CMP Associates Regulation Blog: Risks of Unwinding Monetary Policy, United States Industrial Production, United States International Trade, World Economic Slowdown and Global Recession Risk: Part I

Risks of Unwinding Monetary Policy, United States Industrial Production, United States International Trade, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

Executive Summary

I United States Industrial Production

II United States International Trade

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

Contents of Executive Summary

ESI Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and Global Financial and Economic Risk

ESII Slowing World Economic Growth

ESIII United States Industrial Production

ESIV United States International Trade

ESI Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and 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 for both theory and measurement. 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 for both theory and measurement. The IMF (2013WEOOct) provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2013/02/), of the world financial system with its Global Financial Stability Report (GFSR) (IMF 2013GFSROct) (http://www.imf.org/External/Pubs/FT/GFSR/2013/02/index.htm) and of fiscal affairs with the Fiscal Monitor (IMF 2013FMOct) (http://www.imf.org/external/pubs/ft/fm/2013/02/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 10.8 percent in IIQ2011 to 7.4 percent in IVQ2011 and 5.7 percent in IQ2012, rebounding to 9.1 percent in IIQ2012, 8.2 percent in IIIQ2012 and 7.8 percent in IVQ2012. Annual equivalent growth in IQ2013 fell to 6.1 percent and to 7.8 percent in IIQ2013, rebounding to 9.1 percent in IIIQ2013 (http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/07/tapering-quantitative-easing-policy-and_7005.html 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 28.9 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining/stagnating 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 (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.htm and earlier http://cmpassocregulationblog.blogspot.com/2013/10/world-inflation-waves-regional-economic.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

Chart VIII-1 of the Board of Governors of the Federal Reserve System provides the rate on the overnight fed funds rate and the yields of the 10-year constant maturity Treasury and the Baa seasoned corporate bond. Table VIII-3 provides the data for selected points in Chart VIII-1. There are two important economic and financial events, illustrating the ease of inducing carry trade with extremely low interest rates and the resulting financial crash and recession of abandoning extremely low interest rates because of reversal of carry trades.

The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment. The exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at interest rates close to zero, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV). The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper with the objective of purchasing default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever-increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VIII-1. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 to 5.25 percent in Jun 2006 caused the financial crisis and global recession. The exit triggered reversal of carry trades induced by extremely low interest rates.
On Dec 16, 2008, the policy determining committee of the Fed decided (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm): “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.” Policymakers emphasize frequently that there are tools to exit unconventional monetary policy at the right time. At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states that: “The Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.” Perception of withdrawal of $2489 billion, or $2.5 trillion bank reserves (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), would cause Himalayan increase in interest rates that would cause another recession. There is no painless gradual or sudden exit from zero interest rates because of reversal of exposures created on the commitment of zero interest rates forever. An added problem is that investors, market participants and the public in general have been through a similar event from 2003 to 2007.

Chart VIII-1, Fed Funds Rate and Yields of Ten-year Treasury Constant Maturity and Baa Seasoned Corporate Bond, Jan 2, 2001 to Nov 14, 2013

Source: Board of Governors of the Federal Reserve System

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

Table VIII-3, Selected Data Points in Chart VIII-1, % per Year

	Fed Funds Overnight Rate	10-Year Treasury Constant Maturity	Seasoned Baa Corporate Bond
1/2/2001	6.67	4.92	7.91
10/1/2002	1.85	3.72	7.46
7/3/2003	0.96	3.67	6.39
6/22/2004	1.00	4.72	6.77
6/28/2006	5.06	5.25	6.94
9/17/2008	2.80	3.41	7.25
10/26/2008	0.09	2.16	8.00
10/31/2008	0.22	4.01	9.54
4/6/2009	0.14	2.95	8.63
4/5/2010	0.20	4.01	6.44
2/4/2011	0.17	3.68	6.25
7/25/2012	0.15	1.43	4.73
5/1/13	0.14	1.66	4.48
9/5/13	0.08	2.98	5.53
1/14/2013	0.08	2.63	5.33

Source: Board of Governors of the Federal Reserve System

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

Professionals use a variety of techniques in measuring interest rate risk (Fabozzi, Buestow and Johnson, 2006, Chapter Nine, 183-226):

Full valuation approach in which securities and portfolios are shocked by 50, 100, 200 and 300 basis points to measure their impact on asset values
Stress tests requiring more complex analysis and translation of possible events with high impact even if with low probability of occurrence into effects on actual positions and capital
Value at Risk (VaR) analysis of maximum losses that are likely in a time horizon
Duration and convexity that are short-hand convenient measurement of changes in prices resulting from changes in yield captured by duration and convexity
Yield volatility

Analysis of these methods is in Pelaez and Pelaez (International Financial Architecture (2005), 101-162) and Pelaez and Pelaez, Globalization and the States, Vol. (I) (2008a), 78-100). Frederick R. Macaulay (1938) introduced the concept of duration in contrast with maturity for analyzing bonds. Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from change of 100 basis points in yield. The mathematical formula is the negative of the yield elasticity of the bond price or –[dB/d(1+y)]((1+y)/B), where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (Hallerbach 2001). The duration trap of unconventional monetary policy is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are historically low because of unconventional monetary policy. Duration dumping during a rate increase may trigger the same crossfire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in multiple segments (Brunnermeier and Pedersen 2009; see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 217-24). Financial markets are currently experiencing fear of duration resulting from the debate within and outside the Fed on tapering quantitative easing. Table VIII-2 provides the yield curve of Treasury securities on Nov 15, 2013, Sep 5, 2013, May 1, 2013, Nov 15, 2012 and Nov 15, 2006. There is ongoing steepening of the yield curve for longer maturities, which are also the ones with highest duration. The 10-year yield increased from 1.45 percent on Jul 26, 2012 to 2.98 percent on Sep 5, 2013, as measured by the United States Treasury. Assume that a bond with maturity in 10 years were issued on Sep 5, 2013 at par or price of 100 with coupon of 1.45 percent. The price of that bond would be 86.8530 with instantaneous increase of the yield to 2.98 percent for loss of 13.1 percent and far more with leverage. Assume that the yield of a bond with exactly ten years to maturity and coupon of 2.71 percent as occurred on Nov 15, 2013 would jump instantaneously from 2.71 percent on Nov 15, 2013 to 4.61 percent as occurred on Nov 15, 2006 when the economy was closer to full employment. The price of the hypothetical bond issued with coupon of 2.71 percent would drop from 100 to 84.9138 after an instantaneous increase of the yield to 4.61 percent. The price loss would be 15.1 percent. Losses absorb capital available for positioning, triggering crossfire sales in multiple asset classes (Brunnermeier and Pedersen 2009). What is the path of adjustment of zero interest rates on fed funds and artificially low bond yields? There is no painless exit from unconventional monetary policy. Chris Dieterich, writing on “Bond investors turn to cash,” on Jul 25, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323971204578625900935618178.html), uses data of the Investment Company Institute (http://www.ici.org/) in showing withdrawals of $43 billion in taxable mutual funds in Jun, which is the largest in history, with flows into cash investments such as $8.5 billion in the week of Jul 17 into money-market funds.

Table VIII-2, United States, Treasury Yields

	11/15/13	9/05/13	5/01/13	11/15/12	11/15/06
1 M	0.06	0.03	0.03	0.13	5.24
3 M	0.08	0.02	0.06	0.08	5.09
6 M	0.10	0.06	0.08	0.14	5.16
1 Y	0.13	0.16	0.11	0.17	5.04
2 Y	0.31	0.52	0.20	0.24	4.80
3 Y	0.58	0.97	0.30	0.32	4.69
5 Y	1.36	1.85	0.65	0.62	4.62
7 Y	2.06	2.45	1.07	1.02	4.62
10 Y	2.71	2.98	1.66	1.58	4.61
20 Y	3.50	3.64	2.44	2.30	4.80
30 Y	3.80	3.88	2.83	2.72	4.69

Source: United States Treasury http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Interest rate risk is increasing in the US. Chart VI-13 of the Board of Governors provides the conventional mortgage rate for a fixed-rate 30-year mortgage. The rate stood at 5.87 percent on Jan 8, 2004, increasing to 6.79 percent on Jul 6, 2006. The rate bottomed at 3.35 percent on May 2, 2013. Fear of duration risk in longer maturities such as mortgage-backed securities caused continuing increases in the conventional mortgage rate that rose to 4.51 percent on Jul 11, 2013, 4.58 percent on Aug 22, 2013 and 4.35 percent on Nov 14, 2013, which is the last data point in Chart VI-13.

Chart VI-13, US, Conventional Mortgage Rate, Jan 8, 2004 to Nov 14, 2013

Source: Board of Governors of the Federal Reserve System

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

The major reason and channel of transmission of unconventional monetary policy is through expectations of inflation. Fisher (1930) provided theoretical and historical relation of interest rates and inflation. Let i_n be the nominal interest rate, i_r the real or inflation-adjusted interest rate and π^e the expectation of inflation in the time term of the interest rate, which are all expressed as proportions. The following expression provides the relation of real and nominal interest rates and the expectation of inflation:

(1 + i_r) = (1 + i_n)/(1 + π^e) (1)

That is, the real interest rate equals the nominal interest rate discounted by the expectation of inflation in time term of the interest rate. Fisher (1933) analyzed the devastating effect of deflation on debts. Nominal debt contracts remained at original principal interest but net worth and income of debtors contracted during deflation. Real interest rates increase during declining inflation. For example, if the interest rate is 3 percent and prices decline 0.2 percent, equation (1) calculates the real interest rate as:

(1 +0.03)/(1 – 0.02) = 1.03/(0.998) = 1.032

That is, the real rate of interest is (1.032 – 1) 100 or 3.2 percent. If inflation were 2 percent, the real rate of interest would be 0.98 percent, or about 1.0 percent {[(1.03/1.02) -1]100 = 0.98%}.

The yield of the one-year Treasury security was quoted in the Wall Street Journal at 0.114 percent on Fri May 17, 2013 (http://online.wsj.com/mdc/page/marketsdata.html?mod=WSJ_topnav_marketdata_main). The expected rate of inflation π^e in the next twelve months is not observed. Assume that it would be equal to the rate of inflation in the past twelve months estimated by the Bureau of Economic Analysis (BLS) at 1.1 percent (http://www.bls.gov/cpi/). The real rate of interest would be obtained as follows:

(1 + 0.00114)/(1 + 0.011) = (1 + r_r) = 0.9902

That is, i_r is equal to 1 – 0.9902 or minus 0.98 percent. Investing in a one-year Treasury security results in a loss of 0.98 percent relative to inflation. The objective of unconventional monetary policy of zero interest rates is to induce consumption and investment because of the loss to inflation of riskless financial assets. Policy would be truly irresponsible if it intended to increase inflationary expectations or π^e. The result could be the same rate of unemployment with higher inflation (Kydland and Prescott 1977).

Current focus is on tapering quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “paring” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Oct 30, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20131030a.htm):

There is a critical phrase in the statement of Sep 19, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm): “but mortgage rates have risen further.” Did the increase of mortgage rates influence the decision of the FOMC not to taper? Is FOMC “communication” and “guidance” successful?

At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:

“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.

For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”

In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:

“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.

The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”

Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σ_y and prices σ_p. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).

The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. Indefinite financial repression induces carry trades with high leverage, risks and illiquidity. 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 14,164.53 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 15,961.70 on Fri Nov 15, 2013, which is higher by 12.7 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 12.4 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

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 64.8 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Nov 15, 2013; S&P 500 has gained 75.8 percent and DAX 61.7 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 11/15/13” 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 10.4 percent below the trough. Japan’s Nikkei Average is 71.9 percent above the trough. DJ Asia Pacific TSM is 26.5 percent above the trough. Dow Global is 42.7 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 25.9 percent above the trough. NYSE Financial Index is 46.7 percent above the trough. DJ UBS Commodities is 0.6 percent below the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 61.7 percent above the trough. Japan’s Nikkei Average is 71.9 percent above the trough on Aug 31, 2010 and 33.1 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 15,165.92 on Fri Nov 8, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 47.9 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 13.2 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 11/15/13” in Table VI-4 shows increase of 1.4 percent in the week for China’s Shanghai Composite. DJ Asia Pacific increased 1.8 percent. NYSE Financial increased 1.3 percent in the week. DJ UBS Commodities changed 0.0 percent. Dow Global increased 1.5 percent in the week of Nov 15, 2013. The DJIA increased 1.3 percent and S&P 500 increased 1.6 percent. DAX of Germany increased 1.0 percent. STOXX 50 increased 0.4 percent. The USD depreciated 1.0 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table 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 11/15/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Nov 15, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 11/15/13” but also relative to the peak in column “∆% Peak to 11/15/13.” There are now several equity indexes above the peak in Table VI-4: DJIA 42.5 percent, S&P 500 47.7 percent, DAX 44.8 percent, Dow Global 16.4 percent, DJ Asia Pacific 10.8 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 16.9 percent, Nikkei Average 33.1 percent and STOXX 50 6.7 percent. There is only one equity index below the peak: Shanghai Composite by 32.5 percent. DJ UBS Commodities Index is now 15.0 percent below the peak. The US dollar strengthened 10.8 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. 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. Future company cash flows derive from investment projects. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,143.0 billion in IVQ1986 or 20.1 percent. Real gross private domestic investment in the US decreased 3.1 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,524.9 billion in IIQ2013. Real private fixed investment fell 4.9 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,458.4 billion in IIQ2013. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits of US corporations swelled 263.4 percent from $107.7 billion IQ2007 to $391.4 billion in IIQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured.

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 11/15/ /13	∆% Week 11/15/13	∆% Trough to 11/15/ 13
DJIA	4/26/ 10	7/2/10	-13.6	42.5	1.3	64.8
S&P 500	4/23/ 10	7/20/ 10	-16.0	47.7	1.6	75.8
NYSE Finance	4/15/ 10	7/2/10	-20.3	16.9	1.3	46.7
Dow Global	4/15/ 10	7/2/10	-18.4	16.4	1.5	42.7
Asia Pacific	4/15/ 10	7/2/10	-12.5	10.8	1.8	26.5
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	33.1	7.7	71.9
China Shang.	4/15/ 10	7/02 /10	-24.7	-32.5	1.4	-10.4
STOXX 50	4/15/10	7/2/10	-15.3	6.7	0.4	25.9
DAX	4/26/ 10	5/25/ 10	-10.5	44.8	1.0	61.7
Dollar Euro	11/25 2009	6/7 2010	21.2	10.8	-1.0	-13.2
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-15.0	0.0	-0.6
10-Year T Note	4/5/ 10	4/6/10	3.986	2.784	2.704

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

ESII Slowing World Economic Growth. Table V-3 provides the latest available estimates of GDP for the regions and countries followed in this blog from IQ2012 to IIQ2013 available now for all countries. There are preliminary estimates for all countries for IIIQ2013. Growth is weak throughout most of the world. Japan’s GDP increased 1.2 percent in IQ2012 and 3.4 percent relative to a year earlier but part of the jump could be the low level a year earlier because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. Japan’s GDP fell 0.2 percent in IIQ2012 at the seasonally adjusted annual rate (SAAR) of minus 0.8 percent, which is much lower than 5.1 percent in IQ2012. Growth of 3.8 percent in IIQ2012 in Japan relative to IIQ2011 has effects of the low level of output because of Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan’s GDP contracted 0.9 percent in IIIQ2012 at the SAAR of minus 3.7 percent and increased 0.3 percent relative to a year earlier. Japan’s GDP grew 0.1 percent in IVQ2012 at the SAAR of 0.6 percent and increased 0.3 percent relative to a year earlier. Japan grew 1.1 percent in IQ2013 at the SAAR of 4.3 percent and 0.3 percent relative to a year earlier. Japan’s GDP increased 0.9 percent in IIQ2013 at the SAAR of 3.8 percent and increased 1.1 percent relative to a year earlier. Japan’s GDP grew 0.5 percent in IIIQ2013 at the SAAR of 1.9 percent and increased 2.7 pecent relative to a year earlier. China grew at 2.2 percent in IIQ2012, which annualizes to 9.1 percent and 7.6 percent relative to a year earlier. China grew at 2.0 percent in IIIQ2012, which annualizes at 8.2 percent and 7.4 percent relative to a year earlier. In IVQ2012, China grew at 1.9 percent, which annualizes at 7.8 percent, and 7.9 percent in IVQ2012 relative to IVQ2011. In IQ2013, China grew at 1.5 percent, which annualizes at 6.1 percent and 7.7 percent relative to a year earlier. In IIQ2013, China grew at 1.9 percent, which annualizes at 7.8 percent and 7.5 percent relative to a year earlier. China grew at 2.2 percent in IIIQ2013, which annualizes at 9.1 percent and 7.8 percent relative to a year earlier. There is decennial change in leadership in China (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2013. GDP fell 0.1 percent in the euro area in IQ2012 and decreased 0.2 in IQ2012 relative to a year earlier. Euro area GDP contracted 0.3 percent IIQ2012 and fell 0.5 percent relative to a year earlier. In IIIQ2012, euro area GDP fell 0.1 percent and declined 0.7 percent relative to a year earlier. In IVQ2012, euro area GDP fell 0.5 percent relative to the prior quarter and fell 1.0 percent relative to a year earlier. In IQ2013, the GDP of the euro area fell 0.2 percent and decreased 1.2 percent relative to a year earlier. The GDP of the euro area increased 0.3 percent in IIQ2013 and fell 0.6 percent relative to a year earlier. In III 2013, euro area GDP increased 0.1 percent and fell 0.4 percent relative to a year earlier. Germany’s GDP increased 0.7 percent in IQ2012 and 1.8 percent relative to a year earlier. In IIQ2012, Germany’s GDP decreased 0.1 percent and increased 0.6 percent relative to a year earlier but 1.1 percent relative to a year earlier when adjusted for calendar (CA) effects. In IIIQ2012, Germany’s GDP increased 0.2 percent and 0.4 percent relative to a year earlier. Germany’s GDP contracted 0.5 percent in IVQ2012 and increased 0.0 percent relative to a year earlier. In IQ2013, Germany’s GDP increased 0.0 percent and fell 1.6 percent relative to a year earlier. In IIQ2013, Germany’s GDP increased 0.7 percent and 0.9 percent relative to a year earlier. The GDP of Germany increased 0.3 percent in IIIQ2013 and 1.1 percent relative to a year earlier. Growth of US GDP in IQ2012 was 0.9 percent, at SAAR of 3.7 percent and higher by 3.3 percent relative to IQ2011. US GDP increased 0.3 percent in IIQ2012, 1.2 percent at SAAR and 2.8 percent relative to a year earlier. In IIIQ2012, GDP grew 0.7 percent, 2.8 percent at SAAR and 3.1 percent relative to IIIQ2011. In IVQ2012, GDP grew 0.0 percent, 0.1 percent at SAAR and 2.0 percent relative to IVQ2011. In IQ2013, US GDP grew at 1.1 percent SAAR, 0.3 percent relative to the prior quarter and 1.3 percent relative to the same quarter in 2013. In IIQ2013, US GDP grew at 2.5 percent in SAAR, 0.6 percent relative to the prior quarter and 1.6 percent relative to IIQ2012. US GDP grew at 2.8 percent in SAAR in IIIQ2013, 0.7 percent relative to the prior quarter and 1.6 percent relative to the same quarter a year earlier (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html) with weak hiring (http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-million.html). In IQ2012, UK GDP changed 0.0 percent, increasing 0.6 percent relative to a year earlier. UK GDP fell 0.5 percent in IIQ2012 and changed 0.0 percent relative to a year earlier. UK GDP increased 0.6 percent in IIIQ2012 and changed 0.0 percent relative to a year earlier. UK GDP fell 0.3 percent in IVQ2012 relative to IIIQ2012 and fell 0.2 percent relative to a year earlier. UK GDP increased 0.4 percent in IQ2013 and 0.2 percent relative to a year earlier. UK GDP increased 0.7 percent in IIQ2013 and 1.3 percent relative to a year earlier. In IIIQ2013, UK GDP increased 0.8 percent and 1.5 percent relative to a year earlier. Italy has experienced decline of GDP in nine consecutive quarters from IIIQ2011 to IIIQ2013. Italy’s GDP fell 1.1 percent in IQ2012 and declined 1.8 percent relative to IQ2011. Italy’s GDP fell 0.6 percent in IIQ2012 and declined 2.6 percent relative to a year earlier. In IIIQ2012, Italy’s GDP fell 0.4 percent and declined 2.8 percent relative to a year earlier. The GDP of Italy contracted 0.9 percent in IVQ2012 and fell 3.0 percent relative to a year earlier. In IQ2013, Italy’s GDP contracted 0.6 percent and fell 2.5 percent relative to a year earlier. Italy’s GDP fell 0.3 percent in IIQ2013 and 2.2 percent relative to a year earlier. The GDP of Italy fell 0.1 percent in IIIQ2013 and declined 1.9 percent relative to a year earlier. France’s GDP changed 0.0 percent in IQ2012 and increased 0.4 percent relative to a year earlier. France’s GDP decreased 0.3 percent in IIQ2012 and increased 0.1 percent relative to a year earlier. In IIIQ2012, France’s GDP increased 0.2 percent and changed 0.0 percent relative to a year earlier. France’s GDP fell 0.2 percent in IVQ2012 and declined 0.3 percent relative to a year earlier. In IQ2013, France GDP fell 0.1 percent and declined 0.4 percent relative to a year earlier. The GDP of France increased 0.5 percent in IIQ2013 and 0.5 percent relative to a year earlier. France’s GDP contracted 0.1 percent in IIIQ2013 and increased 0.2 percent relative to a year earlier.

Table V-3, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%

	IQ2012/IVQ2011	IQ2012/IQ2011
United States	QOQ: 0.9 SAAR: 3.7	3.3
Japan	QOQ: 1.2 SAAR: 5.1	3.4
China	1.4	8.1
Euro Area	-0.1	-0.2
Germany	0.7	1.8
France	0.0	0.4
Italy	-1.1	-1.8
United Kingdom	0.0	0.6
	IIQ2012/IQ2012	IIQ2012/IIQ2011
United States	QOQ: 0.3 SAAR: 1.2	2.8
Japan	QOQ: -0.2 SAAR: -0.8	3.8
China	2.2	7.6
Euro Area	-0.3	-0.5
Germany	-0.1	0.6 1.1 CA
France	-0.3	0.1
Italy	-0.6	-2.6
United Kingdom	-0.5	0.0
	IIIQ2012/ IIQ2012	IIIQ2012/ IIIQ2011
United States	QOQ: 0.7 SAAR: 2.8	3.1
Japan	QOQ: –0.9 SAAR: –3.7	0.3
China	2.0	7.4
Euro Area	-0.1	-0.7
Germany	0.2	0.4
France	0.2	0.0
Italy	-0.4	-2.8
United Kingdom	0.6	0.0
	IVQ2012/IIIQ2012	IVQ2012/IVQ2011
United States	QOQ: 0.0 SAAR: 0.1	2.0
Japan	QOQ: 0.1 SAAR: 0.6	0.3
China	1.9	7.9
Euro Area	-0.5	-1.0
Germany	-0.5	0.0
France	-0.2	-0.3
Italy	-0.9	-3.0
United Kingdom	-0.3	-0.2
	IQ2013/IVQ2012	IQ2013/IQ2012
United States	QOQ: 0.3 SAAR: 1.1	1.3
Japan	QOQ: 1.1 SAAR: 4.3	0.3
China	1.5	7.7
Euro Area	-0.2	-1.2
Germany	0.0	-1.6
France	-0.1	-0.4
Italy	-0.6	-2.5
UK	0.4	0.2
	IIQ2013/IQ2013	IIQ2013/IIQ2012
United States	QOQ: 0.6 SAAR: 2.5	1.6
Japan	QOQ: 0.9 SAAR: 3.8	1.1
China	1.9	7.5
Euro Area	0.3	-0.6
Germany	0.7	0.9
France	0.5	0.5
Italy	-0.3	-2.2
UK	0.7	1.3
	IIIQ2013/IIQ2013	III/Q2013/ IIIQ2012
USA	QOQ: 0.7 SAAR: 2.8	1.6
Japan	QOQ: 0.5 SAAR: 1.9	2.7
China	2.2	7.8
Euro Area	0.1	-0.4
Germany	0.3	1.1
France	-0.1	0.2
Italy	-0.1	-1.9
UK	0.8	1.5

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

Source: Country Statistical Agencies http://www.bea.gov/national/index.htm#gdp

ESIII United States Industrial Production. Industrial production decreased 0.1 percent in Oct 2013 after increasing 0.7 percent in Sep 2013 and increasing 0.5 percent in Aug 2013, as shown in Table I-1, with all data seasonally adjusted. The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

“Industrial production edged down 0.1 percent in October after having increased 0.7 percent in September. Manufacturing production rose 0.3 percent in October for its third consecutive monthly gain. The index for mining fell 1.6 percent after having risen for six consecutive months, and the output of utilities dropped 1.1 percent after having jumped 4.5 percent in September. The level of the index for total industrial production in October was equal to its 2007 average and was 3.2 percent above its year-earlier level. Capacity utilization for the industrial sector declined 0.2 percentage point in October to 78.1 percent, a rate 1.1 percentage points above its level of a year earlier and 2.1 percentage points below its long-run (1972-2012) average.“

Table I-1, US, Industrial Production and Capacity Utilization, SA, ∆%

2012-2013	Oct 13	Sep 13	Aug 13	Jul 13	Jun 13	May 13	Oct 13/ Oct 12
Total	-0.1	0.7	0.5	-0.2	0.2	0.2	3.2
Market Groups
Final Products	0.0	0.9	0.5	-1.0	0.5	-0.3	3.1
Consumer Goods	-0.1	0.8	0.3	-1.1	0.4	-0.3	2.5
Business Equipment	0.2	1.1	0.7	-0.8	0.6	-0.1	5.1
Non Industrial Supplies	0.2	0.8	0.3	0.2	0.1	0.1	4.1
Construction	0.3	1.0	0.4	0.5	0.7	-0.5	6.6
Materials	-0.4	0.4	0.5	0.5	0.0	0.5	3.1
Industry Groups
Manufacturing	0.3	0.1	0.7	-0.5	0.3	0.3	3.3
Mining	-1.6	1.0	0.3	1.8	1.1	0.7	4.8
Utilities	-1.1	4.5	-0.9	-0.2	-2.0	-1.8	0.2
Capacity	78.1	78.3	77.9	77.7	77.9	77.9	1.8

Sources: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing increased 0.3 percent in Oct 2013 after increasing 0.1 percent in Sep 2013 and increasing 0.7 percent in Aug 2013 seasonally adjusted, increasing 3.4 percent not seasonally adjusted in 12 months ending in Oct 2013, as shown in Table I-2. Manufacturing grew cumulatively 1.2 percent in the six months ending in Oct 2013 or at the annual equivalent rate of 2.4 percent. Excluding the increase of 0.7 percent in Aug 2013, manufacturing accumulated growth of 0.5 percent from May 2013 to Oct 2013 or at the annual equivalent rate of 1.0 percent. Table I-2 provides a longer perspective of manufacturing in the US. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 into more recent months as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.2 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily in the past six months with some weakness at the margin. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 22, 2013 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization. Measured from fourth quarter to fourth quarter, total IP is now reported to have increased 0.7 percentage point less in 2011 than was previously published. The revisions to IP for other years were smaller: Compared to the previous estimates, industrial production fell slightly less in 2008 and 2009 and increased slightly less in 2010 and 2012. At 97.7 percent of its 2007 average, the index in the fourth quarter of 2012 now stands 0.4 percent below its previous estimate. With these revisions, IP is still estimated to have advanced about 6 percent in 2010, the first full year following the trough in June 2009 of the most recent recession, but it is now estimated to have risen about 3 percent both in 2011 and in 2012. Since the trough of the recession, total IP has reversed about 90 percent of its peak-to-trough decline.”

The bottom part of Table I-2 shows decline of manufacturing by 21.9 from the peak in Jun 2007 to the trough in Apr 2009 and increase by 16.8 percent from the trough in Apr 2009 to Dec 2012. Manufacturing grew 21.2 percent from the trough in Apr 2009 to Oct 2013. Manufacturing output in Oct 2013 is 5.3 percent below the peak in Jun 2007.

Table I-2, US, Monthly and 12-Month Rates of Growth of Manufacturing ∆%

	Month SA ∆%	12-Month NSA ∆%
Oct 2013	0.3	3.4
Sep	0.1	2.4
Aug	0.7	2.4
Jul	-0.5	1.3
Jun	0.3	1.8
May	0.3	1.8
Apr	-0.3	2.2
Mar	-0.2	1.8
Feb	0.6	1.9
Jan	-0.1	2.4
Dec 2012	0.9	3.0
Nov	1.4	3.3
Oct	-0.4	2.1
Sep	0.1	3.1
Aug	-0.7	3.5
Jul	0.2	4.0
Jun	0.3	5.0
May	-0.3	4.8
Apr	0.6	5.1
Mar	-0.5	3.9
Feb	0.6	5.3
Jan	1.0	4.2
Dec 2011	1.0	3.8
Nov	0.0	3.2
Oct	0.6	3.1
Sep	0.4	3.0
Aug	0.4	2.4
Jul	0.7	2.5
Jun	0.1	2.1
May	0.3	1.9
Apr	-0.7	3.1
Mar	0.7	4.9
Feb	0.0	5.4
Jan	0.2	5.6
Dec 2010	0.6	6.2
Nov	0.2	5.3
Oct	0.1	6.6
Sep	0.1	7.0
Aug	0.1	7.4
Jul	0.7	7.8
Jun	0.0	9.3
May	1.4	8.9
Apr	0.9	7.1
Mar	1.3	4.9
Feb	0.0	1.3
Jan	1.0	1.2
Dec 2009	0.0	-3.1
Nov	1.1	-6.1
Oct	0.1	-9.1
Sep	0.8	-10.6
Aug	1.1	-13.6
Jul	1.2	-15.2
Jun	-0.3	-17.6
May	-1.1	-17.6
Apr	-0.8	-18.2
Mar	-1.9	-17.3
Feb	-0.2	-16.1
Jan	-2.9	-16.4
Dec 2008	-3.4	-14.0
Nov	-2.2	-11.3
Oct	-0.6	-9.0
Sep	-3.4	-8.6
Aug	-1.3	-5.1
Jul	-1.1	-3.5
Jun	-0.5	-3.1
May	-0.5	-2.4
Apr	-1.1	-1.1
Mar	-0.3	-0.5
Feb	-0.6	0.9
Jan	-0.4	2.3
Dec 2007	0.2	2.0
Nov	0.5	3.4
Oct	-0.4	2.8
Sep	0.5	3.0
Aug	-0.4	2.6
Jul	0.1	3.4
Jun	0.3	2.9
May	-0.1	3.1
Apr	0.7	3.6
Mar	0.7	2.4
Feb	0.4	1.6
Jan	-0.5	1.3
Dec 2006		2.7
Dec 2005		3.4
Dec 2004		4.0
Dec 2003		1.7
Dec 2002		2.4
Dec 2001		-5.5
Dec 2000		0.4
Dec 1999		5.4
Average ∆% Dec 1986-Dec 2012		2.3
Average ∆% Dec 1986-Dec 1999		4.3
Average ∆% Dec 1999-Dec 2006		1.3
Average ∆% Dec 1999-Dec 2012		0.4
∆% Peak 103.0005 in 06/2007 to 93.9456 in 12/2012		-8.8
∆% Peak 103.0005 on 06/2007 to Trough 80.4617 in 4/2009		-21.9
∆% Trough 80.4617 in 04/2009 to 93.9456 in 12/2012		16.8
∆% Trough 80.4617 in 04/2009 to 97.5417 in 10/2013		21.2
∆% Peak 103.0005 on 06/2007 to Trough 97.5417 in 10/2013		-5.3

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

ESIV United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html). The Census Bureau revised data for 2012 and 2013. The US trade balance deteriorated from deficit of $38,642 million in Jul 2013 to deficit of $38,701 million in Aug 2013 and higher deficit of $41,778 million in Sep 2013. The deterioration in the trade account in Jul 2013 originated in decline of exports by 0.6 percent while imports increased 1.3 percent. Exports and imports did not change in Aug 2013. Exports decreased 0.2 percent in Sep 2012 while imports increased 1.2 percent. The trade balance deteriorated from cumulative deficit of $499,379 million in Jan-Dec 2010 to deficit of $556,838 million in Jan-Dec 2011 and improved to marginally lower deficit of $534,656 million in Jan-Dec 2012.

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

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Sep 2013	-41,778	188,909	-0.2	230,687	1.2
Aug	-38,701	189,295	0.0	227,996	0.0
Jul	-38,642	189,332	-0.6	227,974	1.3
Jun	-34,543	190,528	2.2	225,071	-2.2
May	-43,725	186,487	-0.2	230,212	1.7
Apr	-39,519	186,941	1.3	226,460	2.3
Mar	-36,787	184,578	-1.1	221,365	-3.8
Feb	-43,481	186,698	0.0	230,180	0.5
Jan	-42,364	186,607	-1.1	228,971	0.9
Dec 2012	-38,307	188,686	1.9	226,994	-2.0
Nov	-46,422	185,220	1.4	231,641	2.8
Oct	-42,650	182,655	-2.2	225,304	-1.4
Sep	-41,570	186,829	2.6	228,400	1.0
Aug	-44,007	182,071	-0.7	226,078	-0.3
Jul	-43,451	183,375	-1.0	226,826	-0.4
Jun	-42,430	185,218	0.5	227,648	-1.2
May	-46,247	184,217	0.0	230,464	-0.2
Apr	-46,625	184,267	-1.2	230,892	-1.5
Mar	-47,790	186,505	2.4	234,295	3.7
Feb	-43,763	182,064	1.4	225,827	-2.2
Jan	-51,393	179,477	0.2	230,871	0.2
Jan-Dec 2012	-534,656	2,210,585		2,745,240
Jan-Dec 2011	-556,838	2,112,825		2,669,663
Jan-Dec 2010	-499,379	1,844,468		2,343,847

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

Table IIA-2 provides the US international trade balance, exports and imports on an annual basis from 1992 to 2012. The trade balance deteriorated sharply over the long term. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US decreased from $118.3 billion in IIQ2012, or 2.7 percent of GDP to $104.6 billion in IIQ2013, or 2.4 percent of GDP (http://cmpassocregulationblog.blogspot.com/2013/09/duration-dumping-and-peaking-valuations.html). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The last row of Table IIA-2 shows marginal improvement of the trade deficit from $556,838 million in 2011 to lower $534,656 million in 2012 with exports growing 4.6 percent and imports 2.8 percent. Growth and commodity shocks under alternating inflation waves (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html) have deteriorated the trade deficit from the low of $383,657 million in 2009.

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

Period	Balance	Exports	Imports
1960	3,508	25,940	22,432
1961	4,195	26,403	22,208
1962	3,370	27,722	24,352
1963	4,210	29,620	25,410
1964	6,022	33,341	27,319
1965	4,664	35,285	30,621
1966	2,939	38,926	35,987
1967	2,604	41,333	38,729
1968	250	45,543	45,293
1969	91	49,220	49,129
1970	2,254	56,640	54,386
1971	-1,302	59,677	60,979
1972	-5,443	67,222	72,665
1973	1,900	91,242	89,342
1974	-4,293	120,897	125,190
1975	12,404	132,585	120,181
1976	-6,082	142,716	148,798
1977	-27,246	152,301	179,547
1978	-29,763	178,428	208,191
1979	-24,565	224,131	248,696
1980	-19,407	271,834	291,241
1981	-16,172	294,398	310,570
1982	-24,156	275,236	299,391
1983	-57,767	266,106	323,874
1984	-109,072	291,094	400,166
1985	-121,880	289,070	410,950
1986	-138,538	310,033	448,572
1987	-151,684	348,869	500,552
1988	-114,566	431,149	545,715
1989	-93,141	487,003	580,144
1990	-80,864	535,233	616,097
1991	-31,135	578,344	609,479
1992	-39,212	616,882	656,094
1993	-70,311	642,863	713,174
1994	-98,493	703,254	801,747
1995	-96,384	794,387	890,771
1996	-104,065	851,602	955,667
1997	-108,273	934,453	1,042,726
1998	-166,140	933,174	1,099,314
1999	-263,755	967,008	1,230,764
2000	-377,337	1,072,782	1,450,119
2001	-362,339	1,007,725	1,370,065
2002	-418,165	980,879	1,399,044
2003	-490,545	1,023,937	1,514,482
2004	-604,897	1,163,724	1,768,622
2005	-707,914	1,288,257	1,996,171
2006	-752,399	1,460,792	2,213,191
2007	-699,065	1,652,859	2,351,925
2008	-702,302	1,840,332	2,542,634
2009	-383,657	1,578,187	1,961,844
2010	-499,379	1,844,468	2,343,847
2011	-556,838	2,112,825	2,669,663
2012	-534,656	2,210,585	2,745,240

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

Chart IIA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Sep 2013. There is long-term trend of deterioration of the US trade deficit shown vividly by Chart IIA-2. The trend of deterioration was reversed by the global recession from IVQ2007 to IIQ2009. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4 http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Sep 2013

Source: US Census Bureau

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

Chart IIA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Sep 2013. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Sep 2013

Source: US Census Bureau

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

Chart IIA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Sep 2013. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion.

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Sep 2013

Source: US Census Bureau

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

The balance of international trade in goods of the US seasonally adjusted is shown in Table IIA-3. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The deficit in the balance in international trade of goods increased from deficit of $58,897 million in Sep 2012 to $61,279 million in Sep 2013. The relative deterioration of the goods balance in Sep 2013 relative to Sep 2012 occurred mostly in the nonpetroleum balance, exports less imports of nonpetroleum goods, in the magnitude of increasing the deficit by $4502 million, while there was improvement in the petroleum balance, exports less imports of petroleum goods, in the magnitude of decreasing the deficit by $2092 million. US terms of trade, export prices relative to import prices, and the US trade account fluctuate in accordance with the carry trade from zero interest rates to commodity futures exposures, especially oil futures. Exports decreased 0.5 percent with nonpetroleum exports decreasing 1.0 percent. Total imports increased 0.9 percent with petroleum imports declining 4.0 percent and nonpetroleum imports increasing 2.1 percent. Details do not add because of seasonal adjustment and rounding.

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

	Sep 2013	Sep 2012	∆%
Total Balance	-61,279	-58,897
Petroleum	-19,834	-21,926
Non Petroleum	-40,519	-36,017
Total Exports	132,114	132,752	-0.5
Petroleum	11,849	11,091	6.8
Non Petroleum	119,141	120,325	-1.0
Total Imports	193,393	191,649	0.9
Petroleum	31,682	33,017	-4.0
Non Petroleum	159,660	156,342	2.1

Details may not add because of rounding and seasonal adjustment

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

US exports and imports of goods not seasonally adjusted in Jan-Sep 2013 and Jan-Sep 2012 are shown in Table IIA-4. The rate of growth of exports was 1.6 percent and minus 0.3 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that decreased 0.3 percent and of mineral fuels that increased 5.5 percent both because prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion and portfolio reallocations. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose 1.5 percent while manufactured imports rose 1.0 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 10.9 percent and petroleum decreasing 11.8 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html).

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

	Jan-Sep 2013 $ Millions	Jan-Sep 2012 $ Millions	∆%
Exports	1,169,567	1,151,170	1.6
Manufactured	883,102	869,671	1.5
Agricultural Commodities	99,035	99,368	-0.3
Mineral Fuels	105,295	99,830	5.5
Petroleum	87,265	81,273	7.4
Imports	1,690,485	1,705,300	-0.9
Manufactured	1,359,600	1,345,591	1.0
Agricultural Commodities	78,916	78,112	1.0
Mineral Fuels	290,529	326,093	-10.9
Petroleum	277,763	314,819	-11.8

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

I United States Industrial Production. Industrial production decreased 0.1 percent in Oct 2013 after increasing 0.7 percent in Sep 2013 and increasing 0.5 percent in Aug 2013, as shown in Table I-1, with all data seasonally adjusted. The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

Table I-1, US, Industrial Production and Capacity Utilization, SA, ∆%

2012-2013	Oct 13	Sep 13	Aug 13	Jul 13	Jun 13	May 13	Oct 13/ Oct 12
Total	-0.1	0.7	0.5	-0.2	0.2	0.2	3.2
Market Groups
Final Products	0.0	0.9	0.5	-1.0	0.5	-0.3	3.1
Consumer Goods	-0.1	0.8	0.3	-1.1	0.4	-0.3	2.5
Business Equipment	0.2	1.1	0.7	-0.8	0.6	-0.1	5.1
Non Industrial Supplies	0.2	0.8	0.3	0.2	0.1	0.1	4.1
Construction	0.3	1.0	0.4	0.5	0.7	-0.5	6.6
Materials	-0.4	0.4	0.5	0.5	0.0	0.5	3.1
Industry Groups
Manufacturing	0.3	0.1	0.7	-0.5	0.3	0.3	3.3
Mining	-1.6	1.0	0.3	1.8	1.1	0.7	4.8
Utilities	-1.1	4.5	-0.9	-0.2	-2.0	-1.8	0.2
Capacity	78.1	78.3	77.9	77.7	77.9	77.9	1.8

Sources: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Table I-2, US, Monthly and 12-Month Rates of Growth of Manufacturing ∆%

	Month SA ∆%	12-Month NSA ∆%
Oct 2013	0.3	3.4
Sep	0.1	2.4
Aug	0.7	2.4
Jul	-0.5	1.3
Jun	0.3	1.8
May	0.3	1.8
Apr	-0.3	2.2
Mar	-0.2	1.8
Feb	0.6	1.9
Jan	-0.1	2.4
Dec 2012	0.9	3.0
Nov	1.4	3.3
Oct	-0.4	2.1
Sep	0.1	3.1
Aug	-0.7	3.5
Jul	0.2	4.0
Jun	0.3	5.0
May	-0.3	4.8
Apr	0.6	5.1
Mar	-0.5	3.9
Feb	0.6	5.3
Jan	1.0	4.2
Dec 2011	1.0	3.8
Nov	0.0	3.2
Oct	0.6	3.1
Sep	0.4	3.0
Aug	0.4	2.4
Jul	0.7	2.5
Jun	0.1	2.1
May	0.3	1.9
Apr	-0.7	3.1
Mar	0.7	4.9
Feb	0.0	5.4
Jan	0.2	5.6
Dec 2010	0.6	6.2
Nov	0.2	5.3
Oct	0.1	6.6
Sep	0.1	7.0
Aug	0.1	7.4
Jul	0.7	7.8
Jun	0.0	9.3
May	1.4	8.9
Apr	0.9	7.1
Mar	1.3	4.9
Feb	0.0	1.3
Jan	1.0	1.2
Dec 2009	0.0	-3.1
Nov	1.1	-6.1
Oct	0.1	-9.1
Sep	0.8	-10.6
Aug	1.1	-13.6
Jul	1.2	-15.2
Jun	-0.3	-17.6
May	-1.1	-17.6
Apr	-0.8	-18.2
Mar	-1.9	-17.3
Feb	-0.2	-16.1
Jan	-2.9	-16.4
Dec 2008	-3.4	-14.0
Nov	-2.2	-11.3
Oct	-0.6	-9.0
Sep	-3.4	-8.6
Aug	-1.3	-5.1
Jul	-1.1	-3.5
Jun	-0.5	-3.1
May	-0.5	-2.4
Apr	-1.1	-1.1
Mar	-0.3	-0.5
Feb	-0.6	0.9
Jan	-0.4	2.3
Dec 2007	0.2	2.0
Nov	0.5	3.4
Oct	-0.4	2.8
Sep	0.5	3.0
Aug	-0.4	2.6
Jul	0.1	3.4
Jun	0.3	2.9
May	-0.1	3.1
Apr	0.7	3.6
Mar	0.7	2.4
Feb	0.4	1.6
Jan	-0.5	1.3
Dec 2006		2.7
Dec 2005		3.4
Dec 2004		4.0
Dec 2003		1.7
Dec 2002		2.4
Dec 2001		-5.5
Dec 2000		0.4
Dec 1999		5.4
Average ∆% Dec 1986-Dec 2012		2.3
Average ∆% Dec 1986-Dec 1999		4.3
Average ∆% Dec 1999-Dec 2006		1.3
Average ∆% Dec 1999-Dec 2012		0.4
∆% Peak 103.0005 in 06/2007 to 93.9456 in 12/2012		-8.8
∆% Peak 103.0005 on 06/2007 to Trough 80.4617 in 4/2009		-21.9
∆% Trough 80.4617 in 04/2009 to 93.9456 in 12/2012		16.8
∆% Trough 80.4617 in 04/2009 to 97.5417 in 10/2013		21.2
∆% Peak 103.0005 on 06/2007 to Trough 97.5417 in 10/2013		-5.3

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-1 of the Board of Governors of the Federal Reserve System provides industrial production, manufacturing and capacity since the 1970s. There was acceleration of growth of industrial production, manufacturing and capacity in the 1990s because of rapid growth of productivity in the US (Cobet and Wilson (2002); see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). The slopes of the curves flatten in the 2000s. Production and capacity have not recovered to the levels before the global recession.

Chart I-1, US, Industrial Production, Capacity and Utilization

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg1.gif

The modern industrial revolution of Jensen (1993) is captured in Chart I-2 of the Board of Governors of the Federal Reserve System (for the literature on M&A and corporate control see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 143-56, Globalization and the State, Vol. I (2008a), 49-59, Government Intervention in Globalization (2008c), 46-49). The slope of the curve of total industrial production accelerates in the 1990s to a much higher rate of growth than the curve excluding high-technology industries. Growth rates decelerate into the 2000s and output and capacity utilization have not recovered fully from the strong impact of the global recession. Growth in the current cyclical expansion has been more subdued than in the prior comparably deep contractions in the 1970s and 1980s. Chart II-2 shows that the past recessions after World War II are the relevant ones for comparison with the recession after 2007 instead of common comparisons with the Great Depression (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). The bottom left-hand part of Chart II-2 shows the strong growth of output of communication equipment, computers and semiconductor that continued from the 1990s into the 2000s. Output of semiconductors has already surpassed the level before the global recession.

Chart I-2, US, Industrial Production, Capacity and Utilization of High Technology Industries

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg3.gif

Additional detail on industrial production and capacity utilization is provided in Chart I-3 of the Board of Governors of the Federal Reserve System. Production of consumer durable goods fell sharply during the global recession by more than 30 percent and is still around the level before the contraction. Output of nondurable consumer goods fell around 10 percent and is some 5 percent below the level before the contraction. Output of business equipment fell sharply during the contraction of 2001 but began rapid growth again after 2004. An important characteristic is rapid growth of output of business equipment in the cyclical expansion after sharp contraction in the global recession. Output of defense and space only suffered reduction in the rate of growth during the global recession and surged ahead of the level before the contraction. Output of construction supplies collapsed during the global recession and is well below the level before the contraction. Output of energy materials was stagnant before the contraction but has recovered sharply above the level before the contraction.

Chart I-3, US, Industrial Production and Capacity Utilization

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg2.gif

United States manufacturing output from 1919 to 2012 on a monthly basis is in Chart I-4 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is losing momentum at the margin.

Chart I-4, US, Manufacturing Output, 1919-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing jobs increased 19,000 in Oct 2013 relative to Sep 2013, seasonally adjusted (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/10/twenty-eight-million-unemployed-or.html). Manufacturing jobs not seasonally adjusted increased 49,000 from Oct 2012 to Oct 2013 or at the average monthly rate of 4,083. There are effects of the weaker economy and international trade together with the yearly adjustment of labor statistics. Industrial production decreased 0.1 percent in Oct 2013 after increasing 0.7 percent in Sep 2013 and increasing 0.5 percent in Aug 2013, as shown in Table I-1, with all data seasonally adjusted. The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

In the six months ending in Oct 2013, United States national industrial production accumulated increase of 1.3 percent at the annual equivalent rate of 2.6 percent, which is lower than growth of 3.2 percent in the 12 months ending in Oct 2013. Excluding growth of 0.7 percent in Sep 2013, growth in the remaining five months from May 2012 to Oct 2013 accumulated to 0.6 percent or 1.2 percent annual equivalent. Industrial production fell in two of the past six months. Business equipment accumulated growth of 1.7 percent in the six months from May to Oct 2013 at the annual equivalent rate of 3.4 percent, which is much lower than growth of 5.1 percent in the 12 months ending in Oct 2013. Growth of business equipment accumulated 0.1 percent from Apr to Aug 2013 at the annual equivalent rate of minus 0.2 percent. The Fed analyzes capacity utilization of total industry in its report (http://www.federalreserve.gov/releases/g17/Current/default.htm): “Capacity utilization for the industrial sector declined 0.2 percentage point in October to 78.1 percent, a rate 1.1 percentage points above its level of a year earlier and 2.1 percentage points below its long-run (1972-2012) average.” United States industry apparently decelerated to a lower growth rate. Manufacturing increased 0.3 percent in Oct 2013 after increasing 0.1 percent in Sep 2013 and increasing 0.7 percent in Aug 2013 seasonally adjusted, increasing 3.4 percent not seasonally adjusted in 12 months ending in Oct 2013, as shown in Table I-2. Manufacturing grew cumulatively 1.2 percent in the six months ending in Oct 2013 or at the annual equivalent rate of 2.4 percent. Excluding the increase of 0.7 percent in Aug 2013, manufacturing accumulated growth of 0.5 percent from May 2013 to Oct 2013 or at the annual equivalent rate of 1.0 percent. Manufacturing fell 21.9 from the peak in Jun 2007 to the trough in Apr 2009 and increased 16.8 percent from the trough in Apr 2009 to Dec 2012. Manufacturing grew 21.2 percent from the trough in Apr 2009 to Oct 2013. Manufacturing output in Oct 2013 is 5.3 percent below the peak in Jun 2007.

Table I-3 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 86.7 percent in IIQ2013. Most of US national income is in the form of services. In Oct 2013, there were 137.540 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 115.308 million NSA in Oct 2013 accounted for 83.8 percent of total nonfarm jobs of 137.540 million, of which 12.033 million, or 10.4 percent of total private jobs and 8.7 percent of total nonfarm jobs, were in manufacturing. Private service-producing jobs were 96.328 million NSA in Oct 2013, or 70.0 percent of total nonfarm jobs and 83.5 percent of total private-sector jobs. Manufacturing has share of 10.8 percent in US national income in IIQ2013, as shown in Table I-3. Most income in the US originates in services. Subsidies and similar measures designed to increase manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table I-3, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

	SAAR IQ2013	% Total	SAAR IIQ2013	% Total
National Income WCCA	14,354.5	100.0	14,471.3	100.0
Domestic Industries	14,117.1	98.3	14,224.4	98.3
Private Industries	12,432.9	86.6	12,544.3	86.7
Agriculture	226.4	1.6	220.3	1.5
Mining	247.6	1.7	252.6	1.7
Utilities	209.1	1.5	216.5	1.5
Construction	618.2	4.3	626.4	4.3
Manufacturing	1568.1	10.9	1561.1	10.8
Durable Goods	878.8	6.1	890.3	6.2
Nondurable Goods	689.2	4.8	670.1	4.6
Wholesale Trade	870.0	6.1	875.3	6.0
Retail Trade	971.4	6.8	994.5	6.9
Transportation & WH	434.0	3.0	437.7	3.0
Information	496.0	3.5	504.8	3.5
Finance, Insurance, RE	2418.9	16.8	2437.1	16.8
Professional, BS	1973.6	13.7	1998.1	13.8
Education, Health Care	1423.7	9.9	1439.4	9.9
Arts, Entertainment	569.7	4.0	575.0	4.0
Other Services	406.1	2.8	408.3	2.8
Government	1684.3	11.7	1680.1	11.6
Rest of the World	237.4	1.7	246.8	1.7

Notes: SSAR: Seasonally-Adjusted Annual Rate; WCCA: Without Capital Consumption Adjustment by Industry; WH: Warehousing; RE, includes rental and leasing: Real Estate; Art, Entertainment includes recreation, accommodation and food services; BS: business services

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

Motor vehicle sales and production in the US have been in long-term structural change. Table I-4 provides the data on new motor vehicle sales and domestic car production in the US from 1990 to 2010. New motor vehicle sales grew from 14,137 thousand in 1990 to the peak of 17,806 thousand in 2000 or 29.5 percent. In that same period, domestic car production fell from 6,231 thousand in 1990 to 5,542 thousand in 2000 or -11.1 percent. New motor vehicle sales fell from 17,445 thousand in 2005 to 11,772 in 2010 or 32.5 percent while domestic car production fell from 4,321 thousand in 2005 to 2,840 thousand in 2010 or 34.3 percent. In Jan-Oct 2013, light vehicle sales accumulated to 12.994.572, which is higher by 8.4 percent relative to 11,992,071 a year earlier (http://motorintelligence.com/m_frameset.html). The seasonally adjusted annual rate of light vehicle sales in the US reached 15.23 million in Oct 2013, slightly lower than 15.28 million in Sep 2013 and higher than 14.40 million in Oct 2012 (http://motorintelligence.com/m_frameset.html).

Table I-4, US, New Motor Vehicle Sales and Car Production, Thousand Units

	New Motor Vehicle Sales	New Car Sales and Leases	New Truck Sales and Leases	Domestic Car Production
1990	14,137	9,300	4,837	6,231
1991	12,725	8,589	4,136	5,454
1992	13,093	8,215	4,878	5,979
1993	14,172	8,518	5,654	5,979
1994	15,397	8,990	6,407	6,614
1995	15,106	8,536	6,470	6,340
1996	15,449	8,527	6,922	6,081
1997	15,490	8,273	7,218	5,934
1998	15,958	8,142	7,816	5,554
1999	17,401	8,697	8,704	5,638
2000	17,806	8,852	8,954	5,542
2001	17,468	8,422	9,046	4,878
2002	17,144	8,109	9,036	5,019
2003	16,968	7,611	9,357	4,510
2004	17,298	7,545	9,753	4,230
2005	17,445	7,720	9,725	4,321
2006	17,049	7,821	9,228	4,367
2007	16,460	7,618	8,683	3,924
2008	13,494	6,814	6.680	3,777
2009	10,601	5,456	5,154	2,247
2010	11,772	5,729	6,044	2,840

Source: US Census Bureau http://www.census.gov/compendia/statab/cats/wholesale_retail_trade/motor_vehicle_sales.html

Chart I-5 of the Board of Governors of the Federal Reserve provides output of motor vehicles and parts in the United States from 1972 to 2013. Output has stagnated since the late 1990s.

Chart I-5, US, Motor Vehicles and Parts Output, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-6 of the Board of Governors of the Federal Reserve System provides output of computers and electronic products in the United States from 1972 to 2013. Output accelerated sharply in the 1990s and 2000s and has surpassed the level before the global recession beginning in IVQ2007.

Chart I-6, US, Output of Computers and Electronic Products, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-7 of the Board of Governors of the Federal Reserve System shows that output of durable manufacturing accelerated in the 1980s and 1990s with slower growth in the 2000s perhaps because processes matured. Growth was robust after the major drop during the global recession but appears to vacillate in the final segment.

Chart I-7, US, Output of Durable Manufacturing, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart I-8 of the Board of Governors of the Federal Reserve System provides output of aerospace and miscellaneous transportation equipment from 1972 to 2013. There is long-term upward trend with oscillations around the trend and cycles of large amplitude.

Chart I-8, US, Output of Aerospace and Miscellaneous Transportation Equipment, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

The Empire State Manufacturing Survey Index in Table I-5 provides continuing deterioration that started in Jun 2012 well before Hurricane Sandy in Oct 2012. The current general index has been in negative contraction territory from minus 3.78 in Aug 2012 to minus 7.78 in Jan 2012 and minus 1.43 in May 2013. The current general index deteriorated to 2.21 in Nov 2013, which is again in contraction territory. The index of current orders has also been in negative contraction territory from minus 4.63 in Aug 2012 to minus 7.18 in Jan 2013 and minus 6.69 in Jun 2013. The index of current new orders decreased to minus 5.53 in Nov 2012, again in contraction territory. Number of workers and hours worked have registered negative or declining readings since Sep 2012 with neutral reading at 0.00 for number of workers in Nov 2013 and contraction in the average workweek to 5.26 in Nov 2013. There is contraction in the general index for the next six months at minus 3.95 in Nov 2013 and strengthening new orders at 40.27 in Nov 2013.

Table I-5, US, New York Federal Reserve Bank Empire State Manufacturing Survey Index SA

	General Index	New Orders	Shipments	# Workers	Average Work-week
Current
Nov 2013	-2.21	-5.53	-0.53	0.00	-5.26
Oct	1.52	7.75	13.12	3.61	3.61
Sep	6.29	2.35	16.43	7.53	1.08
Aug	8.24	0.27	1.47	10.84	4.82
Jul	9.46	3.77	8.96	3.26	-7.61
Jun	7.84	-6.69	-11.77	0.00	-11.29
May	-1.43	-1.17	-0.02	5.68	-1.14
Apr	3.05	2.20	0.75	6.82	5.68
Mar	9.24	8.18	7.76	3.23	0.00
Feb	10.04	13.31	13.08	8.08	-4.04
Jan	-7.78	-7.18	-3.08	-4.30	-5.38
Dec 2012	-7.30	-3.44	11.93	-9.68	-10.75
Nov	-4.31	2.93	14.18	-14.61	-7.87
Oct	-6.75	-7.21	-6.48	-1.08	-4.30
Sep	-7.54	-10.60	7.30	4.26	-1.06
Aug	-3.78	-4.63	6.37	16.47	3.53
Jul	7.08	-2.27	11.52	18.52	0.00
Jun	4.15	2.28	6.34	12.37	3.09
May	14.52	8.99	23.11	20.48	12.05
Apr	6.40	4.81	4.51	19.28	6.02
Mar	18.00	6.55	15.97	13.58	18.52
Feb	18.31	7.93	19.90	11.76	7.06
Jan	12.12	11.21	18.94	12.09	6.59
Dec 2011	9.60	6.35	23.77	2.33	-2.33
Nov	1.82	-0.97	11.34	-3.66	2.44
Oct	-7.39	1.51	2.46	3.37	-4.49
Sep	-4.75	-4.31	-4.48	-5.43	-2.17
Six Months
Nov 2013	-3.95	40.27	37.80	22.37	-3.95
Oct	2.41	37.04	32.18	7.23	2.41
Sep	8.60	38.17	37.84	4.30	-2.15
Aug	3.61	30.01	30.02	8.43	-6.02
Jul	1.09	31.12	34.44	1.09	-1.09
Jun	11.29	19.77	20.21	1.61	-9.68
May	4.55	28.84	25.18	11.36	1.14
Apr 2013	5.68	36.23	39.28	25.00	7.95
Mar	2.15	34.94	41.60	19.35	2.15
Feb	8.08	29.11	26.82	15.15	11.11
Jan	10.75	25.11	23.86	7.53	3.23
Dec 2012	1.08	17.19	22.46	10.75	5.38
Nov	5.62	15.96	25.67	-1.12	0.00
Oct	4.30	22.79	17.39	0.00	-11.83
Sep	5.32	27.85	23.35	8.51	2.13
Aug	2.35	14.34	21.16	3.53	-8.24
Jul	3.70	19.85	21.60	6.17	-4.94
Jun	1.03	26.02	22.18	16.49	2.06
May	12.05	31.26	26.00	12.05	8.43
Apr	19.28	38.95	40.75	27.71	10.84
Mar	13.58	39.18	41.64	32.10	20.99
Feb	15.29	39.25	40.92	29.41	18.82
Jan	23.08	45.70	44.12	28.57	17.58
Dec 2011	3.49	42.20	40.36	24.42	22.09
Nov	6.10	30.89	33.01	14.63	8.54
Oct	4.49	19.71	22.65	6.74	-2.25
Sep	8.70	23.52	22.89	0.00	-6.52

Source: http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html

II United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html). The Census Bureau revised data for 2012 and 2013. The US trade balance deteriorated from deficit of $38,642 million in Jul 2013 to deficit of $38,701 million in Aug 2013 and higher deficit of $41,778 million in Sep 2013. The deterioration in the trade account in Jul 2013 originated in decline of exports by 0.6 percent while imports increased 1.3 percent. Exports and imports did not change in Aug 2013. Exports decreased 0.2 percent in Sep 2012 while imports increased 1.2 percent. The trade balance deteriorated from cumulative deficit of $499,379 million in Jan-Dec 2010 to deficit of $556,838 million in Jan-Dec 2011 and improved to marginally lower deficit of $534,656 million in Jan-Dec 2012.

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

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Sep 2013	-41,778	188,909	-0.2	230,687	1.2
Aug	-38,701	189,295	0.0	227,996	0.0
Jul	-38,642	189,332	-0.6	227,974	1.3
Jun	-34,543	190,528	2.2	225,071	-2.2
May	-43,725	186,487	-0.2	230,212	1.7
Apr	-39,519	186,941	1.3	226,460	2.3
Mar	-36,787	184,578	-1.1	221,365	-3.8
Feb	-43,481	186,698	0.0	230,180	0.5
Jan	-42,364	186,607	-1.1	228,971	0.9
Dec 2012	-38,307	188,686	1.9	226,994	-2.0
Nov	-46,422	185,220	1.4	231,641	2.8
Oct	-42,650	182,655	-2.2	225,304	-1.4
Sep	-41,570	186,829	2.6	228,400	1.0
Aug	-44,007	182,071	-0.7	226,078	-0.3
Jul	-43,451	183,375	-1.0	226,826	-0.4
Jun	-42,430	185,218	0.5	227,648	-1.2
May	-46,247	184,217	0.0	230,464	-0.2
Apr	-46,625	184,267	-1.2	230,892	-1.5
Mar	-47,790	186,505	2.4	234,295	3.7
Feb	-43,763	182,064	1.4	225,827	-2.2
Jan	-51,393	179,477	0.2	230,871	0.2
Jan-Dec 2012	-534,656	2,210,585		2,745,240
Jan-Dec 2011	-556,838	2,112,825		2,669,663
Jan-Dec 2010	-499,379	1,844,468		2,343,847

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

Period	Balance	Exports	Imports
1960	3,508	25,940	22,432
1961	4,195	26,403	22,208
1962	3,370	27,722	24,352
1963	4,210	29,620	25,410
1964	6,022	33,341	27,319
1965	4,664	35,285	30,621
1966	2,939	38,926	35,987
1967	2,604	41,333	38,729
1968	250	45,543	45,293
1969	91	49,220	49,129
1970	2,254	56,640	54,386
1971	-1,302	59,677	60,979
1972	-5,443	67,222	72,665
1973	1,900	91,242	89,342
1974	-4,293	120,897	125,190
1975	12,404	132,585	120,181
1976	-6,082	142,716	148,798
1977	-27,246	152,301	179,547
1978	-29,763	178,428	208,191
1979	-24,565	224,131	248,696
1980	-19,407	271,834	291,241
1981	-16,172	294,398	310,570
1982	-24,156	275,236	299,391
1983	-57,767	266,106	323,874
1984	-109,072	291,094	400,166
1985	-121,880	289,070	410,950
1986	-138,538	310,033	448,572
1987	-151,684	348,869	500,552
1988	-114,566	431,149	545,715
1989	-93,141	487,003	580,144
1990	-80,864	535,233	616,097
1991	-31,135	578,344	609,479
1992	-39,212	616,882	656,094
1993	-70,311	642,863	713,174
1994	-98,493	703,254	801,747
1995	-96,384	794,387	890,771
1996	-104,065	851,602	955,667
1997	-108,273	934,453	1,042,726
1998	-166,140	933,174	1,099,314
1999	-263,755	967,008	1,230,764
2000	-377,337	1,072,782	1,450,119
2001	-362,339	1,007,725	1,370,065
2002	-418,165	980,879	1,399,044
2003	-490,545	1,023,937	1,514,482
2004	-604,897	1,163,724	1,768,622
2005	-707,914	1,288,257	1,996,171
2006	-752,399	1,460,792	2,213,191
2007	-699,065	1,652,859	2,351,925
2008	-702,302	1,840,332	2,542,634
2009	-383,657	1,578,187	1,961,844
2010	-499,379	1,844,468	2,343,847
2011	-556,838	2,112,825	2,669,663
2012	-534,656	2,210,585	2,745,240

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

Chart IIA-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. The low average rate of growth of GDP of 2.3 percent during the expansion beginning in IIIQ2009 does not deteriorate further the trade balance. Higher rates of growth may cause sharper deterioration.

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

Source: US Census Bureau

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

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Sep 2013

Source: US Census Bureau

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

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Sep 2013

Source: US Census Bureau

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

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Sep 2013

Source: US Census Bureau

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

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

	Sep 2013	Sep 2012	∆%
Total Balance	-61,279	-58,897
Petroleum	-19,834	-21,926
Non Petroleum	-40,519	-36,017
Total Exports	132,114	132,752	-0.5
Petroleum	11,849	11,091	6.8
Non Petroleum	119,141	120,325	-1.0
Total Imports	193,393	191,649	0.9
Petroleum	31,682	33,017	-4.0
Non Petroleum	159,660	156,342	2.1

Details may not add because of rounding and seasonal adjustment

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

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

	Jan-Sep 2013 $ Millions	Jan-Sep 2012 $ Millions	∆%
Exports	1,169,567	1,151,170	1.6
Manufactured	883,102	869,671	1.5
Agricultural Commodities	99,035	99,368	-0.3
Mineral Fuels	105,295	99,830	5.5
Petroleum	87,265	81,273	7.4
Imports	1,690,485	1,705,300	-0.9
Manufactured	1,359,600	1,345,591	1.0
Agricultural Commodities	78,916	78,112	1.0
Mineral Fuels	290,529	326,093	-10.9
Petroleum	277,763	314,819	-11.8

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

The current account of the US balance of payments is provided in Table IIA2-5 for IIQ2012 and IIQ2013. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US not seasonally adjusted decreased from $118.3 billion in IIQ2012 to $104.6 billion in IIQ2013. The current account deficit seasonally adjusted at annual rate fell from 2.7 percent of GDP in IIQ2012 to 2.5 percent of GDP in IQ2013 and 2.4 percent of GDP in IIQ2013. The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71).

Table IIA2-5, US, Balance of Payments, Millions of Dollars NSA

	IIQ2012	IIQ2013	Difference
Goods Balance	-191,299	-178,171	13,128
X Goods	395,151	400,113	1.3 ∆%
M Goods	-586,450	-578,283	-1.4 ∆%
Services Balance	45,836	52,588	6,752
X Services	160,060	167,200	4.5 ∆%
M Services	-114,224	-114,612	0.3 ∆%
Balance Goods and Services	-145,464	-125,582	19,882
Balance Income	58,505	53,507	-4,998
Unilateral Transfers	-31,381	-32,493	-1,112
Current Account Balance	-118,340	-104,568	13,772
% GDP	IIQ2012	IIQ2013	IQ2013
	2.7	2.4	2.5

X: exports; M: imports

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

Source: Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

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

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

The alternative fiscal scenario of the CBO (2012NovCDR, 2013Sep17) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

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

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

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

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

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below potential. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. In the release of Jun 14, 2013, the Bureau of Economic Analysis (http://www.bea.gov/newsreleases/international/transactions/2013/pdf/trans113.pdf) informs of revisions of US data on US international transactions since 1999:

“The statistics of the U.S. international transactions accounts released today have been revised for the first quarter of 1999 to the fourth quarter of 2012 to incorporate newly available and revised source data, updated seasonal adjustments, changes in definitions and classifications, and improved estimating methodologies.”

Table IIA2-6 provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.1 percent of GDP while the Congressional Budget Office (CBO 2013Sep11) estimates the federal deficit in 2012 at $1087 billion or 6.8 percent of GDP. The combined record federal deficits of the US from 2009 to 2012 are $5090 billion or 31.6 percent of the estimate of GDP for fiscal year 2012 implicit in the CBO (CBO 2013Sep11) estimate of debt/GDP. The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.090 trillion in four years, using the fiscal year deficit of $1087 billion for fiscal year 2012, which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5090 billion. Federal debt in 2012 was 70.1 percent of GDP (CBO 2013Sep11). This situation may worsen in the future (CBO 2013Sep17):

“Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73 percent of the economy’s annual output, or gross domestic product (GDP). That percentage is higher than at any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007. If current laws generally remained in place, federal debt held by the public would decline slightly relative to GDP over the next several years, CBO projects. After that, however, growing deficits would ultimately push debt back above its current high level. CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

The gap between federal spending and revenues would widen steadily after 2015 under the assumptions of the extended baseline, CBO projects. By 2038, the deficit would be 6½ percent of GDP, larger than in any year between 1947 and 2008, and federal debt held by the public would reach 100 percent of GDP, more than in any year except 1945 and 1946. With such large deficits, federal debt would be growing faster than GDP, a path that would ultimately be unsustainable.

Incorporating the economic effects of the federal policies that underlie the extended baseline worsens the long-term budget outlook. The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. With those effects included, debt under the extended baseline would rise to 108 percent of GDP in 2038.”

Table IIA2-6, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011	2012
Goods & Services	-699	-702	-384	-499	-557	-535
Income	101	146	124	178	233	224
UT	-115	-125	-122	-128	-134	-130
Current Account	-713	-681	-382	-449	-458	-440
NGDP	14480	14720	14418	14958	15534	16245
Current Account % GDP	-4.9	-4.6	-2.6	-3.0	-2.9	-2.7
NIIP	-1796	-3260	-2275	-2250	-3730	-3863
US Owned Assets Abroad	18400	19464	18558	20555	21636	21638
Foreign Owned Assets in US	20196	22724	20833	22805	25366	25501
NIIP % GDP	-12.4	-22.1	-15.8	-15.0	-24.0	-23.8
Exports Goods Services Income	2487	2654	2185	2523	2874	2987
NIIP % Exports Goods Services Income	-72	-123	-104	-89	-130	-129
DIA MV	5274	3102	4322	4809	4514	5249
DIUS MV	3551	2486	2995	3422	3510	3924
Fiscal Balance	-161	-459	-1413	-1294	-1296	-1087
Fiscal Balance % GDP	-1.1	-3.1	-9.8	-8.7	-8.4	-6.8
Federal Debt	5035	5803	7545	9019	10128	11281
Federal Debt % GDP	35.1	39.3	52.3	61.0	65.8	70.1
Federal Outlays	2729	2983	3518	3456	3598	3537
∆%	2.8	9.3	17.9	-1.8	4.1	-1.7
% GDP	19.0	20.2	24.4	23.4	23.4	22.0
Federal Revenue	2568	2524	2105	2162	2302	2450
∆%	6.7	-1.7	-16.6	2.7	6.5	6.4
% GDP	17.9	17.1	14.6	14.6	15.0	15.2

Sources:

Notes: UT: unilateral transfers; NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. These discrepancies do not alter conclusions. Budget http://www.cbo.gov/ Balance of Payments and NIIP http://www.bea.gov/international/index.htm#bop Gross Domestic Product, Bureau of Economic Analysis (BEA). http://www.bea.gov/iTable/index_nipa.cfm

Table IIA2-7 provides quarterly estimates NSA of the external and internal imbalances of the United States. The current account deficit seasonally adjusted falls from 3.0 percent of GDP in IQ2012 to 2.5 percent in IQ2013. The net international investment position increases from $3.9 trillion in IQ2012 to $4.3 trillion in IQ2013.

Table IIA2-7, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and % NSA

	IQ2012	IIQ2012	IIIQ2012	IVQ2012	IQ2013
Goods & Services	-122	-145	-144	-122	-100
Income	55	58	55	55	52
UT	-33	-31	-33	-32	-34
Current Account	-100	-118	-122	-99	-82
Current Account % GDP	-3.0	-2.7	-2.6	-2.5	-2.5
NIIP	-3886	-4332	-4109	-3863	-4277
US Owned Assets Abroad	21349	20948	21551	21638	21619
Foreign Owned Assets in US	-25235	-25280	-25660	-25501	-25896
DIA MV	4976	4679	5059	5249	5518
DIUS MV	3856	3765	3962	3924	4261

Sources:

Notes: UT: unilateral transfers; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value..

Sources: US Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

Chart IIA-5, US, Balance on Current Account, 1960-2012, Millions of Dollars

Source: Bureau of Economic Analysis

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

Chart IIA-6, US, Balance on Current Account, Quarterly 1979-2013, Millions of Dollars, NSA

Source: Bureau of Economic Analysis

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

Risk aversion channels funds toward US long-term and short-term securities that finance the US balance of payments and fiscal deficits benefitting from risk flight to US dollar denominated assets. There are now temporary interruptions because of fear of rising interest rates that erode prices of US government securities because of mixed signals on monetary policy and exit from the Fed balance sheet of three trillion dollars of securities held outright. Net foreign purchases of US long-term securities (row C in Table IIA2-8) deteriorated $31.0 billion in Jul 2013 to minus $8.9 billion in Aug 2013. Foreign (residents) purchases minus sales of US long-term securities (row A in Table IIA2-8) in Jul 2013 of $46.6 billion decreased to minus $8.5 billion in Aug 2013. Net US (residents) purchases of long-term foreign securities (row B in Table IIA2-8) increased from minus $15.7 billion in Jul 2013 to minus $0.4 billion in Aug 2013. In Aug 2013,

C = A + B = -$8.5 billion - $0.4 billion = -$8.9 billion

There are minor rounding errors. There is decreasing demand in Table IIA2-8 in Jul in A1 private purchases by residents overseas of US long-term securities of minus $3.7 billion of which increases in A11 Treasury securities of $0.1 billion, increase in A12 of $8.7 billion in agency securities, increase by $1.4 billion of corporate bonds and decrease of $13.8 billion in equities. Worldwide risk aversion causes flight into US Treasury obligations with significant oscillations. Official purchases of securities in row A2 decreased $4.8 billion with decrease of Treasury securities of $10.9 billion in Aug 2013. Official purchases of agency securities increased $8.1 billion in Jul. Row D shows decrease in Aug 2013 of $5.8 billion in purchases of short-term dollar denominated obligations. Foreign private holdings of US Treasury bills increased $17.5 billion (row D11) with foreign official holdings increasing $10.0 billion while the category “other” decreased $23.3 billion. Foreign private holdings of US Treasury bills increased $7.5 billion in what could be decrease of duration exposures. Risk aversion of default losses in foreign securities dominates decisions to accept zero interest rates in Treasury securities with no perception of principal losses. In the case of long-term securities, investors prefer to sacrifice inflation and possible duration risk to avoid principal losses with significant oscillations in risk perceptions.

Table IIA2-8, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Aug 2012 12 Months	Aug 2013 12 Months	Jul 2013	Aug 2013
A Foreign Purchases less Sales of US LT Securities	579.6	206.6	46.6	-8.5
A1 Private	343.3	70.5	41.7	-3.7
A11 Treasury	300.5	-7.1	49.8	0.1
A12 Agency	118.3	43.8	2.1	8.7
A13 Corporate Bonds	-65.1	1.6	-1.0	1.4
A14 Equities	-10.4	32.1	-9.2	-13.8
A2 Official	236.4	136.1	5.0	-4.8
A21 Treasury	231.5	32.4	-15.9	-10.9
A22 Agency	-4.3	80.4	20.1	8.1
A23 Corporate Bonds	0.8	18.3	0.0	1.0
A24 Equities	8.4	4.9	0.7	-3.1
B Net US Purchases of LT Foreign Securities	77.8	-180.8	-15.7	-0.4
B1 Foreign Bonds	102.7	-44.3	0.4	12.7
B2 Foreign Equities	-24.9	-136.5	-16.0	-13.2
C Net Foreign Purchases of US LT Securities	657.5	25.8	31.0	-8.9
D Increase in Foreign Holdings of Dollar Denominated Short-term	19.9	-14.6	-14.1	-5.8
D1 US Treasury Bills	23.5	16.1	-20.8	17.5
D11 Private	59.8	16.1	-21.1	7.5
D12 Official	-36.3	0.0	0.2	10.0
D2 Other	-3.6	-30.7	6.7	-23.3

C = A + B;

A = A1 + A2

A1 = A11 + A12 + A13 + A14

A2 = A21 + A22 + A23 + A24

B = B1 + B2

D = D1 + D2

Sources: United States Treasury http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/index.aspx

Table IIA2-9 provides major foreign holders of US Treasury securities. China is the largest holder with $1268.1 billion in Aug 2013, increasing 9.8 percent from $1155.2 billion in Aug 2012 while decreasing $11.2 billion from Jul 2013 or 0.9 percent. Japan increased its holdings from $1119.8 billion in Jul 2012 to $1135.4 billion in Jul 2013 or by 1.4 percent. Japan increased its holdings from $1135.4 billion in Jul 2013 to $1149.1 billion in Aug 2013 by $13.7 billion or 1.2 percent. Total foreign holdings of Treasury securities rose from $5443.4 billion in Aug 2012 to $5588.8 billion in Aug 2013, or 2.7 percent. Foreign holdings of Treasury securities fell from $5721.8 in Mar 2013 to $5708.4 in Apr 2013 or 0.2 percent. Foreign holdings of US Treasury securities fell from $5595.7 billion in Jun 2013 to $5593.9 billion in Jul 2013, by $1.8 billion or 0.0 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

Table IIA2-9, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Aug 2013	Jul 2013	Aug 2012
Total	5588.8	5593.9	5443.4
China	1268.1	1279.3	1155.2
Japan	1149.1	1135.4	1120.9
Caribbean Banking Centers	300.5	287.8	263.9
Brazil	252.9	256.4	259.8
Oil Exporters	246.4	257.7	259.1
Taiwan	183.6	185.8	199.5
Switzerland	179.7	178.2	191.7
Belgium	166.8	167.7	130.2
United Kingdom	159.1	157.0	137.1
Luxembourg	143.8	146.8	138.6
Russia	136.0	131.6	162.9
Hong Kong	126.5	120.0	141.7
Foreign Official Holdings	3973.5	3995.5	3957.1
A. Treasury Bills	373.0	363.0	373.0
B. Treasury Bonds and Notes	3600.5	3632.5	3584.1

Source: United States Treasury

http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/index.aspx

Chart IIA2-1 provides prices of total US imports 2001-2013. Prices fell during the contraction of 2001. Import price inflation accelerated after unconventional monetary policy of near zero interest rates in 2003-2004 and quantitative easing by withdrawing supply with the suspension of 30-year Treasury bond auctions. Slow pace of adjusting fed funds rates from 1 percent by increments of 25 basis points in 17 consecutive meetings of the Federal Open Market Committee (FOMC) between Jun 2004 and Jun 2006 continued to give impetus to carry trades. The reduction of fed funds rates toward zero in 2008 fueled a spectacular global hunt for yields that caused commodity price inflation in the middle of a global recession. After risk aversion in 2009 because of the announcement of TARP (Troubled Asset Relief Program) creating anxiety on “toxic assets” in bank balance sheets (see Cochrane and Zingales 2009), prices collapsed because of unwinding carry trades. Renewed price increases returned with zero interest rates and quantitative easing. Monetary policy impulses in massive doses have driven inflation and valuation of risk financial assets in wide fluctuations over a decade.

Chart IIA2-1, US, Prices of Total US Imports 2001=100, 2001-2013

Source: Bureau of Labor Statistics

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

Chart IIA2-2 provides 12-month percentage changes of prices of total US imports from 2001 to 2013. The only plausible explanation for the wide oscillations is by the carry trade originating in unconventional monetary policy. Import prices jumped in 2008 during deep and protracted global recession driven by carry trades from zero interest rates to long, leveraged positions in commodity futures. Carry trades were unwound during the financial panic in the final quarter of 2008 that resulted in flight to government obligations. Import prices jumped again in 2009 with subdued risk aversion because US banks did not have unsustainable toxic assets. Import prices then fluctuated as carry trades were resumed during periods of risk appetite and unwound during risk aversion resulting from the European debt crisis.

Chart IIA2-2, US, Prices of Total US Imports, 12-Month Percentage Changes, 2001-2013

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

Chart IIA2-3 provides prices of US imports from 1982 to 2013. There is no similar episode to that of the increase of commodity prices in 2008 during a protracted and deep global recession with subsequent collapse during a flight into government obligations. Trade prices have been driven by carry trades created by unconventional monetary policy in the past decade.

Chart IIA2-3, US, Prices of Total US Imports, 2001=100, 1982-2013

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

Chart IIA2-4 provides 12-month percentage changes of US total imports from 1982 to 2013. There have not been wide consecutive oscillations as the ones during the global recession of IVQ2007 to IIQ2009.

Chart IIA2-4, US, Prices of Total US Imports, 12-Month Percentage Changes, 1982-2013

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

Chart IIA2-5 provides the index of US export prices from 2001 to 2013. Import and export prices have been driven by impulses of unconventional monetary policy in massive doses. The most recent segment in Chart IIA2-5 shows declining trend resulting from a combination of the world economic slowdown and the decline of commodity prices as carry trade exposures are unwound because of risk aversion to the sovereign debt crisis in Europe and slowdown in the world economy.

Chart IIA2-5, US, Prices of Total US Exports, 2001=100, 2001-2013

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

Chart IIA2-6 provides prices of US total exports from 1982 to 2013. The rise before the global recession from 2003 to 2008, driven by carry trades, is also unique in the series and is followed by another steep increase after risk aversion moderated in IQ2009.

Chart IIA2-6, US, Prices of Total US Exports, 2001=100, 1982-2013

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

Chart IIA2-7 provides 12-month percentage changes of total US exports from 1982 to 2013. The uniqueness of the oscillations around the global recession of IVQ2007 to IIQ2009 is clearly revealed.

Chart IIA2-7, US, Prices of Total US Exports, 12-Month Percentage Changes, 1982-2013

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

Twelve-month percentage changes of US prices of exports and imports are provided in Table IIA2-1. Import prices have been driven since 2003 by unconventional monetary policy of near zero interest rates influencing commodity prices according to moods of risk aversion and portfolio reallocations. In a global recession without risk aversion until the panic of Sep 2008 with flight to government obligations, import prices increased 21.4 percent in the 12 months ending in Jul 2008, 18.1 percent in the 12 months ending in Aug 2008, 13.1 percent in the 12 months ending in Sep 2008, 4.9 percent in the twelve months ending in Oct 2008. Import prices fell 5.9 percent in the 12 months ending in Nov 2008 when risk aversion developed in 2008 until mid 2009 (http://www.bls.gov/mxp/data.htm). Import prices rose again sharply in Nov 2010 by 4.1 percent and in Nov 2011 by 0.1 percent in the presence of zero interest rates with relaxed mood of risk aversion until carry trades were unwound in May 2011 and following months as shown by decrease of import prices by 1.4 percent in the 12 months ending in Nov 2012 and 1.8 percent in Dec 2012 and decrease of 0.3 percent in prices of exports in the 12 months ending in Dec 2012. Import prices increased 15.2 percent in the 12 months ending in Mar 2008, fell 14.9 percent in the 12 months ending in Mar 2009 and increased 11.2 percent in the 12 months ending in Mar 2010. Fluctuations are much sharper in imports because of the high content of oil that as all commodities futures contracts increases sharply with zero interest rates and risk appetite, contracting under risk aversion. There is similar behavior of prices of imports ex fuels, exports and exports ex agricultural goods but less pronounced than for commodity-rich prices dominated by carry trades from zero interest rates. A critical event resulting from unconventional monetary policy driving higher commodity prices by carry trades is the deterioration of the terms of trade, or export prices relative to import prices, that has adversely affected US real income growth relative to what it would have been in the absence of unconventional monetary policy. Europe, Japan and other advanced economies have experienced similar deterioration of their terms of trade. Because of unwinding carry trades of commodity futures because of risk aversion and portfolio reallocations, import prices decreased 2.0 percent in the 12 months ending in Oct 2013, export prices decreased 2.1 percent and prices of nonagricultural exports fell 1.6 percent. Imports excluding fuel fell 1.3 percent in the 12 months ending in Oct 2013. At the margin, price changes over the year in world exports and imports are decreasing or increasing moderately because of unwinding carry trades in a temporary mood of risk aversion and relative allocation of asset classes that reverses exposures in commodity futures.

Table IIA2-1, US, Twelve-Month Percentage Rates of Change of Prices of Exports and Imports

	Imports	Imports Ex Fuels	Exports	Exports Non-Ag
Oct 2013	-2.0	-1.3	-2.1	-1.6
Oct 2012	0.0	0.1	1.5	0.2
Oct 2011	11.1	4.8	6.3	5.8
Oct 2010	3.9	2.5	5.8	4.8
Oct 2009	-5.6	-3.1	-3.6	-2.9
Oct 2008	4.9	4.8	4.0	3.8
Oct 2007	9.1	2.7	5.6	3.9
Oct 2006	-1.0	2.6	2.9	2.6
Oct 2005	8.2	1.6	3.7	3.6
Oct 2004	9.9	2.7	4.4	5.0
Oct 2003	0.8	0.6	1.3	0.6
Oct 2002	1.9	NA	0.4	0.0
Oct 2001	-7.4	NA	-2.0	-2.2

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

Table IIA2-2 provides 12-month percentage changes of the import price index all commodities from 2001 to 2013. Interest rates moving toward zero during unconventional monetary policy in 2008 induced carry trades into highly leveraged commodity derivatives positions that caused increases in 12-month percentage changes of import prices of around 20 percent. The flight into dollars and Treasury securities by fears of toxic assets in banks in the proposal of TARP (Cochrane and Zingales 2009) caused reversion of carry trades and collapse of commodity futures explaining sharp declines in trade prices in 2009. Twelve-month percentage changes of import prices at the end of 2012 and into 2013 occurred during another bout of risk aversion and portfolio reallocation.

Table IIA2-2, US, Twelve-Month Percentage Changes of Import Price Index All Commodities, 2001-2013

Year	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec
2001	-0.7	-0.8	-2.6	-4.1	-4.4	-5.6	-7.4	-8.8	-9.1
2002	-3.6	-3.7	-3.6	-1.7	-1.3	-0.4	1.9	2.5	4.2
2003	1.8	1.0	2.2	2.3	2.0	0.7	0.8	2.3	2.4
2004	4.6	6.9	5.7	5.6	7.1	8.2	9.9	9.0	6.7
2005	8.4	5.9	7.4	8.2	8.2	9.9	8.2	6.4	8.0
2006	5.8	8.6	7.4	7.0	6.0	1.6	-1.0	1.3	2.5
2007	2.1	1.2	2.3	2.8	1.9	4.8	9.1	12.0	10.6
2008	16.9	19.1	21.3	21.4	18.1	13.1	4.9	-5.9	-10.1
2009	-16.4	-17.3	-17.5	-19.1	-15.3	-12.0	-5.6	3.4	8.6
2010	11.2	8.5	4.3	4.9	3.8	3.6	3.9	4.1	5.3
2011	11.9	12.9	13.6	13.7	12.9	12.7	11.1	10.1	8.5
2012	0.8	-0.8	-2.5	-3.3	-1.8	-0.6	0.0	-1.4	-2.0
2013	-2.7	-1.8	0.1	0.9	-0.1	-1.0	-2.0

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

There is finer detail in one-month percentage changes of imports of the US in Table IIA2-3. Carry trades into commodity futures induced by interest rates moving to zero in unconventional monetary policy caused sharp monthly increases in import prices for cumulative increase of 13.8 percent from Mar to Jul 2008 at average rate of 2.6 percent per month or annual equivalent in five months of 36.4 percent (3.1 percent in Mar 2008, 2.8 percent in Apr 2008, 2.8 percent in May 2008, 3.0 percent in Jun 2008 and 1.4 percent in Jul 2008, data from http://www.bls.gov/mxp/data.htm). There is no other explanation for increases in import prices during sharp global recession and contracting world trade. Import prices then fell 23.4 percent from Aug 2008 to Jan 2009 or at the annual equivalent rate of minus 41.4 percent in the flight to US government securities in fear of the need to buy toxic assets from banks in the TARP program (Cochrane and Zingales 2009). Risk aversion during the first sovereign debt crisis of the euro area in May-Jun 2010 caused decline of US import prices at the annual equivalent rate of 11.4 percent. US import prices have been driven by combinations of carry trades induced by unconventional monetary policy and bouts of risk aversion and portfolio reallocation (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html). US import prices increased 0.5 percent in Jan 2013 and 0.9 percent in Feb 2013 for annual equivalent rate of 8.7 percent, similar to those in national price indexes worldwide, originating in carry trades from zero interest rates to commodity futures. Import prices fell 0.1 percent in Mar 2013, 0.7 percent in Apr 2013, 0.6 percent in May 2013 and 0.4 percent in Jun 2013. Import prices changed 0.1 percent in Jul 2013, increased 0.2 percent in Aug 2013 and increased 0.1 percent in Sep 2013. Portfolio reallocations into asset classes other than commodities explains decline of import prices by 0.7 percent in Oct 2013.

Table IIA2-3, US, One-Month Percentage Changes of Import Price Index All Commodities, 2001-2013

Year	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec
2001	-0.5	0.2	-0.4	-1.5	-0.1	-0.1	-2.3	-1.5	-1.0
2002	1.6	0.1	-0.3	0.4	0.3	0.7	0.0	-0.9	0.6
2003	-3.1	-0.7	0.9	0.5	0.0	-0.5	0.1	0.5	0.7
2004	0.2	1.5	-0.2	0.4	1.5	0.5	1.6	-0.3	-1.4
2005	0.9	-0.8	1.2	1.2	1.4	2.1	0.1	-1.9	0.0
2006	2.1	1.8	0.1	0.8	0.5	-2.2	-2.5	0.4	1.1
2007	1.4	0.9	1.2	1.3	-0.3	0.6	1.5	3.2	-0.2
2008	2.8	2.8	3.0	1.4	-3.1	-3.6	-6.0	-7.4	-4.6
2009	1.1	1.7	2.7	-0.6	1.5	0.2	0.8	1.5	0.2
2010	1.1	-0.8	-1.2	0.0	0.4	0.0	1.1	1.7	1.4
2011	2.6	0.1	-0.6	0.1	-0.4	-0.1	-0.4	0.7	0.0
2012	-0.1	-1.5	-2.3	-0.7	1.2	1.0	0.3	-0.7	-0.6
2013	-0.7	-0.6	-0.4	0.1	0.2	0.1	-0.7

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

Chart IIA2-8 shows the US monthly import price index of all commodities excluding fuels from 2001 to 2013. All curves of nominal values follow the same behavior under the influence of unconventional monetary policy. Zero interest rates without risk aversion result in jumps of nominal values while under strong risk aversion even with zero interest rates there are declines of nominal values.

Chart IIA2-8, US, Import Price Index All Commodities Excluding Fuels, 2001=100, 2001-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-9 provides 12-month percentage changes of the US import price index excluding fuels between 2001 and 2013. There is the same behavior of carry trades driving up without risk aversion and down with risk aversion prices of raw materials, commodities and food in international trade during the global recession of IVQ2007 to IIQ2009 and in previous and subsequent periods.

Chart IIA2-9, US, Import Price Index All Commodities Excluding Fuels, 12-Month Percentage Changes, 2002-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-10 provides the monthly US import price index ex petroleum from 2001 to 2013. Prices including or excluding commodities follow the same fluctuations and trends originating in impulses of unconventional monetary policy of zero interest rates

Chart IIA2-10, US, Import Price Index ex Petroleum, 2001=100, 2000-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-11 provides the US import price index ex petroleum from 1985 to 2013. There is the same unique hump in 2008 caused by carry trades from zero interest rates to prices of commodities and raw materials.

Chart IIA2-11, US, Import Price Index ex Petroleum, 2001=100, 1985-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-12 provides 12-month percentage changes of the import price index ex petroleum from 1986 to 2013. The oscillations caused by the carry trade in increasing prices of commodities and raw materials without risk aversion and subsequently decreasing them during risk aversion are unique.

Chart IIA2-12, US, Import Price Index ex Petroleum, 12-Month Percentage Changes, 1986-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-13 of the US Energy Information Administration shows the price of WTI crude oil since the 1980s. Chart IA2-13 captures commodity price shocks during the past decade. The costly mirage of deflation was caused by the decline in oil prices during the recession of 2001. The upward trend after 2003 was promoted by the carry trade from near zero interest rates. The jump above $140/barrel during the global recession in 2008 at $145.29/barrel on Jul 3, 2008, can only be explained by the carry trade promoted by monetary policy of zero fed funds rate. After moderation of risk aversion, the carry trade returned with resulting sharp upward trend of crude prices. Risk aversion resulted in another drop in recent weeks followed by some recovery and renewed deterioration/increase.

Chart IIA2-13, US, Crude Oil Futures Contract

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D

The price index of US imports of petroleum and petroleum products in shown in Chart IIA2-14. There is similar behavior of the curves all driven by the same impulses of monetary policy.

Chart IIA2-14, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 2001-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-15 provides the price index of petroleum and petroleum products from 1982 to 2013. The rise in prices during the global recession in 2008 and the decline after the flight to government obligations is unique in the history of the series. Increases in prices of trade in petroleum and petroleum products were induced by carry trades and declines by unwinding carry trades in flight to government obligations.

Chart IIA2-15, US, Import Price Index of Petroleum and Petroleum Products, 2001=100, 1982-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-16 provides 12-month percentage changes of the price index of US imports of petroleum and petroleum products from 1982 to 2013. There were wider oscillations in this index from 1999 to 2001 (see Barsky and Killian 2004 for an explanation).

Chart IIA2-16, US, Import Price Index of Petroleum and Petroleum Products, 12-Month Percentage Changes, 1982-2013

Source: US Bureau of Labor Statistics

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

The price index of US exports of agricultural commodities is in Chart IIA2-17 from 2001 to 2013. There are similar fluctuations and trends as in all other price index originating in unconventional monetary policy repeated over a decade. The most recent segment in 2011 has declining trend in a new flight from risk resulting from the sovereign debt crisis in Europe followed by declines in Jun 2012 and Nov 2012 with stability in Dec 2012 into 2013.

Chart IIA2-17, US, Exports Price Index of Agricultural Commodities, 2001=100, 2001-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-18 provides the price index of US exports of agricultural commodities from 1982 to 2013. The increase in 2008 in the middle of deep, protracted contraction was induced by unconventional monetary policy. The decline from 2008 into 2009 was caused by unwinding carry trades in a flight to government obligations. The increase into 2011 and current pause were also induced by unconventional monetary policy in waves of increases during relaxed risk aversion and declines during unwinding of positions because of aversion to financial risk.

Chart IIA2-18, US, Exports Price Index of Agricultural Commodities, 2001=100, 1982-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-19 provides 12-month percentage changes of the index of US exports of agricultural commodities from 1986 to 2013. The wide swings in 2008, 2009 and 2011 are only explained by unconventional monetary policy inducing carry trades from zero interest rates to commodity futures and reversals during risk aversion.

Chart IIA2-19, US, Exports Price Index of Agricultural Commodities, 12-Month Percentage Changes, 1986-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-20 shows the export price index of nonagricultural commodities from 2001 to 2013. Unconventional monetary policy of zero interest rates drove price behavior during the past decade. Policy has been based on the myth of stimulating the economy by climbing the negative slope of an imaginary short-term Phillips curve.

Chart IIA2-20, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 2001-2013

Source: US Bureau of Labor Statistics

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

Chart IIA2-21 provides a longer perspective of the price index of US nonagricultural commodities from 1982 to 2013. Increases and decreases around the global contraction after 2007 were caused by carry trade induced by unconventional monetary policy.

Chart IIA2-21, US, Exports Price Index of Nonagricultural Commodities, 2001=100, 1982-2013

Source: US Bureau of Labor Statistics

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

Finally, Chart IIA2-22 provides 12-month percentage changes of the price index of US exports of nonagricultural commodities from 1986 to 2013. The wide swings before, during and after the global recession beginning in 2007 were caused by carry trades induced by unconventional monetary policy.

Chart IIA2-22, US, Exports Price Index of Nonagricultural Commodities, 12-Month Percentage Changes, 1986-2013

Source: US Bureau of Labor Statistics

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

III World Financial Turbulence. Financial markets are being shocked by multiple factors including:

(1) World economic slowdown

(2) Slowing growth in China with political development and slowing growth in Japan and world trade

(3) Slow growth propelled by savings/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse, contraction of real private fixed investment, decline of wealth of households over the business cycle by 0.9 percent adjusted for inflation while growing 651.8 percent adjusted for inflation from IVQ1945 to IVQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes

(4) Outcome of the sovereign debt crisis in Europe.

This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk financial assets during the week. There are various appendixes for convenience of reference of material related to the debt crisis of the euro area. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention and is available in the Appendixes section at the end of the blog comment. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil and is available in the Appendixes section at the end of the blog comment.

IIIA Financial Risks. Financial turbulence, attaining unusual magnitude in recent months, characterized the expansion from the global recession since IIIQ2009. Table III-1, updated with every comment in this blog, provides beginning values on Fri Nov 8 and daily values throughout the week ending on Nov 15, 2013 of various financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Nov 8 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Nov 8, 2013”, first row “USD/EUR 1.3369 0.9% 0.4 %,” provides the information that the US dollar (USD) appreciated 0.9 percent to USD 1.3369/EUR in the week ending on Fri Nov 8 relative to the exchange rate on Fri Nov 1 and appreciated 0.4 percent relative to Thu Nov 7. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. An important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf). The most important source of financial turbulence is shifting toward increasing interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3369/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Nov 8, depreciating to USD 1.3406/EUR on Mon Nov 11, 2013, or by 0.3 percent. The dollar depreciated because more dollars, $1.3406, were required on Mon Nov 11 to buy one euro than $1.3369 on Fri Nov 8. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate such as in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3369/EUR on Nov 8. The second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Nov 8, to the last business day of the current week, in this case Fri Nov 15, such as depreciation of 1.0 percent to USD 1.3497/EUR by Nov 15. The third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 1.0 percent from the rate of USD 1.3369/EUR on Fri Nov 8 to the rate of USD 1.3497/EUR on Fri Nov 15 {[(1.3497/1.3369) – 1]100 = 1.0%}. The dollar depreciated (denoted by negative sign) by 0.3 percent from the rate of USD 1.3459 on Thu Nov 14 to USD 1.3497/EUR on Fri Nov 15 {[(1.3497/1.3459) -1]100 = 0.3%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk assets to the safety of dollar-denominated assets during risk aversion and return to higher yielding risk assets during risk appetite.

Table III-I, Weekly Financial Risk Assets Nov 1 to Nov 8, 2013

Fri Nov 8

Mon 11

Tue 12

Wed 13

Thu 14

Fri 15

USD/ EUR

1.3369

0.9%

0.4%

1.3406

-0.3%

1.3435

-0.5%

-0.2%

1.3486

-0.9%

-0.4%

1.3459

-0.7%

0.2%

1.3497

-1.0%

-0.3%

JPY/ USD

99.07

-0.4%

-1.0%

99.16

-0.1%

99.64

-0.6%

-0.5%

99.24

-0.2%

0.4%

100.01

-0.9%

-0.8%

100.18

-1.1%

-0.2%

CHF/ USD

0.9214

-1.0%

-0.6%

0.9194

0.2%

0.9176

0.4%

0.2%

0.9135

0.9%

0.4%

0.9164

0.5%

-0.3%

0.9149

0.7%

0.2%

CHF/ EUR

1.2315

-0.1%

-0.2%

1.2327

-0.1%

1.2327

-0.1%

0.0%

1.2320

0.0%

0.1%

1.2331

-0.1%

1.2347

-0.3%

-0.1%

USD/ AUD

0.9385

1.0655

-0.6%

-0.7%

0.9361

1.0683

-0.3%

0.9303

1.0749

-0.9%

-0.6%

0.9359

1.0685

-0.3%

0.6%

0.9316

1.0734

-0.7%

-0.5%

0.9370

1.0672

-0.2%

0.6%

10Y Note

2.750

2.739

2.774

2.730

2.693

2.704

2Y Note

0.316

0.302

0.332

0.308

0.292

German Bond

2Y 0.10 10Y 1.76

2Y 0.09 10Y 1.75

2Y 0.10 10Y 1.79

2Y 0.10 10Y 1.73

2Y 0.10 10Y 1.70

DJIA

15761.78

0.9%

1.1%

15783.10

0.1%

15750.67

-0.1%

-0.2%

15821.63

0.4%

0.5%

15876.22

0.7%

0.3%

15961.70

1.3%

0.5%

Dow Global

2394.06

-0.4%

0.1%

2401.77

0.3%

2395.41

0.1%

-0.3%

2402.06

0.3%

2415.11

0.9%

0.5%

2429.28

1.5%

0.6%

DJ Asia Pacific

1422.69

-1.5%

-0.8%

1423.43

0.1%

1429.18

0.5%

0.4%

1418.85

-0.3%

-0.7%

1430.18

0.5%

0.8%

1448.38

1.8%

1.3%

Nikkei

14086.80

-0.8%

-1.0%

14269.84

1.3%

14558.68

3.3%

2.0%

14567.16

3.4%

0.1%

14876.41

5.6%

2.1%

15165.92

7.7%

1.9%

Shanghai

2106.13

-2.0%

-1.1%

2109.47

0.2%

2126.77

1.0%

0.8%

2087.94

-0.9%

-1.8%

2100.51

-0.3%

0.6%

2135.83

1.4%

1.7%

DAX

9078.28

0.8%

0.0%

9107.86

0.3%

9076.48

0.0%

-0.3%

9054.83

-0.3%

-0.2%

9149.66

0.8%

1.0%

9168.69

1.0%

0.2%

DJ UBS Comm.

123.26

-0.5%

0.5%

123.53

0.2%

123.11

-0.1%

-0.3%

122.83

-0.3%

-0.2%

123.23

0.0%

0.3%

123.21

0.0%

WTI $/B

94.32

-0.3%

0.1%

95.08

0.8%

93.07

-1.3%

-2.1%

93.61

-0.8%

0.6%

93.94

-0.4%

0.4%

93.65

-0.7%

-0.3%

Brent $/B

104.96

-1.0%

1.5%

106.47

1.4%

106.11

1.1%

-0.3%

107.08

2.0%

0.9%

108.54

3.4%

1.4%

108.54

3.4%

0.0%

Gold $/OZ

1287.8

-2.0%

-1.5%

1282.4

-0.4%

1267.1

-1.6%

-1.2%

1277.5

-0.8%

0.8%

1287.0

-0.1%

0.7%

1288.5

0.1%

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

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

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

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

There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.

First, risk determining events. Prior risk determining events are in an appendix below following Table III-1A. Current focus is on “tapering” quantitative easing by the Federal Open Market Committee (FOMC). At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:

There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “tapering” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight. What really matters in the statement of the Federal Open Market Committee (FOMC) on Dec 30, 2013, is interest rates of fed funds at 0 to ¼ percent for the foreseeable future, even with paring of purchases of longer term bonds for the portfolio of the Fed (http://www.federalreserve.gov/newsevents/press/monetary/20131030a.htm):

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent” (emphasis added).

Another critical concern in the statement of the FOMC on Sep 18, 2013, is on the effects of tapering expectations on interest rates (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):

“Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth” (emphasis added).

In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:

The President of the European Central Bank (ECB) Mario Draghi explained the indefinite period of low policy rates during the press conference following the meeting on Jul 4, 2013 (http://www.ecb.int/press/pressconf/2013/html/is130704.en.html):

“Yes, that is why I said you haven’t listened carefully. The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney [Governor of the Bank of England] said in London is just a coincidence.”

The European Central Bank (ECB) lowered the policy rates on Nov 7, 2013 (http://www.ecb.europa.eu/press/pr/date/2013/html/pr131107.en.html):

“PRESS RELEASE

7 November 2013 - Monetary policy decisions

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
The interest rate on the deposit facility will remain unchanged at 0.00%.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”

Mario Draghi, President of the ECB, explained as follows (http://www.ecb.europa.eu/press/pressconf/2013/html/is131107.en.html):

“Based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%. These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.”

The ECB decision together with the employment situation report on Fri Nov 8, 2013, influenced revaluation of the dollar. Market expectations were of relatively easier monetary policy in the euro area.

The statement of the meeting of the Monetary Policy Committee of the Bank of England on Jul 4, 2013, may be leading toward the same forward guidance (http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx):

“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report. The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”

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 14,164.53 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 15,961.70 on Fri Nov 15, 2013, which is higher by 12.7 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 12.4 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. There are high costs and risks of this policy because indefinite financial repression induces carry trades with high leverage, risks and illiquidity.

In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows.

Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.

Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 4.073 percent on Nov 15, 2013, and that of the ten-year sovereign bond of Italy at 4.096 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Nov 15, 2013, the yield of the two-year Treasury decreased to 0.292 percent and that of the ten-year Treasury decreased to 2.704 percent while the two-year bond of Germany remained at 0.10 percent and the ten-year decreased to 1.70 percent; and the dollar depreciated to USD 1.3497/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield of 2.750 percent is higher than consumer price inflation of 1.2 percent in the 12 months ending in Sep 2013 (http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/duration-dumping-and-peaking-valuations.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.129 percent is well below the 12-month consumer price inflation of 1.2 percent. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US

Dollar/EUR Exchange rate

	US 2Y	US 10Y	DE 2Y	DE 10Y	USD/ EUR
11/15/13	0.292	2.704	0.10	1.70	1.3497
11/8/13	0.316	2.750	0.10	1.76	1.3369
11/1/13	0.311	2.622	0.11	1.69	1.3488
10/25/13	0.305	2.507	0.18	1.75	1.3804
10/18/13	0.321	2.588	0.17	1.83	1.3686
10/11/13	0.344	2.688	0.18	1.86	1.3543
10/4/13	0.335	2.645	0.17	1.84	1.3557
9/27/13	0.335	2.626	0.16	1.78	1.3523
9/20/13	0.333	2.734	0.21	1.94	1.3526
9/13/13	0.433	2.890	0.22	1.97	1.3297
9/6/13	0.461	2.941	0.26	1.95	1.3179
8/23/13	0.401	2.784	0.23	1.85	1.3221
8/23/13	0.374	2.818	0.28	1.93	1.3380
8/16/13	0.341	2.829	0.22	1.88	1.3328
8/9/13	0.30	2.579	0.16	1.68	1.3342
8/2/13	0.299	2.597	0.15	1.65	1.3281
7/26/13	0.315	2.565	0.15	1.66	1.3279
7/19/13	0.300	2.480	0.08	1.52	1.3141
7/12/13	0.345	2.585	0.10	1.56	1.3068
7/5/13	0.397	2.734	0.11	1.72	1.2832
6/28/13	0.357	2.486	0.19	1.73	1.3010
6/21/13	0.366	2.542	0.26	1.72	1.3122
6/14/13	0.276	2.125	0.12	1.51	1.3345
6/7/13	0.304	2.174	0.18	1.54	1.3219
5/31/13	0.299	2.132	0.06	1.50	1.2996
5/24/13	0.249	2.009	0.00	1.43	1.2932
5/17/13	0.248	1.952	-0.03	1.32	1.2837
5/10/13	0.239	1.896	0.05	1.38	1.2992
5/3/13	0.22	1.742	0.00	1.24	1.3115
4/26/13	0.209	1.663	0.00	1.21	1.3028
4/19/13	0.232	1.702	0.02	1.25	1.3052
4/12/13	0.228	1.719	0.02	1.26	1.3111
4/5/13	0.228	1.706	0.01	1.21	1.2995
3/29/13	0.244	1.847	-0.02	1.29	1.2818
3/22/13	0.242	1.931	0.03	1.38	1.2988
3/15/13	0.246	1.992	0.05	1.46	1.3076
3/8/13	0.256	2.056	0.09	1.53	1.3003
3/1/13	0.236	1.842	0.03	1.41	1.3020
2/22/13	0.252	1.967	0.13	1.57	1.3190
2/15/13	0.268	2.007	0.19	1.65	1.3362
2/8/13	0.252	1.949	0.18	1.61	1.3365
2/1/13	0.26	2.024	0.25	1.67	1.3642
1/25/13	0.278	1.947	0.26	1.64	1.3459
1/18/13	0.252	1.84	0.18	1.56	1.3321
1/11/13	0.247	1.862	0.13	1.58	1.3343
1/4/13	0.262	1.898	0.08	1.54	1.3069
12/28/12	0.252	1.699	-0.01	1.31	1.3218
12/21/12	0.272	1.77	-0.01	1.38	1.3189
12/14/12	0.232	1.704	-0.04	1.35	1.3162
12/7/12	0.256	1.625	-0.08	1.30	1.2926
11/30/12	0.248	1.612	0.01	1.39	1.2987
11/23/12	0.273	1.691	0.00	1.44	1.2975
11/16/12	0.24	1.584	-0.03	1.33	1.2743
11/9/12	0.256	1.614	-0.03	1.35	1.2711
11/2/12	0.274	1.715	0.01	1.45	1.2838
10/26/12	0.299	1.748	0.05	1.54	1.2942
10/19/12	0.296	1.766	0.11	1.59	1.3023
10/12/12	0.264	1.663	0.04	1.45	1.2953
10/5/12	0.26	1.737	0.06	1.52	1.3036
9/28/12	0.236	1.631	0.02	1.44	1.2859
9/21/12	0.26	1.753	0.04	1.60	1.2981
9/14/12	0.252	1.863	0.10	1.71	1.3130
9/7/12	0.252	1.668	0.03	1.52	1.2816
8/31/12	0.225	1.543	-0.03	1.33	1.2575
8/24/12	0.266	1.684	-0.01	1.35	1.2512
8/17/12	0.288	1.814	-0.04	1.50	1.2335
8/10/12	0.267	1.658	-0.07	1.38	1.2290
8/3/12	0.242	1.569	-0.02	1.42	1.2387
7/27/12	0.244	1.544	-0.03	1.40	1.2320
7/20/12	0.207	1.459	-0.07	1.17	1.2158
7/13/12	0.24	1.49	-0.04	1.26	1.2248
7/6/12	0.272	1.548	-0.01	1.33	1.2288
6/29/12	0.305	1.648	0.12	1.58	1.2661
6/22/12	0.309	1.676	0.14	1.58	1.2570
6/15/12	0.272	1.584	0.07	1.44	1.2640
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
5/25/12	0.291	1.738	0.05	1.37	1.2518
5/18/12	0.292	1.714	0.05	1.43	1.2780
5/11/12	0.248	1.845	0.09	1.52	1.2917
5/4/12	0.256	1.876	0.08	1.58	1.3084
4/6/12	0.31	2.058	0.14	1.74	1.3096
3/30/12	0.335	2.214	0.21	1.79	1.3340
3/2/12	0.29	1.977	0.16	1.80	1.3190
2/24/12	0.307	1.977	0.24	1.88	1.3449
1/6/12	0.256	1.957	0.17	1.85	1.2720
12/30/11	0.239	1.871	0.14	1.83	1.2944
8/26/11	0.20	2.202	0.65	2.16	1.450
8/19/11	0.192	2.066	0.65	2.11	1.4390
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

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

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

Appendix: Prior Risk Determining Events. Current risk analysis concentrates on deciphering what the Federal Open Market Committee (FOMC) may decide on quantitative easing. 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.

Financial markets worldwide were affected by the reduction of policy rates of the European Central Bank (ECB) on May 2, 2013. (http://www.ecb.int/press/pr/date/2013/html/pr130502.en.html):

“2 May 2013 - Monetary policy decisions

At today’s meeting, which was held in Bratislava, the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.50%, starting from the operation to be settled on 8 May 2013.
The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
The interest rate on the deposit facility will remain unchanged at 0.00%.”

Financial markets in Japan and worldwide were shocked by new bold measures of “quantitative and qualitative monetary easing” by the Bank of Japan (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The objective of policy is to “achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The main elements of the new policy are as follows:

Monetary Base Control. Most central banks in the world pursue interest rates instead of monetary aggregates, injecting bank reserves to lower interest rates to desired levels. The Bank of Japan (BOJ) has shifted back to monetary aggregates, conducting money market operations with the objective of increasing base money, or monetary liabilities of the government, at the annual rate of 60 to 70 trillion yen. The BOJ estimates base money outstanding at “138 trillion yen at end-2012) and plans to increase it to “200 trillion yen at end-2012 and 270 trillion yen at end 2014” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
Maturity Extension of Purchases of Japanese Government Bonds. Purchases of bonds will be extended even up to bonds with maturity of 40 years with the guideline of extending the average maturity of BOJ bond purchases from three to seven years. The BOJ estimates the current average maturity of Japanese government bonds (JGB) at around seven years. The BOJ plans to purchase about 7.5 trillion yen per month (http://www.boj.or.jp/en/announcements/release_2013/rel130404d.pdf). Takashi Nakamichi, Tatsuo Ito and Phred Dvorak, wiring on “Bank of Japan mounts bid for revival,” on Apr 4, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323646604578401633067110420.html ), find that the limit of maturities of three years on purchases of JGBs was designed to avoid views that the BOJ would finance uncontrolled government deficits.
Seigniorage. The BOJ is pursuing coordination with the government that will take measures to establish “sustainable fiscal structure with a view to ensuring the credibility of fiscal management” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
Diversification of Asset Purchases. The BOJ will engage in transactions of exchange traded funds (ETF) and real estate investment trusts (REITS) and not solely on purchases of JGBs. Purchases of ETFs will be at an annual rate of increase of one trillion yen and purchases of REITS at 30 billion yen.

The European sovereign debt crisis continues to shake financial markets and the world economy. Debt resolution within the international financial architecture requires that a country be capable of borrowing on its own from the private sector. Mechanisms of debt resolution have included participation of the private sector (PSI), or “bail in,” that has been voluntary, almost coercive, agreed and outright coercive (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Creditors and Debtors (2005), Chapter 4, 187-202). Private sector involvement requires losses by the private sector in bailouts of highly indebted countries. The essence of successful private sector involvement is to recover private-sector credit of the highly indebted country. Mary Watkins, writing on “Bank bailouts reshuffle risk hierarchy,” published on Mar 19, 2013, in the Financial Times (http://www.ft.com/intl/cms/s/0/7666546a-9095-11e2-a456-00144feabdc0.html#axzz2OSpbvCn8) analyzes the impact of the bailout or resolution of Cyprus banks on the hierarchy of risks of bank liabilities. Cyprus banks depend mostly on deposits with less reliance on debt, raising concerns in creditors of fixed-income debt and equity holders in banks in the euro area. Uncertainty remains as to the dimensions and structure of losses in private sector involvement or “bail in” in other rescue programs in the euro area. Alkman Granitsas, writing on “Central bank details losses at Bank of Cyprus,” on Mar 30, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324000704578392502889560768.html), analyzes the impact of the agreement with the €10 billion agreement with IMF and the European Union on the banks of Cyprus. The recapitalization plan provides for immediate conversion of 37.5 percent of all deposits in excess of €100,000 to shares of special class of the bank. An additional 22.5 percent will be frozen without interest until the plan is completed. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):

“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.

Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans.

An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):

“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.

The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”

Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.

The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.

First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:

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

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

There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):

“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.

(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):

“6 September 2012 - Technical features of Outright Monetary Transactions

As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:

Conditionality

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.

Coverage

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

Sterilisation

The liquidity created through Outright Monetary Transactions will be fully sterilised.

Transparency

Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

Securities Markets Programme

Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”

Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):

“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.

Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):

“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.

The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”

Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one-month at 4.95 percent, the two-year at 4.59 percent and the ten-year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Nov 14, 2013, with the one-month yield at 0.06 percent, the two-year at 0.29 percent, the ten-year at 2.69 percent, the fed funds rate at 0.09 percent and the corporate Baa bond at 5.41 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with marginal reduction.

Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields, Overnight Fed Funds Rate and Yield of Moody’s Baa Corporate Bond, Jan 2, 1962-Nov 14, 2013

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

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. Future company cash flows derive from investment projects. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,143.0 billion in IVQ1986 or 20.1 percent. Real gross private domestic investment in the US decreased 3.1 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,524.9 billion in IIQ2013. Real private fixed investment fell 4.9 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,458.4 billion in IIQ2013. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits of US corporations swelled 263.4 percent from $107.7 billion IQ2007 to $391.4 billion in IIQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured. 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:

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declines.

There strong performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Nov 15, 2013, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.5 percent on ov 15, increasing 1.3 percent in the week. Germany’s Dax increased 0.2 percent on Fri Nov 15 and increased 1.0 percent in the week. Dow Global increased 0.6 percent on Nov 15 and increased 1.5 percent in the week. Japan’s Nikkei Average increased 1.9 percent on Nov 15 and increased 7.7 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 1.3 percent on Nov 15 and increased 1.8 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2135.83 on Nov 15 for increase of 1.7 percent and increase of 1.4 percent in the week of Nov 15. There is deceleration with oscillations of the world economy that could affect corporate revenue and equity valuations, causing fluctuations in equity markets with increases during favorable risk appetite.

Commodities were mixed in the week of Nov 15, 2013. The DJ UBS Commodities Index changed 0.0 percent on Fri Nov 15 and changed 0.0 percent in the week, as shown in Table III-1. WTI decreased 0.7 percent in the week of Nov 15 while Brent increased 3.4 percent in the week. Gold decreased 1.5 percent on Fri Nov 8 and decreased 2.0 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €729,686 million on Nov 8, 2013 with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €1,322,861 million in the statement of Nov 8, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €90,420 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Nov 8, 2013
1 Gold and other Receivables	367,402	419,822	343,920
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	243,869
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	22,370
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,709
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	729,686
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	83,212
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	593,175
8 General Government Debt Denominated in Euro	34,954	33,928	28,328
9 Other Assets	278,719	336,574	242,163
TOTAL ASSETS	2,004, 432	2,733,235	2,305,431
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,322,861
Capital and Reserves	78,143	81,481	90,420

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

http://www.ecb.europa.eu/press/pr/wfs/2013/html/fs131112.en.html

IIIE Appendix Euro Zone Survival Risk. Resolution of the European sovereign debt crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness. Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would ensure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU), or euro area, are only 40.5 percent of the total in Jan-Aug 2013. Exports to the non-European Union area with share of 45.8 percent in Italy’s total exports are growing at 2.3 percent in Jan-Aug 2013 relative to Jan-Aug 2012 while those to EMU are growing at minus 3.2 percent.

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

Aug 2013	Exports % Share	∆% Jan-Aug 2013/ Jan-Aug 2012	Imports % Share	∆% Jan-Aug 2013/ Jan-Aug 2012
EU	54.2	-2.4	53.2	-2.5
EMU 17	40.5	-3.2	42.7	-2.7
France	11.1	-2.9	8.3	-5.9
Germany	12.5	-3.2	14.6	-6.5
Spain	4.7	-7.5	4.4	-3.4
UK	4.9	1.9	2.5	-0.9
Non EU	45.8	2.3	46.8	-10.7
Europe non EU	13.4	-1.2	11.0	5.5
USA	6.8	-1.6	3.3	-14.6
China	2.3	9.8	6.5	-10.0
OPEC	5.7	8.1	10.8	-26.3
Total	100.0	-0.3	100.0	-6.4

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/101000

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €589 million with the 17 countries of the euro zone (EMU 17) in Aug 2013 and cumulative deficit of €1609 million in Jan-Aug 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €5057 million in Jan-Aug 2013 with Europe non European Union, the trade surplus of €10,003 million with the US and trade surplus with non-European Union of €11,063 million in Jan-Aug 2013. There is significant rigidity in the trade deficits in Jan-Aug 2013 of €9127 million with China and €5475 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Aug 2013 Millions of Euro	Trade Balance Cumulative Jan-Aug 2013 Millions of Euro
EU	392	8,164
EMU 17	-589	-1,609
France	493	8,330
Germany	-245	-2,520
Spain	13	594
UK	773	6,530
Non EU	566	11,063
Europe non EU	399	5,057
USA	1,074	10,003
China	-1,062	-9,127
OPEC	-1,109	-5,475
Total	958	19,227

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/101000

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Aug 2013 relative to Jan-Aug 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 16.7 percent and minus 10.7 percent for durable goods. The higher rate of growth of exports of minus 0.3 percent in Jan-Aug 2013/Jan-Aug 2012 relative to imports of minus 6.4 percent may reflect weak demand in Italy with GDP declining during eight consecutive quarters from IIIQ2011 through IIQ2013 together with softening commodity prices.

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

	Exports Share %	Exports ∆% Jan-Aug 2013/ Jan-Aug 2012	Imports Share %	Imports ∆% Jan-Aug 2013/ Jan-Aug 2012
Consumer Goods	29.3	6.1	25.6	0.4
Durable	5.8	1.8	2.9	-10.7
Non-Durable	23.5	7.1	22.7	1.8
Capital Goods	31.6	1.1	19.5	-5.4
Inter- mediate Goods	33.6	-3.8	32.6	-5.2
Energy	5.5	-20.2	22.3	-16.7
Total ex Energy	94.5	0.8	77.7	-3.4
Total	100.0	-0.3	100.0	-6.4

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/101000

Table III-6 provides Italy’s trade balance by product categories in Aug 2013 and cumulative Jan-Aug 2013. Italy’s trade balance excluding energy generated surplus of €5355 million in Aug 2013 and €55,973 million cumulative in Jan-Aug 2013 but the energy trade balance created deficit of €4397 million in Aug 2013 and cumulative €36,746 million in Jan-Aug 2013. The overall surplus in Aug 2013 was €958 million with cumulative surplus of €19,227 million in Jan-Aug 2013. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Aug 2013	Cumulative Jan-Aug 2013
Consumer Goods	1,383	14,544
Durable	769	8,467
Nondurable	614	6,077
Capital Goods	3,141	35,569
Intermediate Goods	831	5,860
Energy	-4,397	-36,746
Total ex Energy	5,355	55,973
Total	958	19,227

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/101000

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

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30, 2011, the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt exceeding 100 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2013.

Table III-7, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2013 USD Billions	Primary Net Lending Borrowing % GDP 2013	General Government Net Debt % GDP 2013
World	73,454
Euro Zone	12,685	-0.4	74.9
Portugal	219	0.1	119.3
Ireland	221	-3.3	105.5
Greece	243	--	172.6
Spain	1,356	-3.7	80.7
Major Advanced Economies G7	34,068	-3.8	91.5
United States	16,724	-3.6	87.4
UK	2,490	-4.7	84.8
Germany	3,593	1.7	56.3
France	2,739	-2.0	87.2
Japan	5,007	-8.8	139.9
Canada	1,825	-2.8	36.5
Italy	2,068	2.0	110.5
China	8,939	-2.5*	22.9**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2013” to the column “GDP USD Billions.” The total debt of France and Germany in 2013 is $4411.3 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4293.3 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8704.6 billion, which would be equivalent to 137.5 percent of their combined GDP in 2013. Under this arrangement, the entire debt of selected members of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 242.3 percent if including debt of France and 175.8 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing

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

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	9,501.1
B Germany	2,022.9		$8704.6 as % of $3593 =242.3% $6316.2 as % of $3593 =175.8%
C France	2,388.4
B+C	4,411.3	GDP $6,332.0 Total Debt $8704.6 Debt/GDP: 137.5%
D Italy	2,285.1
E Spain	1,094.3
F Portugal	261.3
G Greece	419.4
H Ireland	233.2
Subtotal D+E+F+G+H	4,293.3

Source: calculation with IMF data IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/index.aspx

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Sep 2013. German exports to other European Union (EU) members are 57.9 percent of total exports in Sep 2013 and 57.0 percent in cumulative Jan-Sep 2013. Exports to the euro area are 37.3 percent of the total in Sep and 36.8 percent cumulative in Jan-Sep. Exports to third countries are 42.0 percent of the total in Sep and 43.0 percent cumulative in Jan-Sep. There is similar distribution for imports. Exports to non-euro countries are increasing 7.2 percent in the 12 months ending in Sep 2013, increasing 1.1 percent cumulative in Jan-Sep 2013 while exports to the euro area are increasing 4.4 percent in the 12 months ending in Sep 2013 and decreasing 2.0 percent cumulative in Jan-Sep 2013. Exports to third countries, accounting for 42.0 percent of the total in Sep 2013, are increasing 1.2 percent in the 12 months ending in Sep 2013 and decreasing 0.8 percent cumulative in Jan-Sep 2013, accounting for 43.0 percent of the cumulative total in Jan-Sep 2013. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to Germany’s high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of high share in its exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Sep 2013 € Billions	Sep 12-Month ∆%	Cumulative Jan-Sep 2012 € Billions	Cumulative Jan-Sep 2013/ Jan-Sep 2012 ∆%
Total Exports	94.7	3.6	818.0	-0.9
A. EU Members	54.8 % 57.9	5.4	466.2 % 57.0	-0.9
Euro Area	35.3 % 37.3	4.4	301.0 % 36.8	-2.0
Non-euro Area	19.5 % 20.6	7.2	165.2 % 20.2	1.1
B. Third Countries	39.8 % 42.0	1.2	351.8 % 43.0	-0.8
Total Imports	74.3	-0.3	670.2	-1.4
C. EU Members	48.2 % 64.9	2.6	430.6 % 64.2	0.2
Euro Area	33.0 % 44.4	1.8	300.1 % 44.8	-0.8
Non-euro Area	15.2 % 20.5	4.4	130.5 % 19.5	2.6
D. Third Countries	26.1 % 35.1	-5.2	239.6 % 35.8	-4.3

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2013/11/PE13_372_51.html

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

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Sunday, November 17, 2013

Risks of Unwinding Monetary Policy, United States Industrial Production, United States International Trade, World Economic Slowdown and Global Recession Risk: Part I

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