Peaking Valuations of Risk Financial Assets, United States Commercial Banks, Collapse of United States Dynamism of Income Growth and Employment Creation, World Cyclical Slow Growth and Global Recession Risk: Part I

 

Peaking Valuations of Risk Financial Assets, United States Commercial Banks, Collapse of United States Dynamism of Income Growth and Employment Creation, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014

I Peaking Valuations of Risk Financial Assets

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

II United States Commercial Banks

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 Peaking Valuations of Risk Financial Assets

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

ESIV United States Commercial Banks Assets and Liabilities

ESV Slowing World Economic Growth

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:

1. China’s Economic Growth. Cumulative growth of China’s GDP in IIIQ2014 relative to the same period in 2013 was 7.4 percent. Secondary industry accounts for 44.2 percent of cumulative GDP in IIIQ2014. In cumulative IIIQ2014, industry alone accounts for 37.4 percent of GDP and construction with the remaining 6.8 percent. Tertiary industry accounts for 46.7 percent of cumulative GDP in IIIQ2014 and primary industry for 9.0 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. In IIIQ2014, GDP grew 7.3 percent relative to a year earlier and 1.9 percent relative to the prior quarter, which is 7.8 percent in annual equivalent (Section VC and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.htm 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.
2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 26.0 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.
3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
4. World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2014/12/patience-on-interest-rate-increases.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/squeeze-of-economic-activity-by-carry.html and earlier 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:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies with alternating episodes of revaluation.
3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion 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 Dec 30, 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
10/02/14	0.09	2.44	4.76
10/09/14	0.08	2.34	4.68
10/16/14	0.09	2.17	4.64
10/23/14	0.09	2.29	4.71
11/13/14	0.09	2.35	4.82
11/20/14	0.10	2.34	4.86
11/26/14	0.10	2.24	4.73
12/04/14	0.12	2.25	4.78
12/11/14	0.12	2.19	4.72
12/18/14	0.13	2.22	4.78
12/23/14	0.13	2.26	4.79
12/30/14	0.06	2.20	4.69

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 Dec 17, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20141217a.htm):

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, 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. Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, 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. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated” (emphasis added)” (emphasis added).

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 the press conference following the meeting on Dec 17, 2014, Chair Yellen answered a question by Jon Hilseranth of the Wall Street Journal explaining “patience” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf):

“So I did say that this statement that the committee can be patient

should be interpreted as meaning that it is unlikely to begin the normalization process, for at least

the next couple of meetings. Now that doesn't point to any preset or predetermined time at which

normalization is -- will begin. There are a range of views on the committee, and it will be

dependent on how incoming data bears on the progress, the economy is making. First of all, I

want to emphasize that no meeting is completely off the table in the sense that if we do see faster

progress toward our objectives than we currently expect, then it is possible that the process of

normalization would occur sooner than we now anticipated. And of course the converse is also

true. So at this point, we think it unlikely that it will be appropriate, that we will see conditions

for at least the next couple of meetings that will make it appropriate for us to decide to begin

normalization. A number of committee participants have indicated that in their view, conditions

could be appropriate by the middle of next year. But there is no preset time.”

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 Dec 30, 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 Dec 30, 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 Dec 30, 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.

The minutes of the meeting of the Federal Open Market Committee (FOMC) on Sep 16-17, 2014, reveal concern with global economic conditions (http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm):

“Most viewed the risks to the outlook for economic activity and the labor market as broadly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated, structural productivity continued to increase only slowly, or the recovery in residential construction continued to lag.”

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 Sep 2014 to Nov 2014, CPI inflation for all items seasonally adjusted was minus 0.8 percent in annual equivalent, obtained by calculating accumulated inflation from Sep 2014 to Nov 2014 and compounding for a full year. In the 12 months ending in Nov 2014, CPI inflation of all items not seasonally adjusted was 1.3 percent. Inflation in Nov 2014 seasonally adjusted was minus 0.3 percent relative to Oct 2014, or minus 3.5 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 1.6 percent in annual equivalent Sep 2014-Nov 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 0.018 percent for one month, 0.025 percent for three months, 0.114 percent for six months, 0.224 percent for one year, 0.681 percent for two years, 1.065 percent for three years, 1.612 percent for five years, 1.915 percent for seven years, 2.111 percent for ten years and 2.690 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 Nov 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 Nov 2014/Nov 2013 NSA	∆% Annual Equivalent Sep 2014 to Nov 2014 SA
CPI All Items	1.3	-0.8
CPI ex Food and Energy	1.7	1.6

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 Jan 2, 2015, Dec 31, 2013, May 1, 2013, Jan 2, 2014 and Jan 3, 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 2.12 percent on Jan 2, 2015, 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 2.12 percent would jump instantaneously from yield of 2.12 percent on Jan 2, 2015 to 4.37 percent as occurred on Jan 3, 2006 when the economy was closer to full employment. The price of the hypothetical bond issued with coupon of 2.12 percent would drop from 100 to 81.9289 after an instantaneous increase of the yield to 4.37 percent. The price loss would be 18.1 percent. Losses absorb capital available for positioning, triggering crossfire sales in multiple asset classes (Brunnermeier and Pedersen 2009). What is the path of adjustment of zero interest rates on fed funds and artificially low bond yields? There is no painless exit from unconventional monetary policy. Chris Dieterich, writing on “Bond investors turn to cash,” on Jul 25, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323971204578625900935618178.html), uses data of the Investment Company Institute (http://www.ici.org/) in showing withdrawals of $43 billion in taxable mutual funds in Jun, which is the largest in history, with flows into cash investments such as $8.5 billion in the week of Jul 17 into money-market funds.

Table VIII-2, United States, Treasury Yields

	1/02/15	12/31/13	5/01/13	1/02/14	1/03/06
1 M	0.02	0.01	0.03	0.01	4.05
3 M	0.02	0.07	0.06	0.07	4.16
6 M	0.11	0.10	0.08	0.09	4.40
1 Y	0.25	0.13	0.11	0.13	4.38
2 Y	0.66	0.38	0.20	0.39	4.34
3 Y	1.07	0.78	0.30	0.76	4.30
5 Y	1.61	1.75	0.65	1.72	4.30
7 Y	1.92	2.45	1.07	2.41	4.32
10 Y	2.12	3.04	1.66	3.00	4.37
20 Y	2.41	3.72	2.44	3.68	4.62
30 Y	2.69	3.96	2.83	3.92	NA

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 3.83 percent on Dec 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 Dec 18, 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 1.2003 EUR on Jan 2, 2015 or by 0.7 percent {[(1.20031.192)-1]100 = 2.2%}. 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 6.2063/USD on Fri Jan 2, 2015, or by an additional 9.0 percent, for cumulative revaluation of 25.0 percent. The final row of Table VI-2 shows: devaluation of 0.6 percent in the week of Dec 12, 2014; devaluation of 0.6 percent in the week of Dec 19, 2014; devaluation of 0.1 percent in the week of Dec 26, 2014; and revaluation of 0.3 percent in the week of Jan 2, 2015. 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	1/02/15
Rate	1.1423	1.5914	1.192	1.2003
CNY/USD	01/03 2000	07/21 2005	7/15 2008	1/02/ 2015
Rate	8.2765	8.2765	6.8211	6.2063
Weekly Rates	12/12/2014	12/19/2014	12/26/2014	1/02/ 2015
CNY/USD	6.1852	6.2226	6.2276	6.2063
∆% from Earlier Week*	-0.6	-0.6	-0.1	0.3

*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 Dec 24, 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 6.2148/USD on Dec 24, 2014, which is the last data point in Chart VI-1. Revaluation of the CNY relative to the USD by 25.0 percent by Jan 2, 2015 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. The final segment shows decline or revaluation with another upward move 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-Dec 24, 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 Dec 24, 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 6.2148/USD on Dec 24, 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-Dec 24, 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 Dec 24, 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 1.4 percent. Another devaluation is from CNY 6.0402/USD on Jan 14, 2014 to CNY 6.2148 on Dec 24, 2014, or devaluation of 2.9 percent. The United States Treasury estimates US government debt held by private investors at $9829 billion in Sep 2014. China’s holding of US Treasury securities of $1253 billion in Oct 2014 represent 12.7 percent of US government marketable interest-bearing debt held by private investors (http://www.fiscal.treasury.gov/fsreports/rpt/treasBulletin/treasBulletin_home.htm). 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 $1174.4 billion in Oct 2013 to $1222.4 billion in Oct 2014 or 4.1 percent. The combined holdings of China and Japan in Oct 2014 add to $2475 billion, which is equivalent to 25.2 percent of US government marketable interest-bearing securities held by investors of $9829 billion in Jun 2014 (http://www.fms.treas.gov/bulletin/index.html). Total foreign holdings of Treasury securities rose from $5655.1 billion in Oct 2013 to $6058.9 billion in Oct 2014, or 7.1 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-Dec 24, 2014

Source: Board of Governors of the Federal Reserve System

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

There are major ongoing and unresolved realignments of exchange rates in the international financial system as countries and regions seek parities that can optimize their productive structures. Seeking exchange rate parity or exchange rate optimizing internal economic activities is complex in a world of unconventional monetary policy of zero interest rates and even negative nominal interest rates of government obligations such as negative yields for the two-year government bond of Germany. Regulation, trade and devaluation conflicts should have been expected from a global recession (Pelaez and Pelaez (2007), The Global Recession Risk, Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008a)): “There are significant grounds for concern on the basis of this experience. International economic cooperation and the international financial framework can collapse during extreme events. It is unlikely that there will be a repetition of the disaster of the Great Depression. However, a milder contraction can trigger regulatory, trade and exchange wars” (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 181). Chart VI-2 of the Board of Governors of the Federal Reserve System provides the key exchange rate of US dollars (USD) per euro (EUR) from Jan 4, 1999 to Dec 24, 2014. US recession dates are in shaded areas. The rate on Jan 4, 1999 was USD 1.1812/EUR, declining to USD 0.8279/EUR on Oct 25, 2000, or appreciation of the USD by 29.9 percent. The rate depreciated 21.9 percent to USD 1.0098/EUR on Jul 22, 2002. There was sharp devaluation of the USD of 34.9 percent to USD 1.3625/EUR on Dec 27, 2004 largely because of the 1 percent interest rate between Jun 2003 and Jun 2004 together with a form of quantitative easing by suspension of auctions of the 30-year Treasury, which was equivalent to withdrawing supply from markets. Another depreciation of 17.5 percent took the rate to USD 1.6010/EUR on Apr 22, 2008, already inside the shaded area of the global recession. The flight to the USD and obligations of the US Treasury appreciated the dollar by 22.3 percent to USD 1.2446/EUR on Oct 27, 2008. In the return of the carry trade after stress tests showed sound US bank balance sheets, the rate depreciated 21.2 percent to USD 1.5085/EUR on Nov 25, 2009. The sovereign debt crisis of Europe in the spring of 2010 caused sharp appreciation of 20.7 percent to USD 1.1959/EUR on Jun 6, 2010. Renewed risk appetite depreciated the rate 24.4 percent to USD 1.4875/EUR on May 3, 2011. The rate depreciated 1.9 percent to USD 1.2188/EUR on Dec 24, 2014, which is the last point in Chart VI-2. 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-2, US Dollars (USD) per Euro (EUR), Jan 4, 1999 to Dec 24, 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-3 provides three indexes of the US Dollars (USD) from Jan 4, 1995 to Dec 24, 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 Dec 30, 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:

1. 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.
2. The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
3. 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:

1. 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.
2. 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:

1. 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.
2. The interest rate on the marginal lending facility will be decreased by 10 basis points to 0.30%, with effect from 10 September 2014.
3. 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.”

At the Thirtieth Meeting of the International Monetary and Financial Committee of the IMF (IMFC), the President of the European Central Bank (ECB), Mario Draghi stated (http://www.ecb.europa.eu/press/key/date/2014/html/sp141010.en.html):

“Our monetary policy continues to aim at firmly anchoring medium to long-term inflation expectations, in line with our objective of maintaining inflation rates below, but close to, 2% over the medium term. In this context, we have taken both conventional and unconventional measures that will contribute to a return of inflation rates to levels closer to our aim. Our unconventional measures, more specifically our TLTROs (Targeted Longer-Term Refinancing Operations) and our new purchase programmes for ABSs and covered bonds, will further enhance the functioning of our monetary policy transmission mechanism and facilitate credit provision to the real economy. Should it become necessary to further address risks of too prolonged a period of low inflation, the ECB’s Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate.”

In a speech on “Monetary Policy in the Euro Area,” on Nov 21, 2014, the President of the European Central Bank, Mario Draghi, advised of the determination to bring inflation back to normal levels by aggressive holding of securities in the balance sheet (http://www.ecb.europa.eu/press/key/date/2014/html/sp141121.en.html):

“In short, there is a combination of policies that will work to bring growth and inflation back on a sound path, and we all have to meet our responsibilities in achieving that. For our part, we will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us.

If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.”

In the Introductory Statement to the press conference on Dec 4,2014, the President of the European Central Bank Mario Draghi advised that (http://www.ecb.europa.eu/press/pressconf/2014/html/is141204.en.html):

“In this context, early next year the Governing Council will reassess the monetary stimulus achieved, the expansion of the balance sheet and the outlook for price developments. We will also evaluate the broader impact of recent oil price developments on medium-term inflation trends in the euro area. Should it become necessary to further address risks of too prolonged a period of low inflation, the Governing Council remains unanimous in its commitment to using additional unconventional instruments within its mandate. This would imply altering early next year the size, pace and composition of our measures.”

Chart VI-3, US Dollar Currency Indexes, Jan 4, 1995-Dec 26, 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 Dec 30, 2014

Source: Board of Governors of the Federal Reserve System

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

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 Dec 24, 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 is MXN 14.7460/USD on Dec 24, 2014.

Chart VI-4A, Mexican Peso (MXN) per US Dollar (USD), Nov 8, 1993 to Dec 24, 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.”

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.

Chart VI-4B provides the rate of the Indian rupee (INR) per US dollar (USD) from Jan 2, 1973 to Dec 24, 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 63.5500/USD on Dec 124, 2014.

Chart VI-4B, Indian Rupee (INR) per US Dollar (USD), Jan 2, 1973 to Dec 24, 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 120.4500/USD on Dec 24, 2014 for appreciation of 2.9 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-Dec 24, 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 2.6950/USD on Dec 24, 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 2.6950/USD on Dec 24, 2014 for depreciation of 75.3 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 Dec 24, 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 Dec 24, 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 Dec 17, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20141217a.htm):

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, 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. Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, 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. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated” (emphasis added)” (emphasis added).

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 the press conference following the meeting on Dec 17, 2014, Chair Yellen answered a question by Jon Hilseranth of the Wall Street Journal explaining “patience” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf):

“So I did say that this statement that the committee can be patient

should be interpreted as meaning that it is unlikely to begin the normalization process, for at least

the next couple of meetings. Now that doesn't point to any preset or predetermined time at which

normalization is -- will begin. There are a range of views on the committee, and it will be

dependent on how incoming data bears on the progress, the economy is making. First of all, I

want to emphasize that no meeting is completely off the table in the sense that if we do see faster

progress toward our objectives than we currently expect, then it is possible that the process of

normalization would occur sooner than we now anticipated. And of course the converse is also

true. So at this point, we think it unlikely that it will be appropriate, that we will see conditions

for at least the next couple of meetings that will make it appropriate for us to decide to begin

normalization. A number of committee participants have indicated that in their view, conditions

could be appropriate by the middle of next year. But there is no preset time.”

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.”

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.”

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.”

The minutes of the meeting of the Federal Open Market Committee (FOMC) on Sep 16-17, 2014, reveal concern with global economic conditions (http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm):

“Most viewed the risks to the outlook for economic activity and the labor market as broadly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated, structural productivity continued to increase only slowly, or the recovery in residential construction continued to lag.”

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.”

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 (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

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.

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/2014/11/fluctuating-financial-variables.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/weakening-world-economic-growth.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 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/01/theory-and-reality-of-secular.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 17,832.99 on Fri Jan 2, 2015, which is higher by 25.9 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 25.6 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs. 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).

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 84.1 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Jan 2, 2015; S&P 500 has gained 101.3 percent and DAX 72.2 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 1/2/15” 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 35.7 percent above the trough. Japan’s Nikkei Average is 97.8 percent above the trough. DJ Asia Pacific TSM is 24.7 percent above the trough. Dow Global is 46.5 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 30.3 percent above the trough. NYSE Financial Index is 57.8 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 72.2 percent above the trough. Japan’s Nikkei Average is 97.8 percent above the trough on Aug 31, 2010 and 53.2 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 17,450.77 on Fri Jan 2, 2015 (closed on holiday) (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 70.2 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 0.7 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 1/2/15” in Table VI-4 shows increase of 2.4 percent in the week for China’s Shanghai Composite. DJ Asia Pacific increased 0.2 percent. NYSE Financial decreased 1.2 percent in the week. Dow Global decreased 1.4 percent in the week of Jan 2, 2015. The DJIA decreased 1.2 percent and S&P 500 decreased 1.5 percent. DAX of Germany decreased 1.6 percent. STOXX 50 decreased 0.9 percent. The USD appreciated 1.5 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 1/2/15” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jan 2, 2015. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 1/2/15” but also relative to the peak in column “∆% Peak to 1/2/15.” There are now several equity indexes above the peak in Table VI-4: DJIA 59.2 percent, S&P 500 69.1 percent, DAX 54.2 percent, Dow Global 19.5 percent, DJ Asia Pacific 9.2 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 25.7 percent, Nikkei Average 53.2 percent, STOXX 50 10.3 percent. Shanghai Composite is 2.2 percent above the peak. The US dollar strengthened 20.7 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 $1,194.4 billion in IQ1988 or 25.5 percent. Real gross private domestic investment in the US increased 5.6 percent from $2605.2 billion in IVQ2007 to $2,750.8 billion in IIIQ2014. Real private fixed investment increased 2.2 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,643.3 billion in IIIQ2014. Private fixed investment fell relative to IVQ2007 in all quarters preceding IIQ2014. Growth of real private investment 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 $3.1 billion in IVQ2013. Corporate profits with IVA and CCA fell $201.7 billion in IQ2014 and increased $164.1 billion in IIQ2014. Corporate profits with IVA and CCA increased $64.5 billion in IIIQ2014. In IVQ2013, profits after tax with IVA and CCA decreased $24.7 billion. 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 and at $70.1 billion in IIIQ2014. 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 IQ2014 and fell at $0.5 billion in IIQ2014. Net dividends fell at $3.9 billion in IIIQ2014. Undistributed profits with IVA and CCA 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 and at $73.9 billion in IIIQ2014. Undistributed corporate profits swelled 315.9 percent from $107.7 billion in IQ2007 to $447.9 billion in IIIQ2014 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 1/2/ /15	∆% Week 1/2/15	∆% Trough to 1/2/ 15
DJIA	4/26/ 10	7/2/10	-13.6	59.2	-1.2	84.1
S&P 500	4/23/ 10	7/20/ 10	-16.0	69.1	-1.5	101.3
NYSE Finance	4/15/ 10	7/2/10	-20.3	25.7	-1.2	57.8
Dow Global	4/15/ 10	7/2/10	-18.4	19.5	-1.4	46.5
Asia Pacific	4/15/ 10	7/2/10	-12.5	9.2	0.2	24.7
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	53.2	-2.1	97.8
China Shang.	4/15/ 10	7/02 /10	-24.7	2.2	2.4	35.7
STOXX 50	4/15/10	7/2/10	-15.3	10.3	-0.9	30.3
DAX	4/26/ 10	5/25/ 10	-10.5	54.2	-1.6	72.2
Dollar Euro	11/25 2009	6/7 2010	21.2	20.7	1.5	-0.7
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	2.126

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 Peaking Valuations of Risk Financial Assets. Percentage changes of risk financial assets from the last day of the year relative to the last day of the earlier year are in Table I-1 from 2007 to 2014. Calendar year 2014 was satisfactory for most equity indexes but not as excellent as 2013. Shanghai Composite outperformed all equity indexes in Table I-1 in 2014 with increase of 52.9 percent after falling 6.7 percent in 2012. The second highest increase is 11.4 percent for the Standard and Poor’s 500 (S&P 500). DAX of Germany gained 2.7 percent. NYSE Financial increased 5.6 percent and Dow Global 0.6 percent. Dow Asia Pacific decreased 1.6 percent while the Dow Jones Industrial Average (DJIA) increased 7.1 percent. The USD appreciated 12.0 percent relative to the EUR. Equities also outperformed in calendar year 2012. DAX gained 29.1 percent and NYSE Financial 25.9 percent. Equities soared in 2013. The Nikkei Average increased 56.7 percent. DJIA gained 26.5 percent and S&P 500 29.3 percent. Dax of Germany increased 25.5 percent. The dollar appreciated 8.3 percent relative to the euro. DJ UBS Commodities index fell 9.6 percent. Equities enjoyed a good year in 2012. Nikkei Average gained 22.9 percent in 2012. S&P increased 13.4 percent and DJIA 7.3 percent. Shanghai Composite increased 3.2 percent. Dow Global increased 10.7 percent and Dow Asia Pacific 13.1 percent. DJ UBS Commodities fell 1.1 percent. The only gain for a major equity index in Table I-1 for 2011 is 5.5 percent for the DJIA. S&P 500 is better than other equity markets by remaining flat for 2011. With the exception of a drop of 8.4 percent of the European equity index STOXX 50, all declines of equity markets in 2011 are in excess of 10 percent. China’s Shanghai Composite lost 21.7 percent. The equity index of Germany DAX fell 14.7 percent. The DJ UBS Commodities Index dropped 13.4 percent. Robin Wigglesworth, writing on Dec 30, 2011, on “$6.3tn wiped off markets in 2011,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/483069d8-32f3-11e1-8e0d-00144feabdc0.html#axzz1i2BE7OPa), provides an estimate of $6.3 trillion erased from equity markets globally in 2011. The Bureau of Economic Analysis (BEA) estimates US nominal GDP in 2011 at $15,517.9 billion (http://www.bea.gov/iTable/index_nipa.cfm). The loss in equity markets worldwide in 2011 of $6.3 trillion is equivalent to about 39.3 percent of US GDP or economic activity in 2011. Table I-1 also provides the exchange rate of number of US dollars (USD) required in buying a unit of euro (EUR), USD/EUR. The dollar appreciated 9.5 percent on the last day of trading in 2011 relative to the last day of trading in 2010, suggesting risk aversion. Depreciation of the dollar by 1.1 percent in 2012 and 9.6 percent in 2013 suggests more favorable environment of risk appetite for carry trades from zero interest rates into risk financial assets. The final row of Table I-1 provides the yield of the ten-year Treasury, decreasing to 2.172 percent in 2014. The yield of the ten-year Treasury increased to 3.030 percent in 2013, which is the highest since 3.292 percent in 2010 and 3.844 percent in 2008. The yield at year-end 2007 was 4.077 percent.

Table I-1, Percentage Change of Year-end Values of Financial Assets Relative to Earlier Year-end Values 2007-2014 and Year-end Yield of 10-Year Treasury Note

∆%	2014	2013	2012	2011	2010	2009	2008	2007
DJIA	7.5	26.5	7.3	5.5	11.0	18.8	-33.8	6.4
S&P 500	11.4	29.3	13.4	0.0	12.8	23.5	-38.5	3.5
NYSE Fin	5.6	24.2	25.9	-18.1	5.0	22.7	-53.6	-13.1
Dow Global	0.6	24.5	10.7	-13.6	5.2	30.0	-45.4	30.5
Dow Asia-Pacific	-1.6	10.2	13.1	-17.6	16.0	36.4	-44.2	14.0
Nikkei Av	7.1	56.7	22.9	-17.3	-3.0	19.0	-42.1	-11.1
Shanghai	52.9	-6.7	3.2	-21.7	-14.3	80.0	-65.4	96.7
STOXX 50	2.9	13.3	8.8	-8.4	0.0	25.2	-43.9	-0.4
DAX	2.7	25.5	29.1	-14.7	16.1	23.8	-40.4	22.3
USD/EUR*	12.0	8.3	6.5	9.5	15.6	13.1	17.1	8.3
DJ UBS** Com	NA	-9.6	-1.1	-13.4	16.7	18.7	-36.6	11.2
Year-end Yield 10-Year Treasury %	2.172	3.030	1.758	2.027	3.292	3.844	2.157	4.077

*Negative sign is dollar devaluation; positive sign is dollar appreciation

**DJ UBS available only for 2013 and earlier years

Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata

Table I-2, Percentage Change of Year-end 2014 Values of Financial Assets Relative to Year-end Values 2006-2013

	∆% 2014/ 2013	∆% 2014/ 2012	∆% 2014/ 2011	∆% 2014/ 2010	∆% 2014/2009	∆% 2014/ 2008	∆% 2014/2007	∆% 2014/ 2006
DJIA	7.5	36.0	45.9	53.9	70.9	103.1	34.4	43.0
S&P 500	11.4	44.4	63.7	63.7	84.6	127.9	40.2	45.2
NYSE Fin	5.6	31.1	65.1	35.3	42.1	74.3	-19.2	-29.8
Dow Global	0.6	25.3	38.7	19.8	26.1	63.9	-10.5	16.9
Dow Asia-Pacific	-1.6	8.5	22.7	1.1	17.2	59.9	-10.8	1.8
Nikkei Av	7.1	67.9	106.4	70.6	65.5	97.0	14.0	1.3
Shanghai	52.9	42.6	47.1	15.2	-1.3	77.7	-38.5	20.9
STOXX 50	2.9	16.5	26.8	16.1	16.2	45.4	-18.5	-18.8
DAX	2.7	28.8	66.2	41.8	64.6	103.8	21.5	48.6
USD/EUR*	12.0	-4.2	-6.2	-2.8	4.1	1.3	5.9	-4.2
DJ UBS** Com	NA	-9.6	-10.6	-22.6	-9.7	7.3	-32.0	-24.4

*Negative sign is dollar devaluation; positive sign is dollar appreciation

**DJ UBS available only for 2013 and earlier years; percentage change is to 2013.

Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata

The other yearly percentage changes in Table I-2 are also revealing wide fluctuations in valuations of risk financial assets. To be sure, economic conditions and perceptions of the future do influence valuations of risk financial assets. It is also valid to contend that unconventional monetary policy magnifies fluctuations in these valuations by inducing carry trades from zero interest rates to exposures with high leverage in risk financial assets such as equities, emerging equities, currencies, high-yield structured products and commodities futures and options. In fact, one of the alleged channels of transmission of unconventional monetary policy is through higher consumption induced by increases in wealth resulting from higher valuations of stock markets. Unconventional monetary policy could also result in magnification of values of risk financial assets beyond actual discounted future cash flows, creating financial instability. Separating all these effects in practice may be quite difficult because they are observed simultaneously. Conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects (on counterfactuals see Pelaez and Pelaez, Globalization and the State Vol I (2008a), 125, 136, Harberger (1971, 1997), Fishlow 1965, Fogel 1964, Fogel and Engerman 1974, North and Weingast 1989, Pelaez 1979, 26-7). There is no certainty or evidence that unconventional policies attain their intended effects without risks of costly side effects. Yearly fluctuations of financial assets in Table I-1 are quite wide. In 2007, for example, the equity index Dow Global increased 30.5 percent while Dax gained 22.3 percent and the Shanghai Composite jumped 96.7 percent. The DJIA gained only 6.4 percent as recession began in IVQ2007. The flight to government obligations in 2008 (Cochrane and Zingales 2009, Cochrane 2011Jan) was equivalent to the astronomical declines of world equity markets and commodities. The flight from risk is also in evidence in the appreciation of the dollar by 17.1 percent in 2008 with unwinding carry trades and with renewed carry trades in the depreciation of the dollar by 13.1 percent in 2009. Recovery still continued in 2010 with shocks of the European debt crisis in the spring and in Nov 2010. The flight from risk exposures dominated declines of valuations of risk financial assets in 2011.

Table I-2 is designed to provide a comparison of valuations of risk financial assets at the end of 2014 relative to valuations at the end of every year from 2006 to 2013. For example, the DJIA index is 7.5 percent higher at the end of 2014 relative to the valuation at the end of 2013, 34.4 percent above the valuation at the end of 2007 and 43.0 percent higher relative to the valuation at the end of 2006. It is higher by 103.1 percent at the end of 2014 relative to the depressed valuation at the end of 2008. Several indexes are still lower at the end of 2014 relative to the values at the end of 2007 with exception of gains of 34.4 for DJIA, 40.2 percent for S&P 500, 14.0 percent for Nikkei Average and 21.5 percent for DAX. Some equity indexes are higher at the end of 2014 relative to the end of 2006: DJIA by 43.0 percent, S&P by 45.2 percent, Dow Global by 16.9 percent, Dow Asia Pacific by 1.8 percent and DAX by 48.6 percent. Although the Nikkei Average increased 7.1 percent in 2014 relative to 2013, it is 1.3 percent higher than in 2006 but 14.0 percent higher than in 2007. At the end of 2014, Dow Global is 10.5 percent lower than at the end of 2007 and 16.9 percent higher than at the end of 2006. The Shanghai Composite is 38.5 percent lower than at the end of 2007 and 20.9 percent higher than at the end of 2006. DJ UBS Commodities is 32.0 percent lower at the end of 2013 relative to 2007 and 24.4 percent lower relative to 2006. The USD is 17.1 stronger at the end of 2014 relative to 2007 and 8.3 percent stronger relative to 2006. Zero interest rates do not devalue the dollar during prolonged bouts of relative risk aversion and portfolio reallocations. Low valuations of risk financial assets are intimately related to risk aversion in international financial markets because of the European debt crisis, weakness and unemployment in advanced economies, fiscal imbalances and slowing growth worldwide. Valuations of stock indexes for the US and Germany are peaking at the turn of 2014 into 2015 relative to 2007 and 2006.

Table I-2, Percentage Change of Year-end 2014 Values of Financial Assets Relative to Year-end Values 2006-2013

	∆% 2014/ 2013	∆% 2014/ 2012	∆% 2014/ 2011	∆% 2014/ 2010	∆% 2014/2009	∆% 2014/ 2008	∆% 2014/2007	∆% 2014/ 2006
DJIA	7.5	36.0	45.9	53.9	70.9	103.1	34.4	43.0
S&P 500	11.4	44.4	63.7	63.7	84.6	127.9	40.2	45.2
NYSE Fin	5.6	31.1	65.1	35.3	42.1	74.3	-19.2	-29.8
Dow Global	0.6	25.3	38.7	19.8	26.1	63.9	-10.5	16.9
Dow Asia-Pacific	-1.6	8.5	22.7	1.1	17.2	59.9	-10.8	1.8
Nikkei Av	7.1	67.9	106.4	70.6	65.5	97.0	14.0	1.3
Shanghai	52.9	42.6	47.1	15.2	-1.3	77.7	-38.5	20.9
STOXX 50	2.9	16.5	26.8	16.1	16.2	45.4	-18.5	-18.8
DAX	2.7	28.8	66.2	41.8	64.6	103.8	21.5	48.6
USD/EUR*	12.0	8.3	6.5	9.5	15.6	13.1	17.1	8.3
DJ UBS** Com	NA	-9.6	-10.6	-22.6	-9.7	7.3	-32.0	-24.4

*Negative sign is dollar devaluation; positive sign is dollar appreciation

**DJ UBS available only for 2013 and earlier years; percentage change is to 2013.

Sources: http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata

Table I-3 shows that the DJIA has increased 84.0 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Dec 31, 2014; S&P 500 has gained 101.3 percent and DAX 72.9 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 12/31/14” 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 35.7 percent above the trough. Japan’s Nikkei Average is 97.8 percent above the trough. DJ Asia Pacific TSM is 24.6 percent above the trough. Dow Global is 46.9 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 30.8 percent above the trough. NYSE Financial Index is 57.8 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 72.9 percent above the trough. Japan’s Nikkei Average is 97.8 percent above the trough on Aug 31, 2010 and 53.2 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 17,450.77 on Wed Dec 31, 2014 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 70.2 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 1.5 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% 12/26/14 to 12/31/14” in Table VI-4 shows increase of 2.4 percent in the half-week for China’s Shanghai Composite. DJ Asia Pacific increased 0.1 percent. NYSE Financial decreased 1.2 percent in the half-week. Dow Global decreased 1.1 percent in the half-week of Dec 31, 2014. The DJIA decreased 1.3 percent and S&P 500 decreased 1.4 percent. DAX of Germany decreased 1.2 percent. STOXX 50 decreased 0.5 percent. The USD appreciated 0.7 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 12/31/14” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Dec 31, 2014. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 12/31/14” but also relative to the peak in column “∆% Peak to 12/31/14.” There are now several equity indexes above the peak in Table VI-4: DJIA 59.1 percent, S&P 500 69.1 percent, DAX 54.9 percent, Dow Global 19.9 percent, DJ Asia Pacific 9.1 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 25.7 percent, Nikkei Average 53.2 percent, STOXX 50 10.8 percent. Shanghai Composite is 2.2 percent above the peak. The US dollar strengthened 20.0 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. 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 $1,194.4 billion in IQ1988 or 25.5 percent. Real gross private domestic investment in the US increased 5.6 percent from $2605.2 billion in IVQ2007 to $2,750.8 billion in IIIQ2014. Real private fixed investment increased 2.2 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,643.3 billion in IIIQ2014. Private fixed investment fell relative to IVQ2007 in all quarters preceding IIQ2014. Growth of real private investment 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 $3.1 billion in IVQ2013. Corporate profits with IVA and CCA fell $201.7 billion in IQ2014 and increased $164.1 billion in IIQ2014. Corporate profits with IVA and CCA increased $64.5 billion in IIIQ2014. In IVQ2013, profits after tax with IVA and CCA decreased $24.7 billion. 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 and at $70.1 billion in IIIQ2014. 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 IQ2014 and fell at $0.5 billion in IIQ2014. Net dividends fell at $3.9 billion in IIIQ2014. Undistributed profits with IVA and CCA 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 and at $73.9 billion in IIIQ2014. Undistributed corporate profits swelled 315.9 percent from $107.7 billion in IQ2007 to $447.9 billion in IIIQ2014 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 I-3, Stock Indexes, Commodities, Dollar and 10-Year Treasury  

	Peak	Trough	∆% to Trough	∆% Peak to 12/31/ /14	∆% 12/26/14 to 12/31/14	∆% Trough to 12/31/ 14
DJIA	4/26/ 10	7/2/10	-13.6	59.1	-1.3	84.0
S&P 500	4/23/ 10	7/20/ 10	-16.0	69.1	-1.4	101.3
NYSE Finance	4/15/ 10	7/2/10	-20.3	25.7	-1.2	57.8
Dow Global	4/15/ 10	7/2/10	-18.4	19.9	-1.1	46.9
Asia Pacific	4/15/ 10	7/2/10	-12.5	9.1	0.1	24.6
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	53.2	-2.1	97.8
China Shang.	4/15/ 10	7/02 /10	-24.7	2.2	2.4	35.7
STOXX 50	4/15/10	7/2/10	-15.3	10.8	-0.5	30.8
DAX	4/26/ 10	5/25/ 10	-10.5	54.9	-1.2	72.9
Dollar Euro	11/25 2009	6/7 2010	21.2	20.0	0.7	-1.5
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	2.172

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

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

Table IB-1 provides the data required for broader comparison of long-term and cyclical performance of the United States economy. 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. First, Long-term performance. Using annual data, US GDP grew at the average rate of 3.3 percent per year from 1929 to 2013 and at 3.2 percent per year from 1947 to 2013. Real disposable income grew at the average yearly rate of 3.2 percent from 1929 to 2013 and at 3.7 percent from 1947 to 1999. Real disposable income per capita grew at the average yearly rate of 2.0 percent from 1929 to 2013 and at 2.3 percent from 1947 to 1999. US economic growth was much faster during expansions, compensating contractions in maintaining trend growth for whole cycles. Using annual data, US real disposable income grew at the average yearly rate of 3.5 percent from 1980 to 1989 and real disposable income per capita at 2.6 percent. The US economy has lost its dynamism in the current cycle: real disposable income grew at the yearly average rate of 1.4 percent from 2006 to 2013 and real disposable income per capita at 0.5 percent. Real disposable income grew at the average rate of 1.2 percent from 2007 to 2013 and real disposable income per capita at 0.4 percent. Table IB-1 illustrates the contradiction of long-term growth with the proposition of secular stagnation (Hansen 1938, 1938, 1941 with early critique by Simons (1942). Secular stagnation would occur over long periods. Table IB-1 also provides the corresponding rates of population growth that is only marginally lower at 0.8 to 0.9 percent recently from 1.1 percent over the long-term. GDP growth fell abruptly from 2.6 percent on average from 2000 to 2006 to 1.0 percent from 2006 to 2013 and 0.9 percent from 2007 to 2013 and real disposable income growth fell from 2.9 percent on average from 2000 to 2006 to 1.4 percent from 2006 to 2013. The decline of growth of real per capita disposable income is even sharper from average 2.0 percent from 2000 to 2006 to 0.5 percent from 2006 to 2013 and 0.4 percent from 2007 to 2013 while population growth was 0.8 percent on average. Lazear and Spletzer (2012JHJul122) provide theory and measurements showing that cyclic factors explain currently depressed labor markets. This is also the case of the overall economy. Second, first four quarters of expansion. Growth in the first four quarters of expansion is critical in recovering loss of output and employment occurring during the contraction. In the first four quarters of expansion from IQ1983 to IVQ1983: GDP increased 7.8 percent, real disposable personal income 5.3 percent and real disposable income per capita 4.4 percent. In the first four quarters of expansion from IIIQ2009 to IIQ2010: GDP increased 2.7 percent, real disposable personal income 0.2 percent and real disposable income per capita decreased 0.7 percent. Third, first 21 quarters of expansion. In the expansion from IQ1983 to IQ1988: GDP grew 28.4 percent at the annual equivalent rate of 4.9 percent; real disposable income grew 23.8 percent at the annual equivalent rate of 4.2 percent; and real disposable income per capita grew 18.2 percent at the annual equivalent rate of 3.2 percent. In the expansion from IIIQ2009 to IIIQ2014: GDP grew 12.9 percent at the annual equivalent rate of 2.3 percent; real disposable income grew 8.5 percent at the annual equivalent rate of 1.6 percent; and real disposable personal income per capita grew 4.4 percent at the annual equivalent rate of 0.8 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IQ1988: GDP grew 28.2 percent at the annual equivalent rate of 3.0 percent; real disposable personal income grew 31.0 percent at the annual equivalent rate of 3.2 percent; and real disposable personal income per capita 21.3 percent at the annual equivalent rate of 2.3 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IIIQ2014: GDP grew 8.1 percent at the annual equivalent rate of 1.1 percent; real disposable personal income 10.3 percent at the annual equivalent rate of 1.4 percent; and real disposable personal income per capita 4.7 percent at the annual equivalent rate of 0.7 percent. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction of 4.3 percent from IVQ2007 to IIQ2009 and the financial crisis. The proposition of secular stagnation should explain a long-term process of decay and not the actual abrupt collapse of the economy and labor markets currently.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2013, %

Long-term Average ∆% per Year	GDP	Population
1929-2013	3.3	1.1
1947-2013	3.2	1.2
1947-1999	3.6	1.3
2000-2013	1.7	0.9
2000-2006	2.6	0.9
2006-2013	1.0	0.8
2007-2013	0.9	0.8
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita	Population
1929-2013	3.2	2.0	1.1
1947-1999	3.7	2.3	1.3
2000-2013	2.1	1.2	0.9
2000-2006	2.9	2.0	0.9
2006-2013	1.4	0.5	0.8
2007-2013	1.2	0.4	0.8
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6	0.9
2006-2013	1.4	0.5	0.8
2007-2013	1.2	0.4	0.8
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
GDP
I83 to IV83 IQ83 to IQ87 IQ83 to IIQ87 I83 to III87 IQ83 to IV87 IQ83 to I88	4 17 18 19 20 21
I83 to IV83 I83 to IQ87 I83 to II87 I83 to III87 I83 to IV87 I183 to I88	4 17 18 19 20 21	7.8 23.1 24.5 25.6 27.7 28.4	7.8 5.0 5.0 4.9 5.0 4.9
RDPI
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88	4 17 19 20 21	5.3 19.5 20.5 22.1 23.8	5.3 4.3 4.0 4.1 4.2
RDPI Per Capita
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88	4 17 19 20 21	4.4 15.1 15.5 16.7 18.2	4.4 3.4 3.1 3.1 3.2
Whole Cycle IQ1980 to IQ1988
GDP	34	28.2	3.0
RDPI	34	31.0	3.2
RDPI per Capita	34	21.3	2.3
Population	34	8.0	0.9
GDP
III09 to II10 III09 to III14	4 21	2.7 12.9	2.7 2.3
RDPI
III09 to II10 III09 to III14	4 21	0.2 8.5	0.2 1.6
RDPI per Capita
III09 to II10 III09 to III14	4 21	-0.7 4.4	-0.7 0.8
Population
III09 to II010 III09 to III14	4 21	0.8 3.9	0.8 0.7
IVQ2007 to IIIQ2014	28
GDP	28	8.1	1.1
RDPI	28	10.3	1.4
RDPI per Capita	28	4.7	0.7
Population	28	5.3	0.7

RDPI: Real Disposable Personal Income

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

There are seven basic facts illustrating the current economic disaster of the United States:

• GDP maintained trend growth in the entire business cycle from IQ1980 to IQ1988, including contractions and expansions. GDP is well below trend in the entire business cycle from IVQ2007 to IIIQ2014, including contractions and expansions
• Per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIIQ2014
• Level of employed persons increased in the 1980s but declined into IIIQ2014
• Level of full-time employed persons increased in the 1980s but declined into IIIQ2014
• Level unemployed, unemployment rate and employed part-time for economic reasons fell in the recovery from the recessions in the 1980s but not substantially in the recovery since IIIQ2009
• Wealth of households and nonprofit organizations soared in the 1980s but stagnated in real terms into IIIQ2014
• Gross private domestic investment increased sharply from IQ1980 to IQ1988 but gross private domestic investment stagnated and private fixed investment stagnated from IVQ2007 into IIIQ2014

There is a critical issue of the United States economy will be able in the future to attain again the level of activity and prosperity of projected trend growth. Growth at trend during the entire business cycles built the largest economy in the world but there may be an adverse, permanent weakness in United States economic performance and prosperity. Table IB-2 provides data for analysis of these seven basic facts. The seven blocks of Table IB-2 are separated initially after individual discussion of each one followed by the full Table IB-2.

1. Trend Growth.

i. As shown in Table IB-2, actual GDP grew cumulatively 27.8 percent from IQ1980 to IQ1988, which is relatively close to what trend growth would have been at 28.6 percent. Real GDP grew 28.2 percent from IVQ1979 to IQ1988. Rapid growth at the average annual rate of 4.9 percent per quarter during the expansion from IQ1983 to IQ1988 erased the loss of GDP of 4.6 percent during the contractions and maintained trend growth at 3.0 percent for GDP and 3.2 percent for real disposable personal income over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIIQ2014 was 8.1 percent while trend growth would have been 23.0 percent. GDP in IIIQ2014 at seasonally adjusted annual rate is $16,205.6 billion as estimated by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $18,438.0 billion, or $2,232.4 billion higher, had the economy grown at trend over the entire business cycle as it happened during the 1980s and throughout most of US history. GDP in IIIQ2014 is 12.1 percent below trend. There is about $2.2 trillion of foregone GDP that the economy would have created as it occurred during past cyclical expansions, which explains why employment net of population growth has not rebounded to even higher than before. There would not be recovery of full employment even with growth of 3 percent per year beginning immediately because the opportunity was lost to grow faster during the expansion from IIIQ2009 to IIIQ2014 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 26.0 million people or 15.8 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/12/financial-risks-twenty-six-million.html) that will not diminish significantly even with return to growth of GDP of 3 percent per year because of growth of the labor force by new entrants. The ratio of the labor force of 154.871 million in Jul 2007 to the noninstitutional population of 231.958 million in Jul 2007 was 66.8 percent while the ratio of the labor force of 156.297 million in Nov 2014 to the noninstitutional population of 248.844 million in Nov 2014 was 62.8 percent. The labor force of the US in Nov 2014 corresponding to 66.8 percent of participation in the population would be 166.228 million (0.668 x 248.844. The difference between the measured labor force in Nov 2014 of 156.297 million and the labor force in Nov 2014 with participation rate of 66.8 percent (as in Jul 2007) of 166.228 million is 9.931 million. The level of the labor force in the US has stagnated and is 9.931 million lower than what it would have been had the same participation rate been maintained. Millions of people have abandoned their search for employment because they believe there are no jobs available for them. The key issue is whether the decline in participation of the population in the labor force is the result of people giving up on finding another job.Structural change in demography occurs over relatively long periods and not suddenly as shown by Edward P. Lazear and James R. Spletzer (2012JHJul22). There is an abrupt cyclical event and no evidence for secular stagnation and similar propositions.

Period IQ1980 to IQ1988
GDP SAAR USD Billions
IQ1980	6,524.9
IQ1988	8,339.3
∆% IQ1980 to IQ1988 (28.2 percent from IVQ1979 $6503.9 billion)	27.8
∆% Trend Growth IQ1980 to IQ1988	28.6

Period IVQ2007 to IIIQ2014
GDP SAAR USD Billions
IVQ2007	14,991.8
IIIQ2014	16,205.6
∆% IVQ2007 to IIIQ2014 Actual	8.1
∆% IVQ2007 to IIIQ2014 Trend Growth	23.0

2. Stagnating Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IVQ1987, as shown in Table IB-2, growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 21.3 percent, which is close to what would have been trend growth of 18.3 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IIIQ2014, per capita real disposable income increased 4.7 percent while trend growth would have been 14.9 percent. Income available after inflation and taxes is about the same as before the contraction after 21 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions. Growth of personal income during the expansion has been tepid even with the new revisions. In IVQ2012, nominal disposable personal income grew at the SAAR of 13.8 percent and real disposable personal income at 11.8 percent (Table 2.1 http://bea.gov/iTable/index_nipa.cfm). The BEA explains as follows: “Personal income in November and December was boosted by accelerated and special dividend payments to persons and by accelerated bonus payments and other irregular pay in private wages and salaries in anticipation of changes in individual income tax rates. Personal income in December was also boosted by lump-sum social security benefit payments” (page 2 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi1212.pdf pages 1-2 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0113.pdf). The Bureau of Economic Analysis explains as (http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0213.pdf 2-3): “The January estimate of employee contributions for government social insurance reflected the expiration of the “payroll tax holiday,” that increased the social security contribution rate for employees and self-employed workers by 2.0 percentage points, or $114.1 billion at an annual rate. For additional information, see FAQ on “How did the expiration of the payroll tax holiday affect personal income for January 2013?” at www.bea.gov. The January estimate of employee contributions for government social insurance also reflected an increase in the monthly premiums paid by participants in the supplementary medical insurance program, in the hospital insurance provisions of the Patient Protection and Affordable Care Act, and in the social security taxable wage base.”

The increase was provided in the “fiscal cliff” law H.R. 8 American Taxpayer Relief Act of 2012 (http://www.gpo.gov/fdsys/pkg/BILLS-112hr8eas/pdf/BILLS-112hr8eas.pdf).

In IQ2013, personal income fell at the SAAR of minus 8.6 percent; real personal income excluding current transfer receipts at minus 11.9 percent; and real disposable personal income at minus 12.6 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1014.pdf). The BEA explains as follows (page 3 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0313.pdf):

“The February and January changes in disposable personal income (DPI) mainly reflected the effect of special factors in January, such as the expiration of the “payroll tax holiday” and the acceleration of bonuses and personal dividends to November and to December in anticipation of changes in individual tax rates.”

In IIQ2013, personal income grew at 4.5 percent, real personal income excluding current transfer receipts at 4.6 percent and real disposable income at 3.8 percent (http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1114.pdf). In IIIQ2013, personal income grew at 3.3 percent, real personal income excluding current transfers at 1.5 percent and real disposable income at 2.0 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1114.pdf). In IVQ2013, personal income grew at 1.8 percent and real disposable income at 0.2 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1014.pdf). In IQ2014, personal income grew at 4.9 percent in nominal terms and 3.2 percent in real terms excluding current transfer receipts while nominal disposable income grew at 4.8 percent and real disposable income at 3.4 percent (http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1114.pdf). In IIQ2014, personal income grew at 4.9 percent and 2.2 percent in real terms excluding current transfers. Nominal disposable income grew at 5.5 percent and at 3.1 percent in real terms (http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1114.pdf). In IIIQ2014, personal income grew at 3.6 percent, real personal income excluding current transfers at 2.0 percent and real disposable personal income at 2.0 percent (http://www.bea.gov/newsreleases/national/pi/2014/pdf/pi1114.pdf).

Period IQ1980 to IQ1988

Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,241
Real Disposable Personal Income per Capita IQ1988 Chained 2009 USD	24,543
∆% IQ1980 to IQ1988 (21.3 percent from IVQ1979 $20,230)	21.3
∆% Trend Growth	18.3

Period IVQ2007 to IIIQ2014

Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,819
Real Disposable Personal Income per Capita IIIQ2014 Chained 2009 USD	37,496
∆% IVQ2007 to IIIQ2014	4.7
∆% Trend Growth	14.9

3. Number of Employed Persons

i. As shown in Table IB-2, the number of employed persons increased over the entire business cycle from 98.527 million not seasonally adjusted (NSA) in IQ1980 to 112.867 million NSA in IQ1988 or by 14.6 percent.

ii. In contrast, during the entire business cycle the number employed stagnated from 146.334 million in IVQ2007 to 147.666 million in IIIQ2014 or by 0.9 percent. There are 26.0 million persons unemployed or underemployed, which is 15.8 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/12/financial-risks-twenty-six-million.html). The number employed in Nov 2014 was 147.666 million (NSA) or 0.351 million more people with jobs relative to the peak of 147.315 million in Jul 2007 while the civilian noninstitutional population of ages 16 years and over increased from 231.958 million in Jul 2007 to 248.844 million in Nov 2014 or by 16.886 million. The number employed increased 0.2 percent from Jul 2007 to Nov 2014 while the noninstitutional civilian population of ages of 16 years and over, or those available for work, increased 7.3 percent. The ratio of employment to population in Jul 2007 was 63.5 percent (147.315 million employment as percent of population of 231.958 million). The same ratio in Nov 2014 would result in 158.016 million jobs (0.635 multiplied by noninstitutional civilian population of 248.844 million). There are effectively 10.350 million fewer jobs in Nov 2014 than in Jul 2007, or 158.016 million minus 147.666 million. There is actually not sufficient job creation in merely absorbing new entrants in the labor force because of those dropping from job searches, worsening the stock of unemployed or underemployed in involuntary part-time jobs.

Period IQ1980 to IQ1988

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IQ1988 NSA End of Quarter	112.867
∆% Employed IQ1980 to IQ1988	14.6

Period IVQ2007 to IIIQ2014

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2014 NSA End of Quarter	147.666
∆% Employed IVQ2007 to IIIQ2014	0.9

4. Number of Full-Time Employed Persons

i. As shown in Table IB-2, during the entire business cycle in the 1980s, including contractions and expansion, the number of employed full-time rose from 81.280 million NSA in IQ1980 to 92.760 million NSA in IQ1988 or 14.1 percent.

ii. In contrast, during the entire current business cycle, including contraction and expansion, the number of persons employed full-time fell from 121.042 million in IVQ2007 to 119.791 million in IIIQ2014 or by minus 1.0 percent. The number with full-time jobs in Nov 2014 is 119.441 million, which is lower by 3.778 million relative to the peak of 123.219 million in Jul 2007. The magnitude of the stress in US labor markets is magnified by the increase in the civilian noninstitutional population of the United States from 231.958 million in Jul 2007 to 248.844 million in Nov 2014 or by 16.886 million (http://www.bls.gov/data/) while in the same period the number of full-time jobs fell 3.778 million. The ratio of full-time jobs of 123.219 million Jul 2007 to civilian noninstitutional population of 231.958 million was 53.1 percent. If that ratio had remained the same, there would be 132.157 million full-time jobs with population of 248.884 million in Nov 2014 (0.531 x 248.884) or 12.716 million fewer full-time jobs relative to actual 119.441 million. There appear to be around 10 million fewer full-time jobs in the US than before the global recession while population increased around 17 million. Mediocre GDP growth is the main culprit of the fractured US labor market.

4. Number of Full-time Employed Persons

Period IQ1980 to IQ1988

Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IQ1988 NSA End of Quarter	92.760
∆% Full-time Employed IQ1980 to IQ1988	14.1

Period IVQ2007 to IIIQ2014

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2014 NSA End of Quarter	119.791
∆% Full-time Employed IVQ2007 to IIIQ2014	-1.0

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

i. As shown in Table IB-2 and in the following block, in the cycle from IQ1980 to IQ1988: (a) The rate of unemployment was slightly lower at 5.9 percent in IQ1988 relative to 6.6 percent in IQ1980. (b) The number unemployed increased from 6.983 million in IQ1980 to 7.090 million in IQ1988 or 1.5 percent. (c) The number employed part-time for economic reasons increased 41.5 percent from 3.624 million in IQ1980 to 5.129 million in IQ1988.

ii. In contrast, in the economic cycle from IVQ2007 to IIIQ2014: (a) The rate of unemployment increased from 4.8 percent in IVQ2007 to 5.7 percent in IIIQ2014. (b) The number unemployed increased 21.6 percent from 7.371 million in IVQ2007 to 8.962 million in IIIQ2014. (c) The number employed part-time for economic reasons because they could not find any other job increased 41.3 percent from 4.750 million in IVQ2007 to 6.711 million in IIIQ2014. (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 11.3 percent in IIIQ2014.

Period IQ1980 to IQ1988

Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IQ1988 NSA End of Quarter	5.9
Unemployed IQ1980 Millions End of Quarter	6.983
Unemployed IQ1988 Millions End of Quarter	7.090
∆%	1.5
Employed Part-time Economic Reasons Millions IQ1980 End of Quarter	3.624
Employed Part-time Economic Reasons Millions IQ1988 End of Quarter	5.129
∆%	41.5

Period IVQ2007 to IIIQ2014

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2014 NSA End of Quarter	5.7
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIIQ2014 Millions End of Quarter	8.962
∆%	21.6
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2014 End of Quarter	6.711
∆%	41.3
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2014	11.3

6. Wealth of Households and Nonprofit Organizations.

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and from IVQ1979) to IQ1988 and from IVQ2007 to IIIQ2014 is provided in Table IIA-5. The data reveal the following facts for the cycles in the 1980s:

• IVQ1979 to IQ1988. Net worth increased 104.4 percent from IVQ1979 to IQ1988, the all items CPI index increased 51.9 percent from 76.7 in Dec 1979 to 116.5 in Mar 1988 and real net worth increased 32.6 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 IQ1988. Net worth increased 100.2 percent, the all items CPI index increased 45.4 percent from 80.1 in Mar 1980 to 116.5 in Mar 1988 and real net worth increased 37.6 percent.

There is disastrous performance in the current economic cycle:

• IVQ2007 to IIIQ2014. Net worth increased 21.9 percent, the all items CPI increased 13.3 percent from 210.036 in Dec 2007 to 238.031 in Sep 2014 and real or inflation adjusted net worth increased 7.5 percent. Real estate assets adjusted for inflation fell 16.4 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 2.3 percent on average in the cyclical expansion in the 21 quarters from IIIQ2009 to IIIQ2014. 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 IIIQ2014 (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp3q14_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 (http://cmpassocregulationblog.blogspot.com/2014/12/valuations-of-risk-financial-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/valuations-of-risk-financial-assets.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, 4.9 percent from IQ1983 to IQ1988 and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2014/12/valuations-of-risk-financial-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/valuations-of-risk-financial-assets.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 IIIQ2014 would have accumulated to 23.0 percent. GDP in IIIQ2014 would be $18,438.0 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2,232.4 billion than actual $16,205.6 billion. There are about two trillion dollars of GDP less than at trend, explaining the 26.0 million unemployed or underemployed equivalent to actual unemployment of 15.8 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2014/12/financial-risks-twenty-six-million.html

and earlier (http://cmpassocregulationblog.blogspot.com/2014/11/rules-discretionary-authorities-and.html). US GDP in IIIQ2014 is 12.1 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $16,205.1 billion in IIIQ2014 or 8.1 percent at the average annual equivalent rate of 1.1 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 Nov 2014. Growth at 3.3 percent per year would raise the NSA index of manufacturing output from 99.2392 in Dec 2007 to 124.2256 in Nov 2014. The actual index NSA in Nov 2014 is 101.7487, which is 18.1 percent below trend. Manufacturing output grew at average 2.3 percent between Dec 1986 and Dec 2013, raising the index at trend to 116.1422 in Nov 2014. The output of manufacturing at 101.7487 in Nov 2014 is 12.4 percent below trend under this alternative calculation.

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	9,047.8 9,238.6
IVQ1985 IIIQ1986 IVQ1986 IQ1987 IIQ1987 IIIQ1987 IVQ1987 IQ1988	15,277.2 16,290.8 16,840.3 17,494.6 17,784.0 18,195.3 18,021.9 18,495.2
∆ USD Billions IVQ1985 IVQ1979 to IQ1988 IQ1980-IVQ1985 IQ1980-IIIQ1986 IQ1980-IVQ1986 IQ1980-IQ1987 IQ1980-IIQ1987 IQ1980-IIIQ1987 IQ1980-IVQ1987 IQ1980-IQ1988	+6,229.4  ∆%68.8 R∆%18.5 +9447.4  ∆%104.4 R∆%34.6 +6,038.6 ∆%65.4 R∆%21.2 +7,052.2 ∆%76.3 R∆%28.2 +7,601.7 ∆%82.3 R∆%32.1 +8,256.0 ∆%89.4 R∆%35.3 +8,545.4 ∆%92.5 R∆%35.9 +8,956.7 ∆%96.9 R∆%37.2 +8783.3 ∆%95.1 R∆%35.4 +9256.6 ∆%100.2 R∆%37.6
Period IVQ2007 to IIIQ2014
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	66,753.5
IIIQ2014	81,348.8
∆ USD Billions	+14,595.3 ∆%21.9 R∆%7.5

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

7. Gross Private Domestic Investment.

i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IQ1988 and from IVQ2007 to IIIQ2014 is in the following block and in Table IB-2. Gross private domestic investment increased from $951.6 billion in IQ1980 to $1,194.4 billion in IQ1988 or by 25.5 percent.

ii In the current cycle, gross private domestic investment increased from $2,605.2 billion in IVQ2007 to $2,750.8 billion in IIIQ2014, or 5.6 percent. Private fixed investment edged from $2,586.3 billion in IVQ2007 to $2,643.3 billion in IIIQ2014, or increase by 2.2 percent.

Period IQ1980 to IQ1988
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IQ1988	1,194.4
∆%	25.5
Period IVQ2007 to IIIQ2014
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIIQ2014	2,750.8
∆%	5.6
Private Fixed Investment USD 2009 Billions
IVQ2007	2,586.3
IIIQ2014	2,643.3
∆%	2.2

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

Period IQ1980 to IQ1988
GDP SAAR USD Billions
IQ1980	6,524.9
IQ1988	8,339.3
∆% IQ1980 to IQ1988 (28.2 percent from IVQ1979 $6503.9 billion)	27.8
∆% Trend Growth IQ1980 to IQ1988	28.6
Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,241
Real Disposable Personal Income per Capita IQ1988 Chained 2009 USD	24,543
∆% IQ1980 to IQ1988 (21.3 percent from IVQ1979 $20,230 billion)	21.3
∆% Trend Growth	18.3
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IQ1988 NSA End of Quarter	112.867
∆% Employed IQ1980 to IQ1988	14.6
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IQ1988 NSA End of Quarter	92.760
∆% Full-time Employed IQ1980 to IQ1988	14.1
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IQ1988 NSA End of Quarter	5.9
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IQ1988 Millions NSA End of Quarter	7.090
∆%	1.5
Employed Part-time Economic Reasons IQ1980 Millions NSA End of Quarter	3.624
Employed Part-time Economic Reasons Millions IQ1988 NSA End of Quarter	5.129
∆%	41.5
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	9,047.8
IQ1988	18,495.2
∆ USD Billions	+9,447.4
∆% CPI Adjusted	34.6
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IQ1988	1194.4
∆%	25.5
Period IVQ2007 to IIIQ2014
GDP SAAR USD Billions
IVQ2007	14,991.8
IIIQ2014	16,205.6
∆% IVQ2007 to IIIQ2014	8.1
∆% IVQ2007 to IIIQ2014 Trend Growth	23.0
Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,819
Real Disposable Personal Income per Capita IIIQ2014 Chained 2009 USD	37,496
∆% IVQ2007 to IIIQ2014	4.7
∆% Trend Growth	14.9
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2014 NSA End of Quarter	147.666
∆% Employed IVQ2007 to IIIQ2014	0.9
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2014 NSA End of Quarter	119.791
∆% Full-time Employed IVQ2007 to IIIQ2014	-1.0
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2014 NSA End of Quarter	5.7
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIIQ2014 Millions NSA End of Quarter	8.962
∆%	21.6
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2014 NSA End of Quarter	6.711
∆%	41.3
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2014	11.3
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,753.5
IIIQ2014	81,348.8
∆ USD Billions	14,595.3 ∆%21.9 R∆%7.5
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIIQ2014	2,750.8
∆%	5.6
Private Fixed Investment USD 2009 Billions
IVQ2007	2,586.3
IIIQ2014	2,643.3
∆%	2.2

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

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm US Bureau of Labor Statistics http://www.bls.gov/data/. Board of Governors of the Federal Reserve System. 2014. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2014. Washington, DC, Federal Reserve System, Dec 11.

The Congressional Budget Office (CBO 2014BEOFeb4) estimates potential GDP, potential labor force and potential labor productivity provided in Table IB-3. The CBO estimates average rate of growth of potential GDP from 1950 to 2012 at 3.3 percent per year. The projected path is significantly lower at 2.1 percent per year from 2013 to 2024. The legacy of the economic cycle expansion from IIIQ2009 to IIIQ2014 is GDP growth at 2.3 percent on average is in contrast with 4.9 percent on average in the expansion from IQ1983 to IQ1988 (http://cmpassocregulationblog.blogspot.com/2014/12/valuations-of-risk-financial-assets.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 26.0 million or 15.8 percent of the effective labor force in Nov 2014 (http://cmpassocregulationblog.blogspot.com/2014/12/financial-risks-twenty-six-million.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2014/12/global-financial-and-economic-risk.html).

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

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.2	2.5	0.8
1982-1990	3.2	1.6	1.6
1991-2001	3.2	1.3	1.9
2002-2012	2.2	0.8	1.4
2007-2012	1.7	0.6	1.1
Total 1950-2012	3.3	1.5	1.8
Projected Average Annual ∆%
2013-2018	2.1	0.6	1.5
2019-2024	2.1	0.5	1.6
2013-2024	2.1	0.5	1.6

*Ratio of potential GDP to potential labor force

Source: CBO (2014BEOFeb4), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

Chart IB-1 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.3 percent on average from IIIQ2009 to IIIQ2014 during the current economic expansion in contrast with 4.9 percent on average in the cyclical expansion from IQ1983 to IQ1988 (http://cmpassocregulationblog.blogspot.com/2014/12/valuations-of-risk-financial-assets.html) cannot be explained by the contraction of 4.3 percent of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 26.0 million or 15.8 percent of the labor force as estimated for Nov 2014 (http://cmpassocregulationblog.blogspot.com/2014/12/financial-risks-twenty-six-million.html). There is no exit from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2014/12/global-financial-and-economic-risk.html). The US economy and labor markets collapsed without recovery. Abrupt collapse of economic conditions can be explained only with cyclic factors (Lazear and Spletzer 2012Jul22) and not by secular stagnation (Hansen 1938, 1939, 1941 with early dissent by Simons 1942).

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

Source: Congressional Budget Office, CBO (2013BEOFeb5). The last year in common in both projections is 2017. The revision lowers potential output in 2017 by 7.3 percent relative to the projection in 2007.

Chart IB-2 provides differences in the projections of potential output by the CBO in 2007 and more recently on Feb 4, 2014, which the CBO explains in CBO (2014Feb28).

Chart IB-2, Congressional Budget Office, Revisions of Potential GDP

Source: Congressional Budget Office, 2014Feb 28. Revisions to CBO’s Projection of Potential Output since 2007. Washington, DC, CBO, Feb 28, 2014.

Chart IB-3 provides actual and projected potential GDP from 2000 to 2024. The gap between actual and potential GDP disappears at the end of 2017 (CBO2014Feb4). GDP increases in the projection at 2.5 percent per year.

Chart IB-3, Congressional Budget Office, GDP and Potential GDP

Source: CBO (2013BEOFeb5), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

ESIV United States Commercial Banks Assets and Liabilities. IC 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 Nov 2013 and Nov 2014. Total assets of US commercial banks grew 7.8 percent from $13,983.6 billion in Nov 2013 to $15,076.8 billion in Nov 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 6.9 percent from $10,076.6 billion in Nov 2013 to $10,775.4 billion in Nov 2014. Securities in bank credit increased 6.7 percent from $2606 billion in Nov 2013 to $2886 billion in Nov 2014. A large part of securities in banking credit consists of US Treasury and agency securities, increasing 11.3 percent from $1798 billion in Nov 2013 to $2001 billion in Nov 2014. Credit to the government that issues or backs Treasury and agency securities of $2001 billion in Nov 2014 is about 18.6 percent of total bank credit of US commercial banks of $10,775.4 billion. Mortgage-backed securities, providing financing of home loans, increased 4.6 percent, from $1325 billion in Nov 2013 to $1386 billion in Nov 2014. Loans and leases are relatively more dynamic, growing 7.0 percent from $7371 billion in Nov 2013 to $7890 billion in Nov 2014. The only dynamic class is commercial and industrial loans, growing 12.9 percent from Nov 2013 to Nov 2014 and providing $1756 billion or 22.3 percent of total loans and leases of $7890 billion in Nov 2014. Real estate loans increased 2.6 percent, providing $3532 billion in Nov 2014 or 44.8 percent of total loans and leases. Consumer loans increased 4.7 percent, providing $1198 billion in Nov 2014 or 15.2 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 13.3 percent from $2612 billion in Nov 2013 to $2960 billion in Nov 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 6.7 percent from $9740 billion in Nov 2013 to $10,397 billion in Nov 2014. The difference between bank deposits and total loans and leases in banks increased from $2369 billion in Nov 2013 to $2507 billion in Nov 2014 or by $138 billion. Securities in bank credit increased by $180 billion from $2706 billion in Nov 2013 to $2886 billion in Nov 2014 and Treasury and agency securities increased by $203 billion from $1798 billion in Nov 2013 to $2001 billion in Nov 2014. Loans and leases increased $519 billion from $7371 billion in Nov 2013 to $7890 billion in Nov 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. Real disposable income per capita in IIIQ2014 higher by only 4.7 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 14.9 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 21.3 percent in the cycle from IQ1980 to IQ1988 that was close to trend growth of 18.3 percent.

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

	Nov 2013	Nov 2014	∆%
Total Assets	13,983.6	15,076.8	7.8
Bank Credit	10,076.6	10,775.4	6.9
Securities in Bank Credit	2706	2886	6.7
Treasury & Agency Securities	1798	2001	11.3
Mortgage-Backed Securities	1325	1386	4.6
Loans & Leases	7371	7890	7.0
Real Estate Loans	3532	3625	2.6
Commercial Real Estate Loans	1490	1590	6.7
Consumer Loans	1144	1198	4.7
Commercial & Industrial Loans	1557	1756	12.8
Other Loans & Leases	1138	1310	15.1
Cash Assets*	2612	2960	13.3
Total Liabilities	12,460	13,459	8.0
Deposits	9740	10,397	6.7
Residual (Assets less Liabilities)	1523	1618	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

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 Oct 2014 and Nov 2014. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.7 percent in 2010. Commercial and industrial loans fell 18.7 percent in 2009 and 9.2 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 47.7 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 29.8 percent in Jun 2014. Cash assets of banks increased at 8.4 percent in Jul 2014 and 16.0 percent in Aug 2014. Cash assets of banks increased at 16.8 percent in Sep 2014. Cash assets of banks increased at 2.8 percent in Oct 2014 and fell at 1.1 percent in Nov 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 at 7.9 percent in Jun 2014. Securities in bank credit increased at 10.1 percent in Jul 2014, at 0.3 percent in Aug 2014 and at 7.7 percent in Sep 2014. Securities in bank credit increased at 2.8 percent in Oct 2014 and at 5.3 percent in Nov 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 14.6 percent in Jul 2014, at 6.4 percent in Aug 2014 and at 19.5 percent in Sep 2014. Treasury and agency securities increased at 9.3 percent in Oct 2014 and at 6.5 percent in Nov 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 and 3.4 percent in Jun 2014. Deposits increased at 7.2 percent in Jul 2014, at 1.5 percent in Aug 2014 and at 10.0 percent in Sep 2014. Deposits fell at 4.4 percent in Oct 2014 and increased at 9.8 percent in Nov 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	Oct   2014	Nov  2014
Total Assets	-6.0	-2.7	5.2	2.6	7.2	4.4	4.5
Bank Credit	-6.7	-2.7	1.5	4.1	1.1	3.9	7.0
Securities in Bank Credit	6.2	6.9	1.8	7.5	-1.9	2.8	5.3
Treasury & Agency Securities	13.3	15.4	3.1	8.4	-5.6	9.3	6.5
Other Securities	-4.1	-7.3	-0.9	5.7	6.3	-11.4	2.6
Loans & Leases	-10.2	-5.7	1.4	2.8	2.2	4.3	7.7
Real Estate Loans	-5.6	-5.5	-3.7	-1.1	-1.0	0.3	0.6
Commercial Real Estate Loans	-4.7	-8.8	-6.4	-1.3	4.4	5.1	4.2
Consumer Loans	-3.2	-7.0	-1.7	1.0	3.5	4.1	4.3
Commercial & Industrial Loans	-18.7	-9.2	8.5	11.6	7.2	5.3	12.6
Other Loans & Leases	-22.7	0.5	18.6	7.5	5.0	14.8	24.0
Cash Assets	49.5	-7.8	47.7	-2.1	55.2	2.8	-1.1
Total Liabilities	-7.1	-3.3	5.5	2.3	8.1	3.2	5.5
Deposits	5.2	2.4	6.7	7.2	6.5	-4.4	9.8

Source: Board of Governors of the Federal Reserve System

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

ESV Slowing World Economic Growth. Table V-3 provides the latest available estimates of GDP for the regions and countries followed in this blog from IQ2012 to IIIQ2014 available now for all countries. There are preliminary estimates for all countries for IIIQ2014. Growth is weak throughout most of the world.

• Japan. The GDP of Japan increased 1.1 percent in IQ2012, 4.6 percent at SAAR (seasonally adjusted annual rate) and 3.5 percent relative to a year earlier but part of the jump could be the low level a year earlier because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. Japan’s GDP fell 0.4 percent in IIQ2012 at the seasonally adjusted annual rate (SAAR) of minus 1.7 percent, which is much lower than 4.6 percent in IQ2012. Growth of 3.5 percent in IIQ2012 in Japan relative to IIQ2011 has effects of the low level of output because of Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan’s GDP contracted 0.5 percent in IIIQ2012 at the SAAR of minus 2.0 percent and increased 0.2 percent relative to a year earlier. Japan’s GDP decreased 0.2 percent in IVQ2012 at the SAAR of minus 0.9 percent and changed 0.0 percent relative to a year earlier. Japan grew 1.5 percent in IQ2013 at the SAAR of 6.0 percent and increased 0.5 percent relative to a year earlier. Japan’s GDP increased 0.7 percent in IIQ2013 at the SAAR of 3.0 percent and increased 1.4 percent relative to a year earlier. Japan’s GDP grew 0.4 percent in IIIQ2013 at the SAAR of 1.6 percent and increased 2.2 percent relative to a year earlier. In IVQ2013, Japan’s GDP decreased 0.4 percent at the SAAR of minus 1.5 percent, increasing 2.3 percent relative to a year earlier. Japan’s GDP increased 1.4 percent in IQ2014 at the SAAR of 5.8 percent and increased 2.5 percent relative to a year earlier. In IIQ2014, Japan’s GDP fell 1.7 percent at the SAAR of minus 6.7 percent and fell 0.3 percent relative to a year earlier. Japan’s GDP contracted 0.5 percent in IIIQ2014 at the SAAR of minus 1.9 percent and fell 1.3 percent relative to a year earlier.
• China. China’s GDP grew 1.4 percent in IQ2012, annualizing to 5.7 percent, and 8.1 percent relative to a year earlier. The GDP of China grew at 2.1 percent in IIQ2012, which annualizes to 8.7 percent and 7.6 percent relative to a year earlier. China grew at 2.0 percent in IIIQ2012, which annualizes at 8.2 percent and 7.4 percent relative to a year earlier. In IVQ2012, China grew at 1.9 percent, which annualizes at 7.8 percent, and 7.9 percent in IVQ2012 relative to IVQ2011. In IQ2013, China grew at 1.6 percent, which annualizes at 6.6 percent and 7.7 percent relative to a year earlier. In IIQ2013, China grew at 1.8 percent, which annualizes at 7.4 percent and 7.5 percent relative to a year earlier. China grew at 2.3 percent in IIIQ2013, which annualizes at 9.5 percent and 7.8 percent relative to a year earlier. China grew at 1.7 percent in IVQ2013, which annualized to 7.0 percent and 7.7 percent relative to a year earlier. China’s GDP grew 1.5 percent in IQ2014, which annualizes to 6.1 percent, and 7.4 percent relative to a year earlier. China’s GDP grew 2.0 percent in IIQ2014, which annualizes at 8.2 percent, and 7.5 percent relative to a year earlier. China’s GDP grew 1.9 percent in IIIQ2014, which is equivalent to 7.8 percent in a year, and 7.3 percent relative to a year earlier. There is decennial change in leadership in China (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2014.
• Euro Area. GDP fell 0.1 percent in the euro area in IQ2012 and decreased 0.3 in IQ2012 relative to a year earlier. Euro area GDP contracted 0.3 percent IIQ2012 and fell 0.6 percent relative to a year earlier. In IIIQ2012, euro area GDP fell 0.1 percent and declined 0.8 percent relative to a year earlier. In IVQ2012, euro area GDP fell 0.4 percent relative to the prior quarter and fell 0.9 percent relative to a year earlier. In IQ2013, the GDP of the euro area fell 0.4 percent and decreased 1.2 percent relative to a year earlier. The GDP of the euro area increased 0.3 percent in IIQ2013 and fell 0.6 percent relative to a year earlier. In IIIQ2013, euro area GDP increased 0.2 percent and fell 0.3 percent relative to a year earlier. The GDP of the euro area increased 0.2 percent in IVQ2013 and increased 0.4 percent relative to a year earlier. In IQ2014, the GDP of the euro area increased 0.3 percent and 1.1 percent relative to a year earlier. The GDP of the euro area increased 0.1 percent in IIQ2014 and increased 0.8 percent relative to a year earlier. The euro area’s GDP increased 0.2 percent in IIIQ2014 and increased 0.8 percent relative to a year earlier.
• Germany. The GDP of Germany increased 0.3 percent in IQ2012 and 1.5 percent relative to a year earlier. In IIQ2012, Germany’s GDP increased 0.1 percent and increased 0.3 percent relative to a year earlier but 0.8 percent relative to a year earlier when adjusted for calendar (CA) effects. In IIIQ2012, Germany’s GDP increased 0.1 percent and 0.1 percent relative to a year earlier. Germany’s GDP contracted 0.4 percent in IVQ2012 and decreased 0.3 percent relative to a year earlier. In IQ2013, Germany’s GDP decreased 0.4 percent and fell 1.8 percent relative to a year earlier. In IIQ2013, Germany’s GDP increased 0.8 percent and 0.5 percent relative to a year earlier. The GDP of Germany increased 0.3 percent in IIIQ2013 and 0.8 percent relative to a year earlier. In IVQ2013, Germany’s GDP increased 0.4 percent and 1.0 percent relative to a year earlier. The GDP of Germany increased 0.8 percent in IQ2014 and 2.6 percent relative to a year earlier. In IIQ2014, Germany’s GDP contracted 0.1 percent and increased 1.0 percent relative to a year earlier. The GDP of Germany increased 0.1 percent in IIIQ2014 and increased 1.2 percent relative to a year earlier.
• United States. Growth of US GDP in IQ2012 was 0.6 percent, at SAAR of 2.3 percent and higher by 2.6 percent relative to IQ2011. US GDP increased 0.4 percent in IIQ2012, 1.6 percent at SAAR and 2.3 percent relative to a year earlier. In IIIQ2012, US GDP grew 0.6 percent, 2.5 percent at SAAR and 2.7 percent relative to IIIQ2011. In IVQ2012, US GDP grew 0.0 percent, 0.1 percent at SAAR and 1.6 percent relative to IVQ2011. In IQ2013, US GDP grew at 2.7 percent SAAR, 0.7 percent relative to the prior quarter and 1.7 percent relative to the same quarter in 2013. In IIQ2013, US GDP grew at 1.8 percent in SAAR, 0.4 percent relative to the prior quarter and 1.8 percent relative to IIQ2012. US GDP grew at 4.5 percent in SAAR in IIIQ2013, 1.1 percent relative to the prior quarter and 2.3 percent relative to the same quarter a year earlier (http://cmpassocregulationblog.blogspot.com/2014/11/valuations-of-risk-financial-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/growth-uncertainties-mediocre-cyclical.html) with weak hiring (http://cmpassocregulationblog.blogspot.com/2014/12/global-financial-and-economic-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/fluctuating-financial-variables.html). In IVQ2013, US GDP grew 0.9 percent at 3.5 percent SAAR and 3.1 percent relative to a year earlier. In IQ2014, US GDP decreased 0.5 percent, increased 1.9 percent relative to a year earlier and fell 2.1 percent at SAAR. In IIQ2014, US GDP increased 1.1 percent at 4.6 percent SAAR and increased 2.6 percent relative to a year earlier. US GDP increased 1.2 percent in IIIQ2014 at 5.0 percent SAAR and increased 2.7 percent relative to a year earlier.
• United Kingdom. In IQ2012, UK GDP increased 0.1 percent, increasing 1.0 percent relative to a year earlier. UK GDP fell 0.2 percent in IIQ2012 and increased 0.6 percent relative to a year earlier. UK GDP increased 0.8 percent in IIIQ2012 and increased 0.7 percent relative to a year earlier. UK GDP fell 0.3 percent in IVQ2012 relative to IIIQ2012 and increased 0.4 percent relative to a year earlier. UK GDP increased 0.6 percent in IQ2013 and 0.9 percent relative to a year earlier. UK GDP increased 0.6 percent in IIQ2013 and 1.7 percent relative to a year earlier. In IIIQ2013, UK GDP increased 0.7 percent and 1.6 percent relative to a year earlier. UK GDP increased 0.4 percent in IVQ2013 and 2.4 percent relative to a year earlier. In IQ2014, UK GDP increased 0.6 percent and 2.4 percent relative to a year earlier. UK GDP increased 0.8 percent in IIQ2014 and 2.6 percent relative to a year earlier. In IIIQ2014, UK GDP increased 0.7 percent and increased 2.6 percent relative to a year earlier.
• Italy. Italy has experienced decline of GDP in nine consecutive quarters from IIIQ2011 to IIIQ2013 and in IIQ2014 and IIIQ2014. Italy’s GDP fell 0.9 percent in IQ2012 and declined 1.9 percent relative to IQ2011. Italy’s GDP fell 0.4 percent in IIQ2012 and declined 2.4 percent relative to a year earlier. In IIIQ2012, Italy’s GDP fell 0.4 percent and declined 2.5 percent relative to a year earlier. The GDP of Italy contracted 0.8 percent in IVQ2012 and fell 2.5 percent relative to a year earlier. In IQ2013, Italy’s GDP contracted 0.9 percent and fell 2.5 percent relative to a year earlier. Italy’s GDP fell 0.2 percent in IIQ2013 and 2.2 percent relative to a year earlier. The GDP of Italy changed 0.0 percent in IIIQ2013 and declined 1.8 percent relative to a year earlier. Italy’s GDP decreased 0.1 percent in IVQ2013 and decreased 1.2 percent relative to a year earlier. In IQ2014, Italy’s GDP changed 0.0 percent and fell 0.3 percent relative to a year earlier. The GDP of Italy fell 0.2 percent in IIQ2014 and declined 0.4 percent relative to a year earlier. In IIIQ2014, Italy’s GDP contracted 0.1 percent and fell 0.5 percent relative to a year earlier.
• France. France’s GDP increased 0.2 percent in IQ2012 and increased 0.6 percent relative to a year earlier. France’s GDP decreased 0.2 percent in IIQ2012 and increased 0.4 percent relative to a year earlier. In IIIQ2012, France’s GDP increased 0.2 percent and increased 0.4 percent relative to a year earlier. France’s GDP fell 0.2 percent in IVQ2012 and changed 0.0 percent relative to a year earlier. In IQ2013, France’s GDP changed 0.0 percent and declined 0.3 percent relative to a year earlier. The GDP of France increased 0.7 percent in IIQ2013 and 0.7 percent relative to a year earlier. France’s GDP decreased 0.1 percent in IIIQ2013 and increased 0.3 percent relative to a year earlier. The GDP of France increased 0.2 percent in IVQ2013 and 0.8 percent relative to a year earlier. In IQ2014, France’s GDP changed 0.0 percent and increased 0.8 percent relative to a year earlier. In IIQ2014, France’s GDP contracted 0.1 percent and changed 0.0 percent relative to a year earlier. France’s GDP increased 0.3 percent in IIIQ2014 and increased 0.4 percent relative to a year earlier.

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

	IQ2012/IVQ2011	IQ2012/IQ2011
United States	QOQ: 0.6        SAAR: 2.3	2.6
Japan	QOQ: 1.1 SAAR: 4.6	3.5
China	1.4	8.1
Euro Area	-0.1	-0.3
Germany	0.3	1.5
France	0.2	0.6
Italy	-0.9	-1.9
United Kingdom	0.1	1.0
	IIQ2012/IQ2012	IIQ2012/IIQ2011
United States	QOQ: 0.4         SAAR: 1.6	2.3
Japan	QOQ: -0.4 SAAR: -1.7	3.5
China	2.1	7.6
Euro Area	-0.3	-0.6
Germany	0.1	0.3 0.8 CA
France	-0.2	0.4
Italy	-0.4	-2.4
United Kingdom	-0.2	0.6
	IIIQ2012/ IIQ2012	IIIQ2012/ IIIQ2011
United States	QOQ: 0.6  SAAR: 2.5	2.7
Japan	QOQ: –0.5 SAAR: –2.0	0.2
China	2.0	7.4
Euro Area	-0.1	-0.8
Germany	0.1	0.1
France	0.2	0.4
Italy	-0.4	-2.5
United Kingdom	0.8	0.7
	IVQ2012/IIIQ2012	IVQ2012/IVQ2011
United States	QOQ: 0.0 SAAR: 0.1	1.6
Japan	QOQ: -0.2 SAAR: -0.9	0.0
China	1.9	7.9
Euro Area	-0.4	-0.9
Germany	-0.4	-0.3
France	-0.2	0.0
Italy	-0.8	-2.5
United Kingdom	-0.3	0.4
	IQ2013/IVQ2012	IQ2013/IQ2012
United States	QOQ: 0.7 SAAR: 2.7	1.7
Japan	QOQ: 1.5 SAAR: 6.0	0.5
China	1.6	7.7
Euro Area	-0.4	-1.2
Germany	-0.4	-1.8
France	0.0	-0.3
Italy	-0.9	-2.5
UK	0.6	0.9
	IIQ2013/IQ2013	IIQ2013/IIQ2012
United States	QOQ: 0.4 SAAR: 1.8	1.8
Japan	QOQ: 0.7 SAAR: 3.0	1.4
China	1.8	7.5
Euro Area	0.3	-0.6
Germany	0.8	0.5
France	0.7	0.7
Italy	-0.2	-2.2
UK	0.6	1.7
	IIIQ2013/IIQ2013	III/Q2013/  IIIQ2012
USA	QOQ: 1.1 SAAR: 4.5	2.3
Japan	QOQ: 0.4 SAAR: 1.6	2.2
China	2.3	7.8
Euro Area	0.2	-0.3
Germany	0.3	0.8
France	-0.1	0.3
Italy	0.0	-1.8
UK	0.7	1.6
	IVQ2013/IIIQ2013	IVQ2013/IVQ2012
USA	QOQ: 0.9 SAAR: 3.5	3.1
Japan	QOQ: -0.4 SAAR: -1.5	2.3
China	1.7	7.7
Euro Area	0.2	0.4
Germany	0.4	1.0
France	0.2	0.8
Italy	-0.1	-1.2
UK	0.4	2.4
	IQ2014/IVQ2013	IQ2014/IQ2013
USA	QOQ -0.5 SAAR -2.1	1.9
Japan	QOQ: 1.4 SAAR: 5.8	2.5
China	1.5	7.4
Euro Area	0.3	1.1
Germany	0.8	2.6
France	0.0	0.8
Italy	0.0	-0.3
UK	0.6	2.4
	IIQ2014/IQ2014	IIQ2014/IIQ2013
USA	QOQ 1.1 SAAR 4.6	2.6
Japan	QOQ: -1.7 SAAR: -6.7	-0.3
China	2.0	7.5
Euro Area	0.1	0.8
Germany	-0.1	1.0
France	-0.1	0.0
Italy	-0.2	-0.4
UK	0.8	2.6
	IIIQ2014/IIQ2014	IIIQ2014/IIIQ2013
USA	QOQ: 1.2 SAAR: 5.0	2.7
Japan	QOQ: -0.5 SAAR: -1.9	-1.3
China	1.9	7.3
Euro Area	0.2	0.8
Germany	0.1	1.2
France	0.3	0.4
Italy	-0.1	-0.5
UK	0.7	2.6

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

Source: Country Statistical Agencies http://www.census.gov/aboutus/stat_int.html

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014.