CMP Associates Regulation Blog: Collapse of United States Creation of Wealth, Income and Employment, Forty Eight Million in Poverty and without Health Insurance, Unresolved US Balance of Payments Deficits, Global Financial Turbulence and World Economic and Trade Slowdown with Global Recession Risk: Part I

Collapse of United States Creation of Wealth, Income and Employment, Forty Eight Million in Poverty and without Health Insurance, Unresolved US Balance of Payments Deficits, Global Financial Turbulence and World Economic and Trade Slowdown with Global Recession Risk

Carlos M. Pelaez

Executive Summary

I Collapse of United States Creation of Wealth, Income and Employment

IA Household Income at 1996 Levels and Forty Eight Million in Poverty and without Health Insurance

IB Destruction of Three Trillion Dollars of Household Wealth

II Unresolved US Balance of Payments Deficits

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

Executive Summary

ESI Household Income at 1996 Levels and Forty Eight Million in Poverty and without Health Insurance. The report of the US Bureau of the Census on Income, poverty and health insurance coverage in the United States: 2011 provides highly valuable socio-economic information and analysis (DeNavas-Walt, Proctor and Smith 2012Sep). Table ESI-1 provides years of high percentage of people below poverty in the US. Data for 2006 to 2009 are included to provide a framework of reference for the current deterioration. The series has two high points of 15.1 percent of the population in poverty in 2010 and 1993 exceeded only by 15.2 percent in 1983. The prior high numbers of poverty are found in 1960 to 1965 with 17.3 percent in 1965 and higher numbers going to 22.4 percent in 1959. The number of people in poverty in the US in 2011 was 46.247 million, which has increased by 9.787 million from 36.460 million in 2006. The fractured job market with 28.1 million unemployed or underemployed because they cannot find full-time jobs (http://cmpassocregulationblog.blogspot.com/2012/09/twenty-eight-million-unemployed-or.html) and decline of hiring by 17 million (http://cmpassocregulationblog.blogspot.com/2012/09/recovery-without-hiring-world-inflation.html) prevents exit from poverty. Inflation-adjusted average weekly wages declined throughout 2011.

Table ESI-1, US, Historical High Percentage of People below Poverty, Thousands and Percent

	Total Population	Number Below Poverty	Percent Below Poverty
2011	308,456	46,247	15.0
2010	306,130	46,343	15.1
2009	303,820	43,569	14.3
1993	259,278	39,265	15.1
1983	231,700	35,303	15.2
1982	229,412	34,398	15.0
1965	191,413	33,185	17.3
1964	189,710	36,055	19.0
1963	187,258	36,436	19.5
1962	184,276	38,625	21.0
1961	181,277	39,628	21.9
1960	179,503	39,851	22.2
1959	176,557	39,490	22.4
Memo
2009	303,820	46,180	14.3
2008	301,041	38,829	13.2
2007	298,699	37,276	12.5
2006	296,450	36,460	12.3

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Millions in poverty in the calendar year in which the recession ended and in the first calendar year after the recession are provided in Table ESI-2. There have been increases in the number of people in poverty in the first calendar years after the recessions since 1980. The brief recession of Jan to Jul 1980 experienced the highest increase in the first calendar year of 1.0 percent and 2.550 million more in poverty. In the three recessions before 1980 shown in Table ESI-2, the number of people in poverty fell in the first calendar year after the end of the recession.

Table ESI-2, US, Millions in Poverty in the Calendar Year in which Recession Ended and in the First Calendar Year after Recession, Millions and ∆%

	Millions	%	Millions	%	Change Millions	% Points
Dec 2007 to Jun 2009
2009	43.569	14.3
2010			46.343	15.1	2.774	0.8
Mar 2001 to Nov 2001
2001	32.907	11.7
2002			34.570	12.1	1.663	0.4
Jul 1990 to Mar 1991
1991	35.708	14.2
1992			38.014	14.8	2.306	0.6
Jul 1981 to Nov 1982
1982	34.398	15.0
1983			35.303	15.2	0.905	0.2
Jan 1980 to July 1980
1980	29.272	13.0
1981			31.822	14.0	2.550	1.0
Nov 1973 to Mar 1975
1975	25.877	12.3
1976			24.975	11.8	-0.902	-0.5
Dec 1960 to Nov 1970
1970	25.420	12.6
1971			25.559	12.5	-0.139	-0.1
Apr 1960 to Feb 1961
1961	39.628	21.9
1962			38.625	21.0	-1.003	-0.9

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Another dramatic fact revealed by DeNavas-Walt, Proctor and Smith (2012) is the increase in the number people without health insurance shown in Table ESI-3 at 49.951 million for 2010. Approximately 16.3 percent of the US population did not have health insurance in 2010. There was marginal improvement with 48.613 million without health insurance in 2011, corresponding to 15.7 percent of the population.

Table ESI-3, US, People without Health Insurance in the Final Year of Recession and in the First Calendar Year after Recession Ended, Millions and Percent

	Millions Without Health Insurance	Percent of Population
Recession Dec 2007 to Jun 2009
2009	49.985	16.1
2010	49.951	16.3
Change/2009	0.919	0.2 % Points
2011	48.613	15.7
Change/2009	-1.372	-0.4 % Points
Recession Mar 2001 to Nov 2001
2001	38.023	13.5
2002	39.776	13.9
Change	1.753	0.4
Recession Jul 1990 to Mar 1991
1991	35.445	14.1
1992	38.641	15.0
Change	3.196	0.9

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

The population of the US increased by 12.003 million from 296.824 million in 2006 to 308.827 million in 2011, as shown in Table ESI-4. The number uncovered by health insurance increased by 3.399 million between 2006 and 2011. The loss of private health insurance coverage by 6.619 million from 2006 to 2011 was partially compensated by an increase in government coverage by 19.154 million.

Table ESI-4, US, Population, Private and Government Health Insurance and Uncovered by Health Insurance, Thousands and Percent, 2006-2011

	Population	Private Health Insurance	Govern- ment Health Insurance	Uncovered
2011	308,827	197,323	99,497	48,613
2010	306,553	196,147	95,525	49,951
2009	304,280	196,245	93,245	49,985
2008	301,483	202,626	87,586	44,780
2007	299,106	203,903	83,147	44,088
2006	296,824	203,942	80,343	45,214

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Median household income in the US fell 8.1 percent from $54,489 in 2007 to $50,054 in 2011, as shown in Table ESI-5. Median income fell in all years. Median income fell 4.1 percent in 2011 relative to 2009 even after two years of recovery of the economy.

Table ESI-5, US, Median Household Income, Dollars and ∆%

	2011	2010	2009	2007
Total Number of Households	121,084	119,927	117,538	116,783
Median Income Dollars	50,054	50,831	52,195	54,489
∆% 2010/2009	-2.6
∆% 2011/2009	-4.1
∆% 2010/2007	-6.7
∆% 2011/2007	-8.1

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Numbers of households in the US, median income in constant 2011 dollars and mean income also in 2011 dollars are provided in Table ESI-6. There is a dramatic fact in Table ESI-6: inflation-adjusted median household income in the US is higher in all years from 1996 to 2011 than the $50,054 of 2010. The contraction and low rate of growth in the expansion have resulted in the destruction of the progress in household income accomplished in 15 years of technological advance and use of humans, machines and natural resources in economic activity. The median measures the center of the middle class of the US that is no better off after 15 years of efforts. There is sharp contrast with the 1980s. Rapid economic growth after the contraction from Jul 1981 to Nov 1982 (http://www.nber.org/cycles.html) resulted in an increase of household median income from $44,823 in 1983 to $50,624 in 1989, or by 12.9 percent. Another fact of Table ESI-6 is that household income in 2011 of $50,054 is virtually the same as $49,950 in 1989. The typical household in the US is not better off than in 1989, which is separated from the present by 22 years of efforts.

Table ESI-6, Median and Mean Household Income in 2011 Adjusted Dollars

Year	# Households	Median Income 2011 Dollars	Mean Income 2011 Dollars
2011	121,084	50,054	69,677
2010	119,927	50,831	69,518
2009	117,538	52,195	71,278
2008	117,181	52,546	71,475
2007	116,783	54,489	73,337
2006	116,011	53,768	74,259
2005	114,384	53,371	72,977
2004	113,343	52,788	71,997
2003	112,000	52,973	72,232
2002	111,278	53,019	72,326
2001	109,297	53,646	73,947
2000	108,209	54,841	74,621
1999	106,434	54,932	73,885
1998	103,874	53,582	71,455
1997	102,528	51,704	69,430
1996	101,018	50,661	67,263
1995	99,627	49,935	65,852
1994	98,990	48,418	64,729
1993	97,107	47,884	63,497
1992	96,426	48,117	61,003
1991	95,669	48,516	61,071
1990	94,312	49,950	62,395
1989	93,347	50,624	63,958
1988	92,830	49,737	62,145
1987	91,124	49,358	61,382
1986	89,479	48,746	60,223
1985	88,458	47,079	57,939
1984	86,789	46,215	56,625
1983	85,407	44,823	54,516
1982	83,918	45,139	54,399
1981	83,527	45,260	54,070
1980	82,368	46,024	54,737

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

The percentage change in median household income and the change in number of workers with earnings in the first calendar years after recessions are provided in Table ESI-7. The first calendar year after the end of recession in 2010 is by far the worst of any such year in recessions since 1970. Household median income fell 2.3 percent from 2009 to 2010 and the number of workers with earnings fell by 1.608 million. The first calendar year 2010 after the end of recession in 2009 is the only in the recessions back to 1970 in which there was decline of the number of workers with earnings and the only one also with negative change in full-time year-round workers.

Table ESI-7, Percentage Change in Median Household Income and Change in Number of Workers with Earnings in First Calendar Years after Recessions, ∆% and Thousands

	Median Household Income ∆%	Change in Number of Workers with Earnings Thousands	Change in Full-time Year-round Workers Thousands
Recession Dec 2007 to June 2009
2010	-2.3	-1,608	-24
Recession Mar 2001 to Nov 2001
2002	-1.2	470	286
Recession Jul 1990 to Mar 1991
1992	-0.8	1,692	1,468
Recession Jul 1981 to Nov 1982
1983	-0.7	1,696	2,887
Recession Jan 1980 to Jul 1980
1981	-1.7	995	362
Recession Nov 1973 to Mar 1975
1976	1.7	2,821	1,538
Recession Dec 1960 to Nov 1970
1971	-1.0	1,277	1,213

Source:

DeNavas-Walt, Proctor and Smith (2012Sep).

Characteristics of the four cyclical contractions are provided in Table ESI-8 with the first column showing the number of quarters of contraction; the second column the cumulative percentage contraction; and the final column the average quarterly rate of contraction. There were two contractions from IQ1980 to IIIQ1980 and from IIIQ1981 to IVQ1982 separated by three quarters of expansion. The drop of output combining the declines in these two contractions is 4.8 percent, which is almost equal to the decline of 4.7 percent in the contraction from IVQ2007 to IIQ2009. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.7 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

Table ESI-8, US, Number of Quarters, Cumulative Percentage Contraction and Average Percentage Annual Equivalent Rate in Cyclical Contractions

	Number of Quarters	Cumulative Percentage Contraction	Average Percentage Rate
IIQ1953 to IIQ1954	4	-2.5	-0.63
IIIQ1957 to IIQ1958	3	-3.1	-9.0
IQ1980 to IIIQ1980	2	-2.2	-1.1
IIIQ1981 to IVQ1982	4	-2.7	-0.67
IVQ2007 to IIQ2009	6	-4.7	-0.80

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

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

Table ESI-9 shows the extraordinary contrast between the mediocre average annual equivalent growth rate of 2.2 percent of the US economy in the twelve quarters of the current cyclical expansion from IIIQ2009 to IIQ2012 and the average of 6.2 percent in the four earlier cyclical expansions. BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 percent decelerating to 1.8 percent annual growth in 2011 (http://www.bea.gov/iTable/index_nipa.cfm) and cumulative 0.92 percent in the first half of 2012 {(1.02)^1/4(1.017)^1/4 = 0.92%}, which is equivalent to 1.85 percent per year {([(1.02)^1/4(1.015)^1/4 ]² – 1)100 = 1.85%}. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent. The weakest cyclical expansion in the postwar period caused the breakdown of US creation of income.

Table ESI-9, US, Number of Quarters, Cumulative Growth and Average Annual Equivalent Growth Rate in Cyclical Expansions

	Number of Quarters	Cumulative Growth ∆%	Average Annual Equivalent Growth Rate
IIIQ 1954 to IQ1957	11	12.6	4.4
IIQ1958 to IIQ1959	5	10.2	8.1
IIQ1975 to IVQ1976	8	9.5	4.6
IQ1983 to IV1985	13	19.6	5.7
Average Four Above Expansions			6.2
IIIQ2009 to IIQ2012	12	6.80	2.2

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

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

ESII Destruction of Three Trillion Dollars of Household Wealth. The Flow of Funds Accounts of the United States provided by the Federal Reserve (http://www.federalreserve.gov/releases/z1/Current/z1.pdf) is rich in valuable information. Table ESII-1, updated in this blog for every new quarterly release, shows the balance sheet of US households combined with nonprofit organizations in 2007, IIQ2011 and IIQ2012. The data show the strong shock to US wealth during the contraction. Assets fell from $80.3 trillion in 2007 to $74.7 trillion in IIQ2011 even after 8 consecutive quarters of growth beginning in IIIQ2009 (http://wwwdev.nber.org/cycles/cyclesmain.html), for decline of $5.6 trillion or 7.0 percent. Assets stood at $76.1 trillion in IIQ2012 for loss of $4.2 trillion relative to $80.3 trillion in 2007 or decline by 5.2 percent. Liabilities declined from $14.3 trillion in 2007 to $13.5 trillion in IQ2011 or by $804.5 billion equivalent to decline by 5.6 percent. Net worth shrank from $66.1 trillion in 2007 to $62.7 trillion in IIQ2012, that is, $3.4 trillion equivalent to decline of 5.1 percent. There was brutal decline from 2007 to IIQ2012 of $4.5 trillion in real estate assets or by 18.9 percent. The National Association of Realtors estimated that the gains in net worth in homes by Americans were about $4 trillion between 2000 and 2005 (quoted in Pelaez and Pelaez, The Global Recession Risk (2007), 224-5).

Table ESII-1, US, Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars Outstanding End of Period, NSA

	2007	IIQ2011	IIQ2012
Assets	80,320.1	74,704.4	76,126.9
Nonfinancial	28,237.5	23,292.1	24,201.2
Real Estate	23,507.2	18,299.9	19,056.5
Durable Goods	4,468.3	4,681.6	4,819.2
Financial	52,082.6	51,412.3	51,925.6
Deposits	7,502.0	8,169.1	8,658.6
Credit Market	4,956.5	5,135.4	4,788.4
Mutual Fund Shares	4,605.3	5,014.6	5,065.7
Equities Corporate	9,631.6	9,645.2	9,216.3
Equity Noncorporate	9,341.1	7,247.3	7,691.9
Pension	13,390.7	13,434.8	13,656.2
Liabilities	14,263.0	13,556.7	13,458.5
Home Mortgages	10,566.9	9,826.5	9,589.1
Consumer Credit	2,528.8	2,534.2	2,661.1
Net Worth	66,057.1	61,147.6	62,668.4

Net Worth = Assets – Liabilities

Source: Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Washington, DC, Federal Reserve System, Sep 20 http://www.federalreserve.gov/releases/z1/default.htm

The explanation of the sharp contraction of household wealth can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:

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

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

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

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

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

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

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

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

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

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

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

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

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

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

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

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

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

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

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

According to Pinto (2008) in testimony to Congress:

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

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 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”

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.

Table ESII-2 shows the euphoria of prices during the boom and the subsequent decline. House prices rose 93.7 percent in the 10-city composite of the Case-Shiller home price index and 78.1 percent in the 20-city composite between Jun 2000 and Jun 2005. Prices rose around 100 percent from Jun 2000 to Jun 2006, increasing 109.9 percent for the 10-city composite and 93.3 percent for the 20-city composite. House prices rose 39.5 percent between Jun 2003 and Jun 2005 for the 10-city composite and 34.5 percent for the 20-city composite propelled by low fed funds rates of 1.0 percent between Jun 2003 and Jun 2004 and then only increasing by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Jun 2003 and Jun 2006 the 10-city index gained 51.2 percent and the 20-city index increased 46.0 percent. House prices have fallen from Jun 2006 to Jun 2012 by 31.5 percent for the 10-city composite and 31.1 percent for the 20-city composite. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Jun 2012, house prices increased 0.1 percent in the 10-city composite and increased 0.5 percent in the 20-city composite. Table ESII-2 also shows that house prices increased 43.8 percent between Jun 2000 and Jun 2012 for the 10-city composite and increased 33.2 percent for the 20-city composite. House prices are close the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 31.5 percent from the peak in Jun 2006 to Jun 2012 and the 20-city composite fell 31.1 percent from the peak in Jul 2006 to Jun 2012. The final part of Table ESII-2 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2011 for the 10-city composite was 3.2 percent. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2011 was 2.5 percent while the rate of the 20-city composite was 1.9 percent.

Table ESII-2, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Jun 2000 to Jun 2003	38.8	32.4
∆% Jun 2000 to Jun 2005	93.7	78.1
∆% Jun 2003 to Jun 2005	39.5	34.5
∆% Jun 2000 to Jun 2006	109.9	93.3
∆% Jun 2003 to Jun 2006	51.2	46.0
∆% Jun 2005 to Jun 2012	-25.8	-25.2
∆% Jun 2006 to Jun 2012	-31.5	-31.1
∆% Jun 2009 to Jun 2012	1.1	0.2
∆% Jun 2010 to Jun 2012	-3.8	-3.9
∆% Jun 2011 to Jun 2012	0.1	0.5
∆% Jun 2000 to Jun 2012	43.8	33.2
∆% Peak Jun 2006 Jun 2012	-31.5
∆% Peak Jul 2006 Jun 2012		-31.1
Average ∆% Dec 1987-Dec 2011	3.2	NA
Average ∆% Dec 1987-Dec 2000	3.8	NA
Average ∆% Dec 1992-Dec 2000	5.0	NA
Average ∆% Dec 2000-Dec 2011	2.5	1.9

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

Table ESII-3 summarizes the brutal drops in assets and net worth of US households and nonprofit organizations from 2007 to IIQ2011 and IIQ2012. Between 2007 and IIQ2012, real estate fell in value by $4.5 trillion and financial assets decreased $0.157 trillion, explaining most of the drop in net worth of $3.4 trillion obtained by deducting the decrease in liabilities of $804.5 billion from the decrease of assets of $4,193.2 billion. BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 percent decelerating to 1.8 percent annual growth in 2011 (http://www.bea.gov/iTable/index_nipa.cfm) and cumulative 0.92 percent in the first half of 2012 {(1.02)^1/4(1.017)^1/4 = 0.92%}, which is equivalent to 1.85 percent per year {([(1.02)^1/4(1.015)^1/4 ]² – 1)100 = 1.85%} while the expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent. Subpar economic growth in comparison with past cyclical economic expansions is accompanied by a drop of net worth of households and nonprofit organizations of $3.4 trillion.

Table ESII-3, US, Difference of Balance Sheet of Households and Nonprofit Organizations in Millions of Dollars from 2007 to IIQ2011 and IIQ2012

	2009	IIQ2011	IIQ2012
Assets	-10,928.3	-5,615.7	-4,193.2
Nonfinancial	-4,469.9	-4,945.4	-4,036.3
Real Estate	-4,615.9	-5,207.3	-4,450.7
Financial	-6,458.5	-670.3	-157.0
Liabilities	-374.7	-706.3	-804.5
Net Worth	-10,553.7	-4,909.5	-3,388.7

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIQ2012 is provided in Table ESII-4. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980. In contrast, as shown in Table ESII-4, net worth of households and nonprofit organizations fell from $66,057.1 billion in IVQ2007 to $62,668.4 billion in IIQ2012 by $3,388.7 billion or 5.1 percent. The US consumer price index was 210.036 in Dec 2007 and 229.478 in Jun 2012 for increase of 9.3 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 13.2 percent in Jun 2012 after 12 consecutive quarters of expansion from IIIQ2009 to IIQ2012 relative to IVQ2012 when the recession began. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IIQ2012 has been 2.2 percent, which is substantially lower than the average of 6.2 percent in cyclical expansions after World War II and 5.7 percent in the expansion from IQ1983 to IVQ1985 (see Table ESI-9 also Table I-5 at http://cmpassocregulationblog.blogspot.com/2012/09/collapse-of-united-states-dynamism-of.html ). The US missed the opportunity of high growth rates that has been available in past cyclical expansions.

Table ESII-4, Net Worth of Households and Nonprofit Organizations in Billions of Dollars, IVQ1979 to IVQ1985 and IVQ2007 to IIQ2012

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	8,326.4 8,502.9
IVQ1985	14,395.2
∆ USD Billions IQ1980	+6,068.8 +5,892.3
Period IVQ2007 to IIQ2012
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7

Source: Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Sep 20 http://www.federalreserve.gov/releases/z1/default.htm

Chart ESII-1 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ2007 to IIQ2012. There is remarkable stop and go behavior in this series with two sharp declines and two standstills in the 12 quarters of expansion of the economy beginning in IIIQ2009.

Chart ESII-1, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ2007 to IIQ2012

Chart ESII-2 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1979 to IVQ1985. There are changes in the rates of growth of wealth suggested by the changing slopes but there is smooth upward trend. There was significant financial turmoil during the 1980s. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.74 percent of GDP in a year. US GDP in 2011 is estimated at $15,075.7 billion, such that the bailout would be equivalent to cost to taxpayers of about $412.5 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery. Money center banks were under extraordinary pressure from the default of sovereign debt by various emerging nations that represented a large share of their net worth (see Pelaez 1986).

Chart ESII-2, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1979 to IVQ1985

Chart ESII-3 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IQ1945 at $710,125.9 million to IIQ2009 at $62,688,390.9 million or increase of 8,727.8 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 229.478 in Jun 2012 or 1,160.9 percent. There was a gigantic increase of US household and nonprofit net worth over 67 years. The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of US household and nonprofit net worth. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 67 years when US GDP grew at 2.2 percent on average in 12 quarters between IIIQ2009 and IIQ2012 in contrast with average 5.7 percent from IQ1983 to IVQ1985 and average 6.2 percent during cyclical expansions in those 67 years.

Chart ESII-3, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1945 to IIQ2012

ESIII Unresolved US Balance of Payments Deficits. The current account of the US balance of payments is provided in Table ESIII-1 for IIQ2011 and IIQ2012. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US decreased from $124.5 billion in IIQ2011, or 3.2 percent of GDP, to $123.2 billion in IIQ2012, or 3.0 percent of GDP. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table ESIII-1, US Balance of Payments, Millions of Dollars NSA

	IIQ2011	IIQ2012	Difference
Goods Balance	-190,477	-189,344	1,133
X Goods	375,554	396,218	5.5 ∆%
M Goods	-566,031	-585,562	3.5 ∆%
Services Balance	39,949	40,690	741
X Services	148,999	154,291	3.6 ∆%
M Services	-109,050	-113,601	4.2 ∆%
Balance Goods and Services	-150,528	-148,654	1,874
Balance Income	58,335	57,504	-831
Unilateral Transfers	-32,291	-32,049	-242
Current Account Balance	-124,484	-123,199	-1,285
% GDP	IIQ2011	IVQ2011	IIQ2012
	3.2	3.1	3.0

X: exports; M: imports

Balance on Current Account = Balance on Goods and Services + Balance on Income + Unilateral Transfers

Source: Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

“Imagine that fiscal policy dominates monetary policy. The fiscal authority independently sets its budgets, announcing all current and future deficits and surpluses and thus determining the amount of revenue that must be raised through bond sales and seignorage. Under this second coordination scheme, the monetary authority faces the constraints imposed by the demand for government bonds, for it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public. Suppose that the demand for government bonds implies an interest rate on bonds greater than the economy’s rate of growth. Then if the fiscal authority runs deficits, the monetary authority is unable to control either the growth rate of the monetary base or inflation forever. If the principal and interest due on these additional bonds are raised by selling still more bonds, so as to continue to hold down the growth of base money, then, because the interest rate on bonds is greater than the economy’s growth rate, the real stock of bonds will growth faster than the size of the economy. This cannot go on forever, since the demand for bonds places an upper limit on the stock of bonds relative to the size of the economy. Once that limit is reached, the principal and interest due on the bonds already sold to fight inflation must be financed, at least in part, by seigniorage, requiring the creation of additional base money.”

The current real value of government debt plus monetary liabilities depends on the expected discounted values of future primary surpluses or difference between tax revenue and government expenditure excluding interest payments (Cochrane 2011Jan, 27, equation (16)). There is a point when adverse expectations about the capacity of the government to generate primary surpluses to honor its obligations can result in increases in interest rates on government debt.

This analysis suggests that there may be a point of saturation of demand for United States financial liabilities without an increase in interest rates on Treasury securities. A risk premium may develop on US debt. Such premium is not apparent currently because of distressed conditions in the world economy and international financial system. Risk premiums are observed in the spread of bonds of highly indebted countries in Europe relative to bonds of the government of Germany.

The issue of global imbalances centered on the possibility of a disorderly correction (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). Such a correction has not occurred historically but there is no argument proving that it could not occur. The need for a correction would originate in unsustainable large and growing United States current account deficits (CAD) and net international investment position (NIIP) or excess of financial liabilities of the US held by foreigners net of financial liabilities of foreigners held by US residents. The IMF estimated that the US could maintain a CAD of two to three percent of GDP without major problems (Rajan 2004). The threat of disorderly correction is summarized by Pelaez and Pelaez, The Global Recession Risk (2007), 15):

“It is possible that foreigners may be unwilling to increase their positions in US financial assets at prevailing interest rates. An exit out of the dollar could cause major devaluation of the dollar. The depreciation of the dollar would cause inflation in the US, leading to increases in American interest rates. There would be an increase in mortgage rates followed by deterioration of real estate values. The IMF has simulated that such an adjustment would cause a decline in the rate of growth of US GDP to 0.5 percent over several years. The decline of demand in the US by four percentage points over several years would result in a world recession because the weakness in Europe and Japan could not compensate for the collapse of American demand. The probability of occurrence of an abrupt adjustment is unknown. However, the adverse effects are quite high, at least hypothetically, to warrant concern.”

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below potential. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. Table ESIII-2 provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.2 percent of GDP while the Congressional Budget Office (CBO 2011AugBEO, 2) estimates the federal deficit in 2012 at $1128 billion or 7.3 percent of GDP (http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html). The combined record federal deficits of the US from 2009 to 2012 are $5135 billion or 33 percent of the estimate of GDP of $15,538 billion for fiscal year 2012 by the CBO (http://www.cbo.gov/publication/43542 2012AugBEO). Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5135 billion, and corresponded to 36.3 percent of GDP. Federal debt in 2011 was 67.7 percent of GDP and is estimated to reach 72.8 percent of GDP in 2012 (CBO2012AugBEO). This situation may worsen in the future (CBO 2012LTBO):

“The budget outlook is much bleaker under the extended alternative fiscal scenario, which maintains what some analysts might consider “current policies,” as opposed to current laws. Federal debt would grow rapidly from its already high level, exceeding 90 percent of GDP in 2022. After that, the growing imbalance between revenues and spending, combined with spiraling interest payments, would swiftly push debt to higher and higher levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2026, and it would approach 200 percent in 2037.

The changes under this scenario would result in much lower revenues than would occur under the extended baseline scenario because almost all expiring tax provisions are assumed to be extended through 2022 (with the exception of the current reduction in the payroll tax rate for Social Security). After 2022, revenues under this scenario are assumed to remain at their 2022 level of 18.5 percent of GDP, just above the average of the past 40 years.

Outlays would be much higher than under the other scenario. This scenario incorporates assumptions that through 2022, lawmakers will act to prevent Medicare’s payment rates for physicians from declining; that after 2022, lawmakers will not allow various restraints on the growth of Medicare costs and health insurance subsidies to exert their full effect; and that the automatic reductions in spending required by the Budget Control Act of 2011 will not occur (although the original caps on discretionary appropriations in that law are assumed to remain in place). Finally, under this scenario, federal spending as a percentage of GDP for activities other than Social Security, the major health care programs, and interest payments is assumed to return to its average level during the past two decades, rather than fall significantly below that level, as it does under the extended baseline scenario.”

Table ESIII-2, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2000	2007	2008	2009	2010	2011
Goods & Services	-377	-697	-698	-379	-495	-559
Income	19	101	147	119	184	227
UT	-58	-115	-126	-122	-131	-133
Current Account	-416	-710	-677	-382	-442	-466
NGDP	9951	14028	14291	13974	14499	15076
Current Account % GDP	-3.8	-5.1	-4.7	-2.7	-3.1	-3.1
NIIP	-1337	-1796	-3260	-2321	-2474	-4030
US Owned Assets Abroad	6239	18399	19464	18512	20298	21132
Foreign Owned Assets in US	7576	20195	22724	20833	22772	25162
NIIP % GDP	-13.4	-12.8	-22.8	-16.6	-17.1	26.7
Exports Goods Services Income	1425	2488	2657	2181	2519	2848
NIIP % Exports Goods Services Income	-94	-72	-123	-106	-98	-142
DIA MV	2694	5274	3102	4287	4767	4450
DIUS MV	2783	3551	2486	2995	3397	3509
Fiscal Balance	+236	-161	-459	-1413	-1294	-1300
Fiscal Balance % GDP	+2.4	-1.2	-3.2	-10.1	-9.0	-8.7
Federal Debt	3410	5035	5803	7545	9019	10128
Federal Debt % GDP	34.7	36.3	40.5	54.1	62.8	67.7
Federal Outlays	1789	2729	2983	3518	3456	3603
∆%	5.1	2.8	9.3	17.9	-1.8	4.3
% GDP	18.2	19.7	20.8	25.2	24.1	24.1
Federal Revenue	2052	2568	2524	2105	2162	2303
∆%	10.8	6.7	-1.7	-16.6	2.7	6.5
% GDP	20.6	18.5	17.6	15.1	15.1	15.4

Sources:

Notes: UT: unilateral transfers; NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. These discrepancies do not alter conclusions.

Sources: Balance of Payments and NIIP, Bureau of Economic Analysis (BEA) http://www.bea.gov/international/index.htm#bop

Gross Domestic Product, Bureau of Economic Analysis (BEA) http://www.bea.gov/national/index.htm#gdp

Federal Outlays, Revenues and Debt, Congressional Budget Office (CBO) Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB. CBO (2012JanBEO). CBO (2012Jan31). CBO (2012AugBEO).

Congressional Budget Office http://www.cbo.gov/

ESIV Collapse of United States Creation of Wealth, Income and Employment. Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare and regulatory state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in USD fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in Japan and France within the G7 in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. Long-term economic growth and prosperity are measured by the key indicators of growth of real income per capita, or what is earned per person after inflation. A refined concept would include real disposable income per capita, or what is earned per person after inflation and taxes.

Table ESIV-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 12 quarters of the current cyclical expansion from IIIQ2009 to IIQ2012, GDP increased 6.80 percent at the annual equivalent rate of 2.2 percent; real disposable personal income (RDPI) increased 3.8 percent at the annual equivalent rate of 1.3 percent; RDPI per capita increased 1.4 percent at the annual equivalent rate of 0.5 percent; and population increased 2.3 percent at the annual equivalent rate of 0.8 percent. Third, since the beginning of the recession in IVQ2007 to IIQ2012, GDP increased 1.8 percent, or barely above the level before the recession; real disposable personal income increased 3.5 percent; population increased 3.7 percent; and real disposable personal income per capita is 0.2 percent lower than the level before the recession. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing.

Table ESIV-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1985	13
GDP		19.6	5.7
RDPI		14.5	4.3
RDPI Per Capita		11.5	3.4
Population		2.7	0.8
IIIQ2009 to IIQ2012	12
GDP		6.80	2.2
RDPI		3.8	1.3
RDPI per Capita		1.4	0.5
Population		2.3	0.8
IVQ2007 to IIQ2012	19
GDP		1.8
RDPI		3.5
RDPI per Capita		-0.2
Population		3.7

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

There are five basic facts illustrating the current economic disaster of the United States: GDP maintained trend growth in the entire business cycle from IQ1980 to IV1985, including contractions and expansions, but is well below trend in the entire business cycle from IVQ2007 to IIQ2012, including contractions and expansions; per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIQ2012; the number of employed persons increased in the 1980s but declined into IIQ2012; the number of full-time employed persons increased in the 1980s but declined into IIQ2012; and wealth of households and nonprofit organizations soared in the 1980s but declined into IIQ2012. There is a critical issue of whether the United States economy will be able in the future to attain again the level of activity and prosperity of projected trend growth. Growth at trend during the entire business cycles built the largest economy in the world but there may be an adverse, permanent weakness in United States economic performance and prosperity. Table ESIV-2 provides data for analysis of these five basic facts. The five blocks of Table ESIV-2 are separated initially after individual discussion of each one followed by the full Table ESIV-2.

1. Trend Growth.

i. As shown in Table ESIV-2, actual GDP grew cumulatively 17.7 percent from IQ1980 to IVQ1985, which is relatively close to what trend growth would have been at 18.5 percent. Rapid growth at 5.7 percent annual rate on average per quarter during the expansion from IQ1983 to IVQ1985 erased the loss of GDP of 4.8 percent during the contraction and maintained trend growth at 3 percent over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIQ2012 was 1.8 percent while trend growth would have been 14.2 percent. GDP in IIQ2012 at seasonally adjusted annual rate is estimated at $13,564.5 percent by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,218.3 billion, or $1,653 billion higher, had the economy grown at trend over the entire business cycle as it happened during the 1980s and throughout most of US history. There is $1.7 trillion of foregone GDP that would have been created as it occurred during past cyclical expansions, which explains why employment has not rebounded to even higher than before. There would not be recovery of full employment even with growth of 3 percent per year beginning immediately because the opportunity was lost to grow faster during the expansion from IIIQ2009 to IIQ2012 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.8 million people or 17.9 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html) that will not be diminished even with return to growth of GDP of 3 percent per year because of growth of the labor force by new entrants. The US labor force grew from 142.583 million in 2000 to 153.124 million in 2007 or by 7.4 percent at the average yearly rate of 1.0 percent per year. The civilian noninstitutional population increased from 212.577 million in 2000 to 231.867 million in 2007 or 9.1 percent at the average yearly rate of 1.3 percent per year (data from http://www.bls.gov/data/). Data for the past five years cloud accuracy because of the number of people discouraged from seeking employment. The noninstitutional population of the United States increased from 231.867 million in 2007 to 239.618 million in 2011 or by 3.3 percent while the labor force increased from 153.124 million in 2007 to 153.617 million in 2011 or by 0.3 percent (data from http://www.bls.gov/data/). People ceased to seek jobs because they do not believe that there is a job available for them (see http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html).

Period IQ1980 to IVQ1985
GDP SAAR USD Billions
IQ1980	5,903.4
IVQ1985	6,950.0
∆% IQ1980 to IVQ1985	17.7
∆% Trend Growth IQ1980 to IVQ1985	18.5

Period IVQ2007 to IIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIQ2012	13,564.5
∆% IVQ2007 to IIQ2012	1.8
∆% IVQ2007 to IIQ2012	14.2

2. Decline of Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IVQ1985, as shown in Table ESIV-2 trend growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 17.7 percent, which is close to what would have been trend growth of 18.5 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IIQ2012, per capita real disposable income fell 0.2 percent while trend growth would have been 9.3 percent. Income available after inflation and taxes is lower than before the contraction after 12 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions.

Period IQ1980 to IVQ1985

Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IVQ1985 Chained 2005 USD	21,687
∆% IQ1980 to IVQ1985	14.5
∆% Trend Growth	12.1

Period IVQ2007 to IIQ2012

Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIQ2012	-0.2
∆% Trend Growth	9.3

3. Number of Employed Persons

i. As shown in Table ESIV-2, the number of employed persons increased over the entire business cycle from 81.280 million not seasonally adjusted (NSA) in IQ1980 to 88.757 million NSA in IVQ1985 or by 9.2 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 143.202 million in IIQ2012 or by 2.1 percent. There are 28.8 million persons unemployed or underemployed, which is 17.9 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html).

Period IQ1980 to IVQ1985

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IV1985 NSA End of Quarter	107.819
∆% Employed IQ1980 to IV1985	9.4

Period IVQ2007 to IIQ2012

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIQ2012 NSA End of Quarter	143.202
∆% Employed IVQ2007 to IIQ2012	-2.1

4. Number of Full-Time Employed Persons

i. As shown in Table ESIV-2, during the entire business cycle in the 1980s, including contractions and expansion, the number of employed full-time rose from 81.280 million NSA in IQ1980 to 88.757 million NSA in IVQ1985 or 9.2 percent.

ii. In contrast, during the entire current business cycle, including contraction and expansion, the number of persons employed full-time fell from 121.042 million in IVQ2007 to 116.024 million in IIQ2012 or by minus 4.1 percent.

Period IQ1980 to IVQ1985

Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IV1985 NSA End of Quarter	88.757
∆% Full-time Employed IQ1980 to IV1985	9.2

Period IVQ2007 to IIQ2012

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIQ2012 NSA End of Quarter	116.024
∆% Full-time Employed IVQ2007 to IIQ2012	-4.1

5. Wealth of Households and Nonprofit Organizations.

i. The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIQ2012 is provided in the following block and in Table ESIV-2. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980.

ii. In contrast, as shown in the following block and in Table ESIV-2, net worth of households and nonprofit organizations fell from $66,057.1 billion in IVQ2007 to $62,668.4 billion in IIQ2012 by $3,388.7 billion or 5.1 percent. The US consumer price index was 210.036 in Dec 2007 and 229.478 in Jun 2012 for increase of 9.3 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 13.2 percent in Jun 2012 after 12 consecutive quarters of expansion from IIIQ2009 to IIQ2012 relative to IVQ2012 when the recession began. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IIQ2012 has been 2.2 percent, which is substantially lower than the average of 6.2 percent in cyclical expansions after World War II and 5.7 percent in the expansion from IQ1983 to IVQ1985 (see Table I-5 at http://cmpassocregulationblog.blogspot.com/2012/09/collapse-of-united-states-dynamism-of.html). The US missed the opportunity of high growth rates that has been available in past cyclical expansions.

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Period IVQ2007 to IIQ2012
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7

Table ESIV-2, US, GDP and Real Disposable Personal Income per Capita Actual and Trend Growth and Employment, 1980-1985 and 2007-2012, SAAR USD Billions, Millions of Persons and ∆%


Period IQ1980 to IVQ1985
GDP SAAR USD Billions
IQ1980	5,903.4
IVQ1985	6,950.0
∆% IQ1980 to IVQ1985	17.7
∆% Trend Growth IQ1980 to IVQ1985	18.5
Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IVQ1985 Chained 2005 USD	21,687
∆% IQ1980 to IVQ1985	14.5
∆% Trend Growth	12.1
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IV1985 NSA End of Quarter	107.819
∆% Employed IQ1980 to IV1985	9.4
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IV1985 NSA End of Quarter	88.757
∆% Full-time Employed IQ1980 to IV1985	9.2
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Period IVQ2007 to IIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIQ2012	13,564.5
∆% IVQ2007 to IIQ2012	1.8
∆% IVQ2007 to IIQ2012	14.2
Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIQ2012	-0.2
∆% Trend Growth	9.3
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIQ2012 NSA End of Quarter	143.202
∆% Employed IVQ2007 to IIQ2012	-2.1
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIQ2012 NSA End of Quarter	116.024
∆% Full-time Employed IVQ2007 to IIQ2012	-4.1
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7

Note: GDP trend growth used is 3.0 percent per year and GDP per capita is 2.0 percent per year as estimated by Lucas (2011May) on data from 1870 to 2010.

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm US Bureau of Labor Statistics http://www.bls.gov/data/. Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Washington, DC, Federal Reserve System.

ESV Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/update/01/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the second quarter of 2012 of 1.8 percent is equivalent to 7.4 percent per year.

2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.1 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.

3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.

4. World Inflation Waves. Inflation continues in repetitive waves globally (see http://cmpassocregulationblog.blogspot.com/2012/08/world-inflation-waves-loss-of-dynamism.html ).

A list of financial uncertainties includes:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.

2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.

3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.

4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.

5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).

6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion.

It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in the text after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII). Table ESV-1, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 9/21/12,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, 2011, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values have fluctuated with events such as the surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23 but renewed risk appetite in the week of Mar 30 because of the end of the quarter and the increase in the firewall of support of sovereign debts in the euro area. New risks developed in the week of Apr 6 with increase of yields of sovereign bonds of Spain and Italy, doubts on Fed policy and weak employment report. Asia and financial entities are experiencing their own risk environments. Financial markets were under stress in the week of Apr 13 because of the large exposure of Spanish banks to lending by the European Central Bank and the annual equivalent growth rate of China’s GDP of 7.4 percent in IQ2012 [(1.018)⁴], which was repeated in IIQ2012. There was strength again in the week of Apr 20 because of the enhanced IMF firewall and Spain placement of debt, continuing into the week of Apr 27. Risk aversion returned in the week of May 4 because of the expectation of elections in Europe and the new trend of deterioration of job creation in the US. Europe’s sovereign debt crisis and the fractured US job market continued to influence risk aversion in the week of May 11. Politics in Greece and banking issues in Spain were important factors of sharper risk aversion in the week of May 18. Risk aversion continued during the week of May 25 and exploded in the week of Jun 1. Expectations of stimulus by central banks caused valuation of risk financial assets in the week of Jun 8 and in the week of Jun 15. Expectations of major stimulus were frustrated by minor continuance of maturity extension policy in the week of Jun 22 together with doubts on the silent bank run in highly indebted euro area member countries. There was a major rally of valuations of risk financial assets in the week of Jun 29 with the announcement of new measures on bank resolutions by the European Council. New doubts surfaced in the week of Jul 6, 2012 on the implementation of the bank resolution mechanism and on the outlook for the world economy because of interest rate reductions by the European Central, Bank of England and People’s Bank of China. Risk appetite returned in the week of July 13 in relief that economic data suggests continuing high growth in China but fiscal and banking uncertainties in Spain spread to Italy in the selloff of July 20, 2012. Mario Draghi (2012Jul26), president of the European Central Bank, stated: “But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This statement caused return of risk appetite, driving upward valuations of risk financial assets worldwide. Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html). Risk appetite continued in the week of Aug 3, 2012, in expectation of purchases of sovereign bonds by the ECB. Growth of China’s exports by 1.0 percent in the 12 months ending in Jul 2012 released in the week of Aug 10, 2012, together with doubts on the purchases of bonds by the ECB injected a mild dose of risk aversion. There was optimism on the resolution of the European debt crisis on Aug 17, 2012. The week of Aug 24, 2012 had alternating shocks of risk aversion and risk appetite from the uncertainties of success of the Greek adjustment program, the coming decision of the Federal Constitutional Court of Germany on the European Stability Mechanism, disagreements between the Deutsche Bundesbank and the European Central Bank on purchase of sovereign bonds of highly indebted euro area member countries and the exchange of letters between Darrell E. Issa (2012Aug1), Chairman of the House Committee on Oversight and Government Reform, and Chairman Bernanke (2012Aug22) on monetary policy. Bernanke (2012JHAug31) and Draghi (2012Aug29) generated risk enthusiasm in the week of Aug 31, 2012. Risk appetite returned in the week of Sep 7, 2012, with the announcement of the bond-buying program of OMT (Outright Monetary Transactions) on Sep 6, 2012, by the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Valuations of risk financial assets increased sharply after the statement of the FOMC on Sep 13, 2012 with open-ended quantitative easing and self-imposed single-mandate of jobs that would maintain easing monetary policy well after the economy returns to full potential. Risk aversion returned in the week of Sep 21, 2012 on doubts about the success of quantitative easing and weakness in flash purchasing managers’ indices. The highest valuations in column “∆% Trough to 9/21/12” are by US equities indexes: DJIA 40.2 percent and S&P 500 42.8 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. The DJIA reached 13,580.28 on Sep 13, 2012, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 9/21/12” had double digit gains relative to the trough around Jul 2, 2010 but now some valuations of equity indexes show increase of less than 10 percent: China’s Shanghai Composite is 14.9 percent below the trough; Japan’s Nikkei Average is 3.2 percent above the trough; DJ Asia Pacific TSM is 9.9 percent above the trough; Dow Global is 15.9 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 12.7 percent above the trough; and NYSE Financial is 14.1 percent above the trough. DJ UBS Commodities is 19.1 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 31.4 percent above the trough. Japan’s Nikkei Average is 3.2 percent above the trough on Aug 31, 2010 and 20.0 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 9110.00 on Fri Sep 21, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 11.2 percent lower than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 8.9 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 9/21/12” in Table ESV-1 shows that there were decreases of valuations of risk financial assets in the week of Sep 21, 2012 such as 0.5 percent for Japan’s Nikkei Average, 0.8 percent for Dow Global and 2.0 percent for NYSE Financial. STOXX 50 gained 0.5 percent, DAX increased 0.5 percent and DJ Asia Pacific TSM gained 0.1 percent in the week. DJ UBS Commodities decreased 2.9 percent. China’s Shanghai Composite fell 4.6 percent. The DJIA decreased 0.1 percent and S&P 500 decreased 0.4 percent. The USD appreciated 1.1 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ESV-1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 9/21/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Aug 31, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 9/21/12” but also relative to the peak in column “∆% Peak to 9/21/12.” There are now only three equity indexes above the peak in Table ESV-1: DJIA 21.2 percent, S&P 500 19.9 percent and DAX 17.7 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 9.1 percent, Nikkei Average by 20.0 percent, Shanghai Composite by 35.9 percent, DJ Asia Pacific by 3.8 percent, STOXX 50 by 4.6 percent and Dow Global by 5.4 percent. DJ UBS Commodities Index is now 1.8 percent above the peak. The US dollar strengthened 14.2 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.

Table ESV-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 9/21/ /12	∆% Week 9/21/12	∆% Trough to 9/21/ 12
DJIA	4/26/ 10	7/2/10	-13.6	21.2	-0.1	40.2
S&P 500	4/23/ 10	7/20/ 10	-16.0	19.9	-0.4	42.8
NYSE Finance	4/15/ 10	7/2/10	-20.3	-9.1	-2.0	14.1
Dow Global	4/15/ 10	7/2/10	-18.4	-5.4	-0.8	15.9
Asia Pacific	4/15/ 10	7/2/10	-12.5	-3.8	0.1	9.9
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-20.0	-0.5	3.2
China Shang.	4/15/ 10	7/02 /10	-24.7	-35.9	-4.6	-14.9
STOXX 50	4/15/10	7/2/10	-15.3	-4.6	0.5	12.7
DAX	4/26/ 10	5/25/ 10	-10.5	17.7	0.5	31.4
Dollar Euro	11/25 2009	6/7 2010	21.2	14.2	1.1	-8.9
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	1.8	-2.9	19.1
10-Year T Note	4/5/ 10	4/6/10	3.986	1.753

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

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

I Collapse of United States Creation of Wealth, Income and Employment. There are two subsections. Subsection IA Household Income at 1996 Levels and Forty Eight Million in Poverty and without Health Insurance provides analysis of socioeconomic indicators of income, poverty and health insurance by the US Bureau of the Census. Subsection IB Destruction of Three Trillion Dollars of Household Wealth provides analysis of the report on flow of funds by the Board of Governors of the Federal Reserve System.

IA Household Income at 1995 Levels and Forty Eight Million in Poverty and without Health Insurance. The objective of this section is to analyze newly released data by the US Census Bureau on income, poverty and health insurance (DeNavas-Walt, Proctor and Smith 2012Sep). This report depicts 2011 household income of the US in constant 2011 dollars regressing to the level of 1996. The number of people in poverty in the US in 2011 is 46.247 million, equivalent to 15.0 percent of the population, which is the same as 15.0 percent in 1982 and higher than any percentage since 17.3 percent in 1965 with exception of isolated years in the range of 15.1 to 15.2 percent. The number of people without health insurance in 2011 is 49.985 million, which is equivalent to 15.7 percent of the population. Although the economy recovered throughout 2011, income and poverty deteriorated while lack of health insurance remained nearly unchanged. Increasing poverty and lack of health insurance pose strengthening of the social and health safety net because of a sudden jump of needs for social and health services on capacity that provide those needs that is fixed in the short run and the economic need to increase labor input and maintain health of the stock of human capital. The final part of this section shows that part of the explanation of the dramatically poor socio-economic indicators of the US could be explained by the sharp economic contraction from IV2007 to IIQ2009 but part originates in the worst recovery in a cyclical expansion during the postwar period.

The report of the US Bureau of the Census on Income, poverty and health insurance coverage in the United States: 2011 provides highly valuable socio-economic information and analysis (DeNavas-Walt, Proctor and Smith 2012Sep). Table IA-1 provides years of high percentage of people below poverty in the US. Data for 2006 to 2009 are included to provide a framework of reference for the current deterioration. The series has two high points of 15.1 percent of the population in poverty in 2010 and 1993 exceeded only by 15.2 percent in 1983. The prior high numbers of poverty are found in 1960 to 1965 with 17.3 percent in 1965 and higher numbers going to 22.4 percent in 1959. The number of people in poverty in the US in 2011 was 46.247 million, which has increased by 9.787 million from 36.460 million in 2006. The fractured job market with 28.1 million unemployed or underemployed because they cannot find full-time jobs (http://cmpassocregulationblog.blogspot.com/2012/09/twenty-eight-million-unemployed-or.html) and decline of hiring by 17 million (http://cmpassocregulationblog.blogspot.com/2012/09/recovery-without-hiring-world-inflation.html) prevents exit from poverty. Inflation-adjusted average weekly wages declined throughout 2011.

Table IA-1, US, Historical High Percentage of People below Poverty, Thousands and Percent

	Total Population	Number Below Poverty	Percent Below Poverty
2011	308,456	46,247	15.0
2010	306,130	46,343	15.1
2009	303,820	43,569	14.3
1993	259,278	39,265	15.1
1983	231,700	35,303	15.2
1982	229,412	34,398	15.0
1965	191,413	33,185	17.3
1964	189,710	36,055	19.0
1963	187,258	36,436	19.5
1962	184,276	38,625	21.0
1961	181,277	39,628	21.9
1960	179,503	39,851	22.2
1959	176,557	39,490	22.4
Memo
2009	303,820	46,180	14.3
2008	301,041	38,829	13.2
2007	298,699	37,276	12.5
2006	296,450	36,460	12.3

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Millions in poverty in the calendar year in which the recession ended and in the first calendar year after the recession are provided in Table IA-2. There have been increases in the number of people in poverty in the first calendar years after the recessions since 1980. The brief recession of Jan to Jul 1980 experienced the highest increase in the first calendar year of 1.0 percent and 2.550 million more in poverty. In the three recessions before 1980 shown in Table 2, the number of people in poverty fell in the first calendar year after the end of the recession.

Table IA-2, US, Millions in Poverty in the Calendar Year in which Recession Ended and in the First Calendar Year after Recession, Millions and ∆%

	Millions	%	Millions	%	Change Millions	% Points
Dec 2007 to Jun 2009
2009	43.569	14.3
2010			46.343	15.1	2.774	0.8
Mar 2001 to Nov 2001
2001	32.907	11.7
2002			34.570	12.1	1.663	0.4
Jul 1990 to Mar 1991
1991	35.708	14.2
1992			38.014	14.8	2.306	0.6
Jul 1981 to Nov 1982
1982	34.398	15.0
1983			35.303	15.2	0.905	0.2
Jan 1980 to July 1980
1980	29.272	13.0
1981			31.822	14.0	2.550	1.0
Nov 1973 to Mar 1975
1975	25.877	12.3
1976			24.975	11.8	-0.902	-0.5
Dec 1960 to Nov 1970
1970	25.420	12.6
1971			25.559	12.5	-0.139	-0.1
Apr 1960 to Feb 1961
1961	39.628	21.9
1962			38.625	21.0	-1.003	-0.9

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Another dramatic fact revealed by DeNavas-Walt, Proctor and Smith (2012) is the increase in the number people without health insurance shown in Table IA-3 at 49.951 million for 2010. Approximately 16.3 percent of the US population did not have health insurance in 2010. There was marginal improvement with 48.613 million without health insurance in 2011, corresponding to 15.7 percent of the population.

Table IA-3, US, People without Health Insurance in the Final Year of Recession and in the First Calendar Year after Recession Ended, Millions and Percent

	Millions Without Health Insurance	Percent of Population
Recession Dec 2007 to Jun 2009
2009	49.985	16.1
2010	49.951	16.3
Change/2009	0.919	0.2 % Points
2011	48.613	15.7
Change/2009	-1.372	-0.4 % Points
Recession Mar 2001 to Nov 2001
2001	38.023	13.5
2002	39.776	13.9
Change	1.753	0.4
Recession Jul 1990 to Mar 1991
1991	35.445	14.1
1992	38.641	15.0
Change	3.196	0.9

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

The population of the US increased by 12.003 million from 296.824 million in 2006 to 308.827 million in 2011, as shown in Table IA-4. The number uncovered by health insurance increased by 3.399 million between 2006 and 2011. The loss of private health insurance coverage by 6.619 million from 2006 to 2011 was partially compensated by an increase in government coverage by 19.154 million.

Table IA-4, US, Population, Private and Government Health Insurance and Uncovered by Health Insurance, Thousands and Percent, 2006-2011

	Population	Private Health Insurance	Govern- ment Health Insurance	Uncovered
2011	308,827	197,323	99,497	48,613
2010	306,553	196,147	95,525	49,951
2009	304,280	196,245	93,245	49,985
2008	301,483	202,626	87,586	44,780
2007	299,106	203,903	83,147	44,088
2006	296,824	203,942	80,343	45,214

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Median household income in the US fell 8.1 percent from $54,489 in 2007 to $50,054 in 2011, as shown in Table IA-5. Median income fell in all years. Median income fell 4.1 percent in 2011 relative to 2009 even after two years of recovery of the economy.

Table IA-5, US, Median Household Income, Dollars and ∆%

	2011	2010	2009	2007
Total Number of Households	121,084	119,927	117,538	116,783
Median Income Dollars	50,054	50,831	52,195	54,489
∆% 2010/2009	-2.6
∆% 2011/2009	-4.1
∆% 2010/2007	-6.7
∆% 2011/2007	-8.1

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

Numbers of households in the US, median income in constant 2011 dollars and mean income also in 2011 dollars are provided in Table IA-6. There is a dramatic fact in Table IA-6: inflation-adjusted median household income in the US is higher in all years from 1996 to 2011 than the $50,054 of 2010. The contraction and low rate of growth in the expansion have resulted in the destruction of the progress in household income accomplished in 15 years of technological advance and use of humans, machines and natural resources in economic activity. The median measures the center of the middle class of the US that is no better off after 15 years of efforts. There is sharp contrast with the 1980s. Rapid economic growth after the contraction from Jul 1981 to Nov 1982 (http://www.nber.org/cycles.html) resulted in an increase of household median income from $44,823 in 1983 to $50,624 in 1989, or by 12.9 percent. Another fact of Table IA-6 is that household income in 2011 of $50,054 is virtually the same as $49,950 in 1989. The typical household in the US is not better off than in 1989, which is separated from the present by 22 years of efforts.

Table IA-6, Median and Mean Household Income in 2011 Adjusted Dollars

Year	# Households	Median Income 2011 Dollars	Mean Income 2011 Dollars
2011	121,084	50,054	69,677
2010	119,927	50,831	69,518
2009	117,538	52,195	71,278
2008	117,181	52,546	71,475
2007	116,783	54,489	73,337
2006	116,011	53,768	74,259
2005	114,384	53,371	72,977
2004	113,343	52,788	71,997
2003	112,000	52,973	72,232
2002	111,278	53,019	72,326
2001	109,297	53,646	73,947
2000	108,209	54,841	74,621
1999	106,434	54,932	73,885
1998	103,874	53,582	71,455
1997	102,528	51,704	69,430
1996	101,018	50,661	67,263
1995	99,627	49,935	65,852
1994	98,990	48,418	64,729
1993	97,107	47,884	63,497
1992	96,426	48,117	61,003
1991	95,669	48,516	61,071
1990	94,312	49,950	62,395
1989	93,347	50,624	63,958
1988	92,830	49,737	62,145
1987	91,124	49,358	61,382
1986	89,479	48,746	60,223
1985	88,458	47,079	57,939
1984	86,789	46,215	56,625
1983	85,407	44,823	54,516
1982	83,918	45,139	54,399
1981	83,527	45,260	54,070
1980	82,368	46,024	54,737

Source: DeNavas-Walt, Proctor and Smith (2012Sep).

The percentage change in median household income and the change in number of workers with earnings in the first calendar years after recessions are provided in Table IA-7. The first calendar year after the end of recession in 2010 is by far the worst of any such year in recessions since 1970. Household median income fell 2.3 percent from 2009 to 2010 and the number of workers with earnings fell by 1.608 million. The first calendar year 2010 after the end of recession in 2009 is the only in the recessions back to 1970 in which there was decline of the number of workers with earnings and the only one also with negative change in full-time year-round workers.

Table IA-7, Percentage Change in Median Household Income and Change in Number of Workers with Earnings in First Calendar Years after Recessions, ∆% and Thousands

	Median Household Income ∆%	Change in Number of Workers with Earnings Thousands	Change in Full-time Year-round Workers Thousands
Recession Dec 2007 to June 2009
2010	-2.3	-1,608	-24
Recession Mar 2001 to Nov 2001
2002	-1.2	470	286
Recession Jul 1990 to Mar 1991
1992	-0.8	1,692	1,468
Recession Jul 1981 to Nov 1982
1983	-0.7	1,696	2,887
Recession Jan 1980 to Jul 1980
1981	-1.7	995	362
Recession Nov 1973 to Mar 1975
1976	1.7	2,821	1,538
Recession Dec 1960 to Nov 1970
1971	-1.0	1,277	1,213

Source:

DeNavas-Walt, Proctor and Smith (2012Sep).

Characteristics of the four cyclical contractions are provided in Table IA-8 with the first column showing the number of quarters of contraction; the second column the cumulative percentage contraction; and the final column the average quarterly rate of contraction. There were two contractions from IQ1980 to IIIQ1980 and from IIIQ1981 to IVQ1982 separated by three quarters of expansion. The drop of output combining the declines in these two contractions is 4.8 percent, which is almost equal to the decline of 4.7 percent in the contraction from IVQ2007 to IIQ2009. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.7 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

Table IA-8, US, Number of Quarters, Cumulative Percentage Contraction and Average Percentage Annual Equivalent Rate in Cyclical Contractions

	Number of Quarters	Cumulative Percentage Contraction	Average Percentage Rate
IIQ1953 to IIQ1954	4	-2.5	-0.63
IIIQ1957 to IIQ1958	3	-3.1	-9.0
IQ1980 to IIIQ1980	2	-2.2	-1.1
IIIQ1981 to IVQ1982	4	-2.7	-0.67
IVQ2007 to IIQ2009	6	-4.7	-0.80

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

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

Table IA-9 shows the extraordinary contrast between the mediocre average annual equivalent growth rate of 2.2 percent of the US economy in the twelve quarters of the current cyclical expansion from IIIQ2009 to IIQ2012 and the average of 6.2 percent in the four earlier cyclical expansions. BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 percent decelerating to 1.8 percent annual growth in 2011 (http://www.bea.gov/iTable/index_nipa.cfm) and cumulative 0.92 percent in the first half of 2012 {(1.02)^1/4(1.017)^1/4 = 0.92%}, which is equivalent to 1.85 percent per year {([(1.02)^1/4(1.015)^1/4 ]² – 1)100 = 1.85%}. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent.

Table IA-9, US, Number of Quarters, Cumulative Growth and Average Annual Equivalent Growth Rate in Cyclical Expansions

	Number of Quarters	Cumulative Growth ∆%	Average Annual Equivalent Growth Rate
IIIQ 1954 to IQ1957	11	12.6	4.4
IIQ1958 to IIQ1959	5	10.2	8.1
IIQ1975 to IVQ1976	8	9.5	4.6
IQ1983 to IV1985	13	19.6	5.7
Average Four Above Expansions			6.2
IIIQ2009 to IIQ2012	12	6.80	2.2

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

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

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

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

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

Chart IA-2 shows the entirely different situation of real quarterly GDP in the US between 2007 and 2012. The economy has underperformed during the first twelve quarters of expansion for the first time in the comparable contractions since the 1950s. The US economy is now in a perilous standstill.

Chart 2, US, Real GDP, 2007-2012

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

As shown in Tables IA-8 and IA-9 above the loss of real GDP in the US during the contraction was 5.1 percent but the gain in the cyclical expansion has been only 6.80 percent (last row in Table IA-8), using all latest revisions. As a result, the level of real GDP in IIQ2012 with the first estimate and revisions is only higher by 1.8 percent than the level of real GDP in IVQ2007. Table IA-10 provides in the second column real GDP in billions of chained 2005 dollars. The third column provides the percentage change of the quarter relative to IVQ2007; the fourth column provides the percentage change relative to the prior quarter; and the final fifth column provides the percentage change relative to the same quarter a year earlier. The contraction actually concentrated in two quarters: decline of 2.3 percent in IVQ2008 relative to the prior quarter and decline of 1.3 percent in IQ2009 relative to IVQ2008. The combined fall of GDP in IVQ2008 and IQ2009 was 3.6 percent {[(1-0.23) x (1-0.13) -1]100 = -3.6%}, or {[(IIQ2009 $12,711.0)/(IIIQ2008 $13,186.9) – 1]100 = -3.6%}. Those two quarters coincided with the worst effects of the financial crisis. GDP fell 0.1 percent in IIQ2009 but grew 0.4 percent in IIIQ2009, which is the beginning of recovery in the cyclical dates of the NBER. Most of the recovery occurred in four successive quarters from IVQ2009 to IIQ2010 of growth of 1.0 percent in IVQ2009 and equal growth at 0.6 percent in IQ2010, IIQ2010, IIIQ2010 and IVQ2010 for cumulative growth in those three quarters of 3.4 percent, obtained by accumulating the quarterly rates {[(1.01 x 1.006 x 1.006 x 1.006 x 1.006) – 1]100 = 3.4%} or {[(IVQ2010 $13,181.2)/(IIIQ2009 $12,746.7) – 1]100 = 3.4%}. The economy lost momentum already in 2010 growing at 0.6 percent in each quarter, or annual equivalent 2.4 per cent {[(1.006)⁴ – 1]100 = 2.4%}, compared with annual equivalent 4.0 percent in IV2009 {[(1.01)⁴ – 1]100 = 4.0%}. The economy then stalled during the first half of 2011 with growth of 0.0025 percent in IQ2011 and 0.6 percent in IIQ2011 for combined annual equivalent rate of 1.2 percent {(1.00025 x 1.006)²}. The economy grew 0.3 percent in IIIQ2011 for annual equivalent growth of 1.2 percent in the first three quarters {(1.00025 x 1.006 x 1.003)^4/3}. Growth picked up in IVQ2011 with 1.0 percent relative to IIIQ2011. Growth in a quarter relative to a year earlier in Table I-6 slows from over 2.4 percent during three consecutive quarters from IIQ2010 to IVQ2010 to 1.8 percent in IQ2011, 1.9 percent in IIQ2011, 1.6 percent in IIIQ2011 and 2.0 percent in IVQ2011. As shown below, growth of 1.0 percent in IVQ2011 was partly driven by inventory accumulation. In IQ2012, GDP grew 0.5 percent relative to IVQ2011 and 2.4 percent relative to IQ2011, decelerating to 0.4 percent in IIQ2012 and 2.3 percent relative to IIQ2011. Rates of a quarter relative to the prior quarter capture better deceleration of the economy than rates on a quarter relative to the same quarter a year earlier. The critical question for which there is not yet definitive solution is whether what lies ahead is continuing growth recession with the economy crawling and unemployment/underemployment at extremely high levels or another contraction or conventional recession. Forecasts of various sources continued to maintain high growth in 2011 without taking into consideration the continuous slowing of the economy in late 2010 and the first half of 2011. The sovereign debt crisis in the euro area is one of the common sources of doubts on the rate and direction of economic growth in the US but there is weak internal demand in the US with almost no investment and spikes of consumption driven by burning saving because of financial repression forever in the form of zero interest rates.

Table IA-10, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%

	Real GDP, Billions Chained 2005 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	13,326.0	NA	NA	2.2
IQ2008	13,266.8	-0.4	-0.4	1.6
IIQ2008	13,310.5	-0.1	0.3	1.0
IIIQ2008	13,186.9	-1.0	-0.9	-0.6
IVQ2008	12,883.5	-3.3	-2.3	-3.3
IQ2009	12,711.0	-4.6	-1.3	-4.2
IIQ2009	12,701.0	-4.7	-0.1	-4.6
IIIQ2009	12,746.7	-4.3	0.4	-3.3
IV2009	12,873.1	-3.4	1.0	-0.1
IQ2010	12,947.6	-2.8	0.6	1.9
IIQ2010	13,019.6	-2.3	0.6	2.5
IIIQ2010	13,103.5	-1.7	0.6	2.8
IVQ2010	13,181.2	-1.1	0.6	2.4
IQ2011	13,183.8	-1.1	0.0	1.8
IIQ2011	13,264.7	-0.5	0.6	1.9
IIIQ2011	13,306.9	-0.1	0.3	1.6
IV2011	13,441.0	0.9	1.0	2.0
IQ2012	13,506.4	1.4	0.5	2.4
IIQ2012	13,564.5	1.8	0.4	2.3

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

IB Destruction of Three Trillion Dollars of Household Wealth. The Flow of Funds Accounts of the United States provided by the Federal Reserve (http://www.federalreserve.gov/releases/z1/Current/z1.pdf) is rich in valuable information. Table IB-1, updated in this blog for every new quarterly release, shows the balance sheet of US households combined with nonprofit organizations in 2007, IIQ2011 and IIQ2012. The data show the strong shock to US wealth during the contraction. Assets fell from $80.3 trillion in 2007 to $74.7 trillion in IIQ2011 even after 8 consecutive quarters of growth beginning in IIIQ2009 (http://wwwdev.nber.org/cycles/cyclesmain.html), for decline of $5.6 trillion or 7.0 percent. Assets stood at $76.1 trillion in IIQ2012 for loss of $4.2 trillion relative to $80.3 trillion in 2007 or decline by 5.2 percent. Liabilities declined from $14.3 trillion in 2007 to $13.5 trillion in IQ2011 or by $804.5 billion equivalent to decline by 5.6 percent. Net worth shrank from $66.1 trillion in 2007 to $62.7 trillion in IIQ2012, that is, $3.4 trillion equivalent to decline of 5.1 percent. There was brutal decline from 2007 to IIQ2012 of $4.5 trillion in real estate assets or by 18.9 percent. The National Association of Realtors estimated that the gains in net worth in homes by Americans were about $4 trillion between 2000 and 2005 (quoted in Pelaez and Pelaez, The Global Recession Risk (2007), 224-5).

Table IB-1, US, Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars Outstanding End of Period, NSA

	2007	IIQ2011	IIQ2012
Assets	80,320.1	74,704.4	76,126.9
Nonfinancial	28,237.5	23,292.1	24,201.2
Real Estate	23,507.2	18,299.9	19,056.5
Durable Goods	4,468.3	4,681.6	4,819.2
Financial	52,082.6	51,412.3	51,925.6
Deposits	7,502.0	8,169.1	8,658.6
Credit Market	4,956.5	5,135.4	4,788.4
Mutual Fund Shares	4,605.3	5,014.6	5,065.7
Equities Corporate	9,631.6	9,645.2	9,216.3
Equity Noncorporate	9,341.1	7,247.3	7,691.9
Pension	13,390.7	13,434.8	13,656.2
Liabilities	14,263.0	13,556.7	13,458.5
Home Mortgages	10,566.9	9,826.5	9,589.1
Consumer Credit	2,528.8	2,534.2	2,661.1
Net Worth	66,057.1	61,147.6	62,668.4

Net Worth = Assets – Liabilities

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

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

According to Pinto (2008) in testimony to Congress:

Table IB-2 shows the euphoria of prices during the boom and the subsequent decline. House prices rose 93.7 percent in the 10-city composite of the Case-Shiller home price index and 78.1 percent in the 20-city composite between Jun 2000 and Jun 2005. Prices rose around 100 percent from Jun 2000 to Jun 2006, increasing 109.9 percent for the 10-city composite and 93.3 percent for the 20-city composite. House prices rose 39.5 percent between Jun 2003 and Jun 2005 for the 10-city composite and 34.5 percent for the 20-city composite propelled by low fed funds rates of 1.0 percent between Jun 2003 and Jun 2004 and then only increasing by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Jun 2003 and Jun 2006 the 10-city index gained 51.2 percent and the 20-city index increased 46.0 percent. House prices have fallen from Jun 2006 to Jun 2012 by 31.5 percent for the 10-city composite and 31.1 percent for the 20-city composite. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Jun 2012, house prices increased 0.1 percent in the 10-city composite and increased 0.5 percent in the 20-city composite. Table VA-3 also shows that house prices increased 43.8 percent between Jun 2000 and Jun 2012 for the 10-city composite and increased 33.2 percent for the 20-city composite. House prices are close the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 31.5 percent from the peak in Jun 2006 to Jun 2012 and the 20-city composite fell 31.1 percent from the peak in Jul 2006 to Jun 2012. The final part of Table IB-2 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2011 for the 10-city composite was 3.2 percent. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2011 was 2.5 percent while the rate of the 20-city composite was 1.9 percent.

Table IB-2, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Jun 2000 to Jun 2003	38.8	32.4
∆% Jun 2000 to Jun 2005	93.7	78.1
∆% Jun 2003 to Jun 2005	39.5	34.5
∆% Jun 2000 to Jun 2006	109.9	93.3
∆% Jun 2003 to Jun 2006	51.2	46.0
∆% Jun 2005 to Jun 2012	-25.8	-25.2
∆% Jun 2006 to Jun 2012	-31.5	-31.1
∆% Jun 2009 to Jun 2012	1.1	0.2
∆% Jun 2010 to Jun 2012	-3.8	-3.9
∆% Jun 2011 to Jun 2012	0.1	0.5
∆% Jun 2000 to Jun 2012	43.8	33.2
∆% Peak Jun 2006 Jun 2012	-31.5
∆% Peak Jul 2006 Jun 2012		-31.1
Average ∆% Dec 1987-Dec 2011	3.2	NA
Average ∆% Dec 1987-Dec 2000	3.8	NA
Average ∆% Dec 1992-Dec 2000	5.0	NA
Average ∆% Dec 2000-Dec 2011	2.5	1.9

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

Table IB-3 summarizes the brutal drops in assets and net worth of US households and nonprofit organizations from 2007 to IIQ2011 and IIQ2012. Between 2007 and IIQ2012, real estate fell in value by $4.5 trillion and financial assets decreased $0.157 trillion, explaining most of the drop in net worth of $3.4 trillion obtained by deducting the decrease in liabilities of $804.5 billion from the decrease of assets of $4,193.2 billion. BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 percent decelerating to 1.8 percent annual growth in 2011 (http://www.bea.gov/iTable/index_nipa.cfm) and cumulative 0.92 percent in the first half of 2012 {(1.02)^1/4(1.017)^1/4 = 0.92%}, which is equivalent to 1.85 percent per year {([(1.02)^1/4(1.015)^1/4 ]² – 1)100 = 1.85%} while the expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent. Subpar economic growth in comparison with past cyclical economic expansions is accompanied by a drop of net worth of households and nonprofit organizations of $3.4 trillion.

Table IB-3, US, Difference of Balance Sheet of Households and Nonprofit Organizations in Millions of Dollars from 2007 to IIQ2011 and IIQ2012

	2009	IIQ2011	IIQ2012
Assets	-10,928.3	-5,615.7	-4,193.2
Nonfinancial	-4,469.9	-4,945.4	-4,036.3
Real Estate	-4,615.9	-5,207.3	-4,450.7
Financial	-6,458.5	-670.3	-157.0
Liabilities	-374.7	-706.3	-804.5
Net Worth	-10,553.7	-4,909.5	-3,388.7

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIQ2012 is provided in Table IB-4. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980. In contrast, as shown in Table IB-4, net worth of households and nonprofit organizations fell from $66,057.1 billion in IVQ2007 to $62,668.4 billion in IIQ2012 by $3,388.7 billion or 5.1 percent. The US consumer price index was 210.036 in Dec 2007 and 229.478 in Jun 2012 for increase of 9.3 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 13.2 percent in Jun 2012 after 12 consecutive quarters of expansion from IIIQ2009 to IIQ2012 relative to IVQ2012 when the recession began. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IIQ2012 has been 2.2 percent, which is substantially lower than the average of 6.2 percent in cyclical expansions after World War II and 5.7 percent in the expansion from IQ1983 to IVQ1985 (see Table IA-9). The US missed the opportunity of high growth rates that has been available in past cyclical expansions.

Table IB-4, Net Worth of Households and Nonprofit Organizations in Billions of Dollars, IVQ1979 to IVQ1985 and IVQ2007 to IIQ2012

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	8,326.4 8,502.9
IVQ1985	14,395.2
∆ USD Billions IQ1980	+6,068.8 +5,892.3
Period IVQ2007 to IIQ2012
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7

Source: Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Sep 20 http://www.federalreserve.gov/releases/z1/default.htm

Chart IB-1 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ2007 to IIQ2012. There is remarkable stop and go behavior in this series with two sharp declines and two standstills in the 12 quarters of expansion of the economy beginning in IIIQ2009.

Chart IB-1, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ2007 to IIQ2012

Chart IB-2 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1979 to IVQ1985. There are changes in the rates of growth of wealth suggested by the changing slopes but there is smooth upward trend. There was significant financial turmoil during the 1980s. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.74 percent of GDP in a year. US GDP in 2011 is estimated at $15,075.7 billion, such that the bailout would be equivalent to cost to taxpayers of about $412.5 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery. Money center banks were under extraordinary pressure from the default of sovereign debt by various emerging nations that represented a large share of their net worth (see Pelaez 1986).

Chart IB-2, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1979 to IVQ1985

Chart IB-3 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IQ1945 at $710,125.9 million to IIQ2009 at $62,688,390.9 million or increase of 8,727.8 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 229.478 in Jun 2012 or 1,160.9 percent. There was a gigantic increase of US household and nonprofit net worth over 67 years. The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of US household and nonprofit net worth. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 67 years when US GDP grew at 2.2 percent on average in 12 quarters between IIIQ2009 and IIQ2012 in contrast with average 5.7 percent from IQ1983 to IVQ1985 and average 6.2 percent during cyclical expansions in those 67 years.

Chart IB-3, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1945 to IIQ2012

The report on the Flow of Funds Accounts of the United States also provides the percentage changes in debt of the nonfinancial sector, shown in Table IB-4. Households increased debt by 9.8 percent in 2006 but have been reducing their debt continuously with the exception of growth of 0.1 percent in IVQ2011 and 1.2 percent in IIQ2012. Financial repression is intended to increase debt and reduce savings. Business had not been as exuberant in acquiring debt and has been moderately increasing debt benefitting from historically low costs while increasing cash holdings to around $2 trillion because of the uncertainty of capital budgeting. The key to growth and hiring consists in creating the incentives for business to invest. States and local government were forced into increasing debt by the decline in revenues but began to contract in IQ2011, decreasing again from IQ2011 and IQ2012 and increasing by 0.8 percent in IIQ2012. Opposite behavior is found for the federal government that has been rapidly accumulating debt but without success in the self-assigned goal of promoting economic growth. Financial repression constitutes seigniorage of government debt.

Table IB-4, US, Percentage Change of Nonfinancial Domestic Sector Debt

	Total	Households	Business	State & Local Govern-ment	Federal
IIQ2012	5.0	1.2	4.9	0.8	10.9
IQ2012	4.4	-0.9	3.4	-1.2	13.7
IVQ 20111	4.9	0.1	5.3	-2.1	12.7
IIIQ 2011	4.3	-1.7	4.2	-0.2	13.7
IIQ 2011	2.6	-2.7	5.2	-2.6	8.2
IQ 2011	2.5	-2.0	3.7	-2.8	9.1
2011	3.6	-1.6	4.7	-1.9	11.4
2010	4.1	-2.2	0.8	2.2	20.2
2009	3.1	-1.7	-2.3	3.9	22.7
2008	5.9	-0.2	6.1	0.7	24.2
2007	8.5	6.7	13.6	5.4	4.9
2006	8.6	9.8	10.8	3.7	3.9
2005	9.2	11.1	8.9	5.5	7.0
2004	9.3	11.1	6.7	11.9	9.0
2003	8.0	11.8	2.2	8.3	10.9
2002	7.3	10.6	3.0	11.1	7.6
2001	6.3	9.6	5.7	8.8	-0.2

Source: Quarterly data are at seasonally-adjusted annual rates (SAAR). Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Washington, DC, Federal Reserve System, Sep 20 http://www.federalreserve.gov/releases/z1/default.htm

II Unresolved US Balance of Payments Deficits. The current account of the US balance of payments is provided in Table II-1 for IIQ2011 and IIQ2012. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US decreased from $124.5 billion in IIQ2011, or 3.2 percent of GDP, to $123.2 billion in IIQ2012, or 3.0 percent of GDP. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table II-1, US Balance of Payments, Millions of Dollars NSA

	IIQ2011	IIQ2012	Difference
Goods Balance	-190,477	-189,344	1,133
X Goods	375,554	396,218	5.5 ∆%
M Goods	-566,031	-585,562	3.5 ∆%
Services Balance	39,949	40,690	741
X Services	148,999	154,291	3.6 ∆%
M Services	-109,050	-113,601	4.2 ∆%
Balance Goods and Services	-150,528	-148,654	1,874
Balance Income	58,335	57,504	-831
Unilateral Transfers	-32,291	-32,049	-242
Current Account Balance	-124,484	-123,199	-1,285
% GDP	IIQ2011	IVQ2011	IIQ2012
	3.2	3.1	3.0

X: exports; M: imports

Balance on Current Account = Balance on Goods and Services + Balance on Income + Unilateral Transfers

Source: Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below potential. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. Table II-2 provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.2 percent of GDP while the Congressional Budget Office (CBO 2011AugBEO, 2) estimates the federal deficit in 2012 at $1128 billion or 7.3 percent of GDP (http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html). The combined record federal deficits of the US from 2009 to 2012 are $5135 billion or 33 percent of the estimate of GDP of $15,538 billion for fiscal year 2012 by the CBO (http://www.cbo.gov/publication/43542 2012AugBEO). Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5135 billion, and corresponded to 36.3 percent of GDP. Federal debt in 2011 was 67.7 percent of GDP and is estimated to reach 72.8 percent of GDP in 2012 (CBO2012AugBEO). This situation may worsen in the future (CBO 2012LTBO):

Table II-2, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2000	2007	2008	2009	2010	2011
Goods & Services	-377	-697	-698	-379	-495	-559
Income	19	101	147	119	184	227
UT	-58	-115	-126	-122	-131	-133
Current Account	-416	-710	-677	-382	-442	-466
NGDP	9951	14028	14291	13974	14499	15076
Current Account % GDP	-3.8	-5.1	-4.7	-2.7	-3.1	-3.1
NIIP	-1337	-1796	-3260	-2321	-2474	-4030
US Owned Assets Abroad	6239	18399	19464	18512	20298	21132
Foreign Owned Assets in US	7576	20195	22724	20833	22772	25162
NIIP % GDP	-13.4	-12.8	-22.8	-16.6	-17.1	26.7
Exports Goods Services Income	1425	2488	2657	2181	2519	2848
NIIP % Exports Goods Services Income	-94	-72	-123	-106	-98	-142
DIA MV	2694	5274	3102	4287	4767	4450
DIUS MV	2783	3551	2486	2995	3397	3509
Fiscal Balance	+236	-161	-459	-1413	-1294	-1300
Fiscal Balance % GDP	+2.4	-1.2	-3.2	-10.1	-9.0	-8.7
Federal Debt	3410	5035	5803	7545	9019	10128
Federal Debt % GDP	34.7	36.3	40.5	54.1	62.8	67.7
Federal Outlays	1789	2729	2983	3518	3456	3603
∆%	5.1	2.8	9.3	17.9	-1.8	4.3
% GDP	18.2	19.7	20.8	25.2	24.1	24.1
Federal Revenue	2052	2568	2524	2105	2162	2303
∆%	10.8	6.7	-1.7	-16.6	2.7	6.5
% GDP	20.6	18.5	17.6	15.1	15.1	15.4

Sources:

Sources: Balance of Payments and NIIP, Bureau of Economic Analysis (BEA) http://www.bea.gov/international/index.htm#bop

Gross Domestic Product, Bureau of Economic Analysis (BEA) http://www.bea.gov/national/index.htm#gdp

Congressional Budget Office http://www.cbo.gov/

Chart II-1 of the Congressional Budget Office (CBO) and Table II-3 provide actual GDP and potential GDP from IQ2000 to the end of the projection period at IVQ2022. Chart II-1 shows the wide gap between actual and potential GDP resulting from the cumulative contraction of GDP from IVQ2007 to IIQ2009 by 4.7 percent while potential GDP continued to increase. The gap in IIQ2012 is 5.6 percent or about $0.8 trillion. In a sense, the missing $0.8 trillion in economic activity correspond to the stock of idle resources in the economy, in particular the 28.1 million unemployed or underemployed in Aug 2012 (http://cmpassocregulationblog.blogspot.com/2012/09/twenty-eight-million-unemployed-or.html). The average rate of GDP growth of 2.2 percent in the 12 consecutive quarters of expansion from IIIQ2009 to IIQ2012 has been insufficient to return the economy to potential output as has been the case in cyclical expansions since the end of World War II with average GDP growth in the initial expansion at 6.2 percent. Fiscal adjustment is significantly more challenging in a weak economy with high idle capacity because of unresponsive tax revenues.

Chart II-1, US, Actual and Potential GDP, 2000-2020, Trillions of 2005 Dollars

Source: Congressional Budget Office

CBO (2012AugBEO).

Table II-3, US, Actual and Potential GDP, Trillions of 2005 Dollars

	GDP	Potential GDP
2000Q1	11.0	10.8
2000Q2	11.2	10.9
2000Q3	11.3	11.0
2000Q4	11.3	11.1
2001Q1	11.3	11.2
2001Q2	11.4	11.3
2001Q3	11.3	11.4
2001Q4	11.4	11.5
2002Q1	11.5	11.5
2002Q2	11.5	11.6
2002Q3	11.6	11.7
2002Q4	11.6	11.8
2003Q1	11.6	11.9
2003Q2	11.7	11.9
2003Q3	11.9	12.0
2003Q4	12.0	12.1
2004Q1	12.1	12.2
2004Q2	12.2	12.2
2004Q3	12.3	12.3
2004Q4	12.4	12.4
2005Q1	12.5	12.5
2005Q2	12.6	12.5
2005Q3	12.7	12.6
2005Q4	12.7	12.7
2006Q1	12.9	12.8
2006Q2	12.9	12.8
2006Q3	13.0	12.9
2006Q4	13.0	13.0
2007Q1	13.1	13.1
2007Q2	13.2	13.1
2007Q3	13.3	13.2
2007Q4	13.3	13.3
2008Q1	13.3	13.4
2008Q2	13.3	13.5
2008Q3	13.2	13.5
2008Q4	12.9	13.6
2009Q1	12.7	13.7
2009Q2	12.7	13.7
2009Q3	12.7	13.8
2009Q4	12.9	13.8
2010Q1	12.9	13.9
2010Q2	13.0	13.9
2010Q3	13.1	14.0
2010Q4	13.2	14.0
2011Q1	13.2	14.1
2011Q2	13.3	14.2
2011Q3	13.3	14.2
2011Q4	13.4	14.3
2012Q1	13.5	14.4
2012Q2	13.6	14.4
2012Q3	13.6	14.5
2012Q4	13.7	14.5
2013Q1	13.6	14.6
2013Q2	13.5	14.6
2013Q3	13.5	14.7
2013Q4	13.6	14.8
2014Q1	13.8	14.8
2014Q2	13.9	14.9
2014Q3	14.1	15.0
2014Q4	14.2	15.0
2015Q1	14.4	15.1
2015Q2	14.6	15.2
2015Q3	14.7	15.3
2015Q4	14.9	15.4
2016Q1	15.1	15.4
2016Q2	15.2	15.5
2016Q3	15.4	15.6
2016Q4	15.5	15.7
2017Q1	15.7	15.8
2017Q2	15.8	15.9
2017Q3	16.0	16.0
2017Q4	16.1	16.1
2018Q1	16.2	16.2
2018Q2	16.3	16.3
2018Q3	16.5	16.5
2018Q4	16.6	16.6
2019Q1	16.7	16.7
2019Q2	16.8	16.8
2019Q3	16.9	16.9
2019Q4	17.0	17.0
2020Q1	17.1	17.1
2020Q2	17.2	17.2
2020Q3	17.3	17.3
2020Q4	17.4	17.4
2021Q1	17.5	17.5
2021Q2	17.6	17.6
2021Q3	17.6	17.7
2021Q4	17.7	17.7
2022Q1	17.8	17.8
2022Q2	17.9	17.9
2022Q3	18.1	18.1
2022Q4	18.2	18.2

Source: Congressional Budget Office

CBO(2012AugBEO).

Chart II-2 of the Bureau of Economic Analysis of the Department of Commerce shows on the lower negative panel the sharp increase in the deficit in goods and the deficits in goods and services from 1960 to 2011. The upper panel shows the increase in the surplus in services that was insufficient to contain the increase of the deficit in goods and services. The adjustment during the global recession has been in the form of contraction of economic activity that reduced demand for goods.

Chart II-2, US, Balance of Goods, Balance on Services and Balance on Goods and Services, 1960-2011, Millions of Dollars

Source: Bureau of Economic Analysis

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

Chart II-3 of the Bureau of Economic Analysis shows exports and imports of goods and services from 1960 to 2011. Exports of goods and services in the upper positive panel have been quite dynamic but have not compensated for the sharp increase in imports of goods. The US economy apparently has become less competitive in goods than in services.

Chart II-3, US, Exports and Imports of Goods and Services, 1960-2011, Millions of Dollars

Source: Bureau of Economic Analysis

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

Chart II-4 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2011. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and elimination of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.

Chart II-4, US, Balance on Current Account, 1960-2011, Millions of Dollars

Source: Bureau of Economic Analysis

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

Chart II-5 of the Bureau of Economic Analysis provides real GDP in the US from 1960 to 2011. The contraction of economic activity during the global recession was a major factor in the reduction of the current account deficit as percent of GDP.

Chart II-5, US, Real GDP, 1960-2011, Billions of Chained 2005 Dollars

Source: Bureau of Economic Analysis

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

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) slowing growth in China with political development and slowing growth in 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 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 and is available in the Appendixes section at the end of the blog comment. 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 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil and is available in the Appendixes section at the end of the blog comment.

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 Sep 14 and daily values throughout the week ending on Sep 21 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 Sep 14 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Sep 14, 2012”, first row “USD/EUR 1.3130 -2.5%,” provides the information that the US dollar (USD) depreciated 2.5 percent to USD 1.3130/EUR in the week ending on Fri Sep 14 relative to the exchange rate on Fri Sep 7. 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) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3130/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Sep 14, appreciating to USD 1.3114/EUR on Mon Sep 17, or by 0.1 percent. The dollar appreciated because fewer dollars, $1.3114, were required on Mon Sep 17 to buy one euro than $1.3130 on Sep 14. 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 such as 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 1.3130/EUR on Sep 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 Sep 14, to the last business day of the current week, in this case Fri Sep 21, such as appreciation by 1.1 percent to USD 1.2981/EUR by Sep 21; 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 1.3130/EUR on Fri Sep 14 to the rate of USD 1.2981/EUR on Fri Sep 21 {[(1.2981/1.3130) – 1]100 = -1.1%} and depreciated (denoted by negative sign) by 0.1 percent from the rate of USD 1.2967 on Thu Sep 20 to USD 1.2981/EUR on Fri Sep 21 {[(1.2981/1.2967) -1]100 = 0.1%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher 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 Sep 17 to Sep 21, 2012

Fri Sep 14, 2012

M 17

Tue 18

W 19

Thu 20

Fr 21

USD/EUR

1.3130

-2.5%

1.3114

0.1%

1.3044

0.7%

0.5%

1.3048

0.6%

0.0%

1.2967

1.2%

0.6%

1.2981

1.1%

-0.1%

JPY/ USD

78.39

0.2%

78.73

-0.4%

78.81

-0.5%

-0.1%

78.38

0.0%

0.5%

78.24

0.2%

78.16

0.3%

0.1%

CHF/ USD

0.9269

1.8%

0.9275

-0.1%

0.9288

-0.2%

-0.1%

0.9275

-0.1%

0.1%

0.9331

-0.7%

-0.6%

0.9330

-0.7%

0.0%

CHF/ EUR

1.2171

-0.5%

1.2163

0.1%

1.2117

0.4%

1.2120

0.4%

0.0%

1.2100

0.6%

0.2%

1.2111

0.5%

-0.1%

USD/ AUD

1.0549

0.9480

1.5%

1.0471

0.9550

-0.7%

1.0453

0.9567

-0.9%

-0.2%

1.0478

0.9544

0.7%

0.2%

1.0431

0.9587

-1.1%

-0.5%

1.0456

0.9564

-0.9%

0.2%

10 Year T Note

1.863

1.84

1.81

1.77

1.76

1.753

2 Year T Note

0.252

0.25

0.26

German Bond

2Y 0.10 10Y 1.71

2Y 0.08 10Y 1.67

2Y 0.08 10Y 1.64

2Y 0.07 10Y 1.62

2Y 0.04 10Y 1.57

2Y 0.04 10Y 1.60

DJIA

13593.37

2.2%

13553.10

-0.3%

13564.64

-0.2%

0.1%

13577.96

-0.1%

0.1%

13596.93

0.0%

0.1%

13579.47

-0.1%

DJ Global

1988.62

3.1%

1984.15

-0.2%

1975.87

-0.6%

-0.4%

1986.10

-0.1%

0.5%

1968.48

-1.0%

-0.9%

1973.65

-0.8%

0.3%

DJ Asia Pacific

1257.65

3.6%

1255.12

-0.2%

1253.27

-0.3%

-0.1%

1264.82

0.6%

0.9%

1248.79

-0.7%

-1.3%

1258.36

0.1%

0.8%

Nikkei

9159.39

3.2%

9159.39

1.8%

9123.77

-0.4%

9232.21

0.8%

1.2%

9086.98

-0.8%

-1.6%

9110.00

-0.5%

0.3%

Shanghai

2123.85

-0.2%

2078.50

-2.1%

2059.54

-3.0%

-0.9%

2067.83

-2.6%

0.4%

2024.84

-4.7%

-2.1%

2026.69

-4.6%

0.1%

DAX

7412.13

2.7%

7403.69

-0.1%

7347.69

-0.9%

-0.8%

7390.76

-0.3%

0.6%

7389.49

-0.3%

0.0%

7451.62

0.5%

0.8%

DJ UBS

Comm.

152.01

3.2%

148.70

-2.2%

147.42

-3.0%

-0.9%

147.04

-3.3%

-0.3%

146.30

-3.8%

-0.5%

147.65

-2.9%

0.9%

WTI $ B

99.00

2.8%

96.47

-2.6%

95.52

-3.5%

-1.0%

91.48

-7.6%

-4.2%

92.42

-6.6%

1.0%

93.09

-5.9%

0.7%

Brent $/B

116.60

2.1%

113.43

-2.7%

111.61

-4.3%

-1.6%

108.10

-7.3%

-3.1%

110.38

-5.3%

2.1%

111.52

-4.3%

1.0%

Gold $/OZ

1772.7

1.9%

1763.7

-0.5%

1773.7

0.1%

0.6%

1772.5

0.0%

-0.1%

1770.2

-0.1%

1775.7

0.2%

0.3%

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

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

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

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

Discussion of current and recent risk-determining events is followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.

First, Risk-Determining Events. There are two critical factors influencing world financial markets. (1) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):

“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.

(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):

“6 September 2012 - Technical features of Outright Monetary Transactions

As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:

Conditionality

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.

Coverage

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

Sterilisation

The liquidity created through Outright Monetary Transactions will be fully sterilised.

Transparency

Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

Securities Markets Programme

Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”

Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):

“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.

Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):

“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.

The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”

Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).

Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24. On Aug 31, the yield of the 10-year sovereign bond of Italy rose to 5.787 percent and that of Spain to 6.832 percent. The announcement of the OMT of bond-buying by the ECB together with weak employment creation in the US created risk appetite with the yield of the ten-year government bond of Spain collapsing to 5.708 percent on Sep 7 and the yield of the ten-year government bond of Italy to 5.008 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The yield of the ten-year government bond of Spain traded at 5.770 percent on Sep 14 and at 5.739 percent on Sep 21 and ten-year government of Italy traded at 4.953 percent on Sep 14 and 4.982 on Sep 21. Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. Under increasing risk appetite, the yield of the ten-year Treasury rose to 1.544 on Jul 27, 2012 and 1.569 percent on Aug 3, 2012, while the yield of the ten-year Government bond of Germany rose to 1.40 percent on Jul 27 and 1.42 percent on Aug 3. Yields moved on an increasing trend with the US ten-year note at 1.814 percent on Aug 17 and the German ten-year bond at 1.50 percent with sharp decline on Aug 24 to 1.684 percent for the yield of the US ten-year note and 1.35 for the yield of the German ten-year bond. The trend was interrupted with decline of the yield of the ten-year Treasury note to 1.543 percent on Aug 31, 2012, and of the ten-year German bond to 1.33 percent. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2158 on Jul 20, 2012, or by 16.2 percent, but depreciated to USD 1.2320/EUR on Jul 27, 2012 and 1.2387 on Aug 3, 2012 in expectation of massive support of highly indebted euro zone members. Doubts returned at the end of the week of Aug 10, 2012 with appreciation to USD 1.2290/EUR and decline of the yields of the two-year government bond of Germany to -0.07 percent and of the ten-year to 1.38 percent. On Aug 17, the US dollar depreciated by 0.4 percent to USD 1.2335/EUR and the ten-year bond of Germany yielded -0.04 percent. Risk appetite returned in the week of Aug 24 with depreciation by 1.4 percent to USD 1.2512/EUR and lower yield of the German two-year bond to -0.01 percent and of the US two-year note to 0.266 percent. Further risk aversion is captured by decline of yield of the two-year Treasury note to 0.225 percent on Aug 31, 2012, and to -0.03 percent for the two-year sovereign bond of Germany while the USD moved in opposite direction, depreciating to USD 1.2575/EUR. The almost simultaneous announcement of the bond-buying OMT of the ECB on Sep 6 and the weak employment report on Sep 7 suggesting further easing by the FOMC caused risk appetite shown by the increase in yields of government bonds of the US on Sep 7 to 1.668 percent for the ten-year note and 0.252 percent for the two-year while the two-year yield of Germany rose from -0.03 percent to 0.03 percent and the ten-year yield from 1.33 percent to 1.52 percent. Risk aversion retreated again on Sep 14, 2012 because of the open-ended monetary policy of the FOMC with the dollar devaluing to USD 1.3130 and the ten-year yield of the US Treasury note increasing to 1.863 percent (also in part because of bond buying by the Fed at shorter maturities) and the yield of the ten-year German bond increasing to 1.71 percent. Risk aversions returned because of weak flash purchasing managers indices with appreciation to USD1.2981 in the week of Sep 21 and declines of the yield of the ten-year Treasury note to 1.753 percent and of the yield of the ten-year government bond to 1.60 percent. Under zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is still around consumer price inflation of 1.7 percent in the 12 months ending in Jul (see subsection IIB United States Inflation http://cmpassocregulationblog.blogspot.com/2012/09/recovery-without-hiring-world-inflation.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate

	US 2Y	US 10Y	DE 2Y	DE 10Y	USD/ EUR
9/21/12	0.26	1.753	0.04	1.60	1.2981
9/14/12	0.252	1.863	0.10	1.71	1.3130
9/7/12	0.252	1.668	0.03	1.52	1.2816
8/31/12	0.225	1.543	-0.03	1.33	1.2575
8/24/12	0.266	1.684	-0.01	1.35	1.2512
8/17/12	0.288	1.814	-0.04	1.50	1.2335
8/10/12	0.267	1.658	-0.07	1.38	1.2290
8/3/12	0.242	1.569	-0.02	1.42	1.2387
7/27/12	0.244	1.544	-0.03	1.40	1.2320
7/20/12	0.207	1.459	-0.07	1.17	1.2158
7/13/12	0.24	1.49	-0.04	1.26	1.2248
7/6/12	0.272	1.548	-0.01	1.33	1.2288
6/29/12	0.305	1.648	0.12	1.58	1.2661
6/22/12	0.309	1.676	0.14	1.58	1.2570
6/15/12	0.272	1.584	0.07	1.44	1.2640
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
5/25/12	0.291	1.738	0.05	1.37	1.2518
5/18/12	0.292	1.714	0.05	1.43	1.2780
5/11/12	0.248	1.845	0.09	1.52	1.2917
5/4/12	0.256	1.876	0.08	1.58	1.3084
4/6/12	0.31	2.058	0.14	1.74	1.3096
3/30/12	0.335	2.214	0.21	1.79	1.3340
3/2/12	0.29	1.977	0.16	1.80	1.3190
2/24/12	0.307	1.977	0.24	1.88	1.3449
1/6/12	0.256	1.957	0.17	1.85	1.2720
12/30/11	0.239	1.871	0.14	1.83	1.2944
8/26/11	0.20	2.202	0.65	2.16	1.450
8/19/11	0.192	2.066	0.65	2.11	1.4390
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

Source:

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

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

http://www.federalreserve.gov/releases/h15/data.htm

http://www.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year and two-year Treasury constant maturity yields. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe.

Chart III-1A, US, Ten-Year and Two-Year Treasury Constant Maturity Yields Jul 31, 2001-Sep 20, 2012

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h15/update/

Equity indexes in Table III-1 were subdued in the week ending on Sep 21, 2012. The announcement of open-ended quantitative easing by the FOMC and monetary easing even well after the economy returns to sound growth (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm) was mitigated by weak flash indices of purchasing managers for the US, euro area and China, which are discussed before the individual regional and country data tables in V World Economic Slowdown. DJIA decreased 0.1 percent on Sep 21 and 0.1 percent in the week. Germany’s Dax increased 1.4 percent on Fri Sep 14 in reaction to the Sep 13 decision of the FOMC after European and Asian markets had closed and increased 2.4 percent in the week. Dow Global increased 0.8 percent on Sep 21 and 0.5 percent in the week. Japan’s Nikkei Average increased 0.3 percent on Fri Sep 21 and decreased 0.3 percent in the week. Dow Asia Pacific TSM increased 0.8 percent on Sep 21 and increased 0.1 percent in the week while Shanghai Composite fell 4.6 percent in the week on growth concerns. There is evident trend of deceleration of the world economy that could affect corporate revenue and equity valuations.

Commodities also weakened in the week of Sep 21, 2012. The DJ UBS Commodities Index increased 0.9 percent on Fri Sep 21 and decreased 2.9 percent in the week, as shown in Table III-1. WTI decreased 5.9 percent in the week of Sep 21 while Brent decreased 4.3 percent in the week in speculation of release of oil from the strategic reserve of the US. Gold increased 0.3 percent on Fri Sep 14 and increased 0.2 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €1,197,841 million on Sep 14, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,796,257 million in the statement of Sep 14. There is high credit risk in these transactions with capital of only €85,750 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Sep 14, 2012
1 Gold and other Receivables	367,402	419,822	433,778
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	262,555
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	42,682
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	19,325
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,197,841
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	214,542
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	598,416
8 General Government Debt Denominated in Euro	34,954	33,928	30,042
9 Other Assets	278,719	336,574	261,831
TOTAL ASSETS	2,004, 432	2,733,235	3,061,012
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,796,257
Capital and Reserves	78,143	85,748	85,750

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/fs120918.en.html

IIIE Appendix Euro Zone survival risk. 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. 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-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 9.8 percent in Jan-Jul 2012 relative to Jan-Jul 2011 while those to EMU are falling at 1.2 percent.

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

Jul 2012	Exports % Share	∆% Jan-Jul 2012/ Jan-Jul 2011	Imports % Share	Imports ∆% Jan-Jul 2012/ Jan-Jul 2011
EU	56.0	0.0	53.3	-7.0
EMU 17	42.7	-1.2	43.2	-6.6
France	11.6	0.1	8.3	-4.5
Germany	13.1	0.9	15.6	-10.5
Spain	5.3	-8.6	4.5	-7.2
UK	4.7	10.3	2.7	-13.7
Non EU	44.0	9.8	46.7	-3.9
Europe non EU	13.3	11.0	11.1	-6.8
USA	6.1	18.7	3.3	3.4
China	2.7	-12.4	7.3	-15.4
OPEC	4.7	23.5	8.6	24.9
Total	100.0	4.2	100.0	-5.6

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/70437

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade surplus of €910 million with the 17 countries of the euro zone (EMU 17) in Jul 2012 and deficit of €711 million in Jan-Jul 2012. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €6594 million in Jan-Jul with Europe non European Union and of €8071 million with the US. There is significant rigidity in the trade deficits in Jan-Jul of €10,032 million with China and €12,672 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

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

Regions and Countries	Trade Balance Jul 2012 Millions of Euro	Trade Balance Cumulative Jan-Jul 2012 Millions of Euro
EU	2,653	7,782
EMU 17	910	-711
France	1,385	7,286
Germany	19	-3,151
Spain	211	1,162
UK	1,035	5,612
Non EU	1,836	-3,379
Europe non EU	1,630	6,594
USA	1,461	8,071
China	-1,728	-10,032
OPEC	-1,596	-12,672
Total	4.490	4,403

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/70437

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Jul 2012 relative to Jan-Jul 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 5.5 percent in Jan-Jul 2012/Jan-Jul 2011 relative to imports of minus 2.5 percent may reflect weak demand in Italy with GDP declining during four consecutive quarters from IIIQ2011 through IIQ2012.

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

	Exports Share %	Exports ∆% Jan-Jul 2012/ Jan-Jul 2011	Imports Share %	Imports ∆% Jan-Jul 2012/ Jan-Jul 2011
Consumer Goods	28.9	5.5	25.0	-2.5
Durable	5.9	1.5	3.0	-7.2
Non Durable	23.0	6.6	22.0	-1.9
Capital Goods	32.2	2.7	20.8	-11.5
Inter- mediate Goods	34.3	2.8	34.5	-11.6
Energy	4.7	17.8	19.7	8.6
Total ex Energy	95.3	3.5	80.3	-8.9
Total	100.0	4.2	100.0	-4.3

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/70437

Table III-6 provides Italy’s trade balance by product categories in Jul 2012 and cumulative Jan-Jul 2012. Italy’s trade balance excluding energy generated surplus of €9335 million in Jul 2012 and €41,928 million in Jan-Jul 2012 but the energy trade balance created deficit of €4845 million in Jul 2012 and €37,525 million in Jan-Jul 2012. The overall surplus in Jul 2012 was €4403 million and €4403 million in Jan-Jul 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

	Jul 2012	Cumulative Jan-Jul 2012
Consumer Goods	2,654	9,670
Durable	1,242	6,843
Nondurable	1,411	2,827
Capital Goods	5,459	28,954
Intermediate Goods	1,222	3,304
Energy	-4,845	-37,525
Total ex Energy	9,335	41,928
Total	4,490	4,403

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/70437

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

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

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

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

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

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

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.

Table III-7, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2012 USD Billions	Primary Net Lending Borrowing % GDP 2012	General Government Net Debt % GDP 2012
World	69,660
Euro Zone	12,586	-0.5	70.3
Portugal	221	0.1	110.9
Ireland	210	-4.4	102.9
Greece	271	-1.0	153.2
Spain	1,398	-3.6	67.0
Major Advanced Economies G7	34,106	-4.8	88.3
United States	15,610	-6.1	83.7
UK	2,453	-5.3	84.2
Germany	3,479	1.0	54.1
France	2,712.0	-2.2	83.2
Japan	5,981	-8.9	135.2
Canada	1,805	-3.1	35.4
Italy	2,067	2.9	102.3
China	7992	-1.3*	22.0**

*Net Lending/borrowing**Gross Debt

Source: http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselgr.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2012 is $4138.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3927.8 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8066.3 billion, which would be equivalent to 130.3 percent of their combined GDP in 2012. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 231.9 percent if including debt of France and 167.0 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,847.9
B Germany	1,882.1		$8066.3 as % of $3479 =231.9% $5809.9 as % of $3479 =167.0%
C France	2,256.4
B+C	4,138.5	GDP $6,191.0 Total Debt $8066.3 Debt/GDP: 130.3%
D Italy	2,114.5
E Spain	936.7
F Portugal	245.3
G Greece	415.2
H Ireland	216.1
Subtotal D+E+F+G+H	3,927.8

Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Jul 2012. German exports to other European Union (EU) members are 55.3 percent of total exports in Jul 2012 and 57.6 percent in Jan-Jul 2012. Exports to the euro area are 36.4 percent in Jul and 38.2 percent in Jan-Jul. Exports to third countries are 44.7 percent of the total in Jul and 42.4 percent in Jan-Jul. There is similar distribution for imports. Exports to non-euro countries are growing at 6.9 percent in Jul 2012 and 4.8 percent in Jan-Jul 2012 while exports to the euro area are growing 3.2 percent in Jul and decreasing 0.6 percent in Jan-Jul 2012. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of its high share in exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Jul 2012 € Billions	Jul 12-Month ∆%	Jan–Jul 2012 € Billions	Jan-Jul 2012/ Jan-Jul 2011 ∆%
Total Exports	93.6	9.2	644.1	5.4
A. EU Members	51.8 % 55.3	4.4	370.9 % 57.6	1.2
Euro Area	34.1 % 36.4	3.2	246.0 % 38.2	-0.6
Non-euro Area	17.6 % 18.8	6.9	124.9 % 19.4	4.8
B. Third Countries	41.8 % 44.7	15.9	273.2 % 42.4	11.8
Total Imports	76.7	1.9	533.8	2.3
C. EU Members	49.3 % 64.3	5.6	340.0 % 63.7	2.5
Euro Area	34.7 % 45.2	6.7	239.5 % 44.9	2.2
Non-euro Area	14.6 % 19.0	3.3	100.5 % 18.8	3.3
D. Third Countries	27.4 % 35.7	-4.2	193.8 % 36.3	1.9

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

Source:

Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/09/PE12_303_51.html;jsessionid=807581660CF67FED0FC729A83F38D5FB.cae2 https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

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Sunday, September 23, 2012

Collapse of United States Creation of Wealth, Income and Employment, Forty Eight Million in Poverty and without Health Insurance, Unresolved US Balance of Payments Deficits, Global Financial Turbulence and World Economic and Trade Slowdown with Global Recession Risk: Part I

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