CMP Associates Regulation Blog: Financial Volatility, Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars below Trend, Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth, United States Commercial Banks, United States Housing Collapse, Household Income at 1995 Levels, World Cyclical Slow Growth and Global Recession Risk: Part I

Financial Volatility, Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars below Trend, Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth, United States Commercial Banks, United States Housing Collapse, Household Income at 1995 Levels, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

I Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars Below Trend

IA Mediocre Cyclical United States Economic Growth

IA1 Contracting Real Private Fixed Investment

IA2 Swelling Undistributed Corporate Profits

IB Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth

IIA United States Commercial Banks Assets and Liabilities

IA Transmission of Monetary Policy

IB Functions of Banking

Appendix on Monetary Policy

IA1 Theory

IA2 Policy

IA3 Evidence

IA4 Unwinding Strategy

IC United States Commercial Banks Assets and Liabilities

ID Theory and Reality of Economic History, Cyclical Slow Growth not Secular Stagnation and Monetary Policy Based on Fear of Deflation

IIB United States Housing Collapse

IIC Household Income at 1995 Levels, 45 Million in Poverty and 41 Million without Health Insurance

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 Financial “Irrational Exuberance,” Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Competitive Devaluations, Steepening Yield Curve and Global Financial and Economic Risk

ESII Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars below Trend

ESIII Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth

ESIV Household Income at 1995 Levels, 45 Million in Poverty and 41 Million without Health Insurance

ESV United States Housing Collapse

ESVI United States Commercial Banks Assets and Liabilities

ESI “Financial “Irrational Exuberance,” 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 provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/ns/cs.aspx?id=29), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/gfsr/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/ns/cs.aspx?id=262). 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. Growth of China’s GDP in IIQ2014 relative to the same period in 2013 was 7.5 percent. Secondary industry accounts for 46.0 percent of GDP of which industry alone for 39.7 percent in cumulative IIQ2014 and construction with the remaining 6.3 percent. Tertiary industry accounts for 46.6 percent of GDP in cumulative IIQ2014 and primary industry for 7.4 percent. China’s growth strategy consisted of rapid increases in productivity in industry to absorb population from agriculture where incomes are lower (Pelaez and Pelaez, The Global Recession Risk (2007), 56-80). The strategy is changing to lower growth rates while improving living standards. GDP growth decelerated from 12.1 percent in IQ2010 and 11.2 percent in IIQ2010 to 7.7 percent in IQ2013, 7.5 percent in IIQ2013 and 7.8 percent in IIIQ2013. GDP grew 7.7 percent in IVQ2013 relative to a year earlier and 1.7 percent relative to IIIQ2013, which is equivalent to 7.0 percent per year. GDP grew 7.4 percent in IQ2014 relative to a year earlier and 1.5 percent in IQ2014 that is equivalent to 6.1 percent per year. GP grew 7.5 percent in IIQ2014 relative to a year earlier and 2.0 percent relative to the prior quarter, which is equivalent 8.2 percent (Section VC an earlier http://cmpassocregulationblog.blogspot.com/2014/04/imf-view-world-inflation-waves-squeeze.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/capital-flows-exchange-rates-and.html and earlier 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). There is also concern about indebtedness, move to devaluation and deep policy reforms.
United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 26.9 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining/stagnating real wages. Actual GDP is about two trillion dollars lower than trend GDP.
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/2014/09/world-inflation-waves-squeeze-of.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html). There is growing concern on capital outflows and currency depreciation of emerging markets.

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 with alternating episodes of revaluation.
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 mixed with reallocations of portfolios of risk financial assets

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.

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 by the penalty in the form of low interest rates and unsound credit decisions. 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 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession.
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 $2671 billion, or $2.7 trillion, of bank reserves (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), would cause Himalayan increase in interest rates that would provoke another recession. There is no painless gradual or sudden exit from zero interest rates because reversal of exposures created on the commitment of zero interest rates forever.

In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):

“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differ from each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”

Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Friedman 1957). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.

Chart VIII-1, Fed Funds Rate and Yields of Ten-year Treasury Constant Maturity and Baa Seasoned Corporate Bond, Jan 2, 2001 to Sep 25, 2014

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
11/21/2013	0.09	2.79	5.44
11/26/13	0.09	2.74	5.34 (11/26/13)
12/5/13	0.09	2.88	5.47
12/11/13	0.09	2.89	5.42
12/18/13	0.09	2.94	5.36
12/26/13	0.08	3.00	5.37
1/1/2014	0.08	3.00	5.34
1/8/2014	0.07	2.97	5.28
1/15/2014	0.07	2.86	5.18
1/22/2014	0.07	2.79	5.11
1/30/2014	0.07	2.72	5.08
2/6/2014	0.07	2.73	5.13
2/13/2014	0.06	2.73	5.12
2/20/14	0.07	2.76	5.15
2/27/14	0.07	2.65	5.01
3/6/14	0.08	2.74	5.11
3/13/14	0.08	2.66	5.05
3/20/14	0.08	2.79	5.13
3/27/14	0.08	2.69	4.95
4/3/14	0.08	2.80	5.04
4/10/14	0.08	2.65	4.89
4/17/14	0.09	2.73	4.89
4/24/14	0.10	2.70	4.84
5/1/14	0.09	2.63	4.77
5/8/14	0.08	2.61	4.79
5/15/14	0.09	2.50	4.72
5/22/14	0.09	2.56	4.81
5/29/14	0.09	2.45	4.69
6/05/14	0.09	2.59	4.83
6/12/14	0.09	2.58	4.79
6/19/14	0.10	2.64	4.83
6/26/14	0.10	2.53	4.71
7/2/14	0.10	2.64	4.84
7/10/14	0.09	2.55	4.75
7/17/14	0.09	2.47	4.69
7/24/14	0.09	2.52	4.72
7/31/14	0.08	2.58	4.75
8/7/14	0.09	2.43	4.71
8/14/14	0.09	2.40	4.69
8/21/14	0.09	2.41	4.69
8/28/14	0.09	2.34	4.57
9/04/14	0.09	2.45	4.70
9/11/14	0.09	2.54	4.79
9/18/14	0.09	2.63	4.91
9/25/14	0.09	2.52	4.79

Source: Board of Governors of the Federal Reserve System

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

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 Sep 17, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140917a.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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored” (emphasis added).

Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

Chart S provides the yield of the two-year Treasury constant maturity from Mar 17, 2014, two days before the guidance of Chair Yellen on Mar 19, 2014, to Sep 25, 2014. Chart SA provides the yields of the seven-, ten- and thirty-year Treasury constant maturity in the same dates. Yields increased right after the guidance of Chair Yellen. The two-year yield remain at a higher level than before while the ten-year yield fell and increased again. There could be more immediate impact on two-year yields of an increase in the fed funds rates but the effects would spread throughout the term structure of interest rates (Cox, Ingersoll and Ross 1981, 1985, Ingersoll 1987). Yields converged toward slightly lower earlier levels in the week of Apr 24, 2014 with reallocation of portfolios of risk financial assets away from equities and into bonds and commodities. There is ongoing reshuffling of portfolios to hedge against geopolitical events and world/regional economic performance.

Chart S, US, Yield of Two-Year Treasury Constant Maturity, Mar 17 to Sep 25, 2014

Source: Board of Governors of the Federal Reserve System

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

Chart SA, US, Yield of Seven-Year, Ten-Year and Thirty-Year Treasury Constant Maturity, Mar 17 to Sep 25, 2014

Source: Board of Governors of the Federal Reserve System

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

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

“And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February.

Let me explain what I mean by that word "slack" and why it is so important.

Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true.”

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart VI-1B for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart VI-1B cannot be explained without taking into account the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s. The loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:

“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”

Yellen (2014Aug22) states that “Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction.”

Chart VI-1B provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart VI-1B used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.

ChVI1-B, Brazil, Phillips Circuit, 1963-1987

Source:

©Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table VIII-1 provides inflation of the CPI. In the three months from Jun 2014 to Aug 2014, CPI inflation for all items seasonally adjusted was 0.8 percent in annual equivalent, obtained by calculating accumulated inflation from Jun 2014 to Aug 2014 and compounding for a full year. In the 12 months ending in Aug 2014, CPI inflation of all items not seasonally adjusted was 1.7 percent. Inflation in Aug 2014 seasonally adjusted was minus 0.2 percent relative to Jul 2014, or minus 2.4 percent annual equivalent (http://www.bls.gov/cpi/). The second row provides the same measurements for the CPI of all items excluding food and energy: 1.7 percent in 12 months and 0.8 percent in annual equivalent Jun 2014-Aug 2014. The Wall Street Journal provides the yield curve of US Treasury securities (http://professional.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000). The shortest term is 0.005 percent for one month, 0.018 percent for three months, 0.036 percent for six months, 0.099 percent for one year, 0.579 percent for two years, 1.059 percent for three years, 1.798 percent for five years, 2.244 percent for seven years, 2.530 percent for ten years and 3.217 percent for 30 years. The Irving Fisher (1930) definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by the Wall Street Journal, and the rate of inflation expected in the term of the security, which could behave as in Table VIII-1. Inflation in Aug 2014 is low in 12 months because of the unwinding of carry trades from zero interest rates to commodity futures prices but could ignite again with subdued risk aversion. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

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

Negative real rates of interest distort calculations of risk and returns from capital budgeting by firms, through lending by financial intermediaries to decisions on savings, housing and purchases of households. Inflation on near zero interest rates misallocates resources away from their most productive uses and creates uncertainty of the future path of adjustment to higher interest rates that inhibit sound decisions.

Table VIII-1, US, Consumer Price Index Percentage Change 12 Months NSA and Annual Equivalent

	∆% 12 Months Aug 2014/Aug 2013 NSA	∆% Annual Equivalent Jun 2014 to Aug 2014 SA
CPI All Items	1.7	0.8
CPI ex Food and Energy	1.7	0.8

Source: Bureau of Labor Statistics

http://www.bls.gov/cpi/

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 State, 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 and riskier asset classes resulting from the debate within and outside the Fed on tapering quantitative easing. Table VIII-2 provides the yield curve of Treasury securities on Sep 26, 2014, Dec 31, 2013, May 1, 2013, Sep 26, 2013 and Sep 26, 2006. There is oscillating 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 3.04 percent on Dec 31, 2013 and 2.54 percent on Sep 26, 2014, as measured by the United States Treasury. Assume that a bond with maturity in 10 years were issued on Dec 31, 2013, at par or price of 100 with coupon of 1.45 percent. The price of that bond would be 86.3778 with instantaneous increase of the yield to 3.04 percent for loss of 13.6 percent and far more with leverage. Assume that the yield of a bond with exactly ten years to maturity and coupon of 2.54 percent would jump instantaneously from yield of 2.54 percent on Sep 26, 2014 to 4.59 percent as occurred on Sep 26, 2006 when the economy was closer to full employment. The price of the hypothetical bond issued with coupon of 2.54 percent would drop from 100 to 83.7073 after an instantaneous increase of the yield to 4.74 percent. The price loss would be 16.3 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

	9/26/14	12/31/13	5/01/13	9/26/13	9/26/06
1 M	0.01	0.01	0.03	0.04	4.64
3 M	0.01	0.07	0.06	0.00	4.88
6 M	0.03	0.10	0.08	0.03	5.02
1 Y	0.11	0.13	0.11	0.09	4.91
2 Y	0.59	0.38	0.20	0.34	4.68
3 Y	1.08	0.78	0.30	0.67	4.59
5 Y	1.80	1.75	0.65	1.43	4.55
7 Y	2.24	2.45	1.07	2.05	4.55
10 Y	2.54	3.04	1.66	2.66	4.59
20 Y	2.99	3.72	2.44	3.41	4.79
30 Y	3.22	3.96	2.83	3.69	4.71

M: Months; Y: Years

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 with amplifying fluctuations. 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 4.20 percent on Sep 25, 2014, which is the last data point in Chart VI-13. Shayndi Raice and Nick Timiraos, writing on “Banks cut as mortgage boom ends,” on Jan 9, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303754404579310940019239208), analyze the drop in mortgage applications to a 13-year low, as measured by the Mortgage Bankers Association. Nick Timiraos, writing on “Demand for home loans plunges,” on Apr 24, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304788404579522051733228402?mg=reno64-wsj), analyzes data in Inside Mortgage Finance that mortgage lending of $235 billion in IQ2014 is 58 percent lower than a year earlier and 23 percent below IVQ2013. Mortgage lending collapsed to the lowest level in 14 years. In testimony before the Committee on the Budget of the US Senate on May 8, 2004, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm): “One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.”

Chart VI-13, US, Conventional Mortgage Rate, Jan 8, 2004 to Sep 25, 2014

Source: Board of Governors of the Federal Reserve System

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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table VI-7G when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table VI-7G shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table VI-7G, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

1994	FF	30Y	30P	10Y	10P	MOR	CPI
Jan	3.00	6.29	100	5.75	100	7.06	2.52
Feb	3.25	6.49	97.37	5.97	98.36	7.15	2.51
Mar	3.50	6.91	92.19	6.48	94.69	7.68	2.51
Apr	3.75	7.27	88.10	6.97	91.32	8.32	2.36
May	4.25	7.41	86.59	7.18	88.93	8.60	2.29
Jun	4.25	7.40	86.69	7.10	90.45	8.40	2.49
Jul	4.25	7.58	84.81	7.30	89.14	8.61	2.77
Aug	4.75	7.49	85.74	7.24	89.53	8.51	2.69
Sep	4.75	7.71	83.49	7.46	88.10	8.64	2.96
Oct	4.75	7.94	81.23	7.74	86.33	8.93	2.61
Nov	5.50	8.08	79.90	7.96	84.96	9.17	2.67
Dec	6.00	7.87	81.91	7.81	85.89	9.20	2.67

Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months

Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t

Chart VI-14 provides the overnight fed funds rate, the yield of the 10-year Treasury constant maturity bond, the yield of the 30-year constant maturity bond and the conventional mortgage rate from Jan 1991 to Dec 1996. In Jan 1991, the fed funds rate was 6.91 percent, the 10-year Treasury yield 8.09 percent, the 30-year Treasury yield 8.27 percent and the conventional mortgage rate 9.64 percent. Before monetary policy tightening in Oct 1993, the rates and yields were 2.99 percent for the fed funds, 5.33 percent for the 10-year Treasury, 5.94 for the 30-year Treasury and 6.83 percent for the conventional mortgage rate. After tightening in Nov 1994, the rates and yields were 5.29 percent for the fed funds rate, 7.96 percent for the 10-year Treasury, 8.08 percent for the 30-year Treasury and 9.17 percent for the conventional mortgage rate.

Chart VI-14, US, Overnight Fed Funds Rate, 10-Year Treasury Constant Maturity, 30-Year Treasury Constant Maturity and Conventional Mortgage Rate, Monthly, Jan 1991 to Dec 1996

Source: Board of Governors of the Federal Reserve System

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

Chart VI-15 of the Bureau of Labor Statistics provides the all items consumer price index from Jan 1991 to Dec 1996. There does not appear acceleration of consumer prices requiring aggressive tightening.

Chart VI-15, US, Consumer Price Index All Items, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

Chart IV-16 of the Bureau of Labor Statistics provides 12-month percentage changes of the all items consumer price index from Jan 1991 to Dec 1996. Inflation collapsed during the recession from Jul 1990 (III) and Mar 1991 (I) and the end of the Kuwait War on Feb 25, 1991 that stabilized world oil markets. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Policy tightening had adverse collateral effects in the form of emerging market crises in Mexico and Argentina and fixed income markets worldwide.

Chart VI-16, US, Consumer Price Index All Items, Twelve-Month Percentage Change, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

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

Table VI-2 extracts four rows of Table VI-1 with the Dollar/EUR (USD/EUR) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table VI-4 below, the dollar has devalued again to USD 1.2683 EUR on Sep 26, 2014 or by 7.6 percent {[(1.2683/1.192)-1]100 = 6.4%}. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. Risk aversion erodes devaluation of the dollar. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD subsequently revaluing to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent. After fixing again the CNY to the dollar, China revalued to CNY 6.1272/USD on Fri Sep 26, 2014, or by an additional 10.2 percent, for cumulative revaluation of 26.0 percent. The final row of Table VI-2 shows: revaluation of 0.1 percent in the week of Aug 29, 2014; revaluation of 0.1 percent in the week of Sep 5, 2014; revaluation of 0.1 percent in the week of Sep 12, 2014; and devaluation of 0.1 percent in the week of Sep 19, 2014. There could be reversal of revaluation to devalue the Yuan.

Table VI-2, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate

USD/EUR	12/26/03	7/14/08	6/07/10	9/26/14
Rate	1.1423	1.5914	1.192	1.2683
CNY/USD	01/03 2000	07/21 2005	7/15 2008	9/26/ 2014
Rate	8.2765	8.2765	6.8211	6.1272
Weekly Rates	9/5/2014	9/12/2014	9/19/2014	9/26/ 2014
CNY/USD	6.1406	6.1334	6.1412	6.1272
∆% from Earlier Week*	0.1	0.1	-0.1	0.2

*Negative sign is depreciation; positive sign is appreciation

Source: http://professional.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

Professor Edward P Lazear (2013Jan7), writing on “Chinese ‘currency manipulation’ is not the problem,” on Jan 7, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323320404578213203581231448.html), provides clear thought on the role of the yuan in trade between China and the United States and trade between China and Europe. There is conventional wisdom that Chinese exchange rate policy causes the loss of manufacturing jobs in the United States, which is shown by Lazear (2013Jan7) to be erroneous. The fact is that manipulation of the CNY/USD rate by China has only minor effects on US employment. Lazear (2013Jan7) shows that the movement of monthly exports of China to its major trading partners, United States and Europe, since 1995 cannot be explained by the fixing of the CNY/USD rate by China. The period is quite useful because it includes rapid growth before 2007, contraction until 2009 and weak subsequent expansion. Chart VI-1 of the Board of Governors of the Federal Reserve System provides the CNY/USD exchange rate from Jan 3, 1995 to Sep 19, 2014 together with US recession dates in shaded areas. China fixed the CNY/USD rate for a long period as shown in the horizontal segment from 1995 to 2005. There was systematic revaluation of 17.6 percent from CNY 8.2765 on Jul 21, 2005 to CNY 6.8211 on Jul 15, 2008. China fixed the CNY/USD rate until Jun 7, 2010, to avoid adverse effects on its economy from the global recession, which is shown as a horizontal segment from 2009 until mid 2010. China then continued the policy of appreciation of the CNY relative to the USD with oscillations until the beginning of 2012 when the rate began to move sideways followed by a final upward slope of devaluation that is measured in Table VI-2A but virtually disappeared in the rate of CNY 6.3589/USD on Aug 17, 2012 and was nearly unchanged at CNY 6.3558/USD on Aug 24, 2012. China then appreciated 0.2 percent in the week of Dec 21, 2012, to CNY 6.2352/USD for cumulative 1.9 percent revaluation from Oct 28, 2011 and left the rate virtually unchanged at CNY 6.2316/USD on Jan 11, 2013, appreciating to CNY 6.1403/USD on Sep 19, 2014, which is the last data point in Chart VI-1. Revaluation of the CNY relative to the USD by 26.0 percent by Sep 26, 2014 has not reduced the trade surplus of China but reversal of the policy of revaluation could result in international confrontation. The interruption with upward slope in the final segment on the right of Chart VI-I is measured as virtually stability in Table VI-2A followed with decrease or revaluation and subsequent increase or devaluation. Linglin Wei, writing on “China intervenes to lower yuan,” on Feb 26, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304071004579406810684766716?KEYWORDS=china+yuan&mg=reno64-wsj), finds from informed sources that the central bank of China conducted the ongoing devaluation of the yuan with the objective of driving out arbitrageurs to widen the band of fluctuation. There is concern if the policy of revaluation is changing to devaluation.

Chart VI-1, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 3, 1995-Sep 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1A provides the daily CNY/USD rate from Jan 5, 1981 to Sep 19, 2014. The exchange rate was CNY 1.5418/USD on Jan 5, 1981. There is sharp cumulative depreciation of 107.8 percent to CNY 3.2031 by Jul 2, 1986, continuing to CNY 5.8145/USD on Dec 29, 1993 for cumulative 277.1 percent since Jan 5, 1981. China then devalued sharply to CNY 8.7117/USD on Jan 7, 1994 for 49.8 percent relative to Dec 29, 1993 and cumulative 465.0 percent relative to Jan 5, 1981. China then fixed the rate at CNY 8.2765/USD until Jul 21, 2005 and revalued as analyzed in Chart VI-1. The final data point in Chart VI-1A is CNY 6.1403/USD on Sep 19, 2014. To be sure, China fixed the exchange rate after substantial prior devaluation. It is unlikely that the devaluation could have been effective after many years of fixing the exchange rate with high inflation and multiple changes in the world economy. The argument of Lazear (2013Jan7) is still valid in view of the lack of association between monthly exports of China to the US and Europe since 1995 and the exchange rate of China.

Chart VI-1A, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 5, 1981-Sep 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1B provides finer details with the rate of Chinese Yuan (CNY) to the US Dollar (USD) from Oct 28, 2011 to Sep 19, 2014. There have been alternations of revaluation and devaluation. The initial data point is CNY 6.5370 on Oct 28, 2011. There is an episode of devaluation from CNY 6.2790 on Apr 30, 2012 to CNY 6.3879 on Jul 25, 2012, or devaluation of 1.7 percent. Another devaluation is from CNY 6.0402/USD on Jan 14, 2014 to CNY 6.1403 on Sep 19, 2014, or devaluation of 1.7 percent. The United States Treasury estimates US government debt held by private investors at $9800 billion in Mar 2014. China’s holding of US Treasury securities represent 12.9 percent of US government marketable interest-bearing debt held by private investors (http://www.fms.treas.gov/bulletin/index.html). Min Zeng, writing on “China plays a big role as US Treasury yields fall,” on Jul 16, 2004, published in the Wall Street Journal (http://online.wsj.com/articles/china-plays-a-big-role-as-u-s-treasury-yields-fall-1405545034?tesla=y&mg=reno64-wsj), finds that acceleration in purchases of US Treasury securities by China has been an important factor in the decline of Treasury yields in 2014. Japan increased its holdings from $1135.4 billion in Jul 2013 to $1219.0 billion in Jul 2014 or 7.4 percent. The combined holdings of China and Japan in Jul 2014 add to $2484 billion, which is equivalent to 25.3 percent of US government marketable interest-bearing securities held by investors of $9800 billion in Mar 2014 (http://www.fms.treas.gov/bulletin/index.html). Total foreign holdings of Treasury securities rose from $5592.8 billion in Jul 2013 to $5997.2 billion in Jul 2014, or 7.2 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

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

Chart VI-1B, Chinese Yuan (CNY) per US Dollar (US), Business Days, Oct 28, 2011-Sep 19, 2014

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3 provides three indexes of the US Dollars (USD) from Jan 4, 1995 to Sep 19, 2014.

Chart VI-3A provides the overnight fed funds rate and yields of the three-month constant maturity Treasury bill, the ten-year constant maturity Treasury note and Moody’s Baa bond from Jan 4, 1995 to Sep 25, 2014. The first phase from 1995 to 2001 shows sharp trend of appreciation of the USD while interest rates remained at relatively high levels. The dollar revalued partly because of the emerging market crises that provoked inflows of financial investment into the US and partly because of a deliberate strong dollar policy. DeLong and Eichengreen (2001, 4-5) argue:

“That context was an economic and political strategy that emphasized private investment as the engine for U.S. economic growth. Both components of this term, "private" and "investment," had implications for the administration’s international economic strategy. From the point of view of investment, it was important that international events not pressure on the Federal Reserve to raise interest rates, since this would have curtailed capital formation and vitiated the effects of the administration’s signature achievement: deficit reduction. A strong dollar -- or rather a dollar that was not expected to weaken -- was a key component of a policy which aimed at keeping the Fed comfortable with low interest rates. In addition, it was important to create a demand for the goods and services generated by this additional productive capacity. To the extent that this demand resided abroad, administration officials saw it as important that the process of increasing international integration, of both trade and finance, move forward for the interest of economic development in emerging markets and therefore in support of U.S. economic growth.”

The process of integration consisted of restructuring “international financial architecture” (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Debtors and Creditors (2005)). Policy concerns subsequently shifted to the external imbalances, or current account deficits, and internal imbalances, or government deficits (Pelaez and Pelaez, The Global Recession Risk: Dollar Devaluation and the World Economy (2007)). Fed policy consisted of lowering the policy rate or fed funds rate, which is close to the marginal cost of funding of banks, toward zero during the past decade. Near zero interest rates induce carry trades of selling dollar debt (borrowing), shorting the USD and investing in risk financial assets. Without risk aversion, near zero interest rates cause devaluation of the dollar. Chart VI-3 shows the weakening USD between the recession of 2001 and the contraction after IVQ2007. There was a flight to dollar assets and especially obligations of the US government after Sep 2008. Cochrane and Zingales (2009) show that flight was coincident with proposals of TARP (Troubled Asset Relief Program) to withdraw “toxic assets” in US banks (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a) and Regulation of Banks and Finance (2009b)). There are shocks to globalization in the form of regulation, trade and devaluation wars and breakdown of international cooperation (Pelaez and Pelaez, Globalization and the State: Vol. I (2008a), Globalization and the State: Vol. II (2008b) and Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c)). As evident in Chart VI-3A, there is no exit from near zero interest rates without a financial crisis and economic contraction, verified by the increase of interest rates from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. 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). 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 VI-3A. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession. There are conflicts on exchange rate movements among central banks. There is concern of declining inflation in the euro area and appreciation of the euro. On Jun 5, 2014, the European Central Bank introduced cuts in interest rates and a negative rate paid on deposits of banks (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605.en.html):

“5 June 2014 - 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 10 basis points to 0.15%, starting from the operation to be settled on 11 June 2014.
The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
The interest rate on the deposit facility will be decreased by 10 basis points to -0.10%, with effect from 11 June 2014. A separate press release to be published at 3.30 p.m. CET today will provide details on the implementation of the negative deposit facility rate.”

The ECB also introduced new measures of monetary policy on Jun 5, 2014 (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605_2.en.html):

“5 June 2014 - ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechanism

In pursuing its price stability mandate, the Governing Council of the ECB has today announced measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. In particular, the Governing Council has decided:

To conduct a series of targeted longer-term refinancing operations (TLTROs) aimed at improving bank lending to the euro area non-financial private sector ^[¹^], excluding loans to households for house purchase, over a window of two years.
To intensify preparatory work related to outright purchases of asset-backed securities (ABS).”

The President of the European Central Bank (ECB) Mario Draghi analyzed the measures at a press conference (http://www.ecb.europa.eu/press/pressconf/2014/html/is140605.en.html). At the press conference following the meeting of the ECB on Jul 3, 2014, Mario Draghi stated (http://www.ecb.europa.eu/press/pressconf/2014/html/is140703.en.html): “In fact, as I said, interest rates will stay low for an extended period of time, and the Governing Council is unanimous in its commitment to use also nonstandard, unconventional measures to cope with the risk of a too-prolonged period of time of low inflation.”

The President of the ECB Mario Draghi analyzed unemployment in the euro area and the policy response policy in a speech at the Jackson Hole meeting of central bankers on Aug 22, 2014 (http://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html):

“We have already seen exchange rate movements that should support both aggregate demand and inflation, which we expect to be sustained by the diverging expected paths of policy in the US and the euro area (Figure 7). We will launch our first Targeted Long-Term Refinancing Operation in September, which has so far garnered significant interest from banks. And our preparation for outright purchases in asset-backed security (ABS) markets is fast moving forward and we expect that it should contribute to further credit easing. Indeed, such outright purchases would meaningfully contribute to diversifying the channels for us to generate liquidity.”

On Sep 4, 2014, the European Central Bank lowered policy rates (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140904.en.html):

“4 September 2014 - 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 10 basis points to 0.05%, starting from the operation to be settled on 10 September 2014.
The interest rate on the marginal lending facility will be decreased by 10 basis points to 0.30%, with effect from 10 September 2014.
The interest rate on the deposit facility will be decreased by 10 basis points to -0.20%, with effect from 10 September 2014.”

The President of the European Central Bank announced on Sep 4, 2014, the decision to expand the balance sheet by purchases of asset-backed securities (ABS) in a new ABS Purchase Program (ABSPP) and covered bonds (http://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html):

“Based on our regular economic and monetary analyses, the Governing Council decided today to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.05% and the rate on the marginal lending facility by 10 basis points to 0.30%. The rate on the deposit facility was lowered by 10 basis points to -0.20%. In addition, the Governing Council decided to start purchasing non-financial private sector assets. The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme (CBPP3). Interventions under these programmes will start in October 2014. The detailed modalities of these programmes will be announced after the Governing Council meeting of 2 October 2014. The newly decided measures, together with the targeted longer-term refinancing operations which will be conducted in two weeks, will have a sizeable impact on our balance sheet.”

Chart VI-3, US Dollar Currency Indexes, Jan 4, 1995-Sep 19, 2014

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3A, US, Overnight Fed Funds Rate, Yield of Three-Month Treasury Constant Maturity, Yield of Ten-Year Treasury Constant Maturity and Yield of Moody’s Baa Bond, Jan 4, 1995 to Sep 25, 2014

Source: Board of Governors of the Federal Reserve System

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

Chart VI-4 of the Board of Governors of the Federal Reserve System provides the exchange rate of the US relative to the euro, or USD/EUR. During maintenance of the policy of zero fed funds rates the dollar appreciates in periods of significant risk aversion such as flight into US government obligations in late 2008 and early 2009 and in the various risks concerns generated by the European sovereign debt crisis.

Chart VI-4, US Dollars per Euro, 2011-2014

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/DataDownload/Chart.aspx?rel=H10&series=e85cfb140ce469e13bec458013262fa1&lastObs=780&from=&to=&filetype=csv&label=include&layout=seriescolumn&pp=Download&names=%7bH10/H10/RXI$US_N.B.EU%7d

Carry trades induced by zero interest rates increase capital flows into emerging markets that appreciate exchange rates. Portfolio reallocations away from emerging markets depreciate their exchange rates in reversals of capital flows. Chart VI-4A provides the exchange rate of the Mexican peso (MXN) per US dollar from Nov 8, 1993 to Sep 19, 2014. The first data point in Chart VI-4A is MXN 3.1520 on Nov 8, 1993. The rate devalued to 11.9760 on Nov 14, 1995 during emerging market crises in the 1990s and the increase of interest rates in the US in 1994 that stressed world financial markets (Pelaez and Pelaez, International Financial Architecture 2005, The Global Recession Risk 2007, 147-77). The MXN depreciated sharply to MXN 15.4060/USD on Mar 2, 2009, during the global recession. The rate moved to MXN 11.5050/USD on May 2, 2011, during the sovereign debt crisis in the euro area. The rate depreciated to 11.9760 on May 9, 2013. The final data point in the current flight from emerging markets is MXN 13.2390/USD on Sep 19, 2014.

Chart VI-4A, Mexican Peso (MXN) per US Dollar (USD), Nov 8, 1993 to Feb 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

There are collateral effects worldwide from unconventional monetary policy. 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. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. Professor Willem Buiter (2014Feb4), a distinguished economist currently Global Chief Economist at Citigroup (http://www.willembuiter.com/resume.pdf), writing on “The Fed’s bad manners risk offending foreigners,” on Feb 4, 2014, published in the Financial Times (http://www.ft.com/intl/cms/s/0/fbb09572-8d8d-11e3-9dbb-00144feab7de.html#axzz2suwrwkFs), concurs with Raghuram Rajan. Buiter (2014Feb4) argues that international policy cooperation in monetary policy is both in the interest of the world and the United States. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows. In a speech at the Brookings Institution on Apr 10, 2014, Raghuram G. Rajan (2014Apr10, 1, 10) argues:

“As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.”

Chart VI-4B provides the rate of the Indian rupee (INR) per US dollar (USD) from Jan 2, 1973 to Sep 19, 2014. The first data point is INR 8.0200 on Jan 2, 1973. The rate depreciated sharply to INR 51.9600 on Mar 3, 2009, during the global recession. The rate appreciated to INR 44.0300/USD on Jul 28, 2011 in the midst of the sovereign debt event in the euro area. The rate overshot to INR 68.8000 on Aug 28, 2013. The final data point is INR 60.8000/USD on Sep 19, 2014.

Chart VI-4B, Indian Rupee (INR) per US Dollar (USD), Jan 2, 1973 to Feb 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-5 provides the exchange rate of JPY (Japan yen) per USD (US dollars). The first data point on the extreme left is JPY 357.7300/USD for Jan 4, 1971. The JPY has appreciated over the long term relative to the USD with fluctuations along an evident long-term appreciation. Before the global recession, the JPY stood at JPY 124.0900/USD on Jun 22, 2007. The use of the JPY as safe haven is evident by sharp appreciation during the global recession to JPY 110.48/USD on Aug 15, 2008, and to JPY 87.8000/USD on Jan 21, 2009. The final data point in Chart VI-5 is JPY 108.9600/USD on Sep 19, 2014 for appreciation of 12.2 percent relative to JPY 124.0900/USD on Jun 22, 2007 before the global recession and expansion characterized by recurring bouts of risk aversion. Takashi Nakamichi and Eleanor Warnock, writing on “Japan lashes out over dollar, euro,” on Dec 29, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323530404578207440474874604.html?mod=WSJ_markets_liveupdate&mg=reno64-wsj), analyze the “war of words” launched by Japan’s new Prime Minister Shinzo Abe and his finance minister Taro Aso, arguing of deliberate devaluations of the USD and EUR relative to the JPY, which are hurting Japan’s economic activity. Gerard Baker and Jacob M. Shlesinger, writing on “Bank of Japan’s Kuroda signals impatience with Abe government,” on May 23, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303480304579579311491068756?KEYWORDS=bank+of+japan+kuroda&mg=reno64-wsj), analyze concerns of the Governor of the Bank of Japan Haruhiko Kuroda that the JPY has strengthened relative to the USD, partly eroding earlier depreciation. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-5, Japanese Yen JPY per US Dollars USD, Monthly, Jan 4, 1971-Feb 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

Zero interest rates in the United States forever tend to depreciate the dollar against every other currency if there is no risk aversion preventing portfolio rebalancing toward risk financial assets, which include the capital markets and exchange rates of emerging-market economies. The objective of unconventional monetary policy as argued by Yellen 2011AS) is to devalue the dollar to increase net exports that increase US economic growth. Increasing net exports and internal economic activity in the US is equivalent to decreasing net exports and internal economic activity in other countries.

Continental territory, rich endowment of natural resources, investment in human capital, teaching and research universities, motivated labor force and entrepreneurial initiative provide Brazil with comparative advantages in multiple economic opportunities. Exchange rate parity is critical in achieving Brazil’s potential but is difficult in a world of zero interest rates. Chart IV-6 of the Board of Governors of the Federal Reserve System provides the rate of Brazilian real (BRL) per US dollar (USD) from BRL 1.2074/USD on Jan 4, 1999 to BRL 2.3747/USD on Sep 19, 2014. The rate reached BRL 3.9450/USD on Oct 10, 2002 appreciating 60.5 percent to BRL 1.5580/USD on Aug 1, 2008. The rate depreciated 68.1 percent to BRL 2.6187/USD on Dec 5, 2008 during worldwide flight from risk. The rate appreciated again by 41.3 percent to BRL 1.5375/USD on Jul 26, 2011. The final data point in Chart VI-6 is BRL 2.3747/USD on Sep 19, 2014 for depreciation of 54.5 percent. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-6, Brazilian Real (BRL) per US Dollar (USD) Jan 4, 1999 to Feb 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-7 of the Board of Governors of the Federal Reserve System provides the history of the BRL beginning with the first data point of BRL 0.8440/USD on Jan 2, 1995. The rate jumped to BRL 2.0700/USD on Jan 29, 1999 after changes in exchange rate policy and then to BRL 2.2000/USD on Mar 3, 1999. The rate depreciated 26.7 percent to BRL 2.7880/USD on Sep 21, 2001 relative to Mar 3, 1999.

Chart VI-7, Brazilian Real (BRL) per US Dollar (USD), Jan 2, 1995 to Feb 19, 2014

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

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).

Focus is shifting from 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. Markets overreacted to the so-called “paring” of outright purchases to $15 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 Sep 17, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140917a.htm):

How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

Let me explain what I mean by that word "slack" and why it is so important.

Yellen (2014Aug22) provides comprehensive review of the theory and measurement of labor markets. Monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

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

Yellen (2014Aug22) finds that the unemployment rate is not sufficient in determining slack:

“One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

Yellen (2014Aug22) restates that the FOMC determines monetary policy on newly available information and interpretation of labor markets and inflation and does not follow a preset path:

“But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy.”

Chair Yellen analyzes the view of inflation (http://www.federalreserve.gov/newsevents/speech/yellen20140416a.htm):

“Inflation, as measured by the price index for personal consumption expenditures, has slowed from an annual rate of about 2-1/2 percent in early 2012 to less than 1 percent in February of this year. This rate is well below the Committee's 2 percent longer-run objective. Many advanced economies are observing a similar softness in inflation.

To some extent, the low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters. Longer-run inflation expectations have remained remarkably steady, however. We anticipate that, as the effects of transitory factors subside and as labor market gains continue, inflation will gradually move back toward 2 percent.”

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? Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?

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 testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):

“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”

In testimony before the Committee on the Budget of the US Senate on May 8, 2004, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm):

“The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.

Conditions in the labor market have continued to improve. The unemployment rate was 6.3 percent in April, about 1-1/4 percentage points below where it was a year ago. Moreover, gains in payroll employment averaged nearly 200,000 jobs per month over the past year. During the economic recovery so far, payroll employment has increased by about 8-1/2 million jobs since its low point, and the unemployment rate has declined about 3-3/4 percentage points since its peak.

While conditions in the labor market have improved appreciably, they are still far from satisfactory. Even with recent declines in the unemployment rate, it continues to be elevated. Moreover, both the share of the labor force that has been unemployed for more than six months and the number of individuals who work part time but would prefer a full-time job are at historically high levels. In addition, most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.

Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.

Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.”

Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (10

The argument that anemic population growth causes “secular stagnation” in the US (Hansen 1938, 1939, 1941) is as misplaced currently as in the late 1930s (for early dissent see Simons 1942). There is currently population growth in the ages of 16 to 24 years but not enough job creation and discouragement of job searches for all ages (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-risk-recovery-without-hiring.html). This is merely another case of theory without reality with dubious policy proposals. The current reality is cyclical slow growth.

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 http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html). Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.

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 17,113.15 on Fr Sep 26, 2014, which is higher by 20.8 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 20.5 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

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.

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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 76.7 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Sep 26, 2014; S&P 500 has gained 93.9 percent and DAX 67.4 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 9/26/14” 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 1.5 percent below the trough. Japan’s Nikkei Average is 83.9 percent above the trough. DJ Asia Pacific TSM is 28.7 percent above the trough. Dow Global is 49.8 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 33.4 percent above the trough. NYSE Financial Index is 53.6 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 67.4 percent above the trough. Japan’s Nikkei Average is 83.9 percent above the trough on Aug 31, 2010 and 42.5 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 16,229.86 on Fri Sep 26, 2014 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 58.3 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 6.4 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 9/26/14” in Table VI-4 shows increase of 0.8 percent in the week for China’s Shanghai Composite. DJ Asia Pacific decreased 1.6 percent. NYSE Financial decreased 1.8 percent in the week. Dow Global decreased 2.0 percent in the week of Sep 26, 2014. The DJIA decreased 1.0 percent and S&P 500 decreased 1.4 percent. DAX of Germany decreased 3.2 percent. STOXX 50 decreased 1.5 percent. The USD appreciated 1.1 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table 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 9/26/14” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Sep 26, 2014. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 9/26/14” but also relative to the peak in column “∆% Peak to 9/26/14.” There are now several equity indexes above the peak in Table VI-4: DJIA 52.7 percent, S&P 500 62.9 percent, DAX 49.9 percent, Dow Global 22.3 percent, DJ Asia Pacific 12.7 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 22.4 percent, Nikkei Average 42.5 percent and STOXX 50 13.0 percent. There is only one equity index below the peak: Shanghai Composite by 25.8 percent. The US dollar strengthened 16.2 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. Inyoung Hwang, writing on “Fed optimism spurs record bets against stock volatility,” on Aug 21, 2014, published in Bloomberg.com (http://www.bloomberg.com/news/2014-08-21/fed-optimism-spurs-record-bets-against-stock-voalitlity.html), informs that the S&P 500 is trading at 16.6 times estimated earnings, which is higher than the five-year average of 14.3 Tom Lauricella, writing on Mar 31, 2014, on “Stock investors see hints of a stronger quarter,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304157204579473513864900656?mod=WSJ_smq0314_LeadStory&mg=reno64-wsj), finds views of stronger earnings among many money managers with positive factors for equity markets in continuing low interest rates and US economic growth. There is important information in the Quarterly Markets review of the Wall Street Journal (http://online.wsj.com/public/page/quarterly-markets-review-03312014.html) for IQ2014. 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, real gross private domestic investment in the US was $951.6 billion of chained 2009 dollars, growing to $1,254.6 billion in IVQ1987 or 31.8 percent. Real gross private domestic investment in the US increased 3.8 percent from $2,605.2 billion of chained 2009 dollars in IVQ2007 to $2,703.7 billion in IIQ2014, which is stagnation in comparison with growth of 31.8 percent in the comparable first twenty quarters of expansion from IQ1983 to IVQ1987. Real private fixed investment increased 0.3 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,594.5 billion in IIQ2014. Private fixed investment fell relative to IVQ2007 in all quarters preceding IIQ2014. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012. 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 rebounded with $37.1 billion in IIIQ2013 and $3.1 billion in IVQ2013. Corporate profits with IVA and CCA fell $201.7 billion in IIQ2014 and increased $164.1 billion in IIQ2014. In IIIQ2013, profits after tax with IVA and CCA increased $28.7 billion and decreased $24.7 billion in IVQ2013. In IQ2014, profits after tax with IVA and CCA decreased $268.6 billion. Profits after tax with IVA and CCA increased at $118.4 billion in IIQ2014. Net dividends fell at $187.0 billion in IIIQ2013 and increased at $80.6 billion in IVQ2013. Net dividends fell at $89.5 billion in IIQ2014 and fell at $0.5 billion in IIQ2014. Undistributed profits with IVA and CCA rose at $215.8 billion in IIIQ2013 and fell at $105.5 billion in IVQ2013. Undistributed profits with IVA and CCA fell $178.9 percent in IQ2014 and increased at $118.8 billion in IIQ2014. Undistributed corporate profits swelled 262.2 percent from $107.7 billion in IQ2007 to $390.1 billion in IIQ2014 and changed signs from minus $55.9 billion in current dollars in IVQ2007. 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:

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 9/26/ /14	∆% Week 9/26/14	∆% Trough to 9/26/ 14
DJIA	4/26/ 10	7/2/10	-13.6	52.7	-1.0	76.7
S&P 500	4/23/ 10	7/20/ 10	-16.0	62.9	-1.4	93.9
NYSE Finance	4/15/ 10	7/2/10	-20.3	22.4	-1.8	53.6
Dow Global	4/15/ 10	7/2/10	-18.4	22.3	-2.0	49.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	12.7	-1.6	28.7
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	42.5	-0.6	83.9
China Shang.	4/15/ 10	7/02 /10	-24.7	-25.8	0.8	-1.5
STOXX 50	4/15/10	7/2/10	-15.3	13.0	-1.5	33.4
DAX	4/26/ 10	5/25/ 10	-10.5	49.9	-3.2	67.4
Dollar Euro	11/25 2009	6/7 2010	21.2	16.2	1.1	-6.4
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	NA	NA	NA
10-Year T Note	4/5/ 10	4/6/10	3.986	2.784	2.527

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 Mediocre Cyclical United States Economic Growth with GDP Two Trillion Dollars below Trend. Valuations of risk financial assets approach historical highs. Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 20 quarters from IIIQ2009 to IIQ2014. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[$14,745.9/$14,355.6 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,294.6 billion than actual $16,010.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). US GDP in IIQ2014 is 12.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,010.4 billion in IIQ2014 or 6.8 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 123.2212 in Aug 2014. The actual index NSA in Aug 2014 is 101.5145, which is 17.6 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 117.7603 in Aug 2014. The output of manufacturing at 101.5145 in Aug 2014 is 13.8 percent below trend under this alternative calculation. The economy of the US can be summarized in growth of economic activity or GDP as fluctuating from mediocre growth of 2.5 percent on an annual basis in 2010 to 1.6 percent in 2011, 2.3 percent in 2012 and 2.2 percent in 2013. The following calculations show that actual growth is around 2.1 to 2.6 percent per year. The rate of growth of 0.9 percent in the entire cycle from 2007 to 2013 is well below 3 percent per year in trend from 1870 to 2010, which the economy of the US always attained for entire cycles in expansions after events such as wars and recessions (Lucas 2011May). Revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) provide important information on long-term growth and cyclical behavior. Table Summary provides relevant data.

Table Summary, Long-term and Cyclical Growth of GDP, Real Disposable Income and Real Disposable Income per Capita

	GDP
Long-Term
1929-2013	3.3
1947-2013	3.2
Whole Cycles
1980-1989	3.5
2006-2013	1.0
2007-2013	0.9
Cyclical Contractions ∆%
IQ1980 to IIIQ1980, IIIQ1981 to IVQ1982	-4.7
IVQ2007 to IIQ2009	-4.2
Cyclical Expansions Average Annual Equivalent ∆%
IQ1983 to IVQ1985 IQ1983-IQ1986 IQ1983-IIIQ1986 IQ1983-IVQ1986 IQ1983-IQ1987 IQ1983-IIQ1987 IQ1983-IIIQ1987 IQ1983 to IVQ1987	5.9 5.7 5.4 5.2 5.0 5.0 4.9 5.0
First Four Quarters IQ1983 to IVQ1983	7.8
IIIQ2009 to IIQ2014	2.2
First Four Quarters IIIQ2009 to IIQ2010	2.7
	Real Disposable Income	Real Disposable Income per Capita
Long-Term
1929-2013	3.2	2.0
1947-1999	3.7	2.3
Whole Cycles
1980-1989	3.5	2.6
2006-2013	1.3	0.5

Source: Bureau of Economic Analysis

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

The revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) also provide critical information in assessing the current rhythm of US economic growth. The economy appears to be moving at a pace from 2.1 to 2.5 percent per year. Table Summary GDP provides the data.

1. Average Annual Growth in the Past Eight Quarters. GDP growth in the four quarters of 2012, the four quarters of 2013 and the first two quarters of 2014 accumulated to 5.4 percent. This growth is equivalent to 2.1 percent per year, obtained by dividing GDP in IIQ2014 of $16,010.4 billion by GDP in IVQ2011 of $15,190.3 billion and compounding by 4/10: {[($16,010.4/$15,190.3)^4/10 -1]100 = 2.1 percent.

2. Average Annual Growth in the Past Four Quarters. GDP growth in the four quarters of IIQ2013 to IIQ2014 accumulated to 2.6 percent that is equivalent to 2.6 percent in a year. This is obtained by dividing GDP in IIQ2014 of $16,010.4 billion by GDP in IIQ2013 of $15,606.6 billion and compounding by 4/4: {[($16,010.4/$15,606.6)^4/4 -1]100 = 2.6%}. The US economy grew 2.6 percent in IIQ2014 relative to the same quarter a year earlier in IIQ2013. Another important revelation of the revisions and enhancements is that GDP was flat in IVQ2012, which is in the borderline of contraction, and negative in IQ2014. US GDP fell 0.5 percent in IQ2014. The rate of growth of GDP in the revision of IIIQ2013 is 4.5 percent in seasonally adjusted annual rate (SAAR). Inventory accumulation contributed 1.49 percentage points to this rate of growth. The actual rate without this impulse of unsold inventories would have been 3.0 percent, or 0.74 percent in IIIQ2013, such that annual equivalent growth in 2013 is closer to 2.8 percent {[(1.007)(1.004)(1.0074)(1.009)^4/4-1]100 = 2.8%}, compounding the quarterly rates and converting into annual equivalent. Inventory divestment deducted 1.16 percentage points from GDP growth in IQ2014. Without this deduction of inventory divestment, GDP growth would have been minus 0.9 percent in IQ2014, such that the actual growth rates in the four quarters ending in IQ2014 is closer to 2.2 percent {[(1.004)(1.011)(1.009)(0.9977)]^4/4 -1]100 = 2.2%}.

Table Summary GDP, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2005 Dollars and ∆%

	Real GDP, Billions Chained 2009 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	14,991.8	NA	NA	1.9
IVQ2011	15,190.3	1.3	1.1	1.7
IQ2012	15,275.0	1.9	0.6	2.6
IIQ2012	15,336.7	2.3	0.4	2.3
IIIQ2012	15,431.3	2.9	0.6	2.7
IVQ2012	15,433.7	2.9	0.0	1.6
IQ2013	15,538.4	3.6	0.7	1.7
IIQ2013	15,606.6	4.1	0.4	1.8
IIIQ2013	15,779.9	5.3	1.1	2.3
IVQ2013	15,916.2	6.2	0.9	3.1
IQ2014	15,831.7	5.6	-0.5	1.9
IIQ2014	16,010.4	6.8	1.1	2.6
Cumulative ∆% IQ2012 to IQ2014	5.4		5.4
Annual Equivalent ∆%	2.1		2.1

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

The NBER dates another recession in 1980 that lasted about half a year. If the two recessions from IQ1980s to IIIQ1980 and IIIQ1981 to IVQ1982 are combined, the impact of lost GDP of 4.7 percent is more comparable to the latest revised 4.2 percent drop of the recession from IVQ2007 to IIQ2009. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.4 percent cumulatively and fell 45.3 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7 and revisions in http://bea.gov/iTable/index_nipa.cfm). Table I-2 provides the Bureau of Economic Analysis (BEA) quarterly growth rates of GDP in SA yearly equivalents for the recessions of 1981 to 1982 and 2007 to 2009, using the latest major revision published on July 31, 2013 and the second estimate for IIQ2014 GDP (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_2nd.pdf), which are available in the dataset of the US Bureau of Economic Analysis (http://www.bea.gov/iTable/index_nipa.cfm). There were four quarters of contraction in 1981-1982 ranging in rate from -1.4 percent to -6.5 percent and five quarters of contraction in 2007-2009 ranging in rate from -0.5 percent to -8.2 percent. The striking difference is that in the first twenty quarters of expansion from IQ1983 to IIIQ1987, shown in Table I-2 in relief, GDP grew at the high quarterly percentage growth rates of 5.3, 9.4, 8.1, 8.5, 8.2, 7.2, 4.0, 3.2, 4.0, 3.7, 6.4, 3.0, 3.8, 1.9, 4.1, 2.1, 2.8, 4.6, 3.7 and 6.8. In contrast, the percentage growth rates in the first twenty quarters of expansion from IIIQ2009 to IIQ2014 shown in relief in Table I-2 were mediocre: 1.3, 3.9, 1.7, 3.9, 2.7, 2.5, -1.5, 2.9, 0.8, 4.6, 2.3, 1.6, 2.5, 0.1, 2.7, 1.8, 4.5, 3.5, minus 2.1 and 4.6. Inventory accumulation contributed 2.80 percentage points to the rate of growth of 4.6 percent in IVQ2011. Inventory divestment deducted 1.16 percentage points from GDP growth in IQ2014 and added 1.42 percentage points to the rate of growth in IIQ2014. Economic growth and employment creation continued at slow rhythm during 2012 and in 2013 while much stronger growth would be required in movement to full employment. The cycle is now long by historical standards and growth rates are typically weaker in the final periods of cyclical expansions.

Table I-2, US, Quarterly Growth Rates of GDP, % Annual Equivalent SA

Q	1981	1982	1983	1984	2008	2009	2010
I	8.5	-6.5	5.3	8.2	-2.7	-5.4	1.7
II	-2.9	2.2	9.4	7.2	2.0	-0.5	3.9
III	4.7	-1.4	8.1	4.0	-1.9	1.3	2.7
IV	-4.6	0.4	8.5	3.2	-8.2	3.9	2.5
				1985			2011
I				4.0			-1.5
II				3.7			2.9
III				6.4			0.8
IV				3.0			4.6
				1986			2012
I				3.8			2.3
II				1.9			1.6
III				4.1			2.5
IV				2.1			0.1
				1987			2013
I				2.8			2.7
II				4.6			1.8
III				3.7			4.5
IV				6.8			3.5
				1988			2014
I				2.3			-2.1
II				5.4			4.6
III				2.3
IV				5.4

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

Chart I-1 of the Bureau of Economic Analysis (BEA) provides strong growth of real GDP in the US between 1929 and 1999 at the yearly average rate of 3.5 percent. There is an evident acceleration of the rate of GDP growth in the 1990s as shown by a much sharper slope of the growth curve. Cobet and Wilson (2002) define labor productivity as the value of manufacturing output produced per unit of labor input used (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). Between 1950 and 2000, labor productivity in the US grew less rapidly than in Germany and Japan. The major part of the increase in productivity in Germany and Japan occurred between 1950 and 1973 while the rate of productivity growth in the US was relatively subdued in several periods. While Germany and Japan reached their highest growth rates of productivity before 1973, the US accelerated its rate of productivity growth in the second half of the 1990s. Between 1950 and 2000, the rate of productivity growth in the US of 2.9 percent per year was much lower than 6.3 percent in Japan and 4.7 percent in Germany. Between 1995 and 2000, the rate of productivity growth of the US of 4.6 percent exceeded that of Japan of 3.9 percent and the rate of Germany of 2.6 percent.

Chart I-1, US, Real GDP 1929-1999

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

Chart I-1A provides real GDP annually from 1929 to 2013. Growth after the global recession from IVQ2007 to IIQ2009 has not been sufficiently high to compensate for the contraction as it had occurred in past economic cycles. GDP is about two trillion dollars lower than trend GDP, explaining 26.9 million unemployed or underemployed. There is dramatic decline of productivity growth in the whole cycle from 2.2 percent per year on average from 1947 to 2013 to 1.5 percent per year on average from 2007 to 2013 (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html). There is profound drop in the average rate of output growth from 3.2 percent on average from 1947 to 2013 to 1.0 percent from 2007 to 2013. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,294.6 billion than actual $16,010.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). US GDP in IIQ2014 is 12.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,010.4 billion in IIQ2014 or 6.8 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 123.2212 in Aug 2014. The actual index NSA in Aug 2014 is 101.5145, which is 17.6 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 117.7603 in Aug 2014. The output of manufacturing at 101.5145 in Aug 2014 is 13.8 percent below trend under this alternative calculation.

Chart I-1A, US, Real GDP 1929-2013

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

Chart I-2 provides the growth of real quarterly GDP in the US between 1947 and 2014. The drop of output in the recession from IVQ2007 to IIQ2009 has been followed by anemic recovery compared with return to trend at 3.0 percent from 1870 to 2010 after events such as wars and recessions (Lucas 2011May) and a standstill that can lead to growth recession, or low rates of economic growth. The expansion is relatively long compared to earlier expansion and there could be even another contraction or conventional recession in the future. The average rate of growth from 1947 to 2013 is 3.2 percent. The average growth rate from IV2007 to IVQ2013 is only 1.0 percent with 2.8 percent annual equivalent from the end of the recession in IVQ2001 to the end of the expansion in IVQ2007.

Chart I-2, US, Real GDP, Quarterly, 1947-2014

Source: US Bureau of Economic Analysis

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

Chart I-3 provides real GDP percentage change on the quarter a year earlier for 1983-1984. The objective is simply to compare expansion in two recoveries from sharp contractions as shown in Table I-2. Growth rates in the early phase of the recovery in 1983 and 1984 were very high, which is the opportunity to reduce unemployment that has characterized cyclical expansion in the postwar US economy.

Chart I-3, Real GDP Percentage Change on Quarter a Year Earlier 1983-1987

Source: US Bureau of Economic Analysis

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

In contrast, growth rates in the comparable first nineteen quarters of expansion from 2009 to 2014 in Chart I-4 have been mediocre. As a result, growth has not provided the exit from unemployment and underemployment as in other cyclical expansions in the postwar period. Growth rates did not rise in V shape as in earlier expansions and then declined close to the standstill of growth recessions.

Chart I-4, US, Real GDP Percentage Change on Quarter a Year Earlier 2009-2014

Source: US Bureau of Economic Analysis

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

Table I-3 provides percentage change of real GDP in the United States in the 1930s, 1980s and 2000s. The recession in 1981-1982 is quite similar on its own to the 2007-2009 recession. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.4 percent cumulatively and fell 45.3 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7 and revisions in http://bea.gov/iTable/index_nipa.cfm). Data are available for the 1930s only on a yearly basis. US GDP fell 4.7 percent in the two recessions (1) from IQ1980 to IIIQ1980 and (2) from III1981 to IVQ1981 to IVQ1982 and 4.2 percent cumulatively in the recession from IVQ2007 to IIQ2009. It is instructive to compare the first three years of the expansions in the 1980s and the current expansion. GDP grew at 4.6 percent in 1983, 7.3 percent in 1984, 4.2 percent in 1985, 3.5 percent in 1986 and 3.5 percent in 1987. In contrast, GDP grew 2.5 percent in 2010, 1.6 percent in 2011, 2.3 percent in 2012 and 2.2 percent in 2013. Actual annual equivalent GDP growth in the four quarters of 2012, and six quarters from IQ2013 to IIQ2014 is 2.1 percent and 2.6 percent in the four quarters ending in IIQ2014. GDP grew at 4.2 percent in 1985, 3.5 percent in 1986 and 3.5 percent in 1987 while the forecasts of the central tendency of participants of the Federal Open Market Committee (FOMC) are in the range of 2.0 to 2.2 percent in 2014 (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140917.pdf) with less reliable forecast of 2.6 to 3.0 percent in 2015 (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140917.pdf ). Growth of GDP in the expansion from IIIQ2009 to IIQ2014 has been at average 2.2 percent in annual equivalent.

Table I-3, US, Percentage Change of GDP in the 1930s, 1980s and 2000s, ∆%

Year	GDP ∆%	Year	GDP ∆%	Year	GDP ∆%
1930	-8.5	1980	-0.2	2000	4.1
1931	-6.4	1981	2.6	2001	1.0
1932	-12.9	1982	-1.9	2002	1.8
1933	-1.3	1983	4.6	2003	2.8
1934	10.8	1984	7.3	2004	3.8
1935	8.9	1985	4.2	2005	3.3
1936	12.9	1986	3.5	2006	2.7
1937	5.1	1987	3.5	2007	1.8
1938	-3.3	1988	4.2	2008	-0.3
1930	8.0	1989	3.7	2009	-2.8
1940	8.8	1990	1.9	2010	2.5
1941	17.7	1991	-0.1	2011	1.6
1942	18.9	1992	3.6	2012	2.3
1943	17.0	1993	2.7	2013	2.2

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

Chart I-5 provides percentage change of GDP in the US during the 1930s. There is vast literature analyzing the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance (2009), 198-217). Cole and Ohanian (1999) find that US real per capita output was lower by 11 percent in 1939 than in 1929 while the typical expansion of real per capita output in the US during a decade is 31 percent. Private hours worked in the US were 25 percent lower in 1939 relative to 1929.

Chart I-5, US, Percentage Change of GDP in the 1930s

Source: US Bureau of Economic Analysis

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

In contrast, Chart I-6 shows rapid recovery from the recessions in the 1980s. High growth rates in the initial quarters of expansion eliminated the unemployment and underemployment created during the contraction. The economy then returned to grow at the trend of expansion, interrupted by another contraction in 1991.

Chart I-6, US, Percentage Change of GDP in the 1980s

Source: US Bureau of Economic Analysis

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

Chart I-7 provides the rates of growth during the 2000s. Growth rates in the initial eighteen quarters of expansion have been relatively lower than during recessions after World War II. As a result, unemployment and underemployment continue at the rate of 16.4 percent of the US labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html) with weak hiring (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitics-monetary-policy-and.html).

Chart I-7, US, Percentage Change of GDP in the 2000s

Source: US Bureau of Economic Analysis

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

Characteristics of the four cyclical contractions are provided in Table I-4 with the first column showing the number of quarters of contraction; the second column the cumulative percentage contraction; and the final column the average quarterly rate of contraction. There were two contractions from IQ1980 to IIIQ1980 and from IIIQ1981 to IVQ1982 separated by three quarters of expansion. The drop of output combining the declines in these two contractions is 4.7 percent, which is almost equal to the decline of 4.2 percent in the contraction from IVQ2007 to IIQ2009. In contrast, during the Great Depression in the four years of 1930 to 1933, GDP in constant dollars fell 26.4 percent cumulatively and fell 45.3 percent in current dollars (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 150-2, Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 205-7 and revisions in http://bea.gov/iTable/index_nipa.cfm). The comparison of the global recession after 2007 with the Great Depression is entirely misleading.

Table I-4, US, Number of Quarters, GDP Cumulative Percentage Contraction and Average Percentage Annual Equivalent Rate in Cyclical Contractions

	Number of Quarters	Cumulative Percentage Contraction	Average Percentage Rate
IIQ1953 to IIQ1954	3	-2.4	-0.8
IIIQ1957 to IIQ1958	3	-3.0	-1.0
IVQ1973 to IQ1975	5	-3.1	-0.6
IQ1980 to IIIQ1980	2	-2.2	-1.1
IIIQ1981 to IVQ1982	4	-2.5	-0.64
IVQ2007 to IIQ2009	6	-4.2	-0.72

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

Table I-5 shows the mediocre average annual equivalent growth rate of 2.2 percent of the US economy in the twenty quarters of the current cyclical expansion from IIIQ2009 to IIQ2014. In sharp contrast, the average growth rate of GDP was:

5.7 percent in the first thirteen quarters of expansion from IQ1983 to IQ1986
5.4 percent in the first fifteen quarters of expansion from IQ1983 to IIIQ1986
5.2 percent in the first sixteen quarters of expansion from IQ1983 to IVQ1986
5.0 percent in the first seventeen quarters of expansion from IQ1983 to IQ1987
5.0 percent in the first eighteen quarters of expansion from IQ1983 to IIQ1987
4.9 percent in the first nineteen quarters of expansion from IQ1983 to IIIQ1987
5.0 percent in the first twenty quarters of expansion from IQ1983 to IVQ1987

The line “average first four quarters in four expansions” provides the average growth rate of 7.7 percent with 7.8 percent from IIIQ1954 to IIQ1955, 9.2 percent from IIIQ1958 to IIQ1959, 6.1 percent from IIIQ1975 to IIQ1976 and 7.8 percent from IQ1983 to IVQ1983. The United States missed this opportunity of high growth in the initial phase of recovery. BEA data show the US economy in standstill with annual growth of 2.5 percent in 2010 decelerating to 1.6 percent annual growth in 2011, 2.3 percent in 2012 and 2.2 percent in 2013 (http://www.bea.gov/iTable/index_nipa.cfm) The expansion from IQ1983 to IQ1986 was at the average annual growth rate of 5.7 percent, 5.2 percent from IQ1983 to IVQ1986, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983. GDP growth in the four quarters of 2012, the four quarters of 2013 and the first two quarters of 2014 accumulated to 5.4 percent. This growth is equivalent to 2.1 percent per year, obtained by dividing GDP in IIQ2014 of $16,010.4 billion by GDP in IVQ2011 of $15,190.3 billion and compounding by 4/10: {[($16,010.4/$15,190.3)^4/10 -1]100 = 2.1 percent. The rate of growth of GDP in the revision of the third estimate of IIIQ2013 is 4.5 percent in seasonally adjusted annual rate (SAAR). Inventory accumulation contributed 1.49 percentage points to this rate of growth. The actual rate without this impulse of unsold inventories would have been 3.0 percent, or 0.74 percent in IIIQ2013, such that annual equivalent growth in 2013 is closer to 2.8 percent {[(1.007)(1.004)(1.0074)(1.009)^4/4-1]100 = 2.8%}, compounding the quarterly rates and converting into annual equivalent. Inventory divestment deducted 1.16 percentage points from GDP growth in IQ2014. Without this deduction of inventory divestment, GDP growth would have been minus 0.9 percent in IQ2014, such that the actual growth rates in the four quarters ending in IQ2014 is closer to 2.2 percent {[(1.004)(1.011)(1.009)(0.9977)]^4/4 -1]100 = 2.2%}.

Table I-5, US, Number of Quarters, Cumulative Growth and Average Annual Equivalent Growth Rate in Cyclical Expansions

	Number of Quarters	Cumulative Growth ∆%	Average Annual Equivalent Growth Rate
IIIQ 1954 to IQ1957	11	12.8	4.5
First Four Quarters IIIQ1954 to IIQ1955	4	7.8
IIQ1958 to IIQ1959	5	10.0	7.9
First Four Quarters IIIQ1958 to IIQ1959	4	9.2
IIQ1975 to IVQ1976	8	8.3	4.1
First Four Quarters IIIQ1975 to IIQ1976	4	6.1
IQ1983-IQ1986 IQ1983-IIIQ1986 IQ1983-IVQ1986 IQ1983-IQ1987 IQ1983-IIQ1987 IQ1983 to IIIQ1987 IQ1983 to IVQ1987	13 15 16 17 18 19 20	19.9 21.6 22.3 23.1 24.5 25.6 27.7	5.7 5.4 5.2 5.0 5.0 4.9 5.0
First Four Quarters IQ1983 to IVQ1983	4	7.8
Average First Four Quarters in Four Expansions*		7.7
IIIQ2009 to IIQ2014	20	11.5	2.2
First Four Quarters IIIQ2009 to IIQ2010		2.7

*First Four Quarters: 7.8% IIIQ1954-IIQ1955; 9.2% IIIQ1958-IIQ1959; 6.1% IIIQ1975-IQ1976; 7.8% IQ1983-IVQ1983

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

Chart I-8 shows US real quarterly GDP growth from 1980 to 1989. The economy contracted during the recession and then expanded vigorously throughout the 1980s, rapidly eliminating the unemployment caused by the contraction.

Chart I-8, US, Real GDP, 1980-1989

Source: US Bureau of Economic Analysis

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

Chart I-9 shows the entirely different situation of real quarterly GDP in the US between 2007 and 2013. The economy has underperformed during the first twenty quarters of expansion for the first time in the comparable contractions since the 1950s. The US economy is now in a perilous standstill.

Chart I-9, US, Real GDP, 2007-2014

Source: US Bureau of Economic Analysis

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

As shown in Tables I-4 and I-5 above the loss of real GDP in the US during the contraction was 4.3 percent but the gain in the cyclical expansion has been only 11.4 percent (first to the last row in Table I-5), using all latest revisions. As a result, the level of real GDP in IIQ2014 with the first estimate and revisions is only higher by 6.8 percent than the level of real GDP in IVQ2007. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,294.6 billion than actual $16,010.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). US GDP in IIQ2014 is 12.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,010.4 billion in IIQ2014 or 6.8 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 123.2212 in Aug 2014. The actual index NSA in Aug 2014 is 101.5145, which is 17.6 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 117.7603 in Aug 2014. The output of manufacturing at 101.5145 in Aug 2014 is 13.8 percent below trend under this alternative calculation.

The contraction actually concentrated in two quarters: decline of 2.1 percent in IVQ2008 relative to the prior quarter and decline of 1.4 percent in IQ2009 relative to IVQ2008. The combined fall of GDP in IVQ2008 and IQ2009 was 3.5 percent {[(1-0.021) x (1-0.014) -1]100 = -3.5%}, or {[(IQ2009 $14,375.0)/(IIIQ2008 $14,891.6) – 1]100 = -3.5%} except for rounding. Those two quarters coincided with the worst effects of the financial crisis (Cochrane and Zingales 2009). GDP fell 0.1 percent in IIQ2009 but grew 0.3 percent in IIIQ2009, which is the beginning of recovery in the cyclical dates of the NBER. Most of the recovery occurred in five successive quarters from IVQ2009 to IVQ2010 of growth of 1.0 percent in IVQ2009, 0.4 percent in IQ2010, 1.0 percent in IIQ2010 and nearly equal growth at 0.7 percent in IIIQ2010 and 0.6 percent in IVQ2010 for cumulative growth in those five quarters of 3.8 percent, obtained by accumulating the quarterly rates {[(1.01 x 1.004 x 1.01 x 1.007 x 1.006) – 1]100 = 3.8%} or {[(IVQ2010 $14,939.0)/(IIIQ2009 $14,402.5) – 1]100 = 3.7%} with minor rounding difference. The economy then stalled during the first half of 2011 with decline of 0.4 percent in IQ2011 and growth of 0.7 percent in IIQ2011 for combined annual equivalent rate of 0.6 percent {(0.996 x 1.007)²}. The economy grew 0.2 percent in IIIQ2011 for annual equivalent growth of 0.7 percent in the first three quarters {[(0.996 x 1.007 x 1.002)^4/3 -1]100 = 0.7%}. Growth picked up in IVQ2011 with 1.1 percent relative to IIIQ2011. Growth in a quarter relative to a year earlier in Table I-6 slows from over 2.7 percent during three consecutive quarters from IIQ2010 to IVQ2010 to 1.9 percent in IQ2011, 1.7 percent in IIQ2011, 1.2 percent in IIIQ2011 and 1.7 percent in IVQ2011. As shown below, growth of 1.1 percent in IVQ2011 was partly driven by inventory accumulation. In IQ2012, GDP grew 0.6 percent relative to IVQ2011 and 2.6 percent relative to IQ2011, decelerating to 0.4 percent in IIQ2012 and 2.3 percent relative to IIQ2011 and 0.6 percent in IIIQ2012 and 2.7 percent relative to IIIQ2011 largely because of inventory accumulation and national defense expenditures. Growth was 0.0 percent in IVQ2012 with 1.6 percent relative to a year earlier but mostly because of deduction of 1.80 percentage points of inventory divestment and 1.12 percentage points of reduction of one-time national defense expenditures. Growth was 0.7 percent in IQ2013 and 1.7 percent relative to IQ2012 in large part because of burning savings to consume caused by financial repression of zero interest rates. There is similar growth of 0.4 percent in IIQ2013 and 1.8 percent relative to a year earlier. In IIIQ2013, GDP grew 1.1 percent relative to the prior quarter and 2.3 percent relative to the same quarter a year earlier with inventory accumulation contributing 1.49 percentage points to growth at 4.5 percent SAAR in IIIQ2013. GDP increased 0.9 percent in IVQ2013 and 3.1 percent relative to a year earlier. GDP fell 0.5 percent in IQ2014 and grew 1.9 percent relative to a year earlier. Inventory divestment deducted 1.16 percentage points from GDP growth in IQ2014. GDP grew 1.1 percent in IIQ2014, 2.6 percent relative to a year earlier and at 4.6 SAAR with inventory change contributing 1.42 percentage points. Rates of a quarter relative to the prior quarter capture better deceleration of the economy than rates on a quarter relative to the same quarter a year earlier. The critical question for which there is not yet definitive solution is whether what lies ahead is continuing growth recession with the economy crawling and unemployment/underemployment at extremely high levels or another contraction or conventional recession. Forecasts of various sources continued to maintain high growth in 2011 without taking into consideration the continuous slowing of the economy in late 2010 and the first half of 2011. The sovereign debt crisis in the euro area and growth in China are common sources of doubts on the rate and direction of economic growth in the US. There is weak internal demand in the US with almost no investment and spikes of consumption driven by burning saving because of financial repression forever in the form of zero interest rates.

Table I-6, US, Real GDP and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions Chained 2009 Dollars and ∆%

	Real GDP, Billions Chained 2009 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	14,991.8	NA	0.4	1.9
IQ2008	14,889.5	-0.7	-0.7	1.1
IIQ2008	14,963.4	-0.2	0.5	0.8
IIIQ2008	14,891.6	-0.7	-0.5	-0.3
IVQ2008	14,577.0	-2.8	-2.1	-2.8
IQ2009	14,375.0	-4.1	-1.4	-3.5
IIQ2009	14,355.6	-4.2	-0.1	-4.1
IIIQ2009	14,402.5	-3.9	0.3	-3.3
IV2009	14,541.9	-3.0	1.0	-0.2
IQ2010	14,604.8	-2.6	0.4	1.6
IIQ2010	14,745.9	-1.6	1.0	2.7
IIIQ2010	14,845.5	-1.0	0.7	3.1
IVQ2010	14,939.0	-0.4	0.6	2.7
IQ2011	14,881.3	-0.7	-0.4	1.9
IIQ2011	14,989.6	0.0	0.7	1.7
IIIQ2011	15,021.1	0.2	0.2	1.2
IVQ2011	15,190.3	1.3	1.1	1.7
IQ2012	15,275.0	1.9	0.6	2.6
IIQ2012	15,336.7	2.3	0.4	2.3
IIIQ2012	15,431.3	2.9	0.6	2.7
IVQ2012	15,433.7	2.9	0.0	1.6
IQ2013	15,538.4	3.6	0.7	1.7
IIQ2013	15,606.6	4.1	0.4	1.8
IIIQ2013	15,779.9	5.3	1.1	2.3
IVQ2013	15,916.2	6.2	0.9	3.1
IQ2014	15,831.7	5.6	-0.5	1.9
IIQ2014	16,010.4	6.8	1.1	2.6

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

Chart I-10 provides the percentage change of real GDP from the same quarter a year earlier from 1980 to 1989. There were two contractions almost in succession in 1980 and from 1981 to 1983. The expansion was marked by initial high rates of growth as in other recession in the postwar US period during which employment lost in the contraction was recovered. Growth rates continued to be high after the initial phase of expansion.

Chart I-10, Percentage Change of Real Gross Domestic Product from Quarter a Year Earlier 1980-1989

Source: US Bureau of Economic Analysis

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

The experience of recovery after 2009 is not as complete as during the 1980s. Chart I-11 shows the much lower rates of growth in the early phase of the current expansion and sharp decline from an early peak. The US missed the initial high growth rates in cyclical expansions that eliminate unemployment and underemployment.

Chart I-11, Percentage Change of Real Gross Domestic Product from Quarter a Year Earlier 2007-2014

Source: US Bureau of Economic Analysis

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

Chart I-12 provides growth rates from a quarter relative to the prior quarter during the 1980s. There is the same strong initial growth followed by a long period of sustained growth.

Chart I-12, Percentage Change of Real Gross Domestic Product from Prior Quarter 1980-1989

Source: US Bureau of Economic Analysis

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

Chart I-13 provides growth rates in a quarter relative to the prior quarter from 2007 to 2014. Growth in the current expansion after IIIQ2009 has not been as strong as in other postwar cyclical expansions.

Chart I-13, Percentage Change of Real Gross Domestic Product from Prior Quarter 2007-2014

Source: US Bureau of Economic Analysis

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

ESIII Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth. The valuable report on Financial Accounts of the United States formerly Flow of Funds Accounts of the United States provided by the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/releases/z1/Current/ http://www.federalreserve.gov/apps/fof/) is rich in important information and analysis. Table IIA-1, updated in this blog for every new quarterly release, shows the balance sheet of US households combined with nonprofit organizations in 2007, 2011, 2013 and IIQ2014. The data show the strong shock to US wealth during the contraction. Assets fell from $81.2 trillion in 2007 to $77.3 trillion in 2011 even after nine consecutive quarters of growth beginning in IIIQ2009 (Section I and earlier (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html), for decline of $3.9 trillion or 4.8 percent. Assets stood at $92.7 trillion in 2013 for gain of $11.5 trillion relative to $81.2 trillion in 2007 or increase by 14.1 percent. Assets increased to $95.4 trillion in IIQ2014 by $14.2 trillion relative to 2007 or 17.5 percent. Liabilities declined from $14.4 trillion in 2007 to $13.6 trillion in 2011 or by $820.3 billion equivalent to decline by 5.7 percent. Liabilities declined $593.1 billion or 4.1 percent from 2007 to 2013 and increased 1.7 percent from 2011 to 2013. Liabilities fell from $14.4 trillion in 2007 to $13.9 trillion in IQ2014, by $445.9 billion or decline of 3.1 percent. Net worth shrank from $66.8 trillion in 2007 to $63.7 trillion in 2011, that is, $3.1 trillion equivalent to decline of 4.6 percent. Net worth increased from $66,802.7 billion in 2007 to $81,492.8 billion in IIQ2014 by $14,690.1 billion or 22.0 percent. The US consumer price index for all items increased from 210.036 in Dec 2007 to 238.343 in Jun 2014 (http://www.bls.gov/cpi/data.htm) or 13.5 percent. Net worth adjusted by CPI inflation increased 7.5 percent from 2007 to IQ2014. Nonfinancial assets increased $224.1 billion from $28,167.5 billion in 2007 to $28,391.6 billion in IIQ2014 or 0.8 percent. There was decrease from 2007 to IIQ2013 of $0.420 trillion in real estate assets or by 1.8 percent. Real estate assets adjusted for CPI inflation fell 13.5 percent between 2007 and IIQ2014. The National Association of Realtors estimated that the gains in net worth in homes by Americans were about $4 trillion between 2000 and 2005 (quoted in Pelaez and Pelaez, The Global Recession Risk (2007), 224-5).

Table IIA-1, US, Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars Outstanding End of Period, NSA

	2007	2011	2013	IIQ2014
Assets	81,197.0	77,272.1	92,669.2	95,441.2
Nonfinancial	28,167.5	23,347.2	27,669.2	28,391.6
Real Estate	23,358.0	18,221.5	22,295.9	22,938.4
Durable Goods	4,476.0	4,723.3	4,942.2	5,013.2
Financial	53,029.5	53,925.0	65,000.1	67,049.6
Deposits	7,560.6	8,746.6	9,630.5	9,861.0
Credit Market	3,987.7	4,374.0	3,848.8	3,535.9
Mutual Fund Shares	4,597.4	4,661.8	7,152.4	7,688.3
Equities Corporate	9,911.7	8,475.6	12,451.3	13,306.7
Equity Noncorporate	9,003.8	7,418.3	9,057.7	9,188.4
Pension	15,262.2	17,444.7	19,886.1	20,406.1
Liabilities	14,394.3	13,574.0	13,801.2	13,948.4
Home Mortgages	10,611.7	9,698.5	9,415.9	9,374.6
Consumer Credit	2,615.7	2,755.9	3,097.9	3,169.6
Net Worth	66,802.7	63,698.1	78,868.0	81,492.8

Net Worth = Assets – Liabilities

Source: Board of Governors of the Federal Reserve System. 2014. Flow of funds, balance sheets and integrated macroeconomic accounts: second quarter 2014. Washington, DC, Federal Reserve System, Jun 5. http://www.federalreserve.gov/releases/z1/

Reserve System, Sep 18.

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

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

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

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

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

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

W = Y/r (1)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

According to Pinto (2008) in testimony to Congress:

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

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

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

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

Table IIA-2 shows the euphoria of prices during the housing boom and the subsequent decline. House prices rose 93.7 percent in the 10-city composite of the Case-Shiller home price index and 78.1 percent in the 20-city composite between Jun 2000 and Jun 2005. Prices rose around 100 percent from Jun 2000 to Jun 2006, increasing 109.9 percent for the 10-city composite and 93.3 percent for the 20-city composite. House prices rose 38.8 percent between Jun 2003 and Jun 2005 for the 10-city composite and 32.4 percent for the 20-city composite propelled by low fed funds rates of 1.0 percent between Jun 2003 and Jun 2004. Fed funds rates increased by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) from Jun 2004 until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Jun 2003 and Jun 2006, the 10-city index gained 51.2 percent and the 20-city index increased 46.0 percent. House prices have fallen from Jun 2006 to Jun 2014 by 17.3 percent for the 10-city composite and 16.5 percent for the 20-city composite. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Jun 2014, house prices increased 8.1 percent in the 10-city composite and also increased 8.1 percent in the 20-city composite. Table IIA-2 also shows that house prices increased 73.6 percent between Jun 2000 and Jun 2014 for the 10-city composite and increased 61.4 percent for the 20-city composite. House prices are close to the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 17.3 percent from the peak in Jun 2006 to Jun 2014 and the 20-city composite fell 17.4 percent from the peak in Jul 2006 to Jun 2014. The final part of Table I-4 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2013 for the 10-city composite was 3.7 percent. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2013 was 3.6 percent while the rate of the 20-city composite was 3.1 percent.

Table IIA-2, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%

	10-City Composite	20-City Composite
∆% Jun 2000 to Jun 2003	38.8	32.4
∆% Jun 2000 to Jun 2005	93.7	78.1
∆% Jun 2003 to Jun 2005	39.5	34.5
∆% Jun 2000 to Jun 2006	109.9	93.3
∆% Jun 2003 to Jun 2006	51.2	46.0
∆% Jun 2005 to Jun 2014	-10.4	-9.3
∆% Jun 2006 to Jun 2014	-17.3	-16.5
∆% Jun 2009 to Jun 2014	22.1	21.4
∆% Jun 2010 to Jun 2014	16.2	16.4
∆% Jun 2011 to Jun 2014	20.9	21.8
∆% Jun 2012 to Jun 2014	20.8	21.1
∆% Jun 2013 to Jun 2014	8.1	8.1
∆% Jun 2000 to Jun 2014	73.6	61.4
∆% Peak Jun 2006 Jun 2014	-17.3
∆% Peak Jul 2006 Jun 2014		-16.6
Average ∆% Dec 1987-Dec 2013	3.7	NA
Average ∆% Dec 1987-Dec 2000	3.8	NA
Average ∆% Dec 1992-Dec 2000	5.0	NA
Average ∆% Dec 2000-Dec 2013	3.6	3.1

Source: http://us.spindices.com/index-family/real-estate/sp-case-shiller

Table IIA-4 summarizes the brutal drops in assets and net worth of US households and nonprofit organizations from 2007 to 2008 and 2009. Total assets fell $10.4 trillion or 12.8 percent from 2007 to 2008 and $8.9 trillion or 10.9 percent to 2009. Net worth fell $10.3 trillion from 2007 to 2008 or 15.4 percent and $8.8 trillion to 2009 or 12.8 percent. Subsidies to housing prolonged over decades together with interest rates at 1.0 percent from Jun 2003 to Jun 2004 inflated valuations of real estate and risk financial assets such as equities. The increase of fed funds rates by 25 basis points until 5.25 percent in Jun 2006 reversed carry trades through exotic vehicles such as subprime adjustable rate mortgages (ARM) and world financial markets. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9).

Table IIA-4, Difference of Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars from 2007 to 2008 and 2009

	2007	2008	Change to 2008	2009	Change to 2009
A	81,197.0	70,804.9	-10,392.1	72,330.9	-8,866.1
Non FIN	28,167.5	24,756.9	-3,410.6	23,677.1	-4,490.4
RE	23,358.0	19,822.7	-3,535.3	18,720.7	-4,637.3
FIN	53,029.5	46,047.9	-6,981.6	48,653.8	-4,375.7
LIAB	14,394.3	14,278.6	-115.7	14,062.1	-332.2
NW	66,802.7	56,526.2	-10,276.5	58,268.8	-8,833.9

A: Assets; Non FIN: Nonfinancial Assets; RE: Real Estate; FIN: Financial Assets; LIAB: Liabilities; NW: Net Worth

Reserve System, Sep 18.

The apparent improvement in Table IIA-4A is mostly because of increases in valuations of risk financial assets by the carry trade from zero interest rates to leveraged exposures in risk financial assets such as stocks, high-yield bonds, emerging markets, commodities and so on. Zero interest rates also act to increase net worth by reducing debt or liabilities. The net worth of households has become an instrument of unconventional monetary policy by zero interest rates in the theory that increases in net worth increase consumption that accounts for 68.5 percent of GDP in IIQ2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html), generating demand to increase aggregate economic activity and employment. There are neglected and counterproductive risks in unconventional monetary policy. Between 2007 and IIQ2014, real estate fell in value by $419.6 billion and financial assets increased $14,020.1 billion for net gain of real estate and financial assets of $13,600.5 billion, explaining most of the increase in net worth of $14,690.1 billion obtained by adding the decrease in liabilities of $445.9 billion to the increase of assets of $14,244.2 billion. Net worth increased from $66,802.7 billion in 2007 to $81,492.8 billion in IIQ2014 by $14,690.1 billion or 22.0 percent. The US consumer price index for all items increased from 210.036 in Dec 2007 to 238.343 in Jun 2014 (http://www.bls.gov/cpi/data.htm) or 13.5 percent. Net worth adjusted by CPI inflation increased 7.5 percent from 2007 to IIQ2014. Real estate assets adjusted for CPI inflation fell 13.5 percent from 2007 to IQ2014. There are multiple complaints that unconventional monetary policy concentrates income on wealthier individuals because of their holdings of financial assets while the middle class has gained less because of fewer holdings of financial assets and higher share of real estate in family wealth. There is nothing new in these arguments. Interest rate ceilings on deposits and loans have been commonly used. The Banking Act of 1933 imposed prohibition of payment of interest on demand deposits and ceilings on interest rates on time deposits. These measures were justified by arguments that the banking panic of the 1930s was caused by competitive rates on bank deposits that led banks to engage in high-risk loans (Friedman, 1970, 18; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 74-5). The objective of policy was to prevent unsound loans in banks. Savings and loan institutions complained of unfair competition from commercial banks that led to continuing controls with the objective of directing savings toward residential construction. Friedman (1970, 15) argues that controls were passive during periods when rates implied on demand deposit were zero or lower and when Regulation Q ceilings on time deposits were above market rates on time deposits. The Great Inflation or stagflation of the 1960s and 1970s changed the relevance of Regulation Q. Friedman (1970, 26-7) predicted the future:

“The banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.”

In short, Depression regulation exported the US financial system to London and offshore centers. What is vividly relevant currently from this experience is the argument by Friedman (1970, 27) that the controls affected the most people with lower incomes and wealth who were forced into accepting controlled-rates on their savings that were lower than those that would be obtained under freer markets. As Friedman (1970, 27) argues:

“These are the people who have the fewest alternative ways to invest their limited assets and are least sophisticated about the alternatives.” US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 20 quarters from IIIQ2009 to IIQ2014. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[$14,745.9/$14,355.6 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,294.6 billion than actual $16,010.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). US GDP in IIQ2014 is 12.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,010.4 billion in IIQ2014 or 6.8 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 123.2212 in Aug 2014. The actual index NSA in Aug 2014 is 101.5145, which is 17.6 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 117.7603 in Aug 2014. The output of manufacturing at 101.5145 in Aug 2014 is 13.8 percent below trend under this alternative calculation.

Table IIA-4A, US, Difference of Balance Sheet of Households and Nonprofit Organizations Billions of Dollars from 2007 to 2011 and IQ2014

	Value 2007	Change to 2011	Change to 2013	Change to IIQ2014
Assets	81,197.0	-3,924.9	11,472.2	14,244.2
Nonfinancial	28,167.5	-4,820.3	-498.3	224.1
Real Estate	23,358.0	-5,136.5	-1,062.1	-419.6
Financial	53,029.5	895.5	11,970.6	14,020.1
Liabilities	14,394.3	-820.3	-593.1	-445.9
Net Worth	66,802.7	-3,104.6	12,065.3	14,690.1

Net Worth = Assets – Liabilities

Source: Net Worth = Assets – Liabilities

Source: Board of Governors of the Federal Reserve System.

Reserve System, Sep 18.

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and from IVQ1979) to IVQ1987 and from IVQ2007 to IIQ2014 is provided in Table IIA-5. The data reveal the following facts for the cycles in the 1980s:

IVQ1979 to IVQ1987. Net worth increased 99.2 percent from IVQ1979 to IVQ1987, the all items CPI index increased 50.5 percent from 76.7 in Dec 1979 to 115.4 in Dec 1987 and real net worth increased 32.4 percent.
IQ1980 to IVQ1985. Net worth increased 65.4 percent, the all items CPI index increased 36.5 percent from 80.1 in Mar 1980 to 109.3 in Dec 1985 and real net worth increased 21.2 percent.
IVQ1979 to IVQ1985. Net worth increased 68.8 percent, the all items CPI index increased 42.5 percent from 76.7 in Dec 1979 to 109.3 in Dec 1985 and real net worth increased 18.5 percent.
IQ1980 to IVQ1987. Net worth increased 95.1 percent, the all items CPI index increased 44.1 percent from 80.1 in Mar 1980 to 115.4 in Dec 1987 and real net worth increased 35.4 percent.

There is disastrous performance in the current economic cycle:

IVQ2007 to IQ2014. Net worth increased 22.0 percent, the all items CPI increased 13.5 percent from 210.036 in Dec 2007 to 238.343 in Jun 2014 and real or inflation adjusted net worth increased 7.5 percent. Real estate assets adjusted for inflation fell 13.5 percent.

The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 20 quarters from IIIQ2009 to IIQ2014. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp2q14_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by diving GDP of $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[$14,745.9/$14,355.6 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987 and at 7.8 percent from IQ1983 to IVQ1983 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIQ2014 would have accumulated to 22.1 percent. GDP in IIQ2014 would be $18,305.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,294.6 billion than actual $16,010.4 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.9 million unemployed or underemployed equivalent to actual unemployment of 16.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html and earlier (http://cmpassocregulationblog.blogspot.com/2014/08/fluctuating-financial-valuations.html). US GDP in IIQ2014 is 12.5 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,010.4 billion in IIQ2014 or 6.8 percent at the average annual equivalent rate of 1.0 percent. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. The long-term trend is growth at average 3.3 percent per year from Jan 1919 to Jul 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 123.2212 in Aug 2014. The actual index NSA in Aug 2014 is 101.5145, which is 17.6 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 117.7603 in Aug 2014. The output of manufacturing at 101.5145 in Aug 2014 is 13.8 percent below trend under this alternative calculation.

Table IIA-5, Net Worth of Households and Nonprofit Organizations in Billions of Dollars, IVQ1979 to IVQ1985 and IVQ2007 to IVQ2012

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	9,049.0 9,239.9
IVQ1985 IIIQ1986 IVQ1986 IQ1987 IIQ1987 IIIQ1987 IVQ1987	15,279.1 16,292.8 16,842.4 17,496.7 17,786.1 18,197.5 18,024.1
∆ USD Billions IVQ1985 IVQ1987 IQ1980-IVQ1985 IQ1980-IIIQ1986 IQ1980-IVQ1986 IQ1980-IQ1987 IQ1980-IIQ1987 IQ1980-IIIQ1987 IQ1980-IVQ1987	+6,230.1 ∆%68.8 R∆%18.5 +8,975.1 ∆%99.2 R∆%32.4 +6,039.2 ∆%65.4 R∆%21.2 +7,052.9 ∆%76.3 R∆%28.2 +7,602.5 ∆%82.3 R∆%32.1 +8,256.8 ∆%89.4 R∆%35.3 +8,546.2 ∆%92.5 R∆%35.8 +8,957.6 ∆%96.9 R∆%37.2 +8784.2 ∆%95.1 R∆%35.4
Period IVQ2007 to IIQ2013
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	66,802.7
IIQ2014	81,492.8
∆ USD Billions	+14,690.1 ∆%22.0 R∆%7.5

Net Worth = Assets – Liabilities. R∆% real percentage change or adjusted for CPI percentage change.

Reserve System, Sep 18.

Chart IIA-1 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ2007 to IQ2014. There is remarkable stop and go behavior in this series with two sharp declines and two standstills in the 19 quarters of expansion of the economy beginning in IIIQ2009. The increase in net worth of households and nonprofit organizations is the result of increases in valuations of risk financial assets and compressed liabilities resulting from zero interest rates. Wealth of households and nonprofits organization increased 7.5 percent from IVQ2007 to IIQ2014 when adjusting for consumer price inflation.

Chart IIA-1, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ2007 to IIQ2014

Reserve System, Sep 18.

Chart IIA-2 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1979 to IIIQ1987. There are changes in the rates of growth of wealth suggested by the changing slopes but there is smooth upward trend. There was significant financial turmoil during the 1980s. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5657.7 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.65 percent of GDP in a year. US GDP in 2013 is estimated at $16,768.1 billion, such that the bailout would be equivalent to cost to taxpayers of about $444.4 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery. Money center banks were under extraordinary pressure from the default of sovereign debt by various emerging nations that represented a large share of their net worth (see Pelaez 1986). Net worth of households and nonprofit organizations increased 99.2 percent from IVQ1979 to IVQ1987 and 32.4 percent when adjusting for consumer price inflation. Net worth of households and nonprofit organizations increased 95.1 percent from IQ1980 to IVQ1987 and 35.4 percent when adjusting for consumer price inflation.

Chart IIA-2, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1979 to IVQ1987

Reserve System, Sep 18.

Chart IIA-3 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1945 at $767.3 billion to IVQ2013 at $78,867.9 billion or increase of 10,178.6 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 233.049 in Dec 2013 or increase of 1,180.5 percent. There was a gigantic increase of US net worth of households and nonprofit organizations over 68 years with inflation-adjusted increase from $42.159 in dollars of 1945 to $338.418 in IVQ2013 or 702.7 percent. In a simple formula: {[($78,867.9/$767.3)/(233.049/18.2)-1]100 = 702.7%}. Wealth of households and nonprofit organizations increased from $767.3 billion at year-end 1945 to $78,867.9 billion at the end of 2013 or 10,178.6 percent. The consumer price index increased from 18.2 in Dec 1945 to 233.049 in Dec 2013 or 1180.5 percent. Net wealth of households and nonprofit organizations in dollars of 1945 increased from $42.159 in 1945 to $338.418 in 2013 or 702.7 percent at the average yearly rate of 3.1 percent. US real GDP grew at the average rate of 2.9 percent from 1945 to 2013 (http://www.bea.gov/iTable/index_nipa.cfm). The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of net worth of US households and nonprofit organizations. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 68 years when US GDP grew at 2.2 percent on average in the twenty quarters between IIIQ2009 and IIQ2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html). US GDP was $228.2 billion in 1945 and net worth of households and nonprofit organizations $767.3 billion for ratio of wealth to GDP of 3.36. The ratio of net worth of households and nonprofits of $66,802.7 billion in 2007 to GDP of $14,477.6 billion was 4.61. The ratio of net worth of households and nonprofits of $78,867.9 billion in 2013 to GDP of 16,768.1 billion was 4.70. The final data point in Chart IIA-3 is net worth of household and nonprofit institutions at $81,492.8 billion in IIQ2014 for increase of 10,520.7 percent relative to $767.3 billion in IVQ1945. CPI adjusted net worth of household and nonprofit institutions increased from $42.159 in IVQ1945 to $341.914 in IIQ2014 or 711.0 percent at the annual equivalent rate of 3.1 percent.

Chart IIA-3, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1945 to IIQ2014

Reserve System, Sep 18.

ESIV Household Income at 1995 Levels, 45 Million in Poverty and 41 Million without Health Insurance. The objective of this section is to analyze newly released data by the US Census Bureau on income, poverty and health insurance (DeNavas-Walt, Proctor and Smith 2013, DeNavas and Proctor (2014) and Smith and Medalia 2014). This report depicts 2013 household income of the US in constant 2013 dollars regressing to the level of 1995. The number of people in poverty in the US in 2013 is 46.318 million, equivalent to 14.5 percent of the population, which is almost the same as 15.0 percent in 1982 and higher than any percentage since 17.3 percent in 1965 with exception of isolated years in the range of 15.1 to 15.2 percent. The number of people without health insurance in 2013 is 41.953 million, which is equivalent to 13.4 percent of the population. Although the economy recovered throughout 2011, 2012 and 2013, income deteriorated while poverty and lack health insurance remained stress levels. Increasing poverty and lack of health insurance challenge the social and health safety net because of a sudden jump of needs for social and health services on capacity that provide those needs that is fixed in the short run while growth of the economy requires absorbing labor input and maintaining health of the stock of human capital. Part of the explanation of the dramatically poor socio-economic indicators of the US could be explained by the sharp economic contraction from IV2007 to IIQ2009 but part originates in the worst recovery in a cyclical expansion during the postwar period (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/09/geopolitical-and-financial-risks.html).

The report of the US Bureau of the Census on Income, poverty and health insurance coverage in the United States: 2013 provides highly valuable socio-economic information and analysis (DeNavas-Walt and Proctor 2014). Table IIB-1 provides years of high percentage of people below poverty in the US. Data for 2006 to 2009 are included to provide a framework of reference for the current deterioration. The series has two high points of 15.1 percent of the population in poverty in 2010 and 1993 exceeded only by 15.2 percent in 1983. The prior high numbers of poverty are found in 1960 to 1965 with 17.3 percent in 1965 and higher numbers going to 22.4 percent in 1959. The number of people in poverty in the US in 2013 was 45.318 million, which has increased by 8.858 million from 36.460 million in 2006. The fractured job market with 26.9 million unemployed or underemployed because they cannot find full-time jobs (http://cmpassocregulationblog.blogspot.com/2014/09/competitive-monetary-policy-and.html) and decline of hiring by 9.1 million (http://cmpassocregulationblog.blogspot.com/2014/09/geopolitics-monetary-policy-and.html) prevents exit from poverty. Inflation-adjusted average weekly wages stagnated.

Table IIB-1, US, Historical High Percentage of People below Poverty, Thousands and Percent

	Total Population	Number Below Poverty	Percent Below Poverty
2013	312,965	45,318	14.5
2012	310,648	46,496	15.0
2011	308,456	46,247	15.0
2010	306,130	46,343	15.1
2009	303,820	43,569	14.3
1993	259,278	39,265	15.1
1983	231,700	35,303	15.2
1982	229,412	34,398	15.0
1965	191,413	33,185	17.3
1964	189,710	36,055	19.0
1963	187,258	36,436	19.5
1962	184,276	38,625	21.0
1961	181,277	39,628	21.9
1960	179,503	39,851	22.2
1959	176,557	39,490	22.4
Memo
2009	303,820	43,569	14.3
2008	301,041	39,829	13.2
2007	298,699	37,276	12.5
2006	296,450	36,460	12.3

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014).

Millions in poverty in the calendar year in which the recession ended and in the first calendar year after the recession are provided in Table IIB-2. There have been increases in the number of people in poverty in the first calendar years after the recessions since 1980. The brief recession of Jan to Jul 1980 experienced the highest increase in the first calendar year of 1.0 percent and 2.550 million more in poverty. In the three recessions before 1980 shown in Table IIB-2, the number of people in poverty fell in the first calendar year after the end of the recession.

Table IIB-2, US, Millions in Poverty in the Calendar Year in which Recession Ended and in the First Calendar Year after Recession, Millions and ∆%

	Millions	%	Millions	%	Change Millions	% Points
Dec 2007 to Jun 2009
2009	43.569	14.3
2010			46.343	15.1	2.774	0.8
Mar 2001 to Nov 2001
2001	32.907	11.7
2002			34.570	12.1	1.663	0.4
Jul 1990 to Mar 1991
1991	35.708	14.2
1992			38.014	14.8	2.306	0.6
Jul 1981 to Nov 1982
1982	34.398	15.0
1983			35.303	15.2	0.905	0.2
Jan 1980 to July 1980
1980	29.272	13.0
1981			31.822	14.0	2.550	1.0
Nov 1973 to Mar 1975
1975	25.877	12.3
1976			24.975	11.8	-0.902	-0.5
Dec 1960 to Nov 1970
1970	25.420	12.6
1971			25.559	12.5	-0.139	-0.1
Apr 1960 to Feb 1961
1961	39.628	21.9
1962			38.625	21.0	-1.003	-0.9

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014).

Another dramatic fact revealed by DeNavas-Walt, Proctor and Smith (2013) is the increase in the number people without health insurance shown in Table IIB-3 at 49.951 million for 2010. Approximately 16.3 percent of the US population did not have health insurance in 2010. There was marginal improvement with 47.951 million without health insurance in 2012, corresponding to 15.4 percent of the population.

Table IIB-3, US, People without Health Insurance in the Final Year of Recession and in the First Calendar Year after Recession Ended, Millions and Percent

	Millions Without Health Insurance	Percent of Population
Recession Dec 2007 to Jun 2009
2009	49.985	16.4
2010	49.951	16.3
Change/2009	0.919	-0.1 % Points
2012	47.951	15.7
Change/2009	-2.034	-0.7 % Points
Recession Mar 2001 to Nov 2001
2001	38.023	13.5
2002	39.776	13.9
Change	1.753	0.4
Recession Jul 1990 to Mar 1991
1991	35.445	14.1
1992	38.641	15.0
Change	3.196	0.9

Source: DeNavas-Walt, Proctor and Smith (2013).

The population of the US increased by 16.571 million from 296.824 million in 2006 to 311.395 million in 2013, as shown in Table IIB-4. The number uncovered by health insurance decreased by 3.261 million between 2006 and 2013. The loss of private health insurance coverage by 2.878 million from 2006 to 2013 was partially compensated by an increase in government coverage by 27.238 million.

Table IIB-4, US, Population, Private and Government Health Insurance and Uncovered by Health Insurance, Thousands and Percent, 2006-2011

	Population	Private Health Insurance	Govern- ment Health Insurance	Uncovered
2013	313,395	201,064	107,581	41,953
2012	311,116	198,812	101,493	47,951
2011	308,827	197,323	99,497	48,614
2010	306,553	196,147	95,525	49,951
2009	304,280	196,245	93,245	48,985
2008	301,483	202,626	87,586	44,780
2007	299,106	203,903	83,147	44,088
2006	296,824	203,942	80,343	45,214

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014), Smith and Medalia (2014).

Median household income in the US fell 8.0 percent from $56,436 in 2007 to $51,939 in 2013, as shown in Table IIB-5. Median income fell in all years with exception of 2013 relative to 2012. Median income fell 3.9 percent in 2012 relative to 2009 even after four years of recovery of the economy.

Table IIB-5, US, Median Household Income, 2012 Dollars and

	2013	2012	2011	2010	2009	2007
NH	122,952	122,459	121,084	119,927	117,538	116,783
MINC	51,939	51,759	51,842	52,646	54,059	56,436
∆% 2013/2007			-8.0
∆% 2013/2012			0.3
∆% 2013/2011			0.2
∆% 2013/2010			-1.3
∆% 2013/2009			-3.9

Notes: NH: Total Number of Households, Thousands; MINC: Median Income, Dollars

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014).

Numbers of households in the US, median income in constant 2013 dollars and mean income also in 2013 dollars are provided in Table IIB-6. There is a dramatic fact in Table IIB-6: inflation-adjusted median household income in the US is higher in all years from 1996 to 2012 than the $51,939 of 2013. The contraction and low rate of growth in the expansion have resulted in the destruction of the progress in household income accomplished in 18 years of technological advance and use of humans, machines and natural resources in economic activity. The median measures the center of the middle class of the US that is no better off after 18 years of efforts. There is sharp contrast with the 1980s. Rapid economic growth after the contraction from Jul 1981 to Nov 1982 (http://www.nber.org/cycles.html) resulted in an increase of household median income from $46,425 in 1983 to $52,432 in 1989, or by 12.9 percent. Another fact of Table IA-6 is that household income in 2013 of $51,939 is virtually the same as $52,432 in 1989. The typical household in the US is not better off than in 1989, which is separated from the present by 24 years of efforts.

Table IIB-6, Median and Mean Household Income in 2013 Adjusted Dollars

Year	# Households	Median Income 2013 Dollars	Mean Income 2013 Dollars
2013	122,952	51,939	72,641
2012	122,459	51,759	72,310
2011	121,084	51,842	72,166
2010	119,927	52,646	72,001
2009	117,538	54,059	73,824
2008	117,181	54,423	74,029
2007	116,783	56,436	75,957
2006	116,011	55,689	76,912
2005	114,384	55,278	75,584
2004	113,343	54,674	74,569
2003	112,000	54,865	74,812
2002	111,278	54,913	74,910
2001	109,297	55,562	76,588
2000	108,209	56,800	77,287
1999	106,434	56,895	76,524
1998	103,874	55,497	74,007
1997	102,528	53,551	71,910
1996	101,018	52,471	69,666
1995	99,627	51,719	68,204
1994	98,990	50,148	67,041
1993	97,107	49,594	65,766
1992	96,426	49,836	63,182
1991	95,669	50,249	63,253
1990	94,312	51,735	64,624
1989	93,347	52,432	66,243
1988	92,830	51,514	64,365
1987	91,124	51,121	63,575
1986	89,479	50,488	62,375
1985	88,458	48,761	60,009
1984	86,789	47,866	58,648
1983	85,407	46,425	56,463
1982	83,918	46,751	56,342
1981	83,527	46,877	56,002
1980	82,368	47,668	56,693

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014).

The percentage change in median household income and the change in number of workers with earnings in the first calendar years after recessions are provided in Table IIB-7. The first calendar year after the end of recession in 2010 is by far the worst of any such year in recessions since 1970. Household median income fell 2.6 percent from 2009 to 2010 and the number of workers with earnings fell by 1.334 million. The first calendar year 2010 after the end of recession in 2009 is the only in the recessions back to 1970 in which there was decline of the number of workers with earnings and the one with lowest increase in full-time year-round workers.

Table IIB-7, Percentage Change in Median Household Income and Change in Number of Workers with Earnings in First Calendar Years after Recessions, ∆% and Thousands

	Median Household Income ∆%	Change in Number of Workers with Earnings Thousands	Change in Full-time Year-round Workers Thousands
Recession Dec 2007 to June 2009
2010	-2.6	-1,334	192
Recession Mar 2001 to Nov 2001
2002	-1.2	470	286
Recession Jul 1990 to Mar 1991
1992	-0.8	1,692	1,468
Recession Jul 1981 to Nov 1982
1983	-0.7	1,696	2,887
Recession Jan 1980 to Jul 1980
1981	-1.7	995	362
Recession Nov 1973 to Mar 1975
1976	1.7	2,821	1,538
Recession Dec 1960 to Nov 1970
1971	-1.0	1,277	1,213

Source:

DeNavas-Walt, Proctor and Smith (2013).

ESV United States Housing Collapse. Data and other information continue to provide depressed conditions in the US housing market in a longer perspective, with recent improvement at the margin. Table IIB-1 shows sales of new houses in the US at seasonally adjusted annual equivalent rate (SAAR). House sales fell in eighteen of forty-four months from Jan 2011 to Aug 2014 with concentration in monthly declines of five in 2011 and six in 2013. In Jan-Apr 2012, house sales increased at the annual equivalent rate of 11.8 percent and at 22.3 percent in May-Sep 2012. There was significant strength in Sep-Dec 2011 with annual equivalent rate of 48.4 percent. Sales of new houses fell 7.0 percent in Oct 2012 with increase of 9.5 percent in Nov 2012. Sales of new houses rebounded 13.5 percent in Jan 2013 with annual equivalent rate of 62.9 percent from Oct 2012 to Jan 2013 because of the increase of 13.5 percent in Jan 2013. New house sales fell at annual equivalent 16.1 percent in Feb-Mar 2013. New house sales weakened, increasing at 0.8 percent in annual equivalent from Apr to Dec 2013 with significant volatility illustrated by decline of 20.0 percent in Jul 2013 and increase of 12.8 percent in Oct 2013. New house sales fell 0.7 percent in Dec 2013. New house sales increased 3.4 percent in Jan 2014 and fell 5.5 percent in Feb 2014 and 6.7 percent in Mar 201. New house sales increased 2.5 percent in Apr 2014 and 10.9 percent in May 2014. New house sales fell 8.5 percent in Jun 2014 and increased 1.9 percent in Jul 2014. New house sales jumped 18.0 percent in Aug 2014. The annual equivalent rate in Jan-Aug 2014 was 14.0 percent. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), analyze how builders have provided financial assistance to home buyers, including those short of cash and with weaker credit background, explaining the rise in new home sales and the highest gap between prices of new and existing houses. The 30-year conventional mortgage rate increased from 3.40 on Apr 25, 2013 to 4.58 percent on Aug 22, 2013 (http://www.federalreserve.gov/releases/h15/data.htm), which could also be a factor in recent weakness with improvement after the rate fell to 4.26 in Nov 2013. The conventional mortgage rate rose to 4.48 percent on Dec 26, 2013 and fell to 4.32 percent on Jan 30, 2014. The conventional mortgage rate increased to 4.37 percent on Feb 26, 2014 and 4.40 percent on Mar 27, 2014. The conventional mortgage rate fell to 4.14 percent on Apr 22, 2014, stabilizing at 4.14 on Jun 26, 2014. The conventional mortgage rate stood at 4.20 percent on Sep 25, 2014. The conventional mortgage rate measured in a survey by Freddie Mac (http://www.freddiemac.com/pmms/release.html) is the “contract interest rate on commitments for fixed-rate first mortgages” (http://www.federalreserve.gov/releases/h15/data.htm).

Table IIB-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %

	SA Annual Rate Thousands	∆%
Aug 2014	504	18.0
Jul	427	1.9
Jun	419	-8.5
May	458	10.9
Apr	413	2.5
Mar	403	-6.7
Feb	432	-5.5
Jan	457	3.4
AE ∆% Jan-Aug		14.0
Dec 2013	442	-0.7
Nov	445	-1.1
Oct	450	12.8
Sep	399	5.3
Aug	379	3.3
Jul	367	-20.0
Jun	459	6.5
May	431	-4.6
Apr	452	2.7
AE ∆% Apr-Dec		0.8
Mar	440	-1.8
Feb	448	-1.1
AE ∆% Feb-Mar		-16.1
Jan	453	13.5
Dec 2012	399	1.8
Nov	392	9.5
Oct	358	-7.0
AE ∆% Oct-Jan		62.9
Sep	385	2.7
Aug	375	1.6
Jul	369	2.5
Jun	360	-2.7
May	370	4.5
AE ∆% May-Sep		22.3
Apr	354	0.0
Mar	354	-3.3
Feb	366	9.3
Jan	335	-1.8
AE ∆% Jan-Apr		11.8
Dec 2011	341	4.0
Nov	328	3.8
Oct	316	3.9
Sep	304	1.7
AE ∆% Sep-Dec		48.4
Aug	299	1.0
Jul	296	-1.7
Jun	301	-1.3
May	305	-1.6
AE ∆% May-Aug		-10.3
Apr	310	3.3
Mar	300	11.1
Feb	270	-12.1
Jan	307	-5.8
AE ∆% Jan-Apr		-14.2
Dec 2010	326	13.6

AE: Annual Equivalent

Source: US Census Bureau

http://www.census.gov/construction/nrs/

There is additional information of the report of new house sales in Table IIB-2. The stock of unsold houses fell from rates of 6 to 7 percent of sales in 2011 to 4 to 5 percent in 2013 and 4.8 percent in Aug 2014. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), find that inventories of houses have declined as investors acquire distressed houses of higher quality. Median and average house prices oscillate. In Aug 2014, median prices of new houses sold not seasonally adjusted (NSA) decreased 1.6 percent after decreasing 1.1 percent in Jul 2014. Average prices increased 0.8 percent in Aug 2014 and increased 3.3 percent in Jul 2014. Between Dec 2010 and Aug 2014, median prices increased 14.3 percent, partly concentrated in increases of 4.4 percent in May 2014 and 5.2 percent in Mar 2014. Average prices increased 19.3 percent between Dec 2010 and Aug 2014, with increase of 0.8 percent in Aug 2014. Between Dec 2010 and Dec 2012, median prices increased 7.1 percent and average prices increased 2.6 percent. Price increases concentrated in 2012 with increase of median prices of 18.2 percent from Dec 2011 to Dec 2012 and of average prices of 13.8 percent. Median prices increased 6.7 percent from Dec 2012 to Aug 2014, with decrease of 1.6 percent in Aug 2014, while average prices increased 16.3 percent, with increase of 0.8 percent in Aug 2014. Robbie Whelan, writing on “New homes hit record as builders cap supply,” on May 24, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323475304578500973445311276.html?mod=WSJ_economy_LeftTopHighlights), finds that homebuilders are continuing to restrict the number of new homes for sale. Restriction of available new homes for sale increases prices paid by buyers.

Table IIB-2, US, New House Stocks and Median and Average New Homes Sales Price

	Unsold* Stocks in Equiv. Months of Sales SA %	Median New House Sales Price USD NSA	Month ∆%	Average New House Sales Price USD NSA	Month ∆%
Aug 2014	4.8	275,600	-1.6	347,900	0.8
Jul	5.6	280,100	-1.1	345,100	3.3
Jun	5.6	283,100	-1.2	334,100	3.3
May	5.0	286,600	4.4	323,500	-0.5
Apr	5.5	274,500	-2.8	325,100	-1.9
Mar	5.7	282,300	5.2	331,500	1.7
Feb	5.2	268,400	-0.5	325,900	-3.4
Jan	5.0	269,800	-2.1	337,300	5.0
Dec 2013	5.1	275,500	-0.6	321,200	-4.3
Nov	5.0	277,100	4.8	335,600	0.0
Oct	4.9	264,300	-2.0	335,700	4.4
Sep	5.5	269,800	5.7	321,400	3.4
Aug	5.5	255,300	-2.6	310,800	-5.8
Jul	5.6	262,200	0.9	329,900	7.8
Jun	4.2	259,800	-1.5	306,100	-2.5
May	4.5	263,700	-5.6	314,000	-6.8
Apr	4.3	279,300	8.5	337,000	12.3
Mar	4.2	257,500	-2.9	300,200	-3.9
Feb	4.1	265,100	5.4	312,500	1.8
Jan	3.9	251,500	-2.6	306,900	2.6
Dec 2012	4.5	258,300	5.4	299,200	2.9
Nov	4.6	245,000	-0.9	290,700	1.9
Oct	4.9	247,200	-2.9	285,400	-4.1
Sep	4.5	254,600	0.6	297,700	-2.6
Aug	4.6	253,200	6.7	305,500	8.2
Jul	4.6	237,400	2.1	282,300	3.9
Jun	4.8	232,600	-2.8	271,800	-3.2
May	4.7	239,200	1.2	280,900	-2.4
Apr	4.9	236,400	-1.4	287,900	1.5
Mar	4.9	239,800	0.0	283,600	3.5
Feb	4.8	239,900	8.2	274,000	3.1
Jan	5.3	221,700	1.4	265,700	1.1
Dec 2011	5.3	218,600	2.0	262,900	5.2
Nov	5.7	214,300	-4.7	250,000	-3.2
Oct	6.0	224,800	3.6	258,300	1.1
Sep	6.3	217,000	-1.2	255,400	-1.5
Aug	6.5	219,600	-4.5	259,300	-4.1
Jul	6.7	229,900	-4.3	270,300	-1.0
Jun	6.6	240,200	8.2	273,100	4.0
May	6.6	222,000	-1.2	262,700	-2.3
Apr	6.7	224,700	1.9	268,900	3.1
Mar	7.2	220,500	0.2	260,800	-0.8
Feb	8.1	220,100	-8.3	262,800	-4.7
Jan	7.3	240,100	-0.5	275,700	-5.5
Dec 2010	7.0	241,200	9.8	291,700	3.5

*Percent of new houses for sale relative to houses sold

Source: US Census Bureau

http://www.census.gov/construction/nrs/

The depressed level of residential construction and new house sales in the US is evident in Table IIB-3 providing new house sales not seasonally adjusted in Jan-Aug of various years. Sales of new houses are virtually the same in Jan-Aug 2014 relative to Jan-Aug 2013 with increase of 2.7 percent. Sales of new houses in Jan-Aug 2014 are substantially lower than in any year between 1963 and 2014 with the exception of the years from 2009 to 2012. There are only four increases of 20.9 percent relative to Jan-Aug 2012, 46.9 percent relative to Jan-Aug 2011, 32.9 percent relative to Jan-Aug 2010 and 17.6 percent relative to Jan-Aug 2009. Sales of new houses in Jan-Aug 2014 are lower by 15.9 percent relative to Jan-Aug 2008, 46.8 percent relative to 2007, 59.4 percent relative to 2006 and 66.1 percent relative to 2005. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan-Aug 2014 relative to the same period in 2004 fell 63.5 percent and 59.6 percent relative to the same period in 2003. Similar percentage declines are also observed for 2014 relative to years from 2000 to 2004. Sales of new houses in Jan-Aug 2014 fell 34.1 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table IIB-3 reveals catastrophic data: sales of new houses in Jan-Aug 2014 of 307 thousand units are lower by 22.7 percent relative to 341 thousand units of houses sold in Jan-Aug 1963, the first year when data become available. The civilian noninstitutional population increased from 123.360 million in Dec 1963 to 246.745 million in Dec 2013, or 100.0 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”

Table IIB-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan-Aug 2014	307
Jan-Aug 2013	299
∆% Jan-Aug 2014/Jan-Aug 2013	2.7
Jan-Aug 2012	254
∆% Jan-Aug 2014/Jan-Aug 2012	20.9
Jan-Aug 2011	209
∆% Jan-Aug 2014/Jan-Aug 2011	46.9
Jan-Aug 2010	231
∆% Jan-Aug 2014/ Jan-Aug 2010	32.9
Jan-Aug 2009	261
∆% Jan-Aug 2014/ Jan-Aug 2009	17.6
Jan-Aug 2008	365
∆% Jan-Aug 2014/ Jan-Aug 2008	-15.9
Jan-Aug 2007	577
∆% Jan-Aug 2014/ Jan-Aug 2007	-46.8
Jan-Aug 2006	756
∆% Jan-Aug 2014/Jan-Aug 2006	-59.4
Jan-Aug 2005	906
∆% Jan-Aug 2014/Jan-Aug 2005	-66.1
Jan-Aug 2004	841
∆% Jan-Aug 2014/Jan-Aug 2004	-63.5
Jan-Aug 2003	759
∆% Jan-Aug 2014/ Jan-Aug 2003	-59.6
Jan-Aug 2002	670
∆% Jan-Aug 2014/ Jan-Aug 2002	-54.2
Jan-Aug2001	644
∆% Jan-Aug 2014/ Jan-Aug 2001	-52.3
Jan-Aug 2000	608
∆% Jan-Aug 2014/ Jan-Aug 2000	-49.5
Jan-Aug 1995	466
∆% Jan-Aug 2014/ Jan-Aug 1995	-34.1
Jan-Aug 1963	397
∆% Jan-Aug 2014/ Jan-Aug 1963	-22.7

*Computed using unrounded data

Source: US Census Bureau

http://www.census.gov/construction/nrs/

Table IIB-4 provides the entire available annual series of new house sales from 1963 to 2013. The revised level of 306 thousand new houses sold in 2011 is the lowest since 560 thousand in 1963 in the 48 years of available data while the level of 368 thousand in 2012 is only higher than 323 thousand in 2010. The level of sales of new houses of 429 thousand in 2013 is the lowest from 1963 to 2009 with exception of 412 thousand in 1982. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. The civilian noninstitutional population of the US increased from 122.416 million in 1963 to 245.679 million in 2013 or 100.7 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”

The civilian noninstitutional population is the universe of the labor force. In fact, there is no year from 1963 to 2013 in Table IIA-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009, 2010, 2011 and 2012.

Table IIB-4, US, New Houses Sold, NSA Thousands

Year	New Houses Sold Thousands
1963	560
1964	565
1965	575
1966	461
1967	487
1968	490
1969	448
1970	485
1971	656
1972	718
1973	634
1974	519
1975	549
1976	646
1977	819
1978	817
1979	709
1980	545
1981	436
1982	412
1983	623
1984	639
1985	688
1986	750
1987	671
1988	676
1989	650
1990	534
1991	509
1992	610
1993	666
1994	670
1995	667
1996	757
1997	804
1998	886
1999	880
2000	877
2001	908
2002	973
2003	1,086
2004	1,203
2005	1,283
2006	1,051
2007	776
2008	485
2009	375
2010	323
2011	306
2012	368
2013	429

Source: US Census Bureau

http://www.census.gov/construction/nrs/

Chart IIB-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau followed by increase and stability.

Chart IIB-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally Adjusted Annual Rate)

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr051.html

Percentage changes and average rates of growth of new house sales for selected periods are shown in Table IIB-5. The percentage change of new house sales from 1963 to 2013 is minus 23.4 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 6.0 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2013 fell 35.7 percent relative to the same period in 1995 and 66.6 percent relative to 2005.

Table IIB-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses

	∆%	Average Yearly % Rate
1963-2013	-23.4	NA
1991-2001	78.4	6.0
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2013	-35.7	NA
2000-2013	-51.1	NA
2005-2013	-66.6	NA

NA: Not Applicable

Source: US Census Bureau

http://www.census.gov/construction/nrs/

Chart IIB-2 of the US Bureau of the Census provides the entire monthly sample of new houses sold in the US between Jan 1963 and Aug 2014 without seasonal adjustment. The series is almost stationary until the 1990s. There is sharp upward trend from the early 1990s to 2005-2006 after which new single-family houses sold collapse to levels below those in the beginning of the series in the 1960s.

Chart IIB-2, US, New Single-family Houses Sold, NSA, 1963-2014

Source: US Census Bureau

http://www.census.gov/construction/nrs/

ESVI United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are in Table I-1. Data are not seasonally adjusted to permit comparison between Aug 2013 and Aug 2014. Total assets of US commercial banks grew 8.5 percent from $13,661.9 billion in Aug 2013 to $14,816.5 billion in Aug 2014. US GDP in 2013 is estimated at $16,768.1 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 80 percent of US GDP. Bank credit grew 6.0 percent from $9984.8 billion in Aug 2013 to $10,582.9 billion in Aug 2014. Securities in bank credit increased 5.4 percent from $2682.4 billion in Aug 2013 to $2826.9 billion in Aug 2014. A large part of securities in banking credit consists of US Treasury and agency securities, increasing 7.9 percent from $1786.9 billion in Aug 2013 to $1929.0 billion in Aug 2014. Credit to the government that issues or backs Treasury and agency securities of $1929.0 billion in Aug 2014 is about 18.2 percent of total bank credit of US commercial banks of $10,582.9 billion. Mortgage-backed securities, providing financing of home loans, increased 2.3 percent, from $1320.8 billion in Aug 2013 to $1350.8 billion in Aug 2014. Loans and leases are relatively more dynamic, growing 6.2 percent from $7302.4 billion in Aug 2013 to $7756.0 billion in Aug 2014. The only dynamic class is commercial and industrial loans, growing 11.7 percent from Aug 2013 to Aug 2014 and providing $1739.9 billion or 22.4 percent of total loans and leases of $7756.0 billion in Aug 2014. Real estate loans increased 2.4 percent, providing $3612.1 billion in Aug 2014 or 46.6 percent of total loans and leases. Consumer loans increased 3.7 percent, providing $1184.7 billion in Aug 2014 or 15.3 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks increased 24.0 percent from $2342.1 billion in Aug 2013 to $2904.0 billion in Aug 2014 but a single year of the series masks exploding cash in banks because of unconventional monetary policy, which is discussed below. Bank deposits increased 7.3 percent from $9490.2 billion in Aug 2013 to $10,179.8 billion in Aug 2014. The difference between bank deposits and total loans and leases in banks increased from $2187.8 billion in Aug 2013 to $2423.8 billion in Aug 2014 or by $236.0 billion. Securities in bank credit increased by $144.5 billion from $2682.4 billion in Aug 2013 to $2826.9 billion in Aug 2014 and Treasury and agency securities increased by $142.1 billion from $1786.9 billion in Aug 2013 to $1929.0 billion in Aug 2014. Loans and leases increased $453.6 billion from $7302.4 billion in Aug 2013 to $7756.0 billion in Aug 2014. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Investing in securities with high duration, or price elasticity of yields, is riskier because of the increase in yields that can cause loss of principal as investors shift away from bond funds into money market funds invested in short-term assets. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IIQ2014 higher by only 4.6 percent than in IVQ2007 (Table IB-2 IX Conclusion and extended analysis in IB Collapse of United States Dynamism of Income Growth and Employment Creation) in contrast with 14.3 percent higher if the economy had performed in long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May). In contrast, real disposable income per capita grew cumulatively 16.7 percent in the cycle from IQ1980 to IVQ1987 that was close to trend growth of 17.7 percent.

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

	Aug 2013	Aug 2014	∆%
Total Assets	13,661.9	14,816.5	8.5
Bank Credit	9,984.8	10,582.9	6.0
Securities in Bank Credit	2682.4	2826.9	5.4
Treasury & Agency Securities	1786.9	1929.0	7.9
Mortgage-Backed Securities	1320.8	1350.8	2.3
Loans & Leases	7302.4	7756.0	6.2
Real Estate Loans	3526.8	3612.1	2.4
Commercial Real Estate Loans	1460.2	1565.1	7.2
Consumer Loans	1142.1	1184.7	3.7
Commercial & Industrial Loans	1557.3	1739.9	11.7
Other Loans & Leases	1076.1	1219.3	13.3
Cash Assets*	2342.1	2904.0	24.0
Total Liabilities	12,158.3	13,216.1	8.7
Deposits	9490.2	10,179.8	7.3
Residual (Assets less Liabilities)	1503.6	1600.4	NA

Note: balancing item of residual assets less liabilities not included

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

Source: Board of Governors of the Federal Reserve System

Benchmarked to Sep 2013

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

Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are in Table I-2 annually from 2009 to 2013 and for Jul 2014 and Aug 2014. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.6 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.7 percent in 2010. Commercial and industrial loans fell 18.4 percent in 2009 and 9.0 percent in 2010. Unconventional monetary policy caused an increase of cash assets of banks of 159.2 percent in 2008, 49.5 percent in 2009 and 47.6 percent in 2011 followed by decline by 2.1 percent in 2012. Cash assets of banks increased 55.2 percent in 2013. Cash assets of banks increased at the SAAR of 22.5 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012. Cash assets of banks increased at 56.0 percent in Nov 2012, minus 7.8 percent in Dec 2012, 38.8 percent in Jan 2013, 66.2 percent in Feb 2013, 66.0 percent in Mar 2013 and 14.5 percent in Apr 2013. Cash assets of banks increased at the SAAR of 63.2 percent in May 2013, 42.4 percent in Jun 2013, 28.6 percent in Jul 2013, 71.5 percent in Aug 2013, 57.5 percent in Sep 2013 and 50.2 percent in Oct 2013. Cash assets of banks increased at the rate of 29.0 percent in Nov 2013 and fell at 1.5 percent in Dec 2013. Cash assets of banks increased at 20.1 percent in Jan 2014 and at 20.5 percent in Feb 2014. Cash assets of banks increased at 24.4 percent in Mar 2014 and at 8.1 percent in Apr 2014. Cash assets of banks increased at 3.5 percent in May 2014 and 36.0 percent in Jun 2014. Cash assets of banks increased at 6.8 percent in Jul 2014 and 16.2 percent in Aug 2014. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that banks held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit: growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.7 percent in Oct 2012, 1.7 percent in Nov 2012 and 20.5 percent in Dec 2012. There were declines of securities in bank credit at 1.1 percent in Jan 2013, 3.2 percent in Feb 2013 and 2.7 percent in Mar 2013 but growth of 1.5 percent in Apr 2013. Securities in bank credit fell at the SAAR of 2.6 percent in May 2013 and 5.7 percent in Jun 2013. Securities in bank credit fell at the SAAR of 11.9 percent in Jul 2013 and at 8.3 percent in Aug 2013. Securities in bank credit fell at the SAAR of 6.8 percent in Sep 2013 and increased at 3.0 percent in Oct 2013. Securities in bank credit increased at 5.2 percent in Nov 2013 and at 10.5 percent in Dec 2013. Securities in bank credit increased at 4.1 percent in Jan 2014 and at 8.3 percent in Feb 2014. Securities in bank credit increased at 7.8 percent in Mar 2014 and at 4.4 percent in Apr 2014. Securities in bank credit increased at 10.1 percent in May 2014 and 8.4 percent in Jun 2014. Securities in bank credit increased at 11.5 percent in Jul 2014 and fell at 1.4 percent in Aug 2014. Fear of loss of principal in securities with high duration or price elasticity of yield is shifting investments away from bonds into cash and other assets with less price risk. Positions marked to market in balance sheets experience sharp declines. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit: with growth of 13.5 percent in 2009 and 15.2 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012. Treasury and agency securities in bank credit fell at the rate of 0.8 percent in Nov 2012, increasing at 17.2 percent in Dec 2012. Treasury and agency securities in bank credit fell at 5.9 percent in Jan 2013, 3.1 percent in Feb 2013, 7.0 percent in Mar 2013 and 5.4 percent in Apr 2013 and 8.3 percent in May 2013. Treasury and agency securities in US commercial banks fell at the SAAR of 6.8 percent in Jun 2013, 19.7 percent in Jul 2013 and 15.7 percent in Aug 2013. Treasury and agency securities fell at the SAAR of 5.6 percent in Sep 2013 and increased at 1.3 percent in Oct 2013. Treasury and agency securities increased at 5.6 percent in Nov 2013 and at 8.9 percent in Dec 2013. Treasury and agency securities increased at 4.2 percent in Jan 2014 and at 8.1 percent in Feb 2014. Treasury and agency securities increased at 9.3 percent in Mar 2014 and at 7.9 percent in Apr 2014. Treasury and agency securities increased at 17.4 percent in May 2014 and 10.1 percent in Jun 2014. Treasury and agency securities increased at 16.6 percent in Jul 2014 and at 5.4 percent in Aug 2014. Increases in yield result in capital losses that may explain less interest in holding securities with higher duration. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.7 percent in Nov 2012, 18.7 percent in Dec 2012, 2.7 percent in Jan 2013. Deposits grew at the rate of 4.4 percent in Feb 2013, 7.7 percent in Mar 2013, 3.5 percent in Apr 2013 and 2.4 percent in May 2013. Deposits increased at the SAAR of 6.3 percent in Jun 2013, 8.0 percent in Jul 2013 and 3.5 percent in Aug 2013. Deposits grew at the rate of 7.2 percent in Sep 2013 and at 9.0 percent in Oct 2013. Deposits grew at 9.1 percent in Nov 2013 and at 9.1 percent in Dec 2013. Deposits increased at 8.7 percent in Jan 2014 and at 9.6 percent in Feb 2014. Deposits grew at 6.7 percent in Mar 2014 and at 8.4 percent in Apr 2014. Deposits grew at 7.9 percent in May 2014 and 3.4 percent in Jun 2014. Deposits increased at 7.9 percent in Jul 2014 and fell at 0.7 percent in Aug 2014. The credit intermediation function of banks is broken because of adverse expectations on future business and cannot be fixed by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.

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

	2009	2010	2011	2012	2013	Jul 2014	Aug 2014
Total Assets	-6.0	-2.6	5.3	2.6	7.2	9.9	4.9
Bank Credit	-6.7	-2.6	1.6	4.1	1.1	9.7	4.7
Securities in Bank Credit	6.2	6.9	1.8	7.5	-2.0	11.5	-1.4
Treasury & Agency Securities	13.5	15.2	3.2	8.4	-5.6	16.6	5.4
Other Securities	-4.3	-7.1	-1.1	5.7	6.2	0.8	-15.4
Loans & Leases	-10.2	-5.7	1.6	2.9	2.3	9.1	6.8
Real Estate Loans	-5.6	-5.5	-3.7	-1.1	-1.0	3.2	2.3
Commercial Real Estate Loans	-4.7	-8.8	-6.4	-1.2	4.4	7.9	6.6
Consumer Loans	-3.2	-6.8	-1.1	1.0	3.5	9.6	4.1
Commercial & Industrial Loans	-18.4	-9.0	8.5	11.6	7.4	15.2	12.1
Other Loans & Leases	-23.1	0.3	18.8	7.5	4.7	17.6	15.7
Cash Assets	49.5	-7.8	47.6	-2.1	55.2	6.8	16.2
Total Liabilities	-7.1	-3.3	5.5	2.3	8.1	11.5	3.6
Deposits	5.2	2.4	6.7	7.2	6.4	7.9	-0.7

Source: Board of Governors of the Federal Reserve System

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

Chart I-16 is quite revealing in analyzing the state of bank credit in the US economy. The upper curves are (1) deposits and (2) loans and leases in bank credit. Historically since 1973, the level and rate of change of deposits and loans and leases in bank credit were almost identical. The lower two curves are Treasury and agency securities in bank credit and cash assets with treasury and agency securities moving closely with cash assets until the 1990s when Treasury and agency securities exceeded cash assets. The shaded area of the recession from IV2007 to IIQ2009 shows a break in the level and rate of movement of the series. Deposits continued to expand rapidly through the recession and the following expansion period. Loans and leases fell and barely recovered the level before the recession while deposits moved nearly vertically well above the level before the recession. While Treasury and agency securities in bank credit continued to expand at a higher rate, reaching a level well above that before the recession, cash assets jumped as the counterpart of excess reserves in banks that financed quantitative easing or massive outright purchases of securities for the balance sheet of the Fed. Unconventional monetary policy of zero interest rates and outright purchases of securities caused sharp increases of deposits, cash assets and Treasury and agency securities in bank credit but not in loans and leases. There is much discussion about the almost impossible task of evaluating monetary policy in terms of costs and benefits. Before the financial crisis, Chairman Greenspan (2004) analyzes monetary policy and its limitations (see Pelaez and Pelaez, The Global Recession Risk (2007), 13-4, 212-13) that do not differ from those of private financial institutions:

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

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

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

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

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

Risk management tools are as likely to fail in private financial institutions as in central banks because of the difficulty of modeling risk during uncertainty. There is no such thing as riskless financial management.

Chart I-16, US, Deposits, Treasury and Government Securities in Bank Credit, Loans and Leases in Bank Credit and Cash Assets, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2014, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

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

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