CMP Associates Regulation Blog

Chart IB-2 provides US real GDP from 1980 to 2011. Persistent deflation threatening real economic activity would also be reflected in the series of long-term growth of GDP. There is no such behavior in Chart II-2 except for periodic recessions in the US economy that have occurred throughout history.

Chart IB-2, US, Real GDP 1980-2011

Source: US Bureau of Economic Analysis

Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart IB-3 from 1980 to 2011 shows sharp dynamic behavior over time. The US economy is not plagued by deflation but by long-run inflation.

Chart IB-3, US, GDP Implicit Price Deflator 1980-2012

Source: US Bureau of Economic Analysis

Chart IB-4 provides percent change from preceding quarter in prices of GDP at seasonally-adjusted annual rates (SAAR) from 1980 to 2011. There is one case of negative change in IIQ2009. There has not been actual deflation or risk of deflation in the US that would justify unconventional monetary policy.

Chart IB-4, Percent Change from Preceding Period in Prices for GDP Seasonally Adjusted at Annual Rates 1980-2012

Source: US Bureau of Economic Analysis

Chart IB-5 provides percent change from preceding year in prices of GDP from 1980 to 2011. There was not one single year of deflation or risk of deflation in the past three decades.

Chart IB-5, Percent Change from Preceding Year in Prices for Gross Domestic Product 1980-2011

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

The producer price index of the US from 1960 to 2012 in Chart IB-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart IB-6, US, Producer Price Index, Finished Goods, NSA, 1960-2012

Source: US Bureau of Labor Statistics

Chart IB-7 provides 12-month percentage changes of the producer price index from 1960 to 2012. The distinguishing event in Chart IV-2 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2012.

Chart IB-7, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1960-2012

Source: US Bureau of Labor Statistics

The producer price index excluding food and energy from 1973 to 2012, the first historical date of availability in the dataset of the Bureau of Labor Statistics (BLS), shows similarly dynamic behavior as the overall index, as shown in Chart IB-8. There is no evidence of persistent deflation in the US PPI.

Chart IB-8, US Producer Price Index, Finished Goods Excluding Food and Energy, NSA, 1973-2012

Source: US Bureau of Labor Statistics

Chart IB-9 provides 12-month percentage rates of change of the finished goods index excluding food and energy. The dominating characteristic is the Great Inflation of the 1970s. The double hump illustrates how inflation may appear to be subdued and then returns with strength.

Chart IB-9, US Producer Price Index, Finished Goods Excluding Food and Energy, 12-Month Percentage Change, NSA, 1974-2012

Source: US Bureau of Labor Statistics

The producer price index of energy goods from 1974 to 2012 is provided in Chart IB-10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have occurred with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.

Chart IB-10, US, Producer Price Index, Finished Energy Goods, NSA, 1974-2012

Source: US Bureau of Labor Statistics

Chart IB-11 shows 12-month percentage changes of the producer price index of finished energy goods from 1975 to 2012. This index is only available after 1974 and captures only one of the humps of energy prices during the Great Inflation. Fluctuations in energy prices have occurred throughout history in the US but without provoking deflation. Two cases are the decline of oil prices in 2001 to 2002 that has been analyzed by Barsky and Kilian (2004) and the collapse of oil prices from over $140/barrel with shock of risk aversion to the carry trade in Sep 2008.

Chart IB-11, US, Producer Price Index, Finished Energy Goods, 12-Month Percentage Change, NSA, 1974-2012

Source: US Bureau of Labor Statistics

Chart IB-12 provides the consumer price index NSA from 1960 to 2012. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart IB-12, US, Consumer Price Index, NSA, 1960-2012

Source: US Bureau of Labor Statistics

Chart IB-13 provides 12-month percentage changes of the consumer price index from 1960 to 2012. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart IB-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1960-2012

Source: US Bureau of Labor Statistics

Chart IB-14 provides the consumer price index excluding food and energy from 1960 to 2012. There is long-term inflation in the US without episodes of deflation.

Chart IB-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2012

Source: US Bureau of Labor Statistics

Chart IB-15 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2012. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.

Chart IB-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2012

Source: US Bureau of Labor Statistics

The consumer price index of housing is provided in Chart IB-16. There was also acceleration during the Great Inflation of the 1970s. The index flattens after the global recession in IVQ2007 to IIQ2009. Housing prices collapsed under the weight of construction of several times more housing than needed. Surplus housing originated in subsidies and artificially low interest rates in the shock of unconventional monetary policy in 2003 to 2004 in fear of deflation.

Chart IB-16, US, Consumer Price Index Housing, NSA, 1967-2012

Source: US Bureau of Labor Statistics

Chart IB-17 provides 12-month percentage changes of the housing CPI. The Great Inflation also had extremely high rates of housing inflation. Housing is considered as potential hedge of inflation.

Chart IB-17, US, Consumer Price Index, Housing, 12- Month Percentage Change, NSA, 1968-2012

Source: US Bureau of Labor Statistics

IB2 Current US Inflation. Consumer price inflation has fluctuated in recent months. Table IB-2 provides 12-month consumer price inflation in Apr and annual equivalent percentage changes for the months of Feb to Apr 2012 of the CPI and major segments. The final column provides inflation from Mar to Apr 2012. CPI inflation in the 12 months ending in Apr reached 2.3 percent, the annual equivalent rate Feb to Apr was lower at 2.8 percent and the monthly inflation rate of 0.0 percent also annualizes at 0.0 percent {[(1.00)¹² – 1]100}. These inflation rates fluctuate in accordance with inducement of risk appetite or frustration by risk aversion of carry trades from zero interest rates to commodity futures. At the margin, the decline in commodity prices in sharp current risk aversion in financial markets is causing lower inflation worldwide. With zero interest rates, commodity prices would increase again in an environment of risk appetite. Excluding food and energy, CPI inflation was 2.3 percent in the 12 months ending in Apr and 2.0 percent in annual equivalent in Feb-Apr. There is no deflation in the US economy that could justify further quantitative easing. Consumer food prices in the US have risen 3.1 percent in 12 months ending in Apr and at 1.6 percent in annual equivalent in Feb-Apr. Monetary policies stimulating carry trades of commodities that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket. Energy consumer prices increased 0.9 percent in 12 months, 9.8 percent in annual equivalent in Feb-Apr and minus 1.7 percent in Apr as carry trades from zero interest rates to commodity futures were unwound and repositioned during alternating risk aversion and risk appetite originating in the European debt crisis and increasingly in growth and politics in China. For lower income families, food and energy are a major part of the family budget. Inflation is not low or threatening deflation in annual equivalent in Jan-Apr in any of the categories in Table IB-2 but simply reflecting waves of inflation originating in carry trades. An upward trend is determined by carry trades from zero interest rates to commodity futures positions with episodes of risk aversion causing fluctuations.

Table IB-2, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	∆% 12 Months Apr 2012/Apr 2011 NSA	∆% Annual Equivalent Feb to Apr 2012 SA	∆% Apr/Mar SA
CPI All Items	2.3	2.8	0.0
CPI ex Food and Energy	2.3	2.0	0.2
Food	3.1	1.6	0.2
Food at Home	3.3	1.2	0.2
Food Away from Home	2.9	2.4	0.3
Energy	0.9	9.8	-1.7
Gasoline	3.2	21.6	-2.6
Fuel Oil	0.9	18.9	-1.1
New Vehicles	2.2	4.9	0.4
Used Cars and Trucks	3.5	10.9	1.5
Medical Care Commodities	2.7	4.9	0.0
Apparel	5.1	0.0	0.4
Services Less Energy Services	2.4	2.4	0.3
Shelter	2.2	2.4	0.2
Transportation Services	1.7	2.4	0.5
Medical Care Services	3.7	2.8	0.4

Source: US Bureau of Labor Statistics http://www.bls.gov/news.release/pdf/cpi.pdf

The weights of the CPI, US city average for all urban consumers representing about 87 percent of the US population (http://www.bls.gov/cpi/cpiovrvw.htm#item1), are shown in Table IB-3 with the BLS update of Mar 7, 2012 (http://www.bls.gov/cpi/cpiri2011.pdf). Housing has a weight of 41.020 percent. The combined weight of housing and transportation is 58.895 percent or more than one half of consumer expenditures of all urban consumers. The combined weight of housing, transportation and food and beverages is 73.151 percent of the US CPI.

Table IB-3, US, Relative Importance, 2009-2010 Weights, of Components in the Consumer Price Index, US City Average, Dec 2011

All Items	100.000
Food and Beverages	15.256
Food	14.308
Food at home	8.638
Food away from home	5.669
Housing	41.020
Shelter	31.539
Rent of primary residence	6.485
Owners’ equivalent rent	23.957
Apparel	3.562
Transportation	16.875
Private Transportation	15.694
New vehicles	3.195
Used cars and trucks	1.913
Motor fuel	5.463
Gasoline	5.273
Medical Care	7.061
Medical care commodities	1.716
Medical care services	5.345
Recreation	6.044
Education and Communication	6.797
Other Goods and Services	3.385

Note: reissued Mar 7, 2012. Refers to all urban consumers, covering approximately 87 percent of the US population (see http://www.bls.gov/cpi/cpiovrvw.htm#item1)

Source:

US Bureau of Labor Statistics http://www.bls.gov/cpi/cpiri2011.pdf

Chart IB-18 provides the US consumer price index for housing from 2001 to 2012. Housing prices rose sharply during the decade until the bump of the global recession and increased again in 2011 with some stabilization currently. The CPI excluding housing would likely show much higher inflation. Income remaining after paying for indispensable shelter has been compressed by the commodity carry trades resulting from unconventional monetary policy.

Chart IB-18, US, Consumer Price Index, Housing, NSA, 2001-2012

Source: US Bureau of Labor Statistics

Chart IB-19 provides 12-month percentage changes of the housing CPI. Percentage changes collapsed during the global recession but have been rising into positive territory in 2011 and 2012 but with the rate declining recently.

Chart IB-19, US, Consumer Price Index, Housing, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

There have been waves of consumer price inflation in the US in 2011 and into 2012 (Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html) that are illustrated in Table IB-4. The first wave occurred in Jan-Apr and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost in environment of risk appetite was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr was 4.9 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.4 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all-items CPI dropped to 2.8 percent in May-Jul while the annual equivalent rate of the CPI excluding food and energy increased at 3.0 percent. In the third wave in Jul-Sep, annual equivalent CPI inflation rose to 3.7 percent while the core CPI increased at 2.0 percent. The fourth wave occurred in the form of decrease of the CPI all-items annual equivalent rate to 0.6 percent in Oct-Nov with the annual equivalent rate of the CPI excluding food and energy remaining at 2.4 percent. The fifth wave occurred in Dec-Jan with annual equivalent headline inflation of 1.2 percent and core inflation of 1.8 percent. In the sixth wave, headline CPI inflation increased at annual equivalent 4.3 percent in Feb-Mar and core CPI inflation at 1.8 percent but including Apr, the annual equivalent inflation of the headline CPI was 2.8 percent in Feb-Apr and 2.0 percent for the core CPI. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy. Unconventional monetary policy of zero interest rates and withdrawal of bonds to lower long-term interest rates distorts risk/return decisions required for efficient allocation of resources and attaining optimal growth paths and prosperity.

Table IB-4, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%

	All Items SA Month	All Items NSA 12 month	Core SA Month	Core NSA 12 months
Apr 2012	0.0	2.3	0.2	2.3
Mar	0.3	2.7	0.2	2.3
Feb	0.4	2.9	0.1	2.2
AE ∆% Feb-Apr	2.8		2.0
Jan	0.2	2.9	0.2	2.3
Dec 2011	0.0	3.0	0.1	2.2
AE ∆% Dec-Jan	1.2		1.8
Nov	0.1	3.4	0.2	2.2
Oct	0.0	3.5	0.2	2.1
AE ∆% Oct-Nov	0.6		2.4
Sep	0.3	3.9	0.1	2.0
Aug	0.3	3.8	0.2	2.0
Jul	0.3	3.6	0.2	1.8
AE ∆% Jul-Sep	3.7		2.0
Jun	0.1	3.6	0.2	1.6
May	0.3	3.6	0.3	1.5
AE ∆% May-Jul	2.8		3.0
Apr	0.4	3.2	0.2	1.3
Mar	0.5	2.7	0.2	1.2
Feb	0.4	2.1	0.2	1.1
Jan	0.3	1.6	0.2	1.0
AE ∆% Jan-Apr	4.9		2.4
Dec 2010	0.4	1.5	0.1	0.8
Nov	0.2	1.1	0.1	0.8
Oct	0.3	1.2	0.0	0.6
Sep	0.1	1.1	0.0	0.8
Aug	0.2	1.1	0.1	0.9
Jul	0.2	1.2	0.1	0.9
Jun	0.0	1.1	0.1	0.9
May	-0.1	2.0	0.1	0.9
Apr	0.0	2.2	0.0	0.9
Mar	0.0	2.3	0.1	1.1
Feb	0.0	2.1	0.1	1.3
Jan	0.1	1.6	-0.1	1.6

Note: Core: excluding food and energy; AE: annual equivalent

Source: US Bureau of Labor Statistics

The behavior of the US consumer price index NSA from 2001 to 2011 is provided in Chart IB-20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of oil prices toward $140/barrel during the global recession. The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).

Chart IB-20, US, Consumer Price Index, NSA, 2001-2012

Source: US Bureau of Labor Statistics

Chart IB-21 provides 12-month percentage changes of the consumer price index from 2001 to 2012. There was no deflation or threat of deflation from 2008 into 2009. Commodity prices collapsed during the panic of toxic assets in banks. When stress tests in 2009 revealed US bank balance sheets in much stronger position, cheap money at zero opportunity cost exited government obligations and flowed into carry trades of risk financial assets. Increases in commodity prices drove again the all items CPI with interruptions during risk aversion originating in the sovereign debt crisis of Europe.

Chart IB-21, US, Consumer Price Index, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

The trend of increase of the consumer price index excluding food and industry in Chart IB-22 does not reveal any threat of deflation that would justify symmetric inflation targets. There are mild oscillations in a neat upward trend.

Chart IB-22, US, Consumer Price Index Excluding Food and Energy, NSA, 2001-2012

Source: US Bureau of Labor Statistics

Chart IB-23 provides 12-month percentage change of the consumer price index excluding food and energy. Past-year rates of inflation fell toward 1 percent from 2001 into 2003 as a result of the recession and the decline of commodity prices beginning before the recession with declines of real oil prices. Near zero interest rates with fed funds at 1 percent between Jun 2003 and Jun 2004 stimulated carry trades of all types, including in buying homes with subprime mortgages in expectation that low interest rates forever would increase home prices permanently, creating the equity that would permit the conversion of subprime mortgages into creditworthy mortgages (Gorton 2009EFM; see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Inflation rose and then collapsed during the unwinding of carry trades and the housing debacle of the global recession. Carry trade into 2011 and 2012 gave a new impulse to CPI inflation, all items and core. Symmetric inflation targets destabilize the economy by encouraging hunts for yields that inflate and deflate financial assets, obscuring risk/return decisions on production, investment and hiring.

Chart IB-23, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2001-2012

Source: US Bureau of Labor Statistics

Headline and core producer price index are in Table IB-5. The headline PPI SA fell 0.2 percent in Apr while the 12-month rate NSA fell from 4.1 percent in Jan to 3.3 percent in Feb, 2.8 percent in Mar and 1.9 percent in Apr. The core PPI SA increased 0.2 percent in Mar and rose 2.7 percent in 12 months. Analysis of annual equivalent rates of change shows inflation waves similar to those worldwide. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 9.7 percent in the headline PPI in Jan-Apr and 4.0 percent in the core PPI. In the second wave, commodity futures prices collapsed in May with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 1.2 percent in May-Jul but the core annual equivalent inflation rate was much higher at 3.0 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent at 6.6 percent in Jul-Sep and core PPI inflation at 4.1 percent. Core PPI inflation was persistent throughout 2011, jumping from annual equivalent at 2.4 percent in the first four months of 2010 to 2.7 percent in 12 months ending in Apr 2012 and 3.4 percent in annual equivalent rate in Dec 2011 to Mar 2012. Unconventional monetary policy is based on the proposition that core rates reflect more fundamental inflation and are thus better predictors of the future. In practice, the relation of core and headline inflation is as difficult to predict as future inflation (see IIID Supply Shocks in http://cmpassocregulationblog.blogspot.com/2011_05_01_archive.html). In the fourth wave, risk aversion originating in the lack of resolution of the European debt crisis caused unwinding of carry trades with annual equivalent headline PPI inflation of minus 1.2 percent in Oct-Nov and 0.6 percent in the core annual equivalent. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was 0.6 percent for the headline index but 3.7 percent for the core index excluding food and energy. In the sixth wave, headline annual equivalent inflation in Feb-Apr was 0.8 percent for the headline PPI and 2.8 percent for the core. It is impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.

Table IB-5, US, Headline and Core PPI Inflation Monthly SA and 12-Month NSA ∆%

	Finished Goods SA Month	Finished Goods NSA 12 months	Finished Core SA Month	Finished Core NSA 12 months
Apr 2012	-0.2	1.9	0.2	2.7
Mar	0.0	2.8	0.3	2.9
Feb	0.4	3.3	0.2	3.0
AE ∆% Feb-Apr	0.8		2.8
Jan	0.2	4.1	0.4	3.0
Dec 2011	-0.1	4.7	0.2	3.0
AE ∆% Dec-Jan	0.6		3.7
Nov	0.1	5.6	0.1	3.0
Oct	-0.3	5.8	0.0	2.9
AE ∆% Oct-Nov	-1.2		0.6
Sep	0.9	7.0	0.3	2.8
Aug	0.2	6.6	0.2	2.7
Jul	0.5	7.1	0.5	2.7
AE ∆% Jul-Sep	6.6		4.1
Jun	0.1	6.9	0.3	2.3
May	0.1	7.1	0.2	2.1
AE ∆% May-Jun	1.2		3.0
Apr	0.7	6.6	0.3	2.3
Mar	0.5	5.6	0.3	2.0
Feb	1.1	5.4	0.2	1.8
Jan	0.8	3.6	0.5	1.6
AE ∆% Jan-Apr	9.7		4.0
Dec 2010	0.9	3.8	0.2	1.4
Nov	0.4	3.4	-0.1	1.2
Oct	0.8	4.3	-0.2	1.6
Sep	0.4	3.9	0.2	1.6
Aug	0.7	3.3	0.2	1.3
Jul	0.2	4.1	0.2	1.5
Jun	-0.2	2.7	0.1	1.1
May	-0.2	5.1	0.3	1.3
Apr	-0.1	5.4	0.1	0.9
Mar	0.5	5.9	0.2	0.9
Feb	-0.6	4.2	0.0	1.0
Jan	1.0	4.5	0.3	1.0

Note: Core: excluding food and energy; AE: annual equivalent

Source: US Bureau of Labor Statistics

The US producer price index NSA from 2001 to 2012 is shown in Chart IB-24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.

Chart IB-24, US, Producer Price Index, NSA, 2000-2012

Source: US Bureau of Labor Statistics

Twelve-month percentage changes of the PPI NSA from 2001 to 2012 are shown in Chart IB-25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12-month rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.

Chart IB-25, US, Producer Price Index, 12-Month Percentage Change NSA, 2000-2012

Source: US Bureau of Labor Statistics

The US PPI excluding food and energy from 2001 to 2012 is shown in Chart IB-26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.

Chart IB-26, US, Producer Price Index Excluding Food and Energy, NSA, 2000-2012

Source: US Bureau of Labor Statistics

Twelve-month percentage changes of the producer price index excluding food and energy are shown in Chart IB-27. Fluctuations replicate those in the headline PPI. There is an evident trend of increase of 12 months rates of core PPI inflation in 2011 and in the firth month of 2012 but lower rates in the beginning of 2012.

Chart IB-27, US, Producer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 2000-2012

Source: US Bureau of Labor Statistics

The US producer price index of energy goods from 2001 to 2012 is in Chart IB-28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.

Chart IB-28, US, Producer Price Index Finished Energy Goods, NSA, 2000-2012

Source: US Bureau of Labor Statistics

Chart IB-29 provides 12-month percentage changes of the producer price index of energy goods from 2001 to 2012. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12-month rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.

Chart IB-29, US, Producer Price Index Energy Goods, 12-Month Percentage Change, NSA, 2000-2012

Source: US Bureau of Labor Statistics

Table IB-6 provides 12-month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2011. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest in the past few years and programmed in monetary policy statements until 2014 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted.

Table IB-6, CPI All Items, CPI Core and CPI Housing, 12-Month Percentage Change, NSA 2001-2012

Mar	CPI All Items	CPI Core ex Food and Energy	CPI Housing
2012	2.3	2.3	1.7
2011	3.2	1.3	1.0
2010	2.2	0.9	-0.6
2009	-0.7	1.9	1.0
2008	3.9	2.3	3.0
2007	2.6	2.3	3.4
2006	3.5	2.3	3.8
2005	3.5	2.2	3.2
2004	2.3	1.8	2.3
2003	2.2	1.5	2.6
2002	1.6	2.5	2.3
2001	3.3	2.6	4.5

Source: US Bureau of Labor Statistics

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

II Monetary Policy with Deficit Financing of Economic Growth. The advice of Bernanke (2000, 159-161, 165) to the Bank of Japan (BOJ) to reignite growth and employment in the economy consisted of zero interest rates and commitment to a high inflation target as proposed by Krugman (1999):

Bernanke (2002) also finds devaluation to be a powerful policy instrument to move the economy away from deflation and weak economic and financial conditions:

Chairman Bernanke (2012Apr 25, 10-11) explains current FOMC policy:

In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:

In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.

Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf ), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20), is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. Further analysis is provided in Appendix IIA Inflation Surprise and Appendix IIB Unpleasant Monetarist Arithmetic.

In extensive research and analysis, Kahil (1973) finds no evidence of the role of structural factors in Brazilian inflation from 1947 to 1963. In fact, Kahil (1973, 329) concludes:

Kahil (1973, 334) analyzes the impact of inflation on the economy and society of Brazil:

“Contrary to the assertions of some earlier writers on this topic, Kahil concludes that inflation did not lead to accelerated capital formation in Brazil.”

In econometric analysis of Brazil’s inflation from 1947 to 1980, Barbosa (1987) concludes:

Experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table II-1 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19^th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable. Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.

Table II-1, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)

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

Note: growth rates are obtained by regressions of the natural logarithms on time. M1 and M2 definitions of the money stock; Y nominal GDP; y real GDP; y/N real GDP per capita; P prices.

Chart II-1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income.

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

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

Table II-2 provides yearly percentage changes of GDP, GDP per capita, base money, prices and the current account in millions of dollars during the acceleration of inflation after 1947. There was an explosion of base money or the issue of money and three waves of inflation identified by Kahil (1973). Inflation accelerated together with issue of money and political instability from 1960 to 1964. There must be a role for expectations in inflation but there is not much sound knowledge and measurement as Rajan (2012May8) argues. There have been inflation waves documented in periodic comments in this blog (see Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). The risk is ignition of adverse expectations at the crest of one of worldwide inflation waves. Lack of credibility of the commitment by the FOMC to contain inflation could ignite such perverse expectations. Deficit financing of economic growth can lead to inflation and financial instability.

Table II-2, Brazil, GDP, GDP per Capita, Base Money, Prices and Current Account of the Balance of Payments, ∆% and USD Millions

	GDP ∆%	GDP per Capita ∆%	Base Money ∆%	Prices ∆%	Current Account BOP USD Millions
1947	2.4	0.1	-1.4	14.0	162
1948	7.4	4.9	4.6	7.6	-24
1949	6.6	4.2	14.5	4.0	-74
1950	6.5	4.0	23.0	10.0	52
1951	5.9	2.9	15.3	21.9	-291
1952	8.7	5.6	17.7	10.2	-615
1953	2.5	-0.5	15.5	12.1	16
1954	10.1	6.9	23.4	31.0	-203
1955	6.9	3.8	18.0	14.0	17
1956	3.2	0.2	16.9	21.6	194
1957	8.1	4.9	30.5	13.9	-180
1958	7.7	4.6	26.1	10.4	-253
1959	5.6	2.5	32.3	37.7	-154
1960	9.7	6.5	42.4	27.6	-410
1961	10.3	7.1	54.4	36.1	115
1962	5.3	2.2	66.4	54.1	-346
1963	1.6	-1.4	78.4	75.2	-244
1964	2.9	-0.1	82.5	89.7	40
1965	2.7	-0.6	67.6	62.0	331
1966	4.4	1.5	25.8	37.9	153
1967	4.9	2.0	33.9	28.7	-245
1968	11.2	8.1	31.4	25.2	32
1969	9.9	6.9	22.4	18.2	549
1970	8.9	5.8	20.2	20.7	545
1971	13.3	10.2	29.8	22.0	530

Appendix IIA Inflation Surprise. Friedman (1968, 8) defines that “the ‘natural rate of unemployment’ is the level that would be ground out by the Walrasian system of general equilibrium equations” with the multiple structural characteristic of the actual economy. According to Friedman (1968, 8) “Phillips’ analysis of the relation between unemployment and wage change is deservedly celebrated as an important and original contribution” but does not distinguish “between nominal wages and real wages” such that it is based in “a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages.” Friedman (1968, 8-9) uses an example that inflation of 75 percent per year was widely anticipated in Brazil but when policy was successful in reducing it to 45 percent per year “there was a sharp initial rise in unemployment because under the influence of earlier anticipations, wages kept rising at a pace that was higher than the new rate of price rise, though lower than earlier.” Such a rise in unemployment would be expected in “all attempts to reduce the rate of inflation below that widely anticipated” (Friedman 1968, 9). Phelps (1968) formalizes the role of expectations in the Phillips curve and its steady state properties.

The monetary and fiscal framework to attain monetary stability as compromised by business cycles proposed by Friedman (1948, 246) consists of:

“(1) Government must provide a monetary framework for a competitive order since the competitive order cannot provide one for itself. (2) This monetary framework should operate under the ‘rule of law’ rather than the discretionary authority of administrators. (3) While a truly free market in a ‘competitive order’ would yield far less inequality than currently exists, I should hope that the community would desire to reduce inequality even further.”

An important reason for rules instead of discretion is the existence of lags in economic policy:

“(1) the lag between the need for action and the recognition of this need; (2) the lag between recognition of the need for action and the taking of action; and (3) the lag between the action and its effects.”

Forecasting and measuring appropriate doses of policy are also major hurdles. These lags are even more frustrating in designing, approving and implementing international economic coordination such as the case of global imbalances (Pelaez and Pelaez, The Global Recession Risk (2007), 214).

Lucas (1976) warns about the use in policy of econometric relations estimated from a structure before policy implementation because the parameters are likely to change as the public anticipates the policy change. An example from Lucas (1976) is discussed by Chari (1998). A tax credit on investment may be designed to stimulate the economy away from recession or low employment but the anticipation of the credit results in postponement of decisions until the completion of the political process of approval and the legislation being in force. CARD, the Credit Card Accountability and Responsibility and Disclosure Act of 2009 (http://www.gpo.gov/fdsys/pkg/PLAW-111publ24/pdf/PLAW-111publ24.pdf), was signed by the President on May 22, 2009 but did not go into effect until February 22, 2010. In that nine-month interval, credit card issuers protected the interests of their shareholders reducing credit limits and availability of cards to customers with lower credit rating, thus harming consumers at the time when higher consumption was required for growth and employment. CARD was enacted with the wrong supposition that past behavior of credit card issuers would continue even as they knew exactly how their business would be harmed by the new law. In this case, credit decision functions of card issuers based on current and past structures at the time the law was first considered changed with the net effect of harming instead of benefiting consumers. Much the same is happening with the consumer protection agency being implemented under the financial regulation Dodd-Frank act.

The application of optimal control theory even with a specified social objective function may be the best for the current situation but would not be appropriate unless the decisions of economic agents were invariant to changes in economic policy. Policy may be reversed from intentions even if economic agents only “have some knowledge of how policymakers’ decisions will change as a result of changing economic conditions” (Kydland and Prescott 1976, 474). That simple knowledge could be the anticipated change in administration, such as the Nov 2010 congressional elections or currently that everybody is expecting major tax and interest rate increases in the near future, causing higher savings. Kydland and Prescott (1976, 477) provide an example that resembles the life-losing and economically-costly Katrina Hurricane of 2005. The socially-desirable outcome is not to build residences in a region below sea level that can be devastated by tidal waves preceding hurricanes. Rational economic agents would not live in that area unless they anticipated that the army corps of engineers would build dams and levees. If there were not a law prohibiting building in such exposed areas, people would construct there and the army corps of engineers would build the dams and levees that would prove inadequate for the category 3 hurricane winds of 125 miles per hour Hurricane Katrina that hit Plaquemines Parish Louisiana at 7:10 AM on Aug 29, 2005 (http://www.katrina.noaa.gov/). A rule of law of not permitting construction in such an exposed area would have been optimal instead of the discretionary policy of building dams and levees if people constructed in that area.

The inflation-unemployment example of Kydland and Prescott (1976, 477-80) is extremely relevant to current policy:

“The suboptimality of the consistent policy is not generally recognized for the aggregate demand management problem. The standard policy prescription is to select that policy which is best, given the current situation. This may seem reasonable, but for the structure considered, which we argue is a plausible abstraction of reality, such policy results in excessive rates of inflation without any reduction in unemployment. The policy of maintaining price stability is preferable.”

The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983b, 592, equation 1) is:

U_t = Uⁿ_t – α(π_t – π^e) α > 0 (1)

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

W = W(π_t, U_t) (2)

The policymaker maximizes the preferences of the public, (2), subject to the constraint of the tradeoff of inflation and unemployment, (1). The total differential of W set equal to zero provides an indifference map in the Cartesian plane with ordered pairs (π_t, U_t- Uⁿ) such that the consistent equilibrium is found at the tangency of an indifference curve and the Phillips curve in (1). The indifference curves are concave to the origin. The consistent policy is not optimal. Policymakers without discretionary powers following a rule of price stability would attain equilibrium with unemployment not higher than with the consistent policy. The optimal outcome is obtained by the rule of price stability, or zero inflation, and not more unemployment than under the consistent policy with nonzero inflation and the same unemployment.

Barro and Gordon (1963a,b) provide a positive theory of monetary policy using a natural rate model and an analysis of enhancing reputation by the monetary authority. The model attempts to explain two aspects of the world during the Great Inflation: (1) average rates of inflation and growth of money were excessive as measured by a criterion of efficiency; and (2) the Fed engaged in activist countercyclical monetary policies. Equation (1) reflects “the maximizing behavior of private agents on decentralized markets” (Barro and Gordon 1983b, 592). A second equation permits the movement of the natural rate of unemployment over time in response to autonomous shocks, the past rate of unemployment and the mean of the natural rate of unemployment in the long run. A third equation expresses costs of policy actions in terms of deviations of the actual rate of unemployment from the natural rate of unemployment and the rate of inflation. The policymaker minimizes the discounted present value of costs on behalf of the preferences of society on the basis of the initial information available. Equation (1) shows the temptation of the policymaker to create “inflation surprises” by pursuing an inflation rate that is higher than that expected by economic agents that lowers the difference between the actual and natural unemployment rate by the term – α(π_t – π^e). Other benefits include the seigniorage, or gain from purchasing goods before the private sector with the issue of money, and the reduction of the real value of government debt by inflation. Systematic inflation surprises are not feasible after the public learns the intentions of the central bank, triggering adjustment in the decisions of private economic agents. The lack of commitment to a rule of price stability results in discretionary equilibrium in which unemployment is now lower than under commitment but inflation is inefficiently high. The inadequacy of monetary institutions providing commitment to price stability is rational calculation resulting in “excessive inflation, apparently unrewarding countercyclical policy response, and reactions of monetary growth and inflation to other exogenous influences” (Barro and Gordon 1983b, 607).

Ireland (1999) adapts Barro and Gordon (1983b) for empirical analysis with quarterly data from the first quarter of 1960 to the second quarter of 1997. The empirical tests find that inflation and unemployment are cointegrated, meaning that the Great Inflation and subsequent disinflation can be explained by the time-consistency problem raised by Barro and Gordon (1983b).

IIB Unpleasant Monetarist Arithmetic. The assumptions of the monetarist economy of Sargent and Wallace (1981, 1) are:

(1) There is a close connection between the monetary base, or monetary liabilities of the government (consisting of currency held by the public and reserves of depository institutions at the central bank), and the price level

(2) The monetary authority can obtain seigniorage, defined as creating money

There are two constraints of government finance in the monetary economy of Sargent and Wallace (1981, 1) imposed by the demand for issuing interest-bearing securities or, say, bonds, as debt:

(1) The demand for bonds by the public sets a limit on the ratio of the real stock of government bonds and the size of the economy

(2) The demand for bonds affects the interest rate paid by the government on its bonds

These two constraints affect the effectiveness of the government on permanently controlling inflation depending on coordination of alternative arrangements of fiscal and monetary policy. There are two polar extremes of coordination arrangement analyzed by Sargent and Wallace (1981).

First, monetary policy dominates fiscal policy. The monetary authority has the choice of the amount of seigniorage that it will supply to the fiscal authority. Thus, the monetary authority has complete freedom in setting the path of base money, such as by announcing its rate of growth in the current and future periods. Under this coordination arrangement, monetary policy can permanently influence inflation.

Second, fiscal policy dominates monetary policy. The monetary authority divides government debt between government bonds and monetary base. The only form of controlling inflation is by holding on the rate of growth of base money. The demand by the public for government bonds constrains the effectiveness of inflation policy by the monetary authority. If the real rate of interest of the government bonds exceeds the rate of growth of the economy, the growth of the stock of real bonds will exceed the rate of growth of the size of the economy. The public’s demand for government bonds sets a limit on the ratio of the stock of bonds to the size of the economy. After reaching that limit, seigniorage must provide part of financing for maturing principal and interest, that is, additional base money must be printed. In a monetarist economy there is inflation after some point in time.

The model of “unadulterated monetarism” used by Sargent and Wallace (1981) includes the assumption of a natural rate of unemployment or growth of real income that monetary policy cannot affect and a real rate of interest on securities that monetary policy cannot influence. Specifically, there are three assumptions:

(1) An equal constant rate of growth of real income and population, denoted by n

(2) A constant real rate of government securities exceeding n

(3) The analysis includes two different specifications of the demand for money: (a) a quantity theory demand function for base money with constant income velocity; and (b) specification of the demand for base money including expected inflation.

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.

If the demand for base money depends on inflation expectations together with the other assumptions, loser monetary policy can result in higher inflation now and also in the future. Sargent and Wallace (1973, 1046) show that if the demand for real cash balances depends on the expected rate of inflation, “the equilibrium value of the price level at the current moment is seen to depend on the (expected) path of the money supply from now until forever.” The anticipation of high rates of base money growth in the future may increase the rate of inflation now. Sargent and Wallace (1981) show that currently tight monetary policy may not be potent to even lower the current rate of inflation. If fiscal policy dominates monetary policy with a sequence of deficits D(t), monetary policy has to adapt within the budget constraint of equation (1). If the sequence D(t) is “too big for too long,” under the assumptions of the model, “the monetary authority can make money tighter now only by making it looser later” (Sargent and Wallace 1981, 7). In the analysis of the hyperinflations in Europe, Sargent (1983, 89-90) concludes:

“The essential measures that ended hyperinflations in each of Germany, Austria, Hungary, and Poland were, first, the creation of an independent central bank that was legally committed to refuse the government’s demand for additional unsecured credit and, second, a simultaneous alteration in the fiscal policy regime. These measures were interrelated and coordinated. They had the effect of binding the government to place its debt with private parties and foreign governments which would value that debt according to whether it was backed by sufficiently large prospective taxes relative to public expenditures. In each case that we have studied, once it became widely understood that the government would not rely on the central bank for its finance, the inflation terminated and the exchanges stabilized. The four incidents we have studied are akin to laboratory experiments in which the elemental forces that cause and can be used to stop inflation are easiest to spot. I believe that these incidents are full of lessons about our own, less drastic predicament with inflation, if only we interpret them correctly.”

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China with political development, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment, falling wages and hiring collapse; 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. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. 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 IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis.

IIIA Financial Risks. The past half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr May 4 and daily values throughout the week ending on Fri May 11 of various 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 May 4 and the percentage change in that prior week below the label of the financial risk asset. For example, the US dollar (USD) appreciated 1.3 percent to USD 1.3084/EUR in the week ending on May 4. 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. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.2917/EUR in the first row, first column in the block for currencies in Table III-1 for Fri May 11, appreciating to USD 1.2827/EUR on Mon May 14, or by 0.7 percent. The dollar appreciated because fewer dollars, $1.2827, were required on Mon May 14 to buy one euro than $1.2917 on May 11. 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 1.2827/EUR on May 14; 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 May 11, to the last business day of the current week, in this case Fri May 18, such as appreciation by 1.1 percent to USD 1.2780/EUR by May 18; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 1.1 percent from the rate of USD 1.2917/EUR on Fri May 11 to the rate of USD 1.2780/EUR on Fri May 18 {[(1.2780/1.2917) – 1]100 = -1.1%} and depreciated (denoted by negative sign) by 0.7 percent from the rate of USD 1.2694 on Thu May 17 to USD 1.2780/EUR on Fri May 18 {[(1.2780/1.2694) -1]100 = -0.7%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets, depreciating the dollar.

Table III-I, Weekly Financial Risk Assets May 14 to May 18, 2012

Fri May 11, 2012

M 14

Tue 15

W 16

Thu 17

Fr 18

USD/EUR

1.2917

1.3%

1.2827

0.7%

1.2726

1.5%

0.8%

1.2706

1.6%

0.2%

1.2694

1.7%

0.1%

1.2780

1.1%

-0.7%

JPY/ USD

79.94

-0.1%

79.84

0.1%

80.25

-0.4%

-0.5%

80.33

-0.5%

-0.1%

79.33

0.8%

1.2%

79.01

1.2%

0.4%

CHF/ USD

0.9299

-1.3%

0.9363

-0.7%

0.9436

-1.5%

-0.8%

0.9454

-1.7%

-0.2%

0.9463

-1.8%

-0.1%

0.9398

-1.1%

0.7%

CHF/ EUR

1.2011

0.0%

1.2011

0.0%

1.2011

0.0%

1.2010

0.0%

1.2010

0.0%

1.2011

0.0%

USD/ AUD

1.0022

0.9978

-1.5%

0.9963

1.0037

-0.6%

0.9929

1.0072

-0.9%

-0.3%

0.9900

1.0101

-1.2%

-0.3%

0.9888

1.0113

-1.3%

-0.1%

0.9843

1.0160

-1.8%

-0.5%

10 Year T Note

1.845

1.77

1.76

1.70

1.714

2 Year T Note

0.248

0.26

0.27

0.28

0.29

0.292

German Bond

2Y 0.09 10Y 1.52

2Y 0.06 10Y 1.46

2Y 0.07 10Y 1.47

2Y 0.04 10Y 1.41

2Y 0.05 10Y 1.43

DJIA

12820.60

-1.7%

12695.35

-1.0%

12632.00

-1.4%

-0.5%

12598.55

-1.7%

-0.3%

12442.49

-2.9%

-1.2%

12369.38

-3.5%

-0.6%

DJ Global

1853.93

-2.1%

1825.12

-1.6%

1807.27

-2.5%

-1.0%

1789.17

-3.5%

-1.0%

1774.47

-4.3%

-0.8

1754.30

-5.4%

-1.1%

DJ Asia Pacific

1212.53

-4.3%

1204.94

-0.6%

1196.21

-1.3%

-0.7%

1168.11

-3.7%

-2.4%

1180.02

-2.7%

1.0%

1152.04

-5.0%

-2.4%

Nikkei

8953.31

-4.6%

8973.84

0.2%

8900.74

-0.6%

-0.8%

8801.17

-1.7%

-1.1%

8876.59

-0.9%

0.9%

8611.31

-3.8%

-3.0%

Shanghai

2394.98

-2.3%

2380.73

-0.6%

2374.84

-0.8%

-0.3%

2346.19

-2.0%

-1.2%

2378.89

-0.7%

1.4%

2344.52

-2.1%

-1.4%

DAX

6579.93

0.3%

6451.97

-1.9%

6401.06

-2.7%

-0.8%

6384.26

-2.9%

-0.3%

6308.96

-4.1%

-1.2%

6271.22

-4.7%

-0.6%

DJ UBS

Comm.

134.75

-1.7%

133.12

-1.2%

133.88

-0.6%

0.6%

134.32

-0.3%

0.3%

135.05

0.2%

0.5%

136.00

0.9%

0.7%

WTI $ B

95.66

-2.9%

94.20

-1.5%

93.17

-2.6%

-1.1%

92.62

-3.2%

-0.6%

92.51

-3.3%

-0.1%

91.02

-4.9%

-1.6%

Brent $/B

112.06

-1.1%

111.09

-0.9%

111.81

-0.2%

0.6%

109.10

-2.6%

-2.4%

107.13

-4.4%

-1.8%

106.85

-4.6%

-0.3%

Gold $/OZ

1580.0

-3.8%

1557.3

-1.4%

1542.7

-2.4%

-0.9%

1538.5

-2.6%

-0.3%

1573.1

-0.4%

2.2%

1591.1

0.7%

1.1%

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

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

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

The JPY reversed earlier depreciation. The JPY appreciated 1.2 percent in the week of May 18. Japan’s has not been very successful in the past in foreign exchange interventions (Pelaez and Pelaez, The Global Recession Risk (2007), 107-9). Japan is currently combining unconventional monetary policy and exchange intervention. The Policy Board of the Bank of Japan decided at its meeting on Apr 27, 2012 to enhance monetary easing as follows (http://www.boj.or.jp/en/announcements/release_2012/k120427a.pdf):

“1. At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan made the following decisions, by a unanimous vote, regarding the Asset Purchase Program (hereafter referred to as "the Program").

(1) The Bank decided to increase the total size of the Program by about 5 trillion yen, from about 65 trillion yen to about 70 trillion yen, with the following changes in its composition.

(a) An increase in the purchase of Japanese government bonds (JGBs) by about 10 trillion yen

(b) An increase in the purchases of exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) by about 200 billion yen and 10 billion yen, respectively

(c) A reduction in the maximum outstanding amount of the Bank's fixed-rate funds-supplying operation against pooled collateral with a six-month term, by about 5 trillion yen, taking into account the recent episodes of undersubscription

(2) With the aim of smoothly conducting the large-scale purchases after today's increase and encouraging a decline in longer-term interest rates effectively, the Bank decided to extend the remaining maturity of JGBs to be purchased under the Program from "one to two years" to "one to three years." It also decided to extend the remaining maturity of corporate bonds to be purchased under the Program just as is the case of JGBs.

(3) The Bank decided to increase the outstanding amount of the Program to about 70 trillion yen by around end-June 2013, while maintaining the existing schedule of increasing the outstanding amount of the Program to about 65 trillion yen by around end-2012.”

The Policy Board of the Bank of Japan decided at its meeting on April 10, 2010 to continue “powerful easing” (http://www.boj.or.jp/en/announcements/release_2012/k120410a.pdf 2):

“The Bank recognizes that Japan's economy faces the critical challenge of overcoming deflation and returning to a sustainable growth path with price stability. The goal of overcoming deflation will be achieved both through efforts to strengthen the economy's growth potential and support from the financial side. With this in mind, the Bank will pursue powerful monetary easing, and will support private financial institutions in their efforts to strengthen the foundations for Japan's economic growth via the fund-provisioning measure to support strengthening the foundations for economic growth. At today's meeting, as shown in the Attachment, the Bank established detailed rules for a new U.S. dollar lending arrangement equivalent to 1 trillion yen, of which a preliminary outline was released at the previous meeting in March.”

The Policy Board of the Bank of Japan decided three important measures of enhancing monetary easing at the meeting held on Feb 14, 2012 (Bank of Japan 2012EME, 2012PSG and 2012APP). First, the Bank of Japan (2012Feb14EME, 2012Feb14PSG) adopted a “price stability goal” for the “medium term” of 2 percent of the “year-on-year rate of change of the CPI” with the immediate goal of inflation of 1 percent. Japan’s CPI inflation in the 12 months ending in Dec was minus 0.2 percent. Second, the Bank of Japan (2012Feb14EME, 1-2) will conduct “virtually zero interest rate policy” by maintaining “the uncollateralized overnight call rate at around 0 to 0.1 percent.” Third, the Bank of Japan (20012Feb13EME, 2014Feb14APP) is increasing the size of its quantitative easing:

“The Bank increases the total size of the Asset Purchase Program by about 10 trillion yen, from about 55 trillion yen to about 65 trillion yen. The increase in the Program is earmarked for the purchase of Japanese government bonds. By fully implementing the Program including the additional expansion decided today, by the end of 2012, the amount outstanding of the Program will be increased by about 22 trillion yen from the current level of around 43 trillion yen.”

IIIB Appendix on Safe Haven Currencies analyzes the burden on the Japanese economy of yen appreciation. Policy rates close to zero by major central banks in the world together with quantitative easing tend to depreciate currencies. Monetary policy is an indirect form of currency intervention.

The Swiss franc depreciated another 1.1 percent in the week of May 18 to CHF 0.9398/USD relative to the strong US dollar and remained unchanged relative to the euro at CHF 1.2011/EUR, as shown in Table III-1. The important event was appreciation of 0.3 percent by Apr 6 relative to the euro to the very bottom of the exchange rate floor at CHF 1.2009/EUR. William L. Watts, writing on “Euro weakness triggers Swissie showdown,” on Apr 5, published by MarketWatch (http://www.marketwatch.com/story/euro-weakness-triggers-swissie-showdown-2012-04-05), quotes exchange strategists claiming that at point on Apr 5 the Swiss franc traded at CHF 1.1990/EUR. Some participants believe that there was intervention by the Swiss National Bank to defend the floor of CHF `1.2000/EUR. The Australian dollar appreciated 0.1 percent to USD 1.0378/AUD by Apr 20 because of unfavorable environment for carry trades. The AUD is considered a carry trade commodity currency.

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing aversion is captured by decrease of the yield of the ten-year Treasury. As shown in past updates of Table III-1, the ten-year Treasury yield fell from 2.234 percent on Mar 23 to 2.214 percent on Mar 30, collapsing to 2.058 percent on Apr 6 after the employment report and declining further to 1.987 percent on Apr 13, 1.959 percent on Apr 20 and 1.931 percent on Apr 27 because of increasing risk aversion. Elections in Europe and the weak employment report in Section I motivated further decline of the 10-year yield to 1.876 on May 4 with deterioration in Spain causing further decline to 1.845 percent on May 11 and then to 1.714 percent during risk aversion in the week of May 18. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.3 percent in the 12 months ending in Apr (see subsection IB United States Inflation and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. As shown in past updates of Table III-1, the two-year Treasury yield fell marginally from 0.35 percent on Mar 23 to 0.335 percent on Mar 30 and then to 0.31 percent on Apr 6 and 0.27 percent on Apr 13, remaining almost unchanged at 0.268 percent on Apr 20 and 0.26 percent on Apr 27, virtually unchanged at 0.256 percent on May 4 and 0.248 on May 11 but rising to 0.292 percent on May 18. 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. The latest statement of the Federal Open Market Committee (FOMC) on Apr 25, 2012 does not have sufficient changes suggesting that it contributed to the rise in Treasury yields (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm). The statement continues to consider inflation low, unemployment high and growth at a moderate pace. Because of the “slack” in the economy, the FOMC anticipates maintaining the zero interest rate policy until 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm):

“In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.6 percent for the 12 months ending in Apr 2012 but jumping 1.3 percent in the month of Mar (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16052012-BP/EN/2-16052012-BP-EN.PDF; see Section VD) but the yield of the two-year German government bond fell from 0.23 percent on Mar 23 to 0.21 percent on Mar 30, 0.14 percent on Apr 6 and 0.13 percent on Apr 13 with 0.14 percent on Apr 20 and 0.10 percent on Apr 27, falling further to 0.08 percent on May 4, 0.09 percent on May 11 and collapsing to 0.05 percent on May 18, while the yield of the ten-year German government bond fell from 1.87 on Mar 23 to 1.79 percent on Mar 30 and then to 1.74 on Apr 6 and also on Apr 13 with 1.71 percent on Apr 20 and 1.70 percent on Apr 27, as shown in Table III-1 and past updates. On May 4, the 10-year yield of Germany fell further to 1.58 percent and then 1.52 percent on May 11 and 1.43 percent on May 18. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds.

Equity indexes in Table III-1 fell sharply in the week of May 18 under stress from the European debt crisis. Germany’s Dax dropped 4.7 percent while DJIA fell 3.5 percent in the week of May 18 and Dow Global lost 5.4 percent. Japan’s Nikkei Average interrupted recent increases with decline of 3.9 percent in the week of Apr 6, decline of 0.5 percent in the week of Apr 13 and declines of 0.8 percent in the week of Apr 20, 0.4 percent in the week of Apr 27 and 1.5 percent in the week of May 4. The Nikkei Average dropped 4.6 percent in the week of Apr 11 and another 3.8 percent in the week of Apr 18. Dow Asia Pacific dropped 5.0 percent in the week of May 18 while Shanghai Composite dropped 2.1 percent.

Commodities were weak during the week of May 18. The DJ UBS Commodities Index decreased 0.9 percent. WTI dropped 4.9 percent and Brent decreased 4.6 percent. Gold increased 0.7 percent.

Spain continues to drive euro area credit risk with hurdles in adjusting its high fiscal deficit, domestic economic recession, high unemployment and unresolved bank balance sheets. Spain’s National Statistics Institute, Instituto Nacional de Estadística (INE), released on Apr 27 its “Economically Active Population Survey” for IQ2012 (http://www.ine.es/en/daco/daco42/daco4211/epa0112_en.pdf). INE’s summary of the survey is as follows (http://www.ine.es/en/daco/daco42/daco4211/epa0112_en.pdf):

“ Employment in the first quarter of 2012 registers a decrease of 374,300 persons, reaching a total of 17,433,200 employed persons. The interannual employment variation rate stands at –3.96%.

The economically active population drops by 8,400 persons this quarter. The number of unemployed persons increases by 365,900 persons, the total number thus standing at 5,639,500.

The unemployment rate grows 1.59 points, standing at 24.44%. In turn, the

activity rate remains at 59.94%.

The loss of employment is almost three times higher among men (278,300 less) than among women (96,000 less). Conversely, the loss of employment increases almost the same between men and women.

All sectors record a reduction in the number of employed persons this quarter.

Wage-earners with a permanent contract decrease by 138,400, and wage earners with a temporary contract do so by 279,600.

The number of households with all of their active members unemployed increases

by 153,400 this quarter, standing at 1,728,400.

By Autonomous Community, the unemployment rate fluctuates between 13.55% in País Vasco and 33.17% in Andalucía. The activity rate fluctuates between 51.33%, recorded in Principado de Asturias, and 64.77%, registered in Illes Balears.

Employment registers its greatest decreases in Andalucia, Cataluña and Comunitat Valenciana, and the greatest decrease in unemployment. Comunidad de Madrid was the only Autonomous Community that registers an increase in employment. The unemployment increases in all Autonomous Communities.”

The Bank of Spain released on May 18, 2012 new worrisome data on delinquent credit in Spain’s credit institutions (http://www.bde.es/webbde/es/secciones/prensa/Agenda/Datos_de_credit_ab67f770c520731.html). The aggregate balance sheet of institutions supervised by the Bank of Spain registered total credit of €1,508,626 million in 2006 with delinquent credit of €10,859 million or 0.7 percent. The latest available data for Mar 2012 registers total credit of €1,768,454 million with delinquent credit of €147,968 million or 8.4 percent. Total credit has contracted from a peak of €1,869,882 million in 2008 to €1,768,454 on Mar 2012 or by 5.4 percent. Delinquent credit has risen from €10,859 million in 2006 to €147,968 million in Mar 2012 or by 1263 percent. The credit standing of Spain may be further imperiled if the country is forced into bank nationalizations or absorptions of bad loans by the government. There is troubled history of government ownership and control of banks (Pelaez and Pelaez, Regulation of Banks and Finance: Theory and Policy after the Credit Crisis (2009b), 227-9; Pelaez 1975, Pelaez and Suzigan 1981, following Cameron 1961, 1967, 1972). Christopher Bjork and Jonathan House, writing on “Spanish banks’ ECB borrowing hits high,” on Apr 13, published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702304356604577341133498311916.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyze the impact on valuations of risk financial assets from new data on Spanish bank borrowing. The Bank of Spain, as quoted by Bjork and House, provided information on average Spanish bank borrowing from the European Central Bank increasing from €169.85 billion in Feb to €316.3 billion in Mar, or USD 417.10 billion, which are substantially higher than €106.3 billion before long-term refinancing operations (LTRO). Spain borrowed 28 percent of lending of €1.1 trillion by the ECB to banks in the euro zone. A crucial fact provided by Bjork and House is that Spanish banks devoted €40.6 billion of their assigned LTROs to buying Spanish government debt, which is equivalent to one half of the needs of Spain in 2012. LTROs are effectively a bailout of Spain in which the European Central Bank (ECB) is taking credit risks in contrast with mostly rate risks in quantitative easing by the Fed.

A critical development in the resolution of the European debt crisis is the increase in available resources of the IMF announced in a joint statement of the IMFC and the Group of 20 Finance Ministers and Central Bank Governors (IMFC 2012Apr20):

“There are firm commitments to increase resources made available to the IMF by over $430 billion in addition to the quota increase under the 2010 reform. These resources will be available for the whole membership of the IMF, and not earmarked for any particular region.”

Resources are not earmarked for the European debt crisis but it is the most threatening current vulnerability in the world economy.

Economic and financial risks in the euro area are increasingly being dominated by analytical and political disagreement on conflicts of fiscal adjustment, financial stability, economic growth and employment. Political development is beginning to push for alternative paths of policy. Blanchard (2012WEOApr) and Draghi (2012May3) provide analysis of appropriate directions of policy.

Blanchard (2012WEOApr) finds that interest rates close to zero in advanced economies have not induced higher economic growth because of two main factors—fiscal consolidation and deleveraging—that restrict economic growth in the short-term. First, Blanchard (2012WEOApr, XIII) finds that assuming a multiplier of unity of the fiscal deficit on GDP, decrease of the cyclically-adjusted deficit of advanced economies by 1 percent would reduce economic growth by one percentage point. Second, deleveraging by banks, occurring mainly in Europe, tightens credit supply with similar reduction of euro area economic growth by one percentage point in 2012. The baseline of the World Economic Outlook (WEO) of the IMF (2012WEOApr) for Apr 2012 incorporates both effects, which results in weak economic growth, in particular in Europe, and prolonged unemployment. An important analysis by Blanchard (2012WEOApr, XIII) is that “financial uncertainty, together with sharp shifts in risk appetite, has led to volatile capital flows.” Blanchard (2012WEOApr) still finds that the greatest vulnerability is another profound crisis in Europe (ECB). Crisis prevention should buttress the resilience of affected countries during those shifts in risk appetite. The role of the enhanced firewall of the IMF, European Union (EU) and European Central Bank is gaining time during which countries could engage in fiscal consolidation and structural reforms that would diminish the shifts in risk appetite, preventing devastating effects of financial crises. Volatility in capital flows is equivalent to volatility of valuations of risk financial assets. The challenge to the policy mix consists in balancing the adverse short-term effects of fiscal consolidation and deleveraging with the beneficial long-term effects of eliminating the vulnerability to shocks of risk aversion. Blanchard (2012WEOApr) finds that policy should seek short-term credibility while implementing measures that restrict the path of expenditures together with simultaneous development of institutions and rules that constrain deficits and spending in the future. There is similar policy challenge in deleveraging banks, which is required for sound lending institutions, but without causing an adverse credit crunch. Advanced economies face a tough policy challenge of increasing demand and potential growth.

The President of the European Central Bank (ECB) Mario Draghi (2012May3) also outlines the appropriate policy mix for successful adjustment:

“It is of utmost importance to ensure fiscal sustainability and sustainable growth in the euro area. Most euro area countries made good progress in terms of fiscal consolidation in 2011. While the necessary comprehensive fiscal adjustment is weighing on near-term economic growth, its successful implementation will contribute to the sustainability of public finances and thereby to the lowering of sovereign risk premia. In an environment of enhanced confidence in fiscal balances, private sector activity should also be fostered, supporting private investment and medium-term growth.

At the same time, together with fiscal consolidation, growth and growth potential in the euro area need to be enhanced by decisive structural reforms. In this context, facilitating entrepreneurial activities, the start-up of new firms and job creation is crucial. Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.

In this context, let me make a few remarks on the adjustment process within the euro area. As we know from the experience of other large currency areas, regional divergences in economic developments are a normal feature. However, considerable imbalances have accumulated in the last decade in several euro area countries and they are now in the process of being corrected.

As concerns the monetary policy stance of the ECB, it has to be focused on the euro area. Our primary objective remains to maintain price stability over the medium term. This is the best contribution of monetary policy to fostering growth and job creation in the euro area.

Addressing divergences among individual euro area countries is the task of national governments. They must undertake determined policy actions to address major imbalances and vulnerabilities in the fiscal, financial and structural domains. We note that progress is being made in many countries, but several governments need to be more ambitious. Ensuring sound fiscal balances, financial stability and competitiveness in all euro area countries is in our common interest.”

Economic policy during the debt crisis of 1983 may be useful in analyzing the options of the euro area. Brazil successfully combined fiscal consolidation, structural reforms to eliminate subsidies and devaluation to parity. Brazil’s terms of trade, or export prices relative to import prices, deteriorated by 47 percent from 1977 to 1983 (Pelaez 1986, 46). Table III-1A provides selected economic indicators of the economy of Brazil from 1970 to 1985. In 1983, Brazil’s inflation was 164.9 percent, GDP fell 3.2 percent, idle capacity in manufacturing reached 24.0 percent and Brazil had an unsustainable foreign debt. US money center banks would have had negative capital if loans to emerging countries could have been marked according to loss given default and probability of default (for credit risk models see Pelaez and Pelaez (2005), International Financial Architecture, 134-54). Brazil’s current account of the balance of payments shrank from $16,310 million in 1982 to $6,837 million in 1983 because of the abrupt cessation of foreign capital inflows with resulting contraction of Brazil’s GDP by 3.2 percent. An important part of adjustment consisted of agile coordination of domestic production to cushion the impact of drastic reduction in imports. In 1984, Brazil had a surplus of $45 million in current account, the economy grew at 4.5 percent and inflation was stabilized at 232.9 percent.

Table III-1A, Brazil, Selected Economic Indicators 1970-1985

	Inflation ∆%	GDP Growth ∆%	Idle Capacity in MFG %	BOP Current Account USD MM
1985	223.4	7.4	19.8	-630
1984	232.9	4.5	22.6	45
1983	164.9	-3.2	24.0	-6,837
1982	94.0	0.9	15.2	-16,310
1981	113.0	-1.6	12.3	-11,374
1980	109.2	7.2	3.5	-12,886
1979	55.4	6.4	4.1	-10,742
1978	38.9	5.0	3.3	-6,990
1977	40.6	5.7	3.2	-4,037
1976	40.4	9.7	0.0	-6,013
1975	27.8	5.4	3.0	-6,711
1974	29.1	9.7	0.1	-7,122
1973	15.4	13.6	0.3	-1,688
1972	17.7	11.1	6.5	-1,489
1971	21.5	12.0	9.8	-1,307
1970	19.3	8.8	12.2	-562

Source: Carlos 21.5Manuel Pelaez, O Cruzado e o Austral: São Paulo, Editora Atlas, 1986, 86.

Chart III-1 provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart III-1 used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.

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

A key to success in stabilizing an economy with significant risk aversion is finding parity of internal and external interest rates. Brazil implemented fiscal consolidation and reforms that are advisable in explosive foreign debt environments. In addition, Brazil had the capacity to find parity in external and internal interest rates to prevent capital flight and disruption of balance sheets (for analysis of balance sheets, interest rates, indexing, devaluation, financial instruments and asset/liability management in that period see Pelaez and Pelaez (2007), The Global Recession Risk: Dollar Devaluation and the World Economy, 178-87). Table III-1B provides monthly percentage changes of inflation, devaluation and indexing and the monthly percent overnight interest rate. Parity was attained by means of a simple inequality:

Cost of Domestic Loan ≥ Cost of Foreign Loan

This ordering was attained in practice by setting the domestic interest rate of the overnight interest rate plus spread higher than indexing of government securities with lower spread than loans in turn higher than devaluation plus spread of foreign loans. Interest parity required equality of inflation, devaluation and indexing. Brazil devalued the cruzeiro by 30 percent in 1983 because the depreciation of the German mark DM relative to the USD had eroded the competitiveness of Brazil’s products in Germany and in competition with German goods worldwide. The database of the Board of Governors of the Federal Reserve System quotes DM 1.7829/USD on Mar 3 1980 and DM 2.4425/USD on Mar 15, 1983 (http://www.federalreserve.gov/releases/h10/hist/dat89_ge.htm) for devaluation of 37.0 percent. Parity of costs and rates of domestic and foreign loans and assets required ensuring that there would not be appreciation of the exchange rate, inducing capital flight in expectation of future devaluation that would have reversed stabilization. One of the main problems of adjustment of members of the euro area with high debts is that they cannot adjust the exchange rate because of the common euro currency. This is not an argument in favor of breaking the euro area because there would be also major problems of adjustment such as exiting the euro in favor of a new Drachma in the case of Greece. Another hurdle of adjustment in the euro area is that Brazil could have moved swiftly to adjust its economy in 1983 but the euro area has major sovereignty and distribution of taxation hurdles in moving rapidly.

Table III-1B, Brazil, Inflation, Devaluation, Overnight Interest Rate and Indexing, Percent Per Month

1984	Inflation IGP ∆%	Devaluation ∆%	Overnight Interest Rate %	Indexing ∆%
Jan	9.8	9.8	10.0	9.8
Feb	12.3	12.3	12.2	12.3
Mar	10.0	10.1	11.3	10.0
Apr	8.9	8.8	10.1	8.9
May	8.9	8.9	9.8	8.9
Jun	9.2	9.2	10.2	9.2
Jul	10.3	10.2	11.9	10.3
Aug	10.6	10.6	11.0	10.6
Sep	10.5	10.5	11.9	10.5
Oct	12.6	12.6	12.9	12.6
Nov	9.9	9.9	10.9	9.9
Dec	10.5	10.5	11.5	10.5

Source: Carlos Manuel Pelaez, O Cruzado e o Austral: São Paulo, Editora Atlas, 1986, 86.

Risk aversion during the week of Mar 2, 2012, was dominated by the long-term refinancing operations (LTRO) of the European Central Bank. LTROs and related principles are analyzed in subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort. First, as analyzed by David Enrich, writing on “ECB allots €529.5 billion in long-term refinancing operations,” published on Feb 29, 2012 by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203986604577252803223310964.html?mod=WSJ_hp_LEFTWhatsNewsCollection), the ECB provided a second round of three-year loans at 1.0 percent to about 800 banks. The earlier round provided €489 billion to more than 500 banks. Second, the ECB sets the fixed-rate for main refinancing operations at 1.00 percent and the overnight deposit facility at 0.25 percent (http://www.ecb.int/home/html/index.en.html) for negative spread of 75 basis points. That is, if a bank borrows at 1.0 percent for three years through the LTRO and deposits overnight at the ECB, it incurs negative spread of 75 basis points. An alternative allocation could be to lend for a positive spread to other banks. Richard Milne, writing on “Banks deposit record cash with ECB,” on Mar 2, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/9798fd36-644a-11e1-b30e-00144feabdc0.html#axzz1nxeicB6H), provides important information and analysis that banks deposited a record €776.9 billion at the ECB on Fri Mar 2 at interest receipt of 0.25 percent, just two days after receiving €529.5 billion of LTRO loans at interest cost of 1.0 percent. The main issue here is whether there is ongoing perceptions of high risks in counterparties in financial transactions that froze credit markets in 2008 (see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 57-60, 217-27, Financial Regulation after the Global Recession (2009b), 155-67). Richard Milne and Mary Watkins, writing on “European finance: the leaning tower of perils,” on Mar 27, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/82205f6e-7735-11e1-baf3-00144feab49a.html#axzz1qOqWaqF2), raise concerns that the large volume of LTROs can create future problems for banks and the euro area. An important issue is if the cheap loans at 1 percent for three-year terms finance the carry trade into securities of the governments of banks. Balance sheets of banks may be stressed during future sovereign-credit events. Sam Jones, writing on “ECB liquidity fuels high stakes hedging,” on Apr 4, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/cb74d63a-7e75-11e1-b009-00144feab49a.html#axzz1qyDYxLjS), analyzes unusually high spreads in government bond markets in Europe that could have been caused by LTROs. There has been active relative value arbitrage of these spreads similar to the strategies of Long-Term Capital Management (LTCM) of capturing high spreads in mortgage-backed securities jointly with hedges in Treasury securities (on LTCM see Pelaez and Pelaez, International Financial Architecture (2005), 108-12, 87-9, The Global Recession Risk (2007) 12-3, 102, 176, Globalization and the State, Vol. I (2008a), 59-64).

Table III-1C provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,124,082 million on May 11, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,731,667 million in the statement of May 11.

Table III-1C, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	May 11, 2012
1 Gold and other Receivables	367,402	419,822	432,705
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	242,113
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	51,525
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	19,512
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,124,082
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	208,356
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	607,585
8 General Government Debt Denominated in Euro	34,954	33,928	30,589
9 Other Assets	278,719	336,574	255,047
TOTAL ASSETS	2,004, 432	2,733,235	2,971,515
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,731,667
Capital and Reserves	78,143	81,481	85,545

Source: European Central Bank

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

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

http://www.ecb.int/press/pr/wfs/2012/html/fs120515.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-1D providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 42.7 percent of the total. Exports to the non-European Union area are growing at 12.4 percent in Mar 2012 relative to Mar 2011 while those to EMU are falling at 1.8 percent.

Table III-1D, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%

Mar 2012	Exports % Share	∆% Mar 2012/ Mar 2011	Imports % Share	Imports ∆% Mar 2012/ Mar 2011
EU	56.0	-0.5	53.3	-11.4
EMU 17	42.7	-1.8	43.2	-11.5
France	11.6	0.2	8.3	-9.0
Germany	13.1	2.9	15.6	-17.1
Spain	5.3	-10.3	4.5	-12.6
UK	4.7	12.4	2.7	-12.1
Non EU	44.0	12.4	46.7	-10.3
Europe non EU	13.3	11.5	11.1	-7.1
USA	6.1	23.5	3.3	7.0
China	2.7	-12.3	7.3	-33.3
OPEC	4.7	32.0	8.6	5.5
Total	100.0	4.9	100.0	-10.9

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

Table III-1E provides Italy’s trade balance by regions and countries. Italy had trade deficit of €216 million with the 17 countries of the euro zone (EMU 17) in Mar and deficit of €346 million in Jan-Mar. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €1863 million in Jan-Mar with Europe non European Union and of €2135 million with the US. There is significant rigidity in the trade deficits in Jan-Mar of €4111 million with China and €6162 million with members of the Organization of Petroleum Exporting Countries (OPEC).

Table III-1E, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Mar 2012 Millions of Euro	Trade Balance Cumulative Jan-Mar 2012 Millions of Euro
EU	1,554	2,729
EMU 17	216	-346
France	1,173	2,972
Germany	-491	-1,361
Spain	271	741
UK	836	2,141
Non EU	510	-6,148
Europe non EU	1,165	1,863
USA	1,043	2,135
China	-902	-4,111
OPEC	-1,690	-6,162
Total	2,064	-3,418

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

Growth rates of Italy’s trade and major products are provided in Table VG-4 for the period Mar 2012 relative to Mar 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 4.9 percent relative to imports of minus 10.9 percent may reflect weak demand in Italy with GDP declining during three consecutive quarters from IIIQ2011 through IQ2012.

Table III-1F, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Mar 2012/ Mar 2011	Imports Share %	Imports ∆% Mar 2012/ Mar 2011
Consumer Goods	28.9	5.4	25.0	-8.4
Durable	5.9	2.1	3.0	-17.0
Non Durable	23.0	6.4	22.0	-7.2
Capital Goods	32.2	4.2	20.8	-20.7
Inter- mediate Goods	34.3	3.0	34.5	-16.3
Energy	4.7	20.7	19.7	8.8
Total ex Energy	95.3	4.1	80.3	-15.2
Total	100.0	4.9	100.0	-10.9

Table III-1G provides Italy’s trade balance by product categories in Mar 2012 and cumulative Jan-Mar 2012. Italy’s trade balance excluding energy generated surplus of €7571 million in Mar 2012 and €14,022 million in Jan-Mar 2012 but the energy trade balance created deficit of €5507 million in Mar 2012 and €17,441 million in Jan-Mar 2012. The overall surplus in Mar 2012 was €2064 million but there was an overall deficit of €3418 million in Jan-Mar 2012. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-1G, Italy, Trade Balance by Product Categories, € Millions

	Mar 2012	Cumulative Jan-Mar 2012
Consumer Goods	2,076	3,483
Durable	1,214	2,642
Nondurable	862	842
Capital Goods	4,461	9,622
Intermediate Goods	1,034	916
Energy	-5,507	-17,441
Total ex Energy	7,571	14,022
Total	2,064	-3,418

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The members of the European Monetary Union (EMU), or euro area, established the European Financial Stability Facility (EFSF), on May 9, 2010, to (http://www.efsf.europa.eu/about/index.htm):

“Provide loans to countries in financial difficulties
Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
Act on the basis of a precautionary programme
Finance recapitalisations of financial institutions through loans to governments”

The EFSF will be replaced by the permanent European Stability Mechanism (ESM) in 2013. On Mar 30, 2012, members of the euro area reached an agreement providing for sufficient funding required in rescue programs of members countries facing funding and fiscal difficulties and the transition from the EFSF to the ESM. The agreement of Mar 30, 2012 of the euro area members provides for the following (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf):

· Acceleration of ESM paid-in capital. The acceleration of paid-in capital for the ESM provides for two tranches paid in 2012, in July and Oct; another two tranches in 2013; and a final tranche in the first half of 2014. There could be acceleration of paid-in capital is required to maintain a 15 percent relation of paid-in capital and the outstanding issue of the ESM

· ESM Operation and EFSF transition. ESM will assume all new rescue programs beginning in Jul 2012. EFSF will administer programs begun before initiation of ESM activities. There will be a transition period for the EFSF until mid 2013 in which it can engage in new programs if required to maintain the full lending limit of €500 billion.

· Increase of ESM/EFSF lending limit. The combined ceiling of the ESM and EFSF will be increased to €700 billion to facilitate operation of the transition of the EFSF to the ESM. The ESM lending ceiling will be €500 billion by mid 2013. The combined lending ceiling of the ESM and EFSF will continue to €700 billion

· Prior lending. The bilateral Greek loan facility of €53 billion and €49 billion of the EFSF have been paid-out in supporting programs of countries: “all together the euro area is mobilizing an overall firewall of approximately EUR 800 billion, more than USD 1 trillion” (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf)

· Bilateral IMF contributions. Members of the euro area have made commitments of bilateral contributions to the IMF of €150 billion

A key development in the bailout of Greece is the approval by the Executive Board of the International Monetary Fund (IMF) on Mar 15, 2012, of a new four-year financing in the value of €28 billion to be disbursed in equal quarterly disbursements (http://www.imf.org/external/np/tr/2012/tr031512.htm). The sovereign debt crisis of Europe has moderated significantly with the elimination of immediate default of Greece. New economic and financial risk factors have developed, which are covered in VI Valuation of Risk Financial Assets and V World Economic Slowdown.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. Worsening credit environment

2. Increases in risk premiums for many eurozone borrowers

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

4. More limited perspectives of economic growth

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

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

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

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

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

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

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

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

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

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

Beim (2011Oct9, 6) argues:

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

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

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,124,082 million on May 11, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,731,667 million in the statement of May 11.

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

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

	Dec 31, 2010	Dec 28, 2011	May 11, 2012
1 Gold and other Receivables	367,402	419,822	432,705
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	242,113
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	51,525
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	19,512
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,124,082
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	208,356
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	607,585
8 General Government Debt Denominated in Euro	34,954	33,928	30,589
9 Other Assets	278,719	336,574	255,047
TOTAL ASSETS	2,004, 432	2,733,235	2,971,515
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,731,667
Capital and Reserves	78,143	81,481	85,545

Source: European Central Bank

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

http://www.ecb.int/press/pr/wfs/2012/html/fs120515.en.html

European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 42.7 percent of the total. Exports to the non-European Union area are growing at 12.4 percent in Mar 2012 relative to Mar 2011 while those to EMU are falling at 1.8 percent.

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

Mar 2012	Exports % Share	∆% Mar 2012/ Mar 2011	Imports % Share	Imports ∆% Mar 2012/ Mar 2011
EU	56.0	-0.5	53.3	-11.4
EMU 17	42.7	-1.8	43.2	-11.5
France	11.6	0.2	8.3	-9.0
Germany	13.1	2.9	15.6	-17.1
Spain	5.3	-10.3	4.5	-12.6
UK	4.7	12.4	2.7	-12.1
Non EU	44.0	12.4	46.7	-10.3
Europe non EU	13.3	11.5	11.1	-7.1
USA	6.1	23.5	3.3	7.0
China	2.7	-12.3	7.3	-33.3
OPEC	4.7	32.0	8.6	5.5
Total	100.0	4.9	100.0	-10.9

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

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €216 million with the 17 countries of the euro zone (EMU 17) in Mar and deficit of €346 million in Jan-Mar. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €1863 million in Jan-Mar with Europe non European Union and of €2135 million with the US. There is significant rigidity in the trade deficits in Jan-Mar of €4111 million with China and €6162 million with members of the Organization of Petroleum Exporting Countries (OPEC).

Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Mar 2012 Millions of Euro	Trade Balance Cumulative Jan-Mar 2012 Millions of Euro
EU	1,554	2,729
EMU 17	216	-346
France	1,173	2,972
Germany	-491	-1,361
Spain	271	741
UK	836	2,141
Non EU	510	-6,148
Europe non EU	1,165	1,863
USA	1,043	2,135
China	-902	-4,111
OPEC	-1,690	-6,162
Total	2,064	-3,418

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

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Mar 2012 relative to Mar 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 4.9 percent relative to imports of minus 10.9 percent may reflect weak demand in Italy with GDP declining during three consecutive quarters from IIIQ2011 through IQ2012.

Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Mar 2012/ Mar 2011	Imports Share %	Imports ∆% Mar 2012/ Mar 2011
Consumer Goods	28.9	5.4	25.0	-8.4
Durable	5.9	2.1	3.0	-17.0
Non Durable	23.0	6.4	22.0	-7.2
Capital Goods	32.2	4.2	20.8	-20.7
Inter- mediate Goods	34.3	3.0	34.5	-16.3
Energy	4.7	20.7	19.7	8.8
Total ex Energy	95.3	4.1	80.3	-15.2
Total	100.0	4.9	100.0	-4.6

Table III-6 provides Italy’s trade balance by product categories in Mar 2012 and cumulative Jan-Mar 2012. Italy’s trade balance excluding energy generated surplus of €7571 million in Mar 2012 and €14,022 million in Jan-Mar 2012 but the energy trade balance created deficit of €5507 million in Mar 2012 and €17,441 million in Jan-Mar 2012. The overall surplus in Mar 2012 was €2064 million but there was an overall deficit of €3418 million in Jan-Mar 2012. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Mar 2012	Cumulative Jan-Mar 2012
Consumer Goods	2,076	3,483
Durable	1,214	2,642
Nondurable	862	842
Capital Goods	4,461	9,622
Intermediate Goods	1,034	916
Energy	-5,507	-17,441
Total ex Energy	7,571	14,022
Total	2,064	-3,418