Peaking Valuation of Risk Financial Assets, Budget and Balance of Payments Deficits Threatening Risk Premium on Unsustainable United States Government Debt, World Financial Turbulence and Economic Slowdown with Global Recession Risk
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011, 2012
Executive Summary
IA United States International Trade
IA1 United States International Trade Deficit and Fiscal Imbalance
IA2 Import Export Prices
IB Collapse of United States Dynamism of Income Growth and Employment Creation
IIA Peaking Valuation of Risk Financial Assets since 2006
IIB Budget Deficits Threatening Risk Premium on Unsustainable United States Government Debt
III World Financial Turbulence
IIIA Financial Risks
IIIE Appendix Euro Zone Survival Risk
IIIF Appendix on Sovereign Bond Valuation
IV Global Inflation
V World Economic Slowdown
VA United States
VB Japan
VC China
VD Euro Area
VE Germany
VF France
VG Italy
VH United Kingdom
VI Valuation of Risk Financial Assets
VII Economic Indicators
VIII Interest Rates
IX Conclusion
References
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
There are two important vulnerabilities in the world economy and finance that are likely to interact.
1. High valuations of risk financial assets are considered in Section IIA Peaking Valuation of Risk Financial Assets since 2006. Valuations of stock indexes for the US and Germany are peaking at the turn of 2012 into 2013 relative to 2007 and 2006. All equity indexes are still lower at the end of 2012 relative to the values at the end of 2007. Some equity indexes are higher at the end of 2012 relative to the end of 2006: DJIA by 4.8 percent, S&P by 0.1 percent and DAX by 15.1 percent. The highest valuations relative to the trough on Jul 2, 2010 in the first round of the European sovereign debt crisis are by US equities indexes: DJIA 39.3 percent and S&P 500 43.9 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. DAX of Germany is now 36.1 percent above the trough. The DJIA reached 13,661.87 on Oct 5, 2012, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata) and closed at 13471.22 on Jan 10, 2013, which is only 1.4 percent below the recent 52-week high. The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership.
2. The threat of risk premium on the unsustainable government debt of the United States is considered in Section IIB Budget Deficits Threatening Risk Premium on Unsustainable United States Government Debt. Debt as percent of GDP increases from 72.6 percent in 2012 to 89.7 percent in 2022 in the alternative scenario of the Congressional Budget Office (CBO). The United States is in an unsustainable path of Treasury debt with high risks of a risk premium on issuing new debt and refinancing existing debt that could disrupt economic activity. There is highly unpleasant fiscal arithmetic in the United States. DeNavas-Walt, Proctor and Smith (2012Sep) provide the report on income, poverty and health insurance coverage in the United States for 2011, which consist of the latest available data. There are 121,084 households in the United States in 2011 with mean income of $69,677 or total income of $8437 billion. The highest quintile earns mean income of $178,020 that is equivalent to 51.1 percent of total household income or $4311 billion. A tax of 100 percent on 11 million households in the highest quintile would bring slightly more than outlays of the Treasury of $3603 billion in fiscal year 2011. There are numerous professional households in that 11 million that would default their students loans and be thrown into poverty. After the tax on 100 percent of income of the 11 million in the upper quintile the US Treasury would default because of calamitous disappearance of income that could be taxed to generate revenue. Economic growth at 2.2 percent on average in the 13 quarters of expansion from IIIQ2009 to IIIQ2012 compared with 6.2 percent in earlier expansions of the economic cycle (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html) has been insufficient to restore government revenue to its long-term average of 18.0 percent from 1970 to 2010 while outlays as percent of GDP have jumped to 24.1 percent in 2011 compared with 21.9 percent of GDP on average from 1970 to 2010. Even smaller deficits by restraining outlays to 21.9 percent of GDP will not be sufficient because Treasury debt has 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. United States fiscal affairs resemble those of countries in sovereign debt crises. Attempts to tax current levels of expenditures and debt are unsuccessful with the threat of disorderly adjustment in a future debt crisis in generalized expectation that the government is incapable of generating future primary budget surpluses. Financing budget surpluses with issue of money or seigniorage and various forms of financial repression to lower interest rates on government debt also creates unpleasant outcomes. The major hurdle in adjusting the fiscal situation of the US is 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. 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 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.
IIA Peaking Valuation of Risk Financial Assets since 2006. Percentage changes of risk financial assets from the last day of the year relative to the last day of the earlier year are provided in Table IIA-1 from 2007 to 2012. Calendar year 2012 was excellent for most equity indexes. DAX outperformed all equity indexes in Table IIA-1 with increase of 29.1 percent followed by 25.9 percent for NYSE Financials. Nikkei Average gained 22.9 percent for the first increase in three years. Dow Asia Pacific gained 13.1 percent while DJIA increased 7.3 percent and S&P 500 increased 13.4 percent. The USD depreciated 2.0 percent relative to the EUR and the DJ UBS Commodities Index fell 1.1 percent. The only gain for a major equity market in Table I-1 for 2011 is 5.5 percent for the DJIA. S&P 500 is better than other equity markets by remaining flat for 2011. With the exception of a drop of 8.4 percent of the European equity index STOXX 50, all declines of equity markets in 2011 are in excess of 10 percent. China’s Shanghai Composite lost 21.7 percent. The equity index of Germany Dax fell 14.7 percent. The DJ UBS Commodities Index dropped 13.4 percent. Robin Wigglesworth, writing on Dec 30, 2011, on “$6.3tn wiped off markets in 2011,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/483069d8-32f3-11e1-8e0d-00144feabdc0.html#axzz1i2BE7OPa), provides an estimate of $6.3 trillion erased from equity markets globally in 2011. The Bureau of Economic Analysis (BEA) estimates US nominal GDP in 2011 at $15,075.7 billion (http://www.bea.gov/iTable/index_nipa.cfm). The loss in equity markets worldwide in 2011 of $6.3 trillion is equivalent to about 41 percent of US GDP or economic activity in 2011. Table IIA-1 also provides the exchange rate of number of US dollars (USD) required in buying a unit of euro (EUR), USD/EUR. The dollar appreciated 3.2 percent on the last day of trading in 2011 relative to the last day of trading in 2010, suggesting risk aversion.
Table IIA-1, Percentage Change of Year-end Values of Financial Assets Relative to Earlier Year-end Values 2007-2012
| 2012 | 2011 | 2010 | 2009 | 2008 | 2007 | |
| DJIA | 7.3 | 5.5 | 11.0 | 18.8 | -33.8 | 6.1 |
| S&P 500 | 13.4 | 0.0 | 12.8 | 23.5 | -38.5 | 3.1 |
| NYSE Fin | 25.9 | -18.1 | 5.0 | 22.7 | -53.6 | -13.5 |
| Dow Global | 10.8 | -13.7 | 4.6 | 30.8 | -45.5 | 30.9 |
| Dow Asia-Pacific | 13.1 | -17.6 | 15.9 | 36.4 | -44.2 | 14.2 |
| Nikkei Av | 22.9 | -17.3 | -3.0 | 20.6 | -42.9 | -10.8 |
| Shanghai | 3.2 | -21.7 | -11.9 | 73.9 | -65.2 | 104.9 |
| STOXX 50 | 8.8 | -8.4 | -0.1 | 28.5 | -44.6 | -2.2 |
| DAX | 29.1 | -14.7 | 16.1 | 23.8 | -40.4 | 22.0 |
| USD/EUR* | -2.0 | 3.2 | 6.7 | -2.9 | 4.7 | -10.7 |
| DJ UBS Com | -1.1 | -13.4 | 16.7 | 18.7 | -36.6 | 11.2 |
*Negative sign is dollar devaluation; positive sign is dollar appreciation
Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata
The other yearly percentage changes in Table IIA-1 are also revealing wide fluctuations in valuations of risk financial assets. To be sure, economic conditions and perceptions of the future do influence valuations of risk financial assets. It is also valid to contend that unconventional monetary policy magnifies fluctuations in these valuations by inducing carry trades from zero interest rates to exposures with high leverage in risk financial assets such as equities, emerging equities, currencies, high-yield structured products and commodities futures and options. In fact, one of the alleged channels of transmission of unconventional monetary policy is through higher consumption induced by increases in wealth resulting from higher valuations of stock markets. Unconventional monetary policy could also result in magnification of values of risk financial assets beyond actual discounted future cash flows, creating financial instability. Separating all these effects in practice may be quite difficult because they are observed simultaneously while conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects (on counterfactuals see Pelaez and Pelaez, Globalization and the State Vol I (2008a), 125, 136, Harberger (1971, 1997), Fishlow 1965, Fogel 1964, Fogel and Engerman 1974, North and Weingast 1989, Pelaez 1979, 26-7). There is no certainty or evidence that unconventional policies attain their intended effects without risks of costly side effects. Yearly fluctuations of financial assets in Table IA2-1 are quite wide. In 2007, for example, the equity index Dow Global increased 30.9 percent while Dax gained 22.0 percent and the Shanghai Composite jumped 104.9 percent. The DJIA gained only 6.1 percent as recession began in IVQ2007. The flight to government obligations in 2008 (Cochrane and Zingales 2009, Cochrane 2011Jan) was equivalent to the astronomical declines of world equity markets and commodities. The flight from risk is also in evidence in the appreciation of the dollar by 4.7 percent in 2008 with unwinding carry trades and with renewed carry trades in the depreciation of the dollar by 2.9 percent in 2009. Recovery still continued in 2010 with shocks of the European debt crisis in the spring and in Nov 2010. The flight from risk exposures dominated declines of valuations of risk financial assets in 2011.
Table IIA-2 is designed to provide a comparison of valuations of risk financial assets at the end of 2012 relative to valuations at the end of every year from 2006 to 2011. For example, the DJIA index is 7.3 percent higher at the end of 2012 relative to the valuation at the end of 2011 but is 1.2 percent below the valuation at the end of 2007 and 4.8 percent higher relative to the valuation at the end of 2006. It is higher by 49.3 percent at the end of 2012 relative to the depressed valuation at the end of 2008. Pre-recession valuations of 2006 and 2007 have not been recovered for all financial assets in Table IIA-2. All equity indexes are still lower at the end of 2012 relative to the values at the end of 2007. Some equity indexes are higher at the end of 2012 relative to the end of 2006: DJIA by 4.8 percent, S&P by 0.1 percent and DAX by 15.1 percent. Although the Nikkei Average increased 22.9 percent in 2012 relative to 2011, it is still 32.1 percent lower than in 2007 and 39.5 percent lower than in 2006. At the end of 2012, Dow Global is 28.8 percent lower than at the end of 2007 and 6.8 percent lower than at the end of 2006. The Shanghai Composite increased 3.2 percent at the end of 2012 relative to 2011 but is 56.9 percent lower than at the end of 2007 and 11.7 percent lower than at the end of 2006. DJ UBS Commodities is 24.8 percent lower at the end of 2012 relative to 2007 and 16.4 percent lower relative to 2006. The USD is 9.6 stronger at the end of 2012 relative to 2007 and flat relative to 2006. Low valuations of risk financial assets are intimately related to risk aversion in international financial markets because of the European debt crisis, weakness and unemployment in advanced economies, fiscal imbalances and slowing growth worldwide. Valuations of stock indexes for the US and Germany are peaking at the turn of 2012 into 2013 relative to 2007 and 2006.
Table IIA-2, Percentage Change of Year-end 2012 Values of Financial Assets Relative to Year-end Values 2006-2011
| ∆% 2012/ 2011 | ∆% 2012/ 2010 | ∆% 2012/2009 | ∆% 2012/ 2008 | ∆% 2012/2007 | ∆% 2012/ 2006 | |
| DJIA | 7.3 | 13.2 | 25.7 | 49.3 | -1.2 | 4.8 |
| S&P 500 | 13.4 | 13.4 | 27.9 | 57.9 | -2.9 | 0.1 |
| NYSE Fin | 25.9 | 3.1 | 8.3 | 32.9 | -38.4 | -46.7 |
| Dow Global | 10.8 | -4.4 | 0.0 | 30.8 | -28.8 | -6.8 |
| Dow Asia-Pacific | 13.1 | -6.8 | 8.0 | 47.4 | -17.7 | -6.0 |
| Nikkei Av | 22.9 | 1.6 | -1.4 | 18.8 | -32.1 | -39.5 |
| Shanghai | 3.2 | -19.2 | -28.8 | 23.8 | -56.9 | -11.7 |
| STOXX 50 | 8.8 | -0.3 | -0.5 | 27.9 | -29.1 | -30.6 |
| DAX | 29.1 | 10.1 | 27.8 | 58.3 | -5.6 | 15.1 |
| USD/EUR* | -2.0 | 1.3 | 7.9 | 5.2 | 9.6 | 0.0 |
| DJ UBS Com | -1.1 | -14.4 | -0.1 | 18.6 | -24.8 | -16.4 |
*Negative sign is dollar devaluation; positive sign is dollar appreciation
Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata
The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF (2012WEOOct) provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (IMF 2012GFSROct) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (IMF 2012FMOct) (http://www.imf.org/external/pubs/ft/fm/2012/02/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider global economic and financial risks, which are analyzed in the comments of this blog.
Economic risks include the following:
1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the third quarter of 2012 of 2.2 percent is equivalent to 9.1 percent per year and GDP increased 7.4 percent relative to the third quarter of 2011.
2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 29.5 million in job stress or 18.2 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html), fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.
3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
4. World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html).
A list of financial uncertainties includes:
1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion.
It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in Section VI Valuation of Risk Financial Assets after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII).
The highest valuations in column “∆% Trough to 1/11/13” of Table IIA-3 are by US equities indexes: DJIA 39.3 percent and S&P 500 43.9 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. DAX of Germany is now 36.1 percent above the trough. The DJIA reached 13,661.87 on Oct 5, 2012, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata) and closed at 13471.22 on Jan 10, 2013, which is only 1.4 percent below the recent 52-week high. The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 1/11/13” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior: China’s Shanghai Composite is 5.9 percent below the trough; Japan’s Nikkei Average is 22.4 percent above the trough; DJ Asia Pacific TSM is 17.3 percent above the trough; Dow Global is 21.9 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 15.3 percent above the trough; and NYSE Financial is 25.3 percent above the trough. DJ UBS Commodities is 11.7 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 36.1 percent above the trough. Japan’s Nikkei Average is 22.4 percent above the trough on Aug 31, 2010 and 5.2 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 10801.57 on Fri Jan 11, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 5.3 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 11.9 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 1/11/13” in Table IIA-3 shows that there were increases of valuations of risk financial assets in the week of Jan 11, 2013 such as 0.2 percent for DJ Asia Pacific TSM. Nikkei Average increased 1.1 percent in the week. DJ UBS Commodities increased 0.6 percent. China’s Shanghai Composite decreased 1.5 percent in the week of Jan 11, 2013. The DJIA increased 0.4 percent and S&P 500 increased 0.4 percent. There were increases in several indexes: 1.0 percent for NYSE Financial Index, 1.2 percent for Dow Global. STOXX 50 fell 0.2 percent and DAX of Germany fell 0.8 percent. The USD depreciated 2.1 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table IIA-3 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 1/11/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jan 11, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 1/11/13” but also relative to the peak in column “∆% Peak to 1/11/13.” There are now four equity indexes above the peak in Table IIA-3: DJIA 20.4 percent, S&P 500 20.9 percent, DAX 21.8 percent and DJ Asia Pacific 2.7 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 0.2 percent, Nikkei Average by 5.2 percent, Shanghai Composite by 29.1 percent, STOXX 50 by 2.4 percent and Dow Global by 0.5 percent. DJ UBS Commodities Index is now 4.5 percent below the peak. The US dollar strengthened 11.8 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. 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. 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 Rτ is expected revenue in the time horizon from τ =1 to T; Cτ 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
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declines. Equally, decline in expected revenue from the stock or project, Rτ, causes decline in valuation. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.
Table IIA-3, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 1/11/ /13 | ∆% Week 1/11/13 | ∆% Trough to 1/11/ 13 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 20.4 | 0.4 | 39.3 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 20.9 | 0.4 | 43.9 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -0.2 | 1.0 | 25.3 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -0.5 | 1.2 | 21.9 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | 2.7 | 0.2 | 17.3 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -5.2 | 1.1 | 22.4 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -29.1 | -1.5 | -5.9 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -2.4 | -0.2 | 15.3 |
| DAX | 4/26/ | 5/25/ | -10.5 | 21.8 | -0.8 | 36.1 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 11.8 | -2.1 | -11.9 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -4.5 | 0.6 | 11.7 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 1.862 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
IIB Budget Deficits Threatening Risk Premium on Unsustainable United States Government Debt. The United States Senate passed on Jan 1, 2013, H.R. 8 American Taxpayer Relief Act of 2012 (http://www.gpo.gov/fdsys/pkg/BILLS-112hr8eas/pdf/BILLS-112hr8eas.pdf) subsequently passed in the United States House of Representatives and signed into law by the President. The Congressional Budget Office (CBO) analyzes the effects of the American Taxpayer Relief Act of 2012 (http://www.cbo.gov/publication/43829). The bulk of the effects originate in Title I—General Extensions. Table IIB-1 provides the estimates of effects of the General Extensions and the overall bill. The Treasury deficit of the United States increases by $3,971 billion from 2013 to 2022 or about $4 trillion. The alternative scenario of deficits and debts of CBO appears to be more relevant than the base scenario in which tax rates would increase and expenditures decline. The bulk of this section concentrates on United States unsustainable deficit/debt that may cause an increase in the risk premium of Treasury debt with adverse effects on economic activity and employment.
Table IIB-1, Estimate by the Congressional Budget Office of Budget Effects of H.R.8, the American Taxpayer Relief Act of 2012, Passed by US Senate on January 1, 2013
| General Extensions | Total Changes in Revenues | Net Increase or (-) Decrease in Deficits | |
| 2013 | -206,542 | -279,840 | 329,644 |
| 2014 | -266,004 | -298,778 | 353,881 |
| 2015 | -290,573 | -274,707 | 311,008 |
| 2016 | -315,761 | -305,405 | 340,449 |
| 2017 | -344,090 | -336,613 | 371,139 |
| 2018 | -372,728 | -367,146 | 404,636 |
| 2019 | -395,390 | -393,146 | 415,743 |
| 2020 | -425,716 | -425,585 | 447,618 |
| 2021 | -460,619 | -460,509 | 482,553 |
| 2022 | -496,647 | -496,826 | 514,523 |
| 2013-2017 | -1,422,970 | -1,495,340 | 1,705,118 |
| 2013-2022 | -3,575,062 | -3,638,803 | 3,971,177 |
Source: Congressional Budget Office
http://www.cbo.gov/publication/43829
Table IIB-2 provides federal debt outstanding, held by government accounts and held by the public in millions of dollars for fiscal years from 2007 to 2012. Federal debt outstanding has increased 78.2 percent from fiscal year 2007 to fiscal year 2012 while federal debt held by the public has increased 122.8 percent and federal debt held by government accounts has increased 21.1 percent.
Table IIB-2, US, Federal Debt Outstanding, Held by Government Accounts and Held by the Public, Millions of Dollars
| Outstanding | Held by Government Accounts | Held by the Public | |
| 2012 Sep | 16,090,640 | 4,791,850 | 11,298,790 |
| Fiscal Years | |||
| 2012 | 16,090,640 | 4,791,850 | 11,298,790 |
| 2011 | 14,815,328 | 4,658,307 | 10,157,021 |
| 2010 | 13,585,596 | 4,534,014 | 9,051,582 |
| 2009 | 11,933,031 | 4,355,291 | 7,577,739 |
| 2008 | 10,047,828 | 4,210,491 | 5,837,337 |
| 2007 | 9,030,612 | 3,958,417 | 5,072,195 |
| ∆% 2007-2012 | 78.2 | 21.1 | 122.8 |
Source: United States Treasury. 2012Dec. Treasury Bulletin. Washington, DC, Dec 2012. https://www.fms.treas.gov/bulletin/index.html
Table IIB-3 provides the maturity distribution and average length in months of marketable interest-bearing debt held by private investors from 2007 to Sep 2012. Total debt held by investors increased from $3635 billion in 2007 to $9040 billion in Sep 2012 or increase by 148.7 percent. There are two concerns with the maturity distribution of US debt. (1) Growth of debt is moving total debt to the point of saturation in investors’ portfolio. In a new environment of risk appetite and nonzero fed funds rates with economic growth at historical trend of around 3 percent, yields on risk financial assets are likely to increase. Placement of new debt may require increasing interest rates in an environment of continuing placement of debt by the US Treasury without strong fiscal constraints. (2) Refinancing of maturing debt is likely to occur in an environment of higher interest rates, exerting pressure on future fiscal budgets. In Sep 2012, $2897 billion or 32.1 percent of outstanding debt held by investors matures in less than a year and $3852 billion or 42.6 percent of total debt matures in one to five years. Debt maturing in five years or less adds to $6749 billion or 74.7 percent of total outstanding debt held by investors of $9040 billion. This current episode may be remembered historically as one in which the US managed its government debt with short-dated instruments during record low long-dated yields and on the verge of fiscal pressures on all interest rates, which kind of maximizes over time interest payments on government debt by taxpayers that is precisely the opposite of the objective of sound debt management and taxpayer welfare.
Table IIB-3, Maturity Distribution and Average Length in Months of Marketable Interest-Bearing Public Debt Held by Private Investors, Billions of Dollars
| End of Fiscal Year or Month | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | Sep 2012 |
| Total* | 3635 | 4745 | 6229 | 7676 | 7951 | 9040 | 9040 |
| <1 Year | 1176 | 2042 | 2605 | 2480 | 2504 | 2897 | 2897 |
| 1-5 Years | 1310 | 1468 | 2075 | 2956 | 3085 | 3852 | 3852 |
| 5-10 Years | 678 | 719 | 995 | 1529 | 1544 | 1488 | 1488 |
| 10-20 Years | 292 | 352 | 351 | 341 | 309 | 271 | 271 |
| >20 Years | 178 | 163 | 204 | 371 | 510 | 533 | 533 |
| Average | 58 | 49 | 49 | 57 | 60 | 55 | 55 |
*Amount Outstanding Privately Held
Source: United States Treasury. 2012Dec. Treasury Bulletin. Washington, DC, Dec 2012. https://www.fms.treas.gov/bulletin/index.html
Table IIB-4 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into four parts: Treasury budget in the 2013 fiscal year to Dec 2012; 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. Receipts increased 10.8 percent in the cumulative fiscal year 2013 for Dec 2012 relative to the cumulative in fiscal year 2012. Individual income taxes increased 15.5 percent relative to the same period a year earlier. Outlays increased 3.5 percent relative to a year earlier. 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/2012/12/mediocre-and-decelerating-united-states_24.html). Weakness of growth and employment creation is analyzed in IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 29.5 million people without jobs or underemployed that is equivalent to 18.2 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.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 IIB-4 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 IIB-4, US, Treasury Budget in Fiscal Year to Date Million Dollars
| Dec 2012 | Fiscal Year 2013 | Fiscal Year 2012 | ∆% |
| Receipts | 615,546 | 555,437 | 10.8 |
| Outlays | 907,913 | 877,173 | 3.5 |
| Deficit | -292,367 | -321,735 | NA |
| Individual Income Taxes | 312,398 | 270,370 | 15.5 |
| Social Insurance | 122,778 | 119,411 | 2.8 |
| 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 |
Sources: 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.
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 IIB-5 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. The United States is in an unsustainable path of Treasury debt with high risks of a risk premium on issuing new debt and refinancing existing debt that could disrupt economic activity.
Table IIB-5, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP
| Revenues | Outlays | Deficit | Debt | |
| 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 | 18.0 | 21.9 | NA | 37.0 |
Source: CBO (2012AugBEO). CBO (2012NovCDR).
There is highly unpleasant fiscal arithmetic in the United States. DeNavas-Walt, Proctor and Smith (2012Sep) provide the report on income, poverty and health insurance coverage in the United States for 2011, which consist of the latest available data. There are 121,084 households in the United States in 2011 with mean income of $69,677 or total income of $8437 billion. The highest quintile earns mean income of $178,020 that is equivalent to 51.1 percent of total household income or $4311 billion. A tax of 100 percent on 11 million households in the highest quintile would bring slightly more than outlays of the Treasury of $3603 billion in fiscal year 2011. There are numerous professional households in that 11 million that would default their students loans and be thrown into poverty. After the tax on 100 percent of income of the 11 million in the upper quintile the US Treasury would default because of calamitous disappearance of income that could be taxed to generate revenue. Economic growth at 2.2 percent on average in the 13 quarters of expansion from IIIQ2009 to IIIQ2012 compared with 6.2 percent in earlier expansions of the economic cycle (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html) has been insufficient to restore government revenue to its long-term average of 18.0 percent from 1970 to 2010 while outlays as percent of GDP have jumped to 24.1 percent in 2011 compared with 21.9 percent on average from 1970 to 2010. Even smaller deficits by restraining outlays to 21.9 percent of GDP will not be sufficient because Treasury debt has 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. United States fiscal affairs resemble those of countries in sovereign debt crises. Attempts to tax current levels of expenditures and debt are unsuccessful with the threat of disorderly adjustment in a future debt crisis in generalized expectation that the government is incapable of generating future primary budget surpluses. Financing budget surpluses with issue of money or seigniorage and various forms of financial repression to lower interest rates on government debt also creates unpleasant outcomes.
The major hurdle in adjusting the fiscal situation of the US is shown in Table IIB-6 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 IIB-6 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 IIB-6, Structure of Federal Government Revenues and Outlays, $ Billions and Percent
| 2011 | % Total | Total 2013-2022 | % 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- | 1,346 | 37.4 | 12,664 | 28.9 |
| Defense | 700 | 19.4 | 6,726 | 15.4 |
| Non- | 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).
Chart IIB-1 of the Board of Governors of the Federal Reserve System provides the yield of the ten-year constant maturity Treasury from Jan 3, 1977 to Jan 10, 2013. The yield stood at 7.67 percent on Feb 16, 1977. A peak was reached at 15.21 percent on Oct 26, 1981 during the inflation control effort by the Fed. There is a second local peak in Chart IIB-1 on May 3, 1984 at 13.94 percent followed by another local peak at 8.14 percent on Nov 21, 1994 during another inflation control effort (see Appendix I The Great Inflation). There was sharp reduction of the yields from 5.44 percent on Apr 1, 2002 until they reached a low point of 3.13 percent on Jun 13, 2003. Yields rose again to 4.89 percent on Jun 14, 2004 and 5.23 percent on Jul 5, 2006. Yields declined sharply during the financial crisis, reaching 2.08 percent on Dec 18, 2008, lowered by higher prices originating in sharply increasing demand in the flight to the US dollar and obligations of the US government. Yields rose again to 4.01 percent on Apr 5, 2010 but collapsed to 2.41 percent on Oct 8, 2010 because of higher demand originating in the flight from the European sovereign risk event. During higher risk appetite, yields rose to 3.75 percent on Feb 8, 2011 and collapsed to 1.91 percent on Jan 10, 2013, which is the last data point in Chart IIB-1. There has been a trend of decline of yields with oscillations. During periods of risk aversion investors seek protection in obligations of the US government, causing decline in their yields. In an eventual resolution of international financial risks with higher economic growth there could be the trauma of rising yields with significant capital losses in portfolios of government securities. The data in Table VI-7 in the text is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).
Chart IIB-1, US, Ten-Year Treasury Constant Maturity Yield, Jan 3, 1977 to Jan 10, 2013
Note: US Recessions in Shaded Areas
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h15/update/
Chart IIB-2 of the Board of Governors of the Federal Reserve System provides securities held outright by Federal Reserve banks from 2002 to 2013. The first data point in Chart IIB-2 is the level for Dec 18, 2002 of $629,407 million and the final data point in Chart IIB-2 is level of $2,669,592 million on Jan 9, 2013.
Chart IIB-2, US, Securities Held Outright by Federal Reserve Banks, Wednesday Level, Dec 26, 2002 to Jan 9, 2013, USD Millions
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm
Chart IIB-3 of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields. The beginning yields in Chart IIB-3 for July 31, 2000, are 3.67 percent for one month, 3.79 percent for two years and 5.07 percent for ten years. On July 31, 2007, yields inverted with the one month at 5.13 percent, the two-year at 4.56 percent and the ten year at 5.13 percent. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield1.64 percent and the ten-year yield 3.41. 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. The final point of Chart IIB-3 is for Jan 10, 2013, with the one-month yield at 0.05 percent, the two-year at 0.26 percent and the ten-year at 1.91 percent.
Chart IIB-3, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields Jul 31, 2001-Jan 10, 2013
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h15/update/
Chart IIB-4 of the Board of Governors of the Federal Reserve System provides the overnight Fed funds rate on business days from Jan 3, 1979, at 8.34 percent per year, to Jan 10, 2013, at 0.14 percent per year. US recessions are in shaded areas according to the reference dates of the NBER (http://www.nber.org/cycles.html). In the Fed effort to control the “Great Inflation” of the 1930s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html), the fed funds rate increased from 8.34 percent on Jan 3, 1979 to a high in Chart IIB-4 of 22.36 percent per year on Jul 22, 1981 with collateral adverse effects in the form of impaired savings and loans associations in the United States, emerging market debt and money-center banks (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7; Pelaez 1986, 1987). Another episode in Chart IIB-4 is the increase in the fed funds rate from 3.15 percent on Jan 3, 1994, to 6.56 percent on Dec 21, 1994, which also had collateral effects in impairing emerging market debt in Mexico and Argentina and bank balance sheets in a world bust of fixed income markets during pursuit by central banks of non-existing inflation (Pelaez and Pelaez, International Financial Architecture (2005), 113-5). Another interesting policy impulse is the reduction of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of equally non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85), followed by increments of 25 basis points from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006 in Chart IIB-4. Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. 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 interest rates close to zero, 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 with the objective of purchasing 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). A final episode in Chart IIB-4 is the reduction of the fed funds rate from 5.41 percent on Aug 9, 2007, to 2.97 percent on October 7, 2008, to 0.12 percent on Dec 5, 2008 and close to zero throughout a long period with the final point at 0.14 percent on Jan 10, 2013. Evidently, this behavior of policy would not have occurred had there been theory, measurements and forecasts to avoid these violent oscillations that are clearly detrimental to economic growth and prosperity without inflation. Current policy consists of forecast mandate of maintaining policy accommodation until the forecast of the rate of unemployment reaches 6.5 percent and the rate of personal consumption expenditures excluding food and energy reaches 2.5 percent (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm). It is a forecast mandate because of the lags in effect of monetary policy impulses on income and prices (Romer and Romer 2004). The intention is to reduce unemployment close to the “natural rate” (Friedman 1968, Phelps 1968) of around 5 percent and inflation at or below 2.0 percent. If forecasts were reasonably accurate, there would not be policy errors. A commonly analyzed risk of zero interest rates is the occurrence of unintended inflation that could precipitate an increase in interest rates similar to the Himalayan rise of the fed funds rate from 8.34 percent on Jan 3, 1979, at the beginning point in Chart IIB-4, to 22.36 percent on Jul 22, 1981. There is a less commonly analyzed risk of the development of a risk premium on Treasury securities because of the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html). There is not a fiscal cliff ahead but rather free fall into a fiscal abyss. The combination of the fiscal abyss with zero interest rates could trigger the risk premium on Treasury debt or Himalayan hike in interest rates.
Chart IIB-4, US, Fed Funds Rate, Business Days, Jan 3, 1979 to Jan 10, 2013, Percent per Year
Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h15/
There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table IIB-7 when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table IIB-7 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.
Table IIB-7, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994
| 1994 | FF | 30Y | 30P | 10Y | 10P | MOR | CPI |
| Jan | 3.00 | 6.29 | 100 | 5.75 | 100 | 7.06 | 2.52 |
| Feb | 3.25 | 6.49 | 97.37 | 5.97 | 98.36 | 7.15 | 2.51 |
| Mar | 3.50 | 6.91 | 92.19 | 6.48 | 94.69 | 7.68 | 2.51 |
| Apr | 3.75 | 7.27 | 88.10 | 6.97 | 91.32 | 8.32 | 2.36 |
| May | 4.25 | 7.41 | 86.59 | 7.18 | 88.93 | 8.60 | 2.29 |
| Jun | 4.25 | 7.40 | 86.69 | 7.10 | 90.45 | 8.40 | 2.49 |
| Jul | 4.25 | 7.58 | 84.81 | 7.30 | 89.14 | 8.61 | 2.77 |
| Aug | 4.75 | 7.49 | 85.74 | 7.24 | 89.53 | 8.51 | 2.69 |
| Sep | 4.75 | 7.71 | 83.49 | 7.46 | 88.10 | 8.64 | 2.96 |
| Oct | 4.75 | 7.94 | 81.23 | 7.74 | 86.33 | 8.93 | 2.61 |
| Nov | 5.50 | 8.08 | 79.90 | 7.96 | 84.96 | 9.17 | 2.67 |
| Dec | 6.00 | 7.87 | 81.91 | 7.81 | 85.89 | 9.20 | 2.67 |
Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months
Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t
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 IIB-8 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 IIB-8, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %
| 2000 | 2007 | 2008 | 2009 | 2010 | 2011 | |
| Goods & | -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 | 1425 | 2488 | 2657 | 2181 | 2519 | 2848 |
| NIIP % | -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/
IA United States International Trade. Subsection IA1 United States International Trade provides data and analysis of US foreign trade. Subsection IA2 Import Export Prices provides analysis of prices in US foreign trade.
IA1 United States International Trade. The United States Census Bureau has released revisions of trade statistics from Jan 2009 to Mar 2012 (http://www.census.gov/foreign-trade/Press-Release/2011pr/final_revisions/). Table IA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html). The US trade balance improved from deficit of $51,647 million in Mar 2012 to deficit of $49,647 million in Apr 2012 and lower deficits of $46,930 million in May, $40,846 million in Jun and $41,630 million in Jul 2012 but with increase to 42,581 million in Aug 2012. The increase of exports in Sep of 3.1 percent was higher than increase of imports of 1.5 percent, resulting in decrease of the trade deficit in Sep to $40,277 million. Exports decreased 3.5 percent in Oct 2012 and imports decreased 2.1 percent for increase in the trade deficit to $42,064 million in Oct 2012. The increase of exports by 3.8 percent in Nov 2012 was much higher than the increase in imports of 1.0 percent, resulting in sharply increasing deficit of $48,731 million. The deterioration of the trade deficit from $44,507 million in Feb 2012 to $51,647 million in Mar 2012 resulted from growth of exports of 2.5 percent while imports jumped 5.2 percent. The US trade balance had improved from deficit of $52,209 million in Jan 2012 to lower deficit of $44,507 million in Feb 2012 mostly because of decline of imports by 2.7 percent while exports increased 0.9 percent. The US trade balance deteriorated sharply from Nov 2011 to Jan 2012 with growth of imports by cumulative 3.0 percent and cumulative increase of exports of 0.1 percent, resulting in deficits of $48,835 million in Nov, $51,748 million in Dec and $52,209 million in Jan, which are the highest since $50,234 million in Jun 2011. In the months of Jun to Oct 2011, exports increased 1.8 percent while imports increased 0.5 percent, resulting in improvement of the trade deficit from $50,234 million in Jun to $45,703 million in Oct. The trade balance deteriorated from cumulative deficit of $494,737 million in Jan-Dec 2010 to deficit of $559,880 million in Jan-Dec 2011.
Table IA-1, US, Trade Balance of Goods and Services Seasonally Adjusted Millions of Dollars and ∆%
| Trade Balance | Exports | Month ∆% | Imports | Month ∆% | |
| Nov 2012 | -48,731 | 182,553 | 1.0 | 231,284 | 3.8 |
| Oct | -42,064 | 180,809 | -3.5 | 222,874 | -2.1 |
| Sep | -40,277 | 187,327 | 3.1 | 227,604 | 1.5 |
| Aug | -42,581 | 181,694 | -1.0 | 224,275 | -0.4 |
| Jul | -41,630 | 183,498 | -1.2 | 225,128 | -0.6 |
| Jun | -40,846 | 185,728 | 1.3 | 226,574 | -1.6 |
| May | -46,930 | 183,290 | 0.4 | 230,220 | -0.9 |
| Apr | -49,647 | 182,649 | -1.2 | 232,296 | -1.8 |
| Mar | -51,647 | 184,867 | 2.5 | 236,514 | 5.2 |
| Feb | -44,507 | 180,348 | 0.9 | 224,855 | -2.7 |
| Jan | -52,209 | 178,802 | 0.6 | 231,011 | 0.7 |
| Dec 2011 | -51,748 | 177,751 | 0.6 | 229,499 | 1.8 |
| Nov | -48,835 | 176,710 | -1.1 | 225,545 | 0.5 |
| Oct | -45,703 | 178,742 | -1.0 | 224,445 | -0.3 |
| Sep | -44,467 | 180,629 | 1.3 | 225,096 | 0.9 |
| Aug | -44,775 | 178,382 | 0.0 | 223,157 | -0.3 |
| Jul | -45,580 | 178,339 | 3.3 | 223,919 | 0.4 |
| Jun | -50,234 | 172,664 | -1.7 | 222,988 | -0.2 |
| May | -47,669 | 175,673 | 0.0 | 223,343 | 1.9 |
| Apr | -43,556 | 175,662 | 0.9 | 219,218 | 0.1 |
| Mar | -44,902 | 174,169 | 4.6 | 219,071 | 3.7 |
| Feb | -44,801 | 166,545 | -0.9 | 211,346 | -2.0 |
| Jan | -47,523 | 168,098 | 1.6 | 215,621 | 4.6 |
| Dec 2010 | -40,677 | 165,499 | 2.0 | 206,176 | 2.5 |
| Jan-Dec | -559,880 | 2,103,367 | 2,663,247 | ||
| Jan-Dec | -494,737 | 1,842,485 | 2,337,222 |
Note: Trade Balance of Goods and Services = Exports of Goods and Services less Imports of Goods and Services. Trade balance may not add exactly because of errors of rounding and seasonality. Source: US Census Bureau http://www.census.gov/foreign-trade/
Table IA-2 provides the US international trade balance, exports and imports on an annual basis from 1992 to 2011. The trade balance deteriorated sharply over the long term. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US increased from $128.2 billion in IIIQ2011, or 3.4 percent of GDP to $128.3 billion in IIIQ2012, or 3.3 percent of GDP (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).
Table IA-2, US, International Trade Balance, Exports and Imports SA, Millions of Dollars
| Period | Balance | Exports | Imports |
| Total | |||
| Annual | |||
| 1992 | -39,212 | 616,882 | 656,094 |
| 1993 | -70,311 | 642,863 | 713,174 |
| 1994 | -98,493 | 703,254 | 801,747 |
| 1995 | -96,384 | 794,387 | 890,771 |
| 1996 | -104,065 | 851,602 | 955,667 |
| 1997 | -108,273 | 934,453 | 1,042,726 |
| 1998 | -166,140 | 933,174 | 1,099,314 |
| 1999 | -263,160 | 967,008 | 1,230,168 |
| 2000 | -376,749 | 1,072,783 | 1,449,532 |
| 2001 | -361,771 | 1,007,726 | 1,369,496 |
| 2002 | -417,432 | 980,879 | 1,398,311 |
| 2003 | -490,984 | 1,023,519 | 1,514,503 |
| 2004 | -605,357 | 1,163,146 | 1,768,502 |
| 2005 | -708,624 | 1,287,441 | 1,996,065 |
| 2006 | -753,288 | 1,459,823 | 2,213,111 |
| 2007 | -696,728 | 1,654,561 | 2,351,289 |
| 2008 | -698,338 | 1,842,682 | 2,541,020 |
| 2009 | -379,154 | 1,578,945 | 1,958,099 |
| 2010 | -494,737 | 1,842,485 | 2,337,222 |
| 2011 | -559,880 | 2,103,367 | 2,663,247 |
Source: US Census Bureau http://www.census.gov/foreign-trade/
Chart IA-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. There was slight improvement at the margin from Jul to Oct 2011 but new increase in the gap from Nov 2011 to Jan 2012 and again in Mar 2012 as exports grow less rapidly than imports. There is improvement in Apr 2012 with imports declining at a faster rate of 1.8 percent than decline of exports by 1.2 percent and growth of exports of 0.4 percent in May 2012 with imports declining 0.9 percent. Further improvement occurred in Jun with imports increasing 1.3 percent and exports declining 1.6 percent. There was deterioration in Jul with exports declining 1.2 percent and imports only 0.6 percent but deterioration in Aug with exports decreasing 1.2 percent while imports declined only 0.6 percent. In Sep 2012, exports increased 3.1 percent while imports increased only 1.5 percent. Further deterioration occurred in Oct with exports declining 3.5 percent but imports falling 2.1 percent. The trade deficit widened sharply to $48,731 million in Nov 2012 with growth of imports by 3.8 percent while exports increased 1.0 percent. Weaker world and internal demand and fluctuating commodity price increases explain the declining or less dynamic changes in exports and imports in Chart IA-1.
Chart IA-1, US Balance, Exports and Imports of Goods and Services $ Billions
Source: US Census Bureau
http://www.census.gov/briefrm/esbr/www/esbr042.html
Chart IA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Nov 2012. There is a long-term trend of deterioration of the US trade deficit shown vividly by Chart IA-2. The trend of deterioration was reversed by the global recession from IVQ2007 to IIQ2009. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4 http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.
IA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Nov 2012
Source: US Census Bureau
http://www.census.gov/foreign-trade/
Chart IA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Nov 2012. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.
Chart IA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Nov 2012
Source: US Census Bureau http://www.census.gov/foreign-trade/
Chart IA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Nov 2012. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion.
Chart IA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Nov 2012
Source: US Census Bureau http://www.census.gov/foreign-trade/
The balance of international trade in goods of the US seasonally-adjusted is shown in Table IA-3. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The balance in international trade of goods deteriorated from $63.3 billion in Nov 2011 to $65.7 billion in Nov 2012. Deterioration of the goods balance in Nov 2012 relative to Nov 2011 occurred mostly in the nonpetroleum balance, exports less imports of goods other than petroleum, in the magnitude of increasing the deficit by $6419 million, while there was moderate improvement in the petroleum balance, exports less imports of petroleum goods, in the magnitude of decreasing the deficit by $3.6 billion. US terms of trade, export prices relative to import prices, and the US trade account fluctuate in accordance with the carry trade from zero interest rates to commodity futures exposures, especially oil futures. Exports increased 2.3 percent with nonpetroleum exports increasing 2.2 percent. Total imports increased 2.8 percent with petroleum imports declining 8.8 percent and nonpetroleum imports increasing 5.9 percent
Table IA-3, US, International Trade in Goods Balance, Exports and Imports $ Millions and ∆% SA
| Nov 2012 | Nov 2011 | ∆% | |
| Total Balance | -65,709 | -63,293 | |
| Petroleum | -23,488 | -27,135 | |
| Non Petroleum | -41,464 | -35,045 | |
| Total Exports | 129,305 | 126,385 | 2.3 |
| Petroleum | 10,710 | 10,349 | 3.5 |
| Non Petroleum | 117,395 | 114,887 | 2.2 |
| Total Imports | 195,014 | 189,678 | 2.8 |
| Petroleum | 34,197 | 37,484 | -8.8 |
| Non Petroleum | 158,860 | 149,932 | 5.9 |
Details may not add because of rounding and seasonal adjustment
Source: US Census Bureau http://www.census.gov/foreign-trade/
US exports and imports of goods not seasonally adjusted in Jan-Nov 2012 and Jan-Nov 2011 are shown in Table IA-4. The rate of growth of exports was 4.6 percent and 3.7 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that increased 3.0 percent and of mineral fuels that increased 6.2 percent both because higher prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose 5.2 percent while imports rose 6.2 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 5.1 percent and crude oil decreasing 4.2 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html).
Table IA-4, US, Exports and Imports of Goods, Not Seasonally Adjusted Millions of Dollars and %
| Jan-Nov 2012 $ Millions | Jan-Nov 2011 $ Millions | ∆% | |
| Exports | 1,416,439 | 1,353,595 | 4.6 |
| Manufactured | 935,147 | 888,698 | 5.2 |
| Agricultural | 128,287 | 124,576 | 3.0 |
| Mineral Fuels | 123,453 | 116,211 | 6.2 |
| Crude Oil | 1,838 | 1,303 | 41.1 |
| Imports | 2,098,011 | 2,023,381 | 3.7 |
| Manufactured | 1,568,907 | 1,477,313 | 6.2 |
| Agricultural | 94,858 | 90,680 | 4.6 |
| Mineral Fuels | 394,787 | 415,789 | -5.1 |
| Crude Oil | 294,313 | 307,202 | -4.2 |
Source: US Census Bureau http://www.census.gov/foreign-trade/
The current account of the US balance of payments is provided in Table IA-5 for IIIQ2011 and IIIQ2012. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US increased from $128.2 billion in IIIQ2011, or 3.4 percent of GDP, to $128.3 billion in IIIQ2012, or 3.3 percent of GDP. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).
Table IA-5, US Balance of Payments, Millions of Dollars NSA
| IIIQ2011 | IIIQ2012 | Difference | |
| Goods Balance | -202,153 | -196,249 | 5,904 |
| X Goods | 378,454 | 382,877 | 1.2 ∆% |
| M Goods | -580,607 | -579,126 | -0.3 ∆% |
| Services Balance | 48,571 | 52,218 | 3,647 |
| X Services | 161,319 | 165,492 | 2.6 ∆% |
| M Services | -112,747 | -113,273 | 0.5 ∆% |
| Balance Goods and Services | -153,581 | -144,031 | 9,550 |
| Balance Income | 57,934 | 50,271 | -7,663 |
| Unilateral Transfers | -32,525 | -34,510 | -1,985 |
| Current Account Balance | -128,172 | -128,270 | -98 |
| % GDP | IIIQ2011 | IVQ2011 | IIIQ2012 |
| 3.4 | 3.1 | 3.3 |
X: exports; M: imports
Balance on Current Account = Balance on Goods and Services + Balance on Income + Unilateral Transfers
Source: Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop
In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):
“Imagine that fiscal policy dominates monetary policy. The fiscal authority independently sets its budgets, announcing all current and future deficits and surpluses and thus determining the amount of revenue that must be raised through bond sales and seignorage. Under this second coordination scheme, the monetary authority faces the constraints imposed by the demand for government bonds, for it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public. Suppose that the demand for government bonds implies an interest rate on bonds greater than the economy’s rate of growth. Then if the fiscal authority runs deficits, the monetary authority is unable to control either the growth rate of the monetary base or inflation forever. If the principal and interest due on these additional bonds are raised by selling still more bonds, so as to continue to hold down the growth of base money, then, because the interest rate on bonds is greater than the economy’s growth rate, the real stock of bonds will growth faster than the size of the economy. This cannot go on forever, since the demand for bonds places an upper limit on the stock of bonds relative to the size of the economy. Once that limit is reached, the principal and interest due on the bonds already sold to fight inflation must be financed, at least in part, by 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 IA-6 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 IA-6, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %
| 2000 | 2007 | 2008 | 2009 | 2010 | 2011 | |
| Goods & | -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 | 1425 | 2488 | 2657 | 2181 | 2519 | 2848 |
| NIIP % | -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
Chart IA-5 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2011. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and elimination of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.
Chart IA-5, US, Balance on Current Account, 1960-2011, Millions of Dollars
Source: Bureau of Economic Analysis
http://www.bea.gov/iTable/index_ita.cfm
Chart IA-6 provides the quarterly balance of payments of the United States in millions of dollars from 1995 to IIIQ2012. The global recession appeared to be adjusting the current account deficit that rises to lower dollar values. Recovery of the economy worsened again the current account deficit. Growth at trend worsens the external imbalance of the US that combines now with unsustainable Treasury deficits/debt.
Chart IA-6, US, Balance on Current Account, Quarterly 1995-2012, Millions of Dollars, SA
Source: Bureau of Economic Analysis
http://www.bea.gov/iTable/index_ita.cfm
IA2 Import Export Prices. Chart IA2-1 provides prices of total US imports 2001-2012. Prices fell during the contraction of 2001. Import price inflation accelerated after unconventional monetary policy of near zero interest rates in 2003-2004 and quantitative easing by withdrawing supply with the suspension of 30-year Treasury bond auctions. Slow pace of adjusting fed funds rates from 1 percent by increments of 25 basis points in 17 consecutive meetings of the Federal Open Market Committee (FOMC) between Jun 2004 and Jun 2006 continued to give impetus to carry trades. The reduction of fed funds rates toward zero in 2008 fueled a spectacular global hunt for yields that caused commodity price inflation in the middle of a global recession. After risk aversion in 2009 because of the announcement of TARP (Troubled Asset Relief Program) creating anxiety on “toxic assets” in bank balance sheets (see Cochrane and Zingales 2009), prices collapsed because of unwinding carry trades. Renewed price increases returned with zero interest rates and quantitative easing. Monetary policy impulses in massive doses have driven inflation and valuation of risk financial assets in wide fluctuations over a decade.
Chart IA2-1, US, Prices of Total US Imports 2001=100, 2001-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-2 provides 12-month percentage changes of prices of total US imports from 2001 to 2012. The only plausible explanation for the wide oscillations is by the carry trade originating in unconventional monetary policy. Import prices jumped in 2008 during deep and protracted global recession driven by carry trades from zero interest rates to long, leveraged positions in commodity futures. Carry trades were unwound during the financial panic in the final quarter of 2008 that resulted in flight to government obligations. Import prices jumped again in 2009 with subdued risk aversion because US banks did not have unsustainable toxic assets. Import prices then fluctuated as carry trades were resumed during periods of risk appetite and unwound during risk aversion resulting from the European debt crisis.
Chart IA2-2, US, Prices of Total US Imports, 12-Month Percentage Changes, 2001-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-3 provides prices of US imports from 1982 to 2012. There is no similar episode to that of the increase of commodity prices in 2008 during a protracted and deep global recession with subsequent collapse during a flight into government obligations. Trade prices have been driven by carry trades created by unconventional monetary policy in the past decade.
Chart IA2-3, US, Prices of Total US Imports, 2001=100, 1982-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-4 provides 12-month percentage changes of US total imports from 1982 to 2012. There have not been wide consecutive oscillations as the ones during the global recession of IVQ2007 to IIQ2009.
Chart IA2-4, US, Prices of Total US Imports, 12-Month Percentage Changes, 1982-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-5 provides the index of US export prices from 2001 to 2012. Import and export prices have been driven by impulses of unconventional monetary policy in massive doses. The most recent segment in Chart IA2-5 shows declining trend resulting from a combination of the world economic slowdown and the decline of commodity prices as carry trade exposures are unwound because of risk aversion to the sovereign debt crisis in Europe.
Chart IA2-5, US, Prices of Total US Exports, 2001=100, 2001-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-6 provides prices of US total exports from 1982 to 2012. The rise before the global recession from 2003 to 2008, driven by carry trades, is also unique in the series and is followed by another steep increase after risk aversion moderated in IQ2009.
Chart IA2-6, US, Prices of Total US Exports, 2001=100, 1982-2012
Source: http://www.bls.gov/mxp/data.htm
Chart IA2-7 provides 12-month percentage changes of total US exports from 1982 to 2012. The uniqueness of the oscillations around the global recession of IVQ2007 to IIQ2009 is clearly revealed.
Chart IA2-7, US, Prices of Total US Exports, 12-Month Percentage Changes, 1982-2012
Source: http://www.bls.gov/mxp/data.htm
Twelve-month percentage changes of US prices of exports and imports are provided in Table IA2-1. Import prices have been driven since 2003 by unconventional monetary policy of near zero interest rates influencing commodity prices according to moods of risk aversion. In a global recession without risk aversion until the panic of Sep 2008 with flight to government obligations, import prices increased 21.4 percent in the 12 months ending in Jul 2012, 18.1 percent in the 12 months ending in Aug 2012, 13.1 percent in the 12 months ending in Sep 2012, 4.9 percent in the twelve months ending in Oct 2008 and fell 5.9 percent in the 12 months ending in Nov 2009 when risk aversion developed in 2008 until mid 2009. Import prices rose again sharply in Nov 2010 by 4.1 percent and in Nov 2011 by 10.1 percent in the presence of zero interest rates with relaxed mood of risk aversion until carry trades were unwound in May 2011 and following months as shown by decrease of import prices by 1.5 percent in the 12 months ending in Nov and Dec 2012 and increase of 1.1 percent in exports. Fluctuations are much sharper in imports because of the high content of oil that as all commodities futures contracts increases sharply with zero interest rates and risk appetite, contracting under risk aversion. There is similar behavior of prices of imports ex fuels, exports and exports ex agricultural goods but less pronounced than for commodity-rich prices dominated by carry trades from zero interest rates. A critical event resulting from unconventional monetary policy driving higher commodity prices by carry trades is the deterioration of the terms of trade, or export prices relative to import prices, that has adversely affected US real income growth relative to what it would have been in the absence of unconventional monetary policy. Europe, Japan and other advanced economies have experienced similar deterioration of their terms of trade. Because of unwinding carry trades of commodity futures as a result of risk aversion, import prices decreased 1.5 percent in the 12 months ending in Dec 2012, export prices increased 1.1 percent and prices of nonagricultural exports decreased 0.4 percent. Imports excluding fuel increased only 0.1 percent in the 12 months ending in Dec 2012. At the margin, prices in world exports and imports are decreasing or increasing moderately because of unwinding carry trades in a temporary mood of risk aversion.
Table IA2-1, US, Twelve-Month Percentage Rates of Change of Prices of Exports and Imports
| Imports | Imports Ex Fuels | Exports | Exports Non-Ag | |
| Dec 2012 | -1.5 | 0.1 | 1.1 | -0.4 |
| Dec 2011 | 8.5 | 3.4 | 3.6 | 4.0 |
| Dec 2010 | 5.3 | 3.0 | 6.5 | 5.1 |
| Dec 2009 | 8.6 | 0.3 | 3.4 | 2.9 |
| Dec 2008 | -10.1 | 1.2 | -2.9 | -2.2 |
| Dec 2007 | 10.6 | 3.1 | 6.0 | 4.5 |
| Dec 2006 | 2.5 | 2.9 | 4.5 | 3.7 |
| Dec 2005 | 8.0 | 1.1 | 2.8 | 2.6 |
| Dec 2004 | 6.7 | 3.0 | 4.0 | 5.0 |
| Dec 2003 | 2.4 | 1.0 | 2.2 | 1.3 |
| Dec 2002 | 4.2 | 0.0 | 1.0 | 0.4 |
| Dec 2001 | -9.1 | NA | -2.5 | -2.5 |
Source: Bureau of Labor Statistics http://www.bls.gov/mxp/data.htm
Table IIA2-2 provides 12-month percentage changes of the import price index all commodities from 2001 to 2012. Interest rates moving toward zero during unconventional monetary policy in 2008 induced carry trades into highly-leveraged commodity derivatives positions that caused increased in 12-month percentage changes of import prices of around 20 percent. The flight into dollars and Treasury securities by fears of toxic assets in banks in the proposal of TARP (Cochrane and Zingales 2009) caused reversion of carry trades and collapse of commodity futures with resulting negative 12-month percentage changes of import prices at the end of 2012.
Table IA2-2, US, Twelve-Month Percentage Changes of Import Price Index All Commodities, 2001-2012
| Year | Jun | Jul | Aug | Sep | Oct | Nov | Dec |
| 2001 | -2.6 | -4.1 | -4.4 | -5.6 | -7.4 | -8.8 | -9.1 |
| 2002 | -3.6 | -1.7 | -1.3 | -0.4 | 1.9 | 2.5 | 4.2 |
| 2003 | 2.2 | 2.3 | 2.0 | 0.7 | 0.8 | 2.3 | 2.4 |
| 2004 | 5.7 | 5.6 | 7.1 | 8.2 | 9.9 | 9.0 | 6.7 |
| 2005 | 7.4 | 8.2 | 8.2 | 9.9 | 8.2 | 6.4 | 8.0 |
| 2006 | 7.4 | 7.0 | 6.0 | 1.6 | -1.0 | 1.3 | 2.5 |
| 2007 | 2.3 | 2.8 | 1.9 | 4.8 | 9.1 | 12.0 | 10.6 |
| 2008 | 21.3 | 21.4 | 18.1 | 13.1 | 4.9 | -5.9 | -10.1 |
| 2009 | -17.5 | -19.1 | -15.3 | -12.0 | -5.6 | 3.4 | 8.6 |
| 2010 | 4.3 | 4.9 | 3.8 | 3.6 | 3.9 | 4.1 | 5.3 |
| 2011 | 13.6 | 13.7 | 12.9 | 12.7 | 11.1 | 10.1 | 8.5 |
| 2012 | -2.5 | -3.3 | -1.8 | -0.6 | 0.1 | -1.5 | -1.5 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
There is finer detail in one-month percentage changes of imports of the US in Table IA2-3. Carry trades into commodity futures induced by interest rates moving to zero in unconventional monetary policy caused sharp monthly increases in import prices for cumulative increase of 13.8 percent from Mar to Jul 2012 at average rate of 2.6 percent per month or annual equivalent in five months of 36.4 percent. There is no other explanation for increases in import prices during sharp global recession and contracting world trade. Import prices then fell 23.4 percent from Aug 2008 to Jan 2009 or at the annual equivalent rate of minus 41.4 percent in the flight to US government securities in fear of the need to buy toxic assets from banks in the TARP program (Cochrane and Zingales 2009). Risk aversion during the first sovereign debt crisis of the euro area in May-Jun 2010 caused decline of US import prices at the annual equivalent rate of 11.4 percent. US import prices have been driven by combinations of carry trades induced by unconventional monetary policy and bouts of risk aversion (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html).
Table IA2-3, US, One-Month Percentage Changes of Import Price Index All Commodities, 2001-2012
| Year | May | Jun | Jul | Aug | Sep | Oct | Nov | Dec |
| 2001 | 0.2 | -0.4 | -1.5 | -0.1 | -0.1 | -2.3 | -1.5 | -1.0 |
| 2002 | 0.1 | -0.3 | 0.4 | 0.3 | 0.7 | 0.0 | -0.9 | 0.6 |
| 2003 | -0.7 | 0.9 | 0.5 | 0.0 | -0.5 | 0.1 | 0.5 | 0.7 |
| 2004 | 1.5 | -0.2 | 0.4 | 1.5 | 0.5 | 1.6 | -0.3 | -1.4 |
| 2005 | -0.8 | 1.2 | 1.2 | 1.4 | 2.1 | 0.1 | -1.9 | 0.0 |
| 2006 | 1.8 | 0.1 | 0.8 | 0.5 | -2.2 | -2.5 | 0.4 | 1.1 |
| 2007 | 0.9 | 1.2 | 1.3 | -0.3 | 0.6 | 1.5 | 3.2 | -0.2 |
| 2008 | 2.8 | 3.0 | 1.4 | -3.1 | -3.6 | -6.0 | -7.4 | -4.6 |
| 2009 | 1.7 | 2.7 | -0.6 | 1.5 | 0.2 | 0.8 | 1.5 | 0.2 |
| 2010 | -0.8 | -1.2 | 0.0 | 0.4 | 0.0 | 1.1 | 1.7 | 1.4 |
| 2011 | 0.1 | -0.6 | 0.1 | -0.4 | -0.1 | -0.4 | 0.7 | 0.0 |
| 2012 | -1.5 | -2.3 | -0.7 | 1.2 | 1.0 | 0.4 | -0.8 | -0.1 |
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-8 shows the US monthly import price index of all commodities excluding fuels from 2001 to 2012. All curves of nominal values follow the same behavior under the influence of unconventional monetary policy. Zero interest rates without risk aversion result in jumps of nominal values while under strong risk aversion even with zero interest rates there are declines of nominal values.
Chart IA2-8, US, Import Price Index All Commodities Excluding Fuels, 2001=100, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-9 provides 12-month percentage changes of the US import price index excluding fuels between 2001 and 2012. There is the same behavior of carry trades driving up without risk aversion and down with risk aversion prices of raw materials, commodities and food in international trade during the global recession of IVQ2007 to IIQ2009 and in previous and subsequent periods.
Chart IA2-9, US, Import Price Index All Commodities Excluding Fuels, 12-Month Percentage Changes, 2002-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-10 provides the monthly US import price index ex petroleum from 2001 to 2012. Prices including or excluding commodities follow the same fluctuations and trends originating in impulses of unconventional monetary policy of zero interest rates.
Chart IA2-10, US, Import Price Index ex Petroleum, 2001=100, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-11 provides the US import price index ex petroleum from 1982 to 2012. There is the same unique hump in 2008 caused by carry trades from zero interest rates to prices of commodities and raw materials.
Chart IA2-11, US, Import Price Index ex Petroleum, 2001=100, 1982-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-12 provides 12-month percentage changes of the import price index ex petroleum from 1986 to 2012. The oscillations caused by the carry trade in increasing prices of commodities and raw materials without risk aversion and subsequently decreasing them during risk aversion are quite unique.
Chart IA2-12, US, Import Price Index ex Petroleum, 12-Month Percentage Changes, 1986-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart VII-3 of the US Energy Information Administration shows the price of WTI crude oil since the 1980s. Chart VII-3 captures commodity price shocks during the past decade. The costly mirage of deflation was caused by the decline in oil prices during the recession of 2001. The upward trend after 2003 was promoted by the carry trade from near zero interest rates. The jump above $140/barrel during the global recession in 2008 at $145.29/barrel on Jul 3, 2008, can only be explained by the carry trade promoted by monetary policy of zero fed funds rate. After moderation of risk aversion, the carry trade returned with resulting sharp upward trend of crude prices. Risk aversion resulted in another drop in recent weeks followed by some recovery.
Chart IA2-13, US, Crude Oil Futures Contract
Source: US Energy Information Administration
http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D
The price index of US imports of petroleum and petroleum products in shown in Chart IA2-14. There is similar behavior of the curves all driven by the same impulses of monetary policy.
Chart IA2-14, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-15 provides the price index of petroleum and petroleum products from 1982 to 2012. The rise in prices during the global recession in 2008 and the decline after the flight to government obligations is unique in the history of the series. Increases in prices of trade in petroleum and petroleum products were induced by carry trades and declines by unwinding carry trades in flight to government obligations.
Chart IA2-15, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 1982-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-16 provides 12-month percentage changes of the price index of US imports of petroleum and petroleum products from 1982 to 2012. There were wider oscillations in this index from 1999 to 2001 (see Barsky and Killian 2004 for an explanation).
Chart IA2-16, US, Import Price Index of Petroleum and Petroleum Products, 12-Month Percentage Changes, 1982-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
The price index of US exports of agricultural commodities is in Chart IA2-17 from 2001 to 2012. There are similar fluctuations and trends as in all other price index originating in unconventional monetary policy repeated over a decade. The most recent segment in 2011 has declining trend in a new flight from risk resulting from the sovereign debt crisis in Europe followed by declines in Jun 2012 and Nov 2012 with stability in Dec 2012.
Chart IA2-17, US, Exports Price Index of Agricultural Commodities, 2001=100, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-18 provides the price index of US exports of agricultural commodities from 1982 to 2012. The increase in 2008 in the middle of deep, protracted contraction was induced by unconventional monetary policy. The decline from 2008 into 2009 was caused by unwinding carry trades in a flight to government obligations. The increase into 2011 and current pause were also induced by unconventional monetary policy in waves of increases during relaxed risk aversion and declines during unwinding of positions because of aversion to financial risk.
Chart IA2-18, US, Exports Price Index of Agricultural Commodities, 2001=100, 1982-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-19 provides 12-month percentage changes of the index of US exports of agricultural commodities from 1986 to 2012. The wide swings in 2008, 2009 and 2011 are only explained by unconventional monetary policy inducing carry trades from zero interest rates to commodity futures and reversals during risk aversion.
Chart IA2-19, US, Exports Price Index of Agricultural Commodities, 12-Month Percentage Changes, 1986-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-20 shows the export price index of nonagricultural commodities from 2001 to 2012. Unconventional monetary policy of zero interest rates drove price behavior during the past decade. Policy has been based on the myth of stimulating the economy by climbing the negative slope of an imaginary short-term Phillips curve.
Chart IA2-20, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 2001-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Chart IA2-21 provides a longer perspective of the price index of US nonagricultural commodities from 1982 to 2012. Increases and decreases around the global contraction after 2007 were caused by carry trade induced by unconventional monetary policy.
Chart IA2-21, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 1982-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
Finally, Chart IA2-22 provides 12-month percentage changes of the price index of US exports of nonagricultural commodities from 1986 to 2012. The wide swings before, during and after the global recession beginning in 2007 were caused by carry trades induced by unconventional monetary policy.
Chart IA2-22, US, Exports Price Index of Nonagricultural Commodities, 12-Month Percentage Changes, 1986-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/mxp/data.htm
IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are four major approaches to the analysis of the depth of the financial crisis and global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and the subpar recovery from IIIQ2009 (Jul) to the present IIIQ2012: (1) deeper contraction and slower recovery in recessions with financial crises; (2) counterfactual of avoiding deeper contraction by fiscal and monetary policies; (3) counterfactual that the financial crises and global recession would have been avoided had economic policies been different; and (4) evidence that growth rates are higher after deeper recessions with financial crises. A counterfactual consists of theory and measurements of what would have occurred otherwise if economic policies or institutional arrangements had been different. This task is quite difficult because economic data are observed with all effects as they actually occurred while the counterfactual attempts to evaluate how data would differ had policies and institutional arrangements been different (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008b), 125, 136). Counterfactual data are unobserved and must be calculated using theory and measurement methods. The measurement of costs and benefits of projects or applied welfare economics (Harberger 1971, 1997) specifies and attempts to measure projects such as what would be economic welfare with or without a bridge or whether markets would be more or less competitive in the absence of antitrust and regulation laws (Winston 2006). Counterfactuals were used in the “new economic history” of the United States to measure the economy with or without railroads (Fishlow 1965, Fogel 1964) and also in analyzing slavery (Fogel and Engerman 1974). A critical counterfactual in economic history is how Britain surged ahead of France (North and Weingast 1989). These four approaches are discussed below in turn followed with comparison of the two recessions of the 1980s from IQ1980 (Jan) to IIIQ1980 (Jul) and from IIIQ1981 (Jul) to IVQ1982 (Nov) as dated by the National Bureau of Economic Research (NBER http://www.nber.org/cycles.html). These comparisons are not idle exercises, defining the interpretation of history and even possibly critical policies and institutional arrangements. There is active debate on these issues (Bordo 2012Oct 21 http://www.bloomberg.com/news/2012-10-21/why-this-u-s-recovery-is-weaker.html Reinhart and Rogoff, 2012Oct14 http://www.economics.harvard.edu/faculty/rogoff/files/Is_US_Different_RR_3.pdf Taylor 2012Oct 25 http://www.johnbtaylorsblog.blogspot.co.uk/2012/10/an-unusually-weak-recovery-as-usually.html, Wolf 2012Oct23 http://www.ft.com/intl/cms/s/0/791fc13a-1c57-11e2-a63b-00144feabdc0.html#axzz2AotsUk1q).
(1) Lower Growth Rates in Recessions with Financial Crises. A monumental effort of data gathering, calculation and analysis by Professors Carmen M. Reinhart and Kenneth Rogoff at Harvard University is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). See http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html. The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time periods:
“Our results incorporate data on 44 countries spanning about 200 years. Taken together, the data incorporate over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements and historic circumstances. We also employ more recent data on external debt, including debt owed by government and by private entities.”
Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average is for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the United States: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90.
For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).
An important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):
“The ignorance, of course, stems from the belief that financial crises happen to other people at other time in other places. Outside a small number of experts, few people fully appreciate the universality of financial crises. The arrogance is of those who believe they have figured out how to do things better and smarter so that the boom can long continue without a crisis.”
There is sober warning by Reinhart and Rogoff (2011CEPR, 42) on the basis of the momentous effort of their scholarly data gathering, calculation and analysis:
“Despite considerable deleveraging by the private financial sector, total debt remains near its historic high in 2008. Total public sector debt during the first quarter of 2010 is 117 percent of GDP. It has only been higher during a one-year sting at 119 percent in 1945. Perhaps soaring US debt levels will not prove to be a drag on growth in the decades to come. However, if history is any guide, that is a risky proposition and over-reliance on US exceptionalism may only be one more example of the “This Time is Different” syndrome.”
As both sides of the Atlantic economy maneuver around defaults the experience on debt and growth deserves significant emphasis in research and policy. The world economy is slowing with high levels of unemployment in advanced economies. Countries do not grow themselves out of unsustainable debts but rather through de facto defaults by means of financial repression and in some cases through inflation. The conclusion is that this time is not different.
Professor Alan M. Taylor (2012) at the University of Virginia analyzes own and collaborative research on 140 years of history with data from 14 advanced economies in the effort to elucidate experience anticipating, during and after financial crises. The conclusion is (Allan M. Taylor 2012, 8):
“Recessions might be painful, but they tend to be even more painful when combined with financial crises or (worse) global crises, and we already know that post-2008 experience will not overturn this conclusion. The impact on credit is also very strong: financial crises lead to strong setbacks in the rate of growth of loans as compared to what happens in normal recessions, and this effect is strong for global crises. Finally, inflation generally falls in recessions, but the downdraft is stronger in financial crisis times.”
Alan M. Taylor (2012) also finds that advanced economies entered the global recession with the largest financial sector in history. There was doubling after 1980 of the ratio of loans to GDP and tripling of the size of bank balance sheets. In contrast, in the period from 1950 to 1970 there was high investment, savings and growth in advanced economies with firm regulation of finance and controls of foreign capital flows.
(2) Counterfactual of the Global Recession. There is a difficult decision on when to withdraw the fiscal stimulus that could have adverse consequences on current growth and employment analyzed by Krugman (2011Jun18). CBO (2011JunLTBO, Chapter 2) considers the timing of withdrawal as well as the equally tough problems that result from not taking prompt action to prevent a possible debt crisis in the future. Krugman (2011Jun18) refers to Eggertsson and Krugman (2010) on the possible contractive effects of debt. The world does not become poorer as a result of debt because an individual’s asset is another’s liability. Past levels of credit may become unacceptable by credit tightening, such as during a financial crisis. Debtors are forced into deleveraging, which results in expenditure reduction, but there may not be compensatory effects by creditors who may not be in need of increasing expenditures. The economy could be pushed toward the lower bound of zero interest rates, or liquidity trap, remaining in that threshold of deflation and high unemployment.
Analysis of debt can lead to the solution of the timing of when to cease stimulus by fiscal spending (Krugman 2011Jun18). Excessive debt caused the financial crisis and global recession and it is difficult to understand how more debt can recover the economy. Krugman (2011Jun18) argues that the level of debt is not important because one individual’s asset is another individual’s liability. The distribution of debt is important when economic agents with high debt levels are encountering different constraints than economic agents with low debt levels. The opportunity for recovery may exist in borrowing by some agents that can adjust the adverse effects of past excessive borrowing by other agents. As Krugman (2011Jun18, 20) states:
“Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.”
Besides operational issues, the consideration of this argument would require specifying and measuring two types of gains and losses from this policy: (1) the benefits in terms of growth and employment currently; and (2) the costs of postponing the adjustment such as in the exercise by CBO (2011JunLTO, 28-31) in Table 11. It may be easier to analyze the costs and benefits than actual measurement.
An analytical and empirical approach is followed by Blinder and Zandi (2010), using the Moody’s Analytics model of the US economy with four different scenarios: (1) baseline with all policies used; (2) counterfactual including all fiscal stimulus policies but excluding financial stimulus policies; (3) counterfactual including all financial stimulus policies but excluding fiscal stimulus; and (4) a scenario excluding all policies. The scenario excluding all policies is an important reference or the counterfactual of what would have happened if the government had been entirely inactive. A salient feature of the work by Blinder and Zandi (2010) is the consideration of both fiscal and financial policies. There was probably more activity with financial policies than with fiscal policies. Financial policies included the Fed balance sheet, 11 facilities of direct credit to illiquid segments of financial markets, interest rate policy, the Financial Stability Plan including stress tests of banks, the Troubled Asset Relief Program (TARP) and others (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 157-67; Regulation of Banks and Finance (2009a), 224-7).
Blinder and Zandi (2010, 4) find that:
“In the scenario that excludes all the extraordinary policies, the downturn continues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010 (see Table 3). The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemployment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fiscal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.”
The conclusion by Blinder and Zandi (2010) is that if the US had not taken massive fiscal and financial measures the economy could have suffered far more during a prolonged period. There are still a multitude of questions that cloud understanding of the impact of the recession and what would have happened without massive policy impulses. Some effects are quite difficult to measure. An important argument by Blinder and Zandi (2010) is that this evaluation of counterfactuals is relevant to the need of stimulus if economic conditions worsened again.
(3) Counterfactual of Policies Causing the Financial Crisis and Global Recession. The counterfactual of avoidance of deeper and more prolonged contraction by fiscal and monetary policies is not the critical issue. As Professor John B. Taylor (2012Oct25) argues the critically important counterfactual is that the financial crisis and global recessions would have not occurred in the first place if different economic policies had been followed. The counterfactual intends to verify that a combination of housing policies and discretionary monetary policies instead of rules (Taylor 1993) caused, deepened and prolonged the financial crisis (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB; see http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html) and that the experience resembles that of the Great Inflation of the 1960s and 1970s with stop-and-go growth/inflation that coined the term stagflation (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 Appendix I).
The explanation of the sharp contraction of United States housing can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:
“On the maturity date T, the firm must either pay the promised payment of B to the debtholders or else the current equity will be valueless. Clearly, if at time T, V(T) > B, the firm should pay the bondholders because the value of equity will be V(T) – B > 0 whereas if they do not, the value of equity would be zero. If V(T) ≤ B, then the firm will not make the payment and default the firm to the bondholders because otherwise the equity holders would have to pay in additional money and the (formal) value of equity prior to such payments would be (V(T)- B) < 0.”
Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:
“The house market [in 2006] is probably operating with low historical levels of individual equity. There is an application of structural models [Duffie and Singleton 2003] to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown.”
There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Ingersoll 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.
The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (1)
Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.
Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).
The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.
In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection of skills of the relationship banker converts an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.
Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.
The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):
“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”
Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:
“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”
Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.
In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):
“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”
The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. The Federal Home Loan Bank (FHLB) system was established by Congress in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly-owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.
According to Pinto (2008) in testimony to Congress:
“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in Germany. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
(4) Historically Sharper Recoveries from Deeper Contractions and Financial Crises. Professor Michael D. Bordo (2012Sep27), at Rutgers University, is providing clear thought on the correct comparison of the current business cycles in the United States with those in United States history. There are two issues raised by Professor Bordo: (1) lumping together countries with different institutions, economic policies and financial systems; and (2) the conclusion that growth is mediocre after financial crises and deep recessions, which is repeated daily in the media, but that Bordo and Haubrich (2012DR) persuasively demonstrate to be inconsistent with United States experience.
Depriving economic history of institutions is perilous as is illustrated by the economic history of Brazil. Douglass C. North (1994) emphasized the key role of institutions in explaining economic history. Rondo E. Cameron (1961, 1967, 1972) applied institutional analysis to banking history. Friedman and Schwartz (1963) analyzed the relation of money, income and prices in the business cycle and related the monetary policy of an important institution, the Federal Reserve System, to the Great Depression. Bordo, Choudhri and Schwartz (1995) analyze the counterfactual of what would have been economic performance if the Fed had used during the Great Depression the Friedman (1960) monetary policy rule of constant growth of money(for analysis of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). Alan Meltzer (2004, 2010a,b) analyzed the Federal Reserve System over its history. The reader would be intrigued by Figure 5 in Reinhart and Rogoff (2010FCDC, 15) in which Brazil is classified in external default for seven years between 1828 and 1834 but not again until 64 years later in 1989, above the 50 years of incidence for “serial default”. This void has been filled in scholarly research on nineteenth-century Brazil by William R. Summerhill, Jr. (2007SC, 2007IR). There are important conclusions by Summerhill on the exceptional sample of institutional change or actually lack of change, public finance and financial repression in Brazil between 1822 an 1899, combining tools of economics, political science and history. During seven continuous decades, Brazil did not miss a single interest payment with government borrowing without repudiation of debt or default. What is really surprising is that Brazil borrowed by means of long-term bonds and even more surprising interest rates fell over time. The external debt of Brazil in 1870 was ₤41,275,961 and the domestic debt in the internal market was ₤25,708,711, or 62.3 percent of the total (Summerhill 2007IR, 73).
The experience of Brazil differed from that of Latin America (Summerhill 2007IR). During the six decades when Brazil borrowed without difficulty, Latin American countries becoming independent after 1820 engaged in total defaults, suffering hardship in borrowing abroad. The countries that borrowed again fell again in default during the nineteenth century. Venezuela defaulted in four occasions. Mexico defaulted in 1827, rescheduling its debt eight different times and servicing the debt sporadically. About 44 percent of Latin America’s sovereign debt was in default in 1855 and approximately 86 percent of total government loans defaulted in London originated in Spanish American borrowing countries.
External economies of commitment to secure private rights in sovereign credit would encourage development of private financial institutions, as postulated in classic work by North and Weingast (1989), Summerhill 2007IR, 22). This is how banking institutions critical to the Industrial Revolution were developed in England (Cameron 1967). The obstacle in Brazil found by Summerhill (2007IR) is that sovereign debt credibility was combined with financial repression. There was a break in Brazil of the chain of effects from protecting public borrowing, as in North and Weingast (1989), to development of private financial institutions. According to Pelaez 1976, 283) following Cameron:
“The banking law of 1860 placed severe restrictions on two basic modern economic institutions—the corporation and the commercial bank. The growth of the volume of bank credit was one of the most significant factors of financial intermediation and economic growth in the major trading countries of the gold standard group. But Brazil placed strong restrictions on the development of banking and intermediation functions, preventing the channeling of coffee savings into domestic industry at an earlier date.”
Brazil actually abandoned the gold standard during multiple financial crises in the nineteenth century, as it should have to protect domestic economic activity. Pelaez (1975, 447) finds similar experience in the first half of nineteenth-century Brazil:
“Brazil’s experience is particularly interesting in that in the period 1808-1851 there were three types of monetary systems. Between 1808 and 1829, there was only one government-related Bank of Brazil, enjoying a perfect monopoly of banking services. No new banks were established in the 1830s after the liquidation of the Bank of Brazil in 1829. During the coffee boom in the late 1830s and 1840s, a system of banks of issue, patterned after similar institutions in the industrial countries [Cameron 1967], supplied the financial services required in the first stage of modernization of the export economy.”
Financial crises in the advanced economies were transmitted to nineteenth-century Brazil by the arrival of a ship (Pelaez and Suzigan 1981). The explanation of those crises and the economy of Brazil requires knowledge and roles of institutions, economic policies and the financial system chosen by Brazil, in agreement with Bordo (2012Sep27).
The departing theoretical framework of Bordo and Haubrich (2012DR) is the plucking model of Friedman (1964, 1988). Friedman (1988, 1) recalls “I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuation in money and income reflect primarily the influence of money on income or of income on money?” Friedman (1964, 1988) finds useful for this purpose to analyze the relation between expansions and contractions. Analyzing the business cycle in the United States between 1870 and 1961, Friedman (1964, 15) found that “a large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion.” The depth of the contraction opens up more room in the movement toward full employment (Friedman 1964, 17):
“Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities and prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction.”
Kim and Nelson (1999) test the asymmetric plucking model of Friedman (1964, 1988) relative to a symmetric model using reference cycles of the NBER and find evidence supporting the Friedman model. Bordo and Haubrich (2012DR) analyze 27 cycles beginning in 1872, using various measures of financial crises while considering different regulatory and monetary regimes. The revealing conclusion of Bordo and Haubrich (2012DR, 2) is that:
“Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength. For many configurations, the evidence for a robust bounce-back is stronger for cycles with financial crises than those without.”
The average rate of growth of real GDP in expansions after recessions with financial crises was 8 percent but only 6.9 percent on average for recessions without financial crises (Bordo 2012Sep27). Real GDP declined 12 percent in the Panic of 1907 and increased 13 percent in the recovery, consistent with the plucking model of Friedman (Bordo 2012Sep27). Bordo (2012Sep27) finds two probable explanations for the weak recovery during the current economic cycle: (1) collapse of United States housing; and (2) uncertainty originating in fiscal policy, regulation and structural changes. There are serious doubts if monetary policy is adequate to recover the economy under these conditions.
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 7.4 percent at the annual equivalent rate of 2.2 percent. In the 12 quarters of cyclical expansion real disposable personal income (RDPI) increased 5.4 percent at the annual equivalent rate of 1.6 percent; RDPI per capita increased 3.0 percent at the annual equivalent rate of 0.9 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 2.5 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IIIQ2012, real disposable personal income increased 3.4 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 0.4 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 | 7.5 | 2.2 | |
| RDPI | 5.4 | 1.6 | |
| RDPI per Capita | 3.0 | 0.9 | |
| Population | 2.3 | 0.7 | |
| IVQ2007 to IIIQ2012 | 20 | ||
| GDP | 2.5 | 0.5 | |
| RDPI | 3.4 | 0.7 | |
| RDPI per Capita | -0.4 | ||
| 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 seven 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 IIIQ2012; (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; (6) wealth of households and nonprofit organizations soared in the 1980s but declined into IIIQ2012; and (7) gross private domestic investment increased sharply from IQ1980 to IVQ1985 but gross private domestic investment and private fixed investment have fallen sharply from IVQ2007 to IIIQ2007. 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 2.5 percent while trend growth would have been 15.1 percent. GDP in IIIQ2012 at seasonally adjusted annual rate is estimated at $13,652.5 by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,338.2 billion, or $1,685.7 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 28.6 million people or 17.7 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/12/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/2012/12/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 | 13,652.5 |
| ∆% IVQ2007 to IIIQ2012 Actual | 2.5 |
| ∆% 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 0.4 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 | 32,691 |
| ∆% IVQ2007 to IIIQ2012 | -0.4 |
| ∆% 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 28.6 million persons unemployed or underemployed, which is 17.7 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/12/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 IIB-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 IIIQ2012 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 Table IB-2, net worth of households and nonprofit organizations fell from $66,000.6 billion in IVQ2007 to $64,768.8 billion in IIIQ2012 by $1,231.8 billion or 1.9 percent. The US consumer price index was 210.036 in Dec 2007 and 231.407 in Sep 2012 for increase of 10.2 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 10.9 percent in Sep 2012 after 13 consecutive quarters of expansion from IIIQ2009 to IIIQ2012 relative to IVQ2007 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 (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states.html). The US missed the opportunity of high growth rates that has been available in past cyclical expansions. US wealth of households and nonprofit organizations grew from IVQ1945 at $710,125.9 million to IIIQ2009 at $64,768,835.3 million or increase of 9,020.8 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 231.407 in Sep 2012 or 1,171.5 percent. There was a gigantic increase of US net worth of households and nonprofit organizations over 67 years with inflation adjusted increase of 617.3 percent. The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of US household and nonprofit net worth. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 67 years when US GDP grew at 2.2 percent on average in 13 quarters between IIIQ2009 and IIIQ2012 in contrast with average 5.7 percent from IQ1983 to IVQ1985 and average 6.2 percent during cyclical expansions in those 67 years.
| 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 | 66,000.6 |
| IIIQ2012 | 64,768.8 |
| ∆ USD Billions | -1,231.8 |
7. Gross Private Domestic Investment.
i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IV1985 and from IVQ2007 to IIQ2012 is provides in the following block and in Table IB-2. Gross private domestic investment increased from $778.3 billion in IQ1980 to $965.9 billion in IVQ1985 or by 24.1 percent.
ii In the current cycle, gross private domestic investment decreased from $2,123.6 billion in IVQ2007 to $1,928.8 billion in IIIQ2012, or decline by 9.2 percent. Private fixed investment fell from $2,111.5 billion in IVQ2007 to $1844.8 billion in IIIQ2012, or decline by 12.6 percent.
| Period IQ1980 to IVQ1985 | |
| Gross Private Domestic Investment USD 2005 Billions | |
| IQ1980 | 778.3 |
| IVQ1985 | 965.9 |
| ∆% | 24.1 |
| Period IVQ2007 to IIIQ2012 | |
| Gross Private Domestic Investment USD Billions | |
| IVQ2007 | 2,123.6 |
| IIIQ2012 | 1,928.8 |
| ∆% | -9.2 |
| Private Fixed Investment USD 2005 Billions | |
| IVQ2007 | 2,111.5 |
| IIIQ2012 | 1,844.8 |
| ∆% | -12.6 |
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 |
| Gross Private Domestic Investment USD 2005 Billions | |
| IQ1980 | 778.3 |
| IVQ1985 | 965.9 |
| ∆% | 24.1 |
| Period IVQ2007 to IIIQ2012 | |
| GDP SAAR USD Billions | |
| IVQ2007 | 13,326.0 |
| IIIQ2012 | 13,652.5 |
| ∆% IVQ2007 to IIIQ2012 | 2.5 |
| ∆% 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 | 32,691 |
| ∆% IVQ2007 to IIIQ2012 | -0.4 |
| ∆% 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 IIIQ2012 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 | 66,000.6 |
| IIIQ2012 | 64,768.8 |
| ∆ USD Billions | -1,231.8 |
| Gross Private Domestic Investment USD Billions | |
| IVQ2007 | 2,123.6 |
| IIIQ2012 | 1,928.8 |
| ∆% | -9.2 |
| Private Fixed Investment USD 2005 Billions | |
| IVQ2007 | 2,111.5 |
| IIIQ2012 | 1,844.8 |
| ∆% | -12.6 |
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.
IIA Peaking Valuation of Risk Financial Assets since 2006. Percentage changes of risk financial assets from the last day of the year relative to the last day of the earlier year are provided in Table IIA-1 from 2007 to 2012. Calendar year 2012 was excellent for most equity indexes. DAX outperformed all equity indexes in Table IIA-1 with increase of 29.1 percent followed by 25.9 percent for NYSE Financials. Nikkei Average gained 22.9 percent for the first increase in three years. Dow Asia Pacific gained 13.1 percent while DJIA increased 7.3 percent and S&P 500 increased 13.4 percent. The USD depreciated 2.0 percent relative to the EUR and the DJ UBS Commodities Index fell 1.1 percent. The only gain for a major equity market in Table I-1 for 2011 is 5.5 percent for the DJIA. S&P 500 is better than other equity markets by remaining flat for 2011. With the exception of a drop of 8.4 percent of the European equity index STOXX 50, all declines of equity markets in 2011 are in excess of 10 percent. China’s Shanghai Composite lost 21.7 percent. The equity index of Germany Dax fell 14.7 percent. The DJ UBS Commodities Index dropped 13.4 percent. Robin Wigglesworth, writing on Dec 30, 2011, on “$6.3tn wiped off markets in 2011,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/483069d8-32f3-11e1-8e0d-00144feabdc0.html#axzz1i2BE7OPa), provides an estimate of $6.3 trillion erased from equity markets globally in 2011. The Bureau of Economic Analysis (BEA) estimates US nominal GDP in 2011 at $15,075.7 billion (http://www.bea.gov/iTable/index_nipa.cfm). The loss in equity markets worldwide in 2011 of $6.3 trillion is equivalent to about 41 percent of US GDP or economic activity in 2011. Table IIA-1 also provides the exchange rate of number of US dollars (USD) required in buying a unit of euro (EUR), USD/EUR. The dollar appreciated 3.2 percent on the last day of trading in 2011 relative to the last day of trading in 2010, suggesting risk aversion.
Table IIA-1, Percentage Change of Year-end Values of Financial Assets Relative to Earlier Year-end Values 2007-2012
| 2012 | 2011 | 2010 | 2009 | 2008 | 2007 | |
| DJIA | 7.3 | 5.5 | 11.0 | 18.8 | -33.8 | 6.1 |
| S&P 500 | 13.4 | 0.0 | 12.8 | 23.5 | -38.5 | 3.1 |
| NYSE Fin | 25.9 | -18.1 | 5.0 | 22.7 | -53.6 | -13.5 |
| Dow Global | 10.8 | -13.7 | 4.6 | 30.8 | -45.5 | 30.9 |
| Dow Asia-Pacific | 13.1 | -17.6 | 15.9 | 36.4 | -44.2 | 14.2 |
| Nikkei Av | 22.9 | -17.3 | -3.0 | 20.6 | -42.9 | -10.8 |
| Shanghai | 3.2 | -21.7 | -11.9 | 73.9 | -65.2 | 104.9 |
| STOXX 50 | 8.8 | -8.4 | -0.1 | 28.5 | -44.6 | -2.2 |
| DAX | 29.1 | -14.7 | 16.1 | 23.8 | -40.4 | 22.0 |
| USD/EUR* | -2.0 | 3.2 | 6.7 | -2.9 | 4.7 | -10.7 |
| DJ UBS Com | -1.1 | -13.4 | 16.7 | 18.7 | -36.6 | 11.2 |
*Negative sign is dollar devaluation; positive sign is dollar appreciation
Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata
The other yearly percentage changes in Table IIA-1 are also revealing wide fluctuations in valuations of risk financial assets. To be sure, economic conditions and perceptions of the future do influence valuations of risk financial assets. It is also valid to contend that unconventional monetary policy magnifies fluctuations in these valuations by inducing carry trades from zero interest rates to exposures with high leverage in risk financial assets such as equities, emerging equities, currencies, high-yield structured products and commodities futures and options. In fact, one of the alleged channels of transmission of unconventional monetary policy is through higher consumption induced by increases in wealth resulting from higher valuations of stock markets. Unconventional monetary policy could also result in magnification of values of risk financial assets beyond actual discounted future cash flows, creating financial instability. Separating all these effects in practice may be quite difficult because they are observed simultaneously while conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects (on counterfactuals see Pelaez and Pelaez, Globalization and the State Vol I (2008a), 125, 136, Harberger (1971, 1997), Fishlow 1965, Fogel 1964, Fogel and Engerman 1974, North and Weingast 1989, Pelaez 1979, 26-7). There is no certainty or evidence that unconventional policies attain their intended effects without risks of costly side effects. Yearly fluctuations of financial assets in Table IA2-1 are quite wide. In 2007, for example, the equity index Dow Global increased 30.9 percent while Dax gained 22.0 percent and the Shanghai Composite jumped 104.9 percent. The DJIA gained only 6.1 percent as recession began in IVQ2007. The flight to government obligations in 2008 (Cochrane and Zingales 2009, Cochrane 2011Jan) was equivalent to the astronomical declines of world equity markets and commodities. The flight from risk is also in evidence in the appreciation of the dollar by 4.7 percent in 2008 with unwinding carry trades and with renewed carry trades in the depreciation of the dollar by 2.9 percent in 2009. Recovery still continued in 2010 with shocks of the European debt crisis in the spring and in Nov 2010. The flight from risk exposures dominated declines of valuations of risk financial assets in 2011.
Table IIA-2 is designed to provide a comparison of valuations of risk financial assets at the end of 2012 relative to valuations at the end of every year from 2006 to 2011. For example, the DJIA index is 7.3 percent higher at the end of 2012 relative to the valuation at the end of 2011 but is 1.2 percent below the valuation at the end of 2007 and 4.8 percent higher relative to the valuation at the end of 2006. It is higher by 49.3 percent at the end of 2012 relative to the depressed valuation at the end of 2008. Pre-recession valuations of 2006 and 2007 have not been recovered for all financial assets in Table IIA-2. All equity indexes are still lower at the end of 2012 relative to the values at the end of 2007. Some equity indexes are higher at the end of 2012 relative to the end of 2006: DJIA by 4.8 percent, S&P by 0.1 percent and DAX by 15.1 percent. Although the Nikkei Average increased 22.9 percent in 2012 relative to 2011, it is still 32.1 percent lower than in 2007 and 39.5 percent lower than in 2006. At the end of 2012, Dow Global is 28.8 percent lower than at the end of 2007 and 6.8 percent lower than at the end of 2006. The Shanghai Composite increased 3.2 percent at the end of 2012 relative to 2011 but is 56.9 percent lower than at the end of 2007 and 11.7 percent lower than at the end of 2006. DJ UBS Commodities is 24.8 percent lower at the end of 2012 relative to 2007 and 16.4 percent lower relative to 2006. The USD is 9.6 stronger at the end of 2012 relative to 2007 and flat relative to 2006. Low valuations of risk financial assets are intimately related to risk aversion in international financial markets because of the European debt crisis, weakness and unemployment in advanced economies, fiscal imbalances and slowing growth worldwide. Valuations of stock indexes for the US and Germany are peaking at the turn of 2012 into 2013 relative to 2007 and 2006.
Table IIA-2, Percentage Change of Year-end 2012 Values of Financial Assets Relative to Year-end Values 2006-2011
| ∆% 2012/ 2011 | ∆% 2012/ 2010 | ∆% 2012/2009 | ∆% 2012/ 2008 | ∆% 2012/2007 | ∆% 2012/ 2006 | |
| DJIA | 7.3 | 13.2 | 25.7 | 49.3 | -1.2 | 4.8 |
| S&P 500 | 13.4 | 13.4 | 27.9 | 57.9 | -2.9 | 0.1 |
| NYSE Fin | 25.9 | 3.1 | 8.3 | 32.9 | -38.4 | -46.7 |
| Dow Global | 10.8 | -4.4 | 0.0 | 30.8 | -28.8 | -6.8 |
| Dow Asia-Pacific | 13.1 | -6.8 | 8.0 | 47.4 | -17.7 | -6.0 |
| Nikkei Av | 22.9 | 1.6 | -1.4 | 18.8 | -32.1 | -39.5 |
| Shanghai | 3.2 | -19.2 | -28.8 | 23.8 | -56.9 | -11.7 |
| STOXX 50 | 8.8 | -0.3 | -0.5 | 27.9 | -29.1 | -30.6 |
| DAX | 29.1 | 10.1 | 27.8 | 58.3 | -5.6 | 15.1 |
| USD/EUR* | -2.0 | 1.3 | 7.9 | 5.2 | 9.6 | 0.0 |
| DJ UBS Com | -1.1 | -14.4 | -0.1 | 18.6 | -24.8 | -16.4 |
*Negative sign is dollar devaluation; positive sign is dollar appreciation
Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata
The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF (2012WEOOct) provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (IMF 2012GFSROct) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (IMF 2012FMOct) (http://www.imf.org/external/pubs/ft/fm/2012/02/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider global economic and financial risks, which are analyzed in the comments of this blog.
Economic risks include the following:
5. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the third quarter of 2012 of 2.2 percent is equivalent to 9.1 percent per year and GDP increased 7.4 percent relative to the third quarter of 2011.
6. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 29.5 million in job stress or 18.2 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html), fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.
7. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
8. World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html).
A list of financial uncertainties includes:
7. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
8. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
9. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
10. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
11. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
12. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion.
It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in Section VI Valuation of Risk Financial Assets after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII).
The highest valuations in column “∆% Trough to 1/11/13” of Table IIA-3 are by US equities indexes: DJIA 39.3 percent and S&P 500 43.9 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. DAX of Germany is now 36.1 percent above the trough. The DJIA reached 13,661.87 on Oct 5, 2012, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata) and closed at 13471.22 on Jan 10, 2013, which is only 1.4 percent below the recent 52-week high. The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 1/11/13” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior: China’s Shanghai Composite is 5.9 percent below the trough; Japan’s Nikkei Average is 22.4 percent above the trough; DJ Asia Pacific TSM is 17.3 percent above the trough; Dow Global is 21.9 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 15.3 percent above the trough; and NYSE Financial is 25.3 percent above the trough. DJ UBS Commodities is 11.7 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 36.1 percent above the trough. Japan’s Nikkei Average is 22.4 percent above the trough on Aug 31, 2010 and 5.2 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 10801.57 on Fri Jan 11, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 5.3 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 11.9 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 1/11/13” in Table IIA-3 shows that there were increases of valuations of risk financial assets in the week of Jan 11, 2013 such as 0.2 percent for DJ Asia Pacific TSM. Nikkei Average increased 1.1 percent in the week. DJ UBS Commodities increased 0.6 percent. China’s Shanghai Composite decreased 1.5 percent in the week of Jan 11, 2013. The DJIA increased 0.4 percent and S&P 500 increased 0.4 percent. There were increases in several indexes: 1.0 percent for NYSE Financial Index, 1.2 percent for Dow Global. STOXX 50 fell 0.2 percent and DAX of Germany fell 0.8 percent. The USD depreciated 2.1 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table IIA-3 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 1/11/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jan 11, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 1/11/13” but also relative to the peak in column “∆% Peak to 1/11/13.” There are now four equity indexes above the peak in Table IIA-3: DJIA 20.4 percent, S&P 500 20.9 percent, DAX 21.8 percent and DJ Asia Pacific 2.7 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 0.2 percent, Nikkei Average by 5.2 percent, Shanghai Composite by 29.1 percent, STOXX 50 by 2.4 percent and Dow Global by 0.5 percent. DJ UBS Commodities Index is now 4.5 percent below the peak. The US dollar strengthened 11.8 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. 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. 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:
![clip_image002[2]](http://lh4.ggpht.com/-p5rvTqi82sM/UPOw9DNES4I/AAAAAAAAPi4/uB4mD0uQNqQ/s1600-h/clip_image002%25255B2%25255D%25255B2%25255D.gif "clip_image002[2]"){kind=small}
Where Rτ is expected revenue in the time horizon from τ =1 to T; Cτ 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
![clip_image002[3]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeDVYiczaXcRvOjWkKnCC3w-6ExFNd2TuoHBzAOxoo292ndewwY6_hUPMB8dX1-DrkNOnnxIdLhK3LC8YhBgK1wp_1YJxqkS9YUtYAeG-Yrmj2IqDr-grfpyBK1rc8IYJsZHpLIUF2gGU/s1600-h/clip_image002%25255B3%25255D%25255B2%25255D.gif "clip_image002[3]"){kind=small}
declines. Equally, decline in expected revenue from the stock or project, Rτ, causes decline in valuation. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.
Table IIA-3, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 1/11/ /13 | ∆% Week 1/11/13 | ∆% Trough to 1/11/ 13 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 20.4 | 0.4 | 39.3 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 20.9 | 0.4 | 43.9 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -0.2 | 1.0 | 25.3 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -0.5 | 1.2 | 21.9 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | 2.7 | 0.2 | 17.3 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -5.2 | 1.1 | 22.4 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -29.1 | -1.5 | -5.9 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -2.4 | -0.2 | 15.3 |
| DAX | 4/26/ | 5/25/ | -10.5 | 21.8 | -0.8 | 36.1 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 11.8 | -2.1 | -11.9 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -4.5 | 0.6 | 11.7 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 1.862 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
IIB Budget Deficits Threatening Risk Premium on Unsustainable United States Government Debt. The United States Senate passed on Jan 1, 2013, H.R. 8 American Taxpayer Relief Act of 2012 (http://www.gpo.gov/fdsys/pkg/BILLS-112hr8eas/pdf/BILLS-112hr8eas.pdf) subsequently passed in the United States House of Representatives and signed into law by the President. The Congressional Budget Office (CBO) analyzes the effects of the American Taxpayer Relief Act of 2012 (http://www.cbo.gov/publication/43829). The bulk of the effects originate in Title I—General Extensions. Table IIB-1 provides the estimates of effects of the General Extensions and the overall bill. The Treasury deficit of the United States increases by $3,971 billion from 2013 to 2022 or about $4 trillion. The alternative scenario of deficits and debts of CBO appears to be more relevant than the base scenario in which tax rates would increase and expenditures decline. The bulk of this section concentrates on United States unsustainable deficit/debt that may cause an increase in the risk premium of Treasury debt with adverse effects on economic activity and employment.
Table IIB-1, Estimate by the Congressional Budget Office of Budget Effects of H.R.8, the American Taxpayer Relief Act of 2012, Passed by US Senate on January 1, 2013
| General Extensions | Total Changes in Revenues | Net Increase or (-) Decrease in Deficits | |
| 2013 | -206,542 | -279,840 | 329,644 |
| 2014 | -266,004 | -298,778 | 353,881 |
| 2015 | -290,573 | -274,707 | 311,008 |
| 2016 | -315,761 | -305,405 | 340,449 |
| 2017 | -344,090 | -336,613 | 371,139 |
| 2018 | -372,728 | -367,146 | 404,636 |
| 2019 | -395,390 | -393,146 | 415,743 |
| 2020 | -425,716 | -425,585 | 447,618 |
| 2021 | -460,619 | -460,509 | 482,553 |
| 2022 | -496,647 | -496,826 | 514,523 |
| 2013-2017 | -1,422,970 | -1,495,340 | 1,705,118 |
| 2013-2022 | -3,575,062 | -3,638,803 | 3,971,177 |
Source: Congressional Budget Office
http://www.cbo.gov/publication/43829
Table IIB-2 provides federal debt outstanding, held by government accounts and held by the public in millions of dollars for fiscal years from 2007 to 2012. Federal debt outstanding has increased 78.2 percent from fiscal year 2007 to fiscal year 2012 while federal debt held by the public has increased 122.8 percent and federal debt held by government accounts has increased 21.1 percent.
Table IIB-2, US, Federal Debt Outstanding, Held by Government Accounts and Held by the Public, Millions of Dollars
| Outstanding | Held by Government Accounts | Held by the Public | |
| 2012 Sep | 16,090,640 | 4,791,850 | 11,298,790 |
| Fiscal Years | |||
| 2012 | 16,090,640 | 4,791,850 | 11,298,790 |
| 2011 | 14,815,328 | 4,658,307 | 10,157,021 |
| 2010 | 13,585,596 | 4,534,014 | 9,051,582 |
| 2009 | 11,933,031 | 4,355,291 | 7,577,739 |
| 2008 | 10,047,828 | 4,210,491 | 5,837,337 |
| 2007 | 9,030,612 | 3,958,417 | 5,072,195 |
| ∆% 2007-2012 | 78.2 | 21.1 | 122.8 |
Source: United States Treasury. 2012Dec. Treasury Bulletin. Washington, DC, Dec 2012. https://www.fms.treas.gov/bulletin/index.html
Table IIB-3 provides the maturity distribution and average length in months of marketable interest-bearing debt held by private investors from 2007 to Sep 2012. Total debt held by investors increased from $3635 billion in 2007 to $9040 billion in Sep 2012 or increase by 148.7 percent. There are two concerns with the maturity distribution of US debt. (1) Growth of debt is moving total debt to the point of saturation in investors’ portfolio. In a new environment of risk appetite and nonzero fed funds rates with economic growth at historical trend of around 3 percent, yields on risk financial assets are likely to increase. Placement of new debt may require increasing interest rates in an environment of continuing placement of debt by the US Treasury without strong fiscal constraints. (2) Refinancing of maturing debt is likely to occur in an environment of higher interest rates, exerting pressure on future fiscal budgets. In Sep 2012, $2897 billion or 32.1 percent of outstanding debt held by investors matures in less than a year and $3852 billion or 42.6 percent of total debt matures in one to five years. Debt maturing in five years or less adds to $6749 billion or 74.7 percent of total outstanding debt held by investors of $9040 billion. This current episode may be remembered historically as one in which the US managed its government debt with short-dated instruments during record low long-dated yields and on the verge of fiscal pressures on all interest rates, which kind of maximizes over time interest payments on government debt by taxpayers that is precisely the opposite of the objective of sound debt management and taxpayer welfare.
Table IIB-3, Maturity Distribution and Average Length in Months of Marketable Interest-Bearing Public Debt Held by Private Investors, Billions of Dollars
| End of Fiscal Year or Month | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | Sep 2012 |
| Total* | 3635 | 4745 | 6229 | 7676 | 7951 | 9040 | 9040 |
| <1 Year | 1176 | 2042 | 2605 | 2480 | 2504 | 2897 | 2897 |
| 1-5 Years | 1310 | 1468 | 2075 | 2956 | 3085 | 3852 | 3852 |
| 5-10 Years | 678 | 719 | 995 | 1529 | 1544 | 1488 | 1488 |
| 10-20 Years | 292 | 352 | 351 | 341 | 309 | 271 | 271 |
| >20 Years | 178 | 163 | 204 | 371 | 510 | 533 | 533 |
| Average | 58 | 49 | 49 | 57 | 60 | 55 | 55 |
*Amount Outstanding Privately Held
Source: United States Treasury. 2012Dec. Treasury Bulletin. Washington, DC, Dec 2012. https://www.fms.treas.gov/bulletin/index.html
Table IIB-4 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into four parts: Treasury budget in the 2013 fiscal year to Dec 2012; 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. Receipts increased 10.8 percent in the cumulative fiscal year 2013 for Dec 2012 relative to the cumulative in fiscal year 2012. Individual income taxes increased 15.5 percent relative to the same period a year earlier. Outlays increased 3.5 percent relative to a year earlier. 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/2012/12/mediocre-and-decelerating-united-states_24.html). Weakness of growth and employment creation is analyzed in IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 29.5 million people without jobs or underemployed that is equivalent to 18.2 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.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 IIB-4 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 IIB-4, US, Treasury Budget in Fiscal Year to Date Million Dollars
| Dec 2012 | Fiscal Year 2013 | Fiscal Year 2012 | ∆% |
| Receipts | 615,546 | 555,437 | 10.8 |
| Outlays | 907,913 | 877,173 | 3.5 |
| Deficit | -292,367 | -321,735 | NA |
| Individual Income Taxes | 312,398 | 270,370 | 15.5 |
| Social Insurance | 122,778 | 119,411 | 2.8 |
| 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 |
Sources: 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.
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 IIB-5 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. The United States is in an unsustainable path of Treasury debt with high risks of a risk premium on issuing new debt and refinancing existing debt that could disrupt economic activity.
Table IIB-5, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP
| Revenues | Outlays | Deficit | Debt | |
| 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 | 18.0 | 21.9 | NA | 37.0 |
Source: CBO (2012AugBEO). CBO (2012NovCDR).
There is highly unpleasant fiscal arithmetic in the United States. DeNavas-Walt, Proctor and Smith (2012Sep) provide the report on income, poverty and health insurance coverage in the United States for 2011, which consist of the latest available data. There are 121,084 households in the United States in 2011 with mean income of $69,677 or total income of $8437 billion. The highest quintile earns mean income of $178,020 that is equivalent to 51.1 percent of total household income or $4311 billion. A tax of 100 percent on 11 million households in the highest quintile would bring slightly more than outlays of the Treasury of $3603 billion in fiscal year 2011. There are numerous professional households in that 11 million that would default their students loans and be thrown into poverty. After the tax on 100 percent of income of the 11 million in the upper quintile the US Treasury would default because of calamitous disappearance of income that could be taxed to generate revenue. Economic growth at 2.2 percent on average in the 13 quarters of expansion from IIIQ2009 to IIIQ2012 compared with 6.2 percent in earlier expansions of the economic cycle (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html) has been insufficient to restore government revenue to its long-term average of 18.0 percent from 1970 to 2010 while outlays as percent of GDP have jumped to 24.1 percent in 2011 compared with 21.9 percent on average from 1970 to 2010. Even smaller deficits by restraining outlays to 21.9 percent of GDP will not be sufficient because Treasury debt has 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. United States fiscal affairs resemble those of countries in sovereign debt crises. Attempts to tax current levels of expenditures and debt are unsuccessful with the threat of disorderly adjustment in a future debt crisis in generalized expectation that the government is incapable of generating future primary budget surpluses. Financing budget surpluses with issue of money or seigniorage and various forms of financial repression to lower interest rates on government debt also creates unpleasant outcomes.
The major hurdle in adjusting the fiscal situation of the US is shown in Table IIB-6 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 IIB-6 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 IIB-6, Structure of Federal Government Revenues and Outlays, $ Billions and Percent
| 2011 | % Total | Total 2013-2022 | % 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- | 1,346 | 37.4 | 12,664 | 28.9 |
| Defense | 700 | 19.4 | 6,726 | 15.4 |
| Non- | 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).
Chart IIB-1 of the Board of Governors of the Federal Reserve System provides the yield of the ten-year constant maturity Treasury from Jan 3, 1977 to Jan 10, 2013. The yield stood at 7.67 percent on Feb 16, 1977. A peak was reached at 15.21 percent on Oct 26, 1981 during the inflation control effort by the Fed. There is a second local peak in Chart IIB-1 on May 3, 1984 at 13.94 percent followed by another local peak at 8.14 percent on Nov 21, 1994 during another inflation control effort (see Appendix I The Great Inflation). There was sharp reduction of the yields from 5.44 percent on Apr 1, 2002 until they reached a low point of 3.13 percent on Jun 13, 2003. Yields rose again to 4.89 percent on Jun 14, 2004 and 5.23 percent on Jul 5, 2006. Yields declined sharply during the financial crisis, reaching 2.08 percent on Dec 18, 2008, lowered by higher prices originating in sharply increasing demand in the flight to the US dollar and obligations of the US government. Yields rose again to 4.01 percent on Apr 5, 2010 but collapsed to 2.41 percent on Oct 8, 2010 because of higher demand originating in the flight from the European sovereign risk event. During higher risk appetite, yields rose to 3.75 percent on Feb 8, 2011 and collapsed to 1.91 percent on Jan 10, 2013, which is the last data point in Chart IIB-1. There has been a trend of decline of yields with oscillations. During periods of risk aversion investors seek protection in obligations of the US government, causing decline in their yields. In an eventual resolution of international financial risks with higher economic growth there could be the trauma of rising yields with significant capital losses in portfolios of government securities. The data in Table VI-7 in the text is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).
![clip_image004[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfilesFC6C8C\ChIIB-1DDPChart%5b3%5d.png "clip_image004[1]")
Chart IIB-1, US, Ten-Year Treasury Constant Maturity Yield, Jan 3, 1977 to Jan 10, 2013
Note: US Recessions in Shaded Areas
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h15/update/
Chart IIB-2 of the Board of Governors of the Federal Reserve System provides securities held outright by Federal Reserve banks from 2002 to 2013. The first data point in Chart IIB-2 is the level for Dec 18, 2002 of $629,407 million and the final data point in Chart IIB-2 is level of $2,669,592 million on Jan 9, 2013.
![clip_image006[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfilesFC6C8C\ChIIB-2DDPChart%5b3%5d.png "clip_image006[1]")
Chart IIB-2, US, Securities Held Outright by Federal Reserve Banks, Wednesday Level, Dec 26, 2002 to Jan 9, 2013, USD Millions
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm
Chart IIB-3 of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields. The beginning yields in Chart IIB-3 for July 31, 2000, are 3.67 percent for one month, 3.79 percent for two years and 5.07 percent for ten years. On July 31, 2007, yields inverted with the one month at 5.13 percent, the two-year at 4.56 percent and the ten year at 5.13 percent. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield1.64 percent and the ten-year yield 3.41. 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. The final point of Chart IIB-3 is for Jan 10, 2013, with the one-month yield at 0.05 percent, the two-year at 0.26 percent and the ten-year at 1.91 percent.
Chart IIB-3, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields Jul 31, 2001-Jan 10, 2013
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h15/update/
Chart IIB-4 of the Board of Governors of the Federal Reserve System provides the overnight Fed funds rate on business days from Jan 3, 1979, at 8.34 percent per year, to Jan 10, 2013, at 0.14 percent per year. US recessions are in shaded areas according to the reference dates of the NBER (http://www.nber.org/cycles.html). In the Fed effort to control the “Great Inflation” of the 1930s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html), the fed funds rate increased from 8.34 percent on Jan 3, 1979 to a high in Chart IIB-4 of 22.36 percent per year on Jul 22, 1981 with collateral adverse effects in the form of impaired savings and loans associations in the United States, emerging market debt and money-center banks (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7; Pelaez 1986, 1987). Another episode in Chart IIB-4 is the increase in the fed funds rate from 3.15 percent on Jan 3, 1994, to 6.56 percent on Dec 21, 1994, which also had collateral effects in impairing emerging market debt in Mexico and Argentina and bank balance sheets in a world bust of fixed income markets during pursuit by central banks of non-existing inflation (Pelaez and Pelaez, International Financial Architecture (2005), 113-5). Another interesting policy impulse is the reduction of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of equally non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85), followed by increments of 25 basis points from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006 in Chart IIB-4. Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. 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 interest rates close to zero, 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 with the objective of purchasing 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). A final episode in Chart IIB-4 is the reduction of the fed funds rate from 5.41 percent on Aug 9, 2007, to 2.97 percent on October 7, 2008, to 0.12 percent on Dec 5, 2008 and close to zero throughout a long period with the final point at 0.14 percent on Jan 10, 2013. Evidently, this behavior of policy would not have occurred had there been theory, measurements and forecasts to avoid these violent oscillations that are clearly detrimental to economic growth and prosperity without inflation. Current policy consists of forecast mandate of maintaining policy accommodation until the forecast of the rate of unemployment reaches 6.5 percent and the rate of personal consumption expenditures excluding food and energy reaches 2.5 percent (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm). It is a forecast mandate because of the lags in effect of monetary policy impulses on income and prices (Romer and Romer 2004). The intention is to reduce unemployment close to the “natural rate” (Friedman 1968, Phelps 1968) of around 5 percent and inflation at or below 2.0 percent. If forecasts were reasonably accurate, there would not be policy errors. A commonly analyzed risk of zero interest rates is the occurrence of unintended inflation that could precipitate an increase in interest rates similar to the Himalayan rise of the fed funds rate from 8.34 percent on Jan 3, 1979, at the beginning point in Chart IIB-4, to 22.36 percent on Jul 22, 1981. There is a less commonly analyzed risk of the development of a risk premium on Treasury securities because of the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html). There is not a fiscal cliff ahead but rather free fall into a fiscal abyss. The combination of the fiscal abyss with zero interest rates could trigger the risk premium on Treasury debt or Himalayan hike in interest rates.
![clip_image010[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfilesFC6C8C\IIB-4DDPChart%5b3%5d.png "clip_image010[1]")
Chart IIB-4, US, Fed Funds Rate, Business Days, Jan 3, 1979 to Jan 10, 2013, Percent per Year
Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h15/
There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table IIB-7 when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table IIB-7 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.
Table IIB-7, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994
| 1994 | FF | 30Y | 30P | 10Y | 10P | MOR | CPI |
| Jan | 3.00 | 6.29 | 100 | 5.75 | 100 | 7.06 | 2.52 |
| Feb | 3.25 | 6.49 | 97.37 | 5.97 | 98.36 | 7.15 | 2.51 |
| Mar | 3.50 | 6.91 | 92.19 | 6.48 | 94.69 | 7.68 | 2.51 |
| Apr | 3.75 | 7.27 | 88.10 | 6.97 | 91.32 | 8.32 | 2.36 |
| May | 4.25 | 7.41 | 86.59 | 7.18 | 88.93 | 8.60 | 2.29 |
| Jun | 4.25 | 7.40 | 86.69 | 7.10 | 90.45 | 8.40 | 2.49 |
| Jul | 4.25 | 7.58 | 84.81 | 7.30 | 89.14 | 8.61 | 2.77 |
| Aug | 4.75 | 7.49 | 85.74 | 7.24 | 89.53 | 8.51 | 2.69 |
| Sep | 4.75 | 7.71 | 83.49 | 7.46 | 88.10 | 8.64 | 2.96 |
| Oct | 4.75 | 7.94 | 81.23 | 7.74 | 86.33 | 8.93 | 2.61 |
| Nov | 5.50 | 8.08 | 79.90 | 7.96 | 84.96 | 9.17 | 2.67 |
| Dec | 6.00 | 7.87 | 81.91 | 7.81 | 85.89 | 9.20 | 2.67 |
Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months
Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t
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 IIB-8 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 IIB-8, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %
| 2000 | 2007 | 2008 | 2009 | 2010 | 2011 | |
| Goods & | -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 | 1425 | 2488 | 2657 | 2181 | 2519 | 2848 |
| NIIP % | -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/
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, contraction of real private fixed investment, decline of wealth of households over the business cycle by 10.9 percent adjusted for inflation while growing 617.2 percent adjusted for inflation from IVQ1945 to IIIQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes; 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 Jan 4 and daily values throughout the week ending on Jan 11 2013 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 Jan 4 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jan 4, 2012”, first row “USD/EUR 1.3069 1.1%,” provides the information that the US dollar (USD) appreciated 1.1 percent to USD 1.3069/EUR in the week ending on Fri Jan 4 relative to the exchange rate on Fri Dec 28. 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 1.3069/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 4, depreciating to USD 1.3117/EUR on Mon Jan 7, 2013, or by 0.4 percent. The dollar depreciated because more dollars, $1.3117, were required on Mon Jan 7 to buy one euro than $1.3069 on Jan 4. 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 1.3069/EUR on Jan 4; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Jan 4, to the last business day of the current week, in this case Fri Jan 11, such as depreciation by 2.1 percent to USD 1.3343/EUR by Jan 11; 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 2.1 percent from the rate of USD 1.3069/EUR on Fri Jan 4 to the rate of USD 1.3343/EUR on Fri Jan 11 {[(1.3343/1.3069) – 1]100 = 2.1%} and depreciated (denoted by negative sign) by 0.6 percent from the rate of USD 1.3269 on Thu Jan 10 to USD 1.3343/EUR on Fri Jan 1 {[(1.3343/1.3269) -1]100 = 0.6%}. 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 Jan 7 to Jan 11, 2013
| Fri Jan 4, 2013 | M 7 | Tue 8 | W 9 | Thu 10 | Fr 11 |
| USD/EUR 1.3069 1.1% | 1.3117 -0.4% -0.4% | 1.3081 -0.1% 0.3% | 1.3065 0.0% 0.1% | 1.3269 -1.5% -1.6% | 1.3343 -2.1% -0.6% |
| JPY/ USD 88.17 -2.6% | 87.79 0.4% 0.4% | 87.04 1.3% 0.9% | 87.88 0.3% -1.0% | 88.78 -0.7% -1.0% | 89.19 -1.2% -0.5% |
| CHF/ USD 0.9247 -1.2% | 0.9212 0.4% 0.4% | 0.9241 0.1% -0.3% | 0.9254 -0.1% -0.1% | 0.9143 1.1% 1.2% | 0.9136 1.2% 0.1% |
| CHF/ EUR 1.2084 -0.1% | 1.2083 0.0% 0.0% | 1.2089 0.0% 0.0% | 1.2089 0.0% 0.0% | 1.2130 -0.4% -0.3% | 1.2190 -0.9% -0.5% |
| USD/ AUD 1.0482 0.9540 1.0% | 1.0503 0.9521 0.2% 0.2% | 1.0503 0.9521 0.2% 0.0% | 1.0515 0.9510 0.3% 0.1% | 1.0598 0.9436 1.1% 0.8% | 1.0536 0.9491 0.5% -0.6% |
| 10 Year T Note 1.898 | 1.90 | 1.862 | 1.856 | 1.896 | 1.862 |
| 2 Year T Note 0.262 | 0.27 | 0.258 | 0.228 | 0.254 | 0.247 |
| German Bond 2Y 0.08 10Y 1.54 | 2Y 0.07 10Y 1.52 | 2Y 0.07 10Y 1.49 | 2Y 0.06 10Y 1.48 | 2Y 0.10 10Y 1.56 | 2Y 0.13 10Y 1.58 |
| DJIA 13435.21 3.8% | 13384.29 -0.4% -0.4% | 13328.85 -0.8% -0.4% | 13390.51 -0.3% 0.5% | 13471.22 0.3% 0.% | 13488.43 0.4% 0.1% |
| DJ Global 2051.22 3.4% | 2049.35 -0.1% -0.1% | 2039.42 -0.6% -0.5% | 2047.94 -0.2% 0.4% | 2067.37 0.8% 0.9% | 2075.84 1.2% 0.4% |
| DJ Asia Pacific 1339.98 1.8% | 1338.23 -0.1% -0.1% | 1331.80 -0.6% -0.5% | 1335.53 -0.3% 0.3% | 1344.52 0.4% 0.7% | 1342.50 0.2% -0.2% |
| Nikkei 10688.11 2.8% | 10599.01 -0.8% -0.8% | 10508.06 -1.7% -0.9% | 10578.57 -1.0% 0.7% | 10652.64 -0.3% 0.7% | 10801.57 1.1% 1.4% |
| Shanghai 2276.99 1.9% | 2285.36 0.4% 0.4% | 2276.07 0.0% -0.4% | 2275.34 -0.1% 0.0% | 2283.66 0.3% 0.4% | 2243.00 -1.5% -1.8% |
| DAX 7776.37 2.2% | 7732.66 -0.6% -0.6% | 7695.83 -1.0% -0.5% | 7720.47 -0.7% 0.3% | 7708.47 -0.9% -0.2% | 7715.53 -0.8% 0.1% |
| DJ UBS Comm. 137.73 -1.0% | 137.96 0.2% 0.2% | 137.92 0.1% 0.0% | 137.30 -0.3% -0.4% | 138.45 0.5% 0.8% | 138.55 0.6% 0.1% |
| WTI $ B 93.09 2.6% | 93.27 0.2% 0.2% | 93.15 0.1% -0.1% | 93.25 0.2% 0.1% | 93.92 0.9% 0.7% | 93.56 0.5% -0.4% |
| Brent $/B 111.31 0.8% | 111.56 0.2% 0.2% | 112.06 0.7% 0.4% | 111.60 0.3% -0.4% | 111.78 0.4% 0.2% | 110.64 -0.6% -1.0% |
| Gold $/OZ 1657.90 0.1% | 1647.30 -0.6% -0.6% | 1662.20 0.3% 0.9% | 1657.60 0.0% -0.3% | 1674.90 1.0% 1.0% | 1660.60 0.1% -0.9% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
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. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States. An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):
“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.
The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”
Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.
The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.
First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. 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. The yield of the ten-year sovereign bond of Spain traded at 5.235 percent on Dec 28 and that of the ten-year sovereign bond of Italy at 4.447 percent with further declines to 5.021 percent for the ten-year sovereign bond of Italy and 4.216 percent for the ten-year sovereign bond of Italy on Jan 4, 2013 and further declines to 4.870 percent for the ten-year sovereign bond of Spain on Jan 11, 2013 and 4.084 percent for the ten-year sovereign bond of Italy (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). 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. Yields backed up in the week of Jan 4, 2013 with the two-year Treasury at 0.262 percent and the ten-year Treasury at 1.898 percent with the same increases of the two-year German bond to 0.08 percent and of the ten-year German bond to 1.54 percent while the dollar appreciated to USD 1.3069/EUR. In the week of Jan 11, 2012, the yield of the two-year Treasury eased to 0.247 percent and that of the ten-year Treasury to 1.862 percent while the two-year bond of Germany rose to 0.13 percent and the ten-year to 1.58 while the dollar depreciated to USD 1.3343/EUR. The 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 about equal to consumer price inflation of 1.8 percent in the 12 months ending in Nov (http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.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 | |
| 1/11/13 | 0.247 | 1.862 | 0.13 | 1.58 | 1.3343 |
| 1/4/13 | 0.262 | 1.898 | 0.08 | 1.54 | 1.3069 |
| 12/28/12 | 0.252 | 1.699 | -0.01 | 1.31 | 1.3218 |
| 12/21/12 | 0.272 | 1.77 | -0.01 | 1.38 | 1.3189 |
| 12/14/12 | 0.232 | 1.704 | -0.04 | 1.35 | 1.3162 |
| 12/7/12 | 0.256 | 1.625 | -0.08 | 1.30 | 1.2926 |
| 11/30/12 | 0.248 | 1.612 | 0.01 | 1.39 | 1.2987 |
| 11/23/12 | 0.273 | 1.691 | 0.00 | 1.44 | 1.2975 |
| 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.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, two-year and one-month Treasury constant maturity yields. The beginning yields in Chart III-1A for July 31, 2000, are 3.67 percent for one month, 3.79 percent for two years and 5.07 percent for ten years. On July 31, 2007, yields inverted with the one month at 5.13 percent, the two-year at 4.56 percent and the ten year at 5.13 percent. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield1.64 percent and the ten-year yield 3.41. 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. The final point of Chart III1-A is for Jan 10, 2013, with the one-month yield at 0.05 percent, the two-year at 0.26 percent and the ten-year at 1.91 percent.
![clip_image008[2]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfilesFC6C8C\ChIIB-3DDPChart%5b7%5d.png "clip_image008[2]")
Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields Jul 31, 2001-Jan 10, 2013
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:
![clip_image002[4]](http://lh4.ggpht.com/-4DjKG-5zHUo/UPOxBAAQAyI/AAAAAAAAPj8/6fZJbMDKCjc/s1600-h/clip_image002%25255B4%25255D%25255B2%25255D.gif "clip_image002[4]"){kind=small}
Where Rτ is expected revenue in the time horizon from τ =1 to T; Cτ 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
![clip_image002[5]](http://lh4.ggpht.com/-yf8Jw3JlWRo/UPOx_jo-2qI/AAAAAAAAPkU/W1zHq-8Y-DI/s1600-h/clip_image002%25255B5%25255D%25255B2%25255D.gif "clip_image002[5]"){kind=small}
declines.
There was strong performance in equity indexes in Table III-1 in the week ending on Jan 4, 2013. Stagnating revenues are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.3 percent on Jan 4, increasing 3.8 percent in the week. Germany’s Dax increased 0.3 percent on Fri Jan 4 and increased 2.2 percent in the week. Dow Global increased 0.4 percent on Jan 4 and increased 3.4 percent in the week. Japan’s Nikkei Average increased 2.8 percent on Fri Jan 4 and increased 2.8 percent in the week as the yen continues to be oscillating but relatively weaker and the stock market gains in expectations of fiscal stimulus by a new administration. Dow Asia Pacific TSM increased 0.4 percent on Jan 4 and increased 1.8 percent in the week while Shanghai Composite increased 0.3 percent on Jan 4 and increased 1.9 percent in the week supported by a fourteen-month high of the HSBC flash manufacturing index, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2276.99 on Fri Jan 4. There is evident trend of deceleration of the world economy that could affect corporate revenue and equity valuations, causing oscillation in equity markets with increases during favorable risk appetite.
Commodities were mixed in the week of Jan 1, 2013. The DJ UBS Commodities Index increased 0.1 percent on Fri Jan 11 and increased 0.6 percent in the week, as shown in Table III-1. WTI increased 0.5 percent in the week of Jan 11 while Brent decreased 0.6 percent in the week even with conflicts in the Middle East. Gold decreased 0.9 percent on Fri Jan 11 and increased 0.1 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 €1,116,994 million on Jan 4, 2013. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,701,938 million in the statement of Jan 4, 2013. There is high credit risk in these transactions with capital of only €85,552 million as analyzed by Cochrane (2012Aug31).
Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Jan 4, 2013 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 438,686 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 250,685 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 32,340 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 19,033 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,116,994 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 203,816 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 584,944 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 29,961 |
| 9 Other Assets | 278,719 | 336,574 | 279,704 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,956,165 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,701,938 |
| Capital and Reserves | 78,143 | 85,748 | 85,556 |
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/2013/html/fs130109.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 42.5 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 9.9 percent in Jan-Oct 2012 relative to Jan-Oct 2011 while those to EMU are falling at 0.9 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Oct 2012 | Exports | ∆% Jan-Oct 2012/ Jan-Oct 2011 | Imports | Imports |
| EU | 56.0 | 0.2 | 53.7 | -7.3 |
| EMU 17 | 42.5 | -0.9 | 43.3 | -7.3 |
| France | 11.6 | 0.0 | 8.4 | -5.9 |
| Germany | 13.1 | 0.1 | 15.5 | -10.9 |
| Spain | 5.3 | -8.1 | 4.5 | -8.1 |
| UK | 4.7 | 10.2 | 2.7 | -13.6 |
| Non EU | 44.0 | 9.9 | 46.3 | -3.1 |
| Europe non EU | 13.3 | 9.7 | 12.5 | -1.4 |
| USA | 6.1 | 18.8 | 3.2 | 2.2 |
| China | 2.7 | -12.0 | 7.4 | -16.3 |
| OPEC | 4.7 | 24.9 | 8.5 | 22.4 |
| Total | 100.0 | 4.4 | 100.0 | -5.4 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/77607
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €330 million with the 17 countries of the euro zone (EMU 17) in Oct 2012 and deficit of €1601 million in Jan-Oct 2012. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €9,267 million in Jan-Oct with Europe non European Union and of €11,391 million with the US and in reducing the deficit with non European Union of €3106 million in Jan-Oct 2012. There is significant rigidity in the trade deficits in Jan-Oct of €14,168 million with China and €16,853 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 Oct 2012 Millions of Euro | Trade Balance Cumulative Jan-Oct 2012 Millions of Euro |
| EU | 981 | 9,634 |
| EMU 17 | -330 | -1,601 |
| France | 1,048 | 10,183 |
| Germany | -375 | -4,837 |
| Spain | 143 | 1,359 |
| UK | 916 | 7,993 |
| Non EU | 1,471 | -3,106 |
| Europe non EU | 1,051 | 9,267 |
| USA | 1,268 | 11,391 |
| China | -1,245 | -14,168 |
| OPEC | -1,128 | -16,853 |
| Total | 2,452 | 6,528 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/77607
Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Oct 2012 relative to Jan-Oct 2011. Growth rates in 12 months of imports are negative with the exception of 9.3 percent for energy. The higher rate of growth of exports of 5.3 percent in Jan-Oct 2012/Jan-Oct 2011 relative to imports of minus 2.6 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 | Exports | Imports | Imports | |
| Consumer | 28.9 | 5.3 | 25.0 | -2.6 |
| Durable | 5.9 | 2.4 | 3.0 | -5.9 |
| Non | 23.0 | 6.0 | 22.0 | -2.2 |
| Capital Goods | 32.3 | 2.5 | 21.1 | -12.3 |
| Inter- | 34.2 | 3.3 | 34.3 | -11.3 |
| Energy | 4.7 | 20.0 | 19.6 | 9.3 |
| Total ex Energy | 95.3 | 3.6 | 80.4 | -8.9 |
| Total | 100.0 | 4.4 | 100.0 | -5.4 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/77607
Table III-6 provides Italy’s trade balance by product categories in Oct 2012 and cumulative Jan-Oct 2012. Italy’s trade balance excluding energy generated surplus of €7613 million in Oct 2012 and €60,206 million in Jan-Oct 2012 but the energy trade balance created deficit of €5161 million in Oct 2012 and €53,677 million in Jan-Oct 2012. The overall surplus in Oct 2012 was €2452 million with surplus of €6528 million in Jan-Oct 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
| Oct 2012 | Cumulative Jan-Oct 2012 | |
| Consumer Goods | 1,834 | 13,406 |
| Durable | 1,089 | 9,371 |
| Nondurable | 745 | 4,035 |
| Capital Goods | 4,711 | 40,621 |
| Intermediate Goods | 1,067 | 6,179 |
| Energy | -5,161 | -53,677 |
| Total ex Energy | 7,613 | 60,206 |
| Total | 2,452 | 6,528 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/77607
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 | Primary Net Lending Borrowing | General Government Net Debt | |
| 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 Nov 2012. German exports to other European Union (EU) members are 56.3 percent of total exports in Nov 2012 and 57.1 percent in Jan-Nov 2012. Exports to the euro area are 37.2 percent in Nov and 37.6 percent in Jan-Nov. Exports to third countries are 43.7 percent of the total in Nov and 42.9 percent in Jan-Nov. There is similar distribution for imports. Exports to non-euro countries are decreasing 0.6 percent in Nov 2012 and increasing 3.9 percent in Jan-Nov 2012 while exports to the euro area are decreasing 5.7 percent in Nov and decreasing 1.7 percent in Jan-Nov 2012. Exports to third countries, accounting for 43.7 percent of the total in Nov 2012, are increasing 5.6 percent in Nov and 10.4 percent in Jan-Nov, accounting for 42.9 percent of the cumulative total in Jan-Nov 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 ∆%
| Nov 2012 | Nov 12-Month | Jan–Nov 2012 € Billions | Jan-Nov 2012/ | |
| Total | 94.1 | 0.0 | 1,018.4 | 4.3 |
| A. EU | 53.0 % 56.3 | -4.0 | 581.5 % 57.1 | 0.2 |
| Euro Area | 35.0 % 37.2 | -5.7 | 382.8 % 37.6 | -1.7 |
| Non-euro Area | 18.0 % 19.1 | -0.6 | 198.8 % 19.5 | 3.9 |
| B. Third Countries | 41.1 % 43.7 | 5.6 | 436.9 % 42.9 | 10.4 |
| Total Imports | 77.1 | -1.2 | 842.2 | 1.4 |
| C. EU Members | 50.0 % 64.9 | 0.9 | 534.4 % 63.5 | 1.6 |
| Euro Area | 34.8 % 45.1 | 1.1 | 374.0 % 44.4 | 1.3 |
| Non-euro Area | 15.3 % 19.8 | 0.5 | 160.4 % 19.1 | 2.3 |
| D. Third Countries | 27.0 % 35.0 | -4.9 | 307.8 % 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/2013/01/PE13_005_51.html;jsessionid=EAAD291DC09A1212A967AB76756E5FFC.cae2
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:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+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 Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (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, 2013
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