United States Commercial Banks Assets and Liabilities, Peaking Financial Risk Assets, IMF World Economic Outlook Projections Update, United States Housing Collapse, World Financial Turbulence and Economic Slowdown with Global Recession Risk
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011, 2012, 2013
Executive Summary
IA United States Commercial Banks Assets and Liabilities
IA1 Transmission of Monetary Policy
IA2 Functions of Banks
IA3 United States Commercial Banks Assets and Liabilities
IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation
IB IMF World Economic Outlook Projections Update
II United States Housing Collapse
IIA United States New House Sales
IIB United States House Prices
IIC Factors of United States Housing Collapse
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
ESI United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table ESI-1. Data are not seasonally adjusted to permit comparison between Dec 2011 and Dec 2012. Total assets of US commercial banks grew 4.3 percent from $12,577.5 billion in Dec 2011 to $13,120.8 billion in Dec 2012. US GDP in 2011 is estimated at $15,075.7 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 87 percent of US GDP. Bank credit grew 5.8 percent from $9465.4 billion in Dec 2011 to $10,011.5 billion in Dec 2012. Securities in bank credit increased 9.8 percent from $2498.6 billion in Dec 2011 to $2742.8 billion in Dec 2012. A large part of securities in banking credit consists of US Treasury and agency securities, growing 10.5 percent from $1700.5 billion in Dec 2011 to $1878.5 billion in Dec 2012. Credit to the government that issues or backs Treasury and agency securities of $1878.5 in Dec 2012 is about 18.8 percent of total bank credit of US commercial banks of $10,011.5 billion. Mortgage-backed securities, providing financing of home loans, grew 7.6 percent, from $1253.4 billion in Dec 2011 to $1348.7 billion in Dec 2012. Loans and leases were less dynamic, growing 4.3 percent from $6966.8 billion in Dec 2011 to $7268.6 billion in Dec 2012. The only dynamic class is commercial and industrial loans, growing 12.8 percent from Dec 2011 to Dec 2012 and providing $1507.7 billion or 20.7 percent of total loans and leases of $7268.6 billion in Dec 2012. Real estate loans increased only 1.5 percent, providing $3557.5 billion in Dec 2012 or 48.9 percent of total loans and leases. Consumer loans increased only 2.3 percent, providing $1131.6 billion in Dec 2012 or 15.6 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks decreased 0.2 percent from $1679.2 billion in Dec 2011 to $1675.5 billion in Dec 2012 but a single year of the series masks exploding cash in banks as a result of unconventional monetary policy, which is discussed below. Bank deposits increased 9.7 percent from $8500.3 billion to $9327.0 billion. The difference between bank deposits and total loans and leases in banks increased from $1533.5 billion in Dec 2011 to $2058.4 billion in Dec 2012 or by $524.9 billion, which is similar to the increase in securities in bank credit by $244.2 billion from $2498.6 billion in Dec 2011 to $2742.8 billion in Dec 2012 and to the increase in Treasury and agency securities by $178.0 billion from $1700.5 billion in Dec 2011 to $1878.5 billion in Dec 2012. Loans and leases increased $301.8 billion from $6966.8 billion in Dec 2011 to $7268.6 billion in Dec 2012. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IIIQ2012 lower by 0.4 percent than in IVQ2007 (Table ESI-3 below) in contrast with long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May).
Table ESI-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars
| Dec 2011 | Dec 2012 | ∆% | |
| Total Assets | 12,577.6 | 13,120.8 | 4.3 |
| Bank Credit | 9465.4 | 10,011.5 | 5.8 |
| Securities in Bank Credit | 2498.6 | 2742.8 | 9.8 |
| Treasury & Agency Securities | 1700.5 | 1878.5 | 10.5 |
| Mortgage-Backed Securities | 1253.4 | 1348.7 | 7.6 |
| Loans & Leases | 6966.8 | 7268.6 | 4.3 |
| Real Estate Loans | 3504.3 | 3557.5 | 1.5 |
| Consumer Loans | 1006.0 | 1131.6 | 2.3 |
| Commercial & Industrial Loans | 1336.3 | 1507.7 | 12.8 |
| Other Loans & Leases | 1020.3 | 1071.8 | 5.0 |
| Cash Assets* | 1679.2 | 1675.5 | -0.2 |
| Total Liabilities | 11,149.3 | 11,612.1 | 4.2 |
| Deposits | 8500.3 | 9327.0 | 9.7 |
Note: balancing item of residual assets less liabilities not included
*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are provided in Table ESI-2 annually from 2007 to 2011 and for Nov and Dec 2012. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.8 percent in 2010. Commercial and industrial loans fell 18.6 percent in 2009 and 9.0 percent in 2011. Unconventional monetary policy caused an increase of cash assets of banks of 158.2 percent in 2008, 48.1 percent in 2009 and 47.8 percent in 2011 and at the SAAR of 22.4 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012 followed by increase of 55.5 percent in Nov 2012 and minus 19.3 percent in Dec 2012. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that were held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit, growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.6 percent in Oct 2012, 0.9 percent in Nov 2012 and 22.6 percent in Dec 2012. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit, with growth of 15.5 percent in 2009 and 15.1 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012 but falling at the rate of 2.1 percent in Nov 2012 and increasing at 18.6 percent in Dec 2012. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.5 percent in Nov 2012 and 20.7 percent in Dec 2012. The credit intermediation function of banks is broken because of adverse expectations on future business and is not easily mended simply by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.
Table ESI-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%
| 2008 | 2009 | 2010 | 2011 | 2012 | Nov 2012 | Dec 2012 | |
| Total Assets | 7.9 | -6.0 | -2.7 | 5.3 | 2.4 | 4.1 | 7.4 |
| Bank Credit | 2.1 | -6.6 | -2.7 | 1.8 | 3.9 | -1.7 | 10.8 |
| Securities in Bank Credit | -2.0 | 6.8 | 6.8 | 1.7 | 7.5 | 0.9 | 22.6 |
| Treasury & Agency Securities | 3.1 | 15.5 | 15.1 | 2.9 | 8.5 | -2.1 | 18.6 |
| Other Securities | -8.4 | -5.1 | -7.1 | -0.8 | 5.3 | 7.5 | 31.4 |
| Loans & Leases | 3.3 | -10.2 | -5.8 | 1.8 | 2.6 | -2.7 | 6.3 |
| Real Estate Loans | -0.2 | -5.6 | -5.5 | -3.8 | -1.1 | -4.2 | -0.3 |
| Consumer Loans | 5.1 | -3.3 | -7.0 | -0.8 | 1.1 | 3.2 | 3.8 |
| Commercial & Industrial Loans | 12.9 | -18.6 | -9.0 | 9.4 | 11.3 | 2.4 | 17.7 |
| Other Loans & Leases | 1.7 | -23.3 | 0.3 | 19.3 | 5.9 | -11.1 | 15.6 |
| Cash Assets | 157.6 | 48.1 | -7.8 | 47.6 | -2.9 | 55.5 | -19.1 |
| Total Liabilities | 10.6 | -7.2 | -3.4 | 5.5 | 2.1 | 3.0 | 10.3 |
| Deposits | 5.4 | 5.2 | 2.4 | 6.7 | 7.2 | 5.5 | 20.7 |
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Table ESI-3 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 ESI-3, 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
Chart ESI-1 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Acquisitions of securities for the portfolio of the central bank were processed by increases in bank cash reserves. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Discovery of such painless and fast adjustment by gigantic impulses of monetary policy of zero interest rates and trillions of dollars of bond buying would have occurred earlier with prior cases of successful implementation. Selective incentives to the private sector of a long-term nature could have been more effective.
Chart ESI-1, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-2 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from 2002 to 2012. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart II-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.
Chart ESI-2, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, 2002 to 2013
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-3 of the Board of Governors of the Federal Reserve System provides deposits in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Deposit growth clearly accelerated after 2001 and continued during the current cyclical expansion after bumps during the global recession.
Chart ESI-3, US, Deposits in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-4 of the Board of Governors of the Federal Reserve System provides Treasury and agency securities in US commercial banks, not seasonally adjusted, in billions of dollars from 1973 to 2012. Holdings stabilized between the recessions of 2001 and after IVQ2007. There was rapid growth during the global contraction especially after unconventional monetary policy in 2008 and nearly vertical increase without prior similar historical experience during the various bouts of unconventional monetary policy. Banks hoard cash and less risky Treasury and agency securities instead of risky lending because of the weakness of the economy and the lack of demand for financing sound business projects.
Chart ESI-4, US, Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-5 of the Board of Governors of the Federal Reserve System provides total loans and leases in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Total loans and leases of US commercial banks contracted sharply and have stalled during the cyclical expansion.
Chart ESI-5, US, Loans and Leases in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-6 of the Board of Governors of the Federal Reserve System provides real estate loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Housing subsidies and low interest rates caused a point of inflexion to higher, nearly vertical growth until 2007. Real estate loans have contracted in downward trend partly because of adverse effects of uncertainty on the impact on balance sheets of the various mechanisms of resolution imposed by policy. Nick Timiraos, writing on “Push for cheaper credit hits wall,” on Dec 24, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324660404578197782701079650.html), provides important information and analysis on housing finance. Quantitative easing consists of withdrawing supply of mortgage-backed securities by acquiring them as assets in the Fed balance sheet. Lending banks obtain funds for mortgages by bundling them according to risk and other characteristics and selling them to investors, using the proceeds from the sale to provide the loans to homebuyers or refinancing homeowners. Banks earn net revenue to remunerate capital required for operations from the spread between the rate received from mortgage debtors and the rate implicit in the yield of the mortgage-backed securities. Nick Timiraos (Ibid) finds that the spread was around 0.5 percentage points before the financial crisis of 2007, widening to 1 percentage point after the crisis but jumping to 1.6 percentage points after the Fed engaged in another program of buying mortgage-backed securities, oscillating currently around 1.3 percentage points. The spread has widened because banks have higher costs originating in regulation, litigation on repurchasing defaulted mortgages, loss in case of default and more prudent but more costly scrutiny of property appraisals and income verification. As a result, even if quantitative easing does lower yields of mortgage-backed securities there would not be proportionate reduction in mortgage rates.
Chart ESI-6, US, Real Estate Loans in Bank Credit, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart ESI-7 of the Board of Governors of the Federal Reserve System provides consumer loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Consumer loans even increased during the contraction then declined and increased vertically to decline again. There was high demand for reposition of durable goods that exhausted and limited consumption again with increase in savings rates in recent periods.
Chart ESI-7, US, Consumer Loans in Bank Credit, Not Seasonally Adjusted, US Commercial Banks, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Finally, Chart ESI-8 of the Board of Governors of the Federal Reserve System provides commercial and industrial loans not seasonally adjusted in billions of dollars from 1973 to 2012. Commercial and industrial loans fell sharply during both contractions in 2001 and after IVQ2007 and then rebounded with accelerated growth. Commercial and industrial loans have not reached again the peak during the global recession.
Chart ESI-8, US, Commercial and Industrial Loans in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
ESII IMF World Economic Outlook Projections Update. The International Financial Institutions (IFI) consist of the International Monetary Fund, World Bank Group, Bank for International Settlements (BIS) and the multilateral development banks, which are the European Investment Bank, Inter-American Development Bank and the Asian Development Bank (Pelaez and Pelaez, International Financial Architecture (2005), The Global Recession Risk (2007), 8-19, 218-29, Globalization and the State, Vol. II (2008b), 114-48, Government Intervention in Globalization (2008c), 145-54). There are four types of contributions of the IFIs:
1. Safety Net. The IFIs contribute to crisis prevention and crisis resolution.
i. Crisis Prevention. An important form of contributing to crisis prevention is by surveillance of the world economy and finance by regions and individual countries. The IMF and World Bank conduct periodic regional and country evaluations and recommendations in consultations with member countries and also jointly with other international organizations. The IMF and the World Bank have been providing the Financial Sector Assessment Program (FSAP) by monitoring financial risks in member countries that can serve to mitigate them before they can become financial crises.
ii. Crisis Resolution. The IMF jointly with other IFIs provides assistance to countries in resolution of those crises that do occur. Currently, the IMF is cooperating with the government of Greece, European Union and European Central Bank in resolving the debt difficulties of Greece as it has done in the past in numerous other circumstances. Programs with other countries involved in the European debt crisis may also be developed.
2. Surveillance. The IMF conducts surveillance of the world economy, finance and public finance with continuous research and analysis. Important documents of this effort are the World Economic Outlook of which the current one is IMF (2012WEOOct http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf) updated in Jan 2013 (http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm), Global Financial Stability Report of which the current one is IMF (2012GFSROct http://www.imf.org/External/Pubs/FT/GFSR/2012/02/pdf/text.pdf) and Fiscal Monitor of which the current one is IMF (2012FMOct http://www.imf.org/external/pubs/ft/fm/2012/02/pdf/fm1202.pdf).
3. Infrastructure and Development. The IFIs also engage in infrastructure and development, in particular the World Bank Group and the multilateral development banks.
4. Soft Law. Significant activity by IFIs has consisted of developing standards and codes under multiple forums. It is easier and faster to negotiate international agreements under soft law that are not binding but can be very effective (on soft law see Pelaez and Pelaez, Globalization and the State, Vol. II (2008c), 114-25). These norms and standards can solidify world economic and financial arrangements.
Table ESII-1 is constructed with the database of the IMF (http://www.imf.org/external/datamapper/index.php?db=WEO) and the update of Jan 2013 (http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm) to show GDP in dollars in 2011 and the growth rate of real GDP of the world and selected regional countries from 2012 to 2015. The data illustrate the concept often repeated of “two-speed recovery” of the world economy from the recession of 2007 to 2009. The IMF has lowered its forecast of the world economy to 3.2 percent in 2012 but accelerating to 3.5 percent in 2013, 4.1 percent in 2014 and 4.4 percent in 2015. Slow-speed recovery occurs in the “major advanced economies” of the G7 that account for $33,697 billion of world output of $69,899 billion, or 48.2 percent, but are projected to grow at much lower rates than world output, 1.9 percent on average from 2012 to 2015 in contrast with 3.8 percent for the world as a whole. While the world would grow 16.1 percent in the four years from 2012 to 2015, the G7 as a whole would grow 7.6 percent. The difference in dollars of 2011 is rather high: growing by 16.1 percent would add $11.5 trillion of output to the world economy, or roughly two times the output of the economy of Japan of $5,867 but growing by 7.6 percent would add $5.3 trillion of output to the world, or somewhat below the output of Japan in 2011. The “two speed” concept is in reference to the growth of the 150 countries labeled as emerging and developing economies (EMDE) with joint output in 2011 of $25,438 billion, or 36.4 percent of world output. The EMDEs would grow cumulatively 24.6 percent or at the average yearly rate of 5.7 percent, contributing $6.3 trillion from 2012 to 2015 or the equivalent of 86.3 percent of $7,298 billion of China in 2011. The final four countries in Table ESII-1 often referred as BRIC (Brazil, Russia, India, China), are large, rapidly growing emerging economies. Their combined output adds to $13,468 billion, or 19.3 percent of world output, which is equivalent to 39.9 percent of the combined output of the major advanced economies of the G7.
Table ESII-1, IMF World Economic Outlook Database Projections of Real GDP Growth
| GDP USD 2011 | Real GDP ∆% | Real GDP ∆% | Real GDP ∆% | Real GDP ∆% | |
| World | 69,899 | 3.2 | 3.5 | 4.1 | 4.4 |
| G7 | 33,697 | 1.3 | 1.4 | 2.2 | 2.5 |
| Canada | 1,739 | 2.0 | 1.8 | 2.3 | 2.4 |
| France | 2,778 | 0.2 | 0.3 | 0.9 | 1.5 |
| DE | 3,607 | 0.9 | 0.6 | 1.4 | 1.4 |
| Italy | 2,199 | -2.1 | -1.0 | 0.5 | 1.2 |
| Japan | 5,867 | 2.0 | 1.2 | 0.7 | 1.2 |
| UK | 2,431 | -0.2 | 1.0 | 1.9 | 2.6 |
| US | 15,076 | 2.3 | 2.0 | 3.0 | 3.4 |
| Euro Area | 13,114 | -0.4 | -0.2 | 1.0 | 1.5 |
| DE | 3,607 | 0.9 | 0.6 | 1.4 | 1.4 |
| France | 2,778 | 0.2 | 0.3 | 0.9 | 1.5 |
| Italy | 2,199 | -2.1 | -1.0 | 0.5 | 1.2 |
| POT | 238 | -3.0 | -1.0 | 1.2 | 1.9 |
| Ireland | 221 | 0.4 | 1.4 | 2.5 | 2.9 |
| Greece | 299 | -6.0 | -4.0 | 0.0 | 2.8 |
| Spain | 1,480 | -1.4 | -1.5 | 0.8 | 1.6 |
| EMDE | 25,438 | 5.1 | 5.5 | 5.9 | 6.1 |
| Brazil | 2,493 | 1.0 | 3.5 | 4.0 | 4.2 |
| Russia | 1,850 | 3.6 | 3.7 | 3.8 | 3.9 |
| India | 1,827 | 4.5 | 5.9 | 6.4 | 6.7 |
| China | 7,298 | 7.8 | 8.2 | 8.5 | 8.5 |
Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries); POT: Portugal
Source: IMF World Economic Outlook databank update http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx http://www.imf.org/external/pubs/ft/survey/so/2013/NEW012313A.htm http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm
World trade projections of the IMF are in Table ESII-2. There is significantly slower growth of the volume of world trade of goods and services from 5.9 percent in 2011 to 2.8 percent in 2012 and 3.8 percent in 2013, increasing to 5.5 percent in 2014. World trade would slow sharply for advanced economies while emerging and developing economies (EMDE) experience slower growth.
Table ESII-2, IMF, Projections of World Trade, ∆%
| 2011 | 2012 | 2013 | 2014 | |
| World Trade Volume (Goods and Services) | 5.9 | 2.8 | 3.8 | 5.5 |
| Imports | ||||
| Advanced Economies | 4.6 | 1.2 | 2.2 | 4.1 |
| EMDE | 8.4 | 6.1 | 6.5 | 7.8 |
| Exports | ||||
| Advanced Economies | 5.6 | 2.1 | 2.8 | 4.5 |
| EMDE | 6.6 | 3.6 | 5.5 | 6.9 |
EMDE: Emerging and Developing Economies (150 countries)
Source: International Monetary Fund World Economic Outlook databank update http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx http://www.imf.org/external/pubs/ft/survey/so/2013/NEW012313A.htm http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm
ESIII United States Housing Collapse. Data and other information continue to provide depressed conditions in the US housing market in a longer perspective with recent improvement that has slowed at the margin. Table ESIII-1 shows sales of new houses in the US at seasonally-adjusted annual equivalent rate (SAAR). House sales fell in ten of twenty four months from Jan 2011 to Sep 2012 but mostly concentrated in Jan-Feb 2011 and May-Aug 2011. In Jan-Apr 2012, house prices increased at the annual equivalent rate of 17.6 percent and at 15.1 percent in May-Sep 2012. There was significant strength in Sep-Dec 2011 with annual equivalent rate of 56.4 percent. Sales of new houses fell at the annual equivalent rate of 10.5 percent in Oct-Dec 2012 with two declines of 7.3 percent in Dec 2012 and 4.0 percent in Oct 2012 with increase of 9.3 percent in Nov 2012. The annual equivalent rate in May-Aug 2011 was minus 18.1 percent and minus 12.2 percent in Jan-Apr 2011 but after increase of 13.6 percent in Dec 2010.
Table ESIII-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate | ∆% | |
| Dec 2012 | 369 | -7.3 |
| Nov | 398 | 9.3 |
| Oct | 364 | -4.0 |
| AE ∆% Oct-Dec | -10.5 | |
| Sep | 379 | 3.3 |
| Aug | 367 | 0.3 |
| Jul | 366 | 1.7 |
| Jun | 360 | -2.4 |
| May | 369 | 3.1 |
| AE ∆% May-Sep | 15.1 | |
| Apr | 358 | 1.7 |
| Mar | 352 | -3.8 |
| Feb | 366 | 7.9 |
| Jan | 339 | 0.0 |
| AE ∆% Jan-Apr | 17.6 | |
| Dec 2011 | 339 | 3.7 |
| Nov | 327 | 4.1 |
| Oct | 314 | 2.6 |
| Sep | 306 | 4.8 |
| AE ∆% Sep-Dec | 56.4 | |
| Aug | 292 | -1.7 |
| Jul | 297 | -2.3 |
| Jun | 304 | -1.3 |
| May | 308 | -1.3 |
| AE ∆% May-Aug | -18.1 | |
| Apr | 312 | 3.7 |
| Mar | 301 | 10.3 |
| Feb | 273 | -11.4 |
| Jan | 308 | -5.5 |
| AE ∆% Jan-Apr | -12.2 | |
| Dec 2010 | 326 | 13.6 |
AE: Annual Equivalent
Source: US Census Bureau http://www.census.gov/construction/nrs/
There is additional information of the report of new house sales in Table ESIII-2. The stock of unsold houses stabilized in Apr-Aug 2011 at average 6.6 monthly equivalent sales at current sales rates and then dropped to 4.7 in Jul-Sep 2012, increasing to 4.9 in Oct 2012, 4.5 in Nov 2012 and 4.9 percent in Dec 2012. Median and average house prices oscillate. In Dec 2012, median prices of new houses sold not seasonally adjusted (NSA) increased 1.3 percent but after increasing 1.0 percent in Nov 2012, decreasing revised 4.5 percent in Oct, increasing 0.6 percent in Sep and increasing 6.7 percent in Aug. Average prices increased 4.9 percent in Dec 2012, 3.1 percent in Nov 2012, fell 5.6 percent in Oct and 2.6 percent in Sep and increased 8.2 percent in Aug. Between Dec 2010 and Dec 2012, median prices increased 3.2 percent and average prices increased 4.2 percent. Median house prices increased 11.2 percent from Dec 2011 to Oct 2012 while average price houses increased 6.9 percent. Price increases concentrated in 2012. There are only ten months with price increases in both median and average house prices: Apr 2011 with 1.9 percent in median prices and 3.1 percent in average prices, Jun 2011 with 8.2 percent in median prices and 3.9 percent in average prices, Oct 2011 with 3.6 percent in median prices and 1.1 percent in average prices, Dec 2011 with 2.0 percent in median prices and 5.2 percent in average prices, Jan 2012 with 1.4 percent in median prices and 1.1 percent in average prices, Feb 2012 with 8.2 percent in median prices and 3.1 percent in average prices, Jul with 2.1 percent in median and 3.9 percent in average, Aug 2012 with 6.7 percent in median prices and 8.2 percent in average prices, Nov 2012 with 1.0 percent in median prices and 3.1 percent in average prices and Dec 2012 with 1.3 percent in median prices and 4.9 percent in average prices. Median prices of new houses sold in the US fell in eleven of the 22 months from Jan 2011 to Oct 2012 and average prices fell in twelve months.
Table ESIII-2, US, New House Stocks and Median and Average New Homes Sales Price
| Unsold* | Median | Month | Average New House Sales Price USD | Month | |
| Dec 2012 | 4.9 | 248,900 | 1.3 | 304,000 | 4.9 |
| Nov | 4.5 | 245,600 | 1.0 | 289,900 | 3.1 |
| Oct | 4.8 | 243,100 | -4.5 | 281,100 | -5.6 |
| Sep | 4.6 | 254,600 | 0.6 | 297,700 | -2.6 |
| Aug | 4.7 | 253,200 | 6.7 | 305,500 | 8.2 |
| Jul | 4.7 | 237,400 | 2.1 | 282,300 | 3.9 |
| Jun | 4.8 | 232,600 | -2.8 | 271,800 | -3.2 |
| May | 4.7 | 239,200 | 1.2 | 280,900 | -2.4 |
| Apr | 4.9 | 236,400 | -1.4 | 287,900 | 1.5 |
| Mar | 4.9 | 239,800 | 0.0 | 283,600 | 3.5 |
| Feb | 4.8 | 239,900 | 8.2 | 274,000 | 3.1 |
| Jan | 5.3 | 221,700 | 1.4 | 265,700 | 1.1 |
| Dec 2011 | 5.4 | 218,600 | 2.0 | 262,900 | 5.2 |
| Nov | 5.7 | 214,300 | -4.7 | 250,000 | -3.2 |
| Oct | 6.1 | 224,800 | 3.6 | 258,300 | 1.1 |
| Sep | 6.3 | 217,000 | -1.2 | 255,400 | -1.5 |
| Aug | 6.6 | 219,600 | -4.5 | 259,300 | -4.1 |
| Jul | 6.7 | 229,900 | -4.3 | 270,300 | -1.0 |
| Jun | 6.6 | 240,200 | 8.2 | 273,100 | 3.9 |
| May | 6.6 | 222,000 | -1.2 | 262,700 | -2.3 |
| Apr | 6.7 | 224,700 | 1.9 | 268,900 | 3.1 |
| Mar | 7.1 | 220,500 | 0.2 | 260,800 | -0.8 |
| Feb | 8.0 | 220,100 | -8.3 | 262,800 | -4.7 |
| Jan | 7.3 | 240,100 | -0.5 | 275,700 | -5.5 |
| Dec 2010 | 7.0 | 241,200 | 9.8 | 291,700 | 3.5 |
*Percent of new houses for sale relative to houses sold
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The depressed level of residential construction and new house sales in the US is evident in Table ESIII-3 providing new house sales not seasonally adjusted in Jan-Dec of various years. Sales of new houses in Jan-Nov 2012 are substantially lower than in any year between 1963 and 2012 with the exception of 2010 and 2011. There are only two increases of 19.9 percent between Jan-Dec 2011 and Jan-Dec 2012 and 13.6 percent from Jan-Dec 2010 to Jan-Dec 2012. Sales of new houses in Jan-Dec 2012 are lower by 2.1 percent relative to Jan-Dec 2009, 24.3 percent relative to 2008, 52.7 percent relative to 2007, 65.1 percent relative to 2006 and 71.4 percent relative to 2005. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan-Dec 2012 relative to the same period in 2004 fell 69.5 percent and 66.2 percent relative to the same period in 2003. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Nov 2012 fell 45.0 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table ESIII-3 reveals catastrophic data: sales of new houses in Jan-Dec 2012 of 367 thousand units are lower by 34.5 percent relative to 560 thousand units houses sold in Jan-Dec 1963, the first year when data become available, while population increased 72.2 percent.
Table ESIII-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %
| Not Seasonally Adjusted Thousands | |
| Jan-Dec 2012 | 367 |
| Jan-Dec 2011 | 306 |
| ∆% | 19.9* |
| Jan-Dec 2010 | 323 |
| ∆% Jan-Dec 2012/ | 13.6 |
| Jan-Dec 2009 | 375 |
| ∆% Jan-Dec 2012/ | -2.1 |
| Jan-Dec 2008 | 485 |
| ∆% Jan-Dec 2012/ | -24.3 |
| Jan-Dec 2007 | 776 |
| ∆% Jan-Dec 2012/ | -52.7 |
| Jan-Dec 2006 | 1,051 |
| ∆% Jan-Dec 2012/Jan-Dec 2006 | -65.1 |
| Jan-Dec 2005 | 1,283 |
| ∆% Jan-Dec 2012/Jan-Dec 2005 | -71.4 |
| Jan-Dec 2004 | 1,203 |
| ∆% Jan-Dec 2012/Jan-Dec 2004 | -69.5 |
| Jan-Dec 2003 | 1,086 |
| ∆% Jan-Dec 2012/ | -66.2 |
| Jan-Dec 2002 | 973 |
| ∆% Jan-Dec 2012/ | -62.3 |
| Jan-Dec 2001 | 908 |
| ∆% Jan-Dec 2012/ | -59.6 |
| Jan-Dec 2000 | 877 |
| ∆% Jan-Dec 2012/ | -58.2 |
| Jan-Dec 1995 | 667 |
| ∆% Jan-Dec 2012/ | -45.0 |
| Jan-Dec 1963 | 560 |
| ∆% Jan-Dec 2012/ | -34.5 |
*Computed using unrounded data
Source: US Census Bureau http://www.census.gov/construction/nrs/
Table ESIII-4 provides the entire available annual series of new house sales from 1963 to 2012. The revised level of 306 thousand new houses sold in 2011 is the lowest since 560,000 in 1963 in the 48 years of available data while the level of 367 thousand in 2012 is only higher than 323 thousand in 2010. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. In fact, there is no year from 1963 to 2012 in Table II-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009, 2010, 2011 and 2012
Table ESIII-4, US, New Houses Sold, NSA Thousands
| 1963 | 560 |
| 1964 | 565 |
| 1965 | 575 |
| 1966 | 461 |
| 1967 | 487 |
| 1968 | 490 |
| 1969 | 448 |
| 1970 | 485 |
| 1971 | 656 |
| 1972 | 718 |
| 1973 | 634 |
| 1974 | 519 |
| 1975 | 549 |
| 1976 | 646 |
| 1977 | 819 |
| 1978 | 817 |
| 1979 | 709 |
| 1980 | 545 |
| 1981 | 436 |
| 1982 | 412 |
| 1983 | 623 |
| 1984 | 639 |
| 1985 | 688 |
| 1986 | 750 |
| 1987 | 671 |
| 1988 | 676 |
| 1989 | 650 |
| 1990 | 534 |
| 1991 | 509 |
| 1992 | 610 |
| 1993 | 666 |
| 1994 | 670 |
| 1995 | 667 |
| 1996 | 757 |
| 1997 | 804 |
| 1998 | 886 |
| 1999 | 880 |
| 2000 | 877 |
| 2001 | 908 |
| 2002 | 973 |
| 2003 | 1,086 |
| 2004 | 1,203 |
| 2005 | 1,283 |
| 2006 | 1,051 |
| 2007 | 776 |
| 2008 | 485 |
| 2009 | 375 |
| 2010 | 323 |
| 2011 | 306 |
| 2012 | 367 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart ESIII-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau.
Chart ESIII-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally-Adjusted Annual Rate)
Source: US Census Bureau
http://www.census.gov/briefrm/esbr/www/esbr051.html
Chart ESIII-2 of the US Bureau of the Census provides the entire monthly sample of new houses sold in the US between Jan 1963 and Dec 2012 without seasonal adjustment. The series is almost stationary until the 1990s. There is sharp upward trend from the early 1990s to 2005-2006 after which new single-family houses sold collapse to levels below those in the beginning of the series in the 1960s.
Chart ESIII-2, US, New Single-family Houses Sold, NSA, 1963-2012
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Percentage changes and average rates of growth of new house sales for selected periods are shown in Table ESIII-5. The percentage change of new house sales from 1963 to 2012 is minus 34.5 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2011 fell 45.0 percent relative to the same period in 1995.
Table ESIII-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses
| ∆% | Average Yearly % Rate | |
| 1963-2012 | -34.5 | NA |
| 1991-2001 | 78.4 | 5.9 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2012 | -45.0 | NA |
| 2000-2012 | -58.2 | NA |
| 2005-2012 | -71.4 | NA |
NA: Not Applicable
Source: US Census Bureau http://www.census.gov/construction/nrs/
ESIV 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 ESIV-1 from 2007 to 2012. Calendar year 2012 was excellent for most equity indexes. DAX outperformed all equity indexes in Table ESIV-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 ESIV-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 ESIV-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 ESIV-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 ESIV-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 ESIV-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 ESIV-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 ESIV-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 ESIV-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 fourth quarter of 2012 of 2.0 percent is equivalent to 8.2 percent per year and GDP increased 7.9 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/2013/01/recovery-without-hiring-world-inflation.html and earlier 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 the text after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII). Table ESIV-3, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 1/25/13,” which has been recently stalling or reversing amidst bouts of risk aversion.
The highest valuations in column “∆% Trough to 1/25/13” of Table ESIV-3 are by US equities indexes: DJIA 43.5 percent and S&P 500 47.0 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 35.6 percent above the trough. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States. A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on “S&P 500 closes above 1500,” on Jan 25, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323539804578263331715973390.html?mod=WSJ_hp_LEFTWhatsNewsCollection), finds that the DJIA closed on Fri Jun 25, 2013 at 13,895.98, or 1.9 percent below its record high of 14,164.53 in Oct 2007 while S&P 500 closed at 1502.96. DJIA closed at 13,984.80 on Oct 15, 2007, or only 0.6 percent higher than 13,895.98 at the close of markets on Jan 25, 2013, reaching a high of 14,157.38 on Oct 15, 2007, which is only 1.9 percent higher than 13,895.98 at the close on Jan 25, 2013 (using interactive chart data at http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The S&P 500 closed at 1502.96 on Jan 25, 2013, which is only 3.0 percent from the close at 1458.71 on Oct 15, 2007, and 4.1 percent from the high at 1564.74 on Oct 15, 2007 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Rita Nazareth and Sarah Pringle, writing on “Dow Average rises to 5-year high amid debt-ceiling talks,” on Jan 18, 2012, published in Bloomberg (http://www.bloomberg.com/news/2013-01-18/u-s-stock-futures-little-changed-before-earnings-data.html), find that the DJIA reached on Jan 18, 2012, the highest level in five years at 13,649.70 with volume of 6.6 billion shares in US exchanges, which is higher by 6.9 percent than the average in three months. Vito J. Bacanelli, writing on “GOP proposal lifts Dow to five-year high,” on Jan 19, 2013, published by Barron’s (http://online.barrons.com/article/SB50001424052748703596604578235762819811322.html?mod=BOL_hpp_mag#articleTabs_article%3D1), finds that the closing level of 13,649.70 on Jan 18, 2013, is the highest close since Dec 10, 2007, only 4 percent lower than the all-time high and the best start for a year since 1997. The DJIA reached 13,939.52 on Jan 25, 2013, 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 13895.98 on Jan 25, 2013, which is only 0.3 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 1/25/13” 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 3.8 percent below the trough; Japan’s Nikkei Average is 23.8 percent above the trough; DJ Asia Pacific TSM is 17.2 percent above the trough; Dow Global is 24.2 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 15.8 percent above the trough; and NYSE Financial Index is 27.3 percent above the trough. DJ UBS Commodities is 13.4 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 38.6 percent above the trough. Japan’s Nikkei Average is 23.8 percent above the trough on Aug 31, 2010 and 4.1 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 10926.65 on Fri Jan 25, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 6.6 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 12.9 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 1/25/13” in Table ESIV-3 shows that there were decreases of valuations of risk financial assets in the week of Jan 25, 2013 such as 0.7 percent for DJ Asia Pacific TSM. Nikkei Average increased 0.1 percent in the week. DJ UBS Commodities decreased 0.6 percent. China’s Shanghai Composite decreased 1.1 percent in the week of Jan 25, 2013. The DJIA increased 1.8 percent and S&P 500 increased 1.1 percent. There were increases in several indexes: 1.2 percent for NYSE Financial Index and 1.3 percent for Dow Global. STOXX 50 increased 1.0 percent and DAX of Germany increased 2.0 percent. The USD depreciated 1.0 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 ESIV-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 1/25/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jan 25, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 1/25/13” but also relative to the peak in column “∆% Peak to 1/25/13.” There are now several equity indexes above the peak in Table ESIV-3: DJIA 24.0 percent, S&P 500 23.5 percent, DAX 24.1 percent, DJ Asia Pacific 2.6 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 1.4 percent and Dow Global 1.4 percent. There are several indexes below the peak: Nikkei Average by 4.1 percent, Shanghai Composite by 27.6 percent and STOXX 50 by 1.9 percent. DJ UBS Commodities Index is now 3.0 percent below the peak. The US dollar strengthened 11.0 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
![clip_image021[1]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuf3X3ecVOZNLXPup_kMNZEglkN34vuERpYQrSywKlYsmOe7bZ17sSjBHCdrMWvf8ubsoiMHKt11ULWWBrBsIYQl0qk6oAKZ50lNO5n7bdS2qvs_ChslZu0oUs-Q9ipCR-fx5QYPVl1Ek/s1600-h/clip_image021%25255B1%25255D%25255B2%25255D.gif "clip_image021[1]"){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 ESIV-3, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 1/25/ /13 | ∆% Week 1/25/13 | ∆% Trough to 1/25/ 13 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 24.0 | 1.8 | 43.5 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 23.5 | 1.1 | 47.0 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | 1.4 | 1.2 | 27.3 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | 1.4 | 1.3 | 24.2 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | 2.6 | -0.7 | 17.2 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -4.1 | 0.1 | 23.8 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -27.6 | -1.1 | -3.8 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -1.9 | 1.0 | 15.8 |
| DAX | 4/26/ | 5/25/ | -10.5 | 24.1 | 2.0 | 38.6 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 11.0 | -1.0 | -12.9 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -3.0 | -0.6 | 13.4 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 1.947 |
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
IA United States Commercial Banks Assets and Liabilities. Subsection IA1 Transmission of Monetary Policy recapitulates the mechanism of transmission of monetary policy. Subsection IA2 Functions of Banking analyzes the functions of banks in modern banking theory. Subsection IA3 United States Commercial Bank Assets and Liabilities provides data and analysis of US commercial bank balance sheets in report H.8 of the Board of Governors of the Federal Reserve System on Assets and Liabilities of Commercial Banks in the United States (http://www.federalreserve.gov/releases/h8/current/default.htm).
IA1 Transmission of Monetary Policy. The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, unconventional monetary policy also includes a battery of measures to also reduce long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.
When inflation is low, the central bank lowers interest rates to stimulate aggregate demand in the economy, which consists of consumption and investment. When inflation is subdued and unemployment high, monetary policy would lower interest rates to stimulate aggregate demand, reducing unemployment. When interest rates decline to zero, unconventional monetary policy would consist of policies such as large-scale purchases of long-term securities to lower their yields. A major portion of credit in the economy is financed with long-term asset-backed securities. Loans for purchasing houses, automobiles and other consumer products are bundled in securities that in turn are sold to investors. Corporations borrow funds for investment by issuing corporate bonds. Loans to small businesses are also financed by bundling them in long-term bonds. Securities markets bridge the needs of higher returns by investors obtaining funds from savers that are channeled to consumers and business for consumption and investment. Lowering the yields of these long-term bonds could lower costs of financing purchases of consumer durables and investment by business. The essential mechanism of transmission from lower interest rates to increases in aggregate demand is portfolio rebalancing. Withdrawal of bonds in a specific maturity segment or directly in a bond category such as currently mortgage-backed securities causes reductions in yield that are equivalent to increases in the prices of the bonds. There can be secondary increases in purchases of those bonds in private portfolios in pursuit of their increasing prices. Lower yields translate into lower costs of buying homes and consumer durables such as automobiles and also lower costs of investment for business. There are two additional intended routes of transmission.
1. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.
2. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).
Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial instability (http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html). During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets. More technical discussion is in IA Appendix: Transmission of Unconventional Monetary Policy at http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html.
Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):
“I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance. There are many ways of doing this, including setting a target for the level of nominal GDP. But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent. Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.
Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation. But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong. Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.
The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low. In addition, I would indicate that clear and steady progress toward stronger growth is essential.”
Evans (2012Nov27) modified the “7/3” approach to a “6.5/2.5” approach:
“I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Price Index) inflation over the next two to three years, would be appropriate.”
The Federal Open Market Committee (FOMC) decided at its meeting on Dec 12, 2012 to implement the “6.5/2.5” approach (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm):
“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 asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
Unconventional monetary policy will remain in perpetuity, or QE∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 1.7 percent, which is well below 3.0 percent estimated by Lucas (2011May) from 1870 to 2010. Unconventional monetary policy interprets the dual mandate of low inflation and maximum employment as mainly a “growth mandate” of forcing economic growth in the US at a rate that generates full employment. A hurdle to this “growth mandate” is that the US economy grew at 6.2 percent on average during cyclical expansions in the postwar period while growth has been at only 2.2 percent on average in the cyclical expansion in the 13 quarters from IIIQ2009 to IIIQ2012. Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.
First, reduction of the unemployment rate to normal would take 35.5 years using conventional measurement of unemployed or 91.9 years when measured to include effectively unemployed of 18.700 million as calculated in this blog (http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html). The number of nonfarm jobs and private jobs created has been declining in 2012 from 275,000 in Jan 2012 to 45,000 in Jun, 132,000 in Sep, 137,000 in Oct, 161,000 in Nov and 155,000 in Dec 2012 for total nonfarm jobs and from 277,000 in Jan 2012 to 63,000 in Jun, 122,000 in Sep, 203,000 in Oct, 171,000 in Nov and 168,000 in Dec 2012 for private jobs. Average new nonfarm jobs in the quarter Dec 2011 to Feb 2012 were 252,333 per month, declining to average 130,100 per month in the ten months from Mar to Dec 2012. Average new private jobs in the quarter Dec 2011 to Feb 2012 were 255,000 per month, declining to average 137,200 per month in the ten months from Mar 2012 to Dec 2012. The US labor force stood at 154.088 million in Oct 2011 and at 155.779 million in Oct 2012, not seasonally adjusted, for increase of 1.691 million, or 140,917 per month. The US labor force stood at 153.683 million in Nov 2011 and 154.953 million in Nov 2012, not seasonally adjusted, for increase of 1.270 million or 105,833 per month. The US labor force stood at 153.373 million in Dec 2011 and 154.904 million in Dec 2012, not seasonally adjusted, for increase of 1.531 million or 127,583 per month. The average increase of 130,100 new nonfarm jobs per month in the US from Mar to Dec 2012 is insufficient even to absorb 127,583 new entrants per month into the labor force. The difference between the average increase of 137,200 new private nonfarm jobs per month in the US from Mar to Dec 2012 and the 127,583 average monthly increase in the labor force from Nov 2011 to Nov 2012 is 9,617 monthly new jobs net of absorption of new entrants in the labor force. There are 29.6 million in job stress in the US currently. The provision of 9,617 new jobs per month net of absorption of new entrants in the labor force would require 3078 months to provide jobs for the unemployed and underemployed (29.6 million divided by 9,617) or 256 years (3078 divided by 12). Net job creation of 9,617 jobs per month only adds 115,404 jobs in a year. The civilian labor force of the US in Dec 2012 not seasonally adjusted stood at 154.904 million with 11.844 million unemployed or effectively 18.700 million unemployed in this blog’s calculation by inferring those who are not searching because they believe there is no job for them. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 8.7 years (1 million divided by product of 9,617 by 12, which is 115,404). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.745 million (0.05 times labor force of 154.904 million) for new net job creation of 4.099 million (11.844 million unemployed minus 7.745 million unemployed at rate of 5 percent) that at the current rate would take 35.5 years (4.099 million divided by 115,404). Under the calculation in this blog there are 18.700 million unemployed by including those who ceased searching because they believe there is no job for them. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 10.612 million jobs net of labor force growth that at the current rate would take 91.9 years (18.700 million minus 0.05(161.760 million) divided by 115,404, using labor force participation of 66.2 percent). These calculations assume that there are no more recessions, defying United States economic history with periodic contractions of economic activity when unemployment increases sharply. The number employed in the US fell from 146.743 million in Oct 2007 to 143.060 million in Dec 2012, by 3.683 million, or 2.5 percent, while the noninstitutional population increased from 232.715 million in Oct 2007 to 244.350 million in Dec 2012, by 11.635 million or increase of 5.0 percent, using not seasonally adjusted data. There is actually not sufficient job creation to merely absorb new entrants in the labor force because of those dropping from job searches, worsening the stock of unemployed or underemployed in involuntary part-time jobs.
Second, calculations show that actual US GDP growth is around 1.7 percent per year that will perpetuate unemployment/underemployment (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). This rate of 1.7 percent is well below trend growth of 3 percent per year from 1870 to 2010, which has been always recovered after events such as wars and recessions (Lucas 2011May). Weakness of growth is shown by the exceptional one-time contributions to growth from items that are not aggregate demand, 2.53 percentage points contributed by inventory change to growth of 4.1 percent in IVQ2011 and 0.64 percentage points contributed by expenditures in national defense together with 0.73 points of inventory accumulation to growth of 3.1 percent in IIIQ2012. Deducting inventory accumulation and one-time national defense expenditures adjusts IIIQ2012 growth to annual 1.73 percent. Cumulative growth of 2.0 percent in IQ2012, 1.3 percent in IIQ2012 and adjusted 1.73 percent in IIIQ2012 annualizes to 1.7 percent in the first three quarters of 2012 {([(1.02)1/4(1.013)1/4(1.01731/4]4/3 -1)100 = 1.7%}. The actual rate required to reduce unemployment/underemployment to normal is even higher than 3 percent in historical trend.
In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is concern of the production and employment costs of controlling future inflation. Even if there is no inflation QE∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.
It may be quite painful to exit QE∞ or use of the balance sheet of the central bank 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_image021[2]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCezhsTwIxyBkl_dxsZqPH11MM6dWzs857Cbz0qvxrd7j0nW7hGTwjIGZfF-gmTrPh-FPmEn35DvlCId8XtpvsCuucZJbxv2xL0MpCHE6G4f4DgZkxZ2nfsdon4WP0RKaNpASnClRDggc/s1600-h/clip_image021%25255B2%25255D%25255B2%25255D.gif "clip_image021[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 discount rates increase without bound, then V → 0, or
![clip_image021[3]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkw5DY-ktLvrJtzHpw_kst0BAk8OlqbtZ8AUYVTzBCWLeB5GRn2OcY-Apyshkmv1A5b2MeLc_EKabu2gwzTXBvB6bDlz1JzuukCKn4lUsq3LcfyvGAWjC1hiBZbZw2RtpK5tee7uvf5eYj/s1600-h/clip_image021%25255B3%25255D%25255B2%25255D.gif "clip_image021[3]"){kind=small}
declines.
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 (Friedman 1957, 10). 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→∞. Equally, as r→∞, W→0. Monetary policy is constrained in a QE∞ trap with all adverse effects of financial repression and resource misallocation because an increase in interest rates causes contraction of wealth, which in the United States is concentrated in home ownership and stocks in own investment portfolios and pension funds that decline during interest rate increases.
IA2 Functions of Banks. Modern banking theory analyzes three important functions provided by banks: monitoring of borrowers, provision of liquidity services and transformation of illiquid assets into immediately liquid assets (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 51-60). These functions require valuation of alternative investment projects that may be distorted by zero interest rates of monetary policy and artificially low long-term interest rates. The QE∞ trap frustrates essential banking functions.
1. Monitoring. Banks monitor projects to ensure that funds are allocated to their intended projects (Diamond 1984, 1996). Banks issue deposits, which are secondary assets, to acquire loans, which are primary assets. Monitoring reduces costs of participating in business projects. Acting as delegated monitor, banks obtain information on the borrower, allowing less costly participation through the issue of unmonitored deposits. Monitoring of borrowers provides enhanced less costly participation by investors through the issue of deposits. There is significant reduction of monitoring costs by delegating to a bank. If there are many potential investors, monitoring by the bank of a credit name is less costly than the sum of individual monitoring of the same credit name by all potential investors. Banks permit borrowers to reach many investors for their projects while affording investors less costly participation in the returns of projects of bank borrowers.
2. Transformation of Illiquid Loans into Liquid Deposits. Diamond and Dybvig (1986) analyze bank services through bank balance sheets.
i. Assets. Banks provide loans to borrowers. The evaluation of borrowers prevents “adverse selection,” which consists of banks choosing unsound projects and failing to finance sound projects. Monitoring of loans prevents “moral hazard,” which consists of borrowers using the funds of the loan for purposes other than the project for which they were lent, as for example, using borrowed bank funds for speculative real estate instead of for the intended industrial project. Relationship banking improves the information on borrowers and the monitoring function.
ii. Liabilities. Banks provide numerous services to their clients such as holding deposits, clearing transactions, currency inventory and payments for goods, services and obligations.
iii. Assets and Liabilities: Transformation Function. The transformation function operates through both sides of the balance sheet: banks convert illiquid loans in the asset side into liquid deposits in the liability side. There is rich theory of banking (Diamond and Rajan 2000, 2001a,b). Securitized banking provides the same transformation function by bundling mortgage and other consumer loans into securities that are then sold to investors who finance them in short-dated sale and repurchase agreements (Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 61-6).
Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Personal consumptions expenditures have share of 70.5 percent of GDP in IIIQ2012 (Table I-10 http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). Most consumers rely on their banks for real estate loans, credit cards and personal consumer loans. Thus, it should be expected that success of monetary policy in stimulating the economy would be processed through bank balance sheets.
IA3 United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table I-1. Data are not seasonally adjusted to permit comparison between Dec 2011 and Dec 2012. Total assets of US commercial banks grew 4.3 percent from $12,577.5 billion in Dec 2011 to $13,120.8 billion in Dec 2012. US GDP in 2011 is estimated at $15,075.7 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 87 percent of US GDP. Bank credit grew 5.8 percent from $9465.4 billion in Dec 2011 to $10,011.5 billion in Dec 2012. Securities in bank credit increased 9.8 percent from $2498.6 billion in Dec 2011 to $2742.8 billion in Dec 2012. A large part of securities in banking credit consists of US Treasury and agency securities, growing 10.5 percent from $1700.5 billion in Dec 2011 to $1878.5 billion in Dec 2012. Credit to the government that issues or backs Treasury and agency securities of $1878.5 in Dec 2012 is about 18.8 percent of total bank credit of US commercial banks of $10,011.5 billion. Mortgage-backed securities, providing financing of home loans, grew 7.6 percent, from $1253.4 billion in Dec 2011 to $1348.7 billion in Dec 2012. Loans and leases were less dynamic, growing 4.3 percent from $6966.8 billion in Dec 2011 to $7268.6 billion in Dec 2012. The only dynamic class is commercial and industrial loans, growing 12.8 percent from Dec 2011 to Dec 2012 and providing $1507.7 billion or 20.7 percent of total loans and leases of $7268.6 billion in Dec 2012. Real estate loans increased only 1.5 percent, providing $3557.5 billion in Dec 2012 or 48.9 percent of total loans and leases. Consumer loans increased only 2.3 percent, providing $1131.6 billion in Dec 2012 or 15.6 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks decreased 0.2 percent from $1679.2 billion in Dec 2011 to $1675.5 billion in Dec 2012 but a single year of the series masks exploding cash in banks as a result of unconventional monetary policy, which is discussed below. Bank deposits increased 9.7 percent from $8500.3 billion to $9327.0 billion. The difference between bank deposits and total loans and leases in banks increased from $1533.5 billion in Dec 2011 to $2058.4 billion in Dec 2012 or by $524.9 billion, which is similar to the increase in securities in bank credit by $244.2 billion from $2498.6 billion in Dec 2011 to $2742.8 billion in Dec 2012 and to the increase in Treasury and agency securities by $178.0 billion from $1700.5 billion in Dec 2011 to $1878.5 billion in Dec 2012. Loans and leases increased $301.8 billion from $6966.8 billion in Dec 2011 to $7268.6 billion in Dec 2012. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IIIQ2012 lower by 0.4 percent than in IVQ2007 (Table I-3 below) in contrast with long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May).
Table I-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars
| Dec 2011 | Dec 2012 | ∆% | |
| Total Assets | 12,577.6 | 13,120.8 | 4.3 |
| Bank Credit | 9465.4 | 10,011.5 | 5.8 |
| Securities in Bank Credit | 2498.6 | 2742.8 | 9.8 |
| Treasury & Agency Securities | 1700.5 | 1878.5 | 10.5 |
| Mortgage-Backed Securities | 1253.4 | 1348.7 | 7.6 |
| Loans & Leases | 6966.8 | 7268.6 | 4.3 |
| Real Estate Loans | 3504.3 | 3557.5 | 1.5 |
| Consumer Loans | 1006.0 | 1131.6 | 2.3 |
| Commercial & Industrial Loans | 1336.3 | 1507.7 | 12.8 |
| Other Loans & Leases | 1020.3 | 1071.8 | 5.0 |
| Cash Assets* | 1679.2 | 1675.5 | -0.2 |
| Total Liabilities | 11,149.3 | 11,612.1 | 4.2 |
| Deposits | 8500.3 | 9327.0 | 9.7 |
Note: balancing item of residual assets less liabilities not included
*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are provided in Table I-2 annually from 2007 to 2011 and for Nov and Dec 2012. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.8 percent in 2010. Commercial and industrial loans fell 18.6 percent in 2009 and 9.0 percent in 2011. Unconventional monetary policy caused an increase of cash assets of banks of 158.2 percent in 2008, 48.1 percent in 2009 and 47.8 percent in 2011 and at the SAAR of 22.4 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012 followed by increase of 55.5 percent in Nov 2012 and minus 19.3 percent in Dec 2012. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that were held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit, growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.6 percent in Oct 2012, 0.9 percent in Nov 2012 and 22.6 percent in Dec 2012. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit, with growth of 15.5 percent in 2009 and 15.1 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012 but falling at the rate of 2.1 percent in Nov 2012 and increasing at 18.6 percent in Dec 2012. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.5 percent in Nov 2012 and 20.7 percent in Dec 2012. The credit intermediation function of banks is broken because of adverse expectations on future business and is not easily mended simply by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.
Table I-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%
| 2008 | 2009 | 2010 | 2011 | 2012 | Nov 2012 | Dec 2012 | |
| Total Assets | 7.9 | -6.0 | -2.7 | 5.3 | 2.4 | 4.1 | 7.4 |
| Bank Credit | 2.1 | -6.6 | -2.7 | 1.8 | 3.9 | -1.7 | 10.8 |
| Securities in Bank Credit | -2.0 | 6.8 | 6.8 | 1.7 | 7.5 | 0.9 | 22.6 |
| Treasury & Agency Securities | 3.1 | 15.5 | 15.1 | 2.9 | 8.5 | -2.1 | 18.6 |
| Other Securities | -8.4 | -5.1 | -7.1 | -0.8 | 5.3 | 7.5 | 31.4 |
| Loans & Leases | 3.3 | -10.2 | -5.8 | 1.8 | 2.6 | -2.7 | 6.3 |
| Real Estate Loans | -0.2 | -5.6 | -5.5 | -3.8 | -1.1 | -4.2 | -0.3 |
| Consumer Loans | 5.1 | -3.3 | -7.0 | -0.8 | 1.1 | 3.2 | 3.8 |
| Commercial & Industrial Loans | 12.9 | -18.6 | -9.0 | 9.4 | 11.3 | 2.4 | 17.7 |
| Other Loans & Leases | 1.7 | -23.3 | 0.3 | 19.3 | 5.9 | -11.1 | 15.6 |
| Cash Assets | 157.6 | 48.1 | -7.8 | 47.6 | -2.9 | 55.5 | -19.1 |
| Total Liabilities | 10.6 | -7.2 | -3.4 | 5.5 | 2.1 | 3.0 | 10.3 |
| Deposits | 5.4 | 5.2 | 2.4 | 6.7 | 7.2 | 5.5 | 20.7 |
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-1 of the Board of Governors of the Federal Reserve System provides quarterly seasonally adjusted annual rates (SAAR) of cash assets in US commercial banks from 1973 to 2012. Unconventional monetary policy caused an increase in cash assets in late 2008 of close to 500 percent at SAAR and also in following policy impulses. Such aggressive policies were not required for growth of GDP at the average rate of 5.7 percent in 13 quarters of cyclical expansion from IQ1983 to IV1985 while the average rate in 13 quarters of cyclical expansion from IIIQ2009 to IIIQ2012 has been at the rate of 2.2 percent (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). The difference in magnitude of the recessions is not sufficient to explain weakness of the current cyclical expansion. Bordo (2012Sep27) and Bordo and Haubrich (2012DR) find that growth is higher after deeper contractions and contractions with financial crises. There were two consecutive contractions in the 1980s with decline of 2.2 percent in two quarters from IQ1980 to IIIQ1980 and 2.7 percent from IIIQ1981 to IVQ1982 that are almost identical to the contraction of 4.7 percent from IVQ2007 to IIQ2009 (Table I-3 below). There was also a decade-long financial and banking crisis during the 1980s. The debt crisis of 1982 (Pelaez 1986) wiped out a large part of the capital of large US money-center banks. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.7 percent of GDP in a year. US GDP in 2011 is estimated at $15,075.7 billion, such that the bailout would be equivalent to cost to taxpayers of about $412.5 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery.
Chart I-1, US, Cash Assets, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-2 of the Board of Governors of the Federal Reserve System provides quarterly SAARs of bank credit at US commercial banks from 1973 to 2012. Rates collapsed sharply during the global recession as during the recessions of the 1980s and then rebounded. In both episodes rates of growth of bank credit did not return to earlier magnitudes.
Chart I-2, US, Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-3 of the Board of Governors of the Federal Reserve System provides deposits at US commercial banks from 1973 to 2012. Deposits fell sharp during and after the global recession but then rebounded in the cyclical expansion.
Chart I-3, US, Deposits, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
There is similar behavior in the 1980s and in the current cyclical expansion of SAARs holdings of Treasury and agency securities in US commercial banks provided in Chart I-4 of the Board of Governors of the Federal Reserve System for the period 1973 to 2012. Sharp reductions of holdings during the contraction were followed by sharp increases.
Chart I-4, US, Treasury and Agency Securities in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-5 of the Board of Governors of the Federal Reserve System provides SAARs of change of total loans and leases in US commercial banks from 1973 to 2012. The decline in the current cycle of SAARs was much sharper and the rebound did not recover earlier growth rates. Part of the explanation originates in demand for loans that was high during rapid economic growth at 5.7 percent per year on average in the cyclical expansion of the 1980s in contrast with lower demand during tepid economic growth at 2.2 percent per year on average in the current weak expansion.
Chart I-5, US, Loans and Leases in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
There is significant difference in the two cycles of the 1980s and the current one in quarterly SAARs of real estate loans in US commercial banks provided in Chart I-6 of the Board of Governors of the Federal Reserve System. The difference is explained by the debacle in real estate after 2006 compared to expansion during the 1980s even in the midst of the crisis of savings and loans and real estate credit. In both cases, government policy tried to influence recovery and avoid market clearing.
Chart I-6, US, Real Estate Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
There is significant difference in quarterly SAARs of change of consumer loans in US commercial banks in the 1980s and during the current cycle as shown in Chart I-7 of the Board of Governors of the Federal Reserve System. Quarterly SAARs of consumer loans in US commercial banks fell sharply during the contraction of 1980 and oscillated with upward trend during the contraction of 1983-1984 but increased sharply in the cyclical expansion. In contrast, SAARs of consumer loans in US commercial banks collapsed to high negative magnitudes during the contraction and have increased at very low magnitudes during the current cyclical expansion.
Chart I-7, US, Consumer Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Table I-3 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 I-3, 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
Chart I-8 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Acquisitions of securities for the portfolio of the central bank were processed by increases in bank cash reserves. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Discovery of such painless and fast adjustment by gigantic impulses of monetary policy of zero interest rates and trillions of dollars of bond buying would have occurred earlier with prior cases of successful implementation. Selective incentives to the private sector of a long-term nature could have been more effective.
Chart I-8, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-9 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from 2002 to 2012. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart II-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.
Chart I-9, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, 2002 to 2013
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-10 of the Board of Governors of the Federal Reserve System provides deposits in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Deposit growth clearly accelerated after 2001 and continued during the current cyclical expansion after bumps during the global recession.
Chart I-10, US, Deposits in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-11 of the Board of Governors of the Federal Reserve System provides Treasury and agency securities in US commercial banks, not seasonally adjusted, in billions of dollars from 1973 to 2012. Holdings stabilized between the recessions of 2001 and after IVQ2007. There was rapid growth during the global contraction especially after unconventional monetary policy in 2008 and nearly vertical increase without prior similar historical experience during the various bouts of unconventional monetary policy. Banks hoard cash and less risky Treasury and agency securities instead of risky lending because of the weakness of the economy and the lack of demand for financing sound business projects.
Chart I-11, US, Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-12 of the Board of Governors of the Federal Reserve System provides total loans and leases in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Total loans and leases of US commercial banks contracted sharply and have stalled during the cyclical expansion.
Chart I-12, US, Loans and Leases in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-13 of the Board of Governors of the Federal Reserve System provides real estate loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Housing subsidies and low interest rates caused a point of inflexion to higher, nearly vertical growth until 2007. Real estate loans have contracted in downward trend partly because of adverse effects of uncertainty on the impact on balance sheets of the various mechanisms of resolution imposed by policy. Nick Timiraos, writing on “Push for cheaper credit hits wall,” on Dec 24, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324660404578197782701079650.html), provides important information and analysis on housing finance. Quantitative easing consists of withdrawing supply of mortgage-backed securities by acquiring them as assets in the Fed balance sheet. Lending banks obtain funds for mortgages by bundling them according to risk and other characteristics and selling them to investors, using the proceeds from the sale to provide the loans to homebuyers or refinancing homeowners. Banks earn net revenue to remunerate capital required for operations from the spread between the rate received from mortgage debtors and the rate implicit in the yield of the mortgage-backed securities. Nick Timiraos (Ibid) finds that the spread was around 0.5 percentage points before the financial crisis of 2007, widening to 1 percentage point after the crisis but jumping to 1.6 percentage points after the Fed engaged in another program of buying mortgage-backed securities, oscillating currently around 1.3 percentage points. The spread has widened because banks have higher costs originating in regulation, litigation on repurchasing defaulted mortgages, loss in case of default and more prudent but more costly scrutiny of property appraisals and income verification. As a result, even if quantitative easing does lower yields of mortgage-backed securities there would not be proportionate reduction in mortgage rates.
Chart I-13, US, Real Estate Loans in Bank Credit, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Chart I-14 of the Board of Governors of the Federal Reserve System provides consumer loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Consumer loans even increased during the contraction then declined and increased vertically to decline again. There was high demand for reposition of durable goods that exhausted and limited consumption again with increase in savings rates in recent periods.
Chart I-14, US, Consumer Loans in Bank Credit, Not Seasonally Adjusted, US Commercial Banks, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
Finally, Chart I-15 of the Board of Governors of the Federal Reserve System provides commercial and industrial loans not seasonally adjusted in billions of dollars from 1973 to 2012. Commercial and industrial loans fell sharply during both contractions in 2001 and after IVQ2007 and then rebounded with accelerated growth. Commercial and industrial loans have not reached again the peak during the global recession.
Chart I-15, US, Commercial and Industrial Loans in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/h8/current/default.htm
IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004 and quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates (for fear of deflation see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (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). Several past comments of this blog elaborate on these arguments, among which: 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
If the forecast of the central bank is of recession and low inflation with controlled inflationary expectations, monetary policy should consist of lowering the short-term policy rate of the central bank, which in the US is the fed funds rate. The intended effect is to lower the real rate of interest (Svensson 2003LT, 146-7). The real rate of interest, r, is defined as the nominal rate, i, adjusted by expectations of inflation, π*, with all variables defined as proportions: (1+r) = (1+i)/(1+π*) (Fisher 1930). If i, the fed funds rate, is lowered by the Fed, the numerator of the right-hand side is lower such that if inflationary expectations, π*, remain unchanged, the left-hand (1+r) decreases, that is, the real rate of interest, r, declines. Expectations of lowering short-term real rates of interest by policy of the Federal Open Market Committee (FOMC) fixing a lower fed funds rate would lower long-term real rates of interest, inducing with a lag investment and consumption, or aggregate demand, that can lift the economy out of recession. Inflation also increases with a lag by higher aggregate demand and inflation expectations (Fisher 1933). This reasoning explains why the FOMC lowered the fed funds rate in Dec 2008 to 0 to 0.25 percent and left it unchanged.
The fear of the Fed is expected deflation or negative π*. In that case, (1+ π*) < 1, and (1+r) would increase because the right-hand side of the equation would be divided by a fraction. A simple numerical example explains the effect of deflation on the real rate of interest. Suppose that the nominal rate of interest or fed funds rate, i, is 0.25 percent, or in proportion 0.25/100 = 0.0025, such that (1+i) = 1.0025. Assume now that economic agents believe that inflation will remain at 1 percent for a long period, which means that π* = 1 percent, or in proportion 1/100 =0.01. The real rate of interest, using the equation, is (1+0.0025)/(1+0.01) = (1+r) = 0.99257, such that r = 0.99257 - 1 = -0.00743, which is a proportion equivalent to –(0.00743)100 = -0.743 percent. That is, Fed policy has created a negative real rate of interest of 0.743 percent with the objective of inducing aggregate demand by higher investment and consumption. This is true if expected inflation, π*, remains at 1 percent. Suppose now that expectations of deflation become generalized such that π* becomes -1 percent, that is, the public believes prices will fall at the rate of 1 percent in the foreseeable future. Then the real rate of interest becomes (1+0.0025) divided by (1-0.01) equal to (1.0025)/(0.99) = (1+r) = 1.01263, or r = (1.01263-1) = 0.01263, which results in positive real rate of interest of (0.01263)100 = 1.263 percent.
Irving Fisher also identified the impact of deflation on debts as an important cause of deepening contraction of income and employment during the Great Depression illustrated by an actual example (Fisher 1933, 346):
“By March, 1933, liquidation had reduced the debts about 20 percent, but had increased the dollar about 75 percent, so that the real debt, that is the debt measured in terms of commodities, was increased about 40 percent [100%-20%)X(100%+75%) =140%]. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized”
The nominal rate of interest must always be nonnegative, that is, i ≥ 0 (Hick 1937, 154-5):
“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”
The interpretation by Hicks of the General Theory of Keynes is the special case in which at interest rates close to zero liquidity preference is infinitely or perfectly elastic, that is, the public holds infinitely large cash balances at that near zero interest rate because there is no opportunity cost of foregone interest. Increases in the money supply by the central bank would not decrease interest rates below their near zero level, which is called the liquidity trap. The only alternative public policy would consist of fiscal policy that would act similarly to an increase in investment, increasing employment without raising the interest rate.
An influential view on the policy required to steer the economy away from the liquidity trap is provided by Paul Krugman (1998). Suppose the central bank faces an increase in inflation. An important ingredient of the control of inflation is the central bank communicating to the public that it will maintain a sustained effort by all available policy measures and required doses until inflation is subdued and price stability is attained. If the public believes that the central bank will control inflation only until it declines to a more benign level but not sufficiently low level, current expectations will develop that inflation will be higher once the central bank abandons harsh measures. During deflation and recession the central bank has to convince the public that it will maintain zero interest rates and other required measures until the rate of inflation returns convincingly to a level consistent with expansion of the economy and stable prices. Krugman (1998, 161) summarizes the argument as:
“The ineffectuality of monetary policy in a liquidity trap is really the result of a looking-glass version of the standard credibility problem: monetary policy does not work because the public expects that whatever the central bank may do now, given the chance, it will revert to type and stabilize prices near their current level. If the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap”
This view is consistent with results of research by Christina Romer that “the rapid rates of growth of real output in the mid- and late 1930s were largely due to conventional aggregate demand stimulus, primarily in the form of monetary expansion. My calculations suggest that in the absence of these stimuli the economy would have remained depressed far longer and far more deeply than it actually did” (Romer 1992, 757-8, cited in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 210-2). The average growth rate of the money supply in 1933-1937 was 10 percent per year and increased in the early 1940s. Romer calculates that GDP would have been much lower without this monetary expansion. The growth of “the money supply was primarily due to a gold inflow, which was in turn due to the devaluation in 1933 and to capital flight from Europe because of political instability after 1934” (Romer 1992, 759). Gold inflow coincided with the decline in real interest rates in 1933 that remained negative through the latter part of the 1930s, suggesting that they could have caused increases in spending that was sensitive to declines in interest rates. Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (Bernanke 2002):
“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”
Fed policy is seeking what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher 1933, 350).
The President of the Federal Reserve Bank of Chicago argues that (Charles Evans 2010):
“I believe the US economy is best described as being in a bona fide liquidity trap. Highly plausible projections are 1 percent for core Personal Consumption Expenditures (PCE) inflation at the end of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual mandate misses are too large to shrug off, and there is currently no policy conflict between improving employment and inflation outcomes”
There are two types of monetary policies that could be used in this situation. First, the Fed could announce a price-level target to be attained within a reasonable time frame (Evans 2010):
“For example, if the slope of the price path is 2 percent and inflation has been underunning the path for some time, monetary policy would strive to catch up to the path. Inflation would be higher than 2 percent for a time until the path was reattained”
Optimum monetary policy with interest rates near zero could consist of “bringing the price level back up to a level even higher than would have prevailed had the disturbance never occurred” (Gauti Eggertsson and Michael Woodford 2003, 207). Bernanke (2003JPY) explains as follows:
“Failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods—greater quantities of assets purchased on the open market for example. So even if the central bank is reluctant to provide a time frame for meetings its objective, the structure of the price-level objective provides a means for the bank to commit to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and Woodford show, the expectations that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank’s own objectives by lowering the current real rate of interest”
Second, the Fed could use its balance sheet to increase purchases of long-term securities together with credible commitment to maintain the policy until the dual mandates of maximum employment and price stability are attained.
The central bank could also be pursuing competitive devaluation of the national currency in the belief that it could increase inflation to a higher level and promote domestic growth and employment at the expense of growth and unemployment in the rest of the world. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press, stating that (Bernanke 2000, 165):
“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”
Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Bernanke 2000, 161):
“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest”
Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others” (Robinson 1947, 156). Devaluation is one of the tools used in these policies (Robinson 1947, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 205-9; for the case of Brazil that devalued early in the Great Depression recovering with an increasing trade balance see Pelaez, 1968, 1968b, 1972; Brazil devalued and abandoned the gold standard during crises in the historical period as shown by Pelaez 1976, Pelaez and Suzigan 1981). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole.
Friedman (1969) finds that the optimal rule for the quantity of money is deflation at a rate that results in a zero nominal interest rate (see Ireland 2003 and Cole and Kocherlakota 1998). Atkeson and Kehoe (2004) argue that central bankers are not inclined to implement policies that could result in deflation because of the interpretation of the Great Depression as closely related to deflation. They use panel data on inflation and growth of real output for 17 countries over more than 100 years. The time-series data for each individual country are broken into five-year events with deflation measured as average negative inflation and depression as average negative growth rate of real output. Atkeson and Kehoe (2004) find that the Great Depression from 1929 to 1934 is the only case of association between deflation and depression without any evidence whatsoever of such relation in any other period. Their conclusion is (Atkeson and Kehoe 2004, 99): “Our finding thus suggests that policymakers’ fear of anticipated policy-induced deflation that would result from following, say, the Friedman rule is greatly overblown.” Their conclusion on the experience of Japan is (Atkeson and Kehoe 2004, 99):
“Since 1960, Japan’s average growth rates have basically fallen monotonically, and since 1970, its average inflation rates have too. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think, is that much of the slowdown is the natural pattern for a country that was far behind the world leaders and had begun to catch up.”
In the sample of Atkeson and Kehoe (2004), there are only eight five-year periods besides the Great Depression with both inflation and depression. Deflation and depression is shown in 65 cases with 21 of depression without deflation. There is no depression in 65 of 73 five-year periods and there is no deflation in 29 episodes of depression. There is a remarkable result of no depression in 90 percent of deflation episodes. Excluding the Great Depression, there is virtually no relation of deflation and depression. Atkeson and Kehoe (2004, 102) find that the average growth rate of Japan of 1.41 percent in the 1990s is “dismal” when compared with 3.20 percent in the United States but is not “dismal” when compared with 1.61 percent for Italy and 1.84 percent for France, which are also catch-up countries in modern economic growth (see Atkeson and Kehoe 1998). The conclusion of Atkeson and Kehoe (2004), without use of controls, is that there is no association of deflation and depression in their dataset.
Benhabib and Spiegel (2009) use a dataset similar to that of Atkeson and Kehoe (2004) but allowing for nonlinearity and inflation volatility. They conclude that in cases of low and negative inflation an increase of average inflation of 1 percent is associated with an increase of 0.31 percent of average annual growth. The analysis of Benhabib and Spiegel (2009) leads to the significantly different conclusion that inflation and economic performance are strongly associated for low and negative inflation. There is no claim of causality by Atkeson and Kehoe (2004) and Benhabib and Spiegel (2009).
Delfim Netto (1959) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):
“First, the null hypothesis of no trend was accepted with high confidence; secondly, the null hypothesis of no oscillation was rejected also with high confidence. Consequently, in the nineteenth century international prices of coffee fluctuated but without long-run trend. This statistical fact refutes the extreme argument of structural weakness of the coffee trade.”
In his classic work on the theory of international trade, Jacob Viner (1937, 563) analyzed the “index of total gains from trade,” or “amount of gain per unit of trade,” denoted as T:
T= (∆Pe/∆Pi)∆Q
Where ∆Pe is the change in export prices, ∆Pi is the change in import prices and ∆Q is the change in export volume. Dorrance (1948, 52) restates “Viner’s index of total gain from trade” as:
“What should be done is to calculate an index of the value (quantity multiplied by price) of exports and the price of imports for any country whose foreign accounts are to be analysed. Then the export value index should be divided by the import price index. The result would be an index which would reflect, for the country concerned, changes in the volume of imports obtainable from its export income (i.e. changes in its "real" export income, measured in import terms). The present writer would suggest that this index be referred to as the ‘income terms of trade’ index to differentiate it from the other indexes at present used by economists.”
What really matters for an export activity especially during modernization is the purchasing value of goods that it exports in terms of prices of imports. For a primary producing country, the purchasing power of exports in acquiring new technology from the country providing imports is the critical measurement. The barter terms of trade of Brazil improved from 1857 to 1906 because international coffee prices oscillated without trend (Delfim Netto 1959) while import prices from the United Kingdom declined at the rate of 0.5 percent per year (Imlah 1958). The accurate measurement of the opportunity afforded by the coffee exporting economy was incomparably greater when considering the purchasing power in British prices of the value of coffee exports, or Dorrance’s (1948) income terms of trade.
The conventional theory that the terms of trade of Brazil deteriorated over the long term is without reality (Pelaez 1976a, 280-281):
“Moreover, physical exports of coffee by Brazil increased at the high average rate of 3.5 per cent per year. Brazil's exchange receipts from coffee-exporting in sterling increased at the average rate of 3.5 per cent per year and receipts in domestic currency at 4.5 per cent per year. Great Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 per cent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 per cent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quality of coffee remained relatively constant, the quality of manufactured products improved significantly during the fifty-year period considered. The trade data and the non-parametric tests refute conclusively the long-run hypothesis. The valid historical fact is that the tropical export economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the "workshop" countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil.”
Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that drove the world’s growth impulse. Inflation in the United Kingdom between 1857 and 1906 is measured by the composite price index of O’Donoghue and Goulding (2004) at minus 7.0 percent or average rate of decline of 0.2 percent per year.
Simon Kuznets (1971) analyzes modern economic growth in his Lecture in Memory of Alfred Nobel:
“The major breakthroughs in the advance of human knowledge, those that constituted dominant sources of sustained growth over long periods and spread to a substantial part of the world, may be termed epochal innovations. And the changing course of economic history can perhaps be subdivided into economic epochs, each identified by the epochal innovation with the distinctive characteristics of growth that it generated. Without considering the feasibility of identifying and dating such economic epochs, we may proceed on the working assumption that modern economic growth represents such a distinct epoch - growth dating back to the late eighteenth century and limited (except in significant partial effects) to economically developed countries. These countries, so classified because they have managed to take adequate advantage of the potential of modern technology, include most of Europe, the overseas offshoots of Western Europe, and Japan—barely one quarter of world population.”
Cameron (1961) analyzes the mechanism by which the Industrial Revolution in Great Britain spread throughout Europe and Cameron (1967) analyzes the financing by banks of the Industrial Revolution in Great Britain. O’Donoghue and Goulding (2004) provide consumer price inflation in England since 1750 and MacFarlane and Mortimer-Lee (1994) analyze inflation in England over 300 years. Lucas (2004) estimates world population and production since the year 1000 with sustained growth of per capita incomes beginning to accelerate for the first time in English-speaking countries and in particular in the Industrial Revolution in Great Britain. The conventional theory is unequal distribution of the gains from trade and technical progress between the industrialized countries and developing economies (Singer 1950, 478):
“Dismissing, then, changes in productivity as a governing factor in changing terms of trade, the following explanation presents itself: the fruits of technical progress may be distributed either to producers (in the form of rising incomes) or to consumers (in the form of lower prices). In the case of manufactured commodities produced in more developed countries, the former method, i.e., distribution to producers through higher incomes, was much more important relatively to the second method, while the second method prevailed more in the case of food and raw material production in the underdeveloped countries. Generalizing, we may say -that technical progress in manufacturing industries showed in a rise in incomes while technical progress in the production of food and raw materials in underdeveloped countries showed in a fall in prices”
Temin (1997, 79) uses a Ricardian trade model to discriminate between two views on the Industrial Revolution with an older view arguing broad-based increases in productivity and a new view concentration of productivity gains in cotton manufactures and iron:
“Productivity advances in British manufacturing should have lowered their prices relative to imports. They did. Albert Imlah [1958] correctly recognized this ‘severe deterioration’ in the net barter terms of trade as a signal of British success, not distress. It is no surprise that the price of cotton manufactures fell rapidly in response to productivity growth. But even the price of woolen manufactures, which were declining as a share of British exports, fell almost as rapidly as the price of exports as a whole. It follows, therefore, that the traditional ‘old-hat’ view of the Industrial Revolution is more accurate than the new, restricted image. Other British manufactures were not inefficient and stagnant, or at least, they were not all so backward. The spirit that motivated cotton manufactures extended also to activities as varied as hardware and haberdashery, arms, and apparel.”
Phyllis Deane (1968, 96) estimates growth of United Kingdom gross national product (GNP) at around 2 percent per year for several decades in the nineteenth century. The facts that the terms of trade of Great Britain deteriorated during the period of epochal innovation and high rates of economic growth while the income terms of trade of the coffee economy of nineteenth-century Brazil improved at the average yearly rate of 4.0 percent from 1857 to 1906 disprove the hypothesis of weakness of trade as an explanation of relatively lower income and wealth. As Temin (1997) concludes, Britain did pass on lower prices and higher quality the benefits of technical innovation. Explanation of late modernization must focus on laborious historical research on institutions and economic regimes together with economic theory, data gathering and measurement instead of grand generalizations of weakness of trade and alleged neocolonial dependence (Stein and Stein 1970, 134-5):
“Great Britain, technologically and industrially advanced, became as important to the Latin American economy as to the cotton-exporting southern United States. [After Independence in the nineteenth century] Latin America fell back upon traditional export activities, utilizing the cheapest available factor of production, the land, and the dependent labor force.”
The experience of the United Kingdom with deflation and economic growth is relevant and rich. Table IE-1 uses yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004). There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. Table II-8 also provides yearly percentage changes of the UK composite price index of O’Donoghue and Goulding (2004) from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.
Table IE-1, United Kingdom, Negative Percentage Changes of Composite Price Index, 1751-1896, 1929-1934, Yearly ∆%
| Year | ∆% | Year | ∆% | Year | ∆% | Year | ∆% |
| 1751 | -2.7 | 1797 | -10.0 | 1834 | -7.8 | 1877 | -0.7 |
| 1753 | -2.7 | 1798 | -2.2 | 1841 | -2.3 | 1878 | -2.2 |
| 1755 | -6.0 | 1802 | -23.0 | 1842 | -7.6 | 1879 | -4.4 |
| 1758 | -0.3 | 1803 | -5.9 | 1843 | -11.3 | 1881 | -1.1 |
| 1759 | -7.9 | 1806 | -4.4 | 1844 | -0.1 | 1883 | -0.5 |
| 1760 | -4.5 | 1807 | -1.9 | 1848 | -12.1 | 1884 | -2.7 |
| 1761 | -4.5 | 1811 | -2.9 | 1849 | -6.3 | 1885 | -3.0 |
| 1768 | -1.1 | 1814 | -12.7 | 1850 | -6.4 | 1886 | -1.6 |
| 1769 | -8.2 | 1815 | -10.7 | 1851 | -3.0 | 1887 | -0.5 |
| 1770 | -0.4 | 1816 | -8.4 | 1857 | -5.6 | 1893 | -0.7 |
| 1773 | -0.3 | 1819 | -2.5 | 1858 | -8.4 | 1894 | -2.0 |
| 1775 | -5.6 | 1820 | -9.3 | 1859 | -1.8 | 1895 | -1.0 |
| 1776 | -2.2 | 1821 | -12.0 | 1862 | -2.6 | 1896 | -0.3 |
| 1777 | -0.4 | 1822 | -13.5 | 1863 | -3.6 | 1929 | -0.9 |
| 1779 | -8.5 | 1826 | -5.5 | 1864 | -0.9 | 1930 | -2.8 |
| 1780 | -3.4 | 1827 | -6.5 | 1868 | -1.7 | 1931 | -4.3 |
| 1785 | -4.0 | 1828 | -2.9 | 1869 | -5.0 | 1932 | -2.6 |
| 1787 | -0.6 | 1830 | -6.1 | 1874 | -3.3 | 1933 | -2.1 |
| 1789 | -1.3 | 1832 | -7.4 | 1875 | -1.9 | 1934 | 0.0 |
| 1791 | -0.1 | 1833 | -6.1 | 1876 | -0.3 |
Source:
O’Donoghue, Jim and Louise Goulding, 2004. Consumer Price Inflation since 1750. UK Office for National Statistics Economic Trends 604, Mar 2004, 38-46.
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. If deflation causes depressions as embedded in the theory of unconventional monetary policy, the United Kingdom would not have been a growth leader in the nineteenth century while staying almost half of the time in deflation.
Nicholas Georgescu-Rogen (1960, 1) reprinted in Pelaez (1973) argues that “the agrarian economy has to this day remained a reality without theory.” The economic history of Latin America shares with the relation of deflation and unconventional monetary policy a more frustrating intellectual misfortune: theory without reality. MacFarlane and Mortimer-Lee (1994, 159) quote in a different context a phrase by Thomas Henry Huxley in the President’s Address to the British Association for the Advancement of Science on Sep 14, 1870 that is appropriate to these issues: “The great tragedy of science—the slaying of a beautiful hypothesis by an ugly fact.”
IB IMF World Economic Outlook Projections Update. The International Financial Institutions (IFI) consist of the International Monetary Fund, World Bank Group, Bank for International Settlements (BIS) and the multilateral development banks, which are the European Investment Bank, Inter-American Development Bank and the Asian Development Bank (Pelaez and Pelaez, International Financial Architecture (2005), The Global Recession Risk (2007), 8-19, 218-29, Globalization and the State, Vol. II (2008b), 114-48, Government Intervention in Globalization (2008c), 145-54). There are four types of contributions of the IFIs:
1. Safety Net. The IFIs contribute to crisis prevention and crisis resolution.
i. Crisis Prevention. An important form of contributing to crisis prevention is by surveillance of the world economy and finance by regions and individual countries. The IMF and World Bank conduct periodic regional and country evaluations and recommendations in consultations with member countries and also jointly with other international organizations. The IMF and the World Bank have been providing the Financial Sector Assessment Program (FSAP) by monitoring financial risks in member countries that can serve to mitigate them before they can become financial crises.
ii. Crisis Resolution. The IMF jointly with other IFIs provides assistance to countries in resolution of those crises that do occur. Currently, the IMF is cooperating with the government of Greece, European Union and European Central Bank in resolving the debt difficulties of Greece as it has done in the past in numerous other circumstances. Programs with other countries involved in the European debt crisis may also be developed.
2. Surveillance. The IMF conducts surveillance of the world economy, finance and public finance with continuous research and analysis. Important documents of this effort are the World Economic Outlook of which the current one is IMF (2012WEOOct http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf) updated in Jan 2013 (http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm), Global Financial Stability Report of which the current one is IMF (2012GFSROct http://www.imf.org/External/Pubs/FT/GFSR/2012/02/pdf/text.pdf) and Fiscal Monitor of which the current one is IMF (2012FMOct http://www.imf.org/external/pubs/ft/fm/2012/02/pdf/fm1202.pdf).
3. Infrastructure and Development. The IFIs also engage in infrastructure and development, in particular the World Bank Group and the multilateral development banks.
4. Soft Law. Significant activity by IFIs has consisted of developing standards and codes under multiple forums. It is easier and faster to negotiate international agreements under soft law that are not binding but can be very effective (on soft law see Pelaez and Pelaez, Globalization and the State, Vol. II (2008c), 114-25). These norms and standards can solidify world economic and financial arrangements.
Table IB-1 is constructed with the database of the IMF (http://www.imf.org/external/datamapper/index.php?db=WEO) and the update of Jan 2013 (http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm) to show GDP in dollars in 2011 and the growth rate of real GDP of the world and selected regional countries from 2012 to 2015. The data illustrate the concept often repeated of “two-speed recovery” of the world economy from the recession of 2007 to 2009. The IMF has lowered its forecast of the world economy to 3.2 percent in 2012 but accelerating to 3.5 percent in 2013, 4.1 percent in 2014 and 4.4 percent in 2015. Slow-speed recovery occurs in the “major advanced economies” of the G7 that account for $33,697 billion of world output of $69,899 billion, or 48.2 percent, but are projected to grow at much lower rates than world output, 1.9 percent on average from 2012 to 2015 in contrast with 3.8 percent for the world as a whole. While the world would grow 16.1 percent in the four years from 2012 to 2015, the G7 as a whole would grow 7.6 percent. The difference in dollars of 2011 is rather high: growing by 16.1 percent would add $11.5 trillion of output to the world economy, or roughly two times the output of the economy of Japan of $5,867 but growing by 7.6 percent would add $5.3 trillion of output to the world, or somewhat below the output of Japan in 2011. The “two speed” concept is in reference to the growth of the 150 countries labeled as emerging and developing economies (EMDE) with joint output in 2011 of $25,438 billion, or 36.4 percent of world output. The EMDEs would grow cumulatively 24.6 percent or at the average yearly rate of 5.7 percent, contributing $6.3 trillion from 2012 to 2015 or the equivalent of 86.3 percent of $7,298 billion of China in 2011. The final four countries in Table IB-1 often referred as BRIC (Brazil, Russia, India, China), are large, rapidly growing emerging economies. Their combined output adds to $13,468 billion, or 19.3 percent of world output, which is equivalent to 39.9 percent of the combined output of the major advanced economies of the G7.
Table IB-1, IMF World Economic Outlook Database Projections of Real GDP Growth
| GDP USD 2011 | Real GDP ∆% | Real GDP ∆% | Real GDP ∆% | Real GDP ∆% | |
| World | 69,899 | 3.2 | 3.5 | 4.1 | 4.4 |
| G7 | 33,697 | 1.3 | 1.4 | 2.2 | 2.5 |
| Canada | 1,739 | 2.0 | 1.8 | 2.3 | 2.4 |
| France | 2,778 | 0.2 | 0.3 | 0.9 | 1.5 |
| DE | 3,607 | 0.9 | 0.6 | 1.4 | 1.4 |
| Italy | 2,199 | -2.1 | -1.0 | 0.5 | 1.2 |
| Japan | 5,867 | 2.0 | 1.2 | 0.7 | 1.2 |
| UK | 2,431 | -0.2 | 1.0 | 1.9 | 2.6 |
| US | 15,076 | 2.3 | 2.0 | 3.0 | 3.4 |
| Euro Area | 13,114 | -0.4 | -0.2 | 1.0 | 1.5 |
| DE | 3,607 | 0.9 | 0.6 | 1.4 | 1.4 |
| France | 2,778 | 0.2 | 0.3 | 0.9 | 1.5 |
| Italy | 2,199 | -2.1 | -1.0 | 0.5 | 1.2 |
| POT | 238 | -3.0 | -1.0 | 1.2 | 1.9 |
| Ireland | 221 | 0.4 | 1.4 | 2.5 | 2.9 |
| Greece | 299 | -6.0 | -4.0 | 0.0 | 2.8 |
| Spain | 1,480 | -1.4 | -1.5 | 0.8 | 1.6 |
| EMDE | 25,438 | 5.1 | 5.5 | 5.9 | 6.1 |
| Brazil | 2,493 | 1.0 | 3.5 | 4.0 | 4.2 |
| Russia | 1,850 | 3.6 | 3.7 | 3.8 | 3.9 |
| India | 1,827 | 4.5 | 5.9 | 6.4 | 6.7 |
| China | 7,298 | 7.8 | 8.2 | 8.5 | 8.5 |
Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries); POT: Portugal
Source: IMF World Economic Outlook databank update http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx http://www.imf.org/external/pubs/ft/survey/so/2013/NEW012313A.htm http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm
World trade projections of the IMF are in Table IB-2. There is significantly slower growth of the volume of world trade of goods and services from 5.9 percent in 2011 to 2.8 percent in 2012 and 3.8 percent in 2013, increasing to 5.5 percent in 2014. World trade would slow sharply for advanced economies while emerging and developing economies (EMDE) experience slower growth.
Table IB-2, IMF, Projections of World Trade, ∆%
| 2011 | 2012 | 2013 | 2014 | |
| World Trade Volume (Goods and Services) | 5.9 | 2.8 | 3.8 | 5.5 |
| Imports | ||||
| Advanced Economies | 4.6 | 1.2 | 2.2 | 4.1 |
| EMDE | 8.4 | 6.1 | 6.5 | 7.8 |
| Exports | ||||
| Advanced Economies | 5.6 | 2.1 | 2.8 | 4.5 |
| EMDE | 6.6 | 3.6 | 5.5 | 6.9 |
EMDE: Emerging and Developing Economies (150 countries)
Source: International Monetary Fund World Economic Outlook databank update http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx http://www.imf.org/external/pubs/ft/survey/so/2013/NEW012313A.htm http://www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm
II United States Housing Collapse. The objective of this section is to provide the latest data and analysis of US housing. Subsection IIA United New House Sales analyzes the collapse of US new house sales. Subsection IIB United States House Prices considers the latest available data on house prices. Subsection IIC Factors of US Housing Collapse provides the analysis of the causes of the housing crisis of the US.
IIA United States New House Sales. Data and other information continue to provide depressed conditions in the US housing market in a longer perspective with recent improvement that has slowed at the margin. Table II-1 shows sales of new houses in the US at seasonally-adjusted annual equivalent rate (SAAR). House sales fell in ten of twenty four months from Jan 2011 to Sep 2012 but mostly concentrated in Jan-Feb 2011 and May-Aug 2011. In Jan-Apr 2012, house prices increased at the annual equivalent rate of 17.6 percent and at 15.1 percent in May-Sep 2012. There was significant strength in Sep-Dec 2011 with annual equivalent rate of 56.4 percent. Sales of new houses fell at the annual equivalent rate of 10.5 percent in Oct-Dec 2012 with two declines of 7.3 percent in Dec 2012 and 4.0 percent in Oct 2012 with increase of 9.3 percent in Nov 2012. The annual equivalent rate in May-Aug 2011 was minus 18.1 percent and minus 12.2 percent in Jan-Apr 2011 but after increase of 13.6 percent in Dec 2010.
Table II-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate | ∆% | |
| Dec 2012 | 369 | -7.3 |
| Nov | 398 | 9.3 |
| Oct | 364 | -4.0 |
| AE ∆% Oct-Dec | -10.5 | |
| Sep | 379 | 3.3 |
| Aug | 367 | 0.3 |
| Jul | 366 | 1.7 |
| Jun | 360 | -2.4 |
| May | 369 | 3.1 |
| AE ∆% May-Sep | 15.1 | |
| Apr | 358 | 1.7 |
| Mar | 352 | -3.8 |
| Feb | 366 | 7.9 |
| Jan | 339 | 0.0 |
| AE ∆% Jan-Apr | 17.6 | |
| Dec 2011 | 339 | 3.7 |
| Nov | 327 | 4.1 |
| Oct | 314 | 2.6 |
| Sep | 306 | 4.8 |
| AE ∆% Sep-Dec | 56.4 | |
| Aug | 292 | -1.7 |
| Jul | 297 | -2.3 |
| Jun | 304 | -1.3 |
| May | 308 | -1.3 |
| AE ∆% May-Aug | -18.1 | |
| Apr | 312 | 3.7 |
| Mar | 301 | 10.3 |
| Feb | 273 | -11.4 |
| Jan | 308 | -5.5 |
| AE ∆% Jan-Apr | -12.2 | |
| Dec 2010 | 326 | 13.6 |
AE: Annual Equivalent
Source: US Census Bureau http://www.census.gov/construction/nrs/
There is additional information of the report of new house sales in Table II-2. The stock of unsold houses stabilized in Apr-Aug 2011 at average 6.6 monthly equivalent sales at current sales rates and then dropped to 4.7 in Jul-Sep 2012, increasing to 4.9 in Oct 2012, 4.5 in Nov 2012 and 4.9 percent in Dec 2012. Median and average house prices oscillate. In Dec 2012, median prices of new houses sold not seasonally adjusted (NSA) increased 1.3 percent but after increasing 1.0 percent in Nov 2012, decreasing revised 4.5 percent in Oct, increasing 0.6 percent in Sep and increasing 6.7 percent in Aug. Average prices increased 4.9 percent in Dec 2012, 3.1 percent in Nov 2012, fell 5.6 percent in Oct and 2.6 percent in Sep and increased 8.2 percent in Aug. Between Dec 2010 and Dec 2012, median prices increased 3.2 percent and average prices increased 4.2 percent. Median house prices increased 11.2 percent from Dec 2011 to Oct 2012 while average price houses increased 6.9 percent. Price increases concentrated in 2012. There are only ten months with price increases in both median and average house prices: Apr 2011 with 1.9 percent in median prices and 3.1 percent in average prices, Jun 2011 with 8.2 percent in median prices and 3.9 percent in average prices, Oct 2011 with 3.6 percent in median prices and 1.1 percent in average prices, Dec 2011 with 2.0 percent in median prices and 5.2 percent in average prices, Jan 2012 with 1.4 percent in median prices and 1.1 percent in average prices, Feb 2012 with 8.2 percent in median prices and 3.1 percent in average prices, Jul with 2.1 percent in median and 3.9 percent in average, Aug 2012 with 6.7 percent in median prices and 8.2 percent in average prices, Nov 2012 with 1.0 percent in median prices and 3.1 percent in average prices and Dec 2012 with 1.3 percent in median prices and 4.9 percent in average prices. Median prices of new houses sold in the US fell in eleven of the 22 months from Jan 2011 to Oct 2012 and average prices fell in twelve months.
Table II-2, US, New House Stocks and Median and Average New Homes Sales Price
| Unsold* | Median | Month | Average New House Sales Price USD | Month | |
| Dec 2012 | 4.9 | 248,900 | 1.3 | 304,000 | 4.9 |
| Nov | 4.5 | 245,600 | 1.0 | 289,900 | 3.1 |
| Oct | 4.8 | 243,100 | -4.5 | 281,100 | -5.6 |
| Sep | 4.6 | 254,600 | 0.6 | 297,700 | -2.6 |
| Aug | 4.7 | 253,200 | 6.7 | 305,500 | 8.2 |
| Jul | 4.7 | 237,400 | 2.1 | 282,300 | 3.9 |
| Jun | 4.8 | 232,600 | -2.8 | 271,800 | -3.2 |
| May | 4.7 | 239,200 | 1.2 | 280,900 | -2.4 |
| Apr | 4.9 | 236,400 | -1.4 | 287,900 | 1.5 |
| Mar | 4.9 | 239,800 | 0.0 | 283,600 | 3.5 |
| Feb | 4.8 | 239,900 | 8.2 | 274,000 | 3.1 |
| Jan | 5.3 | 221,700 | 1.4 | 265,700 | 1.1 |
| Dec 2011 | 5.4 | 218,600 | 2.0 | 262,900 | 5.2 |
| Nov | 5.7 | 214,300 | -4.7 | 250,000 | -3.2 |
| Oct | 6.1 | 224,800 | 3.6 | 258,300 | 1.1 |
| Sep | 6.3 | 217,000 | -1.2 | 255,400 | -1.5 |
| Aug | 6.6 | 219,600 | -4.5 | 259,300 | -4.1 |
| Jul | 6.7 | 229,900 | -4.3 | 270,300 | -1.0 |
| Jun | 6.6 | 240,200 | 8.2 | 273,100 | 3.9 |
| May | 6.6 | 222,000 | -1.2 | 262,700 | -2.3 |
| Apr | 6.7 | 224,700 | 1.9 | 268,900 | 3.1 |
| Mar | 7.1 | 220,500 | 0.2 | 260,800 | -0.8 |
| Feb | 8.0 | 220,100 | -8.3 | 262,800 | -4.7 |
| Jan | 7.3 | 240,100 | -0.5 | 275,700 | -5.5 |
| Dec 2010 | 7.0 | 241,200 | 9.8 | 291,700 | 3.5 |
*Percent of new houses for sale relative to houses sold
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The depressed level of residential construction and new house sales in the US is evident in Table II-3 providing new house sales not seasonally adjusted in Jan-Dec of various years. Sales of new houses in Jan-Nov 2012 are substantially lower than in any year between 1963 and 2012 with the exception of 2010 and 2011. There are only two increases of 19.9 percent between Jan-Dec 2011 and Jan-Dec 2012 and 13.6 percent from Jan-Dec 2010 to Jan-Dec 2012. Sales of new houses in Jan-Dec 2012 are lower by 2.1 percent relative to Jan-Dec 2009, 24.3 percent relative to 2008, 52.7 percent relative to 2007, 65.1 percent relative to 2006 and 71.4 percent relative to 2005. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan-Dec 2012 relative to the same period in 2004 fell 69.5 percent and 66.2 percent relative to the same period in 2003. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Nov 2012 fell 45.0 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table II-3 reveals catastrophic data: sales of new houses in Jan-Dec 2012 of 367 thousand units are lower by 34.5 percent relative to 560 thousand units houses sold in Jan-Dec 1963, the first year when data become available, while population increased 72.2 percent.
Table II-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %
| Not Seasonally Adjusted Thousands | |
| Jan-Dec 2012 | 367 |
| Jan-Dec 2011 | 306 |
| ∆% | 19.9* |
| Jan-Dec 2010 | 323 |
| ∆% Jan-Dec 2012/ | 13.6 |
| Jan-Dec 2009 | 375 |
| ∆% Jan-Dec 2012/ | -2.1 |
| Jan-Dec 2008 | 485 |
| ∆% Jan-Dec 2012/ | -24.3 |
| Jan-Dec 2007 | 776 |
| ∆% Jan-Dec 2012/ | -52.7 |
| Jan-Dec 2006 | 1,051 |
| ∆% Jan-Dec 2012/Jan-Dec 2006 | -65.1 |
| Jan-Dec 2005 | 1,283 |
| ∆% Jan-Dec 2012/Jan-Dec 2005 | -71.4 |
| Jan-Dec 2004 | 1,203 |
| ∆% Jan-Dec 2012/Jan-Dec 2004 | -69.5 |
| Jan-Dec 2003 | 1,086 |
| ∆% Jan-Dec 2012/ | -66.2 |
| Jan-Dec 2002 | 973 |
| ∆% Jan-Dec 2012/ | -62.3 |
| Jan-Dec 2001 | 908 |
| ∆% Jan-Dec 2012/ | -59.6 |
| Jan-Dec 2000 | 877 |
| ∆% Jan-Dec 2012/ | -58.2 |
| Jan-Dec 1995 | 667 |
| ∆% Jan-Dec 2012/ | -45.0 |
| Jan-Dec 1963 | 560 |
| ∆% Jan-Dec 2012/ | -34.5 |
*Computed using unrounded data
Source: US Census Bureau http://www.census.gov/construction/nrs/
Table II-4 provides the entire available annual series of new house sales from 1963 to 2012. The revised level of 306 thousand new houses sold in 2011 is the lowest since 560,000 in 1963 in the 48 years of available data while the level of 367 thousand in 2012 is only higher than 323 thousand in 2010. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. In fact, there is no year from 1963 to 2012 in Table II-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009, 2010, 2011 and 2012
Table II-4, US, New Houses Sold, NSA Thousands
| 1963 | 560 |
| 1964 | 565 |
| 1965 | 575 |
| 1966 | 461 |
| 1967 | 487 |
| 1968 | 490 |
| 1969 | 448 |
| 1970 | 485 |
| 1971 | 656 |
| 1972 | 718 |
| 1973 | 634 |
| 1974 | 519 |
| 1975 | 549 |
| 1976 | 646 |
| 1977 | 819 |
| 1978 | 817 |
| 1979 | 709 |
| 1980 | 545 |
| 1981 | 436 |
| 1982 | 412 |
| 1983 | 623 |
| 1984 | 639 |
| 1985 | 688 |
| 1986 | 750 |
| 1987 | 671 |
| 1988 | 676 |
| 1989 | 650 |
| 1990 | 534 |
| 1991 | 509 |
| 1992 | 610 |
| 1993 | 666 |
| 1994 | 670 |
| 1995 | 667 |
| 1996 | 757 |
| 1997 | 804 |
| 1998 | 886 |
| 1999 | 880 |
| 2000 | 877 |
| 2001 | 908 |
| 2002 | 973 |
| 2003 | 1,086 |
| 2004 | 1,203 |
| 2005 | 1,283 |
| 2006 | 1,051 |
| 2007 | 776 |
| 2008 | 485 |
| 2009 | 375 |
| 2010 | 323 |
| 2011 | 306 |
| 2012 | 367 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart II-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau.
Chart II-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally-Adjusted Annual Rate)
Source: US Census Bureau
http://www.census.gov/briefrm/esbr/www/esbr051.html
Chart II-2 of the US Bureau of the Census provides the entire monthly sample of new houses sold in the US between Jan 1963 and Dec 2012 without seasonal adjustment. The series is almost stationary until the 1990s. There is sharp upward trend from the early 1990s to 2005-2006 after which new single-family houses sold collapse to levels below those in the beginning of the series in the 1960s.
Chart II-2, US, New Single-family Houses Sold, NSA, 1963-2012
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Percentage changes and average rates of growth of new house sales for selected periods are shown in Table II-5. The percentage change of new house sales from 1963 to 2012 is minus 34.5 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2011 fell 45.0 percent relative to the same period in 1995.
Table II-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses
| ∆% | Average Yearly % Rate | |
| 1963-2012 | -34.5 | NA |
| 1991-2001 | 78.4 | 5.9 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2012 | -45.0 | NA |
| 2000-2012 | -58.2 | NA |
| 2005-2012 | -71.4 | NA |
NA: Not Applicable
Source: US Census Bureau http://www.census.gov/construction/nrs/
The available historical annual data of median and average prices of new houses sold in the US between 1963 and 2012 is provided in Table II-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially.
Table II-6, US, Median and Average Prices of New Houses Sold, Annual Data
| Year | Median | Average |
| 1963 | $18,000 | $19,300 |
| 1964 | $18,900 | $20,500 |
| 1965 | $20,000 | $21,500 |
| 1966 | $21,400 | $23,300 |
| 1967 | $22,700 | $24,600 |
| 1968 | $24,700 | $26,600 |
| 1969 | $25,600 | $27,900 |
| 1970 | $23,400 | $26,600 |
| 1971 | $25,200 | $28,300 |
| 1972 | $27,600 | $30,500 |
| 1973 | $32,500 | $35,500 |
| 1974 | $35,900 | $38,900 |
| 1975 | $39,300 | $42,600 |
| 1976 | $44,200 | $48,000 |
| 1977 | $48,800 | $54,200 |
| 1978 | $55,700 | $62,500 |
| 1979 | $62,900 | $71,800 |
| 1980 | $64,600 | $76,400 |
| 1981 | $68,900 | $83,000 |
| 1982 | $69,300 | $83,900 |
| 1983 | $75,300 | $89,800 |
| 1984 | $79,900 | $97,600 |
| 1985 | $84,300 | $100,800 |
| 1986 | $92,000 | $111,900 |
| 1987 | $104,500 | $127,200 |
| 1988 | $112,500 | $138,300 |
| 1989 | $120,000 | $148,800 |
| 1990 | $122,900 | $149,800 |
| 1991 | $120,000 | $147,200 |
| 1992 | $121,500 | $144,100 |
| 1993 | $126,500 | $147,700 |
| 1994 | $130,000 | $154,500 |
| 1995 | $133,900 | $158,700 |
| 1996 | $140,000 | $166,400 |
| 1997 | $146,000 | $176,200 |
| 1998 | $152,500 | $181,900 |
| 1999 | $161,000 | $195,600 |
| 2000 | $169,000 | $207,000 |
| 2001 | $175,200 | $213,200 |
| 2002 | $187,600 | $228,700 |
| 2003 | $195,000 | $246,300 |
| 2004 | $221,000 | $274,500 |
| 2005 | $240,900 | $297,000 |
| 2006 | $246,500 | $305,900 |
| 2007 | $247,900 | $313,600 |
| 2008 | $232,100 | $292,600 |
| 2009 | $216,700 | $270,900 |
| 2010 | $221,800 | $272,900 |
| 2011 | $227,200 | $267,900 |
| 2012 | $243,600 | $288,400 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Percentage changes of median and average prices of new houses sold in selected years are shown in Table II-7. Prices rose sharply between 2000 and 2005. In fact, prices in 2012 are higher than in 2000. Between 2006 and 2012, median prices of new houses sold fell 1.2 percent and average prices fell 5.7 percent. Between 2011 and 2012, median prices increased 7.2 percent and average prices increased7.7 percent.
Table II-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%
| Median New | Average New Home Sales Prices ∆% | |
| ∆% 2000 to 2003 | 15.4 | 18.9 |
| ∆% 2000 to 2005 | 42.5 | 43.5 |
| ∆% 2000 to 2012 | 34.4 | 29.4 |
| ∆% 2005 to 2012 | -5.7 | -9.8 |
| ∆% 2000 to 2006 | 45.9 | 47.8 |
| ∆% 2006 to 2012 | -1.2 | -5.7 |
| ∆% 2009 to 2012 | 12.4 | 6.5 |
| ∆% 2010 to 2012 | 9.8 | 5.7 |
| ∆% 2011 to 2012 | 7.2 | 7.7 |
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart II-3 of the US Census Bureau provides the entire series of new single-family sales median prices from Jan 1963 to Dec 2012. There is long-term sharp upward trend with few declines until the current collapse. Median prices increased sharply during the Great Inflation of the 1960s and 1970s and paused during the savings and loans crisis of the late 1980s and the recession of 1991. Housing subsidies throughout the 1990s caused sharp upward trend of median new house prices that accelerated after the fed funds rate of 1 percent from 2003 to 2004. There was sharp reduction of prices after 2006 with recovery recently toward earlier prices.
Chart II-3, US, Median Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1963-2012
Source: US Census Bureau http://www.census.gov/construction/nrs/
Chart II-4 of the US Census Bureau provides average prices of new houses sold from the mid 1970s to Dec 2012. There is similar behavior as with median prices of new houses sold in Chart II-3. The only stress occurred in price pauses during the savings and loans crisis of the late 1980s and the collapse after 2006 with recent recovery.
Chart II-4, US, Average Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1975-2012
Source: US Census Bureau
Source: US Census Bureau http://www.census.gov/construction/nrs/
IIB United States House Prices. The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae and Freddie Mac-acquired mortgages” (http://fhfa.gov/webfiles/24216/q22012hpi.pdf 1). Table IIB-1 provides the FHFA HPI for purchases only, which shows behavior similar to that of the Case-Shiller index but with lower magnitudes. House prices catapulted from 2000 to 2003, 2005 and 2006. From IIIQ2000 to IIIQ2006, the index for the US as a whole rose 57.4 percent, with 68.6 percent for New England, 75.7 percent for Middle Atlantic, 71.9 percent for South Atlantic but only by 32.5 percent for East South Central. Prices fell relative to 2012 for all years from 2005 to 2007. Prices for the US increased 0.5 in IIIQ2012 relative to IIIQ2010 and 4.1 percent from IIIQ2011 to IIIQ2012. From IIIQ2000 to IIIQ2011, prices rose for the US and the four regions in Table IIB-1.
Table IIB-1, US, FHFA House Price Index Purchases Only NSA ∆%
| United States | New England | Middle Atlantic | South Atlantic | East South Central | |
| 3Q2000 | 23.5 | 40.4 | 35.4 | 25.1 | 10.7 |
| 3Q2000 | 50.2 | 69.7 | 68.8 | 60.7 | 23.7 |
| 3Q2000 to | 57.4 | 68.6 | 75.7 | 71.9 | 32.5 |
| 3Q2005 t0 | -11.1 | -13.5 | -4.9 | -16.0 | 2.9 |
| 3Q2006 | -15.1 | -13.0 | -8.7 | -21.5 | -3.9 |
| 3Q2007 to | -15.0 | -11.5 | -9.5 | -21.4 | -6.9 |
| 3Q2010 to | 0.5 | -2.3 | -2.5 | 0.8 | 0.0 |
| 3Q2011 to | 4.1 | 0.0 | -0.3 | 4.7 | 2.6 |
| 3Q2000 to | 33.6 | 46.7 | 60.5 | 34.9 | 27.3 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
Data of the FHFA HPI for the remaining US regions are provided in Table IIB-2. Behavior is not very different than in Table IIB-1 with the exception of East North Central. House prices in the Pacific region doubled between 2000 and 2006. Although prices of houses declined sharply from 2005 to 2012, there was still appreciation relative to 2000.
Table IIB-2, US, FHFA House Price Index Purchases Only NSA ∆%
| West South Central | West North Central | East North Central | Mountain | Pacific | |
| 3Q2000 | 11.6 | 18.3 | 14.5 | 18.4 | 42.5 |
| 3Q2000 | 22.9 | 31.3 | 24.4 | 55.4 | 109.3 |
| 3Q2000 to 3Q2006 | 31.5 | 35.8 | 26.0 | 69.3 | 117.9 |
| 3Q2005 to | 15.0 | -2.3 | -12.8 | -15.6 | -32.2 |
| 3Q2006 | 7.5 | -5.5 | -13.9 | -22.6 | -34.8 |
| 3Q2007 to | 2.6 | -6.4 | -12.2 | -23.5 | -31.0 |
| 3Q2010 to | 3.5 | 1.0 | 0.0 | 3.9 | -0.8 |
| 3Q2011 to | 5.1 | 3.5 | 2.8 | 10.6 | 6.4 |
| 3Q2000 to 3Q2012 | 41.3 | 28.3 | 8.4 | 31.1 | 42.0 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
Chart IIB-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IIIQ2001 to IIIQ2012. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IIQ2008 but there was another decline after IIIQ2010. The rate of decline improved in the second half of 2011 and into 2012 with movement into positive territory in IIQ2012 and IIIQ2012.
Chart IIB-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change
Source: Federal Housing Finance Agency
http://fhfa.gov/Default.aspx?Page=14
Monthly and 12-month percentage changes of the FHFA House Price Index are provided in Table IIB-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul 2011 while 12 months percentage changes improved steadily from more or equal to minus 6 percent in Mar to May 2011 to minus 4.4 percent in Jun 2011. The FHFA house price index fell 0.8 percent in Oct 2011 and fell 3.2 percent in the 12 months ending in Oct. There was significant recovery in Nov 2012 with increase in the house price index of 0.4 percent and reduction of the 12-month rate of decline to 2.2 percent. The house price index rose 0.5 percent in Dec 2011 and the 12-month percentage change fell to minus 1.3 percent. There was further improvement with revised decline of 0.3 percent in Jan 2012 and decline of the 12-month percentage change to minus 1.0 percent. The index changed to positive change of 0.2 percent in Feb 2012 and increase of 0.3 percent in the 12 months ending in Feb 2012. There was strong improvement in Mar 2012 with gain in prices of 1.5 percent and 2.4 percent in 12 months. The house price index of FHFA increased 0.7 percent in Apr 2012 and 3.0 percent in 12 months and improvement continued with increase of 0.7 percent in May 2012 and 3.8 percent in the 12 months ending in May 2012. Improvement consolidated with increase of 0.6 percent in Jun 2012 and 3.9 percent in 12 months. In Jul 2012, the house price index increased 0.1 percent and 3.8 percent in 12 months. Strong increase of 0.4 percent in Aug 2012 pulled the 12-month change to 4.5 percent. There was another increase of 0.6 percent in Oct and 5.6 percent in 12 months followed by increase of 0.6 percent in Nov 2012 and 5.7 percent in 12 months.
Table IIB-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%
| Month ∆% SA | 12 Month ∆% NSA | |
| Nov 2012 | 0.6 | 5.7 |
| Oct | 0.6 | 5.6 |
| Sep | 0.0 | 4.2 |
| Aug | 0.4 | 4.5 |
| Jul | 0.1 | 3.8 |
| Jun | 0.6 | 3.9 |
| May | 0.7 | 3.8 |
| Apr | 0.7 | 3.0 |
| Mar | 1.5 | 2.4 |
| Feb | 0.2 | 0.3 |
| Jan | -0.3 | -1.0 |
| Dec 2011 | 0.5 | -1.3 |
| Nov | 0.4 | -2.2 |
| Oct | -0.8 | -3.2 |
| Sep | 0.3 | -2.5 |
| Aug | -0.2 | -3.8 |
| Jul | 0.2 | -3.6 |
| Jun | 0.5 | -4.4 |
| May | 0.0 | -6.0 |
| Apr | 0.1 | -5.9 |
| Mar | -0.6 | -6.0 |
| Feb | -1.1 | -5.2 |
| Jan | -0.7 | -4.7 |
| Dec 2010 | -4.0 | |
| Dec 2009 | -1.9 | |
| Dec 2008 | -9.8 | |
| Dec 2007 | -3.1 | |
| Dec 2006 | 2.5 | |
| Dec 2005 | 9.8 | |
| Dec 2004 | 10.2 | |
| Dec 2003 | 8.0 | |
| Dec 2002 | 7.8 | |
| Dec 2001 | 6.7 | |
| Dec 2000 | 7.2 | |
| Dec 1999 | 6.2 | |
| Dec 1998 | 5.9 | |
| Dec 1997 | 3.4 | |
| Dec 1996 | 2.8 | |
| Dec 1995 | 2.9 | |
| Dec 1994 | 2.6 | |
| Dec 1993 | 3.1 | |
| Dec 1992 | 2.4 |
Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
The bottom part of Table IIB-3 provides 12-month percentage changes of the FHFA house price index since 1992 when data become available for 1991. Table IIB-4 provides percentage changes and average rates of percent change per year for various periods. Between 1992 and 2011, the FHFA house price index increased 74.8 percent at the yearly average rate of 3.0 percent. In the period 1992-2000, the FHFA house price index increased 39.4 percent at the average yearly rate of 4.2 percent. The rate of price increase accelerated to 7.5 percent in the period 2000-2003 and to 8.5 percent in 2000-2005 and 7.5 percent in 2000-2006. At the margin the average rate jumped to 10.0 percent in 2003-2005 and 7.5 percent in 2003-2006. House prices measured by the FHFA house price index declined 18.7 percent between 2006 and 2011 and 16.6 percent between 2005 and 2011.
Table IIB-4, US, FHFA House Price Index, Percentage Change and Average Rate of Percentage Change per Year, Selected Dates 1992-2011
| Dec | ∆% | Average ∆% per Year |
| 1992-2011 | 74.8 | 3.0 |
| 1992-2000 | 39.4 | 4.2 |
| 2000-2003 | 24.3 | 7.5 |
| 2000-2005 | 50.4 | 8.5 |
| 2003-2005 | 21.0 | 10.0 |
| 2005-2011 | -16.6 | NA |
| 2000-2006 | 54.3 | 7.5 |
| 2003-2006 | 24.1 | 7.5 |
| 2006-2011 | -18.7 | NA |
Source: Source: Federal Housing Finance Agency http://fhfa.gov/Default.aspx?Page=14
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 18 and daily values throughout the week ending on Jan 25 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 18 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jan 18, 2012”, first row “USD/EUR 1.3321 0.2%,” provides the information that the US dollar (USD) appreciated 0.2 percent to USD 1.3321/EUR in the week ending on Fri Jan 18 relative to the exchange rate on Fri Jan 11. 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 1.3321/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 18, depreciating to USD 1.3377/EUR on Thu Jan 24, 2013, or by 0.4 percent. The dollar depreciated because more dollars, $1.3377, were required on Thu Jan 24 to buy one euro than $1.3321 on Jan 18. 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 1.3321/EUR on Jan 18; 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 18, to the last business day of the current week, in this case Fri Jan 25, such as depreciation by 1.0 percent to USD 1.3459/EUR by Jan 25; 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 1.0 percent from the rate of USD 1.3321/EUR on Fri Jan 18 to the rate of USD 1.3459/EUR on Fri Jan 25 {[(1.3459/1.3321) – 1]100 = 1.0%} and depreciated (denoted by negative sign) by 0.6 percent from the rate of USD 1.3377 on Thu Jan 24 to USD 1.3459/EUR on Fri Jan 25 {[(1.3459/1.3377) -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 21-Jan 25, 2013
| Fri Jan 18, 2012 | M 21 | Tue 22 | W 23 | Thu 24 | Fr 25 |
| USD/EUR 1.3321 0.2% | 1.3313 0.1% 0.1% | 1.3322 0.0% -0.1% | 1.3318 0.0% 0.0% | 1.3377 -0.4% -0.4% | 1.3459 -1.0% -0.6% |
| JPY/ USD 90.09 -1.0% | 89.62 0.5% 0.5% | 88.71 1.5% 1.0% | 88.62 1.6% 0.1% | 90.33 -0.3% -1.9% | 90.87 -0.9% -0.6% |
| CHF/ USD 0.9343 -2.3% | 0.9325 0.2% 0.2% | 0.9294 0.5% 0.3% | 0.9294 0.5% 0.0% | 0.9288 0.6% 0.1% | 0.9266 0.8% 0.2% |
| CHF/ EUR 1.2443 -2.1% | 1.2419 0.2% 0.2% | 1.2377 0.5% 0.3% | 1.2378 0.5% 0.0% | 1.2439 0.0% -0.5% | 1.2470 -0.2% -0.2% |
| USD/ AUD 1.0509 0.9516 -0.3% | 1.0517 0.9508 0.1% 0.1% | 1.0567 0.9463 0.6% 0.5% | 1.0555 0.9474 0.4% -0.1% | 1.0451 0.9568 -0.5% -1.0% | 1.0425 0.9592 -0.8% -0.3% |
| 10 Year T Note 1.84 | 1.84 | 1.84 | 1.832 | 1.852 | 1.947 |
| 2 Year T Note 0.252 | 0.25 | 0.244 | 0.236 | 0.241 | 0.278 |
| German Bond 2Y 0.18 10Y 1.56 | 2Y 0.20 10Y 1.59 | 2Y 0.17 10Y 1.57 | 2Y 0.16 10Y 1.54 | 2Y 0.18 10Y 1.57 | 2Y 0.26 10Y 1.64 |
| DJIA 13649.70 1.2% | 13649.70 0.0% 0.0% | 13712.21 0.5% 0.5% | 13779.33 0.9% 0.5% | 13825.33 1.3% 0.3% | 13895.98 1.8% 0.5% |
| DJ Global 2087.80 0.6% | 2092.08 0.2% 0.2% | 2095.55 0.4% 0.2% | 2092.19 0.2% -0.2% | 2101.08 0.6% 0.4% | 2115.30 1.3% 0.7% |
| DJ Asia Pacific 1350.52 0.6% | 1348.02 -0.2% -0.2% | 1353.86 0.2% 0.4% | 1344.95 -0.4% -0.7% | 1339.65 -0.8% -0.4% | 1341.29 -0.7% 0.1% |
| Nikkei 10913.30 1.0% | 10747.74 -1.5% -1.5% | 10709.93 -1.9% -0.4% | 10486.99 -3.9% -2.1% | 10620.87 -2.7% 1.3% | 10926.65 0.1% 2.9% |
| Shanghai 2317.07 3.3% | 2328.22 0.5% 0.5% | 2315.14 -0.1% -0.6% | 2320.91 0.2% 0.3% | 2302.60 -0.6% -0.8% | 2291.30 -1.1% -0.5% |
| DAX 7702.23 -0.2% | 7748.86 0.6% 0.6% | 7696.21 -0.1% -0.7% | 7707.54 0.1% 0.2% | 7748.13 0.6% 0.5% | 7857.97 2.0% 1.4% |
| DJ UBS Comm. 141.48 2.1% | 141.48 0.0% 0.0% | 141.89 0.3% 0.3% | 141.60 0.1% -0.2% | 141.060 -0.3% -0.4% | 140.65 -0.6% -0.3% |
| WTI $ B 95.33 1.9% | 95.34 0.0% 0.0% | 96.24 0.9% 0.9% | 95.56 0.2% -0.7% | 95.93 0.6% 0.4% | 95.88 0.6% -0.1% |
| Brent $/B 111.79 1.0% | 111.71 -0.1% -0.1% | 112.39 0.5% 0.5% | 110.61 -1.1% -1.6% | 113.21 1.3% 2.4% | 113.28 1.3% 0.1% |
| Gold $/OZ 1684.00 1.4% | 1689.80 0.3% 0.3% | 1691.80 0.5% 0.1% | 1684.50 0.0% -0.4% | 1667.90 -1.0% -1.0% | 1656.60 -1.7% -0.7% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
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. A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on “S&P 500 closes above 1500,” on Jan 25, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323539804578263331715973390.html?mod=WSJ_hp_LEFTWhatsNewsCollection), finds that the DJIA closed on Fri Jun 25, 2013 at 13,895.98, or 1.9 percent below its record high of 14,164.53 in Oct 2007 while S&P 500 closed at 1502.96. DJIA closed at 13,984.80 on Oct 15, 2007, or only 0.6 percent higher than 13,895.98 at the close of markets on Jan 25, 2013, reaching a high of 14,157.38 on Oct 15, 2007, which is only 1.9 percent higher than 13,895.98 at the close on Jan 25, 2013 (using interactive chart data at http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The S&P 500 closed at 1502.96 on Jan 25, 2013, which is only 3.0 percent from the close at 1458.71 on Oct 15, 2007, and 4.1 percent from the high at 1564.74 on Oct 15, 2007 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Rita Nazareth and Sarah Pringle, writing on “Dow Average rises to 5-year high amid debt-ceiling talks,” on Jan 18, 2012, published in Bloomberg (http://www.bloomberg.com/news/2013-01-18/u-s-stock-futures-little-changed-before-earnings-data.html), find that the DJIA reached on Jan 18, 2012, the highest level in five years at 13,649.70 with volume of 6.6 billion shares in US exchanges, which is higher by 6.9 percent than the average in three months. Vito J. Bacanelli, writing on “GOP proposal lifts Dow to five-year high,” on Jan 19, 2013, published by Barron’s (http://online.barrons.com/article/SB50001424052748703596604578235762819811322.html?mod=BOL_hpp_mag#articleTabs_article%3D1), finds that the closing level of 13,649.70 on Jan 18, 2013, is the highest close since Dec 10, 2007, only 4 percent lower than the all-time high and the best start for a year since 1997. The Wall Street Journal finds a 52-week high of 13661.87 on Oct 5, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The S&P 500 at 1485.98 is 5 percent below its all time high of 1565 in 2007. 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, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 5.235 percent on Dec 28, 2012 and that of the ten-year sovereign bond of Italy at 4.447 percent with further declines to 4.926 percent for the ten-year sovereign bond of Spain and 4.086 percent for the ten-year sovereign bond of Italy on Jan 25, 2013 (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. In the week of Jan 25, 2013, the yield of the two-year Treasury increased to 0.278 percent and that of the ten-year Treasury to 1.947 percent while the two-year bond of Germany rose to 0.26 percent and the ten-year to 1.64 while the dollar depreciated to USD 1.3459/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 1.7 percent in the 12 months ending in Dec 2012 (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.
Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 1/18/25 | 0.278 | 1.947 | 0.26 | 1.64 | 1.3459 |
| 1/18/13 | 0.252 | 1.84 | 0.18 | 1.56 | 1.3321 |
| 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 yield 1.64 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 24, 2013, with the one-month yield at 0.06 percent, the two-year at 0.23 percent and the ten-year at 1.88 percent.
Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields Jul 31, 2001-Jan 24, 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_image021[4]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgrC_7UZKl9JEIVG_SfTEAwUsfIfWBlA-2Azq_at9J1PbI3Bg5Do3BAb14Zlmk_bY1-TAXpS_dV-JehUXhLiPJuD20dL-5g1LSuQ573dBZ8xS1IjkvJm8ajd5zG34o9FLu0zbgjWX0i-vM/s1600-h/clip_image021%25255B4%25255D%25255B2%25255D.gif "clip_image021[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_image021[5]](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_ELKxUD-EDoWVln5N0ad0wp-QJsz9-v3bCKbn3uxmHTfar6S9jnkR1Ci_4_faAEt0T-ANm0viDtmJShkLPEDiS9fSlgcgioTTF2PQKEduLVs-YSvOWOhlOMOF3CqKnk-hUJmfz3MsIVI/s1600-h/clip_image021%25255B5%25255D%25255B2%25255D.gif "clip_image021[5]"){kind=small}
declines.
There was strong performance in equity indexes in Table III-1 in the week ending on Jan 25, 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 0.5 percent on Jan 25, increasing 1.8 percent in the week. Germany’s Dax increased 1.4 percent on Fri Jan 25 and increased 2.0 percent in the week. Dow Global increased 0.7 percent on Jan 25 and increased 1.3 percent in the week. Japan’s Nikkei Average increased 2.9 percent on Fri Jan 25 and increased 0.1 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 0.1 percent on Jan 25 and decreased 0.7 percent in the week while Shanghai Composite decreased 0.5 percent on Jan 25 and decreased 1.1 percent in the week supported by stronger GDP and economic data, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2291.30 on Fri Jan 25. 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 25, 2013. The DJ UBS Commodities Index decreased 0.3 percent on Fri Jan 25 and decreased 0.6 percent in the week, as shown in Table III-1. WTI increased 0.6 percent in the week of Jan 25 while Brent increased 1.3 percent in the week even with conflicts in the Middle East. Gold decreased 0.7 percent on Fri Jan 25 and decreased 1.7 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 €1,163,204 million on Jan 18, 2013. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,745,842 million in the statement of Jan 18, 2013. There is high credit risk in these transactions with capital of only €85,608 million as analyzed by Cochrane (2012Aug31).
Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Jan 18, 2013 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 438,687 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 256,361 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 31,538 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 22,357 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,163,204 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 138,027 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 582,638 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 29,961 |
| 9 Other Assets | 278,719 | 336,574 | 279,438 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,942,211 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,745,842 |
| Capital and Reserves | 78,143 | 85,748 | 85,608 |
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/fs130122.en.html
IIIE Appendix Euro Zone survival risk. Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU), or euro area, are only 42.6 percent of the total. Exports to the non-European Union area with share of 44.0 percent in Italy’s total exports are growing at 9.6 percent in Jan-Nov 2012 relative to Jan-Nov 2011 while those to EMU are falling at 1.0 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Nov 2012 | Exports | ∆% Jan-Nov 2012/ Jan-Nov 2011 | Imports | Imports |
| EU | 56.0 | -0.1 | 53.7 | -7.3 |
| EMU 17 | 42.6 | -1.0 | 43.4 | -7.2 |
| France | 11.6 | 0.1 | 8.4 | -6.4 |
| Germany | 13.1 | -0.3 | 15.5 | -11.1 |
| Spain | 5.3 | -8.0 | 4.5 | -8.0 |
| UK | 4.7 | 9.6 | 2.7 | -13.4 |
| Non EU | 44.0 | 10.0 | 46.3 | -3.7 |
| Europe non EU | 13.3 | 9.6 | 10.8 | -1.4 |
| USA | 6.1 | 18.5 | 3.2 | -1.2 |
| China | 2.7 | -10.0 | 7.4 | -16.7 |
| OPEC | 4.7 | 25.6 | 8.5 | 21.2 |
| Total | 100.0 | 4.3 | 100.0 | -5.6 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/79713
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €559 million with the 17 countries of the euro zone (EMU 17) in Nov 2012 and deficit of €2194 million in Jan-Nov 2012. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €10,857 million in Jan-Nov 2012 with Europe non European Union and of €12,716 million with the US and in reducing the deficit with non European Union of €1251 million in Jan-Nov 2012. There is significant rigidity in the trade deficits in Jan-Nov of €15,005 million with China and €18,209 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 Nov 2012 Millions of Euro | Trade Balance Cumulative Jan-Nov 2012 Millions of Euro |
| EU | 508 | 10,111 |
| EMU 17 | -559 | -2,194 |
| France | 1,074 | 11,262 |
| Germany | -632 | -5,472 |
| Spain | 193 | 1,514 |
| UK | 842 | 8,841 |
| Non EU | 1,855 | -1,251 |
| Europe non EU | 1,320 | 10,857 |
| USA | 1,325 | 12,716 |
| China | -838 | -15,005 |
| OPEC | -1,355 | -18,209 |
| Total | 2,363 | 8,860 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/79713
Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Nov 2012 relative to Jan-Nov 2011. Growth rates in 12 months of imports are negative with the exception of 7.9 percent for energy. The higher rate of growth of exports of 4.3 percent in Jan-Nov 2012/Jan-Nov 2011 relative to imports of minus 5.6 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 | 5.4 | 25.0 | -3.0 |
| Durable | 5.9 | 3.2 | 3.0 | -6.7 |
| Non | 23.0 | 6.0 | 22.0 | -2.5 |
| Capital Goods | 32.3 | 2.3 | 21.1 | -12.9 |
| Inter- | 34.2 | 2.9 | 34.3 | -10.7 |
| Energy | 4.7 | 21.7 | 19.6 | 7.9 |
| Total ex Energy | 95.3 | 3.5 | 80.4 | -8.9 |
| Total | 100.0 | 4.3 | 100.0 | -5.6 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/79713
Table III-6 provides Italy’s trade balance by product categories in Nov 2012 and cumulative Jan-Nov 2012. Italy’s trade balance excluding energy generated surplus of €7027 million in Nov 2012 and €67,201 million in Jan-Nov 2012 but the energy trade balance created deficit of €4664 million in Nov 2012 and €58,341 million in Jan-Nov 2012. The overall surplus in Nov 2012 was €2363 million with surplus of €8860 million in Jan-Nov 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
| Nov 2012 | Cumulative Jan-Nov 2012 | |
| Consumer Goods | 2,105 | 15,515 |
| Durable | 1,227 | 10,598 |
| Nondurable | 877 | 4,917 |
| Capital Goods | 4,270 | 44,859 |
| Intermediate Goods | 652 | 6,827 |
| Energy | -4,664 | -58,341 |
| Total ex Energy | 7,027 | 67,201 |
| Total | 2,363 | 8,860 |
Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/79713
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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