CMP Associates Regulation Blog: United States Unsustainable Fiscal Deficit/Government Debt Threatening Prosperity, United States International Trade, Peaking Valuations of Risk Financial Assets and Uncertain World Economic Growth and International Finance: Part I

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United States Unsustainable Fiscal Deficit/Government Debt Threatening Prosperity, United States International Trade, Peaking Valuations of Risk Financial Assets and Uncertain World Economic Growth and International Finance: Part I

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United States Unsustainable Fiscal Deficit/Government Debt Threatening Prosperity, United States International Trade, Peaking Valuations of Risk Financial Assets and Uncertain World Economic Growth and International Finance

Carlos M. Pelaez

Executive Summary

I United States Unsustainable Fiscal Deficit/Debt Threatening Prosperity

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

II United States Unsustainable Fiscal Deficit/Debt

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

Executive Summary

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

ESI-1 of the CBO (2012NovMBR, 2013BEOFeb5, 2013HBDFFeb5, 2013MEFFeb5) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012. The deficit of $1.1 trillion in fiscal-year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR, 2013HBDFeb5).

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

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

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO (2013HBDFeb5).

Table ESI-2 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into three parts: federal fiscal data for the years from 2009 to 2012; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2012. Total revenues of the US from 2009 to 2012 accumulate to $9019 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,111 billion, or $14.1 trillion, with the deficit accumulating to $5092 billion, or $5.1 trillion. Revenues decreased 6.6 percent from $9653 billion in the four years from 2005 to 2008 to $9019 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.1 percent on average in the cyclical expansion from IIIQ2009 to IVQ2012, which is much lower than 6.2 percent on average in cyclical expansions since the 1950s (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). Weakness of growth and employment creation is analyzed in the following Subsection IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 31.4 million people without jobs or underemployed that is equivalent to 19.4 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,111 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.6 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5092 billion in 2009-2012. Federal revenue was 15.4 percent of GDP on average in the years from 2009 to 2012, which is well below 18.0 percent of GDP on average from 1970 to 2010. Federal outlays were 24.1 percent of GDP on average from 2009 to 2012, which is well above 21.9 percent of GDP on average from 1970 to 2010. The lower part of Table ESI-2 shows that debt held by the public swelled from $5803 billion in 2008 to $11,280 billion in 2012, by $5477 billion or 94.4 percent. Debt held by the public as percent of GDP or economic activity jumped from 40.5 percent in 2008 to 72.5 percent in 2012, which is well above the average of 37.0 percent from 1970 to 2010. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table ESI-2, US, Treasury Budget and Debt Held by the Public, Billions of Dollars and Percent of GDP

	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
2012	2,449	3,538	-1,089
Fiscal Year 2011	2,302	3,599	-1,297
Fiscal Year 2010	2,163	3,456	-1,293
Fiscal Year 2009	2,105	3,518	-1,413
Total 2009-2012	9,019	14,111	-5,092
Average % GDP 2009-2012	15.4	24.1	-8.7
Fiscal Year 2008	2,524	2,983	-459
Fiscal Year 2007	2,568	2,729	-161
Fiscal Year 2006	2,407	2,655	-248
Fiscal Year 2005	2,154	2,472	-318
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.9	20.1	-2.2
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	36.9
2006	4,829	36.6
2007	5,035	36.3
2008	5,803	40.5
2009	7,545	54.1
2010	9,019	62.8
2011	10,128	67.7
2012	11,280	72.5

Source: http://www.fms.treas.gov/mts/index.html CBO (2012NovMBR). CBO (2011AugBEO); Office of Management and Budget 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5.

Unusually low economic growth of average 2.1 percent of GDP in the current expansion compared with 6.2 percent in similar expansions in postwar economic cycles (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) has had adverse impact on revenue generation. The impact of low growth on employment creation and labor market hiring is discussed in Subsection IB Collapse of United States Dynamism of Income Growth and Employment. Table ESI-3 provides total United States federal receipts from 2010 to 2012. Individual income taxes of $1132 billion, or $1.1 trillion, increased 25.9 percent from 2010 to 2012 and account for 46.2 percent of US total receipts in 2012. Total receipts stood at 15.8 percent of GDP in 2012, which is lower than 18 percent in the past 40 years (CBO 2012NovBMR).

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

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

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO 2013HBDFeb5).

Total outlays of the federal government of the United States have grown to extremely high levels. Table ESI-4 of the CBO (2012NovMBR, 2013HBDFeb5) provides total outlays from 2010 to 2012. Total outlays of $3538 billion in 2012, or $3.5 trillion, are higher by $809 billion, or $0.8 trillion, relative to $2729 billion in 2007, or $2.7 trillion. Outlays have grown from 19.7 percent of GDP in 2007 to 22.8 percent of GDP in 2012. Outlays as percent of GDP were on average 21.9 percent from 1971 to 2010 and receipts as percent of GDP were on average 18.0 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Adjusted outlays in Table ESI-4 decreased 1.6 percent from 2011 to 2012 but mostly because of decline in defense-military expenditures by 2.9 percent, unemployment benefits by 24.0 percent and Medicaid by 8.9 percent. Much higher expenses of social security benefits increased 6.0 percent and Medicare increased 3.3 percent. There has been no meaningful constraint of spending.

Table ESI-4, United States, Total Outlays, Billions of Dollars and ∆%

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

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

Source: CBO (2012NovMBR, CBO2013HBDFeb5).

The US is facing a major fiscal challenge. Table ESI-5 provides federal revenues, expenditures, deficit and debt as percent of GDP and the yearly change in GDP in the eight decades from 1930 to 2011. The most recent period of debt exceeding 90 percent of GDP based on yearly observations in Table ESI-5 is between 1944 and 1948. The debt/GDP ratio actually rose to 106.2 percent of GDP in 1945 and to 108.7 percent of GDP in 1946. GDP fell 10.9 percent in 1946, which is only matched in Table ESI-5 by the decline of 13.1 percent in 1932. Part of the decline is explained by the bloated US economy during World War II, growing at 17.1 percent in 1941, 18.5 percent in 1942 and 16.4 percent in 1943. Expenditures as a share of GDP rose to their highest in the series: 43.6 percent in 1943, 43.6 percent in 1944 and 41.9 percent in 1945. The repetition of 43.6 percent in 1943 and 1944 is in the original source of Table ESI-5. During the Truman administration from Apr 1945 to Jan 1953, the federal debt held by the public fell systematically from the peak of 108.7 percent of GDP in 1946 to 61.6 percent of GDP in 1952. During the Eisenhower administration from Jan 1953 to Jan 1961, the federal debt held by the public fell from 58.6 percent of GDP in 1953 to 45.6 percent of GDP in 1960. The Truman and Eisenhower debt reductions were facilitated by diverse factors such as low interest rates, lower expenditure/GDP ratios that could be attained again after lowering war outlays and less rigid structure of mandatory expenditures than currently. There is no subsequent jump of debt as the one from 40.5 percent of GDP in 2008 to 67.8 percent of GDP in 2011 and at 72.5 percent in 2012.

Table ESI-5, United States Central Government Revenue, Expenditure, Deficit, Debt and GDP Growth 1930-2011

	Rev % GDP	Exp % GDP	Deficit % GDP	Debt % GDP	GDP ∆%
1930	4.2	3.4	0.8		-8.6
1931	3.7	4.3	-0.6		-6.5
1932	2.8	6.9	-4.0		-13.1
1933	3.5	8.0	-4.5		-1.3
1934	4.8	10.7	-5.9		10.9
1935	5.2	9.2	-4.0		8.9
1936	5.0	10.5	-5.5		13.1
1937	6.1	8.6	-2.5		5.1
1938	7.6	7.7	-0.1		-3.4
1939	7.1	10.3	-3.2		8.1
1940s
1940	6.8	9.8	-3.0	44.2	8.8
1941	7.6	12.0	-4.3	42.3	17.1
1942	10.1	24.3	-14.2	47.0	18.5
1943	13.3	43.6	-30.3	70.9	16.4
1944	20.9	43.6	-22.7	88.3	8.1
1945	20.4	41.9	-21.5	106.2	-1.1
1946	17.7	24.8	-7.2	108.7	-10.9
1947	16.5	14.8	1.7	96.2	-0.9
1948	16.2	11.6	4.6	84.3	4.4
1949	14.5	14.3	0.2	79.0	-0.5
1950s
1950	14.4	15.6	-1.1	80.2	8.7
1951	16.1	14.2	1.9	66.9	7.7
1952	19.0	19.4	-0.4	61.6	3.8
1953	18.7	20.4	-1.7	58.6	4.6
1954	18.5	18.8	-0.3	59.5	-0.6
1955	16.5	17.3	-0.8	57.2	7.2
1956	17.5	16.5	0.9	52.0	2.0
1957	17.7	17.0	0.8	48.6	2.0
1958	17.3	17.9	-0.6	49.2	-0.9
1959	16.2	18.8	-2.6	47.9	7.2
1960s
1960	17.8	17.8	0.1	45.6	2.5
1961	17.8	18.4	-0.6	45.0	2.3
1962	17.6	18.8	-1.3	43.7	6.1
1963	17.8	18.6	-0.8	42.4	4.4
1964	17.6	18.5	-0.9	40.0	5.8
1965	17.0	17.2	-0.2	37.9	6.4
1966	17.3	17.8	-0.5	34.9	6.5
1967	18.4	19.4	-1.1	32.9	2.5
1968	17.6	20.5	-2.9	33.9	4.8
1969	19.7	19.4	0.3	29.3	3.1
1970s
1970	19.0	19.3	-0.3	28.0	0.2
1971	17.3	19.5	-2.1	28.1	3.4
1972	17.6	19.6	-2.0	27.4	5.3
1973	17.6	18.7	-1.1	26.0	5.8
1974	18.3	18.7	-0.4	23.9	-0.6
1975	17.9	21.3	-3.4	25.3	0.2
1976	17.1	21.4	-4.2	27.5	5.4
1977	18.0	20.7	-2.7	27.8	4.6
1978	18.0	20.7	-2.7	27.4	5.6
1979	18.5	20.1	-1.6	25.6	3.1
1980s
1980	19.0	21.7	-2.7	26.1	-0.3
1981	19.6	22.2	-2.6	25.8	2.5
1982	19.2	23.1	-4.0	28.7	-1.9
1983	17.5	23.5	-6.0	33.1	4.5
1984	17.3	22.2	-4.8	34.0	7.2
1985	17.7	22.8	-5.1	36.4	4.1
1986	17.5	22.5	-5.0	39.5	3.5
1987	18.4	21.6	-3.2	40.6	3.2
1988	18.2	21.3	-3.1	41.0	4.1
1989	18.4	21.2	-2.8	40.6	3.6
1990s
1990	18.0	21.9	-3.9	42.1	1.9
1991	17.8	22.3	-4.5	45.3	-0.2
1992	17.5	22.1	-4.7	48.1	3.4
1993	17.5	21.4	-3.9	49.3	2.9
1994	18.0	21.0	-2.9	49.2	4.1
1995	18.4	20.6	-2.2	49.1	2.5
1996	18.8	20.2	-1.4	48.4	3.7
1997	19.2	19.5	-0.3	45.9	4.5
1998	19.9	19.1	0.8	43.0	4.4
1999	19.8	18.5	1.4	39.4	4.8
2000s
2000	20.6	18.2	2.4	34.7	4.1
2001	19.5	18.2	1.3	32.5	1.1
2002	17.6	19.1	-1.5	33.6	1.8
2003	16.2	19.7	-3.4	35.6	2.5
2004	16.1	19.6	-3.5	36.8	3.5
2005	17.3	19.9	-2.6	36.9	3.1
2006	18.2	20.1	-1.9	36.6	2.7
2007	18.5	19.7	-1.2	36.3	1.9
2008	17.6	20.8	-3.2	40.5	-0.3
2009	15.1	25.2	-10.1	54.1	-3.1
2010s
2010	15.1	24.1	-9.0	62.9	2.4
2011	15.4	24.1	-8.7	67.8	1.8
2012	15.8	22.8	-7.0	72.5	2.2

Sources:

Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB. CBO (2012JanBEO). CBO (2012Jan31). CBO (2012AugBEO). CBO (2013BEOFeb5). CBO2013HBDFeb5).

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

Table ESI-6 provides the latest exercise by the CBO (2013BEOFeb5, 2012AugBEO, CBO2012NovCDR) of projecting the fiscal accounts of the US. Table ESI-6 extends data back to 1995 with the projections of the CBO from 2013 to 2023. Budget analysis in the US uses a ten-year horizon. The significant event in the data before 2011 is the budget surpluses from 1998 to 2001, from 0.8 percent of GDP in 1998 to 2.4 percent of GDP in 2000. Debt held by the public fell from 49.1 percent of GDP in 1995 to 32.5 percent of GDP in 2001.

Table ESI-6, US, CBO Baseline Budget Outlook 2013-2023

	Out $B	Out % GDP	Deficit $B	Deficit % GDP	Debt	Debt % GDP
1995	1,516	20.6	-164	-2.2	3,604	49.1
1996	1,560	20.2	-107	-1.4	3,734	48.4
1997	1,601	19.5	-22	-0.3	3,772	45.9
1998	1,652	19.1	+69	+0.8	3,721	43.0
1999	1,702	18.5	+126	+1.4	3,632	39.4
2000	1,789	18.2	+236	+2.4	3,410	34.7
2001	1,863	18.2	+128	+1.3	3,320	32.5
2002	2,011	19.1	-158	-1.5	3,540	33.6
2003	2,159	19.7	-378	-3.4	3,913	35.6
2004	2,293	19.6	-413	-3.5	4,295	36.8
2005	2,472	19.9	-318	-2.6	4,592	36.9
2006	2,655	20.1	-248	-1.9	4,829	36.6
2007	2,729	19.7	-161	-1.2	5,035	36.3
2008	2,983	20.8	-459	-3.2	5,803	40.5
2009	3,518	25.2	-1,413	-10.1	7,545	54.1
2010	3,456	24.1	-1,294	-9.0	9,019	62.9
2011	3,598	24.1	-1,296	-8.7	10,128	67.8
2012	3,538	22.8	-1,089	-7.0	11,280	72.5
2013	3,553	22.2	-845	-5.3	12,229	76.3
2014	3,618	21.7	-616	-3.7	12,937	77.7
2015	3,803	21.6	-430	-2.4	13,462	76.3
2016	4,067	21.6	-476	-2.5	14,025	74.6
2017	4,300	21.5	-535	-2.7	14,642	73.4
2018	4,542	21.7	-605	-2.9	15,316	73.1
2019	4,811	22.0	-710	-3.2	16,092	73.5
2020	5,078	22.2	-798	-3.5	16,957	74.2
2021	5,350	22.4	-854	-3.6	17,876	75.0
2022	5,691	22.9	-957	-3.8	18,902	76.0
2023	5,939	22.9	-978	-2.8	19,944	77.0
2014 to 2018	20,330	21.6	-2,661	-3.3	NA	NA
2014 to 2023	47,199	22.1	-6,958	-1.1	NA	NA

Note: Out = outlays

Sources: CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5.

Table ESI-7 provides baseline CBO projections of federal revenues, outlays, deficit and debt as percent of GDP. The adjustment depends on increasing revenues from 15.4 percent of GDP in 2011 to 19.1 percent of GDP in 2023, which is above the 40-year average of 18 percent of GDP while outlays fall only from 24.1 percent of GDP in 2011 to 22.9 percent of GDP in 2023. The last row of Table ES1-7 provides the CBO estimates of averages for 1971 to 2010 of 18.0 percent for revenues/GDP, 21.9 percent for outlays/GDP and 37.0 percent for debt/GDP.

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

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.8
2012	15.8	22.8	-7.0	72.5
2013	16.9	22.2	-5.3	76.3
2014	18.0	21.7	-3.7	77.7
2015	19.1	21.6	-2.4	76.3
2016	19.1	21.6	-2.5	74.6
2017	18.9	21.5	-2.7	73.4
2018	18.8	21.7	-2.9	73.1
2019	18.7	22.0	-3.2	73.5
2020	18.7	22.2	-3.5	74.2
2021	18.9	22.4	-3.6	75.0
2022	19.0	22.9	-3.8	76.0
2023	19.1	22.9	-3.8	77.0
Total 2014-2018	18.8	21.6	-2.8	NA
Total 2014-2023	18.9	22.1	-3.3	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR). CBO (2013BEOFeb5). CBO 2013HBDFeb5).

Chart ESI-1 provides actual federal debt held by the public as percent of GDP from 1940 to 2012 and projected by the CBO (2013BEOFeb5) from 2013 to 2023. The ratio of debt to GDP climbed from 42.3 percent in 1941 to a peak of 108.7 percent in 1946 because of the Second World War. The ratio of debt to GDP declined to 80.2 percent in 1950 and 66.9 percent in 1951 because of unwinding war effort, economic growing to capacity and less rigid mandatory expenditures. The ratio of debt to GDP of 72.5 percent in 2012 is the highest in the United States since 1950. The CBO (2013BEOFeb5) projects the ratio of debt of GDP of the United States to reach 77.0 percent in 2023, which will be more than double the average ratio of 37.0 percent in 1971-2010. The misleading debate on the so-called “fiscal cliff” has disguised the unsustainable path of United States fiscal affairs.

Chart ESI-1, Congressional Budget Office, Actual and Projections of Federal Debt Held by the Public As Percent of GDP, 1940-2023, %

Source: Congressional Budget Office, CBO (2013BEOFeb5).

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

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

Table ESI-8 provides the projections of the earlier alternative fiscal scenario of the CBO under those assumptions. Debt as percent of GDP increases from 72.6 percent in 2012 to 89.7 percent in 2022.

Table ESI-8, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.8
2012	15.8	22.8	-7.0	72.5
2013	16.3	22.8	-6.5	78.6
2014	17.2	22.9	-5.6	82.3
2015	17.8	22.5	-4.6	82.5
2016	18.1	22.6	-4.5	82.5
2017	18.3	22.5	-4.2	82.5
2018	18.3	22.5	-4.2	82.9
2019	18.4	23.0	-4.6	84.1
2020	18.5	23.3	-4.8	85.7
2021	18.5	23.6	-5.1	87.5
2022	18.6	24.1	-5.5	89.7
Total 2013-2017	17.6	22.6	-5.0	NA
Total 2013-2022	18.1	23.0	-4.9	NA
Average 1971-2010	18.0	21.9	NA	37.0

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

The CBO (2012AugBEO) projects economic variables shown in Table ESI-9 required for the fiscal projections. Real GDP growth is projected at 1.9 percent in 2012 and 1.4 percent in 2013, jumping to 3.6 percent on average from 2015 to 2018 and 2.2 percent from 2019 to 2023. It is not possible to forecast another downturn from 2013 to 2023 that could worsen further the US fiscal situation. The CBO projects subdued inflation but the rate of unemployment remains at high levels, declining to 5.5 percent by 2015-2018, which is around the current measurement of the natural rate of unemployment. Interest rates are assumed to remain at relatively low levels but increase in the latter years of the projections. Different paths of economic variables would alter the projections of fiscal variables.

Table ESI-9, US, CBO Economic Projections for Calendar Years 2013 to 2023, ∆%

	2012 ∆%	2013 ∆%	2015-2018 Average ∆%	2019-2023 Average ∆%
Real GDP	1.9	1.4	3.6	2.2
PCE Inflation	1.5	1.3	1.9	2.0
Core PCE Inflation	1.5	1.5	2.0	2.0
CPI Inflation	1.9	1.5	2.2	2.3
Core CPI Inflation	1.9	1.8	2.2	2.3
Unem- ployment Rate	7.8	8.0	5.5	5.2
3-Month Treasury Bill	0.1	0.1	2.2	4.0
10-Year treasury Note	1.8	2.1	4.5	5.2

Source: CBO (2013BEOFeb5).

The Congressional Budget Office (CBO 2013BEOFeb5) estimates potential GDP, potential labor force and potential labor productivity provided in Table ESI-10. The average rate of growth of potential GDP from 1950 to 2012 is estimated at 3.3 percent per year. The projected path is significantly lower at 2.2 percent per year from 2012 to 2023. The legacy of the economic cycle with expansion from IIIQ2009 to IVQ2012 at 2.1 percent on average in contrast with 6.2 percent in prior expansions of the economic cycle in the postwar (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) may perpetuate unemployment and underemployment estimated at 31.4 million or 19.4 percent of the effective labor force in Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table ESI-10, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.3	2.5	0.8
1982-1990	3.1	1.6	1.5
1991-2001	3.1	1.3	1.8
2002-2012	2.2	0.8	1.4
Total 1950-2012	3.3	1.5	1.7
Projected Average Annual ∆%
2013-2018	2.2	0.6	1.6
2019-2023	2.3	0.5	1.8
2012-2023	2.2	0.5	1.7

*Ratio of potential GDP to potential labor force

Source: CBO (2013BEOFeb5).

Chart ESI-2 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.1 percent on average from IIIQ2009 to IVQ2012 during the current economic expansion in contrast with 6.2 percent on average in postwar cyclical expansions (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) cannot be explained by the contraction of 4.7 of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 31.4 million or 19.4 percent of the labor as estimated for Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) and the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Chart ESI-2, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5).

The major hurdle in adjusting the fiscal situation of the US is shown in Table ESI-11 in terms of the rigid structure of revenues that can be increased and outlays that can be reduced. There is no painless adjustment of a debt exceeding 70 percent of GDP and increasing toward 80-100 percent of GDP. On the side of revenues, taxes provide 90.6 percent of revenue in 2012 and are projected to provide 92.9 percent in the total revenues from 2014 to 2023 in the CBO projections. Thus, revenue measures are a misleading term for what are actually tax increases. The choices are especially difficult because of the risks of balancing inequity and disincentives to economic activity. Individual income taxes are projected to increase from 46.2 percent of federal government revenues in 2012 to 49.1 percent in total revenues projected by the CBO from 2014 to 2023. There are equally difficult conflicts in what the government gives away in a rigid structure of expenditures. Mandatory expenditures account for 57.4 percent of federal government outlays in 2012 and are projected to increase to 61.3 percent of the total projected by the CBO for the years 2014 to 2023. The total of Social Security plus Medicare and Medicaid accounts for 44.4 percent of federal government outlays in 2012 and is projected to increase to 50.0 percent in the total for 2014 to 2023. The inflexibility of what to cut is more evident in the first to the last row of Table ESI-11 with the aggregate of defense plus Social Security plus Medicare plus Medicaid accounting for 63.2 percent of expenditures in 2012, rising to 63.9 percent of the total outlays projected by the CBO from 2014 to 2023. The cuts are in discretionary spending that declines from 36.3 percent of the total in 2012 to 27.2 percent of total outlays in the CBO projection for 2014 to 2023.

Table ESI-11, Structure of Federal Government Revenues and Outlays, $ Billions and Percent

	2012 $ Billions	% Total	Total 2014-2023 $ Billions	% Total
Revenues	2,449	100.00	40,241	100.00
Individual Income Taxes	1,132	46.2	19,747	49.1
Social Insurance Taxes	845	34.5	12,852	31.9
Corporate Income Taxes	242	9.9	4,805	11.9
Other	229	9.4	2,837	7.1

Outlays	3,538	100.00	47,199	100.0
Mandatory	2,031	57.4	28,938	61.3
Social Security	768	20.1	11,149	38.5
Medicare	551	15.5	8,070	17.1
Medicaid	251	7.6	4,360	9.2
SS + Medicare + Medicaid	1,570	44.4	23,579	50.0
Discre- tionary	1,285	36.3	12,852	27.2
Defense	668*	18.9	6,566	13.9
Non- defense	617*	17.4	5,960	12.6
Net Interest	223	6.3	5,410	11.5
Defense +SS + Medicare + Medicaid	2,238	63.2	30,145	63.9
MEMO: GDP	15,549		213,326

*Same proportions of total discretionary spending as in 2011

Source: CBO (2012JanBEO), CBO (2012AugBeo). CBO (2013BEOFeb5).

The CBO (2012NovCDR) focuses on adjustment by fiscal-year 2020. Major segments of the base projections of CBO (2013BEOFeb5) to 2020 and the earlier alternative fiscal scenario (CBO12NovCDR) are shown in Table ES1-12. The base scenario has moved closer to the tougher earlier alternative scenario. The base projection has revenues as percent of GDP of 18.7 percent, higher than 18 percent historically on average from 1970 to 2010 compared with 18.5 percent in the fiscal scenario. The base scenario requires return of growth to trend or whereabouts together with the capacity to increase revenues above the 18.5 percent threshold. Most revenue components are similar under both scenarios with exception of individual income taxes that reach 9.4 percent of GDP in 2020 under the base projection while they reach only 9.0 percent under the alternative fiscal scenario. There is also significant difference in total outlays, reaching 22.2 percent of GDP under the base projection but increasing to 23.3 percent of GDP under the earlier alternative fiscal scenario. Discretionary spending reaches 6.2 percent under the alternative fiscal scenario with increases in the share in GDP of both defense and nondefense components while net interest payments by the federal government are higher by 3.1 percent under the alternative fiscal scenario with much higher debt than 2.9 percent in the base projection. In mandatory spending, the difference is 3.8 percent in the base projection in Medicare with 3.5 percent in the alternative fiscal scenario. Under the base projection, the deficit would decline to $798 billion in 2020 or 3.5 percent of GDP while it would reach $1102 billion, or $1.1 trillion, in the alternative fiscal scenario for 4.8 percent of GDP. Debt held by the public at the end of the year, in the final row, would be $16,957 billion, or $13.9 trillion, in the base projection, for 74.2 percent of GDP, and $19,477 billion, or $19.5 trillion for 85.7 percent of GDP, under the alternative fiscal scenario.

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

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

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

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

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

Table ESI-12, CBO Budget Projections for 2020 Baseline and Alternative Fiscal Scenario, Billions of Dollars and % of GDP

	$ B Base 2020	% GDP Base 2020	$B Alt 2020	% GDP Alt 2020
Revenues	4,279	18.7	4,196	18.5
Individual Income Taxes	2,158	9.4	2,055	9.0
Social Insurance Taxes	1,372	6.0	1,412	6.2
Corporate Income Taxes	492	2.2	424	1.9
Other	258	1.1	305	1.3
Total Outlays	5,078	22.2	5,298	23.3
Mandatory Spending	3,087	13.5	3,190	14.0
Social Security	1,199	5.3	1,202	5.3
Medicare	867	3.8	793	3.5
Medicaid	476	2.1	514	2.3
Other Major Health Care Programs	165	0.1	117	0.5
Other Mandatory Spending	380	1.7	566	2.5
Discretionary Spending	1,324	5.8	1,403	6.2
Defense	679	3.0	750	3.3
Nondefense	616	2.7	653	2.9
Net Interest	667	2.9	704	3.1
Deficit	-798	-3.5	-1,102	-4.8
Debt Held by the Public at the End of the Year	16,957	74.2	19,477	85.7

Source: CBO (2012NovCDR). CBO (2013BEOFeb5).

The fiscal prospects of the United States are summarized by the Congressional Budget Office (2013MEFeb5):

“Federal debt held by the public now exceeds 70 percent of the nation’s annual output (gross domestic product, or GDP) and stands at a higher percentage than in any year since 1950. Under an assumption whereby current laws generally remain unchanged, federal debt will be 77 percent of GDP in 2023, CBO projects. Such a large amount of federal debt will reduce the nation’s output and income below what would occur if the debt was smaller, and it raises the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates). Moreover, the aging of the population and rising health care costs will tend to push debt even higher in the following decades. In evaluating policy changes that would change projected budget deficits, lawmakers would undoubtedly weigh other considerations besides the macroeconomic effects—taking into account, for example, views about the proper size of the federal government and the best allocation of its resources. Lawmakers would also be concerned about the distributional implications of proposed changes—that is, who would bear the burden of any cuts in spending or increases in taxes (or who would benefit from spending increases or tax cuts), and who would gain or lose from changes in economic conditions.”

There are forward alternatives of extremely difficult measurement. The actual outcome is known under historical counterfactuals but all outcomes are generated by models with tough assumptions in forward simulations. The United States risks a point of explosion of its debt in which it would have to pay risk premium in order to borrow with extremely adverse effects on wellbeing with restrictive economic activity and employment. The CBO (2013MEFeb5) provides analysis of three different fiscal paths and their impact on real GDP. The fiscal variable considered is the cumulative primary deficit from 2014 to 2023, which consists of the fiscal deficits of revenues less outlays excluding interest payments. Path 1 considers an increase of the cumulative primary fiscal deficit of $2 trillion that would increase the deficit by $2.5 trillion, raising the federal debt held by the public to 87 percent of GDP in fiscal year 2023. (2) Path 2 considers reduction of $2 trillion of the cumulative primary deficit that would decrease the debt ratio to 67 percent of GDP in fiscal year 2023. (3) Path 3 considers reduction of $4 trillion of the primary deficit that would reduce the debt ratio to 58 percent of GDP in fiscal year 2023. Chart I-3 of the Congressional Budget Office provides the analysis of the three paths. The paths reveal tradeoffs of current versus future adjustment. In Path 1, GNP (Gross National Product) would stand higher by 0.3 percent than in the baseline scenario of the CBO (2013BEOFeb5) but would be lower by 0.9 percent in 2023 than the baseline projection. In Path 2, the cost of adjustment would be upfront with GNP lower by 0.3 percent in 2014 but higher by 0.9 percent in 2023 than under current law or baseline scenario. In Path 3, the cost of adjustment would be upfront with GNP lower by 0.6 percent in 2014 and higher by 1.7 percent in 2023 than under current law or baseline scenario.

Chart ESI-3, Congressional Budget Office, Effects on Real GDP of Alternative Budget Paths

Source: CBO (2013MEFeb5).

Table ESI-13 provides major foreign holders of US Treasury securities. China is the largest holder with $1170.1 billion in Nov 2012, decreasing 6.7 percent from $1254.6 billion in Oct 2011. Japan increased its holdings from $1066.4 billion in Nov 2011 to $1132.8 billion in Nov 2012 or by 6.2 percent likely in part by intervention to buy dollars against the yen to depreciate the overvalued yen/dollar rate that diminishes the competitiveness of Japan. Total foreign holdings of Treasury securities rose from $5009.1 billion in Nov 2011 to $5557.2 billion in Nov 2012, or 10.9 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

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

Table ESI-13, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Nov 2012	Oct 2012	Nov 2011
Total	5557.2	5526.2	5009.1
China	1170.1	1169.9	1254.6
Japan	1132.8	1131.9	1066.4
Caribbean Banking Centers	283.7	273.5	223.3
Oil Exporters	260.1	262.2	254.2
Brazil	257.0	254.1	226.6
Taiwan	193.1	197.2	166.9
Switzerland	186.9	187.8	126.2
Russia	164.1	171.1	145.1
United Kingdom	145.0	133.2	125.2
Luxembourg	144.8	144.7	127.2
Hong Kong	142.3	138.5	107.9
Belgium	135.4	136.4	133.2
Foreign Official Holdings	3985.7	3984.3	3628.9
A. Treasury Bills	383.5	379.4	379.0
B. Treasury Bonds and Notes	3602.2	3604.9	3249.9

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

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

IA United States Unsustainable Fiscal Deficit/Debt. Table I-1 of the CBO (2012NovMBR, 2013BEOFeb5, 2013HBDFFeb5, 2013MEFFeb5) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012. The deficit of $1.1 trillion in fiscal-year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR, 2013HBDFeb5).

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

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

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO (2013HBDFeb5).

Table I-2 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into three parts: federal fiscal data for the years from 2009 to 2012; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2012. Total revenues of the US from 2009 to 2012 accumulate to $9019 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,111 billion, or $14.1 trillion, with the deficit accumulating to $5092 billion, or $5.1 trillion. Revenues decreased 6.6 percent from $9653 billion in the four years from 2005 to 2008 to $9019 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.1 percent on average in the cyclical expansion from IIIQ2009 to IVQ2012, which is much lower than 6.2 percent on average in cyclical expansions since the 1950s (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). Weakness of growth and employment creation is analyzed in the following Subsection IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are 31.4 million people without jobs or underemployed that is equivalent to 19.4 percent of the US effective labor force (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) and hiring is significantly below the earlier cyclical expansion before 2007 (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,111 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.6 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5092 billion in 2009-2012. Federal revenue was 15.4 percent of GDP on average in the years from 2009 to 2012, which is well below 18.0 percent of GDP on average from 1970 to 2010. Federal outlays were 24.1 percent of GDP on average from 2009 to 2012, which is well above 21.9 percent of GDP on average from 1970 to 2010. The lower part of Table I-2 shows that debt held by the public swelled from $5803 billion in 2008 to $11,280 billion in 2012, by $5477 billion or 94.4 percent. Debt held by the public as percent of GDP or economic activity jumped from 40.5 percent in 2008 to 72.5 percent in 2012, which is well above the average of 37.0 percent from 1970 to 2010. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table I-2, US, Treasury Budget and Debt Held by the Public, Billions of Dollars and Percent of GDP

	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
2012	2,449	3,538	-1,089
Fiscal Year 2011	2,302	3,599	-1,297
Fiscal Year 2010	2,163	3,456	-1,293
Fiscal Year 2009	2,105	3,518	-1,413
Total 2009-2012	9,019	14,111	-5,092
Average % GDP 2009-2012	15.4	24.1	-8.7
Fiscal Year 2008	2,524	2,983	-459
Fiscal Year 2007	2,568	2,729	-161
Fiscal Year 2006	2,407	2,655	-248
Fiscal Year 2005	2,154	2,472	-318
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.9	20.1	-2.2
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	36.9
2006	4,829	36.6
2007	5,035	36.3
2008	5,803	40.5
2009	7,545	54.1
2010	9,019	62.8
2011	10,128	67.7
2012	11,280	72.5

Unusually low economic growth of average 2.1 percent of GDP in the current expansion compared with 6.2 percent in similar expansions in postwar economic cycles (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) has had adverse impact on revenue generation. The impact of low growth on employment creation and labor market hiring is discussed in Subsection IB Collapse of United States Dynamism of Income Growth and Employment. Table I-3 provides total United States federal receipts from 2010 to 2012. Individual income taxes of $1132 billion, or $1.1 trillion, increased 25.9 percent from 2010 to 2012 and account for 46.2 percent of US total receipts in 2012. Total receipts stood at 15.8 percent of GDP in 2012, which is lower than 18 percent in the past 40 years (CBO 2012NovBMR).

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

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

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO 2013HBDFeb5).

Total outlays of the federal government of the United States have grown to extremely high levels. Table I-4 of the CBO (2012NovMBR, 2013HBDFeb5) provides total outlays from 2010 to 2012. Total outlays of $3538 billion in 2012, or $3.5 trillion, are higher by $809 billion, or $0.8 trillion, relative to $2729 billion in 2007, or $2.7 trillion. Outlays have grown from 19.7 percent of GDP in 2007 to 22.8 percent of GDP in 2012. Outlays as percent of GDP were on average 21.9 percent from 1971 to 2010 and receipts as percent of GDP were on average 18.0 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Adjusted outlays in Table I-4 decreased 1.6 percent from 2011 to 2012 but mostly because of decline in defense-military expenditures by 2.9 percent, unemployment benefits by 24.0 percent and Medicaid by 8.9 percent. Much higher expenses of social security benefits increased 6.0 percent and Medicare increased 3.3 percent. There has been no meaningful constraint of spending.

Table I-4, United States, Total Outlays, Billions of Dollars and ∆%

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

Source: CBO (2012NovMBR, CBO2013HBDFeb5).

The US is facing a major fiscal challenge. Table I-5 provides federal revenues, expenditures, deficit and debt as percent of GDP and the yearly change in GDP in the eight decades from 1930 to 2011. The most recent period of debt exceeding 90 percent of GDP based on yearly observations in Table I-5 is between 1944 and 1948. The debt/GDP ratio actually rose to 106.2 percent of GDP in 1945 and to 108.7 percent of GDP in 1946. GDP fell 10.9 percent in 1946, which is only matched in Table I-5 by the decline of 13.1 percent in 1932. Part of the decline is explained by the bloated US economy during World War II, growing at 17.1 percent in 1941, 18.5 percent in 1942 and 16.4 percent in 1943. Expenditures as a share of GDP rose to their highest in the series: 43.6 percent in 1943, 43.6 percent in 1944 and 41.9 percent in 1945. The repetition of 43.6 percent in 1943 and 1944 is in the original source of Table I-5. During the Truman administration from Apr 1945 to Jan 1953, the federal debt held by the public fell systematically from the peak of 108.7 percent of GDP in 1946 to 61.6 percent of GDP in 1952. During the Eisenhower administration from Jan 1953 to Jan 1961, the federal debt held by the public fell from 58.6 percent of GDP in 1953 to 45.6 percent of GDP in 1960. The Truman and Eisenhower debt reductions were facilitated by diverse factors such as low interest rates, lower expenditure/GDP ratios that could be attained again after lowering war outlays and less rigid structure of mandatory expenditures than currently. There is no subsequent jump of debt as the one from 40.5 percent of GDP in 2008 to 67.8 percent of GDP in 2011 and at 72.5 percent in 2012.

Table I-5, United States Central Government Revenue, Expenditure, Deficit, Debt and GDP Growth 1930-2011

	Rev % GDP	Exp % GDP	Deficit % GDP	Debt % GDP	GDP ∆%
1930	4.2	3.4	0.8		-8.6
1931	3.7	4.3	-0.6		-6.5
1932	2.8	6.9	-4.0		-13.1
1933	3.5	8.0	-4.5		-1.3
1934	4.8	10.7	-5.9		10.9
1935	5.2	9.2	-4.0		8.9
1936	5.0	10.5	-5.5		13.1
1937	6.1	8.6	-2.5		5.1
1938	7.6	7.7	-0.1		-3.4
1939	7.1	10.3	-3.2		8.1
1940s
1940	6.8	9.8	-3.0	44.2	8.8
1941	7.6	12.0	-4.3	42.3	17.1
1942	10.1	24.3	-14.2	47.0	18.5
1943	13.3	43.6	-30.3	70.9	16.4
1944	20.9	43.6	-22.7	88.3	8.1
1945	20.4	41.9	-21.5	106.2	-1.1
1946	17.7	24.8	-7.2	108.7	-10.9
1947	16.5	14.8	1.7	96.2	-0.9
1948	16.2	11.6	4.6	84.3	4.4
1949	14.5	14.3	0.2	79.0	-0.5
1950s
1950	14.4	15.6	-1.1	80.2	8.7
1951	16.1	14.2	1.9	66.9	7.7
1952	19.0	19.4	-0.4	61.6	3.8
1953	18.7	20.4	-1.7	58.6	4.6
1954	18.5	18.8	-0.3	59.5	-0.6
1955	16.5	17.3	-0.8	57.2	7.2
1956	17.5	16.5	0.9	52.0	2.0
1957	17.7	17.0	0.8	48.6	2.0
1958	17.3	17.9	-0.6	49.2	-0.9
1959	16.2	18.8	-2.6	47.9	7.2
1960s
1960	17.8	17.8	0.1	45.6	2.5
1961	17.8	18.4	-0.6	45.0	2.3
1962	17.6	18.8	-1.3	43.7	6.1
1963	17.8	18.6	-0.8	42.4	4.4
1964	17.6	18.5	-0.9	40.0	5.8
1965	17.0	17.2	-0.2	37.9	6.4
1966	17.3	17.8	-0.5	34.9	6.5
1967	18.4	19.4	-1.1	32.9	2.5
1968	17.6	20.5	-2.9	33.9	4.8
1969	19.7	19.4	0.3	29.3	3.1
1970s
1970	19.0	19.3	-0.3	28.0	0.2
1971	17.3	19.5	-2.1	28.1	3.4
1972	17.6	19.6	-2.0	27.4	5.3
1973	17.6	18.7	-1.1	26.0	5.8
1974	18.3	18.7	-0.4	23.9	-0.6
1975	17.9	21.3	-3.4	25.3	0.2
1976	17.1	21.4	-4.2	27.5	5.4
1977	18.0	20.7	-2.7	27.8	4.6
1978	18.0	20.7	-2.7	27.4	5.6
1979	18.5	20.1	-1.6	25.6	3.1
1980s
1980	19.0	21.7	-2.7	26.1	-0.3
1981	19.6	22.2	-2.6	25.8	2.5
1982	19.2	23.1	-4.0	28.7	-1.9
1983	17.5	23.5	-6.0	33.1	4.5
1984	17.3	22.2	-4.8	34.0	7.2
1985	17.7	22.8	-5.1	36.4	4.1
1986	17.5	22.5	-5.0	39.5	3.5
1987	18.4	21.6	-3.2	40.6	3.2
1988	18.2	21.3	-3.1	41.0	4.1
1989	18.4	21.2	-2.8	40.6	3.6
1990s
1990	18.0	21.9	-3.9	42.1	1.9
1991	17.8	22.3	-4.5	45.3	-0.2
1992	17.5	22.1	-4.7	48.1	3.4
1993	17.5	21.4	-3.9	49.3	2.9
1994	18.0	21.0	-2.9	49.2	4.1
1995	18.4	20.6	-2.2	49.1	2.5
1996	18.8	20.2	-1.4	48.4	3.7
1997	19.2	19.5	-0.3	45.9	4.5
1998	19.9	19.1	0.8	43.0	4.4
1999	19.8	18.5	1.4	39.4	4.8
2000s
2000	20.6	18.2	2.4	34.7	4.1
2001	19.5	18.2	1.3	32.5	1.1
2002	17.6	19.1	-1.5	33.6	1.8
2003	16.2	19.7	-3.4	35.6	2.5
2004	16.1	19.6	-3.5	36.8	3.5
2005	17.3	19.9	-2.6	36.9	3.1
2006	18.2	20.1	-1.9	36.6	2.7
2007	18.5	19.7	-1.2	36.3	1.9
2008	17.6	20.8	-3.2	40.5	-0.3
2009	15.1	25.2	-10.1	54.1	-3.1
2010s
2010	15.1	24.1	-9.0	62.9	2.4
2011	15.4	24.1	-8.7	67.8	1.8
2012	15.8	22.8	-7.0	72.5	2.2

Sources:

Table I-6 provides the latest exercise by the CBO (2013BEOFeb5, 2012AugBEO, CBO2012NovCDR) of projecting the fiscal accounts of the US. Table I-6 extends data back to 1995 with the projections of the CBO from 2013 to 2023. Budget analysis in the US uses a ten-year horizon. The significant event in the data before 2011 is the budget surpluses from 1998 to 2001, from 0.8 percent of GDP in 1998 to 2.4 percent of GDP in 2000. Debt held by the public fell from 49.1 percent of GDP in 1995 to 32.5 percent of GDP in 2001.

Table I-6, US, CBO Baseline Budget Outlook 2013-2023

	Out $B	Out % GDP	Deficit $B	Deficit % GDP	Debt	Debt % GDP
1995	1,516	20.6	-164	-2.2	3,604	49.1
1996	1,560	20.2	-107	-1.4	3,734	48.4
1997	1,601	19.5	-22	-0.3	3,772	45.9
1998	1,652	19.1	+69	+0.8	3,721	43.0
1999	1,702	18.5	+126	+1.4	3,632	39.4
2000	1,789	18.2	+236	+2.4	3,410	34.7
2001	1,863	18.2	+128	+1.3	3,320	32.5
2002	2,011	19.1	-158	-1.5	3,540	33.6
2003	2,159	19.7	-378	-3.4	3,913	35.6
2004	2,293	19.6	-413	-3.5	4,295	36.8
2005	2,472	19.9	-318	-2.6	4,592	36.9
2006	2,655	20.1	-248	-1.9	4,829	36.6
2007	2,729	19.7	-161	-1.2	5,035	36.3
2008	2,983	20.8	-459	-3.2	5,803	40.5
2009	3,518	25.2	-1,413	-10.1	7,545	54.1
2010	3,456	24.1	-1,294	-9.0	9,019	62.9
2011	3,598	24.1	-1,296	-8.7	10,128	67.8
2012	3,538	22.8	-1,089	-7.0	11,280	72.5
2013	3,553	22.2	-845	-5.3	12,229	76.3
2014	3,618	21.7	-616	-3.7	12,937	77.7
2015	3,803	21.6	-430	-2.4	13,462	76.3
2016	4,067	21.6	-476	-2.5	14,025	74.6
2017	4,300	21.5	-535	-2.7	14,642	73.4
2018	4,542	21.7	-605	-2.9	15,316	73.1
2019	4,811	22.0	-710	-3.2	16,092	73.5
2020	5,078	22.2	-798	-3.5	16,957	74.2
2021	5,350	22.4	-854	-3.6	17,876	75.0
2022	5,691	22.9	-957	-3.8	18,902	76.0
2023	5,939	22.9	-978	-2.8	19,944	77.0
2014 to 2018	20,330	21.6	-2,661	-3.3	NA	NA
2014 to 2023	47,199	22.1	-6,958	-1.1	NA	NA

Note: Out = outlays

Table I-7 provides baseline CBO projections of federal revenues, outlays, deficit and debt as percent of GDP. The adjustment depends on increasing revenues from 15.4 percent of GDP in 2011 to 19.1 percent of GDP in 2023, which is above the 40-year average of 18 percent of GDP while outlays fall only from 24.1 percent of GDP in 2011 to 22.9 percent of GDP in 2023. The last row of Table 1-7 provides the CBO estimates of averages for 1971 to 2010 of 18.0 percent for revenues/GDP, 21.9 percent for outlays/GDP and 37.0 percent for debt/GDP.

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

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.8
2012	15.8	22.8	-7.0	72.5
2013	16.9	22.2	-5.3	76.3
2014	18.0	21.7	-3.7	77.7
2015	19.1	21.6	-2.4	76.3
2016	19.1	21.6	-2.5	74.6
2017	18.9	21.5	-2.7	73.4
2018	18.8	21.7	-2.9	73.1
2019	18.7	22.0	-3.2	73.5
2020	18.7	22.2	-3.5	74.2
2021	18.9	22.4	-3.6	75.0
2022	19.0	22.9	-3.8	76.0
2023	19.1	22.9	-3.8	77.0
Total 2014-2018	18.8	21.6	-2.8	NA
Total 2014-2023	18.9	22.1	-3.3	NA
Average 1971-2010	18.0	21.9	NA	37.0

Source: CBO (2012AugBEO). CBO (2012NovCDR). CBO (2013BEOFeb5). CBO 2013HBDFeb5).

Chart I-1 provides actual federal debt held by the public as percent of GDP from 1940 to 2012 and projected by the CBO (2013BEOFeb5) from 2013 to 2023. The ratio of debt to GDP climbed from 42.3 percent in 1941 to a peak of 108.7 percent in 1946 because of the Second World War. The ratio of debt to GDP declined to 80.2 percent in 1950 and 66.9 percent in 1951 because of unwinding war effort, economic growing to capacity and less rigid mandatory expenditures. The ratio of debt to GDP of 72.5 percent in 2012 is the highest in the United States since 1950. The CBO (2013BEOFeb5) projects the ratio of debt of GDP of the United States to reach 77.0 percent in 2023, which will be more than double the average ratio of 37.0 percent in 1971-2010. The misleading debate on the so-called “fiscal cliff” has disguised the unsustainable path of United States fiscal affairs.

Chart I-1, Congressional Budget Office, Actual and Projections of Federal Debt Held by the Public As Percent of GDP, 1940-2023, %

Source: Congressional Budget Office, CBO (2013BEOFeb5).

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

Table I-8 provides the projections of the earlier alternative fiscal scenario of the CBO under those assumptions. Debt as percent of GDP increases from 72.6 percent in 2012 to 89.7 percent in 2022.

Table I-8, US, Alternative Scenario CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.4	24.1	-8.7	67.8
2012	15.8	22.8	-7.0	72.5
2013	16.3	22.8	-6.5	78.6
2014	17.2	22.9	-5.6	82.3
2015	17.8	22.5	-4.6	82.5
2016	18.1	22.6	-4.5	82.5
2017	18.3	22.5	-4.2	82.5
2018	18.3	22.5	-4.2	82.9
2019	18.4	23.0	-4.6	84.1
2020	18.5	23.3	-4.8	85.7
2021	18.5	23.6	-5.1	87.5
2022	18.6	24.1	-5.5	89.7
Total 2013-2017	17.6	22.6	-5.0	NA
Total 2013-2022	18.1	23.0	-4.9	NA
Average 1971-2010	18.0	21.9	NA	37.0

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

The CBO (2012AugBEO) projects economic variables shown in Table I-9 required for the fiscal projections. Real GDP growth is projected at 1.9 percent in 2012 and 1.4 percent in 2013, jumping to 3.6 percent on average from 2015 to 2018 and 2.2 percent from 2019 to 2023. It is not possible to forecast another downturn from 2013 to 2023 that could worsen further the US fiscal situation. The CBO projects subdued inflation but the rate of unemployment remains at high levels, declining to 5.5 percent by 2015-2018, which is around the current measurement of the natural rate of unemployment. Interest rates are assumed to remain at relatively low levels but increase in the latter years of the projections. Different paths of economic variables would alter the projections of fiscal variables.

Table I-9, US, CBO Economic Projections for Calendar Years 2013 to 2023, ∆%

	2012 ∆%	2013 ∆%	2015-2018 Average ∆%	2019-2023 Average ∆%
Real GDP	1.9	1.4	3.6	2.2
PCE Inflation	1.5	1.3	1.9	2.0
Core PCE Inflation	1.5	1.5	2.0	2.0
CPI Inflation	1.9	1.5	2.2	2.3
Core CPI Inflation	1.9	1.8	2.2	2.3
Unem- ployment Rate	7.8	8.0	5.5	5.2
3-Month Treasury Bill	0.1	0.1	2.2	4.0
10-Year treasury Note	1.8	2.1	4.5	5.2

Source: CBO (2013BEOFeb5).

The Congressional Budget Office (CBO 2013BEOFeb5) estimates potential GDP, potential labor force and potential labor productivity provided in Table I-10. The average rate of growth of potential GDP from 1950 to 2012 is estimated at 3.3 percent per year. The projected path is significantly lower at 2.2 percent per year from 2012 to 2023. The legacy of the economic cycle with expansion from IIIQ2009 to IVQ2012 at 2.1 percent on average in contrast with 6.2 percent in prior expansions of the economic cycle in the postwar (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) may perpetuate unemployment and underemployment estimated at 31.4 million or 19.4 percent of the effective labor force in Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table I-10, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.3	2.5	0.8
1982-1990	3.1	1.6	1.5
1991-2001	3.1	1.3	1.8
2002-2012	2.2	0.8	1.4
Total 1950-2012	3.3	1.5	1.7
Projected Average Annual ∆%
2013-2018	2.2	0.6	1.6
2019-2023	2.3	0.5	1.8
2012-2023	2.2	0.5	1.7

*Ratio of potential GDP to potential labor force

Source: CBO (2013BEOFeb5).

Chart I-2 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.1 percent on average from IIIQ2009 to IVQ2012 during the current economic expansion in contrast with 6.2 percent on average in postwar cyclical expansions (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) cannot be explained by the contraction of 4.7 of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 31.4 million or 19.4 percent of the labor as estimated for Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) and the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Chart I-2, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5).

The major hurdle in adjusting the fiscal situation of the US is shown in Table I-11 in terms of the rigid structure of revenues that can be increased and outlays that can be reduced. There is no painless adjustment of a debt exceeding 70 percent of GDP and increasing toward 80-100 percent of GDP. On the side of revenues, taxes provide 90.6 percent of revenue in 2012 and are projected to provide 92.9 percent in the total revenues from 2014 to 2023 in the CBO projections. Thus, revenue measures are a misleading term for what are actually tax increases. The choices are especially difficult because of the risks of balancing inequity and disincentives to economic activity. Individual income taxes are projected to increase from 46.2 percent of federal government revenues in 2012 to 49.1 percent in total revenues projected by the CBO from 2014 to 2023. There are equally difficult conflicts in what the government gives away in a rigid structure of expenditures. Mandatory expenditures account for 57.4 percent of federal government outlays in 2012 and are projected to increase to 61.3 percent of the total projected by the CBO for the years 2014 to 2023. The total of Social Security plus Medicare and Medicaid accounts for 44.4 percent of federal government outlays in 2012 and is projected to increase to 50.0 percent in the total for 2014 to 2023. The inflexibility of what to cut is more evident in the first to the last row of Table I-11 with the aggregate of defense plus Social Security plus Medicare plus Medicaid accounting for 63.2 percent of expenditures in 2012, rising to 63.9 percent of the total outlays projected by the CBO from 2014 to 2023. The cuts are in discretionary spending that declines from 36.3 percent of the total in 2012 to 27.2 percent of total outlays in the CBO projection for 2014 to 2023.

Table I-11, Structure of Federal Government Revenues and Outlays, $ Billions and Percent

	2012 $ Billions	% Total	Total 2014-2023 $ Billions	% Total
Revenues	2,449	100.00	40,241	100.00
Individual Income Taxes	1,132	46.2	19,747	49.1
Social Insurance Taxes	845	34.5	12,852	31.9
Corporate Income Taxes	242	9.9	4,805	11.9
Other	229	9.4	2,837	7.1

Outlays	3,538	100.00	47,199	100.0
Mandatory	2,031	57.4	28,938	61.3
Social Security	768	20.1	11,149	38.5
Medicare	551	15.5	8,070	17.1
Medicaid	251	7.6	4,360	9.2
SS + Medicare + Medicaid	1,570	44.4	23,579	50.0
Discre- tionary	1,285	36.3	12,852	27.2
Defense	668*	18.9	6,566	13.9
Non- defense	617*	17.4	5,960	12.6
Net Interest	223	6.3	5,410	11.5
Defense +SS + Medicare + Medicaid	2,238	63.2	30,145	63.9
MEMO: GDP	15,549		213,326

*Same proportions of total discretionary spending as in 2011

Source: CBO (2012JanBEO), CBO (2012AugBeo). CBO (2013BEOFeb5).

The CBO (2012NovCDR) focuses on adjustment by fiscal-year 2020. Major segments of the base projections of CBO (2013BEOFeb5) to 2020 and the earlier alternative fiscal scenario (CBO12NovCDR) are shown in Table 1-12. The base scenario has moved closer to the tougher earlier alternative scenario. The base projection has revenues as percent of GDP of 18.7 percent, higher than 18 percent historically on average from 1970 to 2010 compared with 18.5 percent in the fiscal scenario. The base scenario requires return of growth to trend or whereabouts together with the capacity to increase revenues above the 18.5 percent threshold. Most revenue components are similar under both scenarios with exception of individual income taxes that reach 9.4 percent of GDP in 2020 under the base projection while they reach only 9.0 percent under the alternative fiscal scenario. There is also significant difference in total outlays, reaching 22.2 percent of GDP under the base projection but increasing to 23.3 percent of GDP under the earlier alternative fiscal scenario. Discretionary spending reaches 6.2 percent under the alternative fiscal scenario with increases in the share in GDP of both defense and nondefense components while net interest payments by the federal government are higher by 3.1 percent under the alternative fiscal scenario with much higher debt than 2.9 percent in the base projection. In mandatory spending, the difference is 3.8 percent in the base projection in Medicare with 3.5 percent in the alternative fiscal scenario. Under the base projection, the deficit would decline to $798 billion in 2020 or 3.5 percent of GDP while it would reach $1102 billion, or $1.1 trillion, in the alternative fiscal scenario for 4.8 percent of GDP. Debt held by the public at the end of the year, in the final row, would be $16,957 billion, or $13.9 trillion, in the base projection, for 74.2 percent of GDP, and $19,477 billion, or $19.5 trillion for 85.7 percent of GDP, under the alternative fiscal scenario.

Table I-12, CBO Budget Projections for 2020 Baseline and Alternative Fiscal Scenario, Billions of Dollars and % of GDP

	$ B Base 2020	% GDP Base 2020	$B Alt 2020	% GDP Alt 2020
Revenues	4,279	18.7	4,196	18.5
Individual Income Taxes	2,158	9.4	2,055	9.0
Social Insurance Taxes	1,372	6.0	1,412	6.2
Corporate Income Taxes	492	2.2	424	1.9
Other	258	1.1	305	1.3
Total Outlays	5,078	22.2	5,298	23.3
Mandatory Spending	3,087	13.5	3,190	14.0
Social Security	1,199	5.3	1,202	5.3
Medicare	867	3.8	793	3.5
Medicaid	476	2.1	514	2.3
Other Major Health Care Programs	165	0.1	117	0.5
Other Mandatory Spending	380	1.7	566	2.5
Discretionary Spending	1,324	5.8	1,403	6.2
Defense	679	3.0	750	3.3
Nondefense	616	2.7	653	2.9
Net Interest	667	2.9	704	3.1
Deficit	-798	-3.5	-1,102	-4.8
Debt Held by the Public at the End of the Year	16,957	74.2	19,477	85.7

Source: CBO (2012NovCDR). CBO (2013BEOFeb5).

The fiscal prospects of the United States are summarized by the Congressional Budget Office (2013MEFeb5):

Chart I-3, Congressional Budget Office, Effects on Real GDP of Alternative Budget Paths

Source: CBO (2013MEFeb5).

Table I-13 provides major foreign holders of US Treasury securities. China is the largest holder with $1170.1 billion in Nov 2012, decreasing 6.7 percent from $1254.6 billion in Oct 2011. Japan increased its holdings from $1066.4 billion in Nov 2011 to $1132.8 billion in Nov 2012 or by 6.2 percent likely in part by intervention to buy dollars against the yen to depreciate the overvalued yen/dollar rate that diminishes the competitiveness of Japan. Total foreign holdings of Treasury securities rose from $5009.1 billion in Nov 2011 to $5557.2 billion in Nov 2012, or 10.9 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

Table I-13, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Nov 2012	Oct 2012	Nov 2011
Total	5557.2	5526.2	5009.1
China	1170.1	1169.9	1254.6
Japan	1132.8	1131.9	1066.4
Caribbean Banking Centers	283.7	273.5	223.3
Oil Exporters	260.1	262.2	254.2
Brazil	257.0	254.1	226.6
Taiwan	193.1	197.2	166.9
Switzerland	186.9	187.8	126.2
Russia	164.1	171.1	145.1
United Kingdom	145.0	133.2	125.2
Luxembourg	144.8	144.7	127.2
Hong Kong	142.3	138.5	107.9
Belgium	135.4	136.4	133.2
Foreign Official Holdings	3985.7	3984.3	3628.9
A. Treasury Bills	383.5	379.4	379.0
B. Treasury Bonds and Notes	3602.2	3604.9	3249.9

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

IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are four major approaches to the analysis of the depth of the financial crisis and global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and the subpar recovery from IIIQ2009 (Jul) to the present IIIQ2012: (1) deeper contraction and slower recovery in recessions with financial crises; (2) counterfactual of avoiding deeper contraction by fiscal and monetary policies; (3) counterfactual that the financial crises and global recession would have been avoided had economic policies been different; and (4) evidence that growth rates are higher after deeper recessions with financial crises. A counterfactual consists of theory and measurements of what would have occurred otherwise if economic policies or institutional arrangements had been different. This task is quite difficult because economic data are observed with all effects as they actually occurred while the counterfactual attempts to evaluate how data would differ had policies and institutional arrangements been different (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008b), 125, 136; Pelaez 1979, 26-8). Counterfactual data are unobserved and must be calculated using theory and measurement methods. The measurement of costs and benefits of projects or applied welfare economics (Harberger 1971, 1997) specifies and attempts to measure projects such as what would be economic welfare with or without a bridge or whether markets would be more or less competitive in the absence of antitrust and regulation laws (Winston 2006). Counterfactuals were used in the “new economic history” of the United States to measure the economy with or without railroads (Fishlow 1965, Fogel 1964) and also in analyzing slavery (Fogel and Engerman 1974). A critical counterfactual in economic history is how Britain surged ahead of France (North and Weingast 1989). These four approaches are discussed below in turn followed with comparison of the two recessions of the 1980s from IQ1980 (Jan) to IIIQ1980 (Jul) and from IIIQ1981 (Jul) to IVQ1982 (Nov) as dated by the National Bureau of Economic Research (NBER http://www.nber.org/cycles.html). These comparisons are not idle exercises, defining the interpretation of history and even possibly critical policies and institutional arrangements. There is active debate on these issues (Bordo 2012Oct 21 http://www.bloomberg.com/news/2012-10-21/why-this-u-s-recovery-is-weaker.html Reinhart and Rogoff, 2012Oct14 http://www.economics.harvard.edu/faculty/rogoff/files/Is_US_Different_RR_3.pdf Taylor 2012Oct 25 http://www.johnbtaylorsblog.blogspot.co.uk/2012/10/an-unusually-weak-recovery-as-usually.html, Wolf 2012Oct23 http://www.ft.com/intl/cms/s/0/791fc13a-1c57-11e2-a63b-00144feabdc0.html#axzz2AotsUk1q).

(1) Lower Growth Rates in Recessions with Financial Crises. A monumental effort of data gathering, calculation and analysis by Professors Carmen M. Reinhart and Kenneth Rogoff at Harvard University is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). See http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html. The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time periods:

“Our results incorporate data on 44 countries spanning about 200 years. Taken together, the data incorporate over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements and historic circumstances. We also employ more recent data on external debt, including debt owed by government and by private entities.”

Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average is for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the United States: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90.

For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).

An important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):

“The ignorance, of course, stems from the belief that financial crises happen to other people at other time in other places. Outside a small number of experts, few people fully appreciate the universality of financial crises. The arrogance is of those who believe they have figured out how to do things better and smarter so that the boom can long continue without a crisis.”

There is sober warning by Reinhart and Rogoff (2011CEPR, 42) on the basis of the momentous effort of their scholarly data gathering, calculation and analysis:

“Despite considerable deleveraging by the private financial sector, total debt remains near its historic high in 2008. Total public sector debt during the first quarter of 2010 is 117 percent of GDP. It has only been higher during a one-year sting at 119 percent in 1945. Perhaps soaring US debt levels will not prove to be a drag on growth in the decades to come. However, if history is any guide, that is a risky proposition and over-reliance on US exceptionalism may only be one more example of the “This Time is Different” syndrome.”

As both sides of the Atlantic economy maneuver around defaults the experience on debt and growth deserves significant emphasis in research and policy. The world economy is slowing with high levels of unemployment in advanced economies. Countries do not grow themselves out of unsustainable debts but rather through de facto defaults by means of financial repression and in some cases through inflation. The conclusion is that this time is not different.

Professor Alan M. Taylor (2012) at the University of Virginia analyzes own and collaborative research on 140 years of history with data from 14 advanced economies in the effort to elucidate experience preciding, during and after financial crises. The conclusion is (Allan M. Taylor 2012, 8):

“Recessions might be painful, but they tend to be even more painful when combined with financial crises or (worse) global crises, and we already know that post-2008 experience will not overturn this conclusion. The impact on credit is also very strong: financial crises lead to strong setbacks in the rate of growth of loans as compared to what happens in normal recessions, and this effect is strong for global crises. Finally, inflation generally falls in recessions, but the downdraft is stronger in financial crisis times.”

Alan M. Taylor (2012) also finds that advanced economies entered the global recession with the largest financial sector in history. There was doubling after 1980 of the ratio of loans to GDP and tripling of the size of bank balance sheets. In contrast, in the period from 1950 to 1970 there was high investment, savings and growth in advanced economies with firm regulation of finance and controls of foreign capital flows.

(2) Counterfactual of the Global Recession. There is a difficult decision on when to withdraw the fiscal stimulus that could have adverse consequences on current growth and employment analyzed by Krugman (2011Jun18). CBO (2011JunLTBO, Chapter 2) considers the timing of withdrawal as well as the equally tough problems that result from not taking prompt action to prevent a possible debt crisis in the future. Krugman (2011Jun18) refers to Eggertsson and Krugman (2010) on the possible contractive effects of debt. The world does not become poorer as a result of debt because an individual’s asset is another’s liability. Past levels of credit may become unacceptable by credit tightening, such as during a financial crisis. Debtors are forced into deleveraging, which results in expenditure reduction, but there may not be compensatory effects by creditors who may not be in need of increasing expenditures. The economy could be pushed toward the lower bound of zero interest rates, or liquidity trap, remaining in that threshold of deflation and high unemployment.

Analysis of debt can lead to the solution of the timing of when to cease stimulus by fiscal spending (Krugman 2011Jun18). Excessive debt caused the financial crisis and global recession and it is difficult to understand how more debt can recover the economy. Krugman (2011Jun18) argues that the level of debt is not important because one individual’s asset is another individual’s liability. The distribution of debt is important when economic agents with high debt levels are encountering different constraints than economic agents with low debt levels. The opportunity for recovery may exist in borrowing by some agents that can adjust the adverse effects of past excessive borrowing by other agents. As Krugman (2011Jun18, 20) states:

“Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.”

Besides operational issues, the consideration of this argument would require specifying and measuring two types of gains and losses from this policy: (1) the benefits in terms of growth and employment currently; and (2) the costs of postponing the adjustment such as in the exercise by CBO (2011JunLTO, 28-31) in Table 11. It may be easier to analyze the costs and benefits than actual measurement.

An analytical and empirical approach is followed by Blinder and Zandi (2010), using the Moody’s Analytics model of the US economy with four different scenarios: (1) baseline with all policies used; (2) counterfactual including all fiscal stimulus policies but excluding financial stimulus policies; (3) counterfactual including all financial stimulus policies but excluding fiscal stimulus; and (4) a scenario excluding all policies. The scenario excluding all policies is an important reference or the counterfactual of what would have happened if the government had been entirely inactive. A salient feature of the work by Blinder and Zandi (2010) is the consideration of both fiscal and financial policies. There was probably more activity with financial policies than with fiscal policies. Financial policies included the Fed balance sheet, 11 facilities of direct credit to illiquid segments of financial markets, interest rate policy, the Financial Stability Plan including stress tests of banks, the Troubled Asset Relief Program (TARP) and others (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 157-67; Regulation of Banks and Finance (2009a), 224-7).

Blinder and Zandi (2010, 4) find that:

“In the scenario that excludes all the extraordinary policies, the downturn continues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010 (see Table 3). The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemployment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fiscal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.”

The conclusion by Blinder and Zandi (2010) is that if the US had not taken massive fiscal and financial measures the economy could have suffered far more during a prolonged period. There are still a multitude of questions that cloud understanding of the impact of the recession and what would have happened without massive policy impulses. Some effects are quite difficult to measure. An important argument by Blinder and Zandi (2010) is that this evaluation of counterfactuals is relevant to the need of stimulus if economic conditions worsened again.

(3) Counterfactual of Policies Causing the Financial Crisis and Global Recession. The counterfactual of avoidance of deeper and more prolonged contraction by fiscal and monetary policies is not the critical issue. As Professor John B. Taylor (2012Oct25) argues the critically important counterfactual is that the financial crisis and global recessions would have not occurred in the first place if different economic policies had been followed. The counterfactual intends to verify that a combination of housing policies and discretionary monetary policies instead of rules (Taylor 1993) caused, deepened and prolonged the financial crisis (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB; see http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html) and that the experience resembles that of the Great Inflation of the 1960s and 1970s with stop-and-go growth/inflation that coined the term stagflation (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I).

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

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

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

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

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

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

W = Y/r (1)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

According to Pinto (2008) in testimony to Congress:

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

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

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

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

(4) Historically Sharper Recoveries from Deeper Contractions and Financial Crises. Professor Michael D. Bordo (2012Sep27), at Rutgers University, is providing clear thought on the correct comparison of the current business cycles in the United States with those in United States history. There are two issues raised by Professor Bordo: (1) lumping together countries with different institutions, economic policies and financial systems; and (2) the conclusion that growth is mediocre after financial crises and deep recessions, which is repeated daily in the media, but that Bordo and Haubrich (2012DR) persuasively demonstrate to be inconsistent with United States experience.

Depriving economic history of institutions is perilous as is illustrated by the economic history of Brazil. Douglass C. North (1994) emphasized the key role of institutions in explaining economic history. Rondo E. Cameron (1961, 1967, 1972) applied institutional analysis to banking history. Friedman and Schwartz (1963) analyzed the relation of money, income and prices in the business cycle and related the monetary policy of an important institution, the Federal Reserve System, to the Great Depression. Bordo, Choudhri and Schwartz (1995) analyze the counterfactual of what would have been economic performance if the Fed had used during the Great Depression the Friedman (1960) monetary policy rule of constant growth of money(for analysis of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). Alan Meltzer (2004, 2010a,b) analyzed the Federal Reserve System over its history. The reader would be intrigued by Figure 5 in Reinhart and Rogoff (2010FCDC, 15) in which Brazil is classified in external default for seven years between 1828 and 1834 but not again until 64 years later in 1989, above the 50 years of incidence for “serial default”. This void has been filled in scholarly research on nineteenth-century Brazil by William R. Summerhill, Jr. (2007SC, 2007IR). There are important conclusions by Summerhill on the exceptional sample of institutional change or actually lack of change, public finance and financial repression in Brazil between 1822 an 1899, combining tools of economics, political science and history. During seven continuous decades, Brazil did not miss a single interest payment with government borrowing without repudiation of debt or default. What is really surprising is that Brazil borrowed by means of long-term bonds and even more surprising interest rates fell over time. The external debt of Brazil in 1870 was ₤41,275,961 and the domestic debt in the internal market was ₤25,708,711, or 62.3 percent of the total (Summerhill 2007IR, 73).

The experience of Brazil differed from that of Latin America (Summerhill 2007IR). During the six decades when Brazil borrowed without difficulty, Latin American countries becoming independent after 1820 engaged in total defaults, suffering hardship in borrowing abroad. The countries that borrowed again fell again in default during the nineteenth century. Venezuela defaulted in four occasions. Mexico defaulted in 1827, rescheduling its debt eight different times and servicing the debt sporadically. About 44 percent of Latin America’s sovereign debt was in default in 1855 and approximately 86 percent of total government loans defaulted in London originated in Spanish American borrowing countries.

External economies of commitment to secure private rights in sovereign credit would encourage development of private financial institutions, as postulated in classic work by North and Weingast (1989), Summerhill 2007IR, 22). This is how banking institutions critical to the Industrial Revolution were developed in England (Cameron 1967). The obstacle in Brazil found by Summerhill (2007IR) is that sovereign debt credibility was combined with financial repression. There was a break in Brazil of the chain of effects from protecting public borrowing, as in North and Weingast (1989), to development of private financial institutions. According to Pelaez 1976, 283) following Cameron:

“The banking law of 1860 placed severe restrictions on two basic modern economic institutions—the corporation and the commercial bank. The growth of the volume of bank credit was one of the most significant factors of financial intermediation and economic growth in the major trading countries of the gold standard group. But Brazil placed strong restrictions on the development of banking and intermediation functions, preventing the channeling of coffee savings into domestic industry at an earlier date.”

Brazil actually abandoned the gold standard during multiple financial crises in the nineteenth century, as it should have to protect domestic economic activity. Pelaez (1975, 447) finds similar experience in the first half of nineteenth-century Brazil:

“Brazil’s experience is particularly interesting in that in the period 1808-1851 there were three types of monetary systems. Between 1808 and 1829, there was only one government-related Bank of Brazil, enjoying a perfect monopoly of banking services. No new banks were established in the 1830s after the liquidation of the Bank of Brazil in 1829. During the coffee boom in the late 1830s and 1840s, a system of banks of issue, patterned after similar institutions in the industrial countries [Cameron 1967], supplied the financial services required in the first stage of modernization of the export economy.”

Financial crises in the advanced economies were transmitted to nineteenth-century Brazil by the arrival of a ship (Pelaez and Suzigan 1981). The explanation of those crises and the economy of Brazil requires knowledge and roles of institutions, economic policies and the financial system chosen by Brazil, in agreement with Bordo (2012Sep27).

The departing theoretical framework of Bordo and Haubrich (2012DR) is the plucking model of Friedman (1964, 1988). Friedman (1988, 1) recalls “I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuation in money and income reflect primarily the influence of money on income or of income on money?” Friedman (1964, 1988) finds useful for this purpose to analyze the relation between expansions and contractions. Analyzing the business cycle in the United States between 1870 and 1961, Friedman (1964, 15) found that “a large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion.” The depth of the contraction opens up more room in the movement toward full employment (Friedman 1964, 17):

“Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities and prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction.”

Kim and Nelson (1999) test the asymmetric plucking model of Friedman (1964, 1988) relative to a symmetric model using reference cycles of the NBER and find evidence supporting the Friedman model. Bordo and Haubrich (2012DR) analyze 27 cycles beginning in 1872, using various measures of financial crises while considering different regulatory and monetary regimes. The revealing conclusion of Bordo and Haubrich (2012DR, 2) is that:

“Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength. For many configurations, the evidence for a robust bounce-back is stronger for cycles with financial crises than those without.”

The average rate of growth of real GDP in expansions after recessions with financial crises was 8 percent but only 6.9 percent on average for recessions without financial crises (Bordo 2012Sep27). Real GDP declined 12 percent in the Panic of 1907 and increased 13 percent in the recovery, consistent with the plucking model of Friedman (Bordo 2012Sep27). Bordo (2012Sep27) finds two probable explanations for the weak recovery during the current economic cycle: (1) collapse of United States housing; and (2) uncertainty originating in fiscal policy, regulation and structural changes. There are serious doubts if monetary policy is adequate to recover the economy under these conditions.

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

Table IB-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IQ1986, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.9 percent at the annual equivalent rate of 4.4 percent; RDPI per capita increased 11.9 percent at the annual equivalent rate of 3.5 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 14 quarters of the current cyclical expansion from IIIQ2009 to IVQ2012, GDP increased 7.5 percent at the annual equivalent rate of 2.1 percent. In the 13 quarters of cyclical expansion real disposable personal income (RDPI) increased 4.5 percent at the annual equivalent rate of 1.3 percent; RDPI per capita increased 4.5 percent at the annual equivalent rate of 1.3 percent; and population increased 2.5 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IVQ2012, GDP increased 2.4 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IVQ2012, real disposable personal income increased 5.1 percent at the annual equivalent rate of 0.9 percent; population increased 4.1 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 1.0 percent higher than the level before the recession. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

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

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1986	13
GDP		19.6	5.7
RDPI		14.9	4.4
RDPI Per Capita		11.9	3.5
Population		2.7	0.8
IIIQ2009 to IVQ2012	14
GDP		7.5	2.1
RDPI		7.1	2.0
RDPI per Capita		4.5	1.3
Population		2.5	0.7
IVQ2007 to IVQ2012	21
GDP		2.4	0.5
RDPI		5.1	0.9
RDPI per Capita		1.0	0.2
Population		4.1	0.8

RDPI: Real Disposable Personal Income

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

There are seven basic facts illustrating the current economic disaster of the United States: (1) GDP maintained trend growth in the entire business cycle from IQ1980 to IV1985 and IQ1986, including contractions and expansions, but is well below trend in the entire business cycle from IVQ2007 to IVQ2012, including contractions and expansions; (2) per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IVQ2012; (3) the number of employed persons increased in the 1980s but declined into IVQ2012; (4) the number of full-time employed persons increased in the 1980s but declined into IVQ2012; (5) the number unemployed, unemployment rate and number employed part-time for economic reasons fell in the recovery from the recessions of the 1980s but not substantially in the recovery after IIQ2009; (6) wealth of households and nonprofit organizations soared in the 1980s but declined into IVQ2012; and (7) gross private domestic investment increased sharply from IQ1980 to IVQ1985 but gross private domestic investment and private fixed investment have fallen sharply from IVQ2007 to IVQ2012. There is a critical issue of whether the United States economy will be able in the future to attain again the level of activity and prosperity of projected trend growth. Growth at trend during the entire business cycles built the largest economy in the world but there may be an adverse, permanent weakness in United States economic performance and prosperity. Table IB-2 provides data for analysis of these five basic facts. The six blocks of Table IB-2 are separated initially after individual discussion of each one followed by the full Table IB-2.

1. Trend Growth.

i. As shown in Table IB-2, actual GDP grew cumulatively 18.9 percent from IQ1980 to IQ1986, which is relatively close to what trend growth would have been at 20.3 percent. Rapid growth at 5.7 percent annual rate on average per quarter during the expansion from IQ1983 to IQ1986 erased the loss of GDP of 4.8 percent during the contraction and maintained trend growth at 3 percent over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IVQ2012 was 2.4 percent while trend growth would have been 16.8 percent. GDP in IVQ2012 at seasonally adjusted annual rate is estimated at $13,647.6 billion by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,564.8 billion, or $1,917.2 billion higher, had the economy grown at trend over the entire business cycle as it happened during the 1980s and throughout most of US history. There is $1.9 trillion of foregone GDP that would have been created as it occurred during past cyclical expansions, which explains why employment has not rebounded to even higher than before. There would not be recovery of full employment even with growth of 3 percent per year beginning immediately because the opportunity was lost to grow faster during the expansion from IIIQ2009 to IVQ2012 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 31.4 million people or 19.4 percent of the effective labor force (Section II, Table II-4 and earlier http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html) that will not be significantly diminished even with return to growth of GDP of 3 percent per year because of growth of the labor force by new entrants. The US labor force grew from 142.583 million in 2000 to 153.124 million in 2007 or by 7.4 percent at the average yearly rate of 1.0 percent per year. The civilian noninstitutional population increased from 212.577 million in 2000 to 231.867 million in 2007 or 9.1 percent at the average yearly rate of 1.3 percent per year (data from http://www.bls.gov/data/). Data for the past five years cloud accuracy because of the number of people discouraged from seeking employment. The noninstitutional population of the United States increased from 231.867 million in 2007 to 243.284 million in 2012 or by 4.9 percent while the labor force increased from 153.124 million in 2007 to 154.975 million in 2012 or by 1.2 percent and only by 0.3 percent to 153.617 million in 2011 while population increased 3.3 percent from 231.867 million in 2007 to 239.618 million in 2011 (data from http://www.bls.gov/data/). People ceased to seek jobs because they do not believe that there is a job available for them (Section II and earlier http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html). Structural change in demography occurs over relatively long periods and not suddenly as shown by Edward P. Lazear and James R. Spletzer (2012JHJul22).

Period IQ1980 to IQ1986
GDP SAAR USD Billions
IQ1980	5,903.4
IQ1986	7,016.8
∆% IQ1980 to IQ1986 (19.6 percent from IVQ1982 $5866.0 billion)	18.9
∆% Trend Growth IQ1980 to IQ1986	20.3

Period IVQ2007 to IVQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IVQ2012	13,647.6
∆% IVQ2007 to IVQ2012 Actual	2.4
∆% IVQ2007 to IVQ2012 Trend	16.8

2. Decline of Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IQ1986, as shown in Table IB-2 trend growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 15.7 percent, which is close to what would have been trend growth of 13.2 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IVQ2012, per capita real disposable income grew 1.0 percent while trend growth would have been 10.9 percent. Income available after inflation and taxes is about the same as before the contraction after 14 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions. In IVQ2012, real disposable income grew at seasonally adjusted annual rate (SAAR) of 6.8 percent and real personal income at 7.8 percent, which the BEA explains as: Personal income in November and December [2012] was boosted by accelerated and special dividend payments to persons and by accelerated bonus payments and other irregular pay in private wages and salaries in anticipation of changes in individual income tax rates. Personal income in December was also boosted by lump-sum social security benefit payments” (page 2 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi1212.pdf). Without these exceptional increases of realization of incomes in anticipation of higher taxes in Jan 2013, per capita disposable real income would likely not be higher in IVQ2012 relative to IVQ2007.

Period IQ1980 to IQ1986

Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IQ1986 Chained 2005 USD	21,902
∆% IQ1980 to IQ1986	15.7
∆% Trend Growth	13.2

Period IVQ2007 to IVQ2012

Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IVQ2012 Chained 2005 USD	33,173
∆% IVQ2007 to IVQ2012	1.0
∆% Trend Growth	10.9

3. Number of Employed Persons

i. As shown in Table IB-2, the number of employed persons increased over the entire business cycle from 98.527 million not seasonally adjusted (NSA) in IQ1980 to 107.819 million NSA in IVQ1985 or by 9.7 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 143.060 million in IVQ2012 or by 2.2 percent. There are 31.4 million persons unemployed or underemployed, which is 19.4 percent of the effective labor force (Section II, Table II-4 and earlier http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html).

Period IQ1980 to IVQ1985

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IVQ1985 NSA End of Quarter	108.063
∆% Employed IQ1980 to IVQ1985	9.7

Period IVQ2007 to IVQ2012

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IVQ2012 NSA End of Quarter	143.060
∆% Employed IVQ2007 to IVQ2012	-2.2

4. Number of Full-Time Employed Persons

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

ii. In contrast, during the entire current business cycle, including contraction and expansion, the number of persons employed full-time fell from 121.042 million in IVQ2007 to 115.079 million in IVQ2012 or by minus 4.9 percent.

Period IQ1980 to IVQ1985

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

Period IVQ2007 to IVQ2012

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IVQ2012 NSA End of Quarter	115.079
∆% Full-time Employed IVQ2007 to IVQ2012	-4.9

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

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

ii. In contrast, in the economic cycle from IVQ2007 to IVQ2012: (a) the rate of unemployment increased from 4.8 percent in IVQ2007 to 7.6 percent in IVQ2012; (b) the number unemployed increased 60.7 percent from 7.371 million in IVQ2007 to 11.844 million in IVQ2012; (c) the number employed part-time for economic reasons increased 71.9 percent from 4.750 million in IVQ2007 to 8.166 million in IVQ2012; and (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 14.4 percent in IVQ2012.

Period IQ1980 to IVQ1985

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

Period IVQ2007 to IVQ2012

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IVQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IVQ2012 Millions End of Quarter	11.844
∆%	60.7
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IVQ2012 End of Quarter	8.166
∆%	71.9
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IVQ2012	14.4

6. Wealth of Households and Nonprofit Organizations.

i. The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIIQ2012 is provided in the following block and in Table IB-2. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980.

ii. In contrast, as shown in Table IB-2, net worth of households and nonprofit organizations fell from $66,000.6 billion in IVQ2007 to $64,768.8 billion in IIIQ2012 by $1,231.8 billion or 1.9 percent. The US consumer price index was 210.036 in Dec 2007 and 231.407 in Sep 2012 for increase of 10.2 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 10.9 percent in Sep 2012 after 13 consecutive quarters of expansion from IIIQ2009 to IIIQ2012 relative to IVQ2007 when the recession began. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IIQ2012 has been 2.2 percent, which is substantially lower than the average of 6.2 percent in cyclical expansions after World War II and 5.7 percent in the expansion from IQ1983 to IVQ1985 (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states.html). The US missed the opportunity of high growth rates that has been available in past cyclical expansions. US wealth of households and nonprofit organizations grew from IVQ1945 at $710,125.9 million to IIIQ2009 at $64,768,835.3 million or increase of 9,020.8 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 231.407 in Sep 2012 or 1,171.5 percent. There was a gigantic increase of US net worth of households and nonprofit organizations over 67 years with inflation adjusted increase of 617.3 percent. The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of US household and nonprofit net worth. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 67 years when US GDP grew at 2.2 percent on average in 13 quarters between IIIQ2009 and IIIQ2012 in contrast with average 5.7 percent from IQ1983 to IVQ1985 and average 6.2 percent during cyclical expansions in those 67 years.

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Period IVQ2007 to IIIQ2012
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,000.6
IIIQ2012	64,768.8
∆ USD Billions	-1,231.8

7. Gross Private Domestic Investment.

i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IVQ1985 and from IVQ2007 to IVQ2012 is provided in the following block and in Table IB-2. Gross private domestic investment increased from $778.3 billion in IQ1980 to $965.9 billion in IVQ1985 or by 24.1 percent.

ii In the current cycle, gross private domestic investment decreased from $2,123.6 billion in IVQ2007 to $1,925.8 billion in IVQ2012, or decline by 9.3 percent. Private fixed investment fell from $2,111.5 billion in IVQ2007 to $1888.0 billion in IVQ2012, or decline by 10.6 percent.

Period IQ1980 to IVQ1985
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IVQ1985	965.9
∆%	24.1
Period IVQ2007 to IVQ2012
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IVQ2012	1,925.8
∆%	-9.3
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IVQ2012	1,888.0
∆%	-10.6

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


Period IQ1980 to IQ1986
GDP SAAR USD Billions
IQ1980	5,903.4
IQ1986	7,016.8
∆% IQ1980 to IQ1986 (19.6 percent from IVQ1982 $5866.0 billion)	18.9
∆% Trend Growth IQ1980 to IQ1986	20.3
Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IQ1986 Chained 2005 USD	21,902
∆% IQ1980 to IQ1986	15.7
∆% Trend Growth	13.2
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IV1985 NSA End of Quarter	108.063
∆% Employed IQ1980 to IVQ1985	9.7
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IVQ1985 NSA End of Quarter	88.757
∆% Full-time Employed IQ1980 to IVQ1985	9.2
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate IVQ1985 NSA End of Quarter	6.7
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IVQ1985 Millions NSA End of Quarter	7.717
∆%	10.5
Employed Part-time Economic Reasons IQ1980 Millions NSA End of Quarter	3.624
Employed Part-time Economic Reasons Millions IVQ1985 NSA End of Quarter	5.402
∆%	49.1
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IVQ1985	965.9
∆%	24.1
Period IVQ2007 to IVQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IVQ2012	13,647.6
∆% IVQ2007 to IVQ2012	2.4
∆% IVQ2007 to IVQ2012 Trend Growth	16.8
Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IVQ2012 Chained 2005 USD	33,173
∆% IVQ2007 to IVQ2012	1.0
∆% Trend Growth	10.9
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IVQ2012 NSA End of Quarter	143.060
∆% Employed IVQ2007 to IVQ2012	-2.2
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IVQ2012 NSA End of Quarter	115.079
∆% Full-time Employed IVQ2007 to IVQ2012	-4.9
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IVQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IVQ2012 Millions NSA End of Quarter	11.742
∆%	59.3
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IVQ2012 NSA End of Quarter	8.166
∆%	71.9
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IVQ2012	14.4
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,000.6
IVQ2012	64,768.8
∆ USD Billions	-1,231.8
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IVQ2012	1,925.8
∆%	-9.3
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IVQ2012	1,888.0
∆%	-10.6

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

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

The Congressional Budget Office (CBO 2013BEOFeb5) estimates potential GDP, potential labor force and potential labor productivity provided in Table IB-3. The average rate of growth of potential GDP from 1950 to 2012 is estimated at 3.3 percent per year. The projected path is significantly lower at 2.2 percent per year from 2012 to 2023. The legacy of the economic cycle with expansion from IIIQ2009 to IVQ2012 at 2.1 percent on average in contrast with 6.2 percent in prior expansions of the economic cycle in the postwar (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) may perpetuate unemployment and underemployment estimated at 31.4 million or 19.4 percent of the effective labor force in Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table IB-3, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.3	2.5	0.8
1982-1990	3.1	1.6	1.5
1991-2001	3.1	1.3	1.8
2002-2012	2.2	0.8	1.4
Total 1950-2012	3.3	1.5	1.7
Projected Average Annual ∆%
2013-2018	2.2	0.6	1.6
2019-2023	2.3	0.5	1.8
2012-2023	2.2	0.5	1.7

*Ratio of potential GDP to potential labor force

Source: CBO (2013BEOFeb5).

Chart IB-1 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.1 percent on average from IIIQ2009 to IVQ2012 during the current economic expansion in contrast with 6.2 percent on average in postwar cyclical expansions (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) cannot be explained by the contraction of 4.7 of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 31.4 million or 19.4 percent of the labor as estimated for Jan 2013 (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html) and the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Chart IB-1, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5

II United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html). Data for 2012 have been revised. The US trade balance improved from deficit of $51,734 million in Mar 2012 to deficit of $49,734 million in Apr 2012 and lower deficits of $47,017 million in May, $40,933 million in Jun and $41,717 million in Jul 2012 but with increase to 42,688 million in Aug 2012. The trade deficits of Mar and Apr 2012 both end in 734. The increase of exports in Sep of 3.1 percent was higher than increase of imports of 1.5 percent, resulting in decrease of the trade deficit in Sep to $40,364 million. Exports decreased 3.5 percent in Oct 2012 and imports decreased 2.1 percent for increase in the trade deficit to $42,151 million in Oct 2012. The increase of exports by 1.0 percent in Nov 2012 was much lower than the increase in imports of 3.7 percent, resulting in sharply increasing deficit of $48,613 million. Export growth of 2.1 with decline of imports by 2.7 resulted in lower trade deficit of $38,539 million in Dec 2012. The deterioration of the trade deficit from $44,507 million in Feb 2012 to $51,647 million in Mar 2012 resulted from growth of exports of 2.5 percent while imports jumped 5.2 percent. The US trade balance had improved from deficit of $52,296 million in Jan 2012 to lower deficit of $44,594 million in Feb 2012 mostly because of decline of imports by 2.7 percent while exports increased 0.9 percent. The US trade balance deteriorated sharply from Nov 2011 to Jan 2012 with growth of imports by cumulative 2.9 percent and cumulative change of exports of 0.0 percent, resulting in deficits of $48,835 million in Nov 2011, $51,748 million in Dec 2011 and $52,296 million in Jan 2012, which are the highest since $50,234 million in Jun 2011. In the months of Jun to Oct 2011, exports increased 1.8 percent while imports increased 0.5 percent, resulting in improvement of the trade deficit from $50,234 million in Jun to $45,703 million in Oct. The trade balance deteriorated from cumulative deficit of $494,737 million in Jan-Dec 2010 to deficit of $559,880 million in Jan-Dec 2011.

Table IIA-1, US, Trade Balance of Goods and Services Seasonally Adjusted Millions of Dollars and ∆%

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Dec 2012	-38,539	186,372	2.1	224,911	-2.7
Nov	-48,613	182,491	1.0	231,104	3.7
Oct	-42,151	180,614	-3.5	222,766	-2.1
Sep	-40,364	187,132	3.1	227,496	1.5
Aug	-42,688	181,499	-1.0	224,167	-0.4
Jul	-41,717	183,303	-1.2	225,020	-0.6
Jun	-40,933	185,533	1.3	226,466	-1.6
May	-47,017	183,095	0.4	230,112	-0.9
Apr	-49,734	182,454	-1.2	232,188	-1.8
Mar	-51,734	184,672	2.5	236,406	5.2
Feb	-44,594	180,153	0.9	224,747	-2.7
Jan	-52,296	178,607	0.5	230,903	0.6
Dec 2011	-51,748	177,751	0.6	229,499	1.8
Nov	-48,835	176,710	-1.1	225,545	0.5
Oct	-45,703	178,742	-1.0	224,445	-0.3
Sep	-44,467	180,629	1.3	225,096	0.9
Aug	-44,775	178,382	0.0	223,157	-0.3
Jul	-45,580	178,339	3.3	223,919	0.4
Jun	-50,234	172,664	-1.7	222,988	-0.2
May	-47,669	175,673	0.0	223,343	1.9
Apr	-43,556	175,662	0.9	219,218	0.1
Mar	-44,902	174,169	4.6	219,071	3.7
Feb	-44,801	166,545	-0.9	211,346	-2.0
Jan	-47,523	168,098	1.6	215,621	4.6
Dec 2010	-40,677	165,499	2.0	206,176	2.5
Jan-Dec 2011	-559,880	2,103,367		2,663,247
Jan-Dec 2010	-494,737	1,842,485		2,337,222

Note: Trade Balance of Goods and Services = Exports of Goods and Services less Imports of Goods and Services. Trade balance may not add exactly because of errors of rounding and seasonality. Source: US Census Bureau http://www.census.gov/foreign-trade/

Table IIA-2 provides the US international trade balance, exports and imports on an annual basis from 1992 to 2012. The trade balance deteriorated sharply over the long term. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US increased from $128.2 billion in IIIQ2011, or 3.4 percent of GDP to $128.3 billion in IIIQ2012, or 3.3 percent of GDP (http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The last row of Table IIA-2 shows improvement of the trade deficit from $559,880 million in 2011 to lower $540,362 million in 2012 with exports growing 4.4 percent and imports 2.7 percent. Growth and commodity shocks under alternating inflation waves (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html) have deteriorated the trade deficit from the low of $379,154 million in 2009.

Table IIA-2, US, International Trade Balance, Exports and Imports SA, Millions of Dollars

	Balance	Exports	Imports
1960	3,508	25,940	22,432
1961	4,195	26,403	22,208
1962	3,370	27,722	24,352
1963	4,210	29,620	25,410
1964	6,022	33,341	27,319
1965	4,664	35,285	30,621
1966	2,939	38,926	35,987
1967	2,604	41,333	38,729
1968	250	45,543	45,293
1969	91	49,220	49,129
1970	2,254	56,640	54,386
1971	-1,302	59,677	60,979
1972	-5,443	67,222	72,665
1973	1,900	91,242	89,342
1974	-4,293	120,897	125,190
1975	12,404	132,585	120,181
1976	-6,082	142,716	148,798
1977	-27,246	152,301	179,547
1978	-29,763	178,428	208,191
1979	-24,565	224,131	248,696
1980	-19,407	271,834	291,241
1981	-16,172	294,398	310,570
1982	-24,156	275,236	299,391
1983	-57,767	266,106	323,874
1984	-109,072	291,094	400,166
1985	-121,880	289,070	410,950
1986	-138,538	310,033	448,572
1987	-151,684	348,869	500,552
1988	-114,566	431,149	545,715
1989	-93,141	487,003	580,144
1990	-80,864	535,233	616,097
1991	-31,135	578,344	609,479
1992	-39,212	616,882	656,094
1993	-70,311	642,863	713,174
1994	-98,493	703,254	801,747
1995	-96,384	794,387	890,771
1996	-104,065	851,602	955,667
1997	-108,273	934,453	1,042,726
1998	-166,140	933,174	1,099,314
1999	-263,160	967,008	1,230,168
2000	-376,749	1,072,783	1,449,532
2001	-361,771	1,007,726	1,369,496
2002	-417,432	980,879	1,398,311
2003	-490,984	1,023,519	1,514,503
2004	-605,357	1,163,146	1,768,502
2005	-708,624	1,287,441	1,996,065
2006	-753,288	1,459,823	2,213,111
2007	-696,728	1,654,561	2,351,289
2008	-698,338	1,842,682	2,541,020
2009	-379,154	1,578,945	1,958,099
2010	-494,737	1,842,485	2,337,222
2011	-559,880	2,103,367	2,663,247
2012	-540,362	2,195,925	2,736,286

Source: US Census Bureau http://www.census.gov/foreign-trade/

Chart IIA-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. There was slight improvement at the margin from Jul to Oct 2011 but new increase in the gap from Nov 2011 to Jan 2012 and again in Mar 2012 as exports grow less rapidly than imports. There is improvement in Apr 2012 with imports declining at a faster rate of 1.8 percent than decline of exports by 1.2 percent and growth of exports of 0.4 percent in May 2012 with imports declining 0.9 percent. Further improvement occurred in Jun with imports increasing 1.3 percent and exports declining 1.6 percent. There was deterioration in Jul with exports declining 1.2 percent and imports only 0.6 percent but deterioration in Aug with exports decreasing 1.0 percent while imports declined only 0.4 percent. In Sep 2012, exports increased 3.1 percent while imports increased only 1.5 percent. Further deterioration occurred in Oct with exports declining 3.5 percent but imports falling 2.1 percent. The trade deficit widened sharply to $48,613 million in Nov 2012 with growth of imports by 3.7 percent while exports increased 1.0 percent. In Dec 2012, the trade deficit narrowed to $38,539 million with growth of exports of 2.1 percent while imports fell 2.7 percent. Weaker world and internal demand and fluctuating commodity price increases explain the declining or less dynamic changes in exports and imports in Chart IIA-1.

Chart IIA-1, US, International Trade Balance, Exports and Imports of Goods and Services $ Billions

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr042.html

Chart IIA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Dec 2012. There is a long-term trend of deterioration of the US trade deficit shown vividly by Chart IIA-2. The trend of deterioration was reversed by the global recession from IVQ2007 to IIQ2009. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4 http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Dec 2012

Source: US Census Bureau

http://www.census.gov/foreign-trade/

Chart IIA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Dec 2012. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Dec 2012

Source: US Census Bureau

http://www.census.gov/foreign-trade/

Chart IIA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Dec 2012. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion.

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Dec 2012

Source: US Census Bureau

http://www.census.gov/foreign-trade/

The balance of international trade in goods of the US seasonally-adjusted is shown in Table IIA-3. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The balance in international trade of goods improved from $65.4 billion in Dec 2011 to $56.2 billion in Dec 2012. The improvement of the goods balance in Dec 2012 relative to Dec 2011 occurred mostly in the petroleum balance, exports less imports of petroleum, in the magnitude of decreasing the deficit by $8796 million, while there was no change in the nonpetroleum balance, exports less imports of nonpetroleum goods, in the magnitude of increasing the deficit by $51 million. US terms of trade, export prices relative to import prices, and the US trade account fluctuate in accordance with the carry trade from zero interest rates to commodity futures exposures, especially oil futures. Exports increased 3.7 percent with nonpetroleum exports increasing 3.2 percent. Total imports decreased 2.3 percent with petroleum imports declining 20.9 percent and nonpetroleum imports increasing 2.5 percent.

Table IIA-3, US, International Trade in Goods Balance, Exports and Imports $ Millions and ∆% SA

	Dec 2012	Dec 2011	∆%
Total Balance	-56,201	-65,436
Petroleum	-18,698	-27,494
Non Petroleum	-36,852	-36,801
Total Exports	132,563	127,862	3.7
Petroleum	11,625	10,826	7.4
Non Petroleum	119,679	115,953	3.2
Total Imports	188,765	193,297	-2.3
Petroleum	30,324	38,320	-20.9
Non Petroleum	156,531	152,753	2.5

Details may not add because of rounding and seasonal adjustment

Source: US Census Bureau http://www.census.gov/foreign-trade/

US exports and imports of goods not seasonally adjusted in Jan-Dec 2012 and Jan-Dec 2011 are shown in Table IIA-4. The rate of growth of exports was 4.5 percent and 3.0 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that increased 3.6 percent and of mineral fuels that increased 6.0 percent both because higher prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose 4.9 percent while imports rose 5.8 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 6.5 percent and crude oil decreasing 6.2 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table IIA-4, US, Exports and Imports of Goods, Not Seasonally Adjusted Millions of Dollars and %

	Jan-Dec 2012 $ Millions	Jan-Dec 2011 $ Millions	∆%
Exports	1,547,137	1,480,432	4.5
Manufactured	1,019,767	971,671	4.9
Agricultural Commodities	141,324	136,351	3.6
Mineral Fuels	136,287	128,564	6.0
Crude Oil	2,184	1,463	49.3
Imports	2,275,043	2,207,824	3.0
Manufactured	1,704,216	1,611,456	5.8
Agricultural Commodities	103,193	99,124	4.1
Mineral Fuels	424,505	453,872	-6.5
Crude Oil	315,663	336,687	-6.2

Source: US Census Bureau http://www.census.gov/foreign-trade/

The current account of the US balance of payments is provided in Table IIA-5 for IIIQ2011 and IIIQ2012. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US increased from $128.2 billion in IIIQ2011, or 3.4 percent of GDP, to $128.3 billion in IIIQ2012, or 3.3 percent of GDP. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table IIA-5, US Balance of Payments, Millions of Dollars NSA

	IIIQ2011	IIIQ2012	Difference
Goods Balance	-202,153	-196,249	5,904
X Goods	378,454	382,877	1.2 ∆%
M Goods	-580,607	-579,126	-0.3 ∆%
Services Balance	48,571	52,218	3,647
X Services	161,319	165,492	2.6 ∆%
M Services	-112,747	-113,273	0.5 ∆%
Balance Goods and Services	-153,581	-144,031	9,550
Balance Income	57,934	50,271	-7,663
Unilateral Transfers	-32,525	-34,510	-1,985
Current Account Balance	-128,172	-128,270	-98
% GDP	IIIQ2011	IVQ2011	IIIQ2012
	3.4	3.1	3.3

X: exports; M: imports

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

Source: Bureau of Economic Analysis

http://www.census.gov/foreign-trade/

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

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

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

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

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

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

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below potential. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. Table IIA-6 provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.2 percent of GDP while the Congressional Budget Office (CBO 2012NovCDR) estimates the federal deficit in 2012 at $1089 billion or 7.7 percent of GDP (http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html). The combined record federal deficits of the US from 2009 to 2012 are $5092 billion or 33 percent of the estimate of GDP of $15,538 billion for fiscal year 2012 by the CBO (http://www.cbo.gov/publication/43542 2012AugBEO). The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5092 trillion in four years, using the fiscal year deficit of $1089.4 billion for fiscal year 2012 (http://www.fms.treas.gov/mts/mts0912.txt), which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5092 billion. Federal debt in 2011 was 67.7 percent of GDP and is estimated to reach 72.5 percent of GDP in 2012 (CBO2012AugBEO, CBO2012NovCDR, CBO2013BEOFeb5). This situation may worsen in the future (CBO 2012LTBO):

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

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

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

Table IIA-6, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2000	2007	2008	2009	2010	2011
Goods & Services	-377	-697	-698	-379	-495	-559
Income	19	101	147	119	184	227
UT	-58	-115	-126	-122	-131	-133
Current Account	-416	-710	-677	-382	-442	-466
NGDP	9951	14028	14291	13974	14499	15076
Current Account % GDP	-3.8	-5.1	-4.7	-2.7	-3.1	-3.1
NIIP	-1337	-1796	-3260	-2321	-2474	-4030
US Owned Assets Abroad	6239	18399	19464	18512	20298	21132
Foreign Owned Assets in US	7576	20195	22724	20833	22772	25162
NIIP % GDP	-13.4	-12.8	-22.8	-16.6	-17.1	26.7
Exports Goods Services Income	1425	2488	2657	2181	2519	2848
NIIP % Exports Goods Services Income	-94	-72	-123	-106	-98	-142
DIA MV	2694	5274	3102	4287	4767	4450
DIUS MV	2783	3551	2486	2995	3397	3509
Fiscal Balance	+236	-161	-459	-1413	-1294	-1297
Fiscal Balance % GDP	+2.4	-1.2	-3.2	-10.1	-9.0	-8.7
Federal Debt	3410	5035	5803	7545	9019	10128
Federal Debt % GDP	34.7	36.3	40.5	54.1	62.8	67.7
Federal Outlays	1789	2729	2983	3518	3456	3603
∆%	5.1	2.8	9.3	17.9	-1.8	4.3
% GDP	18.2	19.7	20.8	25.2	24.1	24.1
Federal Revenue	2052	2568	2524	2105	2162	2302
∆%	10.8	6.7	-1.7	-16.6	2.7	6.5
% GDP	20.6	18.5	17.6	15.1	15.1	15.4

Sources:

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

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

Chart IIA-5 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2011. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and elimination of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.

Chart IIA-5, US, Balance on Current Account, 1960-2011, Millions of Dollars

Source: Bureau of Economic Analysis

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

Chart IIA-6 provides the quarterly balance of payments of the United States in millions of dollars from 1995 to IIIQ2012. The global recession appeared to be adjusting the current account deficit that rises to lower dollar values. Recovery of the economy worsened again the current account deficit. Growth at trend worsens the external imbalance of the US that combines now with unsustainable Treasury deficits/debt.

Chart IIA-6, US, Balance on Current Account, Quarterly 1995-2012, Millions of Dollars, SA

Source: Bureau of Economic Analysis

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

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) slowing growth in China with political development and slowing growth in Japan and world trade; (3) slow growth propelled by savings/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 Feb 1 and daily values throughout the week ending on Feb 8 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 Feb 1 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Feb 1, 2012”, first row “USD/EUR 1.3642 -1.4%,” provides the information that the US dollar (USD) depreciated 1.4 percent to USD 1.3642/EUR in the week ending on Fri Feb 1 relative to the exchange rate on Fri Jan 25. 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 1.3642/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Feb 1, appreciating to USD 1.3514/EUR on Mon Feb 4, 2013, or by 0.9 percent. The dollar appreciated because fewer dollars, $1.3514, were required on Mon Feb 4 to buy one euro than $1.3642 on Feb 1. 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 1.3642/EUR on Feb 1; 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 Feb 1, to the last business day of the current week, in this case Fri Feb 8, such as appreciation by 2.0 percent to USD 1.3365/EUR by Feb 8; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 2.0 percent from the rate of USD 1.3642/EUR on Fri Feb 1 to the rate of USD 1.3365/EUR on Fri Feb 8 {[(1.3365/1.3642) – 1]100 = -2.0%} and appreciated (denoted by positive sign) by 0.2 percent from the rate of USD 1.3397 on Thu Feb 7 to USD 1.3365/EUR on Fri Feb 8 {[(1.3365/1.3397) -1]100 = -0.2%}. 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 Feb 4 to Feb 8, 2013

Fri Feb 1, 2013

M 4

Tue 5

W 6

Thu 7

Fr 8

USD/EUR

1.3642

-1.4%

1.3514

0.9%

1.3582

0.4%

-0.5%

1.3523

0.8%

0.4%

1.3397

1.8%

0.9%

1.3365

2.0%

0.2%

JPY/ USD

92.84

-2.2%

92.38

0.5%

93.65

-0.9

-1.4%

93.64

-0.9%

0.0%

93.63

-0.9%

0.0%

92.69

0.1%

1.0%

CHF/ USD

0.9080

2.0%

0.9084

0.0%

0.9083

0.0%

0.9102

-0.2%

0.9183

-1.1%

-0.9%

0.9174

1.0%

0.1%

CHF/ EUR

1.2389

0.6%

1.2272

0.9%

1.2335

0.4%

-0.5%

1.2305

0.7%

0.2%

1.2367

0.2%

-0.5%

1.2265

1.0%

0.8%

USD/ AUD

1.0407

0.9609

-0.2%

1.0438

0.9580

0.3%

1.0389

0.9626

-0.2%

1.0321

0.9689

-0.8%

-0.7%

1.0283

0.9725

-1.2%

-0.4%

1.0318

0.9692

-0.9%

0.3%

10 Year T Note

2.024

1.957

1.998

1.964

1.957

1.949

2 Year T Note

0.26

0.248

0.26

0.252

German Bond

2Y 0.25 10Y 1.67

2Y 0.20 10Y 1.61

2Y 0.23 10Y 1.65

2Y 0.21 10Y 1.63

2Y 0.18 10Y 1.63

2Y 0.18 10Y 1.61

DJIA

14009.79

0.8%

13880.08

-0.9%

13979.30

-0.2%

0.7%

13986.52

-0.2%

0.1%

13944.05

-0.5%

-0.3%

13992.97

-0.1%

0.4%

DJ Global

2127.53

0.6%

2102.84

-1.2%

2097.27

-1.4%

-0.3%

2113.51

-0.7%

0.8%

2104.37

-1.1%

-0.4%

2111.51

-0.8%

0.3%

DJ Asia Pacific

1351.65

0.8%

1360.27

0.6%

1339.65

-0.9%

-1.5%

1355.42

0.3%

1.2%

1355.10

0.3%

0.0%

1353.66

0.1%

-0.1%

Nikkei

11191.34

2.4%

11260.36

0.6%

11046.92

-1.3%

-1.9%

11463.75

2.4%

3.8%

11357.07

1.5%

-0.9%

11153.16

-0.3%

-1.8%

Shanghai

2419.02

5.6%

2428.15

0.4%

2433.13

0.6%

0.2%

2434.48

0.6%

0.1%

2418.53

0.0%

-0.7%

2432.40

0.6%

DAX

7833.39

-0.3%

7638.23

-2.5%

7664.66

-2.2%

0.3%

7581.18

-3.2%

-1.1%

7590.85

-3.1%

0.1%

7652.14

-2.3

0.8%

DJ UBS

Comm.

142.89

1.6%

142.43

-0.3%

142.86

0.0%

0.3%

142.42

-0.3%

141.18

-1.2%

-0.9%

141.21

-1.2%

0.0%

WTI $ B

97.58

1.8%

96.17

-1.4%

96.65

-0.9%

-0.5%

96.62

-1.0%

0.0%

95.77

-1.9%

-0.9%

95.72

1.9%

-0.1%

Brent $/B

116.53

2.9%

115.58

-0.8%

116.51

0.0%

0.8%

116.90

0.3%

117.27

0.6%

0.3%

118.89

2.0%

1.4%

Gold $/OZ

1668.2

0.7%

1674.6

0.4%

1673.3

0.3%

-0.1%

1678.8

0.6%

0.3%

1672.2

0.2%

-0.4%

1666.9

-0.1%

-0.3%

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

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

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

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

Discussion of current and recent risk-determining events is followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate. 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). The DJIA closed at 13992.97 on Fri Feb 8. The DJIA closed at 14009.79 on Fri Feb 1, which is the first valuation above 14,000 since Oct 2007 when the DJIA reached historical highs. The DJIA closed at 14009.79 only 1.1 percent from the value of 14,157.38 reached on Oct 15, 2007.

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.

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 5.363 percent on Feb 8, 2012 and that of the ten-year sovereign bond of Italy at 4.504 percent. (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 Feb 8, 2013, the yield of the two-year Treasury decreased to 0.252 percent and that of the ten-year Treasury decreased to 1.949 percent while the two-year bond of Germany fell to 0.18 percent and the ten-year decreased to 1.61; and the dollar appreciated to USD 1.3365/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
2/8/13	0.252	1.949	0.18	1.61	1.3365
2/1/13	0.26	2.024	0.25	1.67	1.3642
1/25/13	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.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

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

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields. The beginning yields in Chart III-1A for July 31, 2001, 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 Feb 7, 2013, with the one-month yield at 0.03 percent, the two-year at 0.25 percent and the ten-year at 1.99 percent.

Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields Jul 31, 2001-Feb 7, 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:

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

declines.

There was weakening performance in equity indexes in Table III-1 in the week ending on Feb 8, 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 1.1 percent on Feb 1, increasing 0.8 percent in the week. Germany’s Dax increased 0.4 percent on Fri Feb 8 and decreased 0.1 percent in the week. Dow Global increased 0.3 percent on Feb 8 and decreased 0.8 percent in the week. Japan’s Nikkei Average decreased 1.8 percent on Fri Jan Feb 8 and decreased 0.3 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 decreased 0.1 percent on Feb 8 and increased 0.1 percent in the week while Shanghai Composite increased 0.6 percent on Feb 8 and increased 0.6 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 2432.40 on Fri Feb 8. 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 Feb 8, 2013. The DJ UBS Commodities Index changed 0.0 percent on Fri Feb 8 and decreased 1.2 percent in the week, as shown in Table III-1. WTI increased 1.9 percent in the week of Feb 8 while Brent increased 2.0 percent in the week. Gold decreased 0.3 percent on Fri Feb 8 and decreased 0.1 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €1,015,482 million on Feb 1, 2013. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,591,449 million in the statement of Feb 1, 2013. There is high credit risk in these transactions with capital of only €85,610 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Feb 1, 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	255,050
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	28,703
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	22,045
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,015,482
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	127,288
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	575,967
8 General Government Debt Denominated in Euro	34,954	33,928	29,912
9 Other Assets	278,719	336,574	276,561
TOTAL ASSETS	2,004, 432	2,733,235	2,769,695
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,591,449
Capital and Reserves	78,143	85,748	85,581

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/fs130205.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 % Share	∆% Jan-Nov 2012/ Jan-Nov 2011	Imports % Share	Imports ∆% Jan-Nov 2012/ Jan-Nov 2011
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 Share %	Exports ∆% Jan-Nov 2012/ Jan-Nov 2011	Imports Share %	Imports ∆% Jan-Nov 2012/ Jan-Nov 2011
Consumer Goods	28.9	5.4	25.0	-3.0
Durable	5.9	3.2	3.0	-6.7
Non Durable	23.0	6.0	22.0	-2.5
Capital Goods	32.3	2.3	21.1	-12.9
Inter- mediate Goods	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 USD Billions	Primary Net Lending Borrowing % GDP 2012	General Government Net Debt % GDP 2012
World	71,277
Euro Zone	12,065	-0.5	73.4
Portugal	211	-0.7	110.9
Ireland	205	-4.4	103.0
Greece	255	-1.7	170.7
Spain	1,340	-4.5	78.6
Major Advanced Economies G7	33,769	-5.1	89.0
United States	15,653	-6.5	83.8
UK	2,434	-5.6	83.7
Germany	3,367	1.4	58.4
France	2,580	-2.2	83.7
Japan	5,984	-9.1	135.4
Canada	1,770	-3.2	35.8
Italy	1,980	2.6	103.1
China	8,250	-1.3*	22.2**

*Net Lending/borrowing**Gross Debt

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

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2012 is $4155.8 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3975.1 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8130.8 billion, which would be equivalent to 136.7 percent of their combined GDP in 2012. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 241.5 percent if including debt of France and 177.4 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

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

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,855.7
B Germany	1,996.3		$8130.9 as % of $3367 =241.5% $5971.4 as % of $3367 =177.4%
C France	2,159.5
B+C	4,155.8	GDP $5,947.0 Total Debt $8130.9 Debt/GDP: 136.7%
D Italy	2,041.4
E Spain	1,053.2
F Portugal	234.0
G Greece	435.3
H Ireland	211.2
Subtotal D+E+F+G+H	3,975.1

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

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Dec 2012. German exports to other European Union (EU) members are 55.9 percent of total exports in Dec 2012 and 57.1 percent in Jan-Dec 2012. Exports to the euro area are 37.1 percent in Dec and 37.5 percent in Jan-Dec. Exports to third countries are 44.1 percent of the total in Dec and 43.0 percent in Jan-Dec. There is similar distribution for imports. Exports to non-euro countries are decreasing 4.5 percent in Dec 2012 and increasing 3.3 percent in Jan-Dec 2012 while exports to the euro area are decreasing 7.3 percent in Dec and decreasing 2.1 percent in Jan-Dec 2012. Exports to third countries, accounting for 44.1 percent of the total in Dec 2012, are decreasing 7.5 percent in Dec and increasing 8.8 percent in Jan-Dec, accounting for 43.0 percent of the cumulative total in Jan-Dec 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 ∆%

	Dec 2012 € Billions	Dec 12-Month ∆%	Jan–Dec 2012 € Billions	Jan-Dec 2012/ Jan-Dec 2011 ∆%
Total Exports	79.0	-6.9	1,097.4	3.4
A. EU Members	44.2 % 55.9	-6.4	625.7 % 57.0	-0.3
Euro Area	29.3 % 37.1	-7.3	411.9 % 37.5	-2.1
Non-euro Area	14.9 % 18.9	-4.5	213.8 % 19.5	3.3
B. Third Countries	34.8 % 44.1	-7.5	471.7 % 43.0	8.8
Total Imports	67.0	-7.3	909.2	0.7
C. EU Members	42.6 % 63.6	-7.1	577.1 % 63.5	0.9
Euro Area	29.9 % 44.6	-6.8	402.4 % 44.3	0.7
Non-euro Area	12.8 % 19.1	-7.9	172.9 % 19.0	1.4
D. Third Countries	24.4 % 36.4	-7.6	332.1 % 36.5	0.4

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

Source: Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2013/02/PE13_050_51.html

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.

Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	1.5	1.7	1.3	7.9
Japan	0.5	-0.1	-0.6	4.2
China	7.9	2.5	-1.9
UK	0.0	2.7* RPI 3.1	2.2* output 1.5** input 0.3*	7.7
Euro Zone	-0.6	2.2	2.1	11.7
Germany	0.9	2.0	1.5	5.3
France	0.0	1.5	1.7	10.6
Nether-lands	-1.4	3.4	4.2	5.8
Finland	-1.1	3.5	3.0	7.7
Belgium	-0.3	2.1	6.4	7.5
Portugal	-3.4	2.1	3.6	16.5
Ireland	-0.5	1.6	2.2	14.7
Italy	-2.4	2.6	2.0	11.2
Greece	-7.2	0.3	2.1	NA
Spain	-1.6	3.0	2.7	26.1

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/december-2012/index.html **Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/december-2012/index.html

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/; country statistical sources http://www.census.gov/aboutus/stat_int.html

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.5 percent in IVQ2012 relative to IVQ2011 (Table 8 in http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp4q12_adv.pdf See II Mediocre and Decelerating United States Economic Growth at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). Japan’s GDP fell 0.2 percent in IVQ2011 relative to IVQ2010 and contracted 1.6 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 10.4 percent in IIIQ2011, increasing at the SAAR of 0.3 percent in IVQ 2011, increasing at the SAAR of 5.7 percent in IQ2012 and decreasing at 0.1 percent in IIQ2012 but contracting at the SAAR of 3.5 percent in IIIQ2012 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal_18.html ); the UK grew at minus 0.3 percent in IVQ2012 relative to IIIQ2012 and GDP changed 0.0 percent in IVQ2012 relative to IVQ2011 (see Section VH and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/united-states-commercial-banks-assets.html); and the Euro Zone grew at minus 0.1 percent in IIIQ2012, IIIQ2011 (see Section VD at http://cmpassocregulationblog.blogspot.com/2012/12/twenty-eight-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal_18.html ). These are stagnating or “growth recession” rates, which are positive or about nil growth rates with some contractions that are insufficient to recover employment. The rates of unemployment are quite high: 7.7 percent in the US but 19.4 percent for unemployment/underemployment or job stress of 31.4 million (see Table I-4 at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html), 4.2 percent for Japan (see Section VB at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_2.html), 7.7 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH http://cmpassocregulationblog.blogspot.com/2013/01/united-states-commercial-banks-assets.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 1.7 percent in the US, -0.1 percent for Japan, 2.5 percent for China, 2.2 percent for the Euro Zone and 2.7 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III and earlier http://cmpassocregulationblog.blogspot.com/2013/01/united-states-commercial-banks-assets.html); (2) the tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment and political developments in a decennial transition; (3) slow growth by repression of savings with de facto interest rate controls (see IIB and earlier http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/recovery-without-hiring-forecast-growth.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (Section I at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/thirty-million-unemployed-or.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see Section I http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/08/expanding-bank-cash-and-deposits-with.html http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.

In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.

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 1.5 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 2.1 percent on average in the cyclical expansion in the 14 quarters from IIIQ2009 to IVQ2012. Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.

First, the average increase of 165,900 new nonfarm jobs per month in the US from Mar to Dec 2012 or 166,000 created in Jan 2013 is insufficient even to absorb 113,167 new entrants per month into the labor force. The difference between the average increase of 165,900 new private nonfarm jobs per month in the US from Mar to Dec 2012 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 52,733 monthly new jobs net of absorption of new entrants in the labor force. There are 31.4 million in job stress in the US currently. The provision of 52,733 new jobs per month net of absorption of new entrants in the labor force would require 595 months to provide jobs for the unemployed and underemployed (31.4 million divided by 52,733) or 49.6 years (595 divided by 12). The civilian labor force of the US in Jan 2013 not seasonally adjusted stood at 154.794 million with 13.181 million unemployed or effectively 20.354 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 1.6 years (1 million divided by product of 52,733 by 12, which is 632,796). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.740 million (0.05 times labor force of 154.794 million) for new net job creation of 5.441 million (13.181 million unemployed minus 7.740 million unemployed at rate of 5 percent) that at the current rate would take 8.6 years (5.441 million divided by 632,796). Under the calculation in this blog there are 20.354 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 12.614 million jobs net of labor force growth that at the current rate would take 19.9 years (12.614 million minus 0.05(161.967 million) divided by 632,796, using LF PART 66.2% and Total UEM in Table I-4). 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 141.614 million in Jan 2013, by 5.129 million, or 3.5 percent, while the noninstitutional population increased from 232.715 million in Oct 2007 to 244.663 million in Jan 2013, by 11.948 million or increase of 5.1 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 GDP growth is 1.7 to 1.9 percent. Excluding growth at the SAAR of 2.5 percent in IIQ2011 and 4.1 percent in IVQ2011 while converting growth in IIIQ2012 to 1.3 percent by deducting from 3.1 percent one-time inventory accumulation of 0.73 percentage points and national defense expenditures of 0.64 percentage points and converting growth in IVQ2012 by adding 1.27 percentage points of inventory divestment and 1.28 percentage points of national defense expenditure reductions to obtain 2.54 percent, the US economy grew at 1.7 percent in the remaining six quarters {[(1.00025x1.0032x1.005x1.0032x1.0077x0.0063)^4/6 – 1]100 = 1.7%} with declining growth trend in three consecutive quarters from 4.1 percent in IVQ2011, to 2.0 percent in IQ2012, 1.3 percent in IIQ2012, 3.1 percent in IIIQ2012 that is more like 1.73 percent without inventory accumulation and national defense expenditures and -0.1 percent in IVQ2012 that is more likely 2.54 percent by adding 1.27 percentage points of inventory divestment and 1.28 percentage points of national defense expenditures. Weakness of growth is more clearly shown by adjusting 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; 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; and deduction of 1.27 percentage points of inventory divestment and 1.28 percentage points of national defense expenditure reductions. The Bureau of Economic Analysis (BEA) of the US Department of Commerce released on Wed Jan 30, 2012, the first or advanced estimate of GDP for IVQ2012 at minus 0.1 percent seasonally-adjusted annual rate (SAAR) (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp4q12_adv.pdf). In the four quarters of 2012, the US economy is growing at the annual equivalent rate of 1.9 percent {([(1.02^1/4(1.013)^1/4(1.0173)^1/4(1.0254)^1/4]-1)100 = 1.89%} by excluding inventory accumulation of 0.73 percentage points and exceptional defense expenditures of 0.64 percentage points from growth 3.1 percent at SAAR in IIIQ2012 to obtain adjusted 1.73 percent SSAR and adding 1.28 percentage points of national defense expenditure reductions and 1.27 percentage points of inventory divestment to growth of minus 0.1 percent SAAR in IVQ2012 to obtain 2.54 percent.

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.

The statement of the FOMC at the conclusion of its meeting on Dec 12, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm) practically unchanged in the statement at the conclusion of its meeting on Jan 30, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130130a.htm):

“Release Date: December 12, 2012

For immediate release

Information received since the Federal Open Market Committee met in October suggests that economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions. Although the unemployment rate has declined somewhat since the summer, it remains elevated. Household spending has continued to advance, and the housing sector has shown further signs of improvement, but growth in business fixed investment has slowed. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

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 will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and, in January, will resume rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

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. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

There are several important issues in this statement.

1. Mandate. The FOMC pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

2. Open-ended Quantitative Easing or QE_∞. Earlier programs are continued with an additional open-ended $85 billion of bond purchases per month: “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 will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month.”

3. Advance Guidance on “6 ¼ 2 ½ “Rule. Policy will be accommodative even after the economy recovers satisfactorily: “o 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.”

4. Monitoring and Policy Focus on Jobs. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

Unconventional monetary policy drives wide swings in allocations of positions into risk financial assets that generate instability instead of intended pursuit of prosperity without inflation. There is insufficient knowledge and imperfect tools to maintain the gap of actual relative to potential output constantly at zero while restraining inflation in an open interval of (1.99, 2.0). Symmetric targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output that is actually a target of growth forecast. The impact on the overall economy and the financial system of errors of policy are magnified by large-scale policy doses of trillions of dollars of quantitative easing and zero interest rates. The US economy has been experiencing financial repression as a result of negative real rates of interest during nearly a decade and programmed in monetary policy statements until 2015 or, for practical purposes, forever. The essential calculus of risk/return in capital budgeting and financial allocations has been distorted. If economic perspectives are doomed until 2015 such as to warrant zero interest rates and open-ended bond-buying by “printing” digital bank reserves (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html; see Shultz et al 2012), rational investors and consumers will not invest and consume until just before interest rates are likely to increase. Monetary policy statements on intentions of zero interest rates for another three years or now virtually forever discourage investment and consumption or aggregate demand that can increase economic growth and generate more hiring and opportunities to increase wages and salaries. The doom scenario used to justify monetary policy accentuates adverse expectations on discounted future cash flows of potential economic projects that can revive the economy and create jobs. If it were possible to project the future with the central tendency of the monetary policy scenario and monetary policy tools do exist to reverse this adversity, why the tools have not worked before and even prevented the financial crisis? If there is such thing as “monetary policy science”, why it has such poor record and current inability to reverse production and employment adversity? There is no excuse of arguing that additional fiscal measures are needed because they were deployed simultaneously with similar ineffectiveness.

Table IV-2 provides economic projections of governors of the Board of Governors of the Federal Reserve and regional presidents of Federal Reserve Banks released at the meeting of Dec 12, 2012. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2012 is analyzed at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html (and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html) and the PCE inflation data from the report on personal income and outlays (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). The Bureau of Economic Analysis (BEA) provides the advance estimate of IVQ2012 GDP and annual for 2012 with the second estimate be released on Feb 28 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm See http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm), which is analyzed at http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html and the report for Nov 2012 at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states_24.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/12/mediocre-and-decelerating-united-states.html. The next report on “Personal Income and Outlays” for Jan will be released at 8:30 AM on Mar 1, 2013 (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm). PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog (the Nov report at http://cmpassocregulationblog.blogspot.com/2012/12/twenty-eight-million-unemployed-or.html; the Oct report is analyzed in this blog at http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html; the Sep report is analyzed in this blog at http://cmpassocregulationblog.blogspot.com/2012/10/twenty-nine-million-unemployed-or_7.html; the Aug report is in Section I at http://cmpassocregulationblog.blogspot.com/2012/09/twenty-eight-million-unemployed-or.html and the Jul report is analyzed at http://cmpassocregulationblog.blogspot.com/2012/08/twenty-nine-million-unemployed-or.html). The report for Dec was released on Fri Jan 4, 2013 (http://www.bls.gov/ces/) and analyzed in this blog (http://cmpassocregulationblog.blogspot.com/2013/02/thirty-one-million-unemployed-or.html). The report for Jan 2013 will be released on Mar 8, 2013 (http://www.bls.gov/ces/) and analyzed in this blog on Mar 10, 2013. “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf).

It is instructive to focus on 2012 and 2013 as 2014, 2015 and longer term are too far away, and there is not much information even on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Dec 12, 2012 and the second row “PR” the projection of the Sep 13, 2012 meeting. There are three major changes in the view.

1. Growth “∆% GDP.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun 2011 to 2.5 to 2.9 percent in Nov 2011 and 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 meeting, reducing it to 1.9 to 2.4 percent at the Jun 20, 2012 meeting and further to 1.7 to 2.0 percent at the Sep 13, 2012 meeting and 1.7 to 1.8 percent at the Dec 12, 2012 meeting. GDP growth in 2013 has been increased to 2.5 to 3.0 percent at the meeting on Sep 13

2012 from 2.2 to 2.8 percent at the meeting on Jun 20, 2012 but reduced to 2.3 to 3.0 percent at the Dec 12, 2012 meeting.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun 2011 to 8.5 to 8.7 percent in Nov 2011 but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting and further down to 7.8 to 8.0 percent at the Apr 25, 2012 meeting but increased it to 8.0 to 8.2 percent at the Jun 20, 2012 meeting and did not change it at 8.0 to 8.2 at the meeting on Sep 13, 2012, lowering the projection to 7.8 to 7.9 percent at the Dec 12, 2012 meeting. The rate of unemployment for 2013 has been changed to 7.6 to 7.9 percent at the Sep 13 meeting compared with 7.5 to 8.0 percent at the Jun 20 meeting and reduced to 7.4 to 7.7 percent at the Dec 12 meeting.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun 2011 to virtually the same of 1.4 to 2.0 percent in Nov 2011 but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.2 to 1.7 percent at the Jun 20, 2012 meeting. The interval was increased to 1.7 to 1.8 percent at the Sep 13, 2012 meeting and 1.6 to 1.7 percent at the Dec 12, 2012 meeting.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun 2011 of 1.4 to 2.0 percent and the Nov 2011 projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting but increased to 1.8 to 2.0 percent at the Apr 25, 2012 meeting, reducing it to 1.7 to 2.0 percent at the Jun 20, 2012 meeting. The projection was virtually unchanged at 1.7 to 1.9 percent at the Sep 13 meeting. For 2013, the projection for core inflation was changed from 1.6 to 2.0 percent at the Jun 20, 2012 meeting to 1.7 to 2.0 percent at the Sep 13, 2012 meeting and lowered to 1.7 to 1.9 percent at the Dec 12, 2012 meeting.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, June 2012 and Sep 2012

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012 Sep PR	1.7 to 1.8 1.7 to 2.0	7.8 to 7.9 8.0 to 8.2	1.6 to 1.7 1.7. to 1.8	1.6 to 1.7 1.7 to 1.9
2013 Sep PR	2.3 to 3.0 2.5 to 3.0	7.4 to 7.7 7.6 to 7.9	1.3 to 2.0 1.6 to 2.0	1.6 to 1.9 1.7 to 2.0
2014 Sep PR	3.0 to 3.5 3.0 to 3.8	6.8 to 7.3 6.7 to 7.3	1.5 to 2.0 1.6 to 2.0	1.6 to 2.0 1.8 to 2.0
2015 Sep	3.0 to 3.7 3.0 to 3.8	6.0 to 6.6 6.0 to 6.8	1.7 to 2.0 1.8 to 2.0	1.8 to 2.0 1.9 to 2.0
Longer Run Sep PR	2.3 to 2.5 2.3 to 2.5	5.2 to 6.0 5.2 to 6.0	2.0 2.0
Range
2012 Sep PR	1.6 to 2.0 1.6 to 2.0	7.7 to 8.0 8.0 to 8.3	1.6 to 1.8 1.5 to 1.9	1.6 to 1.8 1.6 to 2.0
2013 Sep PR	2.0 to 3.2 2.3 to 3.5	6.9 to 7.8 7.0 to 8.0	1.3 to 2.0 1.5 to 2.1	1.5 to 2.0 1.6 to 2.0
2014 Sep PR	2.8 to 4.0 2.7 to 4.1	6.1 to 7.4 6.3 to 7.5	1.4 to 2.2 1.6 to 2.2	1.5 to 2.0 1.6 to 2.2
2015 Sep PR	2.5 to 4.2 2.5 to 4.2	5.7 to 6.8 5.7 to 6.9	1.5 to 2.2 1.8 to 2.3	1.7 to 2.2 1.8 to 2.3
Longer Run Sep PR	2.2 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.3	2.0 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf

Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):

“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html See Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 99-116). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. Table IV-3 is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf). There are 19 participants expecting the rate to remain at 0 to ¼ percent in 2012 and none to be higher. Not much change is expected in 2013 either with 17 participants anticipating the rate at the current target of 0 to ¼ percent and only two expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for 14 participants with three expecting the rate to be in the range of 1.0 to 2.0 percent, one participant expecting rates at 0.5 to 1.0 percent and one participant expecting rates from 2.0 to 3.0. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014. For 2015, nine participants expect rates to be below 1.0 percent while nine expect rates from 1.0 to 4.5 percent. In the long-run, all 19 participants expect rates to be between 3.0 and 4.5 percent.

Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2015. It is evident from Table IV-4 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2.

Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, June 20, 2012

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2012	1
2013	2
2014	3
2015	13
2016	1

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20121212.pdf

The producer price index of the euro zone decreased 0.2 percent in Dec 2012 and decreased 0.2 percent in Nov 2012 as shown in Table IV-5. In Jan-Mar 2012, producer prices increased cumulatively 2.0 percent or at annual equivalent rate of 8.3 percent. Energy inflation has oscillated with the shocks of risk aversion that cause unwinding of carry trade positions from zero interest rates to commodity futures. Energy prices fell 0.8 percent in Dec 2012, 0.8 percent in Nov 2012 and fell 0.3 percent in Oct 2012 after 0.0 percent in Sep 2012, increased 2.6 percent in Aug, and 1.4 percent in Jul 2012 or at the annual equivalent rate of 17.2 percent in the quarter Jul-Sep 2012 and at 26.8 percent in Jul-Aug 2012. Energy prices increased 5.2 percent cumulatively in Jan-Mar 2012 or at the annual equivalent rate of 22.4 percent. During periods of relaxed risk aversion, carry trades from zero interest rates to commodity exposures drive high inflation waves. Prices of capital goods have barely moved. Prices of durable consumer goods accelerated at annual equivalent rate of 3.3 percent in Jan-Mar 2012 but were flat in every month from Apr to Jun 2012, increasing 0.1 percent in both Aug and Jul 2012 but then remained unchanged in Sep 2012, increasing at 0.2 percent in Oct 2012 and declining 0.1 percent in Dec 2012. Purchasing managers’ indexes worldwide reflect increasing prices of inputs for business while sales prices are stagnant or declining. Unconventional monetary policy causes uncertainty in business decisions with shocks of declining net revenue margins during worldwide inflation waves (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table IV-5, Euro Zone, Industrial Producer Prices Month ∆%

	Dec 2012	Nov 2012	Oct 2012	Sep 2012	Aug 2012	Jul 2012	Jun 2012
Industry ex Construction	-0.2	-0.2	0.0	0.2	0.9	0.3	-0.5
Industry ex Construction & Energy	0.0	-0.1	0.1	0.3	0.3	-0.1	-0.1
Intermediate Goods	0.0	-0.2	0.0	0.4	0.5	-0.3	-0.3
Energy	-0.8	-0.8	-0.3	0.0	2.6	1.4	-1.8
Capital Goods	0.0	0.0	0.0	0.0	0.0	0.0	0.1
Durable Consumer Goods	-0.1	0.0	0.2	0.0	0.1	0.1	0.0
Nondurable Consumer Goods	0.1	0.2	0.2	0.4	0.4	0.2	0.1

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

Twelve-month percentage changes of industrial prices in the euro zone have moderated significantly, as shown in Table IV-6. The 12-month percentage change of industrial prices excluding construction fell from 4.3 percent in Dec 2011 to 1.7 percent in Jul 2012 but increased to 2.7 percent in both Aug and Sep 2012, falling to 2.6 percent in Oct 2012 and 2.1 percent in Nov 2012 and Dec 2012. Energy prices increased 9.7 percent in Dec 2011 and Jan 2011 but the rate fell to 4.5 percent in the 12 months ending in Jul 2012, increasing to 8.1 percent in Aug 2012 and 7.0 percent in Sep 2012 but falling to 5.9 percent in Oct 2012, 4.1 percent in Nov 2012 and 3.7 percent in Dec 2012. There is major vulnerability in producer price inflation that can return together with long positions in commodity futures with carry trades from zero interest during relaxation of risk aversion. Business net revenue suffers wide oscillation preventing sound calculation of risk/returns and capital budgeting.

Table IV-6, Euro Zone, Industrial Producer Prices 12-Month ∆%

	Dec 2012	Nov 2012	Oct 2012	Sep 2012	Aug 2012	Jul 2012	Jun 2012
Industry ex Construction	2.1	2.1	2.6	2.7	2.7	1.7	1.8
Industry ex Construction & Energy	1.6	1.5	1.5	1.2	1.0	0.7	0.9
Intermediate Goods	1.6	1.4	1.2	0.7	0.2	-0.2	0.1
Energy	3.7	4.1	5.9	7.0	8.1	4.5	4.7
Capital Goods	0.9	0.9	0.8	0.8	0.8	1.0	1.1
Durable Consumer Goods	1.0	1.1	1.3	1.3	1.7	1.8	1.9
Nondurable Consumer Goods	2.3	2.3	2.4	2.4	2.2	2.0	1.9

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

Industrial producer prices in the euro area are following similar inflation waves as in the rest of the world (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html), as shown in Table IV-7. In the first wave in Jan-Apr 2011, annual equivalent producer price inflation was 12.0 percent driven by carry trades from zero interest rates into commodity futures. In the second wave in May-Jun 2011, annual equivalent producer price inflation declined at minus 1.2 percent. In the third wave in Jul-Sep 2011, annual equivalent inflation increased at 2.0 percent. In the third wave in Oct-Dec 2011, risk aversion originating in the European sovereign debt crisis interrupted commodity carry trades, resulting in annual equivalent inflation of only 0.8 percent. In the fifth wave in Jan-Mar 2012, annual equivalent inflation jumped to 8.3 percent with a high annual equivalent rate of 9.4 percent in Jan-Feb 2012. In the sixth wave, risk aversion from the European sovereign debt event caused reversal of commodity carry trades with equivalent annual inflation of minus 3.9 percent in Apr-Jun 2012. In the seventh wave, annual equivalent inflation jumped to 7.4 percent in Jul-Aug 2012 while energy prices driven by carry trades increased at the annual equivalent rate of 26.8 percent. In the eighth wave, annual equivalent inflation retreated to 1.2 percent in Sep-Oct 2012. In the ninth wave, annual equivalent inflation was minus 2.4 percent in Nov-Dec 2012. The bottom part of Table IV-7 provides 12-month percentage changes from 1999 to 2010. The final row of Table IV-7 provides the average annual rate of producer-price inflation in the euro area at 2.6 percent in Dec from 1999 to 2011.

Table IV-7, Euro Area, Industrial Producer Prices Excluding Construction, Month and 12-Month ∆%

	Month ∆%	12-Month ∆%
Dec 2012	-0.2	2.1
Nov	-0.2	2.1
AE ∆% Nov-Dec	-2.4
Oct	0.0	2.6
Sep	0.2	2.7
AE ∆% Sep-Oct	1.2
Aug	0.9	2.7
Jul	0.3	1.7
AE ∆% Jul-Aug	7.4
Jun	-0.5	1.8
May	-0.5	2.3
Apr	0.0	2.6
AE ∆% Apr-Jun	-3.9
Mar	0.5	3.5
Feb	0.6	3.8
Jan	0.9	3.9
AE ∆% Jan-Mar	8.3
Dec 2011	-0.2	4.3
Nov	0.3	5.4
Oct	0.1	5.5
AE ∆% Oct-Dec	0.8
Sep	0.3	5.8
Aug	-0.2	5.8
Jul	0.4	6.1
AE ∆% Jul-Sep	2.0
Jun	0.0	5.9
May	-0.2	6.2
AE ∆% May-Jun	-1.2
Apr	0.9	6.8
Mar	0.8	6.8
Feb	0.8	6.6
Jan	1.3	5.9
AE ∆% Jan-Apr	12.0
Dec 2012		2.1
Dec 2011		4.3
Dec 2010		5.4
Dec 2009		-2.9
Dec 2008		1.1
Dec 2007		4.7
Dec 2006		3.8
Dec 2005		4.5
Dec 2004		3.8
Dec 2003		0.8
Dec 2002		1.5
Dec 2001		-0.6
Dec 2000		4.6
Dec 1999		2.6
Average ∆% 1999-2011		2.6

Source: EUROSTAT http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/

The first wave of commodity price increases in the first four months of Jan-Apr 2011 also influenced the surge of consumer price inflation in Italy shown in Table IV-8. Annual equivalent inflation in the first four months of 2011 was 4.9 percent. The crisis of confidence or risk aversion resulted in reversal of carry trades on commodity positions. Consumer price inflation in Italy was subdued in the second wave in Jun and May 2011 at 0.1 percent for annual equivalent 1.2 percent. In the third wave in Jul-Sep 2011, annual equivalent inflation increased to 2.4 percent. In the fourth wave, annual equivalent inflation in Oct-Nov 2011 jumped again at 3.0 percent. Inflation returned in the fifth wave from Dec 2011 to Jan 2012 at annual equivalent 4.3 percent. In the sixth wave, annual equivalent inflation rose to 5.7 percent in Feb-Apr 2012. In the seventh wave, annual equivalent inflation was 1.2 percent in May-Jun 2012. In the eighth wave, annual equivalent inflation increased to 3.0 percent in Jul-Aug 2012. In the ninth wave, inflation collapsed to zero in Sep-Oct 2012 and was minus 0.8 percent in annual equivalent in Sep-Nov 2012. In the tenth wave, annual equivalent inflation in Dec 2012 to Jan 2013 was 2.4 percent. Economies are shocked worldwide by intermittent waves of inflation originating in combination of zero interest rates and quantitative easing with alternation of risk appetite and risk aversion (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table IV-8, Italy, Consumer Price Index

	Month	12 Months
Jan 2013	0.2	2.2
Dec 2012	0.2	2.3
AE ∆% Dec 2012-Jan 2013	2.4
Nov 2012	-0.2	2.5
Oct	0.0	2.6
Sep	0.0	3.2
AE ∆% Sep-Nov	-0.8
Aug	0.4	3.2
Jul	0.1	3.1
AE ∆% Jul-Aug	3.0
June	0.2	3.3
May	0.0	3.2
AE ∆% May-Jun	1.2
Apr	0.5	3.3
Mar	0.5	3.3
Feb	0.4	3.3
AE ∆% Feb-Apr	5.7
Jan	0.3	3.2
Dec 2011	0.4	3.3
AE ∆% Dec-Jan	4.3
Nov	-0.1	3.3
Oct	0.6	3.4
AE ∆% Oct-Nov	3.0
Sep	0.0	3.0
Aug	0.3	2.8
Jul	0.3	2.7
AE ∆% Jul-Sep	2.4
Jun	0.1	2.7
May	0.1	2.6
AE ∆% May-Jun	1.2
Apr	0.5	2.6
Mar	0.4	2.5
Feb	0.3	2.4
Jan	0.4	2.1
AE ∆% Jan-Apr	4.9
Dec 2010	0.4	1.9
Annual
2011		2.8
2010		1.5
2009		0.8
2008		3.3
2007		1.8
2006		2.1

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/81345

Consumer price inflation in Italy by segments in the estimate by ISTAT for Nov 2012 is provided in Table IV-9. Total consumer price inflation in Jan 2013 was 0.2 percent and 2.2 percent in 12 months. Inflation of goods was 0.4 percent in Jan and 2.3 percent in 12 months. Prices of durable goods increased 0.3 percent in Jan and increased 0.0 percent in 12 months, as typical in most countries. Prices of energy increased 0.2 percent in Jan and increased 5.3 percent in 12 months. Food prices increased 0.8 percent in Jan and increased 3.2 percent in 12 months. Prices of services decreased 0.1 percent in Jan and rose 2.1 percent in 12 months. Transport prices, also influenced by commodity prices, decreased 1.4 percent in Jan and increased 3.8 percent in 12 months. Carry trades from zero interest rates to positions in commodity futures cause increases in commodity prices. Waves of inflation originate in periods when there is no risk aversion and commodity prices decline during periods of risk aversion (http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html).

Table IV-9, Italy, Consumer Price Index and Segments, Month and 12-Month ∆%

Jan 2013	Month ∆%	12-Month ∆%
General Index	0.2	2.2
I Goods	0.4	2.3
Food	0.8	3.2
Energy	0.2	5.3
Durable	0.3	0.0
Nondurable	0.3	0.5
II Services	-0.1	2.1
Housing	0.2	2.1
Communications	0.3	0.1
Transport	-1.4	3.8

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/81345

Chart IV-1 of the Istituto Nazionale di Statistica shows moderation in 12-month percentage changes of the consumer price index of Italy with marginal increase followed by decline to 2.5 percent in Nov 2012, 2.3 percent in Dec 2012 and 2.2 percent in Jan 2013.

Chart, IV-1, Italy, Consumer Price Index, 12-Month Percentage Changes

Source: Istituto Nazionale di Statistica

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

Longer Run