United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity, World Inflation Waves, World Financial Turbulence and Economic Slowdown with Global Recession Risk: Part I

 

United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity, World Inflation Waves, World Financial Turbulence and Economic Slowdown with Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity

IA United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity

IB Collapse of United States Dynamism of Income Growth and Employment Creation

II World Inflation Waves

IIA Appendix: Transmission of Unconventional Monetary Policy

IIA1 Theory

IIA2 Policy

IIA3 Evidence

IIA4 Unwinding Strategy

IIB United States Inflation

IIC Long-term US Inflation

IID Current US Inflation

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 United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity. Table ESI-1 of the CBO (2012NovMBR) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012. The deficit of $1.1 trillion in fiscal-year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR).

Table ESI-1, US, Budget Fiscal Year Totals, Billions of Dollars and % GDP

	2007	2008	2009	2010	2011	2012
Receipts	2568	2524	2105	2163	2302	2449
Outlays	2729	2983	3518	3456	3599	3538
Deficit	-161	-459	1413	1293	1297	1089
% GDP	-1.2	-3.2	-10.1	-9.0	-8.7	-7.0

Source: CBO (2012NovMBR).

Table ESI-1A provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into three parts: federal fiscal data for the years from 2009 to 2012; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2012. Total revenues of the US from 2009 to 2012 accumulate to $9019 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,111 billion, or $14.1 trillion, with the deficit accumulating to $5092 billion, or $5.1 trillion. Revenues decreased 6.6 percent from $9653 billion in the four years from 2005 to 2008 to $9019 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.2 percent on average in the cyclical expansion from IIIQ2009 to IIIQ2012, which is much lower than 6.2 percent on average in cyclical expansions since the 1950s (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Weakness of growth and employment creation is analyzed in the following Subsection IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 28.1 million people without jobs or underemployed that is equivalent to 17.4 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html ) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2012/11/recovery-without-hiring-united-states.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,111 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.6 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5092 billion in 2009-2012. Federal revenue was 15.4 percent of GDP on average in the years from 2009 to 2012, which is well below 18.0 percent of GDP on average from 1970 to 2010. Federal outlays were 24.1 percent of GDP on average from 2009 to 2012, which is well above 21.9 percent of GDP on average from 1970 to 2010. The lower part of Table ESI-1A shows that debt held by the public swelled from $5803 billion in 2008 to $11,280 billion in 2012, by $5477 billion or 94.3 percent. Debt held by the public as percent of GDP or economic activity jumped from 40.5 percent in 2008 to 72.6 percent in 2012, which is well above the average of 37.0 percent from 1970 to 2010. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table ESI-1A, US, Treasury Budget and Debt Held by the Public, Billions of Dollars and Percent of GDP 

	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
2012	2,449	3,538	-1,089
Fiscal Year 2011	2,302	3,599	-1,297
Fiscal Year 2010	2,163	3,456	-1,293
Fiscal Year 2009	2,105	3,518	-1,413
Total 2009-2012	9,019	14,111	-5,092
Average % GDP 2009-2012	15.4	24.1	-8.7
Fiscal Year 2008	2,524	2,983	-459
Fiscal Year 2007	2,568	2,729	-161
Fiscal Year 2006	2,407	2,655	-248
Fiscal Year 2005	2,154	2,472	-318
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.9	20.1	-2.2
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	36.9
2006	4,829	36.6
2007	5,035	36.3
2008	5,803	40.5
2009	7,545	54.1
2010	9,019	62.8
2011	10,128	67.7
2012	11,280	72.6

Source: http://www.fms.treas.gov/mts/index.html CBO (2012NovMBR). CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov.

Unusually low economic growth of average 2.2 percent of GDP in the current expansion compared with 6.2 percent in similar expansions in postwar economic cycles (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html) has had adverse impact on revenue generation. The impact of low growth on employment creation and labor market hiring is discussed in Subsection IB Collapse of United States Dynamism of Income Growth and Employment in the text. Table ESI-2 provides total United States federal receipts from 2010 to 2012. Individual income taxes of $1132 billion, or $1.1 trillion, increased 25.9 percent from 2010 to 2012 and account for 46.2 percent of US total receipts in 2012. Total receipts stood at 15.8 percent of GDP in 2012, which is lower than 18 percent in the past 40 years (CBO 2012NovBMR).

Table ESI-2, United States, Total Receipts, Billions of Dollars and ∆%

Major Source	2010	2011	2012	∆% 2011-2012
Individual Income Taxes	899	1091	1132	3.7
Corporate Income Taxes	191	181	242	33.8
Social Insurance	865	819	845	3.2
Other	208	211	229	8.6
Total	2163	2302	2449	6.4
% of GDP	15.1	15.4	15.8	NA

Source: CBO (2012NovMBR).

Total outlays of the federal government of the United States have grown to extremely high levels. Table ESI-3 of the CBO (2012MBR) provides total outlays from 2010 to 2012. Total outlays of $3538 billion, or $3.5 trillion, are higher by $809 billion, or $0.8 trillion, relative to $2729 billion, or $2.7 trillion. Outlays have grown from 19.7 percent of GDP in 2007 to 22.8 percent of GDP in 2012. Outlays as percent of GDP were on average 21.9 percent from 1971 to 2010 and receipts as percent of GDP were on average 18.0 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Adjusted outlays in Table ESI-3 decreased 1.6 percent from 2011 to 2012 but mostly because of decline in defense-military expenditures by 2.9 percent, unemployment benefits by 24.0 percent and Medicaid by 8.9 percent. Much higher expenses of social security benefits increased 6.0 percent and Medicare increased 3.3 percent. There has been no meaningful constraint of spending.

Table ESI-3, United States, Total Outlays, Billions of Dollars and ∆%

Major Category	2010	2011	2012	∆% Actual 12/11	∆% Adj. 12/11
Defense-Military	667	678	651	-4.0	-2.9
Social Security Benefits	696	720	762	6.0	6.0
Medicare	450	483	469	-2.9	3.3
Medicaid	273	275	251	-8.9	-8.9
Unemployment Benefits	162	126	96	-24.0	-24.0
Other Activities	1048	1084	1022	-5.7	-3.4
Subtotal	3295	3366	3251	-3.4	-1.6
Net Interest on the Public Debt	228	266	258	-3.0	-3.0
TARP	-108	-3.8	24	NM	NM
Payments to GSE	40	5	5	-5.7	-5.7
Total	3456	3599	3538	-1.7	0.1
% of GDP	24.1	24.1	22.8	NA	NA

GSE: Government Sponsored Enterprises (Fannie Mae and Freddie Mac); Adj: Adjusted, excluding effects of payments shifts because of weekends or holidays and prepayment of deposit insurance premiums; NM: not meaningful

Source: CBO (2012NovMBR).

The US is facing a major fiscal challenge. Table ESI-4 provides federal revenues, expenditures, deficit and debt as percent of GDP and the yearly change in GDP in the eight decades from 1930 to 2011. The most recent period of debt exceeding 90 percent of GDP based on yearly observations in Table ESI-4 is between 1944 and 1948. The debt/GDP ratio actually rose to 106.2 percent of GDP in 1945 and to 108.7 percent of GDP in 1946. GDP fell 10.9 percent in 1946, which is only matched in Table ESI-4 by the decline of 13.1 percent in 1932. Part of the decline is explained by the bloated US economy during World War II, growing at 17.1 percent in 1941, 18.5 percent in 1942 and 16.4 percent in 1943. Expenditures as a share of GDP rose to their highest in the series: 43.6 percent in 1943, 43.6 percent in 1944 and 41.9 percent in 1945. The repetition of 43.6 percent in 1943 and 1944 is in the original source of Table ESI-4. During the Truman administration from Apr 1945 to Jan 1953, the federal debt held by the public fell systematically from the peak of 108.7 percent of GDP in 1946 to 61.6 percent of GDP in 1952. During the Eisenhower administration from Jan 1953 to Jan 1961, the federal debt held by the public fell from 58.6 percent of GDP in 1953 to 45.6 percent of GDP in 1960. The Truman and Eisenhower debt reductions were facilitated by diverse factors such as low interest rates, lower expenditure/GDP ratios that could be attained again after lowering war outlays and less rigid structure of mandatory expenditures than currently. There is no subsequent jump of debt as the one from 40.5 percent of GDP in 2008 to 67.7 percent of GDP in 2011 and projected by the Congressional Budget Office (CBO 2012AugBEO, CBO 2012NovCDR) at 72.6 percent in 2012.

Table ESI-4, United States Central Government Revenue, Expenditure, Deficit, Debt and GDP Growth 1930-2011

	Rev % GDP	Exp % GDP	Deficit % GDP	Debt % GDP	GDP ∆%
1930	4.2	3.4	0.8		-8.6
1931	3.7	4.3	-0.6		-6.5
1932	2.8	6.9	-4.0		-13.1
1933	3.5	8.0	-4.5		-1.3
1934	4.8	10.7	-5.9		10.9
1935	5.2	9.2	-4.0		8.9
1936	5.0	10.5	-5.5		13.1
1937	6.1	8.6	-2.5		5.1
1938	7.6	7.7	-0.1		-3.4
1939	7.1	10.3	-3.2		8.1
1940s
1940	6.8	9.8	-3.0	44.2	8.8
1941	7.6	12.0	-4.3	42.3	17.1
1942	10.1	24.3	-14.2	47.0	18.5
1943	13.3	43.6	-30.3	70.9	16.4
1944	20.9	43.6	-22.7	88.3	8.1
1945	20.4	41.9	-21.5	106.2	-1.1
1946	17.7	24.8	-7.2	108.7	-10.9
1947	16.5	14.8	1.7	96.2	-0.9
1948	16.2	11.6	4.6	84.3	4.4
1949	14.5	14.3	0.2	79.0	-0.5
1950s
1950	14.4	15.6	-1.1	80.2	8.7
1951	16.1	14.2	1.9	66.9	7.7
1952	19.0	19.4	-0.4	61.6	3.8
1953	18.7	20.4	-1.7	58.6	4.6
1954	18.5	18.8	-0.3	59.5	-0.6
1955	16.5	17.3	-0.8	57.2	7.2
1956	17.5	16.5	0.9	52.0	2.0
1957	17.7	17.0	0.8	48.6	2.0
1958	17.3	17.9	-0.6	49.2	-0.9
1959	16.2	18.8	-2.6	47.9	7.2
1960s
1960	17.8	17.8	0.1	45.6	2.5
1961	17.8	18.4	-0.6	45.0	2.3
1962	17.6	18.8	-1.3	43.7	6.1
1963	17.8	18.6	-0.8	42.4	4.4
1964	17.6	18.5	-0.9	40.0	5.8
1965	17.0	17.2	-0.2	37.9	6.4
1966	17.3	17.8	-0.5	34.9	6.5
1967	18.4	19.4	-1.1	32.9	2.5
1968	17.6	20.5	-2.9	33.9	4.8
1969	19.7	19.4	0.3	29.3	3.1
1970s
1970	19.0	19.3	-0.3	28.0	0.2
1971	17.3	19.5	-2.1	28.1	3.4
1972	17.6	19.6	-2.0	27.4	5.3
1973	17.6	18.7	-1.1	26.0	5.8
1974	18.3	18.7	-0.4	23.9	-0.6
1975	17.9	21.3	-3.4	25.3	0.2
1976	17.1	21.4	-4.2	27.5	5.4
1977	18.0	20.7	-2.7	27.8	4.6
1978	18.0	20.7	-2.7	27.4	5.6
1979	18.5	20.1	-1.6	25.6	3.1
1980s
1980	19.0	21.7	-2.7	26.1	-0.3
1981	19.6	22.2	-2.6	25.8	2.5
1982	19.2	23.1	-4.0	28.7	-1.9
1983	17.5	23.5	-6.0	33.1	4.5
1984	17.3	22.2	-4.8	34.0	7.2
1985	17.7	22.8	-5.1	36.4	4.1
1986	17.5	22.5	-5.0	39.5	3.5
1987	18.4	21.6	-3.2	40.6	3.2
1988	18.2	21.3	-3.1	41.0	4.1
1989	18.4	21.2	-2.8	40.6	3.6
1990s
1990	18.0	21.9	-3.9	42.1	1.9
1991	17.8	22.3	-4.5	45.3	-0.2
1992	17.5	22.1	-4.7	48.1	3.4
1993	17.5	21.4	-3.9	49.3	2.9
1994	18.0	21.0	-2.9	49.2	4.1
1995	18.4	20.6	-2.2	49.1	2.5
1996	18.8	20.2	-1.4	48.4	3.7
1997	19.2	19.5	-0.3	45.9	4.5
1998	19.9	19.1	0.8	43.0	4.4
1999	19.8	18.5	1.4	39.4	4.8
2000s
2000	20.6	18.2	2.4	34.7	4.1
2001	19.5	18.2	1.3	32.5	1.1
2002	17.6	19.1	-1.5	33.6	1.8
2003	16.2	19.7	-3.4	35.6	2.5
2004	16.1	19.6	-3.5	36.8	3.5
2005	17.3	19.9	-2.6	36.9	3.1
2006	18.2	20.1	-1.9	36.6	2.7
2007	18.5	19.7	-1.2	36.3	1.9
2008	17.6	20.8	-3.2	40.5	-0.3
2009	15.1	25.2	-10.1	54.1	-3.1
2010s
2010	15.1	24.1	-9.0	62.8	2.4
2011	15.4	24.1	-8.7	67.7	1.8

Sources:

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).

The capital budgeting decision of business requires the calculation of present value of projects. This calculation consists of a projection toward the horizon of planning of revenues net of costs, which are discounted to present value by the weighted average cost of capital. Business invests in the projects with highest net present value. The nonpartisan Congressional Budget Office (CBO) provides a similar service. Congress and the administration send budget proposals and legislation for evaluation by the CBO of their effects on federal government revenues, expenditures, deficit or surpluses and debt. The CBO does not provide its own policy proposals but analyzes alternative policies. The CBO uses state of the art knowledge but significant uncertainty remains because of the hurdle of projecting financial and economic variables to the future.

Table ESI-5 provides the latest exercise by the CBO (2012AugBEO, CBO2012NovCDR) of projecting the fiscal accounts of the US. Table ESI-5 extends data back to 1995 with the projections of the CBO from 2012 to 2022. Budget analysis in the US uses a ten-year horizon. The significant event in the data before 2011 is the budget surpluses from 1998 to 2001, from 0.8 percent of GDP in 1998 to 2.4 percent of GDP in 2000. Debt held by the public fell from 49.1 percent of GDP in 1995 to 32.5 percent of GDP in 2001.

Table ESI-5, US, CBO Baseline Budget Outlook 2012-2022

	Out $B	Out % GDP	Deficit $B	Deficit % GDP	Debt	Debt % GDP
1995	1,516	20.6	-164	-2.2	3,604	49.1
1996	1,560	20.2	-107	-1.4	3,734	48.4
1997	1,601	19.5	-22	-0.3	3,772	45.9
1998	1,652	19.1	+69	+0.8	3,721	43.0
1999	1,702	18.5	+126	+1.4	3,632	39.4
2000	1,789	18.2	+236	+2.4	3,410	34.7
2001	1,863	18.2	+128	+1.3	3,320	32.5
2002	2,011	19.1	-158	-1.5	3,540	33.6
2003	2,159	19.7	-378	-3.4	3,913	35.6
2004	2,293	19.6	-413	-3.5	4,295	36.8
2005	2,472	19.9	-318	-2.6	4,592	36.9
2006	2,655	20.1	-248	-1.9	4,829	36.6
2007	2,729	19.7	-161	-1.2	5,035	36.3
2008	2,983	20.8	-459	-3.2	5,803	40.5
2009	3,518	25.2	-1,413	-10.1	7,545	54.1
2010	3,456	24.1	-1,294	-9.0	9,019	62.8
2011	3,603	24.1	-1,300	-8.7	10,128	67.7
2012	3,563	22.8	-1,089	-7.0	11,280	72.6
2013	3,554	22.4	-641	-4.0	12,064	76.1
2014	3,595	21.9	-387	-2.4	12,545	76.6
2015	3,754	21.5	-213	-1.2	12,861	73.8
2016	4,003	21.6	-186	-1.0	13,144	70.8
2017	4,206	21.4	-123	-0.6	13,371	67.9
2018	4,407	21.2	-79	-0.4	13,536	65.2
2019	4,681	21.5	-130	-0.6	13,746	63.2
2020	4,932	21.7	-142	-0.6	13,964	61.4
2021	5,183	21.8	-144	-0.6	14,181	59.8
2022	5,509	22.3	-213	-0.9	14,464	58.5
2013 to 2017	19,111		-1,549		NA	NA
2013 to 2022	43,823	21.7	-2,258	-1.1	NA	NA

Note: Out = outlays

Source: CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov.

Chart ESI-1 shows the sharp impact of the 1946 contraction of 10.9 percent of GDP. Growth rebounded strongly, as in all postwar cyclical expansions, with growth of 8.7 percent in 1950, 7.7 percent in 1951, 3.8 percent in 1952 and 4.6 percent in 1953. The data in Charts ESI-1 and ESI-2 are changes in the level of real GDP in a year, which is different from the seasonally-adjusted quarterly annual equivalent rates (SAAR) (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html).

Chart ESI-1, Percentage Change of Real GDP 1945-2011

Source: Bureau of Economic Analysis, Department of Commerce

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

Yearly changes in Chart ESI-2 show vigorous recovery from the contractions of 1982, 1991 and 2001. Rapid growth recovered levels of employment prior to the contraction. The anemic recovery after IIQ2009 and the current standstill have not occurred in the US postwar economy.

Chart I-2, Percentage Change of Real GDP 1980-2011

Source: Bureau of Economic Analysis, Department of Commerce

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

Table ESI-6 provides baseline CBO projections of federal revenues, outlays, deficit and debt as percent of GDP. The adjustment depends on increasing revenues from 15.4 percent of GDP in 2011 to 21.4 percent of GDP in 2022, which is above the 40-year average of 18 percent of GDP while outlays fall only from 24.1 percent of GDP in 2011 to 22.3 percent of GDP in 2022. The last row of Table ESI-6 provides the CBO estimates of averages for 1971 to 2010 of 18.0 percent for revenues/GDP, 21.9 percent for outlays/GDP and 37.0 percent for debt/GDP.

Table ESI-6, US, Baseline CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.7
2012	15.8	22.8	-7.0	72.6
2013	18.4	22.4	-4.0	76.1
2014	19.6	21.9	-2.4	76.6
2015	20.3	21.5	-1.2	73.8
2016	20.6	21.6	-1.0	70.8
2017	20.7	21.4	-0.6	67.9
2018	20.8	21.2	-0.4	65.2
2019	20.9	21.5	-0.6	63.2
2020	21.1	21.7	-0.6	61.4
2021	21.2	21.8	-0.6	59.8
2022	21.4	22.3	-0.9	58.5
Total 2013-2017	20.0	21.7	-1.8	NA
Total 2013-2022	20.6	21.7	-1.1	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR).

Consecutive deficits of more than one trillion dollars in the four years from 2009 to 2012, adding to $5 billion, resulted in an increase in debt held by the public from 40.5 percent of GDP in 2008 to projected 72.6 percent of GDP in 2012 in a debt explosion without parallel in data after World War II in Table ESI-4. An important part of the fiscal situation is the jump in federal government expenditures from $2,983 billion in 2008 to $3,518 billion in 2009, or 17.9 percent, equivalent to an increase of federal government expenditures from 20.8 percent of GDP in 2008 to 25.2 percent of GDP in 2009. The exercise by the CBO in Table ESI-5 is not able to reduce expenditures back to 20 percent, which is a financeable historical ceiling for the outlays/GDP ratio.

Chart ESI-3 of the Congressional Budget Office (CBO) shows total deficits or surpluses of the US from 2000 to 2022. There is a difficult climb from the record deficit of 10.1 percent of GDP in 2009 and cumulative deficit of $5092 billion in four consecutive years of deficits exceeding one trillion dollars from 2009 to 2012. The CBO projects a baseline scenario with faster and stronger adjustment and an alternative scenario with more delayed and less successful adjustment.

Chart ESI-3, US, Total Deficits or Surplus as Percent of GDP

Source: Congressional Budget Office

CBO (2012AugBEO).

http://www.cbo.gov/

The CBO (2012NovCDR, 4) uses different assumptions to calculate what would happen with the US budget and debt under an alternative fiscal scenario of no measures of fiscal tightening:

“The alternative fiscal scenario incorporates the assumptions that all expiring tax provisions (other than the payroll tax reduction), including those that expired at the end of December 2011, are instead extended; that the alternative minimum tax is indexed for inflation after 2011 (starting at the 2011 exemption amount); that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic enforcement procedures specified by the Budget Control Act of 2011 do not take effect. Outlays under that scenario also include the incremental interest costs associated with projected additional borrowing.”

Table ESI-7 provides the projections of the alternative fiscal scenario of the CBO under those assumptions. Debt as percent of GDP increases from 72.6 percent in 2012 to 89.7 percent in 2022.

Table ESI-7, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.7
2012	15.8	22.8	-7.0	72.6
2013	16.3	22.8	-6.5	78.6
2014	17.2	22.9	-5.6	82.3
2015	17.8	22.5	-4.6	82.5
2016	18.1	22.6	-4.5	82.5
2017	18.3	22.5	-4.2	82.5
2018	18.3	22.5	-4.2	82.9
2019	18.4	23.0	-4.6	84.1
2020	18.5	23.3	-4.8	85.7
2021	18.5	23.6	-5.1	87.5
2022	18.6	24.1	-5.5	89.7
Total 2013-2017	17.6	22.6	-5.0	NA
Total 2013-2022	18.1	23.0	-4.9	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR).

The CBO (2012AugBEO) projects economic variables shown in Table ESI-8 required for the fiscal projections. Real GDP growth is projected at 2.1 percent in 2012 and minus 0.5 percent in 2013, jumping to 4.3 percent on average from 2014 to 2017 and 2.4 percent from 2018 to 2022. The recession of 2012 with negative growth of 0.5 percent would occur from failure to extend tax reductions and prevent expenditure sequestration at the turn of 2013 or so-called “fiscal cliff”. It is not possible to forecast another downturn from 2013 to 2022 that could worsen further the US fiscal situation. The CBO projects subdued inflation but the rate of unemployment remains at high levels, declining to 5.4 percent by 2017, which is around the current measurement of the natural rate of unemployment. Interest rates are assumed to remain at relatively low levels but increase in the latter years of the projections. Different paths of economic variables would alter the projections of fiscal variables.

Table ESI-8, US, CBO Economic Projections for Calendar Years 2012 to 2022, ∆%

	2012 ∆%	2013 ∆%	2014-2017 Average ∆%	2018-2022 Average ∆%
Real GDP	2.1	-0.5	4.3	2.4
PCE Inflation	1.4	1.4	1.8	2.0
Core PCE Inflation	1.9	1.5	1.8	2.0
CPI Inflation	1.3	1.6	2.1	2.3
Core CPI Inflation	2.1	1.7	2.0	2.2
Unem- ployment Rate	8.2	8.8	7.3	5.4
3-Month Treasury Bill	0.1	0.1	1.3	3.7
10-Year treasury Note	1.8	1.8	3.4	5.0

Source: CBO (2012AugBEO).

Chart ESI-4 of the CBO (2012NovCDR) shows vividly the significant difference between the average budget segments for 1972-2011 and the projections of the alternative fiscal scenario. Outlays for social security and health programs would increase sharply as percent of GDP while other outlays would decline. Interest payments would also increase in proportion of GDP under the alternative fiscal scenario as do total outlays, total revenues and the deficit. The CBO (2012NovCDR) analyzes four types of adversities resulting from the alternative fiscal scenario: (1) increase in interest payments by the federal government; (2) lower national savings; (3) constraint of use of federal spending in facing national emergencies, financial crises and recessions, including unemployment insurance and Medicaid; and (4) higher probability of a point of explosion or disorderly correction with a risk premium on yields of US Treasury securities.

Chart ESI-4 CBO, Components of the Federal Budget in 2020 under the Alternative Fiscal Scenario, Compared with Their Averages since 1972

Source: CBO (2012CDR).

The major hurdle in adjusting the fiscal situation of the US is shown in Table ESI-9 in terms of the rigid structure of revenues that can be increased and outlays that can be reduced. There is no painless adjustment of a debt exceeding 70 percent of GDP. On the side of revenues, taxes provide 90.9 percent of revenue in 2011 and are projected to provide 92.2 percent in the total revenues from 2013 to 2022 in the CBO projections. Thus, revenue measures are a misleading term for what are actually tax increases. The choices are especially difficult because of the risks of balancing inequity and disincentives to economic activity. Individual income taxes are projected to increase from 47.4 percent of federal government revenues in 2011 to 51.4 percent in total revenues projected by the CBO from 2013 to 2022. There are equally difficult conflicts in what the government gives away in a rigid structure of expenditures. Mandatory expenditures account for 56.3 percent of federal government outlays in 2011 and are projected to increase to 62.4 percent of the total projected by the CBO for the years 2013 to 2022. The total of Social Security plus Medicare and Medicaid accounts for 43.4 percent of federal government outlays in 2011 and is projected to increase to 51.5 percent in the total for 2013 to 2022. The inflexibility of what to cut is more evident in the first to the last row of Table ESI-9 with the aggregate of defense plus Social Security plus Medicare plus Medicaid accounting for 62.7 percent of expenditures in 2011, rising to 66.6 percent of the total outlays projected by the CBO from 2013 to 2022. The cuts are in discretionary spending that declines from 37.4 percent of the total in 2011 to 28.9 percent of total outlays in the CBO projection for 2013 to 2022.

Table ESI-9, Structure of Federal Government Revenues and Outlays, $ Billions and Percent

	2011 $ Billions	% Total	Total 2013-2022 $ Billions	% Total
Revenues	2,303	100.00	41,565	100.00
Individual Income Taxes	1,091	47.4	21,379	51.4
Social Insurance Taxes	819	35.6	12,476	30.0
Corporate Income Taxes	181	7.9	4,477	10.8
Other	212	9.2	3,232	7.8
Outlays	3,603	100.00	43,823	100.0
Mandatory	2,027	56.3	27,324	62.4
Social Security	725	20.1	10,545	24.1
Medicare	560	15.5	7,722	17.6
Medicaid	275	7.6	4,291	9.8
SS + Medicare + Medicaid	1,560	43.3	22,558	51.5
Discre- tionary	1,346	37.4	12,664	28.9
Defense	700	19.4	6,726	15.4
Non- defense	646	17.9	5,370	12.3
Net Interest	230	6.4	3,835	8.8
Defense + SS + Medicare + Medicaid	2,260	62.7	29,284	66.8
MEMO: GDP	15,076		217,200

Source: CBO (2012JanBEO), CBO (2012AugBeo).

The CBO (2012NovCDR) focuses on adjustment by fiscal-year 2020. Major segments of the base projections of CBO to 2020 and the alternative fiscal scenario are shown in Table ESI-10. The base projection has revenues as percent of GDP of 21.1 percent, higher than 18 percent historically on average from 1970 to 2010 compared with 18.5 percent in the fiscal scenario. The base scenario requires return of growth to trend or whereabouts together with the capacity to increase revenues above the 18.5 percent threshold. Most revenue components are similar under both scenarios with exception of individual income taxes that reach 11.2 percent of GDP in 2020 under the base projection while they reach only 9 percent under the alternative fiscal scenario. There is also significant difference in total outlays, reaching 21.7 percent of GDP under the base projection but increasing to 23.3 percent of GDP under the alternative fiscal scenario. Discretionary spending reaches 6.2 percent under the alternative fiscal scenario with increases in the share in GDP of both defense and nondefense components while net interest payments by the federal government are higher by 3.1 percent under the alternative fiscal scenario with much higher debt than 2.3 percent in the base projection. In mandatory spending, the difference is 3.3 percent in the base projection in Medicare with 3.5 percent in the alternative fiscal scenario. Under the base projection, the deficit would decline to $142 billion in 2020 or 0.6 percent of GDP while it would reach $1102 billion, or $1.1 trillion, in the alternative fiscal scenario for 4.8 percent of GDP. Debt held by the public at the end of the year, in the final row, would be $13,964 billion, or $13.9 trillion, in the base projection, for 61.4 percent of GDP, and $19,477 billion, or $19.5 trillion for 85.7 percent of GDP, under the alternative fiscal scenario.

The CBO (2012NovEEP) provides analysis of what would happen in two alternatives: (1) there is no extension of tax reductions and mandatory cuts; and (2) there is extension of some or all of the tax reductions and mandatory cuts. The CBO (2012NovEEP) actually identifies what will be a continuing tradeoff of short-term and long-term measures for the unsustainable fiscal situation of the United States.

The CBO (2012NovEEP) estimates that fiscal tightening from failure to extend tax rates and mandatory spending would cause: decline of inflation-adjusted or real GDP by 0.5 percent from IVQ2012 to IVQ2013 and increase of the rate of unemployment to 9.1 percent by IVQ2013. Growth would increase after 2013 with return to potential output and unemployment rate of 5.5 percent in 2018.

The CBO (2012NovEEP) estimates that growth will continue to be weak and unemployment high even if there were removal of all or a large part of fiscal tightening by not extending some or all tax rates and preventing mandatory cuts in spending. The future would be troubled according to the CBO (2012NovEEP, 1):

“Moreover, if the fiscal tightening was removed and the policies that are currently in effect were kept in place indefinitely, a continued surge in federal debt during the rest of this decade and beyond would raise the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates) and would eventually reduce the nation’s output and income below what would occur if the fiscal tightening was allowed to take place as currently set by law.”

The CBO (2012NovEEP, 7) estimates that the non-extension of lower tax rates on income above certain thresholds would result in revenue effect of $38 billion in 2014, which hardly has an effect on budget deficits of trillion dollars. Elimination of deductions is the same as tax increases. There are no easy fixes for the fiscal situation of the United States and tough tradeoffs between the present and the future in a multitude of combinations of alternative policies with effects on growth and employment that are quite difficult to calculate.

Table ESI-10, CBO Budget Projections for 2020 Baseline and Alternative Fiscal Scenario, Billions of Dollars and % of GDP

	$ B Base 2020	% GDP Base 2020	$B Alt 2020	% GDP Alt 2020
Revenues	4,790	21.1	4,196	18.5
Individual Income Taxes	2,542	11.2	2,055	9.0
Social Insurance Taxes	1,412	6.2	1,412	6.2
Corporate Income Taxes	473	2.1	424	1.9
Other	363	1.6	305	1.3
Total Outlays	4,932	21.7	5,298	23.3
Mandatory Spending	3,104	13.7	3,190	14.0
Social Security	1,202	5.3	1,202	5.3
Medicare	750	3.3	793	3.5
Medicaid	514	2.3	514	2.3
Other Major Health Care Programs	117	0.5	117	0.5
Other Mandatory Spending	523	2.3	566	2.5
Discretionary Spending	1,316	5.8	1,403	6.2
Defense	696	3.1	750	3.3
Nondefense	620	2.7	653	2.9
Net Interest	512	2.3	704	3.1
Deficit	-142	-0.6	-1,102	-4.8
Debt Held by the Public at the End of the Year	13,964	61.4	19,477	85.7

Source: CBO (2012NovCDR).

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 seignorage, requiring the creation of additional base money.”

The alternative fiscal scenario of the CBO (2012NovCDR) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

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 ESI-11 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 2012NovCDR) estimates the federal deficit in 2012 at $1089 billion or 7.7 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 $5092 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). The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5092 trillion in four years, using the fiscal year deficit of $1089.4 billion for fiscal year 2012 (http://www.fms.treas.gov/mts/mts0912.txt), which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5092 billion. Federal debt in 2011 was 67.7 percent of GDP and is estimated to reach 72.6 percent of GDP in 2012 (CBO2012AugBEO, CBO2012NovCDR). 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 ESI-11, 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	-1297
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	2302
∆%	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

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

The United States finances its trade and fiscal deficits with foreign savings. Table ESI-12 provides major foreign holders of Treasury securities. Total foreign holdings of US debt reached $5455 billion in Sep 2012, increasing 11.1 percent from $4908.3 billion in Sep 2011. A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt.

Table ESI-12, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Sep 2012	Aug 2012	Sep 2011
Total	5455.0	5448.8	4908.3
China	1155.5	1155.2	1270.2
Japan	1130.7	1122.8	983.9
Oil Exporters	267.0	269.1	252.1
Brazil	250.5	259.8	226.4
Caribbean Banking Centers	240.4	263.9	209.7
Taiwan	200.4	199.5	166.6
Switzerland	195.8	191.7	158.2
Russia	162.8	162.9	149.9
Luxembourg	148.1	139.3	127.9
Hong Kong	135.7	141.7	111.6
Belgium	133.7	130.2	132.1
United Kingdom	132.1	137.1	116.9
Foreign Official Holdings	3968.7	3957.0	3619.5
A. Treasury Bills	383.8	373.0	387.3
B. Treasury Bonds and Notes	3584.9	3584.0	3232.2

Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticsec2.aspx#ussecs

http://www.meti.go.jp/english/statistics/index.html

Unconventional monetary policy could accentuate the frustration of prosperity caused by unsustainable deficit/debt in the United States. 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→∞. The rise of risk premium on yields of Treasury securities would coincide with zero interest rates. If interest rates are expected to increase, r → ∞, W, or wealth, declines, W → 0. The combination of zero interest rates of unconventional monetary policy with unsustainable deficit/debt in the United States could be a toxic cocktail.

ESII World Economic Slowdown. Table ESII-1 provides the latest available estimates of GDP for the regions and countries followed in this blog for IQ2012, IIQ2012 and IIIQ2012 available now for all countries. Growth is weak throughout most of the world. Japan’s GDP increased 1.3 percent in IQ2012 and 2.9 percent relative to a year earlier but part of the jump could be the low level a year earlier because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. Japan’s GDP grew 0.1 percent in IIQ2012 at the seasonally adjusted annual rate (SAAR) of 0.3 percent, which is much lower than 5.2 percent in IQ2012. Growth of 3.3 percent in IIQ2012 in Japan relative to IIQ2011 has effects of the low level of output because of Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan’s GDP contracted 0.9 percent in IIIQ2012 at the SAAR of minus 3.5 percent and increased 0.1 percent relative to a year earlier. China grew at 1.8 percent in IIQ2012, which annualizes to 7.4 percent. China grew at 2.2 percent in IIIQ2012, which annualizes at 7.4 percent. Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). There is decennial change in leadership in China (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). China’s GDP grew 7.6 percent in IIQ2012 relative to IIQ2011. Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2012. China’s GDP grew 8.1 percent in IQ2012 relative to a year earlier but only 7.6 percent in IIQ2012 relative to a year earlier and 7.4 percent in IIIQ2012 relative to IIIQ2011. GDP was flat in the euro area in IQ2012 and also in IQ2012 relative to a year earlier. Euro area GDP contracted 0.2 percent IIQ2012 and fell 0.4 percent relative to a year earlier. In IIIQ2012, euro area GDP fell 0.1 percent and declined 0.6 percent relative to a year earlier. Germany’s GDP increased 0.5 percent in IQ2012 and 1.7 percent relative to a year earlier. In IIQ2012, Germany’s GDP increased 0.3 percent and 0.5 percent relative to a year earlier but 1.0 percent relative to a year earlier when adjusted for calendar (CA) effects. In IIIQ2012, Germany’s GDP increased 0.2 percent and 0.4 percent relative to a year earlier. Growth of US GDP in IQ2012 was 0.5 percent, at SAAR of 2.0 percent and higher by 2.4 percent relative to IQ2011. US GDP increased 0.3 percent in IIQ2012, 1.3 percent at SAAR and 2.1 percent relative to a year earlier. In IIIQ2012, GDP grew 0.5 percent, 2.0 percent at SAAR and 2.3 percent relative to IIIQ2011 (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html) but with substantial unemployment and underemployment (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html ) and weak hiring (http://cmpassocregulationblog.blogspot.com/2012/11/recovery-without-hiring-united-states.html). In IQ2012, UK GDP fell 0.3 percent, declining 0.1 percent relative to a year earlier. UK GDP fell 0.4 percent in IIQ2012 and 0.5 percent relative to a year earlier. UK GDP increased 1.0 percent in IIIQ2012 and was unchanged relative to a year earlier. Italy has experienced decline of GDP in five consecutive quarters from IIIQ2011 to IIIQ2012. Italy’s GDP fell 0.8 percent in IQ2012 and declined 1.4 percent relative to IQ2011. Italy’s GDP fell 0.7 percent in IIQ2012 and declined 2.4 percent relative to a year earlier. In IIIQ2012, Italy’s GDP fell 0.2 percent and declined 2.4 percent relative to a year earlier. France’s GDP stagnated in IQ2012 and increased 0.4 percent relative to a year earlier. France’s GDP decreased 0.1 percent in IIQ2012 and increased 0.1 percent relative to a year earlier. In IIIQ2012, France’s GDP increased 0.2 percent and increased 0.2 percent relative to a year earlier.

Table ESII-1, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%

	IQ2012/IVQ2011	IQ2012/IQ2011
United States	QOQ: 0.5        SAAR: 2.0	2.4
Japan	QOQ: 1.3 SAAR: 5.2	2.9
China	1.8	8.1
Euro Area	0.0	0.0
Germany	0.5	1.7
France	0.0	0.4
Italy	-0.8	-1.4
United Kingdom	-0.3	-0.1
	IIQ2012/IQ2012	IIQ2012/IIQ2011
United States	QOQ: 0.3         SAAR: 1.3	2.1
Japan	QOQ: 0.1 SAAR: 0.3	3.3
China	1.8	7.6
Euro Area	-0.2	-0.4
Germany	0.3	0.5 1.0 CA
France	-0.1	0.1
Italy	-0.7	-2.4
United Kingdom	-0.4	-0.5
	IIIQ2012/ IIQ2012	IIIQ2012/ IIIQ2011
United States	QOQ: 0.5  SAAR: 2.0	2.3
Japan	QOQ: –0.9 SAAR: –3.5	0.1
China	2.2	7.4
Euro Area	-0.1	-0.6
Germany	0.2	0.4
France	0.2	0.2
Italy	-0.2	-2.4
United Kingdom	1.0	0.0

QOQ: Quarter relative to prior quarter; SAAR: seasonally adjusted annual rate

Source: Country Statistical Agencies

http://www.bea.gov/national/index.htm#gdp

I United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity. The Congressional Budget Office (CBO) provides historical data, analysis and projections of United States federal deficits and debt that are considered in this section. United States federal deficit and debt could be in an unsustainable path with adverse consequences for future economic performance of growth and employment that determine prosperity. There are also unpleasant threats of broad fiscal measures such as reductions in health benefits of Medicare, Medicaid and social security as well as major tax increases. There are no simple fixes for this complex fiscal imbalance with a multitude of alternative policies some of which may be unfeasible politically by repudiation of voters. Growth and employment effects of these policies individually or combined in subsets are almost impossible to quantify and analyze. The central issue is the tradeoff of fiscal tightening presently relative to fiscal tightening at a more difficult juncture in the future, which has been ignored in the past. There are two subsections below: IA United States Unsustainable Fiscal Deficit/Debt considers fiscal deficits and debt with the information, analysis and projections provided by the CBO; and IB Collapse of United States Dynamism of Income Growth and Employment Creation provides the dire economic/social environment of the unsustainable fiscal deficit/debt of the US.

IA United States Unsustainable Fiscal Deficit/Debt. Table I-1 of the CBO (2012NovMBR) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012. The deficit of $1.1 trillion in fiscal-year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR).

Table I-1, US, Budget Fiscal Year Totals, Billions of Dollars and % GDP

	2007	2008	2009	2010	2011	2012
Receipts	2568	2524	2105	2163	2302	2449
Outlays	2729	2983	3518	3456	3599	3538
Deficit	-161	-459	1413	1293	1297	1089
% GDP	-1.2	-3.2	-10.1	-9.0	-8.7	-7.0

Source: CBO (2012NovMBR).

Table I-1A provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into three parts: federal fiscal data for the years from 2009 to 2012; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2012. Total revenues of the US from 2009 to 2012 accumulate to $9019 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,111 billion, or $14.1 trillion, with the deficit accumulating to $5092 billion, or $5.1 trillion. Revenues decreased 6.6 percent from $9653 billion in the four years from 2005 to 2008 to $9019 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.2 percent on average in the cyclical expansion from IIIQ2009 to IIIQ2012, which is much lower than 6.2 percent on average in cyclical expansions since the 1950s (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Weakness of growth and employment creation is analyzed in the following Subsection IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 28.1 million people without jobs or underemployed that is equivalent to 17.4 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html ) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2012/11/recovery-without-hiring-united-states.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,111 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.6 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5092 billion in 2009-2012. Federal revenue was 15.4 percent of GDP on average in the years from 2009 to 2012, which is well below 18.0 percent of GDP on average from 1970 to 2010. Federal outlays were 24.1 percent of GDP on average from 2009 to 2012, which is well above 21.9 percent of GDP on average from 1970 to 2010. The lower part of Table I-1A shows that debt held by the public swelled from $5803 billion in 2008 to $11,280 billion in 2012, by $5477 billion or 94.3 percent. Debt held by the public as percent of GDP or economic activity jumped from 40.5 percent in 2008 to 72.6 percent in 2012, which is well above the average of 37.0 percent from 1970 to 2010. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table I-1A, US, Treasury Budget and Debt Held by the Public, Billions of Dollars and Percent of GDP 

	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
2012	2,449	3,538	-1,089
Fiscal Year 2011	2,302	3,599	-1,297
Fiscal Year 2010	2,163	3,456	-1,293
Fiscal Year 2009	2,105	3,518	-1,413
Total 2009-2012	9,019	14,111	-5,092
Average % GDP 2009-2012	15.4	24.1	-8.7
Fiscal Year 2008	2,524	2,983	-459
Fiscal Year 2007	2,568	2,729	-161
Fiscal Year 2006	2,407	2,655	-248
Fiscal Year 2005	2,154	2,472	-318
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.9	20.1	-2.2
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	36.9
2006	4,829	36.6
2007	5,035	36.3
2008	5,803	40.5
2009	7,545	54.1
2010	9,019	62.8
2011	10,128	67.7
2012	11,280	72.6

Source: http://www.fms.treas.gov/mts/index.html CBO (2012NovMBR). CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov.

Unusually low economic growth of average 2.2 percent of GDP in the current expansion compared with 6.2 percent in similar expansions in postwar economic cycles (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html) has had adverse impact on revenue generation. The impact of low growth on employment creation and labor market hiring is discussed in Subsection IB Collapse of United States Dynamism of Income Growth and Employment. Table I-2 provides total United States federal receipts from 2010 to 2012. Individual income taxes of $1132 billion, or $1.1 trillion, increased 25.9 percent from 2010 to 2012 and account for 46.2 percent of US total receipts in 2012. Total receipts stood at 15.8 percent of GDP in 2012, which is lower than 18 percent in the past 40 years (CBO 2012NovBMR).

Table I-2, United States, Total Receipts, Billions of Dollars and ∆%

Major Source	2010	2011	2012	∆% 2011-2012
Individual Income Taxes	899	1091	1132	3.7
Corporate Income Taxes	191	181	242	33.8
Social Insurance	865	819	845	3.2
Other	208	211	229	8.6
Total	2163	2302	2449	6.4
% of GDP	15.1	15.4	15.8	NA

Source: CBO (2012NovMBR).

Total outlays of the federal government of the United States have grown to extremely high levels. Table I-3 of the CBO (2012MBR) provides total outlays from 2010 to 2012. Total outlays of $3538 billion, or $3.5 trillion, are higher by $809 billion, or $0.8 trillion, relative to $2729 billion, or $2.7 trillion. Outlays have grown from 19.7 percent of GDP in 2007 to 22.8 percent of GDP in 2012. Outlays as percent of GDP were on average 21.9 percent from 1971 to 2010 and receipts as percent of GDP were on average 18.0 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Adjusted outlays in Table I-3 decreased 1.6 percent from 2011 to 2012 but mostly because of decline in defense-military expenditures by 2.9 percent, unemployment benefits by 24.0 percent and Medicaid by 8.9 percent. Much higher expenses of social security benefits increased 6.0 percent and Medicare increased 3.3 percent. There has been no meaningful constraint of spending.

Table I-3, United States, Total Outlays, Billions of Dollars and ∆%

Major Category	2010	2011	2012	∆% Actual 12/11	∆% Adj. 12/11
Defense-Military	667	678	651	-4.0	-2.9
Social Security Benefits	696	720	762	6.0	6.0
Medicare	450	483	469	-2.9	3.3
Medicaid	273	275	251	-8.9	-8.9
Unemployment Benefits	162	126	96	-24.0	-24.0
Other Activities	1048	1084	1022	-5.7	-3.4
Subtotal	3295	3366	3251	-3.4	-1.6
Net Interest on the Public Debt	228	266	258	-3.0	-3.0
TARP	-108	-3.8	24	NM	NM
Payments to GSE	40	5	5	-5.7	-5.7
Total	3456	3599	3538	-1.7	0.1
% of GDP	24.1	24.1	22.8	NA	NA

GSE: Government Sponsored Enterprises (Fannie Mae and Freddie Mac); Adj: Adjusted, excluding effects of payments shifts because of weekends or holidays and prepayment of deposit insurance premiums; NM: not meaningful

Source: CBO (2012NovMBR).

The US is facing a major fiscal challenge. Table I-4 provides federal revenues, expenditures, deficit and debt as percent of GDP and the yearly change in GDP in the eight decades from 1930 to 2011. The most recent period of debt exceeding 90 percent of GDP based on yearly observations in Table I-4 is between 1944 and 1948. The debt/GDP ratio actually rose to 106.2 percent of GDP in 1945 and to 108.7 percent of GDP in 1946. GDP fell 10.9 percent in 1946, which is only matched in Table I-4 by the decline of 13.1 percent in 1932. Part of the decline is explained by the bloated US economy during World War II, growing at 17.1 percent in 1941, 18.5 percent in 1942 and 16.4 percent in 1943. Expenditures as a share of GDP rose to their highest in the series: 43.6 percent in 1943, 43.6 percent in 1944 and 41.9 percent in 1945. The repetition of 43.6 percent in 1943 and 1944 is in the original source of Table I-4. During the Truman administration from Apr 1945 to Jan 1953, the federal debt held by the public fell systematically from the peak of 108.7 percent of GDP in 1946 to 61.6 percent of GDP in 1952. During the Eisenhower administration from Jan 1953 to Jan 1961, the federal debt held by the public fell from 58.6 percent of GDP in 1953 to 45.6 percent of GDP in 1960. The Truman and Eisenhower debt reductions were facilitated by diverse factors such as low interest rates, lower expenditure/GDP ratios that could be attained again after lowering war outlays and less rigid structure of mandatory expenditures than currently. There is no subsequent jump of debt as the one from 40.5 percent of GDP in 2008 to 67.7 percent of GDP in 2011 and projected by the Congressional Budget Office (CBO 2012AugBEO, CBO 2012NovCDR) at 72.6 percent in 2012.

Table I-4, United States Central Government Revenue, Expenditure, Deficit, Debt and GDP Growth 1930-2011

	Rev % GDP	Exp % GDP	Deficit % GDP	Debt % GDP	GDP ∆%
1930	4.2	3.4	0.8		-8.6
1931	3.7	4.3	-0.6		-6.5
1932	2.8	6.9	-4.0		-13.1
1933	3.5	8.0	-4.5		-1.3
1934	4.8	10.7	-5.9		10.9
1935	5.2	9.2	-4.0		8.9
1936	5.0	10.5	-5.5		13.1
1937	6.1	8.6	-2.5		5.1
1938	7.6	7.7	-0.1		-3.4
1939	7.1	10.3	-3.2		8.1
1940s
1940	6.8	9.8	-3.0	44.2	8.8
1941	7.6	12.0	-4.3	42.3	17.1
1942	10.1	24.3	-14.2	47.0	18.5
1943	13.3	43.6	-30.3	70.9	16.4
1944	20.9	43.6	-22.7	88.3	8.1
1945	20.4	41.9	-21.5	106.2	-1.1
1946	17.7	24.8	-7.2	108.7	-10.9
1947	16.5	14.8	1.7	96.2	-0.9
1948	16.2	11.6	4.6	84.3	4.4
1949	14.5	14.3	0.2	79.0	-0.5
1950s
1950	14.4	15.6	-1.1	80.2	8.7
1951	16.1	14.2	1.9	66.9	7.7
1952	19.0	19.4	-0.4	61.6	3.8
1953	18.7	20.4	-1.7	58.6	4.6
1954	18.5	18.8	-0.3	59.5	-0.6
1955	16.5	17.3	-0.8	57.2	7.2
1956	17.5	16.5	0.9	52.0	2.0
1957	17.7	17.0	0.8	48.6	2.0
1958	17.3	17.9	-0.6	49.2	-0.9
1959	16.2	18.8	-2.6	47.9	7.2
1960s
1960	17.8	17.8	0.1	45.6	2.5
1961	17.8	18.4	-0.6	45.0	2.3
1962	17.6	18.8	-1.3	43.7	6.1
1963	17.8	18.6	-0.8	42.4	4.4
1964	17.6	18.5	-0.9	40.0	5.8
1965	17.0	17.2	-0.2	37.9	6.4
1966	17.3	17.8	-0.5	34.9	6.5
1967	18.4	19.4	-1.1	32.9	2.5
1968	17.6	20.5	-2.9	33.9	4.8
1969	19.7	19.4	0.3	29.3	3.1
1970s
1970	19.0	19.3	-0.3	28.0	0.2
1971	17.3	19.5	-2.1	28.1	3.4
1972	17.6	19.6	-2.0	27.4	5.3
1973	17.6	18.7	-1.1	26.0	5.8
1974	18.3	18.7	-0.4	23.9	-0.6
1975	17.9	21.3	-3.4	25.3	0.2
1976	17.1	21.4	-4.2	27.5	5.4
1977	18.0	20.7	-2.7	27.8	4.6
1978	18.0	20.7	-2.7	27.4	5.6
1979	18.5	20.1	-1.6	25.6	3.1
1980s
1980	19.0	21.7	-2.7	26.1	-0.3
1981	19.6	22.2	-2.6	25.8	2.5
1982	19.2	23.1	-4.0	28.7	-1.9
1983	17.5	23.5	-6.0	33.1	4.5
1984	17.3	22.2	-4.8	34.0	7.2
1985	17.7	22.8	-5.1	36.4	4.1
1986	17.5	22.5	-5.0	39.5	3.5
1987	18.4	21.6	-3.2	40.6	3.2
1988	18.2	21.3	-3.1	41.0	4.1
1989	18.4	21.2	-2.8	40.6	3.6
1990s
1990	18.0	21.9	-3.9	42.1	1.9
1991	17.8	22.3	-4.5	45.3	-0.2
1992	17.5	22.1	-4.7	48.1	3.4
1993	17.5	21.4	-3.9	49.3	2.9
1994	18.0	21.0	-2.9	49.2	4.1
1995	18.4	20.6	-2.2	49.1	2.5
1996	18.8	20.2	-1.4	48.4	3.7
1997	19.2	19.5	-0.3	45.9	4.5
1998	19.9	19.1	0.8	43.0	4.4
1999	19.8	18.5	1.4	39.4	4.8
2000s
2000	20.6	18.2	2.4	34.7	4.1
2001	19.5	18.2	1.3	32.5	1.1
2002	17.6	19.1	-1.5	33.6	1.8
2003	16.2	19.7	-3.4	35.6	2.5
2004	16.1	19.6	-3.5	36.8	3.5
2005	17.3	19.9	-2.6	36.9	3.1
2006	18.2	20.1	-1.9	36.6	2.7
2007	18.5	19.7	-1.2	36.3	1.9
2008	17.6	20.8	-3.2	40.5	-0.3
2009	15.1	25.2	-10.1	54.1	-3.1
2010s
2010	15.1	24.1	-9.0	62.8	2.4
2011	15.4	24.1	-8.7	67.7	1.8

Sources:

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).

The capital budgeting decision of business requires the calculation of present value of projects. This calculation consists of a projection toward the horizon of planning of revenues net of costs, which are discounted to present value by the weighted average cost of capital. Business invests in the projects with highest net present value. The nonpartisan Congressional Budget Office (CBO) provides a similar service. Congress and the administration send budget proposals and legislation for evaluation by the CBO of their effects on federal government revenues, expenditures, deficit or surpluses and debt. The CBO does not provide its own policy proposals but analyzes alternative policies. The CBO uses state of the art knowledge but significant uncertainty remains because of the hurdle of projecting financial and economic variables to the future.

Table I-5 provides the latest exercise by the CBO (2012AugBEO, CBO2012NovCDR) of projecting the fiscal accounts of the US. Table I-5 extends data back to 1995 with the projections of the CBO from 2012 to 2022. Budget analysis in the US uses a ten-year horizon. The significant event in the data before 2011 is the budget surpluses from 1998 to 2001, from 0.8 percent of GDP in 1998 to 2.4 percent of GDP in 2000. Debt held by the public fell from 49.1 percent of GDP in 1995 to 32.5 percent of GDP in 2001.

Table I-5, US, CBO Baseline Budget Outlook 2012-2022

	Out $B	Out % GDP	Deficit $B	Deficit % GDP	Debt	Debt % GDP
1995	1,516	20.6	-164	-2.2	3,604	49.1
1996	1,560	20.2	-107	-1.4	3,734	48.4
1997	1,601	19.5	-22	-0.3	3,772	45.9
1998	1,652	19.1	+69	+0.8	3,721	43.0
1999	1,702	18.5	+126	+1.4	3,632	39.4
2000	1,789	18.2	+236	+2.4	3,410	34.7
2001	1,863	18.2	+128	+1.3	3,320	32.5
2002	2,011	19.1	-158	-1.5	3,540	33.6
2003	2,159	19.7	-378	-3.4	3,913	35.6
2004	2,293	19.6	-413	-3.5	4,295	36.8
2005	2,472	19.9	-318	-2.6	4,592	36.9
2006	2,655	20.1	-248	-1.9	4,829	36.6
2007	2,729	19.7	-161	-1.2	5,035	36.3
2008	2,983	20.8	-459	-3.2	5,803	40.5
2009	3,518	25.2	-1,413	-10.1	7,545	54.1
2010	3,456	24.1	-1,294	-9.0	9,019	62.8
2011	3,603	24.1	-1,300	-8.7	10,128	67.7
2012	3,563	22.8	-1,089	-7.0	11,280	72.6
2013	3,554	22.4	-641	-4.0	12,064	76.1
2014	3,595	21.9	-387	-2.4	12,545	76.6
2015	3,754	21.5	-213	-1.2	12,861	73.8
2016	4,003	21.6	-186	-1.0	13,144	70.8
2017	4,206	21.4	-123	-0.6	13,371	67.9
2018	4,407	21.2	-79	-0.4	13,536	65.2
2019	4,681	21.5	-130	-0.6	13,746	63.2
2020	4,932	21.7	-142	-0.6	13,964	61.4
2021	5,183	21.8	-144	-0.6	14,181	59.8
2022	5,509	22.3	-213	-0.9	14,464	58.5
2013 to 2017	19,111		-1,549		NA	NA
2013 to 2022	43,823	21.7	-2,258	-1.1	NA	NA

Note: Out = outlays

Source: CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov.

Chart I-1 shows the sharp impact of the 1946 contraction of 10.9 percent of GDP. Growth rebounded strongly, as in all postwar cyclical expansions, with growth of 8.7 percent in 1950, 7.7 percent in 1951, 3.8 percent in 1952 and 4.6 percent in 1953. The data in Charts I-1 and I-2 are changes in the level of real GDP in a year, which is different from the seasonally-adjusted quarterly annual equivalent rates (SAAR) (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html).

Chart I-1, Percentage Change of Real GDP 1945-2011

Source: Bureau of Economic Analysis, Department of Commerce

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

Yearly changes in Chart I-2 show vigorous recovery from the contractions of 1982, 1991 and 2001. Rapid growth recovered levels of employment prior to the contraction. The anemic recovery after IIQ2009 and the current standstill have not occurred in the US postwar economy.

Chart I-2, Percentage Change of Real GDP 1980-2011

Source: Bureau of Economic Analysis, Department of Commerce

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

Table I-6 provides baseline CBO projections of federal revenues, outlays, deficit and debt as percent of GDP. The adjustment depends on increasing revenues from 15.4 percent of GDP in 2011 to 21.4 percent of GDP in 2022, which is above the 40-year average of 18 percent of GDP while outlays fall only from 24.1 percent of GDP in 2011 to 22.3 percent of GDP in 2022. The last row of Table 1-6 provides the CBO estimates of averages for 1971 to 2010 of 18.0 percent for revenues/GDP, 21.9 percent for outlays/GDP and 37.0 percent for debt/GDP.

Table I-6, US, Baseline CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.7
2012	15.8	22.8	-7.0	72.6
2013	18.4	22.4	-4.0	76.1
2014	19.6	21.9	-2.4	76.6
2015	20.3	21.5	-1.2	73.8
2016	20.6	21.6	-1.0	70.8
2017	20.7	21.4	-0.6	67.9
2018	20.8	21.2	-0.4	65.2
2019	20.9	21.5	-0.6	63.2
2020	21.1	21.7	-0.6	61.4
2021	21.2	21.8	-0.6	59.8
2022	21.4	22.3	-0.9	58.5
Total 2013-2017	20.0	21.7	-1.8	NA
Total 2013-2022	20.6	21.7	-1.1	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR).

Consecutive deficits of more than one trillion dollars in the four years from 2009 to 2012, adding to $5 billion, resulted in an increase in debt held by the public from 40.5 percent of GDP in 2008 to projected 72.6 percent of GDP in 2012 in a debt explosion without parallel in data after World War II in Table I-4. An important part of the fiscal situation is the jump in federal government expenditures from $2,983 billion in 2008 to $3,518 billion in 2009, or 17.9 percent, equivalent to an increase of federal government expenditures from 20.8 percent of GDP in 2008 to 25.2 percent of GDP in 2009. The exercise by the CBO in Table I-5 is not able to reduce expenditures back to 20 percent, which is a financeable historical ceiling for the outlays/GDP ratio.

Chart I-3 of the Congressional Budget Office (CBO) shows total deficits or surpluses of the US from 2000 to 2022. There is a difficult climb from the record deficit of 10.1 percent of GDP in 2009 and cumulative deficit of $5092 billion in four consecutive years of deficits exceeding one trillion dollars from 2009 to 2012. The CBO projects a baseline scenario with faster and stronger adjustment and an alternative scenario with more delayed and less successful adjustment.

Chart I-3, US, Total Deficits or Surplus as Percent of GDP

Source: Congressional Budget Office

CBO (2012AugBEO).

http://www.cbo.gov/

The CBO (2012NovCDR, 4) uses different assumptions to calculate what would happen with the US budget and debt under an alternative fiscal scenario of no measures of fiscal tightening:

“The alternative fiscal scenario incorporates the assumptions that all expiring tax provisions (other than the payroll tax reduction), including those that expired at the end of December 2011, are instead extended; that the alternative minimum tax is indexed for inflation after 2011 (starting at the 2011 exemption amount); that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic enforcement procedures specified by the Budget Control Act of 2011 do not take effect. Outlays under that scenario also include the incremental interest costs associated with projected additional borrowing.”

Table I-7 provides the projections of the alternative fiscal scenario of the CBO under those assumptions. Debt as percent of GDP increases from 72.6 percent in 2012 to 89.7 percent in 2022.

Table I-7, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.7
2012	15.8	22.8	-7.0	72.6
2013	16.3	22.8	-6.5	78.6
2014	17.2	22.9	-5.6	82.3
2015	17.8	22.5	-4.6	82.5
2016	18.1	22.6	-4.5	82.5
2017	18.3	22.5	-4.2	82.5
2018	18.3	22.5	-4.2	82.9
2019	18.4	23.0	-4.6	84.1
2020	18.5	23.3	-4.8	85.7
2021	18.5	23.6	-5.1	87.5
2022	18.6	24.1	-5.5	89.7
Total 2013-2017	17.6	22.6	-5.0	NA
Total 2013-2022	18.1	23.0	-4.9	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR).

The CBO (2012AugBEO) projects economic variables shown in Table I-8 required for the fiscal projections. Real GDP growth is projected at 2.1 percent in 2012 and minus 0.5 percent in 2013, jumping to 4.3 percent on average from 2014 to 2017 and 2.4 percent from 2018 to 2022. The recession of 2012 with negative growth of 0.5 percent would occur from failure to extend tax reductions and prevent expenditure sequestration at the turn of 2013 or so-called “fiscal cliff”. It is not possible to forecast another downturn from 2013 to 2022 that could worsen further the US fiscal situation. The CBO projects subdued inflation but the rate of unemployment remains at high levels, declining to 5.4 percent by 2017, which is around the current measurement of the natural rate of unemployment. Interest rates are assumed to remain at relatively low levels but increase in the latter years of the projections. Different paths of economic variables would alter the projections of fiscal variables.

Table I-8, US, CBO Economic Projections for Calendar Years 2012 to 2022, ∆%

	2012 ∆%	2013 ∆%	2014-2017 Average ∆%	2018-2022 Average ∆%
Real GDP	2.1	-0.5	4.3	2.4
PCE Inflation	1.4	1.4	1.8	2.0
Core PCE Inflation	1.9	1.5	1.8	2.0
CPI Inflation	1.3	1.6	2.1	2.3
Core CPI Inflation	2.1	1.7	2.0	2.2
Unem- ployment Rate	8.2	8.8	7.3	5.4
3-Month Treasury Bill	0.1	0.1	1.3	3.7
10-Year treasury Note	1.8	1.8	3.4	5.0

Source: CBO (2012AugBEO).

Chart I-4 of the CBO (2012NovCDR) shows vividly the significant difference between the average budget segments for 1972-2011 and the projections of the alternative fiscal scenario. Outlays for social security and health programs would increase sharply as percent of GDP while other outlays would decline. Interest payments would also increase in proportion of GDP under the alternative fiscal scenario as do total outlays, total revenues and the deficit. The CBO (2012NovCDR) analyzes four types of adversities resulting from the alternative fiscal scenario: (1) increase in interest payments by the federal government; (2) lower national savings; (3) constraint of use of federal spending in facing national emergencies, financial crises and recessions, including unemployment insurance and Medicaid; and (4) higher probability of a point of explosion or disorderly correction with a risk premium on yields of US Treasury securities.

Chart I-4 CBO, Components of the Federal Budget in 2020 under the Alternative Fiscal Scenario, Compared with Their Averages since 1972

Source: CBO (2012CDR).

The major hurdle in adjusting the fiscal situation of the US is shown in Table I-9 in terms of the rigid structure of revenues that can be increased and outlays that can be reduced. There is no painless adjustment of a debt exceeding 70 percent of GDP. On the side of revenues, taxes provide 90.9 percent of revenue in 2011 and are projected to provide 92.2 percent in the total revenues from 2013 to 2022 in the CBO projections. Thus, revenue measures are a misleading term for what are actually tax increases. The choices are especially difficult because of the risks of balancing inequity and disincentives to economic activity. Individual income taxes are projected to increase from 47.4 percent of federal government revenues in 2011 to 51.4 percent in total revenues projected by the CBO from 2013 to 2022. There are equally difficult conflicts in what the government gives away in a rigid structure of expenditures. Mandatory expenditures account for 56.3 percent of federal government outlays in 2011 and are projected to increase to 62.4 percent of the total projected by the CBO for the years 2013 to 2022. The total of Social Security plus Medicare and Medicaid accounts for 43.4 percent of federal government outlays in 2011 and is projected to increase to 51.5 percent in the total for 2013 to 2022. The inflexibility of what to cut is more evident in the first to the last row of Table I-9 with the aggregate of defense plus Social Security plus Medicare plus Medicaid accounting for 62.7 percent of expenditures in 2011, rising to 66.6 percent of the total outlays projected by the CBO from 2013 to 2022. The cuts are in discretionary spending that declines from 37.4 percent of the total in 2011 to 28.9 percent of total outlays in the CBO projection for 2013 to 2022.

Table I-9, Structure of Federal Government Revenues and Outlays, $ Billions and Percent

	2011 $ Billions	% Total	Total 2013-2022 $ Billions	% Total
Revenues	2,303	100.00	41,565	100.00
Individual Income Taxes	1,091	47.4	21,379	51.4
Social Insurance Taxes	819	35.6	12,476	30.0
Corporate Income Taxes	181	7.9	4,477	10.8
Other	212	9.2	3,232	7.8
Outlays	3,603	100.00	43,823	100.0
Mandatory	2,027	56.3	27,324	62.4
Social Security	725	20.1	10,545	24.1
Medicare	560	15.5	7,722	17.6
Medicaid	275	7.6	4,291	9.8
SS + Medicare + Medicaid	1,560	43.3	22,558	51.5
Discre- tionary	1,346	37.4	12,664	28.9
Defense	700	19.4	6,726	15.4
Non- defense	646	17.9	5,370	12.3
Net Interest	230	6.4	3,835	8.8
Defense + SS + Medicare + Medicaid	2,260	62.7	29,284	66.8
MEMO: GDP	15,076		217,200

Source: CBO (2012JanBEO), CBO (2012AugBeo).

The CBO (2012NovCDR) focuses on adjustment by fiscal-year 2020. Major segments of the base projections of CBO to 2020 and the alternative fiscal scenario are shown in Table 1-10. The base projection has revenues as percent of GDP of 21.1 percent, higher than 18 percent historically on average from 1970 to 2010 compared with 18.5 percent in the fiscal scenario. The base scenario requires return of growth to trend or whereabouts together with the capacity to increase revenues above the 18.5 percent threshold. Most revenue components are similar under both scenarios with exception of individual income taxes that reach 11.2 percent of GDP in 2020 under the base projection while they reach only 9 percent under the alternative fiscal scenario. There is also significant difference in total outlays, reaching 21.7 percent of GDP under the base projection but increasing to 23.3 percent of GDP under the alternative fiscal scenario. Discretionary spending reaches 6.2 percent under the alternative fiscal scenario with increases in the share in GDP of both defense and nondefense components while net interest payments by the federal government are higher by 3.1 percent under the alternative fiscal scenario with much higher debt than 2.3 percent in the base projection. In mandatory spending, the difference is 3.3 percent in the base projection in Medicare with 3.5 percent in the alternative fiscal scenario. Under the base projection, the deficit would decline to $142 billion in 2020 or 0.6 percent of GDP while it would reach $1102 billion, or $1.1 trillion, in the alternative fiscal scenario for 4.8 percent of GDP. Debt held by the public at the end of the year, in the final row, would be $13,964 billion, or $13.9 trillion, in the base projection, for 61.4 percent of GDP, and $19,477 billion, or $19.5 trillion for 85.7 percent of GDP, under the alternative fiscal scenario.

The CBO (2012NovEEP) provides analysis of what would happen in two alternatives: (1) there is no extension of tax reductions and mandatory cuts; and (2) there is extension of some or all of the tax reductions and mandatory cuts. The CBO (2012NovEEP) actually identifies what will be a continuing tradeoff of short-term and long-term measures for the unsustainable fiscal situation of the United States.

The CBO (2012NovEEP) estimates that fiscal tightening from failure to extend tax rates and mandatory spending would cause: decline of inflation-adjusted or real GDP by 0.5 percent from IVQ2012 to IVQ2013 and increase of the rate of unemployment to 9.1 percent by IVQ2013. Growth would increase after 2013 with return to potential output and unemployment rate of 5.5 percent in 2018.

The CBO (2012NovEEP) estimates that growth will continue to be weak and unemployment high even if there were removal of all or a large part of fiscal tightening by not extending some or all tax rates and preventing mandatory cuts in spending. The future would be troubled according to the CBO (2012NovEEP, 1):

“Moreover, if the fiscal tightening was removed and the policies that are currently in effect were kept in place indefinitely, a continued surge in federal debt during the rest of this decade and beyond would raise the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates) and would eventually reduce the nation’s output and income below what would occur if the fiscal tightening was allowed to take place as currently set by law.”

The CBO (2012NovEEP, 7) estimates that the non-extension of lower tax rates on income above certain thresholds would result in revenue effect of $38 billion in 2014, which hardly has an effect on budget deficits of trillion dollars. Elimination of deductions is the same as tax increases. There are no easy fixes for the fiscal situation of the United States and tough tradeoffs between the present and the future in a multitude of combinations of alternative policies with effects on growth and employment that are quite difficult to calculate.

Table I-10, CBO Budget Projections for 2020 Baseline and Alternative Fiscal Scenario, Billions of Dollars and % of GDP

	$ B Base 2020	% GDP Base 2020	$B Alt 2020	% GDP Alt 2020
Revenues	4,790	21.1	4,196	18.5
Individual Income Taxes	2,542	11.2	2,055	9.0
Social Insurance Taxes	1,412	6.2	1,412	6.2
Corporate Income Taxes	473	2.1	424	1.9
Other	363	1.6	305	1.3
Total Outlays	4,932	21.7	5,298	23.3
Mandatory Spending	3,104	13.7	3,190	14.0
Social Security	1,202	5.3	1,202	5.3
Medicare	750	3.3	793	3.5
Medicaid	514	2.3	514	2.3
Other Major Health Care Programs	117	0.5	117	0.5
Other Mandatory Spending	523	2.3	566	2.5
Discretionary Spending	1,316	5.8	1,403	6.2
Defense	696	3.1	750	3.3
Nondefense	620	2.7	653	2.9
Net Interest	512	2.3	704	3.1
Deficit	-142	-0.6	-1,102	-4.8
Debt Held by the Public at the End of the Year	13,964	61.4	19,477	85.7

Source: CBO (2012NovCDR).

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 seignorage, requiring the creation of additional base money.”

The alternative fiscal scenario of the CBO (2012NovCDR) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

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 I-11 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 2012NovCDR) estimates the federal deficit in 2012 at $1089 billion or 7.7 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 $5092 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). The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5092 trillion in four years, using the fiscal year deficit of $1089.4 billion for fiscal year 2012 (http://www.fms.treas.gov/mts/mts0912.txt), which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5092 billion. Federal debt in 2011 was 67.7 percent of GDP and is estimated to reach 72.6 percent of GDP in 2012 (CBO2012AugBEO, CBO2012NovCDR). 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 I-11, 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	-1297
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	2302
∆%	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

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

The United States finances its trade and fiscal deficits with foreign savings. Table I-12 provides major foreign holders of Treasury securities. Total foreign holdings of US debt reached $5455 billion in Sep 2012, increasing 11.1 percent from $4908.3 billion in Sep 2011. A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt.

Table I-12, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Sep 2012	Aug 2012	Sep 2011
Total	5455.0	5448.8	4908.3
China	1155.5	1155.2	1270.2
Japan	1130.7	1122.8	983.9
Oil Exporters	267.0	269.1	252.1
Brazil	250.5	259.8	226.4
Caribbean Banking Centers	240.4	263.9	209.7
Taiwan	200.4	199.5	166.6
Switzerland	195.8	191.7	158.2
Russia	162.8	162.9	149.9
Luxembourg	148.1	139.3	127.9
Hong Kong	135.7	141.7	111.6
Belgium	133.7	130.2	132.1
United Kingdom	132.1	137.1	116.9
Foreign Official Holdings	3968.7	3957.0	3619.5
A. Treasury Bills	383.8	373.0	387.3
B. Treasury Bonds and Notes	3584.9	3584.0	3232.2

Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticsec2.aspx#ussecs

http://www.meti.go.jp/english/statistics/index.html

Unconventional monetary policy could accentuate the frustration of prosperity caused by unsustainable deficit/debt in the United States. 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→∞. The rise of risk premium on yields of Treasury securities would coincide with zero interest rates. If interest rates are expected to increase, r → ∞, W, or wealth, declines, W → 0. The combination of zero interest rates of unconventional monetary policy with unsustainable deficit/debt in the United States could be a toxic cocktail.

IB Collapse of United States Dynamism of Income Growth and Employment Creation. 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 IB-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 13 quarters of the current cyclical expansion from IIIQ2009 to IIIQ2012, GDP increased 7.2 percent at the annual equivalent rate of 2.2 percent. In the 12 quarters of cyclical expansion real disposable personal income (RDPI) increased 5.7 percent at the annual equivalent rate of 1.7 percent; RDPI per capita increased 3.3 percent at the annual equivalent rate of 1.0 percent; and population increased 2.3 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IIIQ2012, GDP increased 2.2 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IIIQ2012, real disposable personal income increased 3.7 percent at the annual equivalent rate of 0.7 percent; population increased 3.9 percent at the annual equivalent rate of 0.8 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. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table IB-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 IIIQ2012	13
GDP		7.2	2.2
RDPI		5.7	1.7
RDPI per Capita		3.3	1.0
Population		2.3	0.7
IVQ2007 to IIIQ2012	20
GDP		2.2	0.4
RDPI		3.7	0.7
RDPI per Capita		-0.2
Population		3.9	0.8

RDPI: Real Disposable Personal Income

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

There are six basic facts illustrating the current economic disaster of the United States: (1) 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; (2) per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIQ2012; (3) the number of employed persons increased in the 1980s but declined into IIQ2012; (4) the number of full-time employed persons increased in the 1980s but declined into IIQ2012; (5) the number unemployed, unemployment rate and number employed part-time for economic reasons fell in the recovery from the recessions of the 1980s but not substantially in the recovery after IIQ2009; and (6) 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 IB-2 provides data for analysis of these five basic facts. The six blocks of Table IB-2 are separated initially after individual discussion of each one followed by the full Table IB-2.

1. Trend Growth.

i. As shown in Table IB-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 IIIQ2012 was 2.2 percent while trend growth would have been 15.1 percent. GDP in IIIQ2012 at seasonally adjusted annual rate is estimated at $13,616.2 percent by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,338.2 billion, or $1,722 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 IIIQ2012 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.1 million people or 17.4 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html) that will not be significantly 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 (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-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 IIIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIIQ2012	13,616.2
∆% IVQ2007 to IIIQ2012 Actual	2.2
∆% IVQ2007 to IIIQ2012 Trend	15.1

2. Decline of Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IVQ1985, as shown in Table IB-2 trend growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 14.5 percent, which is close to what would have been trend growth of 12.1 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IIIQ2012, per capita real disposable income fell 0.2 percent while trend growth would have been 10.4 percent. Income available after inflation and taxes is lower than before the contraction after 13 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 IIIQ2012

Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIIQ2012	-0.2
∆% Trend Growth	10.4

3. Number of Employed Persons

i. As shown in Table IB-2, the number of employed persons increased over the entire business cycle from 98.527 million not seasonally adjusted (NSA) in IQ1980 to 107.819 million NSA in IVQ1985 or by 9.4 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 143.202 million in IIIQ2012 or by 2.1 percent. There are 28.1 million persons unemployed or underemployed, which is 17.4 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-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 IIIQ2012

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2012 NSA End of Quarter	143.333
∆% Employed IVQ2007 to IIIQ2012	-2.1

4. Number of Full-Time Employed Persons

i. As shown in Table IB-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 115.678 million in IIIQ2012 or by minus 4.4 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 IIIQ2012

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2012 NSA End of Quarter	115.678
∆% Full-time Employed IVQ2007 to IIIQ2012	-4.4

5. Unemployed, Unemployment Rate and Employed Part-time for Economic Reasons.

i. As shown in Table IB-2 and in the following block, in the cycle from IQ1980 to IVQ1985: (a) the rate of unemployment was virtually the same at 6.7 percent in IQ1985 relative to 6.6 percent in IQ1980; (b) the number unemployed increased from 6.983 million in IQ1980 to 7.717 million in IVQ1985 or 10.5 percent; and (c) the number employed part-time for economic reasons increased 49.1 percent from 3.624 million in IQ1980 to 5.402 million in IVQ1985.

ii. In contrast, in the economic cycle from IVQ2007 to IIIQ2012: (a) the rate of unemployment increased from 4.8 percent in IVQ2007 to 7.6 percent in IIIQ2012; (b) the number unemployed increased 59.3 percent from 7.371 million in IVQ2007 to 11.742 million in IIIQ2012; (c) the number employed part-time for economic reasons increased 70.7 percent from 4.750 million in IVQ2007 to 8.110 million in IIIQ2012; and (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 14.2 percent in IIIQ2012.

Period IQ1980 to IVQ1985

Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IV1985 NSA End of Quarter	6.7
Unemployed IQ1980 Millions End of Quarter	6.983
Unemployed IV 1985 Millions End of Quarter	7.717
Employed Part-time Economic Reasons Millions IQ1980 End of Quarter	3.624
Employed Part-time Economic Reasons Millions IVQ1985 End of Quarter	5.402
∆%	49.1

Period IVQ2007 to IIIQ2012

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIIQ2009 Millions End of Quarter	11.742
∆%	59.3
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2009 End of Quarter	8.110
∆%	70.7
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2012	14.2

6. 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 IB-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 IB-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 http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.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 IB-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
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IV1985 NSA End of Quarter	6.7
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IV 1985 Millions NSA End of Quarter	7.717
∆%	11.9
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2009 NSA End of Quarter	8.394
∆%	76.7
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 IIIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIIQ2012	13,616.2
∆% IVQ2007 to IIIQ2012	2.2
∆% IVQ2007 to IIIQ2012 Trend Growth	15.1
Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIIQ2012	-0.2
∆% Trend Growth	10.4
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2012 NSA End of Quarter	143.333
∆% Employed IVQ2007 to IIIQ2012	-2.1
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2012 NSA End of Quarter	115.678
∆% Full-time Employed IVQ2007 to IIIQ2012	-4.4
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIIQ2009 Millions NSA End of Quarter	11.742
∆%	59.3
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2009 NSA End of Quarter	8.110
∆%	70.7
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2012	14.2
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.

II World Inflation Waves. This section provides analysis and data on world inflation waves. IIA Appendix: Transmission of Unconventional Monetary Policy provides more technical analysis. Section IIB United States Inflation analyzes inflation in the United States in two subsections: IIC Long-term US Inflation and IID Current US Inflation.

The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, unconventional monetary policy also includes a battery of measures to also reduce long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

When inflation is low, the central bank lowers interest rates to stimulate aggregate demand in the economy, which consists of consumption and investment. When inflation is subdued and unemployment high, monetary policy would lower interest rates to stimulate aggregate demand, reducing unemployment. When interest rates decline to zero, unconventional monetary policy would consist of policies such as large-scale purchases of long-term securities to lower their yields. A major portion of credit in the economy is financed with long-term asset-backed securities. Loans for purchasing houses, automobiles and other consumer products are bundled in securities that in turn are sold to investors. Corporations borrow funds for investment by issuing corporate bonds. Loans to small businesses are also financed by bundling them in long-term bonds. Securities markets bridge the needs of higher returns by savers obtaining funds from investors that are channeled to consumers and business for consumption and investment. Lowering the yields of these long-term bonds could lower costs of financing purchases of consumer durables and investment by business. The essential mechanism of transmission from lower interest rates to increases in aggregate demand is portfolio rebalancing. Withdrawal of bonds in a specific maturity segment or directly in a bond category such as currently mortgage-backed securities causes reductions in yield that are equivalent to increases in the prices of the bonds. There can be secondary increases in purchases of those bonds in private portfolios in pursuit of their increasing prices. Lower yields translate into lower costs of buying homes and consumer durables such as automobiles and also lower costs of investment for business. There are two additional intended routes of transmission.

1. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.

2. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial instability. During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets. More technical discussion is in IIA Appendix: Transmission of Unconventional Monetary Policy.

Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output. Monetary easing by unconventional measures is now open ended in perpetuity, or QE∞, 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 concern of the production and employment costs of controlling future inflation. Even if there is no inflation QE∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.

Table IIA-1 provides annual equivalent rates of inflation for producer price indexes followed in this blog of countries and regions that account for close to three quarters of world output. The behavior of the US producer price index in 2011 and into 2012 shows neatly multiple waves. (1) In Jan-Apr 2011, without risk aversion, US producer prices rose at the annual equivalent rate of 9.7 percent. (2) After risk aversion, producer prices increased in the US at the annual equivalent rate of 1.2 percent in May-Jun 2011. (3) From Jul to Sep 2011, under alternating episodes of risk aversion, producer prices increased at the annual equivalent rate of 6.6 percent. (4) Under the pressure of risk aversion because of the European debt crisis US producer prices fell at the annual equivalent rate of minus 1.2 percent in Oct-Nov 2011. (5) From Dec 2011 to Jan 2012, US producer prices rose at the annual equivalent rate of 1.2 percent with relaxed risk aversion and commodity-price increases at the margin. (6) Inflation of producer prices returned with 1.2 percent annual equivalent in Feb-Mar 2012. (7) With return of risk aversion from the European debt crisis, producer prices fell at the annual equivalent rate of 7.5 percent in Apr-Jun 2012. (8) New positions in commodity futures even with continuing risk aversion caused annual equivalent inflation of 3.0 percent in Jun-Jul 2012. (9) Relaxed risk aversion because of announcement of sovereign bond-buying by the European Central Bank caused relaxed risk aversion inducing carry trades that resulted in annual equivalent producer price inflation in the US of 18.2 percent in Aug-Sep 2012. (10) Renewed risk aversion caused unwinding of carry trades of zero interest rates to commodity futures exposures with annual equivalent inflation of minus 2.4 percent in Oct 2012. Resolution of the European debt crisis if there is not an unfavorable growth event with political development in China would result in jumps of valuations of risk financial assets. Increases in commodity prices would cause the same high producer price inflation experienced in Jan-Apr 2011 and Aug-Sep 2012. An episode of exploding commodity prices could ignite inflationary expectations that would result in an inflation phenomenon of costly resolution. There are nine producer-price indexes in Table IIA-1 for seven countries (two for the UK) and one region (euro area) showing very similar behavior. Zero interest rates without risk aversion cause increases in commodity prices that in turn increase input and output prices. Producer price inflation rose at very high rates during the first part of 2011 for the US, Japan, China, Euro Area, Germany, France, Italy and the UK when risk aversion was contained. With the increase in risk aversion in May and Jun 2011, inflation moderated because carry trades were unwound. Producer price inflation returned after July 2011, with alternating bouts of risk aversion. In the final months of the year producer price inflation collapsed because of the disincentive to exposures in commodity futures resulting from fears of resolution of the European debt crisis. There is renewed worldwide inflation in the early part of 2012 with subsequent collapse because of another round of sharp risk aversion. Sharp worldwide jump in producer prices occurred recently as a result of the combination of zero interest rates forever or QE∞ with temporarily relaxed risk aversion. Producer prices are moderating or falling currently because of renewed risk aversion that causes unwinding of carry trades from zero interest rates to commodity futures exposures. Unconventional monetary policy fails in stimulating the overall real economy, merely introducing undesirable instability as monetary authorities cannot control allocation of floods of money at zero interest rates to carry trades into risk financial assets. The economy is constrained in a suboptimal allocation of resources that is perpetuated along a continuum of short-term periods results in long-term or dynamic inefficiency in the form of a trajectory of economic activity that is lower than what would be attained with rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).

Table IIA-1, Annual Equivalent Rates of Producer Price Indexes

INDEX 2011-2012	AE ∆%
US Producer Price Index
AE  ∆% Oct	-2.4
AE  ∆% Aug-Sep 2012	18.2
AE  ∆% Jun-Jul 2012	3.0
AE  ∆% Apr-May 2012	-7.5
AE  ∆% Feb-Mar 2012	1.2
AE  ∆% Dec 2011-Jan-2012	1.2
AE  ∆% Oct-Nov 2011	-1.2
AE ∆% Jul-Sep 2011	6.6
AE ∆% May-Jun 2011	1.2
AE ∆% Jan-Apr 2011	9.7
Japan Corporate Goods Price Index
AE ∆% Oct	-3.5
AE ∆% Aug-Sep 2012	2.4
AE ∆%  May-Jul 2012	-5.8
AE ∆%  Feb-Apr 2012	2.4
AE ∆% Dec 2011-Jan 2012	-0.6
AE ∆% Jul-Nov 2011	-2.2
AE ∆% May-Jun 2011	-1.2
AE ∆% Jan-Apr 2011	5.9
China Producer Price Index
AE ∆% Oct	2.4
AE ∆% May-Sep 2012	-5.8
AE ∆% Feb-Apr 2012	2.4
AE ∆% Dec 2011-Jan 2012	-2.4
AE ∆% Jul-Nov 2011	-3.1
AE ∆% Jan-Jun 2011	6.4
Euro Zone Industrial Producer Prices
AE ∆% Jul-Sep 2012	5.7
AE ∆% Apr-Jun 2012	-3.9
AE ∆% Jan-Mar 2012	8.3
AE ∆% Oct-Dec 2011	0.8
AE ∆% Jul-Sep	2.0
AE ∆% May-Jun	-1.2
AE ∆% Jan-Apr	12.0
Germany Producer Price Index
AE ∆% Aug-Sep 2012	4.9 NSA 5.5 SA
AE ∆% May-Jul 2012	-2.8 NSA –0.8 SA
AE ∆% Feb-Apr 2012	4.9 NSA 1.2 SA
AE ∆% Dec 2011-Jan 2012	1.2 NSA –0.6 SA
AE ∆% Oct-Nov 2011	1.8 NSA 3.7 SA
AE ∆% Jul-Sep 2011	2.8 NSA 3.7 SA
AE ∆% May-Jun 2011	0.6 NSA 3.7 SA
AE ∆% Jan-Apr 2011	10.4 NSA 6.2 SA
France Producer Price Index for the French Market
AE ∆% Jul-Sep 2012	9.2
AE ∆% Apr-Jun 2012	-7.7
AE ∆% Jan-Mar 2012	8.3
AE ∆% Oct-Dec 2011	2.4
AE ∆% Jul-Sep 2011	2.8
AE ∆% May-Jun 2011	-3.5
AE ∆% Jan-Apr 2011	11.7
Italy Producer Price Index
AE ∆% Jul –Sep 2012	4.1
AE ∆% May-Jun 2012	-2.4
AE ∆% Mar-Apr 2012	4.3
AE ∆% Jan-Feb 2012	7.4
AE ∆% Oct-Dec 2011	0.4
AE ∆% Jul-Sep 2011	2.4
AE ∆% May-Jun 2011	-1.2
AE ∆% Jan-April 2011	10.7
UK Output Prices
AE ∆% Jul-Oct	3.7
AE ∆% May-Jun 2012	-5.3
AE ∆% Feb-Apr 2012	7.9
AE ∆% Nov 2011-Jan-2012	1.6
AE ∆% May-Oct 2011	2.0
AE ∆% Jan-Apr 2011	12.0
UK Input Prices
AE ∆% Jul-Oct 2012	7.7
AE ∆% Apr-Jun 2012	-21.9
AE ∆% Jan-Mar 2012	18.1
AE ∆% Nov-Dec 2011	-1.2
AE ∆% May-Oct 2011	-3.1
AE ∆% Jan-Apr 2011	35.6

AE: Annual Equivalent

Sources:

http://www.bls.gov/ppi/

http://www.boj.or.jp/en/

http://www.stats.gov.cn/enGliSH/

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

http://www.istat.it/en/

http://www.ons.gov.uk/ons/index.html

Similar world inflation waves are in the behavior of consumer price indexes of six countries and the euro zone in Table IIA-2. US consumer price inflation shows similar waves. (1) Under risk appetite in Jan-Apr 2011 consumer prices increased at the annual equivalent rate of 4.9 percent. (2) Risk aversion caused the collapse of inflation to annual equivalent 2.8 percent in May-Jul 2011. (3) Risk appetite drove the rate of consumer price inflation in the US to 3.7 percent in Jul-Sep 2011. (4) Gloomier views of carry trades caused the collapse of inflation in Oct-Nov 2011 to annual equivalent 0.6 percent. (5) Consumer price inflation resuscitated with increased risk appetite at annual equivalent of 1.2 percent in Dec 2011 to Jan 2012. (6) Consumer price inflation returned at 2.8 percent annual equivalent in Feb-Apr 2012. (7) Under renewed risk aversion, annual equivalent consumer price inflation in the US is minus 1.2 percent in May-Jul 2012. (8) Inflation jumped to annual equivalent 7.4 percent in Aug-Sep 2012 and 5.3 percent in Aug-Oct 2012. Inflationary expectations can be triggered in one of these episodes of rapidly inflation because of commodity carry trades induced by unconventional monetary policy of zero interest rates in perpetuity or QE∞. Alternating episodes of increase and decrease of inflation introduce uncertainty in household planning that frustrates consumption and home buying. Announcement of purchases of impaired sovereign bonds by the European Central Bank relaxed risk aversion that induced carry trades into commodity exposures, increasing prices of food, raw materials and energy. There is similar behavior in all the other consumer price indexes in Table I-2. China’s CPI increased at annual equivalent 8.3 percent in Jan-Mar 2011, 2.0 percent in Apr-Jun, 2.9 percent in Jul-Dec and resuscitated at 5.8 percent annual equivalent in Dec 2011 to Mar 2012, declining to minus 3.9 percent in Apr-Jun 2012 but resuscitating at 4.1 percent in Jul-Sep 2012, declining to minus 1.2 percent in Oct 2012. The euro zone harmonized index of consumer prices (HICP) increased at annual equivalent 5.2 percent in Jan-Apr 2011, minus 2.4 percent in May-Jul 2011, 4.3 percent in Aug-Dec 2011, minus 3.0 percent in Dec 2011-Jan 2012 and then 9.6 percent in Feb-Apr 2012, falling to minus 2.8 percent annual equivalent in May-Jul 2012 but resuscitating at 5.3 percent in Aug-Oct 2012. The price indexes of the largest members of the euro zone, Germany, France and Italy, and the euro zone as a whole, exhibit the same inflation waves. The United Kingdom CPI increased at annual equivalent 6.5 percent in Jan-Apr 2011, falling to only 0.4 percent in May-Jul 2011 and then increasing at 4.6 percent in Aug-Nov 2011. UK consumer prices fell at 0.6 percent annual equivalent in Dec 2011 to Jan 2012 but increased at 6.2 percent annual equivalent from Feb to Apr 2012. In May-Jun 2012, with renewed risk aversion, UK consumer prices fell at the annual equivalent rate of minus 3.0 percent. Inflation returned in the UK at average annual equivalent of 4.6 percent in Jul-Oct 2012 with inflation in Oct 2012 caused mostly by increases of university tuition fees. Inflation returned at 4.1 percent annual equivalent in Jul-Sep 2012 and was higher in annual equivalent producer price inflation in the UK in Jul-Oct 2012 at 3.7 percent for output prices and 7.7 percent for input prices (see Table IIA-1).

Table IIA-2, Annual Equivalent Rates of Consumer Price Indexes

Index 2011-2012	AE ∆%
US Consumer Price Index
AE ∆% Aug-Oct 2012	5.3
AE ∆% May-Jul 2012	-1.2
AE ∆% Feb-Apr 2012	2.8
AE ∆% Dec 2011-Jan  2012	1.2
AE ∆% Oct-Nov 2011	0.6
AE ∆% Jul-Sep 2011	3.7
AE ∆% May-Jul 2011	2.8
AE ∆% Jan-Apr 2011	4.9
China Consumer Price Index
AE ∆% Oct	-1.2
AE ∆% Jul-Sep	4.1
AE ∆% Apr-Jun 2012	-3.9
AE ∆% Dec 2011-Mar 2012	5.8
AE ∆% Jul-Nov 2011	2.9
AE ∆% Apr-Jun 2011	2.0
AE ∆% Jan-Mar 2011	8.3
Euro Zone Harmonized Index of Consumer Prices
AE ∆% Aug-Oct 2012	5.3
AE ∆% May-Jul 2012	-2.8
AE ∆% Feb-Apr 2012	9.6
AE ∆% Dec 2011-Jan 2012	-3.0
AE ∆% Aug-Nov 2011	4.3
AE ∆% May-Jul 2011	-2.4
AE ∆% Jan-Apr 2011	5.2
Germany Consumer Price Index
AE ∆% Sep-Oct 2012	0.0 NSA 1.2 SA
AE ∆% Jul-Aug 2012	4.9 NSA 3.7 SA
AE ∆% May-Jun 2012	-1.8 NSA  1.2 SA
AE ∆% Feb-Apr 2012	4.9 NSA 2.4 SA
AE ∆% Dec 2011-Jan 2012	1.8 NSA 1.8 SA
AE ∆% Jul-Nov 2011	1.2 NSA 1.9 SA
AE ∆% May-Jun 2011	0.6 NSA 2.4 SA
AE ∆% Feb-Apr 2011	4.9 NSA 2.4 SA
France Consumer Price Index
AE ∆% Aug-Oct 2012	2.4
AE ∆% May-Jul 2012	-2.0
AE ∆% Feb-Apr 2012	5.3
AE ∆% Dec 2011-Jan 2012	0.0
AE ∆% Aug-Nov 2011	2.7
AE ∆% May-Jul 2011	-0.8
AE ∆% Jan-Apr 2011	4.3
Italy Consumer Price Index
AE ∆% Sep-Oct 2012	0.0
AE ∆% Jul-Aug 2012	3.0
AE ∆% May-Jun 2012	1.2
AE ∆% Feb-Apr 2012	5.7
AE ∆% Dec 2011-Jan 2012	4.3
AE ∆% Oct-Nov 2011	3.0
AE ∆% Jul-Sep 2011	2.4
AE ∆% May-Jun 2011	1.2
AE ∆% Jan-Apr 2011	4.9
UK Consumer Price Index
AE ∆% Jul-Oct 2012	4.6
AE ∆% May-Jun 2012	-3.0
AE ∆% Feb-Apr 2012	6.2
AE ∆% Dec 2011-Jan 2012	-0.6
AE ∆% Aug-Nov 2011	4.6
AE ∆% May-Jul 2011	0.4
AE ∆% Jan-Apr 2011	6.5

AE: Annual Equivalent

Sources:

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

http://www.stats.gov.cn/enGliSH/

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

https://www.destatis.de/EN/Homepage.html

http://www.insee.fr/en/default.asp

http://www.istat.it/en/

http://www.ons.gov.uk/ons/index.html

IIA Appendix: Transmission of Unconventional Monetary Policy. Janet L. Yellen, Vice Chair of the Board of Governors of the Federal Reserve System, provides analysis of the policy of purchasing large amounts of long-term securities for the Fed’s balance sheet. The new analysis provides three channels of transmission of quantitative easing to the ultimate objectives of increasing growth and employment and increasing inflation to “levels of 2 percent or a bit less that most Committee participants judge to be consistent, over the long run, with the FOMC’s dual mandate” (Yellen 2011AS, 4, 7):

“There are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boost household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”

The new analysis by Yellen (2011AS) is considered below in four separate subsections: IIA1 Theory; IIA2 Policy; IIA3 Evidence; and IIA4 Unwinding Strategy.

IIA1 Theory. The transmission mechanism of quantitative easing can be analyzed in three different forms. (1) Portfolio choice theory. General equilibrium value theory was proposed by Hicks (1935) in analyzing the balance sheets of individuals and institutions with assets in the capital segment consisting of money, debts, stocks and productive equipment. Net worth or wealth would be comparable to income in value theory. Expected yield and risk would be the constraint comparable to income in value theory. Markowitz (1952) considers a portfolio of individual securities with mean μ_p and variance σ_p. The Markowitz (1952, 82) rule states that “investors would (or should” want to choose a portfolio of combinations of (μ_p, σ_p) that are efficient, which are those with minimum variance or risk for given expected return μ_p or more and maximum expected μ_p for given variance or risk or less. The more complete model of Tobin (1958) consists of portfolio choice of monetary assets by maximizing a utility function subject to a budget constraint. Tobin (1961, 28) proposes general equilibrium analysis of the capital account to derive choices of capital assets in balance sheets of economic units with the determination of yields in markets for capital assets with the constraint of net worth. A general equilibrium model of choice of portfolios was developed simultaneously by various authors (Hicks 1962; Treynor 1962; Sharpe 1964; Lintner 1965; Mossin 1966). If shocks such as by quantitative easing displace investors from the efficient frontier, there would be reallocations of portfolios among assets until another efficient point is reached. Investors would bid up the prices or lower the returns (interest plus capital gains) of long-term assets targeted by quantitative easing, causing the desired effect of lowering long-term costs of investment and consumption.

(2) General Equilibrium Theory. Bernanke and Reinhart (2004, 88) argue that “the possibility monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (James Tobin 1969) and monetarists (Karl Brunner and Allan Meltzer 1973).” Andres et al. (2004) explain the Tobin (1969) contribution by optimizing agents in a general-equilibrium model. Both Tobin (1969) and Brunner and Meltzer (1973) consider capital assets to be gross instead of perfect substitutes with positive partial derivatives of own rates of return and negative partial derivatives of cross rates in the vector of asset returns (interest plus principal gain or loss) as argument in portfolio balancing equations (see Pelaez and Suzigan 1978, 113-23). Tobin (1969, 26) explains portfolio substitution after monetary policy:

“When the supply of any asset is increased, the structure of rates of return, on this and other assets, must change in a way that induces the public to hold the new supply. When the asset’s own rate can rise, a large part of the necessary adjustment can occur in this way. But if the rate is fixed, the whole adjustment must take place through reductions in other rates or increases in prices of other assets. This is the secret of the special role of money; it is a secret that would be shared by any other asset with a fixed interest rate.”

Andrés et al. (2004, 682) find that in their multiple-channels model “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rates spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied.”

The interrelation among yields of default-free securities is measured by the term structure of interest rates. This schedule of interest rates along time incorporates expectations of investors. (Cox, Ingersoll and Ross 1985). The expectations hypothesis postulates that the expectations of investors about the level of future spot rates influence the level of current long-term rates. The normal channel of transmission of monetary policy in a recession is to lower the target of the fed funds rate that will lower future spot rates through the term structure and also the yields of long-term securities. The expectations hypothesis is consistent with term premiums (Cox, Ingersoll and Ross 1981, 774-7) such as liquidity to compensate for risk or uncertainty about future events that can cause changes in prices or yields of long-term securities (Hicks 1935; see Cox, Ingersoll and Ross 1981, 784; Chung et al. 2011, 22).

(3) Preferred Habitat. Another approach is by the preferred-habitat models proposed by Culbertson (1957, 1963) and Modigliani and Sutch (1966). This approach is formalized by Vayanos and Vila (2009). The model considers investors or “clientele” who do not abandon their segment of operations unless there are extremely high potential returns and arbitrageurs who take positions to profit from discrepancies. Pension funds matching benefit liabilities would operate in segments above 15 years; life insurance companies operate around 15 years or more; and asset managers and bank treasury managers are active in maturities of less than 10 years (Ibid, 1). Hedge funds, proprietary trading desks and bank maturity transformation activities are examples of potential arbitrageurs. The role of arbitrageurs is to incorporate “information about current and future short rates into bond prices” (Ibid, 12). Suppose monetary policy raises the short-term rate above a certain level. Clientele would not trade on this information, but arbitrageurs would engage in carry trade, shorting bonds and investing at the short-term rate, in a “roll-up” trade, resulting in decline of bond prices or equivalently increases in yields. This is a situation of an upward-sloping yield curve. If the short-term rate were lowered, arbitrageurs would engage in carry trade borrowing at the short-term rate and going long bonds, resulting in an increase in bond prices or equivalently decline in yields, or “roll-down” trade. The carry trade is the mechanism by which bond yields adjust to changes in current and expected short-term interest rates. The risk premiums of bonds are positively associated with the slope of the term structure (Ibid, 13). Fama and Bliss (1987, 689) find with data for 1964-85 that “1-year expected returns for US Treasury maturities to 5 years, measured net of the interest rate on a 1-year bond, vary through time. Expected term premiums are mostly positive during good times but mostly negative during recessions.” Vayanos and Vila (2009) develop a model with two-factors, the short-term rate and demand or quantity. The term structure moves because of shocks of short-term rates and demand. An important finding is that demand or quantity shocks are largest for intermediate and long maturities while short-rate shocks are largest for short-term maturities.

IIA2 Policy. A simplified analysis could consider the portfolio balance equations A_ij = f(r, x) where A_ij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, r_i, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of A_ij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher; and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. There have been at least seven approaches on the role of monetary policy in purchasing long-term securities that have increased the classes of rates of return targeted by the Fed:

(1) Suspension of Auctions of 30-year Treasury Bonds. Auctions of 30-year Treasury bonds were suspended between 2001 and 2005. This was Treasury policy not Fed policy. The effects were similar to those of quantitative easing: withdrawal of supply from the segment of 30-year bonds would result in higher prices or lower yields for close-substitute mortgage-backed securities with resulting lower mortgage rates. The objective was to encourage refinancing of house loans that would increase family income and consumption by freeing income from reducing monthly mortgage payments.

(2) Purchase of Long-term Securities by the Fed. Between Nov 2008 and Mar 2009 the Fed announced the intention of purchasing $1750 billion of long-term securities: $600 billion of agency mortgage-backed securities and agency debt announced on Nov 25 and $850 billion of agency mortgaged-backed securities and agency debt plus $300 billion of Treasury securities announced on Mar 18, 2009 (Yellen 2011AS, 5-6). The objective of buying mortgage-backed securities was to lower mortgage rates that would “support the housing sector” (Bernanke 2009SL). The FOMC statement on Dec 16, 2008 informs that: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and its stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant” (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). The Mar 18, 2009, statement of the FOMC explained that: “to provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities up to $1.25 trillion this year, and to increase its purchase of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months” (http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm). Policy changed to increase prices or reduce yields of mortgage-backed securities and Treasury securities with the objective of supporting housing markets and private credit markets by lowering costs of housing and long-term private credit.

(3) Portfolio Reinvestment. On Aug 10, 2010, the FOMC statement explains the reinvestment policy: “to help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in long-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature” (http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm). The objective of policy appears to be supporting conditions in housing and mortgage markets with slow transfer of the portfolio to Treasury securities that would support private-sector markets.

(4) Increasing Portfolio. As widely anticipated, the FOMC decided on Dec 3, 2010: “to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The emphasis appears to shift from housing markets and private-sector credit markets to the general economy, employment and preventing deflation.

(5) Increasing Stock Market Valuations. Chairman Bernanke (2010WP) explained on Nov 4 the objectives of purchasing an additional $600 billion of long-term Treasury securities and reinvesting maturing principal and interest in the Fed portfolio. Long-term interest rates fell and stock prices rose when investors anticipated the new round of quantitative easing. Growth would be promoted by easier lending such as for refinancing of home mortgages and more investment by lower corporate bond yields. Consumers would experience higher confidence as their wealth in stocks rose, increasing outlays. Income and profits would rise and, in a “virtuous circle,” support higher economic growth. Bernanke (2000) analyzes the role of stock markets in central bank policy (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-100). Fed policy in 1929 increased interest rates to avert a gold outflow and failed to prevent the deepening of the banking crisis without which the Great Depression may not have occurred. In the crisis of Oct 19, 1987, Fed policy supported stock and futures markets by persuading banks to extend credit to brokerages. Collapse of stock markets would slow consumer spending.

(6) Devaluing the Dollar. Yellen (2011AS, 6) broadens the effects of quantitative easing by adding dollar devaluation: “there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.”

(7) Let’s Twist Again Monetary Policy. The term “operation twist” grew out of the dance “twist” popularized by successful musical performer Chubby Chekker (http://www.youtube.com/watch?v=aWaJ0s0-E1o). Meulendyke (1998, 39) describes the coordination of policy by Treasury and the FOMC in the beginning of the Kennedy administration in 1961 (see Modigliani and Sutch 1966, 1967; 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):

“In 1961, several developments led the FOMC to abandon its “bills only” restrictions. The new Kennedy administration was concerned about gold outflows and balance of payments deficits and, at the same time, it wanted to encourage a rapid recovery from the recent recession. Higher rates seemed desirable to limit the gold outflows and help the balance of payments, while lower rates were wanted to speed up economic growth.

To deal with these problems simultaneously, the Treasury and the FOMC attempted to encourage lower long-term rates without pushing down short-term rates. The policy was referred to in internal Federal Reserve documents as “operation nudge” and elsewhere as “operation twist.” For a few months, the Treasury engaged in maturity exchanges with trust accounts and concentrated its cash offerings in shorter maturities.

The Federal Reserve participated with some reluctance and skepticism, but it did not see any great danger in experimenting with the new procedure.

It attempted to flatten the yield curve by purchasing Treasury notes and bonds while selling short-term Treasury securities. The domestic portfolio grew by $1.7 billion over the course of 1961. Note and bond holdings increased by a substantial $8.8 billion, while certificate of indebtedness holdings fell by almost $7.4 billion (Table 2). The extent to which these actions changed the yield curve or modified investment decisions is a source of dispute, although the predominant view is that the impact on yields was minimal. The Federal Reserve continued to buy coupon issues thereafter, but its efforts were not very aggressive. Reference to the efforts disappeared once short-term rates rose in 1963. The Treasury did not press for continued Fed purchases of long-term debt. Indeed, in the second half of the decade, the Treasury faced an unwanted shortening of its portfolio. Bonds could not carry a coupon with a rate above 4 1/4 percent, and market rates persistently exceeded that level. Notes—which were not subject to interest rate restrictions—had a maximum maturity of five years; it was extended to seven years in 1967.”

As widely anticipated by markets, perhaps intentionally, the Federal Open Market Committee (FOMC) decided at its meeting on Sep 21 that it was again “twisting time” (http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm):

“Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.

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

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

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

The FOMC decided at its meeting on Jun 20, 2012, to continue “Let’s Twist Again” monetary policy until the end of 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120620a.htm http://www.newyorkfed.org/markets/opolicy/operating_policy_120620.html):

“The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities. Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. The Committee 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. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

IIA3 Evidence. There are multiple empirical studies on the effectiveness of quantitative easing that have been covered in past posts such as (Andrés et al. 2004, D’Amico and King 2010, Doh 2010, Gagnon et al. 2010, Hamilton and Wu 2010). On the basis of simulations of quantitative easing with the FRB/US econometric model, Chung et al (2011, 28-9) find that:

”Lower long-term interest rates, coupled with higher stock market valuations and a lower foreign exchange value of the dollar, provide a considerable stimulus to real activity over time. Phase 1 of the program by itself is estimated to boost the level of real GDP almost 2 percent above baseline by early 2012, while the full program raises the level of real GDP almost 3 percent by the second half of 2012. This boost to real output in turn helps to keep labor market conditions noticeably better than they would have been without large scale asset purchases. In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, that would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone.”

An additional conclusion of these simulations is that quantitative easing may have prevented actual deflation. Empirical research is continuing.

IIA4 Unwinding Strategy. Fed Vice-Chair Yellen (2011AS) considers four concerns on quantitative easing discussed below in turn. First, Excessive Inflation. Yellen (2011AS, 9-12) considers concerns that quantitative easing could result in excessive inflation because fast increases in aggregate demand from quantitative easing could raise the rate of inflation, posing another problem of adjustment with tighter monetary policy or higher interest rates. The Fed estimates significant slack of resources in the economy as measured by the difference of four percentage points between the high current rate of unemployment above 9 percent and the NAIRU (non-accelerating rate of unemployment) of 5.75 percent (Ibid, 2). Thus, faster economic growth resulting from quantitative easing would not likely result in upward trend of costs as resources are bid up competitively. The Fed monitors frequently slack indicators and is committed to maintaining inflation at a “level of 2 percent or a bit less than that” (Ibid, 13), say, in the narrow open interval (1.9, 2.1).

Second, Inflation and Bank Reserves. On Jan 12, 2012, the line “Reserve Bank credit” in the Fed balance sheet stood at $2450.6 billion, or $2.5 trillion, with the portfolio of long-term securities of $2175.7 billion, or $2.2 trillion, composed of $987.6 billion of notes and bonds, $49.7 billion of inflation-adjusted notes and bonds, $146.3 billion of Federal agency debt securities, and $992.1 billion of mortgage-backed securities; reserves balances with Federal Reserve Banks stood at $1095.5 billion, or $1.1 trillion (http://federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The concern addressed by Yellen (2011AS, 12-4) is that this high level of reserves could eventually result in demand growth that could accelerate inflation. Reserves would be excessively high relative to the levels before the recession. Reserves of depository institutions at the Federal Reserve Banks rose from $45.6 billion in Aug 2008 to $1084.8 billion in Aug 2010, not seasonally adjusted, multiplying by 23.8 times, or to $1038.2 billion in Nov 2010, multiplying by 22.8 times. The monetary base consists of the monetary liabilities of the government, composed largely of currency held by the public plus reserves of depository institutions at the Federal Reserve Banks. The monetary base not seasonally adjusted, or issue of money by the government, rose from $841.1 billion in Aug 2008 to $1991.1 billion or by 136.7 percent and to $1968.1 billion in Nov 2010 or by 133.9 percent (http://federalreserve.gov/releases/h3/hist/h3hist1.pdf). Policy can be viewed as creating government monetary liabilities that ended mostly in reserves of banks deposited at the Fed to purchase $2.1 trillion of long-term securities or assets, which in nontechnical language would be “printing money” (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). The marketable debt of the US government in Treasury securities held by the public stood at $8.7 trillion on Nov 30, 2010 (http://www.treasurydirect.gov/govt/reports/pd/mspd/2010/opds112010.pdf). The current holdings of long-term securities by the Fed of $2.1 trillion, in the process of converting fully into Treasury securities, are equivalent to 24 percent of US government debt held by the public, and would represent 29.9 percent with the new round of quantitative easing if all the portfolio of the Fed, as intended, were in Treasury securities. Debt in Treasury securities held by the public on Dec 31, 2009, stood at $7.2 trillion (http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds122009.pdf), growing on Nov 30, 2010, to $1.5 trillion or by 20.8 percent. In spite of this growth of bank reserves, “the 12-month change in core PCE [personal consumption expenditures] prices dropped from about 2 ½ percent in mid-2008 to around 1 ½ percent in 2009 and declined further to less than 1 percent by late 2010” (Yellen 2011AS, 3). The PCE price index, excluding food and energy, is around 0.8 percent in the past 12 months, which could be, in the Fed’s view, too close for comfort to negative inflation or deflation. Yellen (2011AS, 12) agrees “that an accommodative monetary policy left in place too long can cause inflation to rise to undesirable levels” that would be true whether policy was constrained or not by “the zero bound on interest rates.” The FOMC is monitoring and reviewing the “asset purchase program regularly in light of incoming information” and will “adjust the program as needed to meet its objectives” (Ibid, 12). That is, the FOMC would withdraw the stimulus once the economy is closer to full capacity to maintain inflation around 2 percent. In testimony at the Senate Committee on the Budget, Chairman Bernanke stated that “the Federal Reserve has all the tools its needs to ensure that it will be able to smoothly and effectively exit from this program at the appropriate time” (http://federalreserve.gov/newsevents/testimony/bernanke20110107a.htm). The large quantity of reserves would not be an obstacle in attaining the 2 percent inflation level. Yellen (2011A, 13-4) enumerates Fed tools that would be deployed to withdraw reserves as desired: (1) increasing the interest rate paid on reserves deposited at the Fed currently at 0.25 percent per year; (2) withdrawing reserves with reverse sale and repurchase agreement in addition to those with primary dealers by using mortgage-backed securities; (3) offering a Term Deposit Facility similar to term certificates of deposit for member institutions; and (4) sale or redemption of all or parts of the portfolio of long-term securities. The Fed would be able to increase interest rates and withdraw reserves as required to attain its mandates of maximum employment and price stability.

Third, Financial Imbalances. Fed policy intends to lower costs to business and households with the objective of stimulating investment and consumption generating higher growth and employment. Yellen (2011A, 14-7) considers a possible consequence of excessively reducing interest rates: “a reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields. This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring financial indicators for signs of potential threats to financial stability.” Regulation and supervision would be the “first line of defense” against imbalances threatening financial stability but the Fed would also use monetary policy to check imbalances (Yellen 2011AS, 17).

Fourth, Adverse Effects on Foreign Economies. The issue is whether the now recognized dollar devaluation would promote higher growth and employment in the US at the expense of lower growth and employment in other countries.

IIB United States Inflation. Monetary policy pursues symmetric inflation targets of maintaining core inflation of the index of personal consumption expenditures (core PCE) in an open interval of 2.00 percent. If inflation increases above 2.00 percent, the central bank could use restrictive monetary policy such as increases in interest rates to contain inflation in a tight range or interval around 2.00 percent. If inflation falls below 2 percent, the central bank could use restrictive monetary policy such as lowering interest rates to prevent inflation from falling too much below 2.00 percent. Currently, with about thirty million unemployed and underemployed (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html ) and depressed hiring (http://cmpassocregulationblog.blogspot.com/2012/11/recovery-without-hiring-united-states.html), there may even be a policy bias to raise or at least ignore inflation, even with falling real wages, maintaining accommodation as a form of promoting full employment. There are two arguments in favor of symmetric inflation targets preventing inflation from falling to very low levels.

1. Room for interest rate policy. Nominal interest rates hardly ever fall below zero. In economic jargon, the floor of zero nominal interest rates is referred to as “the zero bound.” Symmetric targets are proposed to maintain a sufficiently high inflation rate such that interest rates can be lowered to promote economic activity when recession threatens. With inflation close to zero there is no room for lowering interest rates with policy tools.

2. Fear of Deflation. Inflation is a process of sustained increases in prices. Deflation is a process of sustained decreases in prices. The probability of deflation increases as inflation approximates zero. The influence of fear of deflation in monetary policy is discussed in Pelaez and Pelaez (International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-95).

IIB United States Inflation. Subsection IIC Long-term US Inflation evaluates long-term inflation in the US, concluding that there has not been deflation risk since World War II. Subsection IID Current US Inflation finds no evidence in current inflation justifying fear of deflation.

IIC Long-term US Inflation. Key percentage average yearly rates of the US economy on growth and inflation are provided in Table II-1 updated with release of new data. The choice of dates prevents the measurement of long-term potential economic growth because of two recessions from IQ2001 (Mar) to IVQ2001 (Nov) with decline of GDP of 0.4 percent and the drop in GDP of 4.7 percent in the recession from IVQ2007 (Dec) to IIQ2009 (June) (http://www.nber.org/cycles.html) followed with unusually low economic growth for an expansion phase after recession (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). 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 1.3 percent in the first three quarters of 2012 {[(1.02)^1/4(1.013)^1/4(1.02)^1/4 -1]100 = 1.3%}, which is equivalent to 1.77 percent per year {([(1.02)^1/4(1.013)^1/4(1.02)^1/4 - 1]^4/3 – 1)100 = 1.77%}. The expansion of IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Between 2000 and 2011, real GDP grew at the average rate of 1.6 percent per year, nominal GDP at 3.9 percent and the implicit deflator at 2.3 percent. Between 2000 and 2012, the average rate of CPI inflation was 2.4 percent per year and 2.0 percent excluding food and energy. PPI inflation increased at 2.9 percent per year on average from 2000 to 2012 and at 1.7 percent excluding food and energy. Producer price inflation of finished energy goods increased at average 5.9 percent between 2000 and 2012. There is also inflation in international trade. Import prices increased at 2.8 percent per year between 2000 and 2012. The commodity price shock is revealed by inflation of import prices of petroleum increasing at 12.2 percent per year between 2000 and 2011 and at 11.3 percent between 2000 and 2012. The average percentage rates of increase of import prices excluding fuels are much lower at 2.1 percent for 2002 to 2011 and 1.9 percent for 2002 to 2012. Export prices rose at the average rate of 2.6 percent between 2000 and 2011 and at 2.5 percent from 2000 to 2012. What spared the US of sharper decade-long deterioration of the terms of trade, (export prices)/(import prices), was its diversification and competitiveness in agriculture. Agricultural export prices grew at the average yearly rate of 6.6 percent from 2000 to 2011 and at 7.0 percent from 2000 to 2012. US nonagricultural export prices rose at 2.2 percent per year from 2000 to 2011 and at 2.1 percent from 2000 to 2012. The share of petroleum imports in US trade far exceeds that of agricultural exports. Unconventional monetary policy inducing carry trades in commodities has deteriorated US terms of trade, prices of exports relative to prices of imports, tending to restrict growth of US aggregate real income. These dynamic inflation rates are not similar to those for the economy of Japan where inflation was negative in seven of the 10 years in the 2000s.

II-1, US, Average Growth Rates of Real and Nominal GDP, Consumer Price Index, Producer Price Index and Import and Export Prices, Percent per Year

Real GDP	2000-2011: 1.6%
Nominal GDP	2000-2011: 3.9%
Implicit Price Deflator	2000-2011: 2.3%
CPI	2000-2011: 2.4% 2000-2012: 2.4%
CPI ex Food and Energy	2000-2011: 2.0% 2000-2012: 2.0%
PPI	2000-2011: 2.9% 2000-2012: 2.9%
PPI ex Food and Energy	2000-2011: 1.7% 2000-2012: 1.7%
PPI Finished Energy Goods	2000-2011: 6.1% 2000-2012: 5.9%
Import Prices	2000-2011: 3.1% 2000-2012: 2.8%
Import Prices of Petroleum and Petroleum Products	2000-2011: 12.2% 2000-2012: 11.3%
Import Prices Excluding Petroleum	2000-2011: 1.4% 2000-2012: 1.3%
Import Prices Excluding Fuels	2002-2011: 2.1% 2002-2012:  1.9%
Export Prices	2000-2011: 2.6% 2000-2012: 2.5%
Agricultural Export Prices	2000-2011: 6.6% 2000-2012: 7.0%
Nonagricultural Export Prices	2000-2011: 2.2% 2000-2012: 2.1%

Note: rates for price indexes in the row beginning with “CPI” and ending in the row “Nonagricultural Export Prices” are for Oct 2000 to Oct 2011 and for Oct 2000 to Oct 2012 using not seasonally adjusted indexes. Import prices excluding fuels are not available before 2002.

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

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

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

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

-0.3 percent in 1963,

-1.4 percent in 1986,

-0.8 percent in 1986,

-0.8 percent in 1998,

-1.3 percent in 2001

-2.6 percent in 2009.

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

Chart II-1 provides US nominal GDP from 1980 to 2010. The only major bump in the chart occurred in the recession of IVQ2007 to IIQ2009 with revised cumulative decline of GDP of 4.7 percent. Tendency for deflation would be reflected in persistent bumps. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.5 percent cumulatively and fell 45.6 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7). The comparison of the global recession after 2007 with the Great Depression is entirely misleading (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html).

Chart II-1, US, Nominal GDP 1980-2011

Source: US Bureau of Economic Analysis

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

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

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

Source: US Bureau of Economic Analysis

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

Deflation would also be in evidence in long-term series of prices in the form of bumps. The GDP implicit deflator series in Chart II-3 from 1980 to 2012 shows sharp dynamic behavior over time. The US economy is not plagued by deflation but by long-run inflation.

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

Source: US Bureau of Economic Analysis

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

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

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

Source: US Bureau of Economic Analysis

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

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

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

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

The producer price index of the US from 1947 to 2012 in Chart II-6 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart II-6, US, Producer Price Index, Finished Goods, NSA, 1947-2012

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

Chart II-7 provides 12-month percentage changes of the producer price index from 1948 to 2012. The distinguishing event in Chart II-7 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2012.

Chart II-7, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1948-2012

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

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

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

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

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

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

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

The producer price index of energy goods from 1974 to 2012 is provided in Chart II-10. The first jump occurred during the Great Inflation of the 1970s analyzed in various comments of this blog (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html) and in Appendix I. There is relative stability of producer prices after 1986 with another jump and decline in the late 1990s into the early 2000s. The episode of commodity price increases during a global recession in 2008 could only have occurred with interest rates dropping toward zero, which stimulated the carry trade from zero interest rates to leveraged positions in commodity futures. Commodity futures exposures were dropped in the flight to government securities after Sep 2008. Commodity future exposures were created again when risk aversion diminished around Mar 2011 after the finding that US bank balance sheets did not have the toxic assets that were mentioned in proposing TARP in Congress (see Cochrane and Zingales 2009). Fluctuations in commodity prices and other risk financial assets originate in carry trade when risk aversion ameliorates.

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

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

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

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

Source: US Bureau of Labor Statistics http://www.bls.gov/ppi/

Chart II-12 provides the consumer price index NSA from 1913 to 2012. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart II-12, US, Consumer Price Index, NSA, 1913-2012

Source: US Bureau of Labor Statistics

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

Chart II-13 provides 12-month percentage changes of the consumer price index from 1914 to 2012. The only episode of deflation after 1950 is in 2009, which is explained by the reversal of speculative commodity futures carry trades that were induced by interest rates driven to zero in a shock of monetary policy in 2008. The only persistent case of deflation is from 1930 to 1933, which has little if any relevance to the contemporary United States economy. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart II-13, US, Consumer Price Index, All Items, 12- Month Percentage Change 1914-2012

Source: US Bureau of Labor Statistics

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

Table II-2 provides annual percentage changes of United States consumer price inflation from 1914 to 2011. There have been only cases of annual declines of the CPI after World War II: -1.2 percent in 1949, -0.4 percent in 1955 and -0.4 percent in 2009. The decline of 0.4 percent in 2009 followed increase of 3.8 percent in 2008 and is explained by the reversal of speculative carry trades that were created in 2008 as monetary policy rates were driven to zero. The reversal occurred after misleading statement on toxic assets in banks in the proposal for TARP (Cochrane and Zingales 2009). The only persistent deflationary period since 1914 was during the Great Depression in the years from 1930 to 1933. Fear of deflation on the basis of that experience does not justify unconventional monetary policy of zero interest rates that has failed to stop deflation in Japan. Financial repression causes far more adverse effects on allocation of resources by distorting the calculus of risk/returns than alleged employment-creating effects or there would not be current recovery without jobs and hiring after zero interest rates since Dec 2008 and intended now forever in a self-imposed growth and employment mandate of monetary policy.

Table II-2, US, Annual CPI Inflation ∆% 1914-2011

Year	Annual
1914	1.0
1915	1.0
1916	7.9
1917	17.4
1918	18.0
1919	14.6
1920	15.6
1921	-10.5
1922	-6.1
1923	1.8
1924	0.0
1925	2.3
1926	1.1
1927	-1.7
1928	-1.7
1929	0.0
1930	-2.3
1931	-9.0
1932	-9.9
1933	-5.1
1934	3.1
1935	2.2
1936	1.5
1937	3.6
1938	-2.1
1939	-1.4
1940	0.7
1941	5.0
1942	10.9
1943	6.1
1944	1.7
1945	2.3
1946	8.3
1947	14.4
1948	8.1
1949	-1.2
1950	1.3
1951	7.9
1952	1.9
1953	0.8
1954	0.7
1955	-0.4
1956	1.5
1957	3.3
1958	2.8
1959	0.7
1960	1.7
1961	1.0
1962	1.0
1963	1.3
1964	1.3
1965	1.6
1966	2.9
1967	3.1
1968	4.2
1969	5.5
1970	5.7
1971	4.4
1972	3.2
1973	6.2
1974	11.0
1975	9.1
1976	5.8
1977	6.5
1978	7.6
1979	11.3
1980	13.5
1981	10.3
1982	6.2
1983	3.2
1984	4.3
1985	3.6
1986	1.9
1987	3.6
1988	4.1
1989	4.8
1990	5.4
1991	4.2
1992	3.0
1993	3.0
1994	2.6
1995	2.8
1996	3.0
1997	2.3
1998	1.6
1999	2.2
2000	3.4
2001	2.8
2002	1.6
2003	2.3
2004	2.7
2005	3.4
2006	3.2
2007	2.8
2008	3.8
2009	-0.4
2010	1.6
2011	3.2

Source: US Bureau of Labor Statistics

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

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

Chart II-14, US, Consumer Price Index Excluding Food and Energy, NSA, 1957-2012

Source: US Bureau of Labor Statistics

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

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

Chart II-15, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1958-2012

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

IID Current US Inflation. Consumer price inflation has fluctuated in recent months. Table II-3 provides 12-month consumer price inflation in Oct and annual equivalent percentage changes for the months of Aug to Oct 2012 of the CPI and major segments. The final column provides inflation from Sep 2012 to Oct 2012. CPI inflation in the 12 months ending in Oct reached 2.2 percent, the annual equivalent rate Aug to Oct was 5.3 percent in the new sharp inflation wave and the monthly inflation rate of 0.1 percent annualizes at 1.2 percent. These inflation rates fluctuate in accordance with inducement of risk appetite or frustration by risk aversion of carry trades from zero interest rates to commodity futures. At the margin, the decline in commodity prices in sharp current risk aversion in financial markets caused lower inflation worldwide that is followed by a jump in Aug-Sep 2012 because of the relaxed risk aversion resulting from the bond-buying program of the European Central Bank. With zero interest rates, commodity prices would increase again in an environment of risk appetite. Excluding food and energy, CPI inflation was 2.0 percent in the 12 months ending in Oct 2012 and 1.6 percent in annual equivalent in Aug-Oct 2012. There is no deflation in the US economy that could justify further quantitative easing, which is now open-ended or forever with zero interest rates and bond-buying by the central bank, or QE∞, even if the economy grows back to potential. Financial repression of zero interest rates is now intended as a permanent distortion of resource allocation by clouding risk/return decisions, preventing the economy from expanding along its optimal growth path. Consumer food prices in the US have risen 1.7 percent in 12 months ending in Oct 2012 and at 1.6 percent in annual equivalent in Aug-Oct 2012. Monetary policies stimulating carry trades of commodities futures that increase prices of food constitute a highly regressive tax on lower income families for whom food is a major portion of the consumption basket especially with wage increases below inflation in a recovery without hiring (http://cmpassocregulationblog.blogspot.com/2012/11/recovery-without-hiring-united-states.html) and without jobs (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html). Energy consumer prices increased 4.0 percent in 12 months, increased 47.1 percent in annual equivalent in Aug-Oct and decreased 0.2 percent in Oct or at minus 2.4 percent in annual equivalent as carry trades from zero interest rates to commodity futures were unwound and repositioned during alternating risk aversion and risk appetite originating in the European debt crisis and increasingly in growth and politics in China. For lower income families, food and energy are a major part of the family budget. Inflation is not low or threatening deflation in annual equivalent in Aug-Oct in any of the categories in Table II-2 but simply reflecting waves of inflation originating in carry trades. An upward trend is determined by carry trades from zero interest rates to commodity futures positions with episodes of risk aversion causing fluctuations.

Table II-3, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	∆% 12 Months Oct 2012/Oct 2011 NSA	∆% Annual Equivalent Aug to Oct 2012 SA	∆% Oct 2012/Sep 2012 SA
CPI All Items	2.2	5.3	0.1
CPI ex Food and Energy	2.0	1.6	0.2
Food	1.7	2.0	0.2
Food at Home	1.0	1.6	0.3
Food Away from Home	2.7	2.4	0.1
Energy	4.0	47.1	-0.2
Gasoline	9.1	80.6	-0.6
Fuel Oil	5.6	46.9	1.1
New Vehicles	1.0	0.0	-0.1
Used Cars and Trucks	-2.1	-12.1	-0.9
Medical Care Commodities	3.0	0.8	0.0
Apparel	3.0	2.0	0.7
Services Less Energy Services	2.5	2.8	0.3
Shelter	2.3	2.8	0.3
Transportation Services	2.0	4.9	0.7
Medical Care Services	3.9	2.4	0.0

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

The weights of the CPI, US city average for all urban consumers representing about 87 percent of the US population (http://www.bls.gov/cpi/cpiovrvw.htm#item1), are shown in Table II-4 with the BLS update of Mar 7, 2012 (http://www.bls.gov/cpi/cpiri2011.pdf). Housing has a weight of 41.020 percent. The combined weight of housing and transportation is 57.895 percent or more than one half of consumer expenditures of all urban consumers. The combined weight of housing, transportation and food and beverages is 73.151 percent of the US CPI.

Table II-4, US, Relative Importance, 2009-2010 Weights, of Components in the Consumer Price Index, US City Average, Dec 2011

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

Note: reissued Mar 7, 2012. Refers to all urban consumers, covering approximately 87 percent of the US population (see http://www.bls.gov/cpi/cpiovrvw.htm#item1). Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/cpiri2011.pdf http://www.bls.gov/cpi/cpiriar.htm

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

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

There have been waves of consumer price inflation in the US in 2011 and into 2012 (Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/10/world-inflation-waves-stagnating-united.html) that are illustrated in Table II-5. The first wave occurred in Jan-Apr 2011 and was caused by the carry trade of commodity prices induced by unconventional monetary policy of zero interest rates. Cheap money at zero opportunity cost in environment of risk appetite was channeled into financial risk assets, causing increases in commodity prices. The annual equivalent rate of increase of the all-items CPI in Jan-Apr 2011 was 4.9 percent and the CPI excluding food and energy increased at annual equivalent rate of 2.4 percent. The second wave occurred during the collapse of the carry trade from zero interest rates to exposures in commodity futures as a result of risk aversion in financial markets created by the sovereign debt crisis in Europe. The annual equivalent rate of increase of the all-items CPI dropped to 2.8 percent in May-Jul 2011 while the annual equivalent rate of the CPI excluding food and energy increased at 3.0 percent. In the third wave in Jul-Sep 2011, annual equivalent CPI inflation rose to 3.7 percent while the core CPI increased at 2.0 percent. The fourth wave occurred in the form of decrease of the CPI all-items annual equivalent rate to 0.6 percent in Oct-Nov 2011 with the annual equivalent rate of the CPI excluding food and energy remaining at 2.4 percent. The fifth wave occurred in Dec 2011 to Jan 2012 with annual equivalent headline inflation of 1.2 percent and core inflation of 1.8 percent. In the sixth wave, headline CPI inflation increased at annual equivalent 4.3 percent in Feb-Mar 2012 and core CPI inflation at 1.8 percent but including Apr, the annual equivalent inflation of the headline CPI was 2.8 percent in Feb-Apr and 2.0 percent for the core CPI. The seventh wave in May-Jul occurred with annual equivalent inflation of minus 1.2 percent for the headline CPI in May-Jul 2012 and 2.0 percent for the core CPI. The eighth wave is with annual equivalent inflation of 7.4 percent in Aug-Sep 2012 but 5.3 percent including Oct. The conclusion is that inflation accelerates and decelerates in unpredictable fashion that turns symmetric inflation targets in a source of destabilizing shocks to the financial system and eventually the overall economy. Unconventional monetary policy of zero interest rates and withdrawal of bonds to lower long-term interest rates distorts risk/return decisions required for efficient allocation of resources and attaining optimal growth paths and prosperity.

Table II-5, US, Headline and Core CPI Inflation Monthly SA and 12 Months NSA ∆%

	All Items  SA Month	All Items NSA 12 month	Core SA Month	Core NSA 12 months
Oct 2012	0.1	2.2	0.2	2.0
Sep	0.6	2.0	0.1	2.0
Aug	0.6	1.7	0.1	1.9
AE ∆% Aug-Oct	5.3		1.6
Jul	0.0	1.4	0.1	2.1
Jun	0.0	1.7	0.2	2.2
May	-0.3	1.7	0.2	2.3
AE ∆% May-Jul	-1.2		2.0
Apr	0.0	2.3	0.2	2.3
Mar	0.3	2.7	0.2	2.3
Feb	0.4	2.9	0.1	2.2
AE ∆% Feb-Apr	2.8		2.0
Jan	0.2	2.9	0.2	2.3
Dec 2011	0.0	3.0	0.1	2.2
AE ∆% Dec-Jan	1.2		1.8
Nov	0.1	3.4	0.2	2.2
Oct	0.0	3.5	0.2	2.1
AE ∆% Oct-Nov	0.6		2.4
Sep	0.3	3.9	0.1	2.0
Aug	0.3	3.8	0.2	2.0
Jul	0.3	3.6	0.2	1.8
AE ∆% Jul-Sep	3.7		2.0
Jun	0.1	3.6	0.2	1.6
May	0.3	3.6	0.3	1.5
AE ∆%  May-Jul	2.8		3.0
Apr	0.4	3.2	0.2	1.3
Mar	0.5	2.7	0.2	1.2
Feb	0.4	2.1	0.2	1.1
Jan	0.3	1.6	0.2	1.0
AE ∆%  Jan-Apr	4.9		2.4
Dec 2010	0.4	1.5	0.1	0.8
Nov	0.2	1.1	0.1	0.8
Oct	0.3	1.2	0.0	0.6
Sep	0.1	1.1	0.0	0.8
Aug	0.2	1.1	0.1	0.9
Jul	0.2	1.2	0.1	0.9
Jun	0.0	1.1	0.1	0.9
May	-0.1	2.0	0.1	0.9
Apr	0.0	2.2	0.0	0.9
Mar	0.0	2.3	0.1	1.1
Feb	0.0	2.1	0.1	1.3
Jan	0.1	2.6	-0.1	1.6

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

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

The behavior of the US consumer price index NSA from 2001 to 2011 is provided in Chart II-20. Inflation in the US is very dynamic without deflation risks that would justify symmetric inflation targets. The hump in 2008 originated in the carry trade from interest rates dropping to zero into commodity futures. There is no other explanation for the increase of the Cushing OK Crude Oil Future Contract 1 from $55.64/barrel on Jan 9, 2007 to $145.29/barrel on July 3, 2008 during deep global recession, collapsing under a panic of flight into government obligations and the US dollar to $37.51/barrel on Feb 13, 2009 and then rising by carry trades to $113.93/barrel on Apr 29, 2012, collapsing again and then recovering again to $105.23/barrel, all during mediocre economic recovery with peaks and troughs influenced by bouts of risk appetite and risk aversion (data from the US Energy Information Administration EIA, http://www.eia.gov/). The unwinding of the carry trade with the TARP announcement of toxic assets in banks channeled cheap money into government obligations (see Cochrane and Zingales 2009).

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

Headline and core producer price indexes are in Table II-6. The headline PPI SA decreased 0.2 percent in Oct 2012 and increased 2.3 percent NSA in the 12 months ending in Oct 2012. The core PPI SA decreased 0.2 percent in Oct 2012 and rose 2.1 percent in 12 months. Analysis of annual equivalent rates of change shows inflation waves similar to those worldwide. In the first wave, the absence of risk aversion from the sovereign risk crisis in Europe motivated the carry trade from zero interest rates into commodity futures that caused the average equivalent rate of 9.7 percent in the headline PPI in Jan-Apr 2011 and 4.0 percent in the core PPI. In the second wave, commodity futures prices collapsed in May 2011 with the return of risk aversion originating in the sovereign risk crisis of Europe. The annual equivalent rate of headline PPI inflation collapsed to 1.2 percent in May-Jun 2011 but the core annual equivalent inflation rate was much higher at 3.0 percent. In the third wave, headline PPI inflation resuscitated with annual equivalent at 6.6 percent in Jul-Sep 2011 and core PPI inflation at 4.1 percent. Core PPI inflation was persistent throughout 2011, jumping from annual equivalent at 1.8 percent in the first four months of 2010 to 3.0 percent in 12 months ending in Dec 2011. Unconventional monetary policy is based on the proposition that core rates reflect more fundamental inflation and are thus better predictors of the future. In practice, the relation of core and headline inflation is as difficult to predict as future inflation (see IIID Supply Shocks in http://cmpassocregulationblog.blogspot.com/2011_05_01_archive.html). In the fourth wave, risk aversion originating in the lack of resolution of the European debt crisis caused unwinding of carry trades with annual equivalent headline PPI inflation of minus 1.2 percent in Oct-Nov 2011 and 0.6 percent in the core annual equivalent. In the fifth wave from Dec 2011 to Jan 2012, annual equivalent inflation was 1.2 percent for the headline index but 4.9 percent for the core index excluding food and energy. In the sixth wave, annual equivalent inflation in Feb-Mar 2012 was 1.2 percent for the headline PPI and 1.8 percent for the core. In the seventh wave, renewed risk aversion caused reversal of carry trade commodity exposures with annual equivalent headline inflation of minus 7.5 percent in Apr-May 2012 while core PPI inflation was at annual equivalent 1.2 percent. In the eighth wave, annual equivalent inflation returned at 3.0 percent in Jun-Jul and 4.3 percent for the core index. In the ninth wave, relaxed risk aversion because of the announcement of the impaired bond buying program or outright monetary transactions (OMT) of the European Central Bank induced carry trades that drove annual equivalent inflation of producer prices of the United States at 18.2 percent in Aug-Sep 2012 and 1.2 percent in the core index. In the tenth wave, renewed risk aversion caused annual equivalent inflation of minus 2.4 percent in Oct in the head and core PPI index. It is almost impossible to forecast PPI inflation and its relation to CPI inflation. “Inflation surprise” by monetary policy could be proposed to climb along a downward sloping Phillips curve, resulting in higher inflation but lower unemployment (see Kydland and Prescott 1977, Barro and Gordon 1983 and past comments of this blog http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html). The architects of monetary policy would require superior inflation forecasting ability compared to forecasting naivety by everybody else. In practice, we are all naïve in forecasting inflation and other economic variables and events.

Table II-6, US, Headline and Core PPI Inflation Monthly SA and 12-Month NSA ∆%

	Finished Goods SA Month	Finished Goods NSA 12 months	Finished Core SA Month	Finished Core NSA 12 months
Oct 2012	-0.2	2.3	-0.2	2.1
AE ∆%  Oct	-2.4		-2.4
Sep	1.1	2.1	0.0	2.3
Aug	1.7	2.0	0.2	2.5
AE ∆% Aug-Sep	18.2		1.2
Jul	0.3	0.5	0.5	2.5
Jun	0.2	0.7	0.2	2.6
AE ∆% Jun-Jul	3.0		4.3
May	-1.0	0.6	0.1	2.7
Apr	-0.3	1.8	0.1	2.7
AE ∆% Apr-May	-7.5		1.2
Mar	-0.2	2.8	0.2	2.9
Feb	0.4	3.4	0.1	3.1
AE ∆% Feb-Mar	1.2		1.8
Jan	0.3	4.1	0.6	3.1
Dec 2011	-0.1	4.7	0.2	3.0
AE ∆% Dec-Jan	1.2		4.9
Nov	0.1	5.6	0.1	3.0
Oct	-0.3	5.8	0.0	2.9
AE ∆% Oct-Nov	-1.2		0.6
Sep	0.9	7.0	0.3	2.8
Aug	0.2	6.6	0.2	2.7
Jul	0.5	7.1	0.5	2.7
AE ∆% Jul-Sep	6.6		4.1
Jun	0.1	6.9	0.3	2.3
May	0.1	7.1	0.2	2.1
AE ∆%  May-Jun	1.2		3.0
Apr	0.7	6.6	0.3	2.3
Mar	0.5	5.6	0.3	2.0
Feb	1.1	5.4	0.2	1.8
Jan	0.8	3.6	0.5	1.6
AE ∆%  Jan-Apr	9.7		4.0
Dec 2010	0.9	3.8	0.2	1.4
Nov	0.4	3.4	-0.1	1.2
Oct	0.8	4.3	-0.2	1.6
Sep	0.4	3.9	0.2	1.6
Aug	0.7	3.3	0.2	1.3
Jul	0.2	4.1	0.2	1.5
Jun	-0.2	2.7	0.1	1.1
May	-0.2	5.1	0.3	1.3
Apr	-0.1	5.4	0.1	0.9
Mar	0.5	5.9	0.2	0.9
Feb	-0.6	4.2	0.0	1.0
Jan	1.0	4.5	0.3	1.0

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

Source: US Bureau of Labor Statistics

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

The US producer price index NSA from 2000 to 2012 is shown in Chart II-24. There are two episodes of decline of the PPI during recessions in 2001 and in 2008. Barsky and Kilian (2004) consider the 2001 episode as one in which real oil prices were declining when recession began. Recession and the fall of commodity prices instead of generalized deflation explain the behavior of US inflation in 2008.

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

Source: US Bureau of Labor Statistics

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

Twelve-month percentage changes of the PPI NSA from 2000 to 2012 are shown in Chart II-25. It may be possible to forecast trends a few months in the future under adaptive expectations but turning points are almost impossible to anticipate especially when related to fluctuations of commodity prices in response to risk aversion. In a sense, monetary policy has been tied to behavior of the PPI in the negative 12-month rates in 2001 to 2003 and then again in 2009 to 2010. Monetary policy following deflation fears caused by commodity price fluctuations would introduce significant volatility and risks in financial markets and eventually in consumption and investment.

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

Source: US Bureau of Labor Statistics

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

The US PPI excluding food and energy from 2000 to 2012 is shown in Chart II-26. There is here again a smooth trend of inflation instead of prolonged deflation as in Japan.

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

Source: US Bureau of Labor Statistics

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

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

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

Source: US Bureau of Labor Statistics

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

The US producer price index of energy goods from 2000 to 2012 is in Chart II-28. There is a clear upward trend with fluctuations that would not occur under persistent deflation.

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

Source: US Bureau of Labor Statistics

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

Chart II-29 provides 12-month percentage changes of the producer price index of energy goods from 2000 to 2012. The episode of declining prices of energy goods in 2001 to 2002 is related to the analysis of decline of real oil prices by Barsky and Kilian (2004). Interest rates dropping to zero during the global recession explain the rise of the PPI of energy goods toward 30 percent. Bouts of risk aversion with policy interest rates held close to zero explain the fluctuations in the 12-month rates of the PPI of energy goods in the expansion phase of the economy. Symmetric inflation targets induce significant instability in inflation and interest rates with adverse effects on financial markets and the overall economy.

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

Source: US Bureau of Labor Statistics

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

Table II-7 provides 12-month percentage changes of the CPI all items, CPI core and CPI housing from 2001 to 2012. There is no evidence in these data supporting symmetric inflation targets that would only induce greater instability in inflation, interest rates and financial markets. Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). Symmetric targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm): “The [Federal Open Market] Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the recovery strengthens.” The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest during nearly a decade and programmed in monetary policy statements until 2015 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted. If economic perspectives are doomed until 2015 such as to warrant zero interest rates and open-ended bond-buying by “printing” digital bank reserves (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html), rational investors and consumers will not invest and consume until just before interest rates are likely to increase. Monetary policy statements on intentions of zero interest rates for another three years or now virtually forever with QE∞ discourage investment and consumption or aggregate demand that can increase economic growth and generate more hiring and opportunities to increase wages and salaries. The doom scenario used to justify monetary policy accentuates adverse expectations on discounted future cash flows of potential economic projects that can revive the economy and create jobs. If it were possible to project the future with the central tendency of the monetary policy scenario and monetary policy tools do exist to reverse this adversity, why the tools have not worked before and even prevented the financial crisis? If there is such thing as “monetary policy science”, why it has such poor record and current inability to reverse production and employment adversity? There is no excuse of arguing that additional fiscal measures are needed because they were deployed simultaneously with similar ineffectiveness.

It may be quite painful to exit QE∞ or use of the balance sheet of the central together with zero interest rates forever. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation. 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 is no simple exit from the trap of zero interest rates. If interest rates are expected to increase, r → ∞, W, or wealth, declines, W → 0.

Table II-7, CPI All Items, CPI Core and CPI Housing, 12-Month Percentage Change, NSA 2001-2012

Oct	CPI All Items	CPI Core ex Food and Energy	CPI Housing
2012	2.2	2.0	1.6
2011	3.5	2.1	1.9
2010	1.2	0.6	-0.2
2009	-0.2	1.7	-0.4
2008	3.7	2.2	3.2
2007	3.5	2.2	3.1
2006	1.3	2.7	3.0
2005	4.3	2.1	3.9
2004	3.2	2.0	2.9
2003	2.0	1.3	2.4
2002	2.0	2.2	2.7
2001	2.1	2.6	2.9

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

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/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse and unsustainable fiscal deficit/debt threatening prosperity; 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 financial 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 Nov 9 and daily values throughout the week ending on Nov 16 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 Nov 9 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Nov 9, 2012”, first row “USD/EUR 1.2711 1.0 %,” provides the information that the US dollar (USD) appreciated 1.0 percent to USD 1.2711/EUR in the week ending on Fri Nov 9 relative to the exchange rate on Fri Nov 2. 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 1.2711/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Nov 9, appreciating to USD 1.2704/EUR on Tue Nov 13, or by 0.1 percent. The dollar appreciated because fewer dollars, $1.2704, were required on Tue Nov 13 to buy one euro than $1.2711 on Nov 9. 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 1.2711/EUR on Nov 9; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Nov 9, to the last business day of the current week, in this case Fri Nov 16, such as depreciation by 0.3 percent to USD 1.2743/EUR by Nov 16; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.3 percent from the rate of USD 1.2711/EUR on Fri Nov 9 to the rate of USD 1.2743/EUR on Fri Nov 16 {[(1.2743/1.2711) – 1]100 = 0.3%} and appreciated (denoted by positive sign) by 0.3 percent from the rate of USD 1.2781 on Thu Nov 15 to USD 1.2743/EUR on Fri Nov 16 {[(1.2743/1.2781) -1]100 = -0.3%}. 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 Nov 12 to Nov 16, 2012

Fri Nov 9, 2012	M 12	Tue 13	W 14	Thu 15	Fr 16
USD/EUR 1.2711 1.0%	1.2708 0.0% 0.0%	1.2704 0.1% 0.0%	1.2734 -0.2% -0.2%	1.2781 -0.6% -0.4%	1.2743 -0.3% 0.3%
JPY/  USD 79.49 1.2%	79.54 -0.1% -0.1%	79.39 0.1% 0.2%	80.24 -0.9% -1.1%	81.18 -2.1% -1.2%	81.31 -2.3 -0.2%
CHF/  USD 0.9488 -0.9%	0.9484 0.0% 0.0%	0.9474 0.1% 0.1%	0.9452 0.4% 0.2%	0.9421 0.7% 0.3%	0.9455 0.3% -0.4%
CHF/ EUR 1.2059 0.1%	1.2051 0.1% 0.1%	1.2037 0.2% 0.1%	1.2036 0.2% 0.0%	1.2042 0.1% 0.0%	1.2047 0.1% 0.0%
USD/  AUD 1.0385 0.9629 0.5%	1.0427 0.9590 0.4% 0.4%	1.0435 0.9583 0.5% 0.1%	1.0370 0.9643 -0.1% -0.6%	1.0328 0.9682 -0.6% -0.4%	1.0341 0.9670 -0.4% 0.1%
10 Year  T Note 1.614	1.61	1.59	1.59	1.59	1.584
2 Year     T Note 0.256	0.26	0.25	0.25	0.24	0.24
German Bond 2Y -0.03 10Y 1.35	2Y -0.04 10Y 1.34	2Y -0.03 10Y 1.34	2Y -0.02 10Y 1.34	2Y -0.03 10Y 1.34	2Y -0.03 10Y 1.33
DJIA 12815.39 -2.1%	12815.08 0.0% 0.0%	12756.18 -0.5% -0.5%	12570.95 -1.9% -1.5%	12542.38 -2.1% -0.2%	12588.31 -1.8% 0.4%
DJ Global 1881.43 -2.6%	1876.88 -0.2% -0.2%	1873.02 -0.4% -0.2%	1852.92 -1.5% -1.1%	1853.18 -1.5% 0.0%	1848.57 -1.7% -0.2%
DJ Asia Pacific 1237.15 -1.0%	1232.32 -0.4% -0.4%	1224.20 -1.0% -0.7%	1221.46 -1.3% -0.2%	1217.56 -1.6% -0.3%	1221.23 -1.3% 0.3%
Nikkei 8757.60 -3.2%	8676.44 -0.9% -0.9%	8661.05 -1.1% -0.2%	8664.73 -1.1% 0.0%	8829.72 0.8% 1.9%	9024.16 3.0% 2.2%
Shanghai 2069.07 -2.3%	2079.27 0.5% 0.5%	2047.89 -1.0% -1.5%	2055.42 -0.7% 0.4%	2030.29 -1.9% -1.2%	2014.72 -2.6% -0.8%
DAX 7163.50 -2.7%	7168.76 0.1% 0.1%	7169.12 0.1% 0.0%	7101.92 -0.9% -0.9%	7043.42 -1.7% -0.8%	6950.53 -3.0% -1.3%
DJ UBS Comm. 140.79 0.3%	140.43 -0.3% -0.3%	140.96 0.1% 0.4%	141.50 0.5% 0.4%	140.64 -0.1% -0.6%	140.95 0.1% 0.2%
WTI $ B 86.12 1.5%	85.57 -0.6% -0.6%	85.33 -0.9% -0.3%	86.32 0.2% 1.2%	85.35 -0.9% -1.1%	87.08 1.1% 2.0%
Brent    $/B 109.44 3.6%	108.78 -0.6% -0.6%	108.15 -1.2% -0.6%	110.05 0.6% 1.8%	107.58 -1.7% -2.2%	109.11 -0.3% 1.4%
Gold  $/OZ 1731.0 3.3%	1730.9 0.0% 0.0%	1725.5 -0.3% -0.3%	1727.2 -0.2% 0.1%	1716.0 -0.9% -0.6%	1713.60 -1.0% -0.1%

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. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:

“The European Council called for work to proceed on the proposals on the Single Supervisory Mechanism as a matter of priority with the objective of agreeing on the legislative framework by 1st January 2013 and agreed on a number of orientations to that end. It also took note of issues relating to the integrated budgetary and economic policy frameworks and democratic legitimacy and accountability which should be further explored. It agreed that the process towards deeper economic and monetary union should build on the EU's institutional and legal framework and be characterised by openness and transparency towards non-euro area Member States and respect for the integrity of the Single Market. It looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based.”

Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. The Bank of Spain released new data on doubtful debtors in Spain’s credit institutions (http://www.bde.es/bde/en/secciones/prensa/Agenda/Datos_de_credit_a6cd708c59cf931.html). In 2006, the value of doubtful credits reached €10,859 million or 0.7 percent of total credit of €1,508,626 million. In Aug 2012, doubtful credit reached €178,579 million or 10.5 percent of total credit of €1,698,714 million.

There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) 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. Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. 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. The imminence of a bailout of Spain drove the yield of the ten-year sovereign bond of Spain to 5.979 percent on Fri Sep 28 and that of Italy to 5.031 percent but both traded higher during the day. Sovereign yields continued to decline by Oct 5 with the yield of the ten-year sovereign bond of Spain trading at 5.663 percent and that of Italy at 4.922 percent. On Oct 12, 2012, the yield of the ten-year sovereign bond of Spain traded at 5.612 percent and that of Italy at 4.856 percent. Sovereign bonds continued to decline in the week of Oct 19 with the ten-year government bond Spain trading at 5.289 percent and that of Italy at 4.655 percent. On Oct 26, the yield of the ten-year government bond of Spain traded at 5.574 percent and that of Italy at 4.838 percent. On Nov 2, the ten-year government bond of Spain traded at 5.649 percent, increasing to 5.820 percent on Nov 9 while the ten-year bond of Italy traded at 4.879 percent on Nov 2, increasing o 4.898 percent on Nov 9 under renewed concerns about Greece. The ten-year bond of Italy traded at 4.816 percent on Nov 16 while the yield of the ten-year bond of Spain traded at 5.864 percent. 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. Risk aversion because of the potential bailout of Spain drove down the US ten-year yield to 1.631 and the ten-year yield of Germany to 1.44 percent while the dollar appreciated to USD 1.2859/EUR. Increasing risk appetite drove the yield of the ten-year Treasury to 1.737 percent on Oct 5, 2012 and depreciated the dollar to USD 1.3036 with more muted response in the yield of the ten-year bond of Germany rising to 1.52 percent and the two-year yield to 0.06 percent. There is indication of some risk aversion in the week of Oct 12, 2012, with decline of the yield of the ten-year Treasury to 1.663 percent and that of Germany to 1.45 percent, stability of the two-year Treasury yield at 0.264 percent and marginal decline of the yield of the two-year German bond to 0.04 percent while the dollar appreciated to USD 1.2953/EUR. Risk aversion fluctuated in the week of Oct 19 but the week ended with the increase of the yield of the two-year note of the US to 0.296 percent and of the ten-year note to 1.766 percent; there was similar increase of the yield of the two-year government bond of Germany to 0.11 percent and of the ten-year yield to 1.59 percent; and the dollar depreciated 0.5 percent to USD 1.3023 percent. Mild risk aversion returned in the week of Oct 26, with the 10-year Treasury yield declining marginally to 1.748 percent and that of Germany to 1.54 percent while the dollar appreciated to USD 1.2942/EUR. Mild risk aversion continued in the week of Nov 2 with declines in the yield of the ten-year Treasury note to 1.715 percent and of the ten-year government bond of Germany to 1.45 percent while the dollar appreciated to USD 1.2838/EUR. Risk aversion deepened in the week of Nov 9 with the two-year Treasury trading at 0.256 percent and the ten-year at 1.614 percent while the two-year government bond of Germany traded at minus 0.03 percent and the ten-year at 1.35 percent while the dollar strengthened to USD 1.2711/EUR. There is continuing risk aversion in the week of Nov 16, with the yields of the two-year Treasury at 0.24 percent and of the ten-year Treasury at 1.584, the yield of the two-year government bond at minus 0.03 percent and of the ten-year German government bond at 1.33 percent and the rate of USD 1.2743/EUR. 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 below consumer price inflation of 2.2 percent in the 12 months ending in Oct (see Section I and earlier http://cmpassocregulationblog.blogspot.com/2012/10/world-inflation-waves-stagnating-united.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
11/16/12	0.24	1.584	-0.03	1.33	1.2743
11/9/12	0.256	1.614	-0.03	1.35	1.2711
11/2/12	0.274	1.715	0.01	1.45	1.2838
10/26/12	0.299	1.748	0.05	1.54	1.2942
10/19/12	0.296	1.766	0.11	1.59	1.3023
10/12/12	0.264	1.663	0.04	1.45	1.2953
10/5/12	0.26	1.737	0.06	1.52	1.3036
9/28/12	0.236	1.631	0.02	1.44	1.2859
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-Nov 15, 2012

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines.

Equity indexes in Table III-1 weakened the week ending on Nov 16, 2012. Stagnating revenues are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal unsustainability. DJIA increased 0.4 percent on Nov 16, declining 1.8 percent in the week. Germany’s Dax decreased 1.3 percent on Fri Nov 16 and decreased 3.0 percent in the week. Dow Global decreased 0.2 percent on Nov 16 and lost 1.7 percent in the week. Japan’s Nikkei Average increased 2.2 percent on Fri Nov 16 and increased 3.0 percent in the week. Dow Asia Pacific TSM increased 0.3 percent on Nov 16 and decreased 1.3 percent in the week while Shanghai Composite decreased 0.8 percent on Nov 16 and increased 2.6 percent in the week. There is evident trend of deceleration of the world economy that could affect corporate revenue and equity valuations.

Commodities were mixed in the week of Nov 16, 2012. The DJ UBS Commodities Index increased 0.2 percent on Fri Nov 16 and increased 0.1 percent in the week, as shown in Table III-1. WTI increased 1.1 percent in the week of Nov 9 while Brent decreased 0.3 percent in the week with conflicts in the Middle East. Gold increased 0.1 percent on Fri Nov 16 and decreased 1.0 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 €1,127,854 million on Nov 9, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,717,270 million in the statement of Nov 9. There is high credit risk in these transactions with capital of only €85,551 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Nov 9, 2012
1 Gold and other Receivables	367,402	419,822	479,108
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	256,877
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	37,323
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	15,299
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,127,854
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	232,297
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	589,416
8 General Government Debt Denominated in Euro	34,954	33,928	30,011
9 Other Assets	278,719	336,574	269,687
TOTAL ASSETS	2,004, 432	2,733,235	3,038,871
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,717,270
Capital and Reserves	78,143	85,748	85,551

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/fs121113.en.html

IIIE Appendix Euro Zone survival risk. 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), or euro area, are only 42.6 percent of the total. Exports to the non-European Union area with share of 44.0 percent in Italy’s total exports are growing at 9.1 percent in Jan-Sep 2012 relative to Jan-Sep 2011 while those to EMU are falling at 1.8 percent.

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

Sep 2012	Exports % Share	∆% Jan-Aug 2012/ Jan-Sep 2011	Imports % Share	Imports ∆% Jan-Sep 2012/ Jan-Sep 2011
EU	56.0	-0.7	53.7	-8.1
EMU 17	42.6	-1.8	43.4	-8.0
France	11.6	-0.6	8.4	-7.0
Germany	13.1	-0.7	15.5	-11.2
Spain	5.3	-8.6	4.5	-8.4
UK	4.7	9.2	2.7	-14.5
Non EU	44.0	9.1	46.3	-3.7
Europe non EU	13.3	9.3	10.8	-3.0
USA	6.1	18.7	3.2	1.1
China	2.7	-12.2	7.4	-16.6
OPEC	4.7	23.2	8.5	22.7
Total	100.0	3.5	100.0	-6.0

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/74537

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €156 million with the 17 countries of the euro zone (EMU 17) in Sep 2012 and deficit of €1283 million in Jan-Sep 2012. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €8217 million in Jan-Sep with Europe non European Union and of €10124 million with the US and in reducing the deficit with non European Union of €688 million in Sep and €4577 million in Jan-Sep 2012. There is significant rigidity in the trade deficits in Jan-Sep of €12,923 million with China and €15,725 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 Sep 2012 Millions of Euro	Trade Balance Cumulative Jan-Sep 2012 Millions of Euro
EU	1,002	8,652
EMU 17	-156	-1,283
France	1,185	9,143
Germany	-563	-4,465
Spain	94	1,217
UK	839	7,076
Non EU	-594	-4,577
Europe non EU	688	8,217
USA	1,149	10,124
China	-1,483	-12,923
OPEC	-1,607	-15,725
Total	408	4,075

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/74537

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Sep 2012 relative to Jan-Sep 2011. Growth rates in 12 months of imports are negative with the exception of 9.8 percent for energy. The higher rate of growth of exports of 3.5 percent in Jan-Sep 2012/Jan-Sep 2011 relative to imports of minus 6.0 percent may reflect weak demand in Italy with GDP declining during five consecutive quarters from IIIQ2011 through IIIQ2012.

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

	Exports Share %	Exports ∆% Jan-Sep 2012/ Jan-Sep 2011	Imports Share %	Imports ∆% Jan-Sep 2012/ Jan-Sep 2011
Consumer Goods	28.9	4.6	25.0	-3.4
Durable	5.9	1.7	3.0	-6.7
Non Durable	23.0	5.3	22.0	-3.0
Capital Goods	32.3	1.6	21.1	-13.0
Inter- mediate Goods	34.2	2.5	34.3	-12.5
Energy	4.7	18.1	19.6	9.8
Total ex Energy	95.3	2.8	80.4	-9.8
Total	100.0	3.5	100.0	-6.0

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/74537

Table III-6 provides Italy’s trade balance by product categories in Aug 2012 and cumulative Jan-Aug 2012. Italy’s trade balance excluding energy generated surplus of €5163 million in Aug 2012 and €47,109 million in Jan-Aug 2012 but the energy trade balance created deficit of €5761 million in Aug 2012 and €43,284 million in Jan-Aug 2012. The overall deficit in Aug 2012 was €598 million with surplus of €3825 million in Jan-Aug 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

	Sep 2012	Cumulative Jan-Sep 2012
Consumer Goods	1,292	11,563
Durable	885	8,296
Nondurable	407	3,267
Capital Goods	3,964	35,918
Intermediate Goods	163	5,110
Energy	-5,011	-48,517
Total ex Energy	5,419	52,591
Total	408	4,075

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/74537

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

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 Subsection IIIF 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/datamapper/index.php?db=WEO) 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	71,277
Euro Zone	12,065	-0.5	73.4
Portugal	211	-0.7	110.9
Ireland	205	-4.4	103.0
Greece	255	-1.7	170.7
Spain	1,340	-4.5	78.6
Major Advanced Economies G7	33,769	-5.1	89.0
United States	15,653	-6.5	83.8
UK	2,434	-5.6	83.7
Germany	3,367	1.4	58.4
France	2,580	-2.2	83.7
Japan	5,984	-9.1	135.4
Canada	1,770	-3.2	35.8
Italy	1,980	2.6	103.1
China	8,250	-1.3*	22.2**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/datamapper/index.php?db=WEO

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 $4155.8 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 $3975.1 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 $8130.8 billion, which would be equivalent to 136.7 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 241.5 percent if including debt of France and 177.4 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	8,855.7
B Germany	1,996.3		$8130.9 as % of $3367 =241.5% $5971.4 as % of $3367 =177.4%
C France	2,159.5
B+C	4,155.8	GDP $5,947.0 Total Debt $8130.9 Debt/GDP: 136.7%
D Italy	2,041.4
E Spain	1,053.2
F Portugal	234.0
G Greece	435.3
H Ireland	211.2
Subtotal D+E+F+G+H	3,975.1

Source: calculation with IMF data http://www.imf.org/external/datamapper/index.php?db=WEO

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 Sep 2012. German exports to other European Union (EU) members are 57.4 percent of total exports in Sep 2012 and 57.2 percent in Jan-Sep 2012. Exports to the euro area are 37.6 percent in Sep and 37.6 percent in Jan-Sep. Exports to third countries are 42.8 percent of the total in Sep and 42.8 percent in Jan-Sep. There is similar distribution for imports. Exports to non-euro countries are decreasing at 2.7 percent in Sep 2012 and increasing 3.8 percent in Jan-Sep 2012 while exports to the euro area are decreasing 9.1 percent in Sep and decreasing 2.1 percent in Jan-Sep 2012. Exports to third countries, accounting for 42.8 percent of the total in Sep 2012, are increasing at 1.8 percent, and 10.4 percent in Jan-Sep, accounting for 42.8 percent of the cumulative total in Jan-Sep 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 high share in its 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 ∆%

	Sep 2012  € Billions	Sep 12-Month ∆%	Jan–Sep 2012 € Billions	Jan-Sep 2012/ Jan-Sep 2011 ∆%
Total Exports	91.7	-3.4	825.9	4.1
A. EU Members	52.6 % 57.4	-7.0	472.2 % 57.2	-0.2
Euro Area	34.5 % 37.6	-9.1	310.7 % 37.6	-2.1
Non-euro Area	18.1 % 19.7	-2.7	161.4 % 19.5	3.8
B. Third Countries	39.2 % 42.8	1.8	353.7 % 42.8	10.4
Total Imports	74.9	-3.6	682.4	1.2
C. EU Members	47.5 % 63.4	-4.8	432.5 % 63.3	1.3
Euro Area	32.7 % 43.7	-5.7	303.7 % 44.5	0.9
Non-euro Area	14.8 % 19.8	-2.8	128.8 % 18.9	2.1
D. Third Countries	27.4 % 36.6	-1.4	249.9 % 36.6	1.1

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

Source:

Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/11/PE12_385_51.html;jsessionid=61633506F891355DDF446AAB5332A764.cae4 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.

© Carlos M. Pelaez, 2010, 2011, 2012