Economic Growth, Stimulus Policy, Rising Yields, Regulation and Government Debt
Carlos M. Pelaez
© Carlos M. Pelaez, 2010
This post relates low economic growth with stimulus policy, rising yields, regulation and government debt. The content is as follows:
I Economic Growth
II Stimulus Policy
III Rising Yields
IV Regulation
V Government Debt
VI Economic Indicators
VII Interest Rates
VIII Conclusion
I Economic Growth. The Bureau of Economic Analysis estimates real GDP, which is “the output of goods and services provided by labor and property located in the United States” (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_3rd.pdf). The third estimate by the BEA is that real GDP grew at the seasonally-adjusted quarterly annual equivalent rate of 2.6 percent in IIIQ10 (the third (III) quarter (Q) of 2010 (10)). GDP has grown positively during five consecutive quarters from IIIQ09 to IIIQ10. Table 1 provides a framework for comparison of the current expansion from IIIQ09 to IIIQ10 following the contraction from (Dec)IVQ07 to (Jun)IIQ09 with the expansion phase from IQ83 to IQ84 following a similarly deep contraction in (Jul)IIIQ81-(Nov)IVQ82 that occurred after an immediately earlier contraction in (Jan)IQ80-(Jul)IIIQ80 (http://www.nber.org/cycles/cyclesmain.html). The recession beginning in 2007 lasted 18 months from peak to trough compared with 16 months for the recession after 1981 but 22 months when adding six months of the almost contiguous recession in 1980. Growth was far more robust in the first five quarters of expansion from IQ83 to IQ84 than from IIIQ09 to IIIQ10. Mediocre growth in the current expansion has been the major cause of 26.4 million people in the US in job stress, consisting of 15.1 million unemployed (of whom 6.2 million long-term unemployed for 27 weeks and over or 41.9 percent of total unemployed), 9 million employed part-time for economic reasons (who are unable to find full-time jobs) and 2.3 million marginally attached to the labor force (who want and are willing to work and have been looking for employment sometime 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 | 2.6 |
| IV | -4.9 | 0.3 | 8.5 | 5.4 | -6.8 | 5.0 |
Table 2 provides the decomposition of the rate of growth of GDP into percentage point contributions by demand, consisting of personal consumption expenditures (PCE) and gross domestic investment (GDI), trade or the difference between exports of goods and services and imports of goods and services and government consumption expenditures and gross investment (GOV). A separate column shows change in private inventories (∆ PI). The seasonally adjusted annual rate of growth of 2.6 percent in IIIQ10 is equal to: +1.67 (PCE) + 1.80 (GDI) -1.70 (Trade) + 0.79 (GOV) = 2.6. While in 1983-1984 growth of demand, PCE and GDI, dominated growth of GDP, the expansion in 2009-2010 has been significantly in the form of change in private inventories (∆ PI). In IIIQ10, the contribution in percentage points was: 1.67 PCE, 1.80 GDI and 1.61 ∆ PI. At this stage of the expansion, demand should be more vigorous. The acceleration of the rate of growth of GDP to 2.6 percent in IIIQ10 was largely the result of two changes in percentage points contributions of ∆ PI from 0.82 in IIQ10 to 1.61 in IIIQ10 and of trade from -3.50 in IIQ10 to -1.70 in IIIQ10 (see Table 2). The contribution of trade originated in the rate of growth of 6.8 percent of exports of goods and services in IIIQ10, declining from the rate of 9.1 percent in IIQ10, but not by as much as the decline of growth of imports of goods and services from the rate of 33.5 percent in IIQ10 to 16.8 percent in IIIQ10. The rate of growth of personal consumption expenditures in IIIQ10 was 2.4 percent, slightly higher than around 2 percent in the five quarters of expansion with the exception of 0.9 percent in IVQ09. The rate of growth of GDI in IIIQ10 was 15.0 percent, lower than the range of 26.2 percent to 29.1 percent in the prior three quarters. Fixed private investment grew at 1.5 percent, with nonresidential investment growing by 10 percent to compensate for the decline in residential investment of 27.3 percent. With the exception of an increase at the rate of 10.6 percent in IIIQ09, residential investment has been declining at high quarterly annual-equivalent rates since at least IVQ06 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_3rd.pdf Table 1). Weakness in aggregate demand is evident in relevant low quarterly annual-equivalent growth rates for IIIQ10: 0.9 percent in final sales and 2.6 percent in final sales to domestic purchasers with 0.9 percent for disposable personal income. There has not been a full rebound in private sector demand from the deep contraction from (Dec)IVQ07 to (Jun)IIQ09.
Table 2, Contributions to the Rate of Growth of GDP in Percentage Points
GDP | PCE | GDI | ∆ PI | Trade | GOV | |
2010 | ||||||
I | 3.7 | 1.33 | 3.04 | 2.64 | -0.31 | -0.32 |
II | 1.7 | 1.54 | 2.88 | 0.82 | -3.50 | 0.80 |
III | 2.6 | 1.67 | 1.80 | 1.61 | -1.70 | 0.79 |
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 Stimulus Policy. The objective of the combined monetary and fiscal stimulus is to turn around the economy, creating the conditions for the private sector to grow and create jobs. The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by Mar 2009 to $11.6 trillion committed and $3.0 trillion used by Sep 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc see Pelaez and Pelaez, Regulation of Banks and Finance (2009b) 224-7, Financial Regulation after the Global Recession (2009a), 157-70). The Federal Reserve total commitment by Sep 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. Even the most optimistic are beginning to realize that the combined stimulus did not work as intended.
The fiscal stimulus was provided by the American Recovery and Reinvestment Act of 2009 (ARRA) that was designed: “(1) to preserve and create jobs and promote economic recovery; (2) to assist those most impacted by the recession; (3) to provide investments needed to increase economic efficiency by spurring technological advances in science and health; (4) to invest in transportation, environmental protection, and other infrastructure that will provide long-term economic benefits; (5) to stabilize State and local government budgets, in order to minimize and avoid reductions in essential services and counterproductive state and local tax increases” (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.pdf). The economic rationale for ARRA was that a “stimulus package” of $757 billion would increase GDP by 3.7 percent by IVQ10 over what it would have been without that stimulus, increasing jobs by 3,675,000 over what would have been payroll employment without the package (Romer and Bernstein 2009, 4). These effects of the stimulus would result from the estimate that additional “government purchases” by 1 percent of GDP increase or “multiply” output by 1.51 times by the fifth quarter after the purchases (Ibid, 12). The policy debate has focused on the actual size of the multiplier of government purchases that would explain the impact on output of ARRA (Cogan and Taylor 2010Oct). Commerce Department data show that government purchases increased by 3 percent of the $862 billion ARRA stimulus package or by $24 billion; infrastructure spending increased by only $4 billion; and these spending and purchases are negligible relative to GDP of the US of around $14.5 trillion (Cogan and Taylor 2010Dec). State and local government purchases have remained below their 2008 levels, that is, failing to increase after ARRA. Cogan and Taylor (2010Dec) conclude that ARRA grants did not have statistically significant effects on purchases by state and local government: even if the multiplier was 1.5 there was not enough multiplicand in the form of government purchases. The conclusion is that limited effects of ARRA instead of insufficient volume of stimulus explain the failure of the fiscal stimulus.
III Rising Yields. The interview of Fed Chairman Bernanke in CBS’s “60 Minutes” aired on Dec 5 provides important information on policy needs and actions (http://blogs.wsj.com/economics/2010/12/05/bernanke-on-cbss-60-minutes/ http://www.cbsnews.com/video/watch/?id=7117930n&tag=cbsnewsMainColumnArea.6 http://www.cbsnews.com/video/watch/?id=7120553n&tag=cbsnewsMainColumnArea.6). According to Chairman Bernanke, there are two major factors of the need for further monetary stimulus by the Fed: (1) the economy is growing slowly, which is a major reason why lending is at low levels; unemployment is high, posing the risk of further slowdown of the economy; and the economy is barely growing at 2.5 percent, close to the level where growth may not be self-sustaining; (2) inflation is at a very low level, approximating the point where prices could fall or what would be an adverse situation of deflation. The action by the Fed consists of quantitative easing, or the purchase of $600 billion of Treasury securities to lower their yields with the objective of lowering interest rates to the private sector that could cause faster economic growth. Fed policy during the credit/dollar crisis and global recession consisted of: (1) interest rates of 0 to ¼ percent since Dec 16, 2010; (2) provision of direct credit and liquidity through 11 facilities of the Fed (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62); and quantitative easing, consisting of using the Fed’s balance sheet to acquire long-term securities. On Dec 22, the line “Reserve Bank credit” of the Fed balance sheet was $2410.4 billion, or $2.4 trillion, with $2138.5 billion, or $2.1 trillion, of a portfolio of long term securities composed of $934.5 billion of Treasury notes and bonds, $48.1 billion of Treasury inflation-indexed notes and bonds, $147.5 billion of Federal agency debt securities and $1008.4 billion of mortgage backed securities; the Fed held monetary liabilities of $1012.8 billion in the form of bank reserves deposited at the Federal Reserve Banks (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The portfolio of long-term securities is increasing because of the decision by the Federal Open Market Committee (FOMC) at the meeting on Nov 2-3: “the Committee will maintain its existing policy of reinvesting principal payments from its securities. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm).
Table 3 provides the actual yields of the 10-year benchmark Treasury note at the close of market in selected dates. The peak was on May 1, 2001, with a yield of 5.51 percent that for a Treasury note paying coupon of 2.625 percent and maturing in exactly ten years would represent an instantaneous price loss of 22.9 percent relative to the comparable 10-year note at the yield traded on Nov 4, 2010, a day after the meeting of the FOMC deciding on a new round of quantitative easing. Since Nov 4, the 10-year Treasury yield has backed up from 2.481 percent to 3.397 percent on Dec 23 for a loss of price of 7.7 percent. If there is an effect of movements in Treasury yields on private-sector borrowing costs, quantitative easing did not prevent an increase in costs of borrowing for investment, home purchases and refinancing and purchases of consumer durable goods. There could be an argument that yields would have risen to higher levels in the absence of quantitative easing. Without observation of yields in the absence of quantitative easing, this counterfactual argument is not easily verifiable and may even lack any substance. The causes of higher bond yields are analyzed in an earlier comment of this blog (http://cmpassocregulationblog.blogspot.com/2010/12/causes-of-high-bond-yields.html).
Table 3, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note
| Date | Yield | Price | ∆% 11/04/10 |
| 05/01/01 | 5.510 | 78.0582 | -22.9 |
| 06/10/03 | 3.112 | 95.8452 | -5.3 |
| 06/12/07 | 5.297 | 79.4747 | -21.5 |
| 12/19/08 | 2.213 | 104.4981 | 3.2 |
| 12/31/08 | 2.240 | 103.4295 | 2.1 |
| 03/19/09 | 2.605 | 100.1748 | -1.1 |
| 06/09/09 | 3.862 | 89.8257 | -11.3 |
| 10/07/09 | 3.182 | 95.2643 | -5.9 |
| 11/27/09 | 3.197 | 95.1403 | -6.0 |
| 12/31/09 | 3.835 | 90.0347 | -11.1 |
| 02/09/10 | 3.646 | 91.5239 | -9.6 |
| 03/04/10 | 3.605 | 91.8384 | -9.3 |
| 04/05/10 | 3.986 | 88.8726 | -12.2 |
| 08/31/10 | 2.473 | 101.3338 | 0.08 |
| 10/07/10 | 2.385 | 102.1224 | 0.8 |
| 10/28/10 | 2.658 | 99.7119 | -1.5 |
| 11/04/10 | 2.481 | 101.2573 | - |
| 11/15/10 | 2.964 | 97.0867 | -4.1 |
| 11/26/10 | 2.869 | 97.8932 | -3.3 |
| 12/03/10 | 3.007 | 96.7241 | -4.5 |
| 12/10/10 | 3.324 | 94.0982 | -7.1 |
| 12/15/10 | 3.517 | 92.5427 | -8.6 |
| 12/17/10 | 3.338 | 93.9842 | -7.2 |
| 12/23/17 | 3.397 | 93.5051 | -7.7 |
Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates
Source:
http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020
The policy of quantitative easing postulates that monetary policy works in two ways: (1) reductions in overnight fed funds rates reduce forward rates through the term structure of interest rates; and (2) an additional channel in which “base money expansion now matters for the deviations of long rates from the expected path of short rates. Monetary policy operates by both the expectations channel (the path of current and expected future short rates) and this additional channel. As in Tobin’s framework, interest rate spreads (specifically, the deviations from the pure expectations theory of the term structure) are an endogenous function of the relative quantities of assets supplied” (Andrés et al. 2004, 682). In the celebrated model by Tobin (1969), an increase in base money to acquire securities causes portfolio reshuffling toward alternative risk assets because of the fixed remuneration of money that raises rates of return of alternative risk assets. The increase in base money is printing money that in this case occurred by digital impulse in the form of increases in bank reserves deposited at the Federal Reserve Banks as explained in an earlier post of this blog (http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html) and also clarified by Jon Hilsenrath in the blog of the Wall Street Journal on Real Time Economics (http://blogs.wsj.com/economics/2010/12/22/is-the-fed-printing-money/). Near zero interest rates of 1 percent in 2003-2004 were combined with a form of quantitative easing by suspension of the auction of 30-year Treasury bonds with the objective of refinancing mortgages to add free cash in households. The result was stimulus of real estate investment on top of the enormous housing subsidy and a sustained boom of risk financial assets in a carry trade from borrowing at zero interest rates to long positions in anything with risk but quick realizable return, as shown in Table 4.
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
The new round of zero interest rates after Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm), and with more explicit purchases of long-term securities by the Fed, now at $2.1 trillion, has stimulated higher valuation of risk financial assets instead of real economic activity. Table 5, which is updated with every post of this blog, shows that the effects of zero interest rates after temporary calming of the sovereign risk issues in Europe around Jul 2 have been depreciation of the dollar by 10.1 percent and high double-digit increases in all types of risk financial assets.
Table 5, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 12/23 | ∆% Week 12/23 | ∆% T to 12/23 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | 3.3 | 0.7 | 19.5 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | 3.2 | 1.0 | 22.9 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -7.7 | 1.8 | 15.9 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -0.4 | 1.1 | 22.1 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 5.8 | 1.1 | 20.8 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -9.8 | -0.2 | 16.5 |
| China Shanghai | 4/15/10 | 7/02/10 | -24.7 | -10.4 | -2.0 | 21.4 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -2.1 | 1.9 | 15.6 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 11.5 | 1.1 | 24.5 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 13.2 | 0.5 | -10.1 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | 9.6 | 2.4 | 28.2 |
| 10-Year Tre. | 4/5/10 | 4/6/10 | 3.986 | 3.397 |
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
Table 6, which is updated with every post, shows fluctuations in risk financial assets from the recent peak on Apr 26. The sovereign risk issues in Europe and fears of the interruption of two-digit GDP growth in China alternate to frustrate and restart the carry trade of borrowing at nearly zero short-term interest rates and taking long positions in risk financial assets. The stock indexes of the US, DJIA and S&P 500, exhibit close correlation with other risk financial assets and depict the expansions and contractions of positions in accordance with risk aversion. The carry trade has become more opportunistic in hit-and-run transactions instead of “sitting” on long positions in risk financial assets as common before the credit/dollar crisis after 2007 because of the “friendly” trend of asset valuations.
Table 6, Percentage Changes of DJIA and S&P 500 in Selected Dates
| 2010 | ∆% DJIA from earlier date | ∆% DJIA from Apr 26 | ∆% S&P 500 from earlier date | ∆% S&P 500 from Apr 26 |
| Apr 26 | ||||
| May 6 | -6.1 | -6.1 | -6.9 | -6.9 |
| May 26 | -5.2 | -10.9 | -5.4 | -11.9 |
| Jun 8 | -1.2 | -11.3 | 2.1 | -12.4 |
| Jul 2 | -2.6 | -13.6 | -3.8 | -15.7 |
| Aug 9 | 10.5 | -4.3 | 10.3 | -7.0 |
| Aug 31 | -6.4 | -10.6 | -6.9 | -13.4 |
| Nov 5 | 14.2 | 2.1 | 16.8 | 1.0 |
| Nov 30 | -3.8 | -3.8 | -3.7 | -2.6 |
| Dec 17 | 4.4 | 2.5 | 5.3 | 2.6 |
| Dec 23 | 0.7 | 3.3 | 1.0 | 3.7 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
Fed policy intends to reverse potential deflation in the US economy. An old-fashioned tool to attain such intentions, with origins in the Great Depression, is loose monetary policy to devalue the dollar. Table 7, also updated with every post, shows the depreciation of the dollar relative to almost every currency in the world, which has created an unsavory claim of the Fed promoting a world devaluation war.
Table 7, Exchange Rates
| Peak | Trough | ∆% P/T | Dec 23 2010 | ∆% T Dec 23 | ∆% P Dec 23 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 12/23 2010 | |||
| Rate | 1.59 | 1.192 | 1.312 | |||
| ∆% | -33.4 | 9.1 | -21.2 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 12/23 2010 | |||
| Rate | 110.19 | 83.07 | 82.86 | |||
| ∆% | 24.6 | 0.3 | 24.8 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 12/23 2010 | |||
| Rate | 1.225 | 1.025 | 0.9621 | |||
| ∆% | 16.3 | 6.1 | 21.5 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 12/23 2010 | |||
| Rate | 2.006 | 1.388 | 1.5438 | |||
| ∆% | -44.5 | 10.1 | -29.9 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 12/23 2010 | |||
| Rate | 0.979 | 0.601 | 1.0033 | |||
| ∆% | -62.9 | 40.1 | 2.4 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 12/23 2010 | |||
| Rate | 11.578 | 7.238 | 6.711 | |||
| ∆% | 37.5 | 7.3 | 42.0 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 12/23 2010 | |||
| Rate | 1.553 | 1.348 | 1.299 | |||
| ∆% | 13.2 | 3.6 | 16.3 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 12/23 2010 | |||
| Rate | 7.813 | 7.752 | 7.7814 | |||
| ∆% | 0.8 | -0.4 | 0.4 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 12/23 2010 | |||
| Rate | 2.43 | 1.737 | 1.6907 | |||
| ∆% | 28.5 | 2.7 | 30.4 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 12/23 2010 | |||
| Rate | 22.19 | 18.693 | 19.228 | |||
| ∆% | 15.7 | -2.9 | 13.3 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 12/23 2010 | |||
| Rate | 9.313 | 7.108 | 6.8553 | |||
| ∆% | 23.7 | 3.5 | 26.4 |
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
IV Regulation. The Basel Committee on Banking Supervision (BCBS), the august forum for banking regulation and supervision, has produced the initial Capital Accord of 1988, or Basel I, followed by the rich architecture crafted for the Basel II agreement of 2004 (see Pelaez and Pelaez, International Financial Architecture (2005), 239-99, Globalization and the State, Vol. II (2008b), 126-48, Government Intervention in Globalization (2008c), 145-54, Financial Regulation after the Global Recession (2009a), 54-6, Regulation of Banks and Finance (2009b), 69-70). The BCBS (2010DecBIII) provides the rules text for the Basel III global standards of regulatory bank capital and liquidity as approved by the Governors and Heads of Supervision and with endorsement by the G20 Leaders during their Summit in Seoul in Nov. The BCBS (2010DecBIII) identifies specific causes of the severity of the credit/dollar crisis and global recession after 2007: (1) excessive leverage by banks on- and off-balance sheet that eroded the capital base of banks; (2) insufficient liquidity buffers preventing banks from absorbing the trading losses resulting from systemic effects of large banks affecting the entire financial system; (3) unsound credit exposures; (4) complex transactions that when unwound amplified effects of deleveraging because of “interconnectedness of systemic institutions” (Ibid, 1); and (5) global financial crisis and recession resulting from contraction of liquidity and credit. The approach of Basel III is by microprudential reforms to strengthen regulation that can improve the resilience of individual banking institutions during crises; and by macroprudential reforms to prevent the spread of crisis among financial institutions and avoid procyclical effects that may amplify crises over time. The two sets of reforms are interrelated. Some of the features of the new framework include (Ibid): (1) enhancing the quality of banks’ capital basis by higher ratios of Tier 1 capital consisting of common shares and retained earnings; (2) enhancing coverage of risks such as by using stressed inputs for counterparty credit risk; (3) adding a leverage ratio capital requirement; (4) using countercyclical capital buffers; (5) measures reducing the cyclicality of the minimum capital requirement; (6) conserving capital with buffer requirements for use during periods of stress; (7) countercyclical capital buffer to strengthen the bank during periods of excess credit growth; (8) measures to contain systemic risks; (9) introducing harmonized global liquidity standards with a “liquidity coverage ratio” (Ibid, 9); and (10) monitoring rules. The Basel III framework consists of a transition period with observation period for some of the measures. The BCBS (2010DecQIS) also released the Results of the Comprehensive Quantitative Impact Study (QIS). An important issue is the impact on banks of the redefinition of bank capital by means of a common equity Tier 1 (CET1) standard and changes in its eligibility that increase the regulatory capital in the form of common shares and retained earnings. The QIS (BCBS 2010DecQIS, 2) finds that: “the capital shortfall for Group 1 banks in the QIS sample is estimated to be between €165 billion for the CET1 minimum requirement of 4.5% and €577 billion for a CET1 target level of 7.0% had the Basel III requirements been in place at the end of 2009.”
Tightening bank regulation and supervision may be counterproductive after $1.8 trillion of bank losses and write downs during the credit/dollar crisis. The wider participation and exchange within the BCBS results in a prudent approach of delaying the application of new regulatory rules toward more stable conditions (http://noir.bloomberg.com/apps/news?pid=20601087&sid=apOiFuxg7pIA&pos=4). The Dodd-Frank act of financial regulation (http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf) is a labyrinth of 2319 pages with individual provisions that tend to restrict credit and increase interest rates and a combined bill that may increase financial instability. The rush to regulation through rules by regulatory agencies implemented without adequate time for analysis and consultation makes Dodd-Frank more threatening to the provision of credit required for growth that can reduce unemployment. The Fed is considering a rule to implement Dodd-Frank provisions that would reduce the fees received currently by banks from merchants on transactions using debit cards from 44 cents per transaction to 7 to 12 cents per transaction or a reduction of bank revenues from 84.1 percent to 72.7 percent. A major bank provisioned a loss of $10 billion in the third quarter for the reduction in value of its cards business with an annual drop of $2.3 billion (http://professional.wsj.com/article/SB10001424052748704073804576023514056278814.html?mod=WSJPRO_hps_LEFTWhatsNews). This debit card rule is equivalent to profit controls by regulation, with resulting decline in volume of financing and increases in interest rates while frustrating innovation that is the driver of economic growth and progress. Dodd-Frank mandates authority for regulation of over-the-counter securities to the Commodities Futures Trading Commission (CFTC). The jurisdiction of the CFTC broadens from notional values of $40 trillion in futures markets to notional values of about $300 trillion in swaps markets (http://professional.wsj.com/article/SB10001424052748703727804576017800488345750.html?mod=WSJPRO_hps_LEFTWhatsNews). In a rush to comply with the mandate in Dodd-Frank to complete dozens of rules by Jul, the CFTC has been considering as many as six rules per week, which is close to the number of rules considered before in an entire year. Some rules exceed 100 pages and commissioners complain that they do not have sufficient time to analyze them. One proposal by the CFTC provides a questionnaire of 100 items to the industry with only 60 days for reply (Ibid).
Section 956 (a)(2)(b) of Dodd-Frank states:
“PROHIBITION OF CERTAIN COMPENSATION ARRANGEMENTS.—Not later than 9 months after the date of enactment of this title, the appropriate Federal regulators shall jointly prescribe regulations or guidelines that prohibit any type of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions” (http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf 1440).
The Wall Street Journal informs that the Fed, Securities and Exchange Commission (SEC) and other regulators are rushing to meet the Apr deadline of Dodd-Frank. A possible proposal is deferring compensation for three years or more at banks, brokerages and money managers. The reason for the provision in Dodd-Frank is allegedly that banks and other financial institutions took excessive risks in pursuit of cash bonuses that caused the financial crisis. There are six deficiencies in the Dodd-Frank interpretation of the financial crisis and in the mandate of Section 956 (a)(2)(b) that prevent clear thought and sound policy:
1. Causes of the Financial Crisis. The BCBS (2010DecBIII), as analyzed above, identifies four causes of the credit/dollar crisis and global recession: (i) excessive leverage; (ii) insufficient liquidity; (iii) unsound credit; and (iv) complex transactions. The carry trade that is relevant to explain portfolio rebalancing is from borrowing at near zero interest rates of fed funds to take long positions in risk assets. This carry trade encourages: (i) financing everything at near zero interest rates; (ii) taking excessive risks with high leverage to magnify what appear opportunities with low risk because of the commitment of the Fed to keep rates near zero indefinitely; (iii) ignoring sound credit practices because increases in asset prices given as collateral, such as housing, can provide repayment of debt; and (iv) minimizing liquidity because of its high opportunity cost of near zero short-term interest rates. These four practices of financial markets were induced by the Fed’s interest rates near zero and eventually resulted in a financial crisis that provoked a global recession when the Fed increased the interest rate from 1 percent in 2003-2004 to 5.25 percent in 2006 while consumer price inflation jumped from 1.9 percent in 2003 to 4.1 percent in 2007 (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)). Table 4 shows the inflation of financial assets caused by the zero interest rate until 2007 and the subsequent collapse when underlying mortgages soured under pressure of the rise in interest rates. A similar event could be in the making when the Fed attempts to control inflation rising above its target of 2 percent in fear of losing credibility.
2. Functional Structural Finance (FSF). The approach of FSF consists of “financial institutions, financial markets, products, services, organization of operations, and supporting infrastructure such as regulatory rules and the accounting system” (Merton and Bodie 2005; see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 30-42). The financial system provides six functions (Merton and Bodie 1995): (i) clearing and settlement system; (ii) mobilization of savings; (iii) intertemporal and spatial transfer of resources; (iv) risk management; (v) information; and (vi) incentives such as ameliorating differences in knowledge among borrowers, creditors, depositors and investors. There are harmful effects of policies restricting financial innovation: “policies designed to stimulate innovation in the financial system would thus appear to be more important for long-term economic development” (Merton and Bodie 2005, 18). Dodd-Frank and similar financial regulation stifles financial innovation with adverse effects on economic growth, employment and prosperity by constraining the capacity of financial institutions to attract highly-qualified finance professionals, thus transferring overseas highly-remunerated financial services, innovation and jobs.
3. Incentive Compensation. There are no conflicts of interest between shareholder and manager if the manager is the shareholder (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 129-43). The principal/agent problem arises when there is separation of control with the shareholder (principal) delegating administration to the manager (agent). Agency costs consists of the difference in the value of the firm between what would be attained in ideal conditions, known by economists as Pareto optimality, and the value if managers appropriated nonpecuniary perquisites such as sumptuous offices, corporate jets, contributions to favored charities, purchases of inputs from friends and so on (Jensen and Meckling 1976). Organizations survive by delivering products at prices that are sufficient to cover costs (Fama and Jensen 1983a, 327). Controlling agency costs is critical in the survival of organizations. Agency costs are ameliorated by corporations through the establishment of hierarchical structures for decision and control by management (Fama and Jensen 1983b). The risk management process of Basel II capital requirements constitutes an excellent example (see Pelaez and Pelaez, International Financial Architecture (2005), 239-99, Globalization and the State, Vol. II (2008b), 126-48, Government Intervention in Globalization (2008c), 145-54, Financial Regulation after the Global Recession (2009a), 54-6, Regulation of Banks and Finance (2009b), 69-70). Agency problems are disciplined by stock prices in organized stock markets and capital markets for corporate control and job markets for managers (Fama and Jensen 1983b). Common law on governance and takeover provides the rules of the game. Horizontal as opposed to vertical specialization and increasing importance of human capital relative to inanimate capital (Rajan and Zingales 2000) is modifying the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Technological advance such as option pricing formulas by Black and Scholes (1973), Merton (1973, 1974, 1998) and important subsequent contributions created techniques for pricing complex products. Investment in human capital and talented professionals are required for trading, structuring and developing these new products. These professionals have sunk costs in acquiring and developing knowledge, belonging to them and not to the institutions. There is little value in a financial institution if it is restricted in its capacity to hire, retain and reward professionals with advanced knowledge. Dodd-Frank restrictions may result in the migration overseas of the talent that drives the modern financial institution, which is required for rapid growth, employment and prosperity.
4. Gestation Period. Money managers create profits almost instantaneously and not over a period of many years as it is the case of industrial enterprises. The quality of management of a portfolio of bonds with high duration and leverage of 10:1 is known rapidly after the change of several base points in yield that can consume significant portion of corporate capital.
5. Short Careers. Sports athletes have high remuneration because their current returns are high but their careers end after a few years. There is a similar issue with remuneration of finance professionals.
6. Investments and Relative Performance of Finance Professionals. There were complaints about the bonuses paid to finance professionals in institutions that suffered heavy losses and received support from the government. Finance professionals who received contractual bonuses generated profits that reduced the losses that would have occurred without their transactions. Privately-controlled financial institutions repaid their assistance from the government with high interest for taxpayers. Most finance professionals invested in the stock of their companies such that many lost their life savings when the companies disappeared.
V Government Debt. A significant source of uncertainty in household and private-sector decisions is the worsening fiscal situation of the US. In 2008, US debt held by the public was $5.8 trillion, which was equivalent to 40 percent of GDP and slightly above the 40-year average of 35 percent. In fiscal year 2010, the debt is estimated by the Congressional Budget Office (CBO) to exceed $9 trillion, equivalent to 62 percent of GDP for the highest relative share since World War II (http://www.cbo.gov/ftpdocs/119xx/doc11999/12-14-FederalDebt_Summary.pdf). Under current law on Dec 14, the CBO projects that the debt will exceed $16 trillion in 2020, which would be about 70 percent of GDP. There is an alternative scenario analyzed by the CBO:
“if, for example, the tax reductions enacted earlier in the decade were continued, the alternative minimum tax was indexed for inflation, and future annual appropriations remained the same share of GDP that they were in 2010, debt held by the public would total nearly 100 percent of GDP by 2020. Interest costs would be correspondingly higher” (Ibid, 1).
Higher debt leads to higher interest payments:
“In CBO’s most recent projections, which assume that current laws remain the same, annual deficits decline from the $1.3 trillion recorded in 2010, but the cumulative deficit from 2011 through 2020 exceeds $6.2 trillion. Borrowing to finance that deficit—in combination with an expected rise in interest rates—would lead to a fourfold increase in net interest payments over the next 10 years, from $197 billion in 2010 to $778 billion in 2020. As a percentage of GDP, net interest outlays would more than double during that period, rising from 1.4 percent to 3.4 percent”(Ibid, 4).
Fiscal stress is spread throughout states and local government. The CBO finds that expenditures of local government in 2009 were equal to 8.7 percent of GDP and that employment in local government was slightly over 9 percent of the labor force (http://www.cbo.gov/ftpdocs/120xx/doc12005/12-09-Municipalities_Brief.pdf). The conclusion is that “to the extent that local governments address budget gaps by reducing spending or raising taxes, such changes will partially counteract the federal government’s fiscal support for the economy” (http://www.cbo.gov/ftpdocs/120xx/doc12005/12-09-Municipalities_Brief.pdf). The fiscal situation of many states is similarly difficult.
The tax reduction bill is estimated as $858 billion but the tax benefits account for $700 billion (http://professional.wsj.com/article/SB10001424052748703395204576023772342189318.html?mod=WSJPRO_hps_LEADNewsCollection). The most important provision of the bill is extending the current tax rates for two years but the $858 billion are measured as if the extension were enacted for ten years, creating the misleading impression that there is a new $858 billion stimulus package. The part of the bill extending the tax rates is not an infusion of cash but rather the maintenance of the status quo tax rates for two years such that it cannot be considered a stimulus but rather avoiding an effective tax increase. The bill also reduces the OASDI withholding tax on employees to 4.2 percent (http://www.ssa.gov/OACT/ProgData/taxRates.html), which is a new tax reduction, but also of temporary nature; the estimated gain for households earning $35,000 to $64,000 is about $613 or 0.9 percent of income (http://professional.wsj.com/article/SB10001424052748703395204576023772342189318.html?mod=WSJPRO_hps_LEADNewsCollection http://taxpolicycenter.org/taxtopics/Compromise_Agreement_Taxes.cfm). Other provisions protect middle class households from the alternative minimum tax, extend unemployment insurance for 13 months and lower estate taxes to 35 percent for the next two years with the effective exemption of $5 million. The combination of the fiscal situation of the federal, state and local governments and the two-year horizon of extension of tax rates may result in higher savings in expectation for the big tax increase ahead. The expansion curve of the economy in the next few years may be flattened by higher taxes and rising interest rates.
VI Economic Indicators. US economic indicators show improvement in income, consumption and sales but recession levels in real estate and marginal improvements in claims for unemployment insurance. The BEA estimates monthly percentage increases in income and consumption of the US in Nov as: personal income 0.3 percent; disposable income 0.3 percent and 0.2 percent after adjusting for inflation; and personal consumption expenditures (PCE) 0.4 percent and 0.3 percent after adjusting for inflation. Real disposable income grew by 2.4 percent in the 12 months ending in Nov, following 2.4 percent in Oct and 2.1 percent in Sep. Real PCE grew by 2.8 percent in the 12 months ending in Nov, following 2.5 percent in Oct and 2.3 percent in Sep. Real PCE in durable goods rose 10.7 percent in the 12 months ending in Nov, following 12.4 percent in Oct and 10.7 percent in Sep (http://www.bea.gov/newsreleases/national/pi/2010/pdf/pi1110.pdf). The price index of PCE rose 1.0 percent in the 12 months ending in Nov, following 1.2 percent in Oct and 1.3 percent in Sep; the Fed’s closely watched PCE price index excluding food and energy rose 0.8 percent in the 12 months ending in Nov after 0.8 percent in Oct and 1.1 percent in Sep (Ibid, Table 11, 12). Corporate profits before tax were at a seasonally-adjusted annual equivalent rate of $1864.5 billion in IIIQ10 and at $1427.1 billion after tax corresponding to an increase by 28.2 percent relative to IIIQ09 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp3q10_2nd.pdf Table 11, 13). Durable goods manufacturers’ new orders seasonally adjusted fell 1.3 percent in Nov relative to Oct, because of sharp decline in nondefense aircraft and parts, but the not-seasonally adjusted cumulative in Jan-Nov 2010 rose 14.3 percent relative to 2009; excluding transportation new orders rose 2.4 percent in Nov relative to Oct and 13.8 percent in the first eleven months of 2010 relative to the same period in 2009 (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf). Sales of new single-family houses in Nov 2010 rose to the seasonally-adjusted annual rate of 290,000, which is 5.5 percent higher than the revised Oct rate of 275,000, but 21.2 percent lower than 368,000 in Nov 2009. Sales of new single-family houses in the first eleven months of 2010, not seasonally adjusted, stood at 299,000, lower by 14.6 percent than 350,000 in the first eleven months of 2009 (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf Table 1) and 75.1 percent below 1,202,000 sold in the first eleven months of 2005 (http://www.census.gov/const/newressales_200511.pdf Table 1). The National Association of Realtors estimates that existing home sales stood at a seasonally-adjusted annual rate of 4.68 million in Nov for an increase of 5.6 percent relative to 4.43 million in Oct but 27.9 percent below 6.49 million in Nov 2009; the inventory of houses fell 4 percent in Nov to 3.71 million available existing homes for sale, which are equivalent to 9.5 months of sales at the current rate (http://www.realtor.org/press_room/news_releases/2010/12/existing_prices). The seasonally adjusted index of house prices of the Federal Housing Finance Agency (FHFA) rose 0.7 percent in Sep relative to Oct but the decline in Oct was revised from -0.7 percent to -1.2 percent and the decline in the 12 months ending in Oct is estimated at 3.4 percent; the index is 14.5 percent lower than its peak in Apr 2007 (http://www.fhfa.gov/webfiles/19604/OctHPI122210F.pdf). Seasonally-adjusted initial claims for unemployment insurance declined by 3,000 to 420,000 in the week ending Dec 18 from the prior week’s revised level of 423,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm).
VII Interest Rates. The central bank of China, People’s Bank of China (PBC), increased interest rates on Dec 25 by 25 basis points, raising the lending rate to 5.81 percent and the deposit rate to 2.75 percent. On Oct 19, the PBC raised interest rates for the first time in three years. The intention of the interest rate increase is to curb lending with ultimate objective of reducing inflation that rose to a 28-month peak of 5.1 percent in Nov after 4.4 percent in Oct (http://www.ft.com/cms/s/0/084630ba-1020-11e0-be4a-00144feabdc0.html#axzz198jCWzAy). The interest rate increase on Christmas Day, which is not celebrated in China, may be designed to dilute the news when markets open again after the holiday. Increases in interest rates in China and other measures tightening monetary policy elevate risk aversion in financial markets because of the impact of lower growth in China on commodities markets, intraregional trade and the world economy. The impact of fears of growth of China is augmented by sovereign risk issues in Europe. The yield curve of the US has shifted upwardly with sharper slope in the 2-year to 10-year segment contrary to the intentions of quantitative easing. The 10-year Treasury yield rose to 3.40 percent on Dec 23 relative to 3.31 percent a month ago and 2.91 percent a month before. The 5-year Treasury yield rose to 2.06 percent on Dec 23 from 1.93 percent a week ago and 1.57 percent a month before (http://markets.ft.com/markets/bonds.asp). Yields on Treasury notes have been increasing sharply instead of the decline that would be expected from continuing weekly purchases of Treasury securities by the Fed. The yield of the 10-year government bond of Germany rose to 2.98 percent for a negative spread of 41 basis points relative to the comparable Treasury (Ibid). The 10-year Treasury with coupon of 2.625 maturing in 11/20 was quoted on Dec 23 for yield of 3.40 percent equivalent to price of 93.56 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-241210).
VIII Conclusion. The GDP data show a slowly improving economy relative to the need of alleviating the job stress of 26.4 million persons. Economic indicators are improving at the margin for income, consumption and sales but there are still recession levels in real estate while labor markets are weak. Stimulus policy has failed in promoting growth and employment, creating a difficult deficit/budget environment that generates expectations of tax increases. The Fed policy of zero interest rates and quantitative easing causes worrisome valuations of risk financial assets and presents a high risk of increases in interest rates. A large number of regulatory rules are proceeding at a pace that raises doubts on their quality. The combination of draconian regulation distorting business model with expectations of tax and interest rate increases hinders economic growth and hiring. Postponement of regulatory changes as in Basel III may promote credit, growth and employment far better than stimulus policy. A change in course of economic policy is required to induce higher economic growth that can reduce unemployment and underemployment. (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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© Carlos M. Pelaez, 2010
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