The Global Currency War, Quantitative Easing and the G20

 

The Global Currency War, Quantitative Easing and the G20

Carlos M. Pelaez

The first part of this post relates quantitative easing (I), the global currency war (II) and the G20 (III). Economic indicators are considered in (IV), interest rates in (V) and the conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/).

I Quantitative Easing. A part of the General Theory of John Maynard Keynes is interpreted as the ineffectiveness of monetary policy at very low interest rates. Income and the interest rate are key determinants of the demand for liquidity or cash balances (John R. Hicks, Mr. Keynes and the “classics”: a suggested interpretation. Econometrica 1937 (5, 3), 154-5):

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

In that special case, which economists call the liquidity trap, monetary policy would be ineffective because the interest rate cannot be lowered below zero to induce more investment that could increase income. Keynes proposed that fiscal policy could increase employment without raising the rate of interest. The expected change in the price level influences the nominal interest rate such that low expected inflation typically coincides with low interest rates (http://www.econlib.org/library/YPDBooks/Fisher/fshToI19.html). In contemporary analysis, the issue becomes how to design and implement monetary policy during periods of low inflation.

An important discovery in economics is that economic policy must be credible, which is known as time consistency (Pelaez and Pelaez, Regulation of Banks and Finance, 112-6) . For example, expectations of inflation would increase immediately if the public were not to believe the perseverance of the central bank in maintaining tight monetary policy that would be abandoned in favor of promoting growth and employment with the consequence of rising inflation. The experience of Japan in the 1990s reversed this inflation focus (Paul Krugram, It’s baaack: Japan’s slump and the return of the Liquidity Trap. Brookings Papers on Economic Activity1998, 139):

“The traditional view that money policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level”

Section 2a, Monetary Policy Objectives of the Federal Reserve Act mandates that “the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (http://www.federalreserve.gov/aboutthefed/section2a.htm). The mandate-consistent inflation rate promoting the dual mandate of maximum employment and stable prices is not exactly zero such that moderate inflation in the long run is, according to Chairman Bernanke, “most consistent with the dual mandate” (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm). The FOMC may require some nominal interest rate that could be lowered to stimulate economic activity during recessions or periods of growth that is insufficient for full employment. Moderate inflation could maintain the nominal interest rate at a level affording such policy alternative.

The President of the Federal Reserve Bank of Chicago argues that (Charles Evans, http://chicagofed.org/webpages/publications/speeches/2010/10_16_boston_speech.cfm#_ftn1):

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

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

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

Optimum monetary policy with interest rates near zero could consist of “bringing the price level back up to a level even higher than would have prevailed had the disturbance never occurred” (Gauti Eggertsson and Michael Woodford, The zero bound on interest rates and optimal monetary policy. BPEA 2003 (1), 207). Bernanke explains as follows (http://www.federalreserve.gov/boarddocs/speeches/2003/20030531/default.htm):

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

Second, the Fed could use its balance sheet to increase purchases of long-term securities together with credible commitment to maintain the policy until the dual mandates of maximum employment and price stability are attained. The Federal Open Market Committee (FOMC) announced in Nov 2008 the purchase of up to $600 billion of housing agency debt and agency mortgage-backed securities. In Mar 2009, the FOMC announced the purchase of total assets of up to $1.75 trillion, including also long-term Treasury securities. The objective of purchasing agency-related securities is improving conditions in financial markets for housing and the purchase of long-term securities intends improving private credit markets (http://www.newyorkfed.org/research/staff_reports/sr441.pdf, 1-2). The purchase of $1.7 trillion in assets by the Fed between Dec 2008 and Mar 2010 is equivalent to 22 percent of the $7.7 trillion outstanding stock in the beginning of the program of the three asset classes acquired of long-term agency debt, fixed-rate agency mortgage-backed securities and Treasuries. The amount of duration withdrawn from the market can be measured in terms of 10-year equivalents, or the amount of 10-year par Treasuries with the same duration as the acquired portfolio, equivalent to $850 billion or more than 20 percent of the $3.7 trillion outstanding stock of 10-year equivalents in the three asset classes (Ibid, 8). There are two types of effects of the purchases of securities by the Fed: (1) the purchases lower yields by bidding up the prices of the purchased securities; and (2) the purchases reduce the duration premium required by investors for holding long-term securities and increase liquidity and reduce the risk premium of securities such as mortgage-backed securities because of embedded options in prepayment alternatives (Ibid, 4-7). Research by the staff of the Fed finds that quantitative easing reduced the 10-year premium “between 30 and 100 basis points, with most estimates in the lower and middle thirds of the range” and that the “programs had an even more powerful effect on longer-term interest rates on agency debt and agency MBS by improving market liquidity and by removing assets with high prepayment risk from private portfolios” (Ibid, 28).

The unemployment rate of 9.6 percent, core PCE inflation at 1 percent while the Fed goal is “about 2 percent or a bit below” (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm) and multiple recent statements by members of the FOMC in support of further action to discharge their dual mandate strongly suggest further quantitative easing. Market participants and the financial press have been expecting another round of quantitative easing. It may not necessarily be the “shock and awe” version during the global recession of purchasing $1.725 trillion. The Financial Times reports the study in the Fed of a more flexible approach with three ingredients: (1) guidance on the volume to be purchased; (2) the pace of acquisition and the timing of the program; and (3) specific determinants of the review of the volume of purchases (http://www.ft.com/cms/s/0/30fe59b6-dc7b-11df-a0b9-00144feabdc0.html). The objective of the program would be steering unemployment lower and inflation higher.

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” (Milton Friedman, A Theory of the Consumption Function, Princeton University Press, 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Michael R. Darby, The permanent income theory of consumption—a restatement. QJE 1974 (88, 2), 229, where * denotes permanent). There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). The simplified relation of income and wealth can be restated as: W = Y/r, such that as r goes to zero, W grows without bound. The lowering of 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, the so-called “shadow banking system” (http://www.ny.frb.org/research/staff_reports/sr458.pdf) and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper.

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. The Fed 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 structured investment vehicles (SIV) created off-balance sheet to issue short-term commercial paper to purchase risky 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 Fed 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. 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 Fed put option on wealth, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the Fed put option on wealth 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 consequences of the global hunt for yields created by monetary and housing policy are shown in Table 1. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, a rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and an increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates fostered significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 on Jun 12, 2007, collapsing to 2.247 on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. The combination of short-term zero interest rates, quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.

 

Table 1, Volatility of Assets

DJIA	10/08/02-10/01/07	10/01/07-3/4/09	3/4/09- 4/6/10
∆%	87.8	-51.2	60.3
NYSE Financial	1/15/04- 6/13/07	6/13/07- 3/4/09	3/4/09- 4/16/07
∆%	42.3	-75.9	121.1
Shanghai Composite	6/10/05- 10/15/07	10/15/07- 10/30/08	10/30/08- 7/30/09
∆%	444.2	-70.8	85.3
STOXX EUROPE 50	3/10/03- 7/25/07	7/25/07- 3/9/09	3/9/09- 4/21/10
∆%	93.5	-57.9	64.3
UBS Com.	1/23/02- 7/1/08	7/1/08- 2/23/09	2/23/09- 1/6/10
∆%	165.5	-56.4	41.4
10-Year Treasury	6/10/03	6/12/07	12/31/08	4/5/10
%	3.112	5.297	2.247	3.986
USD/EUR	7/14/08	6/03/10	8/13/10
Rate	1.59	1.216	1.323
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

 

The values of most financial assets in the world have sharply increased since the fixing of expectations of another round of quantitative easing in late August. Equity indexes have soared by two-digit percentages since the trough of declines resulting from the uncertainties of sovereign risks in Europe, as shown in the last column of Table 2. The dollar depreciated 17 percent from $1.192/euro on Jun 6, 2010 to $1.395/euro on Oct 22, 2010 but is still stronger by 7.8 percent relative to $1.513/euro on Nov 25, 2009. The Fed is cornered in taking strong policy action in that no decision or low policy doses could provoke an exit out of risk exposures with declining values of financial assets. The management of assets and liabilities with these shocks of monetary policies, combined with legislative restructurings and regulation, has become challenging, stifling intermediation required for growth, precisely the opposite outcome intended by policy.

 

Table 2, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 10/22	∆% Week 10/22	∆% T to 10/22
DJIA	4/26/10	7/2/10	-13.6	-0.6	0.6	14.9
S&P 500	4/23/10	7/20/10	-16.0	-2.8	0.6	15.7
NYSE Finance	4/15/10	7/2/10	-20.3	-10.2	1.0	12.7
Dow Global	4/15/10	7/2/10	-18.4	-2.7	0.1	19.2
Asia Pacific	4/15/10	7/2/10	-12.5	1.8	-0.7	16.3
China Shanghai	4/15/10	7/2/10	-24.7	-6.0	0.1	22.7
STOXX 50	4/15/10	7/2/10	-15.3	-5.9	0.1	11.1
DAX	4/26/10	5/25/10	-10.5	4.3	1.7	16.5
Dollar Euro	11/25 2009	6/7 2010	21.2	7.8	0.2	-17.0
DJ UBS Comm.	1/6/10	7/2/10	-14.5	-0.1	-0.6	16.9
10-Year Tre.	4/5/10	4/6/10	3.986	2.561

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://online.wsj.com/mdc/page/marketsdata.html

 

II The Global Currency War. Another article in the Financial Times explores the relation of quantitative easing to the value of the dollar in terms of three issues: (1) the effect of quantitative easing on long-term interest rates; (2) the dimension of dollar weakening resulting from lower long-term interest rates; and (3) the devaluation of the dollar already priced in financial assets (http://www.ft.com/cms/s/0/e075c278-da0d-11df-bdd7-00144feabdc0.html). Analysis of a sample from Jan 1984 to May 2005, characterized by sharp fluctuations of the economy and financial markets, finds that “foreign inflows into US bonds reduce the 10-year Treasury yield by an economically (and statistically) significant amount” (http://www.federalreserve.gov/pubs/ifdp/2005/840/ifdp840.pdf). The model used shows that had foreigners not accumulated US bonds in the 12 months ending in May 2005, the 10-year Treasury would have been 150 basis points higher. This is evidence of close relation in international interest rates. Research at the Federal Reserve Bank of St. Louis finds that long-term yields in the US declined on average by 74 basis points in the purchase events of quantitative easing; the decline of 10-year yields was by an average of 45 basis points in foreign markets of advanced economies. The dollar declined on average by 6.56 percent in the events of quantitative easing, ranging from depreciation of 10.8 percent relative to the Japanese yen to 3.6 percent relative to the pound sterling (http://research.stlouisfed.org/wp/2010/2010-018.pdf). A critical assumption of Rudiger Dornbusch in his celebrated analysis of overshooting (http://www.imf.org/external/np/speeches/2001/kr/112901.pdf) is “that exchange rates and asset markets adjust fast relative to goods markets” (Rudiger Dornbusch, Expectations and exchange rate dynamics. JPE 84 (6), 1162). The market response of a monetary expansion is “to induce an immediate depreciation in the exchange rate and accounts therefore for fluctuations in the exchange rate and the terms of trade. During the adjustment process, rising prices may be accompanied by an appreciating exchange rate so that the trend behavior of exchange rates stands potentially in strong contrast with the cyclical behavior of exchange rates and prices” (Ibid, 1162). The volatility of the exchange rate “is needed to temporarily equilibrate the system in response to monetary shocks, because underlying national prices adjust so slowly” (http://www.imf.org/external/np/speeches/2001/kr/112901.pdf 3). The exchange rate “is identified as a critical channel for the transmission of monetary policy to aggregate demand for domestic output” (Dornbusch, op. cit., 1162). The question in (3) above is whether the fact of quantitative easing will reverse part of the devaluation of the dollar that has already occurred. Reviewing the estimates of various efforts and adjusting them for $1 trillion quantitative easing, the Financial Times finds dollar devaluation between 2 to 5 percent, with the weight toward the lower part of the interval but warns that economists are not fully confident of estimates because of the limited experience in measuring effects of quantitative easing (http://www.ft.com/cms/s/0/e075c278-da0d-11df-bdd7-00144feabdc0.html).

Measuring overshooting proves elusive. Table 3 merely provides recent wide swings of exchange rates. Two sources of conflict arise in the appreciation of the euro, which affects the major exporting economy of Germany, and affecting  another major exporting economy through the appreciation of the Japanese yen. The euro has appreciated from $1.192/euro on Jun 7 to $1.395/euro on Oct 22 while the yen has appreciated from Y110.19/USD on Aug 18, 2008 to Y81.35/USD on Oct 22. The Bank of England, European Central Bank and Bank of Japan are all engaged in quantitative easing, but they pale in comparison with the gigantic balance sheet of the Federal Reserve with $2.3 trillion on Oct 20, including a portfolio of long-term securities of $1.98 trillion consisting of $766 billion of Treasury notes and bonds, $151 billion of agency debt securities and $1066 billion of mortgage-backed securities with reserve balances of banks of $983 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). A common estimate by market participants is that the Fed may buy another trillion dollars of long-term securities but, to be sure, no such decision has been already made by the FOMC. Exchange rate appreciation is particularly painful to the exports of countries such as Brazil, which has a diversified economy with comparative advantage in both primary commodities and industrialized products, and various countries in Asia. Economies of all types have engaged in policies of preventing appreciation of their currencies in response to generalized dollar devaluation, including Israel as revealed by the governor of the Bank of Israel who is a prominent economist (http://professional.wsj.com/article/SB10001424052702303550904575562313029626460.html?mod=wsjproe_hps_MIDDLESecondNews). Scandinavian countries and Switzerland have been also experiencing significant appreciation of their currencies.

 

Table 3, Exchange Rates

	Peak	Trough	∆% P/T	Oct 22 2010	∆% T Oct 22	∆% P Oct 22
EUR USD	7/15 2008	6/7 2010		10/22 2010
Rate	1.59	1.192		1.395
∆%			-33.4		14.5	-13.9
JPY USD	8/18 2008	9/15 2010		10/22 2010
Rate	110.19	83.07		81.35
∆%			24.6		2.0	26.2
CHF USD	11/21 2008	12/8 2009		10/22 2010
Rate	1.225	1.025		0.976
∆%			16.3		4.7	20.3
USD GBP	7/15 2008	1/2/ 2009		10/22 2010
Rate	2.006	1.388		1.568
∆%			-44.5		11.5	-27.9
USD AUD	7/15 2008	10/27 2008		10/22 2010
Rate	0.979	0.601		0.983
∆%			-62.9		38.9	0.4
ZAR USD	10/22 2008	8/15 2010		10/22 2010
Rate	11.578	7.238		6.95
∆%			37.5		3.9	39.9
SGD USD	3/3 2009	8/9 2010		10/22 2010
Rate	1.553	1.348		1.296
∆%			13.2		3.9	16.5
HKD USD	8/15 2008	12/14 2009		10/22 2010
Rate	7.813	7.752		7.761
∆%			0.8		-0.1	0.7
BRL USD	12/5 2008	4/30 2010		10/22 2010
Rate	2.43	1.737		1.691
∆%			28.5		2.6	30.4
CZK USD	2/13 2009	8/6 2010		10/22 2010
Rate	22.19	18.693		17.565
∆%			15.7		2.6	30.4
SEK USD	3/4 2009	8/9 2010		10/22 2010
Rate	9.313	7.108		6.617
∆%			23.7		6.9	28.9

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

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

 

III The G20. The critical issue discussed at the G20 meeting of finance ministers and central bank governors in Gyeongju, Republic of Korea, on Oct 23 is shown in Table 4. The first three rows show the current account surpluses of Germany, China and Japan, which exceed 4 percent in 2010, especially in the case of 6.7 percent for Germany and 9.6 percent for China. The IMF projects the surpluses to still be quite high in 2015 at 7.8 percent for China and 3.9 percent for Germany while the surplus of Japan is expected to decline to 1.9 percent. The US had a deficit in current account of 4.7 percent of GDP in 2008 and Brazil of 1.7 percent and the IMF projection is for both countries to have a deficit of 3.3 percent of GDP in 2015. The US Treasury Secretary proposed in a letter to G20 members three types of policies to be adopted: (1) reduction of external imbalances by a specified percentage of GDP, allowing for countries with large surpluses of raw materials, by increasing national savings to attain sustainable government debt levels; (2) avoidance of competitive devaluations and undervalued exchange rates; and (3) monitoring progress by the IMF (http://www.ft.com/cms/s/0/651377aa-ddc4-11df-8354-00144feabdc0.html). The proposal is similar to the “doctrine of shared responsibility” (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II, 180-194, Government Intervention in Globalization, 167-70, and earlier events in International Financial Architecture, 1-63). The Communiqué of finance ministers and central bank governors agrees to “move toward more market determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies” (http://www.g20.utoronto.ca/2010/g20finance101023.pdf). An objective is to prevent “excess volatility and disorderly movements in exchange rates” with the objective of reducing volatility in emerging-market capital flows. The IMF will work in promoting “a stable and well-functioning international monetary system.” The G20 also agreed to “strengthen multilateral cooperation to promote external sustainability and pursue the full range of policies conducive to reducing excessive imbalances and maintaining current account imbalances at sustainable levels.” The IMF will provide an assessment of “the progress toward external sustainability and the consistency of fiscal, monetary, financial sector, structural, exchange rate and other policies.” These principles could still find more precise guidelines through the work of the IMF before the Seoul Summit in November and in subsequent international cooperation.

 

Table 4, Current Account Balance as Percent of GDP

	2008	2010	2015
Germany	6.7	6.1	3.9
Japan	3.2	3.1	1.9
China	9.6	4.7	7.8
USA	-4.7	-3.2	-3.3
Brazil	-1.7	-2.6	-3.3

Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

 

Another risk of the world economy and international monetary system is the rise of budget deficits and growing government debts in some countries. Table 5 provides the net debt as percent of GDP for the same countries, with evident rise in the debt/GDP ratio for Japan and the US. The G20 also agreed that advanced countries should “formulate and implement clear, credible, ambitious and growth-friendly medium-term fiscal consolidation plans differentiated according to national circumstances.” The G20 also agreed to shift to emerging countries two of the nine European seats in the IMF board together with shifting 6 percent of the Fund’s voting and financing quota from advanced countries to emerging countries (http://professional.wsj.com/article/SB10001424052702303738504575567431511483738.html?mod=WSJ_hpp_MIDDLETopStories).

 

Table 5, Net Government Debt as Percent of GDP

	2008	2010	2015
Germany	49.7	58.7	61.7
Japan	94.9	120.7	153.4
China	16.8	19.1	13.9
USA	47.6	65.8	84.7
Brazil	37.9	36.7	30.8

Note: China is gross debt.

Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

 

IV Economic Indicators. The economic indicators suggest deceleration of industrial activity, depressed conditions in housing and weak labor markets. The Fed reported that industrial production in Sep fell by 0.2 percent and that production in the third quarter increased at the annual rate of 4.8 percent after growing at the annual rate of 7 percent in the first and second quarters. Manufacturing growth “decelerated sharply” to a 3.6 percent annual rate in the third quarter after growing at the annual rate of 9.1 percent in the second quarter. Capacity utilization for total industry fell to 74.7 percent, which is 4.2 percentage points above the rate a year earlier but 5.9 percentage points below the average in 1972-2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm). The general index of the business outlook survey of the Philadelphia Fed improved from -0.7 in Sep to 1.0 in Oct. However, new orders at -5.0 continue to show monthly contraction even being stronger than -8.1 in Sep and -7.1 in Oct. Stocks declined by 18.6 in Oct after declining 16.7 in Aug and 11.6 in Jul (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos1010.pdf). Housing starts stood at the seasonally adjusted (SA) annual rate of 610,000 units in Sep, higher by 0.3 percent over the Aug rate of 608,000 units and higher by 4.1 percent relative to 586,000 units in Sep 2009. Permits stood at 539,000, which are lower by 5.6 percent than 571,000 in Aug and 10.9 percent below 605,000 in Sep 2009. In the first nine months of 2005 the annual rate without seasonal adjustment was 1,649,999 (http://www.census.gov/const/newresconst_200509.pdf Table 1). In the first nine months of 2010 the annual rate without seasonal adjustment was 464,800 (http://www.census.gov/const/newresconst_201009.pdf Table 1). The decrease in housing starts between Sep 2010 and Sep 2005 is 71.8 percent, a decline of magnitude rarely found in physical data. The Beige Book of the Fed finds that: “reports from the twelve Federal Reserve Districts suggest that, on balance, national economic activity continued to rise, albeit at a modest pace, during the reporting period from September to early October” (http://www.federalreserve.gov/fomc/beigebook/2010/20101020/fullreport20101020.pdf). Initial claims for unemployment insurance SA fell by 23,000 to 452,000 in the week ending Oct 16. A large part of the decline is due to the revision of the prior week from 462,000 to 475,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm). After declining sharply, claims have stabilized around 450,000 throughout 2010.

V Interest Rates. The yield of the 10-year Treasury has stabilized at 2.56 percent on Oct 22 compared with 2.57 percent a week earlier and 2.62 percent a month earlier. The yield of the 10-year German government bond rose to 2.47 percent for a negative spread relative to the equivalent Treasury of 10 basis points. The Treasury with 2.63 percent coupon maturing on 08/20 traded on Oct 22 at 100.55 or equivalent yield of 2.56 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-221010). If the yield were to back up to 3.986 percent traded on Apr 5, the price for settlement on Oct 25 would be 89.0661, for a principal loss of 11.4 percent. Unconventional monetary policy, both price level targets and quantitative easing, ignores the pain of rising inflation on artificially-reduced interest rates when the objective is to create the expectation of rising inflation.

VI Conclusion. The expectation of quantitative easing since late Aug has depreciated the dollar against most currencies in the world and increased the values of financial assets. Deliberately or as an acceptable side effect, US monetary policy is devaluing the dollar. An agreement among nations on exchange rates and global imbalances does not appear feasible in the short term. Unconventional monetary policies have profound effects on financial variables and asset values that are not typically recognized. Managing asset and liabilities of financial institutions during these policy shocks is quite challenging. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

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