Subpar US Growth, European Sovereign Risk, Financial Turbulence and Policy Failure
Carlos M. Pelaez
©Carlos M. Pelaez, 2010
Subpart US growth with job stress, European sovereign risk doubts, policy failure and concerns with growth in China are contributing to financial turbulence. The contents of this post are as follows:
I Subpar US Growth
II European Sovereign Risk
III Financial Turbulence
IV Policy Failure
V The Global Devaluation War
VI Economic Indicators
VII Interest Rates
VIII Conclusion
I Subpar US Growth. The main economic issue in the US is that the economy is growing at subpar rates relative to recovery from earlier contractions such that there are 26.6 million people in job stress. The Bureau of Economic Analysis (BEA) estimates real Gross Domestic Product (GDP) as “the output of goods and services produced by labor and property located in the United States” (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_2nd.pdf 1). Real GDP increased from the second to the third quarter of 2010 at the seasonally adjusted (SA) annual equivalent rate of 2.5 percent. This growth rate is subpar relative to past expansions from strong contractions in the 1980s, 1970s and 1950s. Statements comparing the global recession in 2008-2009 and the Great Depression are misleading. Real GDP fell in the US by 8.6 percent in 1930, 6.4 percent in 1931, 13.0 percent in 1932 and 1.3 percent in 1933 for cumulative decline of 25.6 percent. Nominal GDP without adjustment for inflation fell by 45.6 percent (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 151, Globalization and the State, Vol. II (2008b), 206; for analysis of the literature on the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). The rates of decline of GDP in 1981-1982 are comparable with those of 2008-2009 but both contractions are quite different from the Great Depression. The current expansion is mediocre compared with past rebounds of economic activity from US contractions. Real GDP grew by 10.8 percent in 1934. The rates of growth of GDP in the first five quarters after the contraction were 5.1 percent in IQ83 (first quarter 1983), 9.3 percent in IIQ83, 8.1 percent in IIIQ83, 8.5 percent in IVQ83 and 7.1 percent in IQ84 (see columns 3 and 4 in Table 1) while the growth rates in the first five quarters of expansion currently have been 1.6 percent in IIIQ09, 5.0 percent in IVQ2009, 3.7 percent in IQ10, 1.7 percent in IIQ10 and 2.5 percent in IIIQ10 (see columns 7 and 8 in Table 1). Relative to the same quarter a year before, GDP grew at: -2.7 percent in IIIQ09, 2.4 percent in IQ2010, 3.0 percent in IIQ2010 and 3.2 percent in IIIQ2010 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_2nd.pdf Table 8, 11). The consequence of subpar growth is that there are 26.6 million persons in job stress in the US in Oct composed of: 14.8 million unemployed (of whom 6.2 million unemployed for 27 weeks or longer or 41.8 percent of total unemployed), 9.2 million “employed part-time for economic reasons” (because their hours were reduced or could not find a full-time job) and 2.6 million “marginally attached to the labor force” (who are not part of the labor force but are willing and available for work and had looked for employment in the past 12 months) (http://www.bls.gov/news.release/pdf/empsit.pdf).
Table 1, Quarterly Growth Rates of GDP, % Annual Equivalent SA
| Quarter | 1981 | 1982 | 1983 | 1984 | 2008 | 2009 | 2010 |
| I | 8.6 | -6.4 | 5.1 | 7.1 | -0.7 | -4.9 | 3.7 |
| II | -3.2 | 2.2 | 9.3 | 3.9 | 0.6 | -0.7 | 1.7 |
| III | 4.9 | -1.5 | 8.1 | 3.3 | -4.0 | 1.6 | 2.5 |
| IV | -4.9 | 0.3 | 8.5 | 5.4 | -6.8 | 5.0 |
The BEA provides an important breakdown of the rate of growth of GDP by percentage points (pps) contributions of various components shown in Table 2: PCE (personal consumption expenditures), GDI (gross domestic investment), trade (exports of goods and services less exports of goods and services) and GOV (government consumption, expenditures and gross investment). The comparison in Table 2 of the expansion of the US economy during five consecutive quarters from IIIQ09 to IIIQ10 shows much lower percentage point contributions to GDP growth than those in the first five quarters of expansion IVQ83 to IVQ84 in the critical items of private aggregate demand, PCE, or consumption, and GDI, or investment. PCE contributes 70.4 percent of GDP in the US (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2009&LastYear=2010&Freq=Qtr). In the revision of IIIQ10, the contribution of 1.97 pps by PCE is the highest in the first five quarters of expansion, breaking down into subcomponents of 0.81 pps by goods and 1.16 pps by services. A weakness is in GDI, contributing 1.51 pps, which breaks down into only 0.20 pps contributed by fixed investment and 1.30 pps by change in private inventories, ∆ PI, which is also shown in a separate column in Table 2. Change in private inventories was important but not dominant in GDI in the 1982-1983 expansion. The key to growth with rapid employment creation is growth of aggregate demand or PCE (private consumption) and GDI (private investment). Actual policies followed and alternative policies available are discussed in section IV on policy failure.
Table 2, Contributions to the Rate of Growth of GDP in Percentage Points
| GDP | PCE | GDI | ∆ PI | Trade | GOV | |
| 2010 | ||||||
| I | 3.5 | 1.33 | 3.04 | 2.64 | -0.31 | -0.32 |
| II | 1.7 | 1.54 | 2.88 | 0.82 | -3.50 | 0.80 |
| III | 2.5 | 1.97 | 1.51 | 1.30 | -1.76 | 0.81 |
| IV | ||||||
| 2009 | ||||||
| I | -4.9 | -0.34 | -6.80 | -1.09 | 2.88 | -0.61 |
| II | -0.7 | -1.12 | -2.30 | -1.03 | 1.47 | 1.24 |
| III | 1.6 | 1.41 | 1.22 | 1.10 | -1.37 | 0.33 |
| IV | 5.0 | 0.69 | 2.70 | 2.83 | 1.90 | -0.28 |
| 1982 | ||||||
| I | -6.4 | 1.62 | -7.50 | -5.47 | -0.49 | -0.03 |
| II | -2.2 | 0.90 | -0.05 | 2.35 | 0.84 | 0.50 |
| III | -1.5 | 1.92 | -0.72 | 1.15 | -3.31 | 0.57 |
| IV | 0.3 | 4.64 | -5.66 | -5.48 | -0.10 | 1.44 |
| 1983 |
|
|
|
|
|
|
| I | 5.1 | 2.54 | 2.20 | 0.94 | -0.30 | 0.63 |
| II | 9.3 | 5.22 | 5.87 | 3.51 | -2.54 | 0.75 |
| III | 8.1 | 4.66 | 4.30 | 0.60 | -2.32 | 1.48 |
| IV | 8.5 | 4.20 | 6.84 | 3.09 | -1.17 | -1.35 |
Note: PCE: personal consumption expenditures; GDI: gross private domestic investment; ∆ PI: change in private inventories; Trade: net exports of goods and services; GOV: government consumption expenditures and gross investment
GDP: percent change at annual rate; percentage points at annual rates
II European Sovereign Risk. The BIS Quarterly Review, Sep 2010, provides the exposures of banks from various jurisdictions to Greece, Ireland, Portugal and Spain at the end of the first quarter of 2010 at $1102.6 billion with the highest exposures by French banks of $244.2 billion, German banks $217.9 billion and US banks $186.4 billion (http://www.bis.org/publ/qtrpdf/r_qt1009.pdf#page=19 Table 1, 16). The Joint External Debt Hub of the BIS, IMF, OECD and World Bank provides international debt securities: Portugal $162.1 billion, Ireland $1199.4 billion, Greece $277.5 billion and Spain $1303.5 billion (http://www.jedh.org/jedh_creditor.html). Table 3 provides GDP, debt/GDP ratios and current account/GDP ratios for various countries in the euro area, the US, UK, Japan and China. The dimensions of countries confronting sovereign risk issues are small in terms of GDP: Portugal $224 billion, Ireland $204 billion and Greece $305 billion, for total $733 billion or 6.1 percent of total euro area GDP of $12,067 billion. Adding Spain’s GDP of $1275 billion, the total for the countries confronting sovereign risk issues increases to $2000.8 billion or 16.6 percent of the euro area’s GDP. Financial institutions and markets in other countries could be affected through the linkages to the banking and debt markets of countries resolving sovereign risk issues
Table 3, GDP, Debt/GDP and Current Account/GDP for Selected Countries
| GDP $ Billions | Debt/GDP 2010 % | Debt/GDP 2015 % | Current Account % GDP 2010 | Current Account % GDP 2015 | |
| Euro Area | 12,067 | 53.4 | 67.4 | 73.8 | 0.2 |
| Germany | 3,652 | 58.7 | 61.8 | 6.1 | 3.9 |
| France | 2,865 | 74.5 | 78.7 | -1.8 | -1.8 |
| Portugal | 224 | 79.9 | 93.6 | -9.9 | -8.4 |
| Ireland | 204 | 55.2 | 71.4 | -2.7 | -1.2 |
| Italy | 2,037 | 98.9 | 99.5 | -2.9 | -2.4 |
| Greece | 305 | 109.5 | 112.6 | -10.8 | -4.0 |
| Spain | 1,275 | 54.1 | 72.6 | -5.2 | -4.3 |
| USA | 14,624 | 65.8 | 84.7 | -3.2 | -3.4 |
| UK | 2,259 | 68.8 | 76.0 | -2.2 | -1.1 |
| Japan | 6,517 | 120.7 | 153.4 | 3.1 | 1.9 |
| China | 5,745 | 19.1 | 13.9 | 4.7 | 7.8 |
Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx
The 16 member states of the euro area provided on May 9, 2010 for the creation of the European Financial Stability Facility (EFSF) after decisions within the Ecofin Council (http://www.efsf.europa.eu/about/index.htm). A company, EFSF, was registered under Luxembourg law and owned by the 16 member states of the euro area, to issue bonds guaranteed by the 16 member states in value of up to €440 billion “for on-lending to euro area member states in difficulty, subject to conditions negotiated with the European Commission in liaison with the European Central Bank and International Monetary Fund and to be approved by the Eurogroup” (Ibid). Standard & Poor’s and Fitch Ratings have assigned their highest credit rating to EFSF. The mechanism is similar to that of the multilateral development banks: Inter-American Development Bank, European Investment Bank and Asian Development Bank. These banks issue debt with their AAA rating, derived from the sovereign rating of their member countries, to fund investments and loans within their mission objectives (Pelaez and Pelaez, International Financial Architecture (2005), 72-74, Globalization and the State, Vol. I (2008a), 27-8). In both cases, the AAA-rating of sovereign members is transferred to an institution to enhance the volume of funding and reduce interest payments. The objective of the EFSF is of an emergency nature of preventing crises in euro area member states instead of the long-term objectives of economic development of the multilateral banks. The debts of multilateral development banks have not experienced stress during decades of operations and constitute an important part of the international financial institutions together with the IMF, BIS and World Bank. The risks of the EFSF are higher because of the stress of the sovereigns experiencing emergency funding needs. The total value of the rescue package of the sovereigns in potential need of emergency funding is €750 billion, consisting of the €440 billion of the EFSF, €60 billion from an emergency lending facility provided by the European Commission from the budget of the European Union and €250 billion from additional resources that would be provided by the IMF.
The Wall Street Journal provides important analysis on the actual amount of funds that can be used in sovereign funding emergencies (http://professional.wsj.com/article/SB10001424052748704526504575634913516773290.html?mod=WSJ_hpp_MIDDLTopStories). The IMF cannot commit the €250 billion in advance. Member countries must approve loans on an individual country basis. Although denial of a loan is not likely, there is no full guarantee of support. The €440 billion of the EFSF provides loans instead of cash. The bonds must have AAA-rating, requiring that countries hold 40 percent of the cash proceeds as cash guarantees. Thus, the total available from the EFSF for lending is only €250 billion, which becomes €310 billion when adding the European Commission’s emergency lending facility of €60 billion, instead of €440 billion.
The volume of resources required by a country facing sovereign risk issues has been quite difficult to predict and in many cases estimates are frequently revised upwardly. Exposures of financial institutions are difficult to measure with multiple uncertainties on their evolution under alternative assumptions and the linkages among financial institutions and the rest of the economy. The process is even more complex when various countries are involved. The estimate of funding for Ireland is €60 billion from the EFSF and €30 billion from the IMF (Ibid). Portugal’s use of the EFSF could be between €50 and €100 billion. The rollover needs of Spain’s sovereign debt are around €300 billion (Ibid). The total needs from the EFSF could be €460 billion, exceeding the effective resources of the EFSF of €310 billion (Ibid). Portugal and Spain have not expressed need for funding from the EFSF or IMF. The head of the Bundesbank advised that the rescue facility could be expanded to prevent pressure on the euro (http://professional.wsj.com/article/SB10001424052748703572404575635320548229734.html?mod=wsjproe_hps_LEFTWhatsNews). A proposal by the European Commission to double or expand the EFSF was vetoed by a major member state (http://professional.wsj.com/article/SB10001424052748704638304575636580416827208.html?mod=WSJ_hpp_MIDDLETopStories). There is the possibility of a change in attitudes with approval of an increase in the rescue package if more countries need assistance (http://professional.wsj.com/article/SB10001424052748703572404575635320548229734.html?mod=wsjproe_hps_LEFTWhatsNews). The situation appears to be changing rapidly.
III Financial Turbulence. There are four key factors of turbulence in international financial markets. First, unresolved sovereign risk doubts in Europe, discussed in section II, recur periodically with strong effects on returns on financial assets. If the doubts remained concentrated in Greece and Ireland, the European rescue package, probably with higher funding, would provide bridge to better markets and economic conditions. Debt restructuring could not be ruled out in a more troubled adjustment. If the sovereign risk doubts also affect Portugal and Europe, resolution may be more complex, requiring higher funding and enhanced cooperation. Debt restructuring could be far more complex. The larger countries would require internal measures to ensure that banks and debt markets do not experience challenges. It is difficult operationally to find a definite fix for these sovereign risk challenges because of the changing rescue estimates and the spread to countries and financial institutions. Perhaps one important lesson of this experience is parsimony in budget management.
Second, there are also recurring doubts on the continuance of high rates of growth in China. China is an important source of demand at the margin for raw materials and deceleration of its growth rate could cause declines of commodity prices. There are repercussions of oscillations of commodity prices in countries exporting raw materials to China. Disruption of the web of interregional trade between China and other Asian countries could decelerate Asia-Pacific growth, affecting the world economy. The increase in inflation in China and concerns with property prices may prompt further measures of monetary policy tightening that could decelerate economic growth.
Third, regional international conflicts affect financial variables. These conflicts are not predictable. There are repercussions also on the willingness to engage in international financial and economic cooperation in solving issues of trade and capital flows.
Fourth, subpar economic growth in the US generates alternative views on the future pace of recovery. Monetary policy of quantitative easing, or large-scale purchase of financial assets, is based on the current view of the Fed of slow growth and continuing unemployment. The issue of policy failure in the US is discussed in the following section.
IV Policy Failure. The minutes of the meeting on Nov 2-3 of the Federal Open Market Committee (FOMC) constitute the most important official document on policy at the moment (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20101103.pdf). Members of the FOMC concluded that the economy was not making sufficient progress in moving toward what they considered consistent with their “dual mandate of maximum employment and price stability” (Ibid, 8). Most members of the FOMC “judged it appropriate to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with the Committee’s mandate” (Ibid, 8). The action consisted in maintaining the target range of fed funds at 0 to ¼ percent and to reinvest payments on the existing portfolio of securities in long-term Treasury securities. The FOMC also decided on another round of quantitative easing “to purchase a further $600 billion of longer-term Treasury securities at a pace of about $75 billion per month through the second quarter of 2011” (Ibid, 8).
The FOMC had a meeting by videoconference on Oct 15 in which a rather unusual policy was discussed (Ibid, 10):
“Finally, participants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce long-term interest rates and thus provide additional stimulus to the economy. But participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts of the relevant security in order to keep its yield close to the target level”
There is no indication of what yield would be targeted by the Fed and in what segment of the Treasury yield curve. If the target were to fix the 10-year Treasury yield at 2.5 percent, for example, the Fed would have to buy unlimited amounts of 10-year Treasury securities at 2.5 percent (http://www.ft.com/cms/s/0/63b58a42-f737-11df-9b06 00144feab49a.html#axzz169o4Rp2r).
The FOMC soundly did not purse this policy option. It is part of what is called financial repression or setting ceilings on deposit rates and sometimes on lending rates with disastrous consequences (Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 81-6). The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession (2009a), 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Friedman (1970) analyzed that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman (1970, 26-7) predicted the future as revealingly as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York” (cited by Pelaez and Pelaez, Financial Regulation after the Global Recession (200a), 58). People of modest means with lower income and wealth having no alternatives other than bankbook accounts received rates on their savings below those that would prevail in freer markets. Regulation transferred income from poorer depositors to endow banks with market power. The financial system was forced into costly readjustments while highly-paid financial jobs and economic activity were exported to foreign countries. The interest rate is the main compass of allocating savings and capital in a market economy but it was distorted by ill-conceived Great Depression regulation that is still emulated currently. The new Dodd-Frank financial regulation bill will also harm the most people of modest means.
The Fed is repeating the same policy that led to the credit/dollar crisis and global recession of 2008-2009: fixing the short-term interest rate near zero percent while withdrawing supply of securities in long-term segments to lower their yields and related long-term borrowing costs. The Fed began to lower the fed funds rate from 6.50 percent on May 16, 2000, to 6.0 percent on Jan 3, 2001, and then rapidly to 1.75 percent on Dec 11, 2001 with further lowering to 1.25 percent on Nov 6, 2002 (http://www.federalreserve.gov/monetarypolicy/openmarket_archive.htm). At the meeting of Jun 26, 2003, the Fed fixed the fed funds target at 1.00 percent and left it at that level until Jun 30, 2004, when it lifted the target to 1.25 percent (http://www.federalreserve.gov/monetarypolicy/openmarket.htm). The FOMC increased the fed funds rate target by 25 basis points in 17 consecutive meetings beginning on Jun 30, 2004 and ending on Jun 29, 2006. The FOMC began to lower the fed funds target aggressively on Sep 18, 2007, until Dec 16, 2008 when it was fixed at 0 to ¼ percent, where it has remained (Ibid). The mechanism is the same as what would have occurred under the term target for long-term bonds: the open market desk of the New York Fed engages in daily open market operations adding or withdrawing reserves as required in maintaining the FOMC rate decision at the target level.
The rationale for lowering the fed funds rate to 1 percent was fear of deflation (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm). When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. Lowering the nominal fed funds rate would lower the real rate of interest, or the nominal rate less expected inflation, encouraging personal consumption expenditures and gross domestic investment or aggregate demand. Increased economic activity would set upward pressure on prices and generate higher employment. Treasury suspended auctions of 30-year bonds effective February 2002 (http://www.treas.gov/press/releases/po749.htm).
An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart 2004, 88). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans. In the framework of Tobin (1969), the withdrawal of supply of 30-year securities would cause rebalancing of portfolios in that segment (Andrés et al. 2004). Pension funds would match pension benefits payments with income obtained by buying mortgage-backed securities with similar maturities, increasing their prices, which is equivalent to lowering their yields. Homeowners would refinance mortgages, lowering their monthly payments, which released cash in higher magnitude than tax rebates. As it is the case currently, the Fed was concerned with its dual mandate that inflation was too low and unemployment too high and took actions.
The policy of near-zero short-term interest rates created arbitrage opportunities. Professional investors and the public borrowed as much short-term money as they could to buy risky financial and real assets with the highest possible returns. This is carry trade financing with short-term borrowing a long position in financial assets. The communication of the policy by the Fed was in the form of a forward guidance that rates would remain at low levels until warranted by economic conditions. A widely accepted interpretation consisted of the “great moderation,” by which centrals banks had mastered technically how to control inflation with fewer recessions resulting in lower loss of economic activity and employment. Investors and the public perceived that interest rates would remain low forever. Financial and real assets that comprise the wealth of investors and the general public are inversely related to interest rates. The policy of near-zero interest rates created the impression that wealth was increasing to permanently higher levels, inducing further borrowing for consumption and investment.
Professional investors felt comfortable with higher leverage and risks because the Fed would maintain rates at low levels indefinitely. Creditors relaxed the requirements of loan to value ratios in houses, or the value of the mortgage relative to the actual price of the home, that is, there was relatively little equity contributed by homeowners to cushion potential declines in home prices. Low interest rates forever as in the forward guidance of the Fed guaranteed high and increasing prices in the future. A housing subsidy of $221 billion per year, affordable housing policies and the purchase and guarantee by Fannie and Freddie of $1.6 trillion of nonprime mortgages fueled further housing construction. Arbitrage consisted of borrowing with short-term financing to profit from increases in prices of financial and real assets. Nearly all term credit was grouped into long-term securities that were financed in short-term overnight sale and repurchase agreements to earn the spread between the short- and long-term rates. Homeowners could afford more expensive houses by adjustable rate mortgages that were related to the near-zero lower fed funds rate such that monthly mortgage payments were much lower than under conventional 30-year mortgages that had much higher rates. Credit standards were relaxed on the belief that nothing could be wrong because the Fed would maintain low rates indefinitely, guaranteeing high and increasing prices of all assets. The price appreciation of the home of a subprime borrower would cover the mortgage and even leave a small profit. Monetary policy in 2003-2004 induced high leverage, excessive risks, low liquidity, short-term financing and unsound credit decisions that were the primary cause of the credit/dollar crisis and global recession (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).
The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 2. 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 2005-2007, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds 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 (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent 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. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to 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 4, 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
V The Global Devaluation War. A simplified explanation helps in understanding the mechanism of transmission of monetary policy. The objective of quantitative easing is lowering yields of long-term Treasury securities, in particular those with 5 to 6 years of maturity. The open market desk of the New York Fed withdraws supply of Treasury securities, which causes increases of their prices that is equivalent to lowering their yields. In a preferred-habitat model of the term structure, the carry trade of arbitrageurs consists of borrowing at the near-zero short-term rate and going long in the Treasury securities in the target segment of the Fed (Vayanos and Vila 2009, Greenwood and Vayanos 2010, D’Amico and King 2010, Hamilton and Wu 2010).
Lower yields of Treasury securities would process through the capital asset demand functions in the Tobin (1969, 18-9) model (see Pelaez and Suzigan, 1978, 120-3). The demand for a capital asset depends on its own rate of return, the rates of return of other capital assets and other variables. The Tobin model consists of asset demand functions, Aj of j = 1, 2, ∙∙∙ m assets or sectors depending on a vector of rates of returns of i = 1, 2, ∙∙∙ n assets, including the own rate of the asset and rates on other assets, and other possible variables. Quantitative easing enters in the capital asset demand functions by a reduction in the rate of return or yield of Treasury securities. Relative returns of alternative capital assets increase, causing portfolio rebalancing in the form of increasing purchases of bonds backed with mortgages, credit card receivables, auto loans, consumer loans, leverage equity transactions, corporate debt, junk bond and so on. The yields on bonds providing financing for credit would decline. Personal consumption expenditures in consumer durables would increase because of more attractive rates of financing. Gross domestic investment would increase for production of goods to meet rising demand. Companies would hire again, reducing unemployment.
There is a major wedge between quantitative easing and increase in aggregate demand, consisting of uncertainty in consumption and investment decisions by the private sector. Fed policies are now being processed during major transformation of the economy by legislative restructurings and regulation. Fiscal policy of increasing expenditures to 24.7 percent of GDP while revenue declined to 14.8 percent of GDP in 2009 created record deficits and debt/GDP ratios since World War II (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml). The expectation of future tax increases has added to the uncertainty, frustrating growth of investment and consumption.
Quantitative easing is being implemented jointly with a policy of symmetric inflation target. The Fed would take monetary easing measures to bring the rate of inflation from its low level of 0.9 percent in 12 months for PCEs to somewhat less than 2 percent but would also take monetary-tightening measures to prevent inflation from rising above 2 percent. Inflation in Europe has risen to 1.9 percent in the 12 months ending in Oct and to 4.4 percent in China. In the prior near-zero interest rate policy US inflation jumped from 1.9 percent in 2003 to 4.1 percent in 2007. Calibrating inflation by monetary policy may be unpredictable especially if 26.6 million people continue in job stress.
The yield of the 10-year Treasury stood at 3.835 percent on Dec 31, 2009, staying above 3 percent in 2010 and reaching a peak of 3.986 percent on Apr 5. The sovereign risk crisis and uncertainties with growth in China caused flows of funds away from risk financial assets into the temporary safe haven of Treasury securities, resulting in decline of the 10-year yield to 2.385 percent on Oct 7. An added downward pressure on yields was the sequence of statements by FOMC members, beginning on Aug 27 at the Jackson Hole meeting, suggesting the Fed would engage in another round of quantitative easing. The 10-year yield stood at 2.481 percent on Nov 4, one day after the announcement of $600 billion of new purchases of securities by the Fed but then rose to 2.964 percent on Nov 15 and closed at 2.869 percent on Nov 26 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond). The upward trend of 10-year yields in Nov is in opposite direction of the objectives of quantitative easing. The 10-year yield rose on Nov 24 by 1 9/32 or 1.28 percent (http://professional.wsj.com/article/SB10001424052748703572404575634420088971074.html?mod=wsjproe_hps_LEFTWhatsNews). If the long position was not reversed, it would have lost $12,800 per one million dollars, but the capital of a trader financing with leverage of 10:1 would have lost 12.8 percent of $100,000. Professional traders would have reversed the position, probably explaining the magnitude of decline. The rise in yields in Nov raises doubts as to a painless exit strategy from quantitative easing. The Fed balance sheet stood at $2.3 billion on Nov 24 with a portfolio of long-term securities of $2 trillion, consisting of $877 billion of Treasury bonds and notes (including inflation indexed), $148 billion of agency securities and $1 trillion of mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit strategy from this position without pains of sharp interest rate increases.
The zero cost of carry resulting from FOMC policy with uncertainty wedge on private-sector decisions may stimulate the carry trade of borrowing at near-zero interest rates and going long in commodities, equities, currencies and high-risk fixed income. The sovereign risk doubts have resulted in more oscillations in the upward trend of risk financial assets benefitting from the carry trade of zero fed funds rates. The last column of Table 5 still shows a vigorous upward trend of risk financial assets together with dollar devaluation of 11.1 percent. Quantitative easing may stimulate demand for risk financial assets, creating threats of future declines of asset prices when conditions change that could have adverse effects on financial markets.
Table 5, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% to 11/26 | ∆% Week 11/26 | ∆% T to 11/26 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | -1.0 | -0.9 | 14.5 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | -2.3 | -0.9 | 16.3 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -13.6 | -3.4 | 8.5 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -5.2 | -2.4 | 16.2 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 0.8 | -2.1 | 15.1 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -11.9 | 0.2 | 13.8 |
| China Shanghai | 4/15/10 | 7/16/10 | -24.7 | -9.3 | -0.6 | 18.5 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -6.9 | -1.5 | 9.9 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 8.2 | 0.01 | 20.8 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 11.1 | 3.2 | -11.1 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | 0.9 | 0.9 | 18.0 |
| 10-Year Tre. | 4/5/10 | 4/6/10 | 3.986 | 2.870 |
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
Dollar devaluation is an important ingredient in forecasting the US economy as revealed by the following statement in the FOMC minutes (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20101103.pdf 6):
“In light of asset market developments over the intermeeting period, which in large part appeared to reflect heightened expectations among investors that the Federal Reserve would undertake additional purchases of longer-term securities, the November forecast was conditioned on lower long-term interest rates, higher stock prices, and a lower foreign exchange value of the dollar than was the staff’s previous forecast. These factors were expected to provide additional support to the recovery in economic activity”
Devaluation of the dollar is a favorable but perhaps not intentional consequence of quantitative easing in raising inflation toward the level desired by the FOMC and also increasing exports and economic activity in accordance with the employment mandate of the Fed. Table 6 shows the update of exchange rates for the week of Nov 26. Many countries complain that the US is promoting a global competitive devaluation of the dollar with the purpose of growing the US economy out of its current employment stress.
Table 6, Exchange Rates
| Peak | Trough | ∆% P/T | Nov 26 2010 | ∆% T Nov 26 | ∆% P Nov 26 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 11/26 2010 | |||
| Rate | 1.59 | 1.192 | 1.324 | |||
| ∆% | -33.4 | 9.9 | -20.1 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 11/26 2010 | |||
| Rate | 110.19 | 83.07 | 84.09 | |||
| ∆% | 24.6 | -1.2 | 23.7 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 11/26 2010 | |||
| Rate | 1.225 | 1.025 | 1.003 | |||
| ∆% | 16.3 | 2.1 | 18.1 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 11/26 2010 | |||
| Rate | 2.006 | 1.388 | 1.559 | |||
| ∆% | -44.5 | 10.9 | -28.7 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 11/26 2010 | |||
| Rate | 0.979 | 0.601 | 0.964 | |||
| ∆% | -62.9 | 37.7 | 1.6 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 11/26 2010 | |||
| Rate | 11.578 | 7.238 | 7.14 | |||
| ∆% | 37.5 | 1.4 | 38.3 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 11/26 2010 | |||
| Rate | 1.553 | 1.348 | 1.319 | |||
| ∆% | 13.2 | 2.1 | 15.1 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 11/26 2010 | |||
| Rate | 7.813 | 7.752 | 7.762 | |||
| ∆% | 0.8 | -0.1 | 0.6 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 11/26 2010 | |||
| Rate | 2.43 | 1.737 | 1.7278 | |||
| ∆% | 28.5 | 0.5 | 28.9 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 11/26 2010 | |||
| Rate | 22.19 | 18.693 | 18.663 | |||
| ∆% | 15.7 | 0.2 | 15.9 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 11/26 2010 | |||
| Rate | 9.313 | 7.108 | 6.992 | |||
| ∆% | 23.7 | 1.6 | 24.9 |
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
VI Economic Indicators. The US economy continues to expand with some improvement in the decline of new jobless claims but continuing weakness in real estate. Personal income rose 0.5 percent in Oct and 4.1 percent relative to a year earlier while personal consumption expenditures rose 0.4 percent in Oct and 3.6 percent relative to a year earlier. The price index of personal consumption expenditures excluding food and energy rose 0.9 percent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm). Corporate profits increased $44.4 billion in the third quarter compared with $47.5 billion in the second quarter (http://www.bea.gov/newsreleases/national/gdp/2010/gdp3q10_2nd.htm). New orders of durable goods fell 3.3 percent in Oct and 2.7 percent excluding transportation (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf). Durable goods is a very volatile indicator and of difficult interpretation. New single-family sales of new houses seasonally adjusted fell 8.1 percent in Oct relative to Sep and stood 28.5 percent below the level in Oct 2009. Sales of single-family houses not seasonally adjusted in Jan-Oct were 279,000 (http://www.census.gov/const/newressales.pdf Table 1, 2), or 74.9 percent lower than 1,115,000 in Jan-Oct 2005 (http://www.census.gov/const/newressales_200510.pdf Table 1, 2). The National Association of Realtors informed that existing home sales fell 2.2 percent in Oct relative to Nov and 25.9 percent relative to Oct 2009 (http://www.realtor.org/press_room/news_releases/2010/11/october_retreat). Initial jobless claims seasonally adjusted fell 34,000 in the week ending Nov 30 to 407,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm).
VII Interest Rates. The US 10-year Treasury traded at 2.87 percent on Nov 26, which is slightly lower than 2.88 percent a week earlier but higher than 2.72 percent a month earlier. The 10-year German government bond traded at 2.74 percent with a negative spread of 13 basis points relative to the comparable Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1290895073435). The Treasury with coupon of 2.63 percent maturing in 11/20/20 traded at price of 97.89 or equivalent yield of 2.87 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-261110). The loss of principal in a backup of yield to 3.986 percent traded on Apr 5, 2010, would be 9.2 percent and 18.8 percent in a backup of yield to 5.297 percent traded on Jun 12, 2007.
VIII. Conclusion. A combination of sovereign risk doubts, concerns on China’s growth, subpar growth and job stress in the US and failures of economic policy is introducing renewed financial turbulence. Because of uncertainties of legislative restructuring, regulation, tax and interest rate increases quantitative easing may increase valuations of assets of risk financial assets instead of aggregate demand. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
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NYC 11/28/10
©Carlos M. Pelaez, 2010
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