 22.2 percent inflation of materials and fuels purchased in 2008 and 16.9 percent excluding food, beverages and petroleum. UK input and output inflation is sensitive to commodity price increases driven by carry trades from zero interest rates. The mirage of false deflation is also observed in input prices in 1999 and then again from 2001 to 2003.

Table IV-13, UK Input Prices 12 Months ∆% NSA

	Materials and Fuels Purchased	Excluding Food, Tobacco, Beverages and Petroleum
Dec 2011	8.7	6.9
Nov	13.6	10.0
Oct	14.3	10.8
Sep	18.0	13.2
Aug	16.3	13.0
Jul	18.5	13.3
Jun	16.8	12.6
May	16.3	11.4
Apr	17.9	12.2
Mar	14.8	10.3
Feb	14.9	10.7
Jan	14.2	10.5
Dec 2010	13.1	9.0
Year ∆%
2010	9.9	5.7
2009	-3.8	1.6
2008	22.2	16.9
2007	2.9	2.3
2006	9.8	7.3
2005	10.9	6.9
2004	3.3	1.6
2003	1.2	-0.6
2002	-4.4	-4.8
2001	-1.2	-1.2
2000	7.4	3.7
1999	-1.3	-3.6

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html

Table IV-14 provides monthly percentage changes of UK input prices for materials and fuels purchased and excluding food, tobacco, beverages and petroleum. The carry trade from zero interest rates to commodity futures drove input price inflation to annual equivalent 35.6 percent in Jan-Apr 2011 with input price inflation excluding food, tobacco, beverages and petroleum at annual equivalent of 18.5 percent in Jan-Apr. Risk aversion originating in the sovereign debt crisis in Europe caused unwinding of carry trades with annual equivalent inflation in May-Dec of input price inflation of minus 2.9 percent but a high 1.9 percent excluding foods, tobacco, beverages and petroleum.

Table IV-14, UK Input Prices Month ∆% 

	Materials and Fuels Purchased NSA	Excluding Food, Tobacco, Beverages and Petroleum SA
Dec 2011	-0.6	-0.7
Nov	0.3	0.1
Oct	-0.8	-0.5
Sep	2.0	0.6
Aug	-1.9	0.2
Jul	0.6	0.8
Jun	0.1	0.9
May	-1.6	-0.1
May-Dec ∆% AE	-2.9	1.9
Apr	2.8	1.9
Mar	3.8	1.2
Feb	1.4	1.2
Jan	2.3	1.2
Jan-Apr ∆% AE	35.6	18.5
Dec 2010	3.9	1.9

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12 months rates of inflation of manufactured products, shown in Table IV-15. Petroleum is the largest contributor with 1.17 percentage points to the 12-month rate in Dec followed by 1.12 percentage points contributed by food products. There are diversified sources of contributions to 12 months output price inflation such as 0.60 percentage points by clothing, textile and leather and 0.29 percentage points by chemical and pharmaceutical. In general, contributions by products rich in commodities are the drivers of inflation. Petroleum was also the most important contributor to monthly output prices with minus 0.16 percentage points with 0.00 percentage points by tobacco and alcohol and minus 0.11 percentage points by chemical and pharmaceutical.

Table IV-15, Contributions to Month and 12 Month Change in Prices of All Manufactured Products, Percentage Points

Dec 2011	12 Months % Points	12 Months ∆%	Month  % Points	Month ∆%
Total %	4.8	4.8	-0.2	-0.2
Food Products	1.12	7.1	0.03	0.1
Tobacco & Alcohol	0.67	6.6	0.00	0.0
Clothing, Textile & Leather	0.60	5.5	0.01	0.0
Paper and Printing	0.13	3.5	0.01	0.1
Petroleum	1.17	10.5	-0.16	-0.9
Chemical & Pharmaceutical	0.29	3.3	-0.11	-0.9
Metal, Machinery & Equipment	0.13	3.6	0.00	-0.1
Computer, Electrical & Optical	0.04	0.5	0.01	0.1
Transport Equipment	0.10	0.9	-0.03	-0.2
Other Manufactured Products	0.55	3.3	0.04	0.2

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/stb-producer-price-index---december-2011.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12 months rates of inflation of input prices, shown in Table IV-16. Crude oil is the large contributor with 5.20 percentage points to the 12 months rate and minus 0.28 percentage points to the monthly rate in Dec. Inflation also transfers to the domestic economy through the prices of imported inputs.

Table IV-16, UK, Contributions to Month and 12 Month Change in Prices of Inputs, Percentage Points

Dec 2011	12 Months % Points	12 Months ∆%	Month % Points	Month ∆%
Total	8.7	8.7	-0.6	-0.6
Fuel	0.63	6.3	0.01	0.1
Crude Oil	5.20	21.2	-0.28	-1.0
Domestic Food Materials	0.17	1.6	0.05	0.5
Imported Food Materials	0.35	6.4	0.00	0.0
Other Domestic Produced Materials	0.20	4.9	-0.01	-0.2
Imported Metals	0.03	0.4	-0.06	-0.7
Imported Chemicals	0.51	4.6	-0.15	-1.3
Imported Parts and Equipment	0.66	4.2	-0.09	-0.6
Other Imported Materials	0.97	9.7	-0.08	-0.7

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2011/index.html

© Carlos M. Pelaez, 2010, 2011, 2012