CMP Associates Regulation Blog: United States Commercial Banks Assets and Liabilities, United States Housing Collapse, Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation, Collapse of United States Dynamism of Income Growth and Employment Creation, Peaking Valuations of Risk Financial Assets, World Economic Slowdown and Global Recession Risk: Part I

United States Commercial Banks Assets and Liabilities, United States Housing Collapse, Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation, Collapse of United States Dynamism of Income Growth and Employment Creation, Peaking Valuations of Risk Financial Assets, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

Executive Summary

IA United States Commercial Banks Assets and Liabilities

IA1 Transmission of Monetary Policy

IA2 Functions of Banks

IA3 United States Commercial Banks Assets and Liabilities

IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation

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

II United States Housing Collapse

IIA1 United States New House Sales

IIA2 United States House Prices

IIA3 Factors of United States Housing Collapse

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

Executive Summary

ESI United States Commercial Banks Assets and Liabilities. Modern banking theory analyzes three important functions provided by banks: monitoring of borrowers, provision of liquidity services and transformation of illiquid assets into immediately liquid assets (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 51-60). These functions require valuation of alternative investment projects that may be distorted by zero interest rates of monetary policy and artificially low long-term interest rates. The QE∞ trap frustrates essential banking functions.

Monitoring. Banks monitor projects to ensure that funds are allocated to their intended projects (Diamond 1984, 1996). Banks issue deposits, which are secondary assets, to acquire loans, which are primary assets. Monitoring reduces costs of participating in business projects. Acting as delegated monitor, banks obtain information on the borrower, allowing less costly participation through the issue of unmonitored deposits. Monitoring of borrowers provides enhanced less costly participation by investors through the issue of deposits. There is significant reduction of monitoring costs by delegating to a bank. If there are many potential investors, monitoring by the bank of a credit name is less costly than the sum of individual monitoring of the same credit name by all potential investors. Banks permit borrowers to reach many investors for their projects while affording investors less costly participation in the returns of projects of bank borrowers.
Transformation of Illiquid Loans into Liquid Deposits. Diamond and Dybvig (1986) analyze bank services through bank balance sheets.

i. Assets. Banks provide loans to borrowers. The evaluation of borrowers prevents “adverse selection,” which consists of banks choosing unsound projects and failing to finance sound projects. Monitoring of loans prevents “moral hazard,” which consists of borrowers using the funds of the loan for purposes other than the project for which they were lent, as for example, using borrowed bank funds for speculative real estate instead of for the intended industrial project. Relationship banking improves the information on borrowers and the monitoring function.

ii. Liabilities. Banks provide numerous services to their clients such as holding deposits, clearing transactions, currency inventory and payments for goods, services and obligations.

iii. Assets and Liabilities: Transformation Function. The transformation function operates through both sides of the balance sheet: banks convert illiquid loans in the asset side into liquid deposits in the liability side. There is rich theory of banking (Diamond and Rajan 2000, 2001a,b). Securitized banking provides the same transformation function by bundling mortgage and other consumer loans into securities that are then sold to investors who finance them in short-dated sale and repurchase agreements (Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 61-6).

Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Personal consumptions expenditures have share of 71.0 percent of GDP in IQ2013 (Table I-10 http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). Most consumers rely on their banks for real estate loans, credit cards and personal consumer loans. Thus, it should be expected that success of monetary policy in stimulating the economy would be processed through bank balance sheets.

Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table IA-1. Data are not seasonally adjusted to permit comparison between Apr 2012 and Apr 2013. Total assets of US commercial banks grew 5.5 percent from $12,645.2 billion in Apr 2012 to $13,346.2 billion in Apr 2013. US GDP in 2012 is estimated at $15,684.8 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 85 percent of US GDP. Bank credit grew 4.4 percent from $9604.7 billion in Apr 2012 to $10,023.4 billion in Apr 2013. Securities in bank credit increased 6.2 percent from $2596.3 billion in Apr 2012 to $2757.0 billion in Apr 2013. A large part of securities in banking credit consists of US Treasury and agency securities, growing 4.3 percent from $1803.5 billion in Apr 2012 to $1881.4 billion in Apr 2013. Credit to the government that issues or backs Treasury and agency securities of $1881.4 billion in Apr 2013 is about 18.8 percent of total bank credit of US commercial banks of $10,023.2 billion. Mortgage-backed securities, providing financing of home loans, grew 2.3 percent, from $1335.5 billion in Apr 2012 to $1366.2 billion in Apr 2013. Loans and leases were less dynamic, growing 3.7 percent from $7008.4 billion in Apr 2012 to $7266.5 billion in Apr 2013. The only dynamic class is commercial and industrial loans, growing 10.5 percent from Apr 2012 to Apr 2013 and providing $1552.7 billion or 21.4 percent of total loans and leases of $7266.5 billion in Apr 2013. Real estate loans increased only 0.3 percent, providing $3538.8 billion in Apr 2013 or 48.7 percent of total loans and leases. Consumer loans increased only 2.7 percent, providing $1118.8 billion in Apr 2013 or 15.4 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks increased 19.1 percent from $1638.1 billion in Apr 2012 to $1950.9 billion in Apr 2013 but a single year of the series masks exploding cash in banks because of unconventional monetary policy, which is discussed below. Bank deposits increased 8.2 percent from $8654.7 billion to $9365.1 billion. The difference between bank deposits and total loans and leases in banks increased from $1646.3 billion in Apr 2012 to $2098.6 billion in Apr 2013 or by $452.3 billion, which is similar to the increase in securities in bank credit by $160.7 billion from $2596.3 billion in Apr 2012 to $2757.0 billion in Apr 2013 and to the increase in Treasury and agency securities by $77.9 billion from $1803.5 billion in Apr 2012 to $1881.4 billion in Apr 2013. Loans and leases increased $258.1 billion from $7008.4 billion in Apr 2012 to $7266.5 billion in Apr 2013. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IQ2013 lower by 0.6 percent than in IVQ2007 (Table IA-3 below; see IX Conclusion and extended analysis in IB Collapse of United States Dynamism of Income Growth and Employment Creation) in contrast with 11.5 percent higher if the economy had performed in long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May). In contrast, growth of real disposable income grew cumulatively 17.0 percent in the cycle from IQ1980 to IIIQ1986 that was higher than trend growth of 14.9 percent.

Table IA-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars

	Apr 2012	Apr 2013	∆%
Total Assets	12,654.2	13,346.2	5.5
Bank Credit	9604.7	10,023.4	4.4
Securities in Bank Credit	2596.3	2757.0	6.2
Treasury & Agency Securities	1803.5	1881.4	4.3
Mortgage-Backed Securities	1335.5	1366.2	2.3
Loans & Leases	7008.4	7266.5	3.7
Real Estate Loans	3528.9	3538.8	0.3
Consumer Loans	1089.0	1118.8	2.7
Commercial & Industrial Loans	1404.7	1552.7	10.5
Other Loans & Leases	985.8	1056.2	7.1
Cash Assets*	1638.1	1950.5	19.1
Total Liabilities	11,197.2	11,836.3	5.7
Deposits	8654.7	9365.1	8.2

Note: balancing item of residual assets less liabilities not included

*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are provided in Table IA-2 annually from 2007 to 2012 and for Mar 2013 and Apr 2013. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.8 percent in 2010. Commercial and industrial loans fell 18.6 percent in 2009 and 9.0 percent in 2010. Unconventional monetary policy caused an increase of cash assets of banks of 158.3 percent in 2008, 48.2 percent in 2009, 47.9 percent in 2011 followed by decline by 2.4 percent in 2012. Cash assets of banks increased at the SAAR of 22.4 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012 followed by increase of 56.0 percent in Nov 2012, minus 7.8 percent in Dec 2012, 38.8 percent in Jan 2013, 66.2 percent in Feb 2013, 85.6 percent in Mar 2013 and 9.0 percent in Apr 2013. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that were held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit: growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.7 percent in Oct 2012, 1.7 percent in Nov 2012 and 20.5 percent in Dec 2012 with declines at 1.1 percent in Jan 2013, 3.2 percent in Feb 2013 and 4.3 percent in Mar 2013 but growth of 1.0 percent in Apr 2013. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit: with growth of 14.5 percent in 2009 and 15.3 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012 but falling at the rate of 0.8 percent in Nov 2012, increasing at 17.2 percent in Dec 2012 but falling at 5.9 percent in Jan 2013, 3.2 percent in Feb 2013, 9.2 percent in Mar 2013 and 6.1 percent in Apr 2013. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.7 percent in Nov 2012, 18.7 percent in Dec 2012, 2.7 percent in Jan 2013, 4.4 percent in Feb 2013, 7.5 percent in Mar 2013 and 2.4 percent in Apr 2013. The credit intermediation function of banks is broken because of adverse expectations on future business and is not easily mended simply by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.

Table IA-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%

	2008	2009	2010	2011	2012	Mar 2013	Apr 2013
Total Assets	7.9	-6.0	-2.7	5.4	2.5	10.9	4.2
Bank Credit	2.2	-6.7	-2.7	1.8	4.0	0.1	4.0
Securities in Bank Credit	-1.8	6.4	6.9	1.8	7.5	-4.3	1.0
Treasury & Agency Securities	3.5	14.5	15.3	3.1	8.6	-9.1	-6.1
Other Securities	-8.3	-4.9	-7.2	-0.8	5.0	6.4	16.4
Loans & Leases	3.3	-10.2	-5.8	1.8	2.7	1.8	5.1
Real Estate Loans	-0.2	-5.6	-5.5	-3.7	-1.1	-1.4	2.6
Consumer Loans	5.1	-3.3	-7.1	-0.7	1.1	5.3	6.1
Commercial & Industrial Loans	12.9	-18.6	-9.0	9.5	11.4	9.3	6.6
Other Loans & Leases	1.8	-23.3	0.3	19.4	6.3	-1.6	10.4
Cash Assets	158.3	48.2	-7.9	47.9	-2.4	85.6	9.0
Total Liabilities	10.6	-7.2	-3.4	5.5	2.2	8.6	4.1
Deposits	5.4	5.2	2.4	6.6	7.1	7.5	2.4

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-16 is quite revealing in analyzing the state of bank credit in the US economy. The upper curves are deposits and loans and leases in bank credit. Historically since 1973, the level and rate of change of deposits and loans and leases in bank credit were almost identical. The lower two curves are Treasury and agency securities in bank credit and cash assets with treasury and agency securities moving closely with cash assets until the 1990s when Treasury and agency securities exceeded cash assets. The shaded area of the recession from IV2007 to IIQ2009 shows a break in the level and rate of movement of the series. Deposits continued to expand rapidly through the recession and the following expansion period. Loans and leases fell and barely recovered the level before the recession while deposits moved nearly vertically well above the level before the recession. While Treasury and agency securities in bank credit continued to expand at a higher rate, reaching a level well above that before the recession, cash assets jumped as the counterpart of excess reserves in banks that financed quantitative easing or massive outright purchases of securities for the balance sheet of the Fed. Unconventional monetary policy of zero interest rates and outright purchases of securities has result in sharp increases of deposits, cash assets and Treasury and agency securities in bank credit but not in loans and leases.

Chart IA-16, US, Deposits, Treasury and Government Securities in Bank Credit and Loans and Leases in Bank Credit and Consumer Loans, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

ESII Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004 and quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates (for fear of deflation see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

If the forecast of the central bank is of recession and low inflation with controlled inflationary expectations, monetary policy should consist of lowering the short-term policy rate of the central bank, which in the US is the fed funds rate. The intended effect is to lower the real rate of interest (Svensson 2003LT, 146-7). The real rate of interest, r, is defined as the nominal rate, i, adjusted by expectations of inflation, π*, with all variables defined as proportions: (1+r) = (1+i)/(1+π*) (Fisher 1930). If i, the fed funds rate, is lowered by the Fed, the numerator of the right-hand side is lower such that if inflationary expectations, π*, remain unchanged, the left-hand (1+r) decreases, that is, the real rate of interest, r, declines. Expectations of lowering short-term real rates of interest by policy of the Federal Open Market Committee (FOMC) fixing a lower fed funds rate would lower long-term real rates of interest, inducing with a lag investment and consumption, or aggregate demand, that can lift the economy out of recession. Inflation also increases with a lag by higher aggregate demand and inflation expectations (Fisher 1933). This reasoning explains why the FOMC lowered the fed funds rate in Dec 2008 to 0 to 0.25 percent and left it unchanged.

The fear of the Fed is expected deflation or negative π*. In that case, (1+ π*) < 1, and (1+r) would increase because the right-hand side of the equation would be divided by a fraction. A simple numerical example explains the effect of deflation on the real rate of interest. Suppose that the nominal rate of interest or fed funds rate, i, is 0.25 percent, or in proportion 0.25/100 = 0.0025, such that (1+i) = 1.0025. Assume now that economic agents believe that inflation will remain at 1 percent for a long period, which means that π* = 1 percent, or in proportion 1/100 =0.01. The real rate of interest, using the equation, is (1+0.0025)/(1+0.01) = (1+r) = 0.99257, such that r = 0.99257 - 1 = -0.00743, which is a proportion equivalent to –(0.00743)100 = -0.743 percent. That is, Fed policy has created a negative real rate of interest of 0.743 percent with the objective of inducing aggregate demand by higher investment and consumption. This is true if expected inflation, π*, remains at 1 percent. Suppose now that expectations of deflation become generalized such that π* becomes -1 percent, that is, the public believes prices will fall at the rate of 1 percent in the foreseeable future. Then the real rate of interest becomes (1+0.0025) divided by (1-0.01) equal to (1.0025)/(0.99) = (1+r) = 1.01263, or r = (1.01263-1) = 0.01263, which results in positive real rate of interest of (0.01263)100 = 1.263 percent.

Irving Fisher also identified the impact of deflation on debts as an important cause of deepening contraction of income and employment during the Great Depression illustrated by an actual example (Fisher 1933, 346):

“By March, 1933, liquidation had reduced the debts about 20 percent, but had increased the dollar about 75 percent, so that the real debt, that is the debt measured in terms of commodities, was increased about 40 percent [100%-20%)X(100%+75%) =140%]. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized”

The nominal rate of interest must always be nonnegative, that is, i ≥ 0 (Hick 1937, 154-5):

“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”

The interpretation by Hicks of the General Theory of Keynes is the special case in which at interest rates close to zero liquidity preference is infinitely or perfectly elastic, that is, the public holds infinitely large cash balances at that near zero interest rate because there is no opportunity cost of foregone interest. Increases in the money supply by the central bank would not decrease interest rates below their near zero level, which is called the liquidity trap. The only alternative public policy would consist of fiscal policy that would act similarly to an increase in investment, increasing employment without raising the interest rate.

An influential view on the policy required to steer the economy away from the liquidity trap is provided by Paul Krugman (1998). Suppose the central bank faces an increase in inflation. An important ingredient of the control of inflation is the central bank communicating to the public that it will maintain a sustained effort by all available policy measures and required doses until inflation is subdued and price stability is attained. If the public believes that the central bank will control inflation only until it declines to a more benign level but not sufficiently low level, current expectations will develop that inflation will be higher once the central bank abandons harsh measures. During deflation and recession the central bank has to convince the public that it will maintain zero interest rates and other required measures until the rate of inflation returns convincingly to a level consistent with expansion of the economy and stable prices. Krugman (1998, 161) summarizes the argument as:

“The ineffectuality of monetary policy in a liquidity trap is really the result of a looking-glass version of the standard credibility problem: monetary policy does not work because the public expects that whatever the central bank may do now, given the chance, it will revert to type and stabilize prices near their current level. If the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap”

This view is consistent with results of research by Christina Romer that “the rapid rates of growth of real output in the mid- and late 1930s were largely due to conventional aggregate demand stimulus, primarily in the form of monetary expansion. My calculations suggest that in the absence of these stimuli the economy would have remained depressed far longer and far more deeply than it actually did” (Romer 1992, 757-8, cited in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 210-2). The average growth rate of the money supply in 1933-1937 was 10 percent per year and increased in the early 1940s. Romer calculates that GDP would have been much lower without this monetary expansion. The growth of “the money supply was primarily due to a gold inflow, which was in turn due to the devaluation in 1933 and to capital flight from Europe because of political instability after 1934” (Romer 1992, 759). Gold inflow coincided with the decline in real interest rates in 1933 that remained negative through the latter part of the 1930s, suggesting that they could have caused increases in spending that was sensitive to declines in interest rates. Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (Bernanke 2002):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”

Fed policy is seeking what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher 1933, 350).

The President of the Federal Reserve Bank of Chicago argues that (Charles Evans 2010):

“I believe the US economy is best described as being in a bona fide liquidity trap. Highly plausible projections are 1 percent for core Personal Consumption Expenditures (PCE) inflation at the end of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual mandate misses are too large to shrug off, and there is currently no policy conflict between improving employment and inflation outcomes”

There are two types of monetary policies that could be used in this situation. First, the Fed could announce a price-level target to be attained within a reasonable time frame (Evans 2010):

“For example, if the slope of the price path is 2 percent and inflation has been underunning the path for some time, monetary policy would strive to catch up to the path. Inflation would be higher than 2 percent for a time until the path was reattained”

Optimum monetary policy with interest rates near zero could consist of “bringing the price level back up to a level even higher than would have prevailed had the disturbance never occurred” (Gauti Eggertsson and Michael Woodford 2003, 207). Bernanke (2003JPY) explains as follows:

“Failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods—greater quantities of assets purchased on the open market for example. So even if the central bank is reluctant to provide a time frame for meetings its objective, the structure of the price-level objective provides a means for the bank to commit to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and Woodford show, the expectations that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank’s own objectives by lowering the current real rate of interest”

Second, the Fed could use its balance sheet to increase purchases of long-term securities together with credible commitment to maintain the policy until the dual mandates of maximum employment and price stability are attained.

In the restatement of the liquidity trap and large-scale policies of monetary/fiscal stimulus, Krugman (1998, 162) finds:

“In the traditional open economy IS-LM model developed by Robert Mundell [1963] and Marcus Fleming [1962], and also in large-scale econometric models, monetary expansion unambiguously leads to currency depreciation. But there are two offsetting effects on the current account balance. On one side, the currency depreciation tends to increase net exports; on the other side, the expansion of the domestic economy tends to increase imports. For what it is worth, policy experiments on such models seem to suggest that these effects very nearly cancel each other out.

Krugman (1998) uses a different dynamic model with expectations that leads to similar conclusions.

The central bank could also be pursuing competitive devaluation of the national currency in the belief that it could increase inflation to a higher level and promote domestic growth and employment at the expense of growth and unemployment in the rest of the world. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press, stating that (Bernanke 2000, 165):

“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Bernanke 2000, 161):

“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest”

Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others” (Robinson 1947, 156). Devaluation is one of the tools used in these policies (Robinson 1947, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 205-9; for the case of Brazil that devalued early in the Great Depression recovering with an increasing trade balance see Pelaez, 1968, 1968b, 1972; Brazil devalued and abandoned the gold standard during crises in the historical period as shown by Pelaez 1976, Pelaez and Suzigan 1981). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole.

Chairman Bernanke (2013Mar 25) reinterprets devaluation and recovery from the Great Depression:

“The uncoordinated abandonment of the gold standard in the early 1930s gave rise to the idea of "beggar-thy-neighbor" policies. According to this analysis, as put forth by important contemporary economists like Joan Robinson, exchange rate depreciations helped the economy whose currency had weakened by making the country more competitive internationally. Indeed, the decline in the value of the pound after 1931 was associated with a relatively early recovery from the Depression by the United Kingdom, in part because of some rebound in exports. However, according to this view, the gains to the depreciating country were equaled or exceeded by the losses to its trading partners, which became less internationally competitive--hence, ‘beggar thy neighbor.’ Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression. However, modern research on the Depression, beginning with the seminal 1985 paper by Barry Eichengreen and Jeffrey Sachs, has changed our view of the effects of the abandonment of the gold standard. Although it is true that leaving the gold standard and the resulting currency depreciation conferred a temporary competitive advantage in some cases, modern research shows that the primary benefit of leaving gold was that it freed countries to use appropriately expansionary monetary policies. By 1935 or 1936, when essentially all major countries had left the gold standard and exchange rates were market-determined, the net trade effects of the changes in currency values were certainly small. Yet the global economy as a whole was much stronger than it had been in 1931. The reason was that, in shedding the strait jacket of the gold standard, each country became free to use monetary policy in a way that was more commensurate with achieving full employment at home.”

Nurkse (1944) raised concern on the contraction of trade by competitive devaluations during the 1930s. Haberler (1937) dwelled on the issue of flexible exchange rates. Bordo and James (2001) provide perceptive exegesis of the views of Haberler (1937) and Nurkse (1944) together with the evolution of thought by Haberler. Policy coordination among sovereigns may be quite difficult in practice even if there were sufficient knowledge and sound forecasts. Friedman (1953) provided strong case in favor of a system of flexible exchange rates.

Eichengreen and Sachs (1985) argue theoretically with measurements using a two-sector model that it is possible for series of devaluations to improve the welfare of all countries. There were adverse effects of depreciation on other countries but depreciation by many countries could be beneficial for all. The important counterfactual is if depreciations by many countries would have promoted faster recovery from the Great Depression. Depreciation in the model of Eichengreen and Sachs (1985) affected domestic and foreign economies through real wages, profitability, international competitiveness and world interest rates. Depreciation causes increase in the money supply that lowers world interest rates, promoting growth of world output. Lower world interest rates could compensate contraction of output from the shift of demand away from home goods originating in neighbor’s exchange depreciation. Eichengreen and Sachs (1985, 946) conclude:

“This much, however, is clear. We do not present a blanket endorsement of the competitive devaluations of the 1930s. Though it is indisputable that currency depreciation conferred macroeconomic benefits on the initiating country, because of accompanying policies the depreciations of the 1930s had beggar-thy-neighbor effects. Though it is likely that currency depreciation (had it been even more widely adopted) would have worked to the benefit of the world as a whole, the sporadic and uncoordinated approach taken to exchange-rate policy in the 1930s tended, other things being equal, to reduce the magnitude of the benefits.”

There could major difference in the current world economy. The initiating impulse for depreciation originates in zero interest rates on the fed funds rate. The dollar is the world’s reserve currency. Risk aversion intermittently channels capital flight to the safe haven of the dollar and US Treasury securities. In the absence of risk aversion, zero interest rates induce carry trades of short positions in dollars and US debt (borrowing) together with long leveraged exposures in risk financial assets such as stocks, emerging stocks, commodities and high-yield bonds. Without risk aversion, the dollar depreciates against every currency in the world. The dollar depreciated against the euro by 39.3 percent from USD 1.1423/EUR con Jun 26, 2003 to USD 1.5914/EUR on Jun 14, 2008 during unconventional monetary policy before the global recession (Table VI-1). Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can increases net exports of the US that increase aggregate economic activity (Yellen 2011AS). The country issuing the world’s reserve currency appropriates the advantage from initiating devaluation that in policy intends to generate net exports that increase domestic output.

Pelaez and Pelaez (Regulation of Banks and Finance (2009b), 208-209) summarize the experience of Brazil as follows:

“During 1927–9, Brazil accumulated ￡30 million of foreign exchange of which ￡20 million were deposited at its stabilization fund (Pelaez 1968, 43–4). After the decline in coffee prices and the first impact of the Great Depression in Brazil a hot money movement wiped out foreign exchange reserves. In addition, capital inflows stopped entirely. The deterioration of the terms of trade further complicated matters, as the value of exports in foreign currency declined abruptly. Because of this exchange crisis, the service of the foreign debt of Brazil became impossible. In August 1931, the federal government was forced to cancel the payment of principal on certain foreign loans. The balance of trade in 1931 was expected to yield ￡20 million whereas the service of the foreign debt alone amounted to ￡22.6 million. Part of the solution given to these problems was typical of the 1930s. In September 1931, the government of Brazil required that all foreign transactions were to be conducted through the Bank of Brazil. This monopoly of foreign exchange was exercised by the Bank of Brazil for the following three years. Export permits were granted only after the exchange derived from sales abroad was officially sold to the Bank, which in turn allocated it in accordance with the needs of the economy. An active black market in foreign exchange developed. Brazil was in the first group of countries that abandoned early the gold standard, in 1931, and suffered comparatively less from the Great Depression. The Brazilian federal government, advised by the BOE, increased taxes and reduced expenditures in 1931 to compensate a decline in custom receipts (Pelaez 1968, 40). Expenditures caused by a revolution in 1932 in the state of Sao Paulo and a drought in the northeast explain the deficit. During 1932–6, the federal government engaged in strong efforts to stabilize the budget. Apart from the deliberate efforts to balance the budget during the 1930s, the recovery in economic activity itself may have induced a large part of the reduction of the deficit (Ibid, 41). Brazil’s experience is similar to that of the United States in that fiscal policy did not promote recovery from the Great Depression.”

Is depreciation of the dollar the best available tool currently for achieving the dual mandate of higher inflation and lower unemployment? Bernanke (2002) finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.¹⁷ The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Should the US devalue following Roosevelt? Or has monetary policy intended devaluation? Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment.

Friedman (1969) finds that the optimal rule for the quantity of money is deflation at a rate that results in a zero nominal interest rate (see Ireland 2003 and Cole and Kocherlakota 1998). Atkeson and Kehoe (2004) argue that central bankers are not inclined to implement policies that could result in deflation because of the interpretation of the Great Depression as closely related to deflation. They use panel data on inflation and growth of real output for 17 countries over more than 100 years. The time-series data for each individual country are broken into five-year events with deflation measured as average negative inflation and depression as average negative growth rate of real output. Atkeson and Kehoe (2004) find that the Great Depression from 1929 to 1934 is the only case of association between deflation and depression without any evidence whatsoever of such relation in any other period. Their conclusion is (Atkeson and Kehoe 2004, 99): “Our finding thus suggests that policymakers’ fear of anticipated policy-induced deflation that would result from following, say, the Friedman rule is greatly overblown.” Their conclusion on the experience of Japan is (Atkeson and Kehoe 2004, 99):

“Since 1960, Japan’s average growth rates have basically fallen monotonically, and since 1970, its average inflation rates have too. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think, is that much of the slowdown is the natural pattern for a country that was far behind the world leaders and had begun to catch up.”

In the sample of Atkeson and Kehoe (2004), there are only eight five-year periods besides the Great Depression with both inflation and depression. Deflation and depression is shown in 65 cases with 21 of depression without deflation. There is no depression in 65 of 73 five-year periods and there is no deflation in 29 episodes of depression. There is a remarkable result of no depression in 90 percent of deflation episodes. Excluding the Great Depression, there is virtually no relation of deflation and depression. Atkeson and Kehoe (2004, 102) find that the average growth rate of Japan of 1.41 percent in the 1990s is “dismal” when compared with 3.20 percent in the United States but is not “dismal” when compared with 1.61 percent for Italy and 1.84 percent for France, which are also catch-up countries in modern economic growth (see Atkeson and Kehoe 1998). The conclusion of Atkeson and Kehoe (2004), without use of controls, is that there is no association of deflation and depression in their dataset.

Benhabib and Spiegel (2009) use a dataset similar to that of Atkeson and Kehoe (2004) but allowing for nonlinearity and inflation volatility. They conclude that in cases of low and negative inflation an increase of average inflation of 1 percent is associated with an increase of 0.31 percent of average annual growth. The analysis of Benhabib and Spiegel (2009) leads to the significantly different conclusion that inflation and economic performance are strongly associated for low and negative inflation. There is no claim of causality by Atkeson and Kehoe (2004) and Benhabib and Spiegel (2009).

Delfim Netto (1959) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):

“First, the null hypothesis of no trend was accepted with high confidence; secondly, the null hypothesis of no oscillation was rejected also with high confidence. Consequently, in the nineteenth century international prices of coffee fluctuated but without long-run trend. This statistical fact refutes the extreme argument of structural weakness of the coffee trade.”

In his classic work on the theory of international trade, Jacob Viner (1937, 563) analyzed the “index of total gains from trade,” or “amount of gain per unit of trade,” denoted as T:

T= (∆P^e/∆Pⁱ)∆Q

Where ∆P^e is the change in export prices, ∆Pⁱ is the change in import prices and ∆Q is the change in export volume. Dorrance (1948, 52) restates “Viner’s index of total gain from trade” as:

“What should be done is to calculate an index of the value (quantity multiplied by price) of exports and the price of imports for any country whose foreign accounts are to be analysed. Then the export value index should be divided by the import price index. The result would be an index which would reflect, for the country concerned, changes in the volume of imports obtainable from its export income (i.e. changes in its "real" export income, measured in import terms). The present writer would suggest that this index be referred to as the ‘income terms of trade’ index to differentiate it from the other indexes at present used by economists.”

What really matters for an export activity especially during modernization is the purchasing value of goods that it exports in terms of prices of imports. For a primary producing country, the purchasing power of exports in acquiring new technology from the country providing imports is the critical measurement. The barter terms of trade of Brazil improved from 1857 to 1906 because international coffee prices oscillated without trend (Delfim Netto 1959) while import prices from the United Kingdom declined at the rate of 0.5 percent per year (Imlah 1958). The accurate measurement of the opportunity afforded by the coffee exporting economy was incomparably greater when considering the purchasing power in British prices of the value of coffee exports, or Dorrance’s (1948) income terms of trade.

The conventional theory that the terms of trade of Brazil deteriorated over the long term is without reality (Pelaez 1976a, 280-281):

“Moreover, physical exports of coffee by Brazil increased at the high average rate of 3.5 per cent per year. Brazil's exchange receipts from coffee-exporting in sterling increased at the average rate of 3.5 per cent per year and receipts in domestic currency at 4.5 per cent per year. Great Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 per cent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 per cent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quality of coffee remained relatively constant, the quality of manufactured products improved significantly during the fifty-year period considered. The trade data and the non-parametric tests refute conclusively the long-run hypothesis. The valid historical fact is that the tropical export economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the "workshop" countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil.”

Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that drove the world’s growth impulse. Inflation in the United Kingdom between 1857 and 1906 is measured by the composite price index of O’Donoghue and Goulding (2004) at minus 7.0 percent or average rate of decline of 0.2 percent per year.

Simon Kuznets (1971) analyzes modern economic growth in his Lecture in Memory of Alfred Nobel:

“The major breakthroughs in the advance of human knowledge, those that constituted dominant sources of sustained growth over long periods and spread to a substantial part of the world, may be termed epochal innovations. And the changing course of economic history can perhaps be subdivided into economic epochs, each identified by the epochal innovation with the distinctive characteristics of growth that it generated.Without considering the feasibility of identifying and dating such economic epochs, we may proceed on the working assumption that modern economic growth represents such a distinct epoch - growth dating back to the late eighteenth century and limited (except in significant partial effects) to economically developed countries. These countries, so classified because they have managed to take adequate advantage of the potential of modern technology, include most of Europe, the overseas offshoots of Western Europe, and Japan—barely one quarter of world population.”

Cameron (1961) analyzes the mechanism by which the Industrial Revolution in Great Britain spread throughout Europe and Cameron (1967) analyzes the financing by banks of the Industrial Revolution in Great Britain. O’Donoghue and Goulding (2004) provide consumer price inflation in England since 1750 and MacFarlane and Mortimer-Lee (1994) analyze inflation in England over 300 years. Lucas (2004) estimates world population and production since the year 1000 with sustained growth of per capita incomes beginning to accelerate for the first time in English-speaking countries and in particular in the Industrial Revolution in Great Britain. The conventional theory is unequal distribution of the gains from trade and technical progress between the industrialized countries and developing economies (Singer 1950, 478):

“Dismissing, then, changes in productivity as a governing factor in changing terms of trade, the following explanation presents itself: the fruits of technical progress may be distributed either to producers (in the form of rising incomes) or to consumers (in the form of lower prices). In the case of manufactured commodities produced in more developed countries, the former method, i.e., distribution to producers through higher incomes, was much more important relatively to the second method, while the second method prevailed more in the case of food and raw material production in the underdeveloped countries. Generalizing, we may say -that technical progress in manufacturing industries showed in a rise in incomes while technical progress in the production of food and raw materials in underdeveloped countries showed in a fall in prices”

Temin (1997, 79) uses a Ricardian trade model to discriminate between two views on the Industrial Revolution with an older view arguing broad-based increases in productivity and a new view concentration of productivity gains in cotton manufactures and iron:

“Productivity advances in British manufacturing should have lowered their prices relative to imports. They did. Albert Imlah [1958] correctly recognized this ‘severe deterioration’ in the net barter terms of trade as a signal of British success, not distress. It is no surprise that the price of cotton manufactures fell rapidly in response to productivity growth. But even the price of woolen manufactures, which were declining as a share of British exports, fell almost as rapidly as the price of exports as a whole. It follows, therefore, that the traditional ‘old-hat’ view of the Industrial Revolution is more accurate than the new, restricted image. Other British manufactures were not inefficient and stagnant, or at least, they were not all so backward. The spirit that motivated cotton manufactures extended also to activities as varied as hardware and haberdashery, arms, and apparel.”

Phyllis Deane (1968, 96) estimates growth of United Kingdom gross national product (GNP) at around 2 percent per year for several decades in the nineteenth century. The facts that the terms of trade of Great Britain deteriorated during the period of epochal innovation and high rates of economic growth while the income terms of trade of the coffee economy of nineteenth-century Brazil improved at the average yearly rate of 4.0 percent from 1857 to 1906 disprove the hypothesis of weakness of trade as an explanation of relatively lower income and wealth. As Temin (1997) concludes, Britain did pass on lower prices and higher quality the benefits of technical innovation. Explanation of late modernization must focus on laborious historical research on institutions and economic regimes together with economic theory, data gathering and measurement instead of grand generalizations of weakness of trade and alleged neocolonial dependence (Stein and Stein 1970, 134-5):

“Great Britain, technologically and industrially advanced, became as important to the Latin American economy as to the cotton-exporting southern United States. [After Independence in the nineteenth century] Latin America fell back upon traditional export activities, utilizing the cheapest available factor of production, the land, and the dependent labor force.”

The experience of the United Kingdom with deflation and economic growth is relevant and rich. Table IA-6 provides yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004). There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. Table IA-6 also provides yearly percentage changes of the UK composite price index of O’Donoghue and Goulding (2004) from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.

Table IA-6, United Kingdom, Negative Percentage Changes of Composite Price Index, 1751-1896, 1929-1934, Yearly ∆%

Year	∆%	Year	∆%	Year	∆%	Year	∆%
1751	-2.7	1797	-10.0	1834	-7.8	1877	-0.7
1753	-2.7	1798	-2.2	1841	-2.3	1878	-2.2
1755	-6.0	1802	-23.0	1842	-7.6	1879	-4.4
1758	-0.3	1803	-5.9	1843	-11.3	1881	-1.1
1759	-7.9	1806	-4.4	1844	-0.1	1883	-0.5
1760	-4.5	1807	-1.9	1848	-12.1	1884	-2.7
1761	-4.5	1811	-2.9	1849	-6.3	1885	-3.0
1768	-1.1	1814	-12.7	1850	-6.4	1886	-1.6
1769	-8.2	1815	-10.7	1851	-3.0	1887	-0.5
1770	-0.4	1816	-8.4	1857	-5.6	1893	-0.7
1773	-0.3	1819	-2.5	1858	-8.4	1894	-2.0
1775	-5.6	1820	-9.3	1859	-1.8	1895	-1.0
1776	-2.2	1821	-12.0	1862	-2.6	1896	-0.3
1777	-0.4	1822	-13.5	1863	-3.6	1929	-0.9
1779	-8.5	1826	-5.5	1864	-0.9	1930	-2.8
1780	-3.4	1827	-6.5	1868	-1.7	1931	-4.3
1785	-4.0	1828	-2.9	1869	-5.0	1932	-2.6
1787	-0.6	1830	-6.1	1874	-3.3	1933	-2.1
1789	-1.3	1832	-7.4	1875	-1.9	1934	0.0
1791	-0.1	1833	-6.1	1876	-0.3

Source:

O’Donoghue, Jim and Louise Goulding, 2004. Consumer Price Inflation since 1750. UK Office for National Statistics Economic Trends 604, Mar 2004, 38-46.

Nicholas Georgescu-Rogen (1960, 1) reprinted in Pelaez (1973) argues that “the agrarian economy has to this day remained a reality without theory.” The economic history of Latin America shares with the relation of deflation and unconventional monetary policy a more frustrating intellectual misfortune: theory without reality. MacFarlane and Mortimer-Lee (1994, 159) quote in a different context a phrase by Thomas Henry Huxley in the President’s Address to the British Association for the Advancement of Science on Sep 14, 1870 that is appropriate to these issues: “The great tragedy of science—the slaying of a beautiful hypothesis by an ugly fact.”

ESIII Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF (2012WEOOct) provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (IMF 2012GFSROct) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (IMF 2012FMOct) (http://www.imf.org/external/pubs/ft/fm/2012/02/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. China’s GDP growth decelerated significantly from annual equivalent 9.9 percent in IIQ2011 to 7.4 percent in IVQ2011 and 6.6 percent in IQ2012, rebounding to 7.8 percent in IIQ2012, 8.7 percent in IIIQ2012 and 8.2 percent in IVQ2012. Annual equivalent growth in IQ2013 fell to 6.6 percent. (See Subsection VC and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/10/world-inflation-waves-stagnating-united_21.html).
United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.6 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining real wages.
Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
World Inflation Waves. Inflation continues in repetitive waves globally (Section ESI and earlier http://cmpassocregulationblog.blogspot.com/2013/04/world-inflation-waves-squeeze-of.html and earlier http://cmpassocregulationblog.blogspot.com/2013/03/recovery-without-hiring-ten-million.html ).

A list of financial uncertainties includes:

Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on Dow industrials set record,” on Mar 5, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324156204578275560657416332.html), analyzes that the DJIA broke the closing high of 14164.53 set on Oct 9, 2007, and subsequently also broke the intraday high of 14,198.10 reached on Oct 11, 2007. The DJIA closed at 15303.10

The week of May 24 was dominated by the testimony of Chairman Bernanke to the Joint Economic Committee of the US Congress on May 22, 2013 (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm), followed by questions and answers and the release on May 22, 2013 of the minutes of the meeting of the Federal Open Market Committee (FOMC) from Apr 30 to May 1, 2013 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm). Monetary policy emphasizes communication of policy intentions to avoid that expectations reverse outcomes in reality (Kydland and Prescott 1977). Jon Hilsenrath, writing on “In bid for clarity, Fed delivers opacity,” on May 23, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath), analyzes discrepancies in communication by the Fed. The annotated chart of values of the Dow Jones Industrial Average (DJIA) during trading on May 23,2013 provided by Hinselrath, links the prepared testimony of Chairman Bernanke at 10:AM, following questions and answers and the release of the minutes of the FOMC at 2PM. Financial markets strengthened between 10 and 10:30AM on May 23, 2013, perhaps because of the statement by Chairman Bernanke in prepared testimony (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm):

“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.”

In that testimony, Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm) also analyzes current weakness of labor markets:

“Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers' skills and--particularly relevant during this commencement season--by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.”

Hilsenrath (op. cit. http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath) analyzes the subsequent decline of the market from 10:30AM to 10:40AM as Chairman Bernanke responded questions with the statement that withdrawal of stimulus would be determined by data but that it could begin in one of the “next few meetings.” The DJIA recovered part of the losses between 10:40AM and 2PM. The minutes of the FOMC released at 2PM on May 23, 2013, contained a phrase that troubled market participants (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm): “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.” The DJIA closed at 15,387.58 on May 21, 2013 and fell to 15,307.17 at the close on May 22, 2013, with the loss of 0.5 percent occurring after release of the minutes of the FOMC at 2PM when the DJIA stood at around 15,400. The concern about exist of the Fed from stimulus affected markets worldwide as shown in declines of equity indexes in Table III-1 with delays because of differences in trading hours. This behavior shows the trap of unconventional monetary policy with no exit from zero interest rates without risking financial crash and likely adverse repercussions on economic activity.

The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. The DJIA has increased 58.0 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to May 24, 2013, S&P 500 has gained 61.3 percent and DAX 46.5 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 5/24/13” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior: China’s Shanghai Composite is 4.0 percent below the trough; Japan’s Nikkei Average is 65.6 percent above the trough; DJ Asia Pacific TSM is 23.6 percent above the trough; Dow Global is 29.7 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 21.0 percent above the trough; and NYSE Financial Index is 36.9 percent above the trough. DJ UBS Commodities is 6.4 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 46.5 percent above the trough. Japan’s Nikkei Average is 65.6 percent above the trough on Aug 31, 2010 and 28.3 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 14,612.45

on Fri May 24, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 42.5 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 8.5 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 5/24/13” in Table VI-4 shows increase of 0.2 percent for China’s Shanghai Composite in the week. DJ Asia Pacific decreased 2.7 percent. NYSE Financial decreased 2.4 percent in the week. DJ UBS Commodities increased 0.2 percent. Dow Global decreased 1.2 percent in the week of May 24, 2013. The DJIA decreased 0.3 percent and S&P 500 decreased 1.1 percent. DAX of Germany decreased 1.1 percent. STOXX 50 decreased 1.5 percent. The USD depreciated 0.7 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 5/24/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to May 24, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 5/24/13” but also relative to the peak in column “∆% Peak to 5/24/13.” There are now several equity indexes above the peak in Table VI-4: DJIA 36.6 percent, S&P 500 35.5 percent, DAX 31.2 percent, Dow Global 5.8 percent, DJ Asia Pacific 8.3 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 9.0 percent, Nikkei Average 28.3 percent and STOXX 50 2.5 percent. There is only one equity index below the peak: Shanghai Composite by 27.7 percent. DJ UBS Commodities Index is now 9.0 percent below the peak. The US dollar strengthened 14.5 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Alexandra Scaggs, writing on “Tepid profits, roaring stocks,” on May 16, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323398204578487460105747412.html), analyzes stabilization of earnings growth: 70 percent of 458 reporting companies in the S&P 500 stock index reported earnings above forecasts but sales fell 0.2 percent relative to forecasts of increase of 0.5 percent. Paul Vigna, writing on “Earnings are a margin story but for how long,” on May 17, 2013, published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2013/05/17/earnings-are-a-margin-story-but-for-how-long/), analyzes that corporate profits increase with stagnating sales while companies manage costs tightly. More than 90 percent of S&P components reported moderate increase of earnings of 3.7 percent in IQ2013 relative to IQ2012 with decline of sales of 0.2 percent. Earnings and sales have been in declining trend. In IVQ2009, growth of earnings reached 104 percent and sales jumped 13 percent. Net margins reached 8.92 percent in IQ2013, which is almost the same at 8.95 percent in IIIQ2006. Operating margins are 9.58 percent. There is concern by market participants that reversion of margins to the mean could exert pressure on earnings unless there is more accelerated growth of sales. Vigna (op. cit.) finds sales growth limited by weak economic growth. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. It may be quite painful to exit QE→∞ or use of the balance sheet of the central together with zero interest rates forever. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

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

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.

Table VI-4, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 5/24/ /13	∆% Week 5/24/13	∆% Trough to 5/24/ 13
DJIA	4/26/ 10	7/2/10	-13.6	36.6	-0.3	58.0
S&P 500	4/23/ 10	7/20/ 10	-16.0	35.5	-1.1	61.3
NYSE Finance	4/15/ 10	7/2/10	-20.3	9.0	-2.4	36.9
Dow Global	4/15/ 10	7/2/10	-18.4	5.8	-1.2	29.7
Asia Pacific	4/15/ 10	7/2/10	-12.5	8.3	-2.7	23.6
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	28.3	-3.5	65.6
China Shang.	4/15/ 10	7/02 /10	-24.7	-27.7	0.2	-4.0
STOXX 50	4/15/10	7/2/10	-15.3	2.5	-1.5	21.0
DAX	4/26/ 10	5/25/ 10	-10.5	31.2	-1.1	46.5
Dollar Euro	11/25 2009	6/7 2010	21.2	14.5	-0.7	-8.5
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-9.0	0.2	6.4
10-Year T Note	4/5/ 10	4/6/10	3.986	2.009

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

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

IA United States Commercial Banks Assets and Liabilities. Subsection IA1 Transmission of Monetary Policy recapitulates the mechanism of transmission of monetary policy. Subsection IA2 Functions of Banking analyzes the functions of banks in modern banking theory. Subsection IA3 United States Commercial Bank Assets and Liabilities provides data and analysis of US commercial bank balance sheets in report H.8 of the Board of Governors of the Federal Reserve System on Assets and Liabilities of Commercial Banks in the United States (http://www.federalreserve.gov/releases/h8/current/default.htm). Subsection IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation analyzes and compares unconventional monetary policy.

IA1 Transmission of Monetary Policy. The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, unconventional monetary policy also includes a battery of measures in also reducing long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

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

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

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

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial instability (http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets. More technical discussion is in IA Appendix: Transmission of Unconventional Monetary Policy at http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html.

Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):

“I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance. There are many ways of doing this, including setting a target for the level of nominal GDP. But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent. Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.

Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation. But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong. Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.

The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low. In addition, I would indicate that clear and steady progress toward stronger growth is essential.”

Evans (2012Nov27) modified the “7/3” approach to a “6.5/2.5” approach:

“I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Price Index) inflation over the next two to three years, would be appropriate.”

The Federal Open Market Committee (FOMC) decided at its meeting on Dec 12, 2012 to implement the “6.5/2.5” approach (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm):

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 1.6 to 2.1 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 US economic growth has been at only 2.1 percent on average in the cyclical expansion in the 15 quarters from IIIQ2009 to IQ2013. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The average of 7.8 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 3.2 percent obtained by diving GDP of $13,103.5 billion in IIIQ2010 by GDP of $12,701.0 billion in IIQ2009 {[$13.103.5/$12,701.0 -1]100 = 3.2%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.7 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.

First, total nonfarm payroll employment seasonally adjusted (SA) increased 165,000 in Apr 2013 and private payroll employment rose 176,000. The average number of nonfarm jobs created in Jan-Apr 2012 was 224,750 while the average number of nonfarm jobs created in Jan-Apr 2013 was 195,750, or decline by 12.9 percent. The average number of private jobs created in the US in Jan-Apr 2012 was 229,000 while the average in Jan-Apr 2013 was 203,250, or decline by 11.2 percent. The US labor force increased from 153.617 million in 2011 to 154.975 million in 2012 by 1.358 million or 113,167 per month. The average increase of nonfarm jobs in the four months from Jan to Mar 2013 was 195,750, which is a rate of job creation inadequate to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 28.6 million unemployed or underemployed. The difference between the average increase of 203,250 new private nonfarm jobs per month in the US from Jan to Mar 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 90,083 monthly new jobs net of absorption of new entrants in the labor force. There are 28.6 million in job stress in the US currently. The provision of 90,083 new jobs per month net of absorption of new entrants in the labor force would require 318 months to provide jobs for the unemployed and underemployed (28.637 million divided by 90,083) or 26.5 years (318 divided by 12). The civilian labor force of the US in Apr 2013 not seasonally adjusted stood at 154.739 million with 11.014 million unemployed or effectively 18.581 million unemployed in this blog’s calculation by inferring those who are not searching because they believe there is no job for them for effective labor force of 162.306 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 0.9 years (1 million divided by product of 90,083 by 12, which is 1,080,996). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.737 million (0.05 times labor force of 154.739 million) for new net job creation of 3.277 million (11.014 million unemployed minus 7.737 million unemployed at rate of 5 percent) that at the current rate would take 3.0 years (3.277 million divided by 1.080996). Under the calculation in this blog there are 18.581 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.306 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 11.381 million jobs net of labor force growth that at the current rate would take 9.7 years (18.581 million minus 0.05(162.306 million) or 10.466 million divided by 1.080996, using LF PART 66.2% and Total UEM (in Table I-4 http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). 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 147.315 million in Jul 2007 to 143.724 million in Apr 2013, by 3.591 million, or decline of 2.4 percent, while the noninstitutional population increased from 231.958 million in Jul 2007 to 245.175 million in Apr 2013, by 13.217 million or increase of 5.7 percent, using not seasonally adjusted data. There is actually not sufficient job creation in merely absorbing 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, the economy of the US can be summarized in growth of economic activity or GDP as decelerating from mediocre growth of 2.4 percent on an annual basis in 2010 and 1.8 percent in 2011 to 2.2 percent in 2012. Calculations below show that actual growth is around 1.9 percent per year. This rate is well below 3 percent per year in trend from 1870 to 2010, which has been always recovered after events such as wars and recessions (Lucas 2011May). United States real GDP grew at the rate of 3.2 percent between 1929 and 2012 and at 3.2 percent between 1947 and 2012 (http://www.bea.gov/iTable/index_nipa.cfm see http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). Growth is not only mediocre but also sharply decelerating to a rhythm that is not consistent with reduction of unemployment and underemployment of 28.6 million people corresponding to 17.6 percent of the effective labor force of the United States (http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). In the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013, US real GDP grew at the seasonally-adjusted annual equivalent rates of 0.1 percent in the first quarter of 2011 (IQ2011), 2.5 percent in IIQ2011, 1.3 percent in IIIQ2011, 4.1 percent in IVQ2011, 2.0 percent in IQ2012, 1.3 percent in IIQ2012, revised 3.1 percent in IIIQ2012, 0.4 percent in IVQ2012 and 2.5 percent in IQ2013. The annual equivalent rate of growth of GDP for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 percent, obtained as follows. Discounting 0.1 percent to one quarter is 0.025 percent {[(1.001)^1/4 -1]100 = 0.025}; discounting 2.5 percent to one quarter is 0.62 percent {[(1.025)^1/4 – 1]100}; discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 – 1]100}; discounting 4.1 percent to one quarter is 1.0 {[(1.04)^1/4 -1]100; discounting 2.0 percent to one quarter is 0.50 percent {[(1.020)^1/4 -1]100); discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 -1]100}; discounting 3.1 percent to one quarter is 0.77 {[(1.031)^1/4 -1]100); discounting 0.4 percent to one quarter is 0.1 percent {[(1.004)^1/4 – 1]100}; and discounting 2.5 percent to one quarter is 0.62 percent {[(1.025)^1/4 -1}100}. Real GDP growth in the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 accumulated to 4.3 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0062) - 1]100 = 4.3%}. This is equivalent to growth from IQ2011 to IVQ2012 obtained by dividing the seasonally-adjusted annual rate (SAAR) of IQ2013 of $13,750.1 billion by the SAAR of IVQ2010 of $13,181.2 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1 and Table I-6 below) and expressing as percentage {[($13,750.1/$13,181.2) - 1]100 = 4.3%}. The growth rate in annual equivalent for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0062)^4/9 -1]100 = 1.9%], or {[($13,750.1/$13,181.2)]^4/9-1]100 = 1.9%} dividing the SAAR of IVQ2012 by the SAAR of IVQ2010 in Table I-6 below, obtaining the average for nine quarters and the annual average for one year of four quarters. Growth in the four quarters of 2012 accumulates to 1.7 percent {[(1.02)^1/4(1.013)^1/4(1.031)^1/4(1.004)^1/4 -1]100 = 1.7%}. This is equivalent to dividing the SAAR of $13,665.4 billion for IVQ2012 in Table I-6 by the SAAR of $13,441.0 billion in IVQ2011 except for a rounding discrepancy to obtain 1.7 percent {[($13,665.4/$13,441.0) – 1]100 = 1.7%}. The US economy is still close to a standstill especially considering the GDP report in detail.

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is concern of the production and employment costs of controlling future inflation. Even if there is no inflation, QE→∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.

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

clip_image004[1]

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 discount rates increase without bound, then V → 0, or

clip_image004[1]

declines.

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

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞. Equally, as r→∞, W→0. Monetary policy is constrained in a QE∞ trap with all adverse effects of financial repression and resource misallocation because an increase in interest rates causes contraction of wealth, which in the United States is concentrated in home ownership and stocks in own investment portfolios and pension funds that decline during interest rate increases.

IA2 Functions of Banks. Modern banking theory analyzes three important functions provided by banks: monitoring of borrowers, provision of liquidity services and transformation of illiquid assets into immediately liquid assets (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 51-60). These functions require valuation of alternative investment projects that may be distorted by zero interest rates of monetary policy and artificially low long-term interest rates. The QE∞ trap frustrates essential banking functions.

Monitoring. Banks monitor projects to ensure that funds are allocated to their intended projects (Diamond 1984, 1996). Banks issue deposits, which are secondary assets, to acquire loans, which are primary assets. Monitoring reduces costs of participating in business projects. Acting as delegated monitor, banks obtain information on the borrower, allowing less costly participation through the issue of unmonitored deposits. Monitoring of borrowers provides enhanced less costly participation by investors through the issue of deposits. There is significant reduction of monitoring costs by delegating to a bank. If there are many potential investors, monitoring by the bank of a credit name is less costly than the sum of individual monitoring of the same credit name by all potential investors. Banks permit borrowers to reach many investors for their projects while affording investors less costly participation in the returns of projects of bank borrowers.
Transformation of Illiquid Loans into Liquid Deposits. Diamond and Dybvig (1986) analyze bank services through bank balance sheets.

iv. Assets. Banks provide loans to borrowers. The evaluation of borrowers prevents “adverse selection,” which consists of banks choosing unsound projects and failing to finance sound projects. Monitoring of loans prevents “moral hazard,” which consists of borrowers using the funds of the loan for purposes other than the project for which they were lent, as for example, using borrowed bank funds for speculative real estate instead of for the intended industrial project. Relationship banking improves the information on borrowers and the monitoring function.

v. Liabilities. Banks provide numerous services to their clients such as holding deposits, clearing transactions, currency inventory and payments for goods, services and obligations.

vi. Assets and Liabilities: Transformation Function. The transformation function operates through both sides of the balance sheet: banks convert illiquid loans in the asset side into liquid deposits in the liability side. There is rich theory of banking (Diamond and Rajan 2000, 2001a,b). Securitized banking provides the same transformation function by bundling mortgage and other consumer loans into securities that are then sold to investors who finance them in short-dated sale and repurchase agreements (Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 61-6).

IA3 United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table IA-1. Data are not seasonally adjusted to permit comparison between Apr 2012 and Apr 2013. Total assets of US commercial banks grew 5.5 percent from $12,645.2 billion in Apr 2012 to $13,346.2 billion in Apr 2013. US GDP in 2012 is estimated at $15,684.8 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 85 percent of US GDP. Bank credit grew 4.4 percent from $9604.7 billion in Apr 2012 to $10,023.4 billion in Apr 2013. Securities in bank credit increased 6.2 percent from $2596.3 billion in Apr 2012 to $2757.0 billion in Apr 2013. A large part of securities in banking credit consists of US Treasury and agency securities, growing 4.3 percent from $1803.5 billion in Apr 2012 to $1881.4 billion in Apr 2013. Credit to the government that issues or backs Treasury and agency securities of $1881.4 billion in Apr 2013 is about 18.8 percent of total bank credit of US commercial banks of $10,023.2 billion. Mortgage-backed securities, providing financing of home loans, grew 2.3 percent, from $1335.5 billion in Apr 2012 to $1366.2 billion in Apr 2013. Loans and leases were less dynamic, growing 3.7 percent from $7008.4 billion in Apr 2012 to $7266.5 billion in Apr 2013. The only dynamic class is commercial and industrial loans, growing 10.5 percent from Apr 2012 to Apr 2013 and providing $1552.7 billion or 21.4 percent of total loans and leases of $7266.5 billion in Apr 2013. Real estate loans increased only 0.3 percent, providing $3538.8 billion in Apr 2013 or 48.7 percent of total loans and leases. Consumer loans increased only 2.7 percent, providing $1118.8 billion in Apr 2013 or 15.4 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks increased 19.1 percent from $1638.1 billion in Apr 2012 to $1950.9 billion in Apr 2013 but a single year of the series masks exploding cash in banks because of unconventional monetary policy, which is discussed below. Bank deposits increased 8.2 percent from $8654.7 billion to $9365.1 billion. The difference between bank deposits and total loans and leases in banks increased from $1646.3 billion in Apr 2012 to $2098.6 billion in Apr 2013 or by $452.3 billion, which is similar to the increase in securities in bank credit by $160.7 billion from $2596.3 billion in Apr 2012 to $2757.0 billion in Apr 2013 and to the increase in Treasury and agency securities by $77.9 billion from $1803.5 billion in Apr 2012 to $1881.4 billion in Apr 2013. Loans and leases increased $258.1 billion from $7008.4 billion in Apr 2012 to $7266.5 billion in Apr 2013. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IQ2013 lower by 0.6 percent than in IVQ2007 (Table IA-3 below; see IX Conclusion and extended analysis in IB Collapse of United States Dynamism of Income Growth and Employment Creation) in contrast with 11.5 percent higher if the economy had performed in long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May). In contrast, growth of real disposable income grew cumulatively 17.0 percent in the cycle from IQ1980 to IIIQ1986 that was higher than trend growth of 14.9 percent.

Table IA-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars

	Apr 2012	Apr 2013	∆%
Total Assets	12,654.2	13,346.2	5.5
Bank Credit	9604.7	10,023.4	4.4
Securities in Bank Credit	2596.3	2757.0	6.2
Treasury & Agency Securities	1803.5	1881.4	4.3
Mortgage-Backed Securities	1335.5	1366.2	2.3
Loans & Leases	7008.4	7266.5	3.7
Real Estate Loans	3528.9	3538.8	0.3
Consumer Loans	1089.0	1118.8	2.7
Commercial & Industrial Loans	1404.7	1552.7	10.5
Other Loans & Leases	985.8	1056.2	7.1
Cash Assets*	1638.1	1950.5	19.1
Total Liabilities	11,197.2	11,836.3	5.7
Deposits	8654.7	9365.1	8.2

Note: balancing item of residual assets less liabilities not included

*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Table IA-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%

	2008	2009	2010	2011	2012	Mar 2013	Apr 2013
Total Assets	7.9	-6.0	-2.7	5.4	2.5	10.9	4.2
Bank Credit	2.2	-6.7	-2.7	1.8	4.0	0.1	4.0
Securities in Bank Credit	-1.8	6.4	6.9	1.8	7.5	-4.3	1.0
Treasury & Agency Securities	3.5	14.5	15.3	3.1	8.6	-9.1	-6.1
Other Securities	-8.3	-4.9	-7.2	-0.8	5.0	6.4	16.4
Loans & Leases	3.3	-10.2	-5.8	1.8	2.7	1.8	5.1
Real Estate Loans	-0.2	-5.6	-5.5	-3.7	-1.1	-1.4	2.6
Consumer Loans	5.1	-3.3	-7.1	-0.7	1.1	5.3	6.1
Commercial & Industrial Loans	12.9	-18.6	-9.0	9.5	11.4	9.3	6.6
Other Loans & Leases	1.8	-23.3	0.3	19.4	6.3	-1.6	10.4
Cash Assets	158.3	48.2	-7.9	47.9	-2.4	85.6	9.0
Total Liabilities	10.6	-7.2	-3.4	5.5	2.2	8.6	4.1
Deposits	5.4	5.2	2.4	6.6	7.1	7.5	2.4

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-1 of the Board of Governors of the Federal Reserve System provides quarterly seasonally adjusted annual rates (SAAR) of cash assets in US commercial banks from 1973 to 2013. Unconventional monetary policy caused an increase in cash assets in late 2008 of close to 500 percent at SAAR and also in following policy impulses. Such aggressive policies were not required for growth of GDP at the average rate of 5.7 percent in 13 quarters of cyclical expansion from IQ1983 to IV1985 while the average rate in 15 quarters of cyclical expansion from IIIQ2009 to IQ2013 has been at the rate of 2.1 percent (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). The difference in magnitude of the recessions is not sufficient to explain weakness of the current cyclical expansion. Bordo (2012Sep27) and Bordo and Haubrich (2012DR) find that growth is higher after deeper contractions and contractions with financial crises. There were two consecutive contractions in the 1980s with decline of 2.2 percent in two quarters from IQ1980 to IIIQ1980 and 2.7 percent from IIIQ1981 to IVQ1982 that are almost identical to the contraction of 4.7 percent from IVQ2007 to IIQ2009. There was also a decade-long financial and banking crisis during the 1980s. The debt crisis of 1982 (Pelaez 1986) wiped out a large part of the capital of large US money-center banks. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.74 percent of GDP in a year. US GDP in 2012 is estimated at $15,684.8 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the bailout would be equivalent to cost to taxpayers of about $429.8 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery.

Chart IA-1, US, Cash Assets, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-2 of the Board of Governors of the Federal Reserve System provides quarterly SAARs of bank credit at US commercial banks from 1973 to 2013. Rates collapsed sharply during the global recession as during the recessions of the 1980s and then rebounded. In both episodes, rates of growth of bank credit did not return to earlier magnitudes.

Chart IA-2, US, Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-3 of the Board of Governors of the Federal Reserve System provides deposits at US commercial banks from 1973 to 2013. Deposits fell sharp during and after the global recession but then rebounded in the cyclical expansion.

Chart IA-3, US, Deposits, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is similar behavior in the 1980s and in the current cyclical expansion of SAARs holdings of Treasury and agency securities in US commercial banks provided in Chart IA-4 of the Board of Governors of the Federal Reserve System for the period 1973 to 2013. Sharp reductions of holdings during the contraction were followed by sharp increases.

Chart IA-4, US, Treasury and Agency Securities in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-5 of the Board of Governors of the Federal Reserve System provides SAARs of change of total loans and leases in US commercial banks from 1973 to 2013. The decline in the current cycle of SAARs was much sharper and the rebound did not recover earlier growth rates. Part of the explanation originates in demand for loans that was high during rapid economic growth at 5.7 percent per year on average in the cyclical expansion of the 1980s in contrast with lower demand during tepid economic growth at 2.1 percent per year on average in the current weak expansion.

Chart IA-5, US, Loans and Leases in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in the two cycles of the 1980s and the current one in quarterly SAARs of real estate loans in US commercial banks provided in Chart IA-6 of the Board of Governors of the Federal Reserve System. The difference is explained by the debacle in real estate after 2006 compared to expansion during the 1980s even in the midst of the crisis of savings and loans and real estate credit. In both cases, government policy tried to influence recovery and avoid market clearing.

Chart IA-6, US, Real Estate Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in quarterly SAARs of change of consumer loans in US commercial banks in the 1980s and during the current cycle as shown in Chart IA-7 of the Board of Governors of the Federal Reserve System. Quarterly SAARs of consumer loans in US commercial banks fell sharply during the contraction of 1980 and oscillated with upward trend during the contraction of 1983-1984 but increased sharply in the cyclical expansion. In contrast, SAARs of consumer loans in US commercial banks collapsed to high negative magnitudes during the contraction and have increased at very low magnitudes during the current cyclical expansion.

Chart IA-7, US, Consumer Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1958-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

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 IA-3 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IIIQ1986 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. In the 15 quarters from IQ1983 to IQ1II986: GDP increased 21.3 percent at the annual equivalent rate of 5.3 percent; real disposable personal income (RDPI) increased 16.9 percent at the annual equivalent rate of 4.2 percent; RDPI per capita increased 13.3 percent at the annual equivalent rate of 3.4 percent; and population increased 3.2 percent at the annual equivalent rate of 0.8 percent Second, in the 15 quarters of the current cyclical expansion from IIIQ2009 to IQ2013, GDP increased 8.3 percent at the annual equivalent rate of 2.1 percent. In the 15 quarters of cyclical expansion: real disposable personal income (RDPI) increased 5.6 percent at the annual equivalent rate of 1.5 percent; RDPI per capita increased 2.9 percent at the annual equivalent rate of 0.8 percent; and population increased 2.6 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IQ2013, GDP increased 3.2 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IQ2013, real disposable personal income increased 5.0 percent at the annual equivalent rate of 0.9 percent; population increased 4.2 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 0.6 percent lower than the level before the recession. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table IA-3, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2012, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15
GDP IQ1983 to IVQ1985 IQ1983 to IIIQ1986	13 15	19.6 21.3	5.7 5.3
RDPI IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	14.9 16.9	4.4 4.2
RDPI Per Capita IQ1983 to IVQ1986 IQ1983 to IIIQ1986	13 15	11.9 13.3	3.5 3.4
Population IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	2.7 3.2	0.8 0.8
IIIQ2009 to IQ2013	15
GDP		8.3	2.1
RDPI		5.6	1.5
RDPI per Capita		2.9	0.8
Population		2.6	0.7
IVQ2007 to IQ2013	22
GDP		3.2	0.6
RDPI		5.0	0.9
RDPI per Capita		-0.6	NA
Population		4.2	0.8

RDPI: Real Disposable Personal Income

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

Chart IA-8 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2013. Increases in bank cash reserves processed acquisitions of securities for the portfolio of the central bank. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Discovery of such painless and fast adjustment by gigantic impulses of monetary policy of zero interest rates and trillions of dollars of bond buying would have occurred earlier with prior cases of successful implementation. Selective incentives to the private sector of a long-term nature could have been more effective.

Chart IA-8, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-9 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from Dec 18, 2002 to May 22, 2013. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart IA-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.

Chart IA-9, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, Dec 18, 2002 to Apr 24, 2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1

Chart IA-10 of the Board of Governors of the Federal Reserve System provides deposits in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2013. Deposit growth clearly accelerated after 2001 and continued during the current cyclical expansion after bumps during the global recession.

Chart IA-10, US, Deposits in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-11 of the Board of Governors of the Federal Reserve System provides Treasury and agency securities in US commercial banks, not seasonally adjusted, in billions of dollars from 1947 to 2013. Holdings stabilized between the recessions of 2001 and after IVQ2007. There was rapid growth during the global contraction especially after unconventional monetary policy in 2008 and nearly vertical increase without prior similar historical experience during the various bouts of unconventional monetary policy. Banks hoard cash and less risky Treasury and agency securities instead of risky lending because of the weakness of the economy and the lack of demand for financing sound business projects.

Chart IA-11, US, Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-12 of the Board of Governors of the Federal Reserve System provides total loans and leases in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Total loans and leases of US commercial banks contracted sharply and have stalled during the cyclical expansion.

Chart IA-12, US, Loans and Leases in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-13 of the Board of Governors of the Federal Reserve System provides real estate loans in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Housing subsidies and low interest rates caused a point of inflexion to higher, nearly vertical growth until 2007. Real estate loans have contracted in downward trend partly because of adverse effects of uncertainty on the impact on balance sheets of the various mechanisms of resolution imposed by policy. Nick Timiraos, writing on “Push for cheaper credit hits wall,” on Dec 24, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324660404578197782701079650.html), provides important information and analysis on housing finance. Quantitative easing consists of withdrawing supply of mortgage-backed securities by acquiring them as assets in the Fed balance sheet. Lending banks obtain funds for mortgages by bundling them according to risk and other characteristics and selling them to investors, using the proceeds from the sale to provide the loans to homebuyers or refinancing homeowners. Banks earn net revenue to remunerate capital required for operations from the spread between the rate received from mortgage debtors and the rate implicit in the yield of the mortgage-backed securities. Nick Timiraos (Ibid) finds that the spread was around 0.5 percentage points before the financial crisis of 2007, widening to 1 percentage point after the crisis but jumping to 1.6 percentage points after the Fed engaged in another program of buying mortgage-backed securities, oscillating currently around 1.3 percentage points. The spread has widened because banks have higher costs originating in regulation, litigation on repurchasing defaulted mortgages, loss in case of default and more prudent but more costly scrutiny of property appraisals and income verification. As a result, even if quantitative easing does lower yields of mortgage-backed securities there would not be proportionate reduction in mortgage rates and even less likely construction and sales of houses.

Chart IA-13, US, Real Estate Loans in Bank Credit, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-14 of the Board of Governors of the Federal Reserve System provides consumer loans in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Consumer loans even increased during the contraction then declined and increased vertically to decline again. There was high demand for reposition of durable goods that exhausted and limited consumption again with increase in savings rates in recent periods.

Chart IA-14, US, Consumer Loans in Bank Credit, Not Seasonally Adjusted, US Commercial Banks, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IA-15 of the Board of Governors of the Federal Reserve System provides commercial and industrial loans not seasonally adjusted in billions of dollars from 1947 to 2013. Commercial and industrial loans fell sharply during both contractions in 2001 and after IVQ2007 and then rebounded with accelerated growth. Commercial and industrial loans have not reached again the peak during the global recession.

Chart IA-15, US, Commercial and Industrial Loans in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

“The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision making.

This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy's dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions.

However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis.

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”

“Whale” trades at official institutions causing wide swings of financial and economic variables do not receive the same media attention as those in large private banking institutions such as the teapot storm over JP Morgan Chase.

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004 and quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates (for fear of deflation see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html