CMP Associates Regulation Blog: Decline of United States New House Sales by 46 percent since 1963 while Population Increased 72 Percent, World Financial Turbulence, Global Inflation and World Economic Slowdown: Part I

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Decline of United States New House Sales by 46 percent since 1963 while Population Increased 72 Percent, World Financial Turbulence, Global Inflation and World Economic Slowdown: Part I

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Decline of United States New House Sales by 46 percent since 1963 while Population Increased 72 Percent, World Financial Turbulence, Global Inflation and World Economic Slowdown

Carlos M. Pelaez

Executive Summary

I United States New House Sales

II United States House Prices

III World Financial Turbulence

IIIA Financial Risks

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

IIID Appendix on European Central Bank Large Scale Lender of Last Resort

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendix I The Great Inflation

Executive Summary

The depressed level of residential construction and new house sales in the US is evident in Table ES1 providing new house sales not seasonally adjusted in Jan of various years. Sales of new houses in Jan 2012 are substantially lower than in any year between 1995 and 2010. There is only an increase of 4.8 percent between Jan 2011 and Jan 2012 that will likely disappear as the year proceeds. Sales of new houses in 2012 are lower by 8.3 percent in relation to 2010 and also 8.3 percent below the level in 2009. The housing boom peaked in 2005 and 2006 when increases in fed funds rates affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan 2011 relative to the same period in 2005 fell 76.1 percent and 75.3 percent relative to the same period in 2006. Similar percentage declines are also observed for 2011 relative to years from 2000 to 2004. Sales of new houses in Jan 2012 fell 53.2 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hoobs and Snoops 2012, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table ES1 reveals catastrophic data: sales of new houses in Jan 2012 of 22 thousand units are lower by 47.6 percent relative to 42 thousand units houses sold in Jan 1963, the first year when data become available, while population increased 72.2 percent.

Table ES1, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan 2012	22
Jan 2011	21
∆%	4.8
Jan 2010	24
∆% Jan 2012/ Jan 2010	-8.3
Jan 2009	24
∆% Jan 2012/ Jan 2009	-8.3
Jan 2008	44
∆% Jan 2012/ Jan 2008	-50.0
Jan 2007	66
∆% Jan 2012/ Jan 2007	-66.7
Jan 2006	89
∆% Jan 2012/Jan 2006	-75.3
Jan 2005	92
∆% Jan 2012/Jan 2005	-76.1
Jan 2004	89
∆% Jan 2012/Jan 2004	-75.3
Jan-Dec 2003	76
∆% Jan 2012/ Jan 2003	-71.1
Jan 2002	66
∆% Jan 2012/ Jan 2001	-66.7
Jan 2001	72
∆% Jan 2012/ Jan 2001	-69.4
Jan-Dec 2000	67
∆% Jan 2012/ Jan 2000	-67.2
Jan 1995	47
∆% Jan 2012/ Jan 1995	-53.2
Jan 1963	42
∆% Jan 2012/ Jan 1963	-47.6

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

Table ES2 provides the entire available series of new house sales from 1963 to 2011. The level of 304 thousand new houses sold in 2011 is the lowest since 560,000 in 1963 in the 48 years of available data. In that period, the population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. In fact, there is no year from 1963 to 2010 in Table ES2 with sales of new houses below 400 thousand.

Table ES2, US, New Houses Sold, NSA Thousands

1963	560
1964	565
1965	575
1966	461
1967	487
1968	490
1969	448
1970	485
1971	656
1972	718
1973	634
1974	519
1975	549
1976	646
1977	819
1978	817
1979	709
1980	545
1981	436
1982	412
1983	623
1984	639
1985	688
1986	750
1987	671
1988	676
1989	650
1990	534
1991	509
1992	610
1993	666
1994	670
1995	667
1996	757
1997	804
1998	886
1999	880
2000	877
2001	908
2002	973
2003	1,086
2004	1,203
2005	1,283
2006	1,051
2007	776
2008	485
2009	375
2010	323
2011	304

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

Percentage changes and average rates of growth of new house sales for selected periods are shown in Table ES3. The percentage change of new house sales from 1963 to 2011 is minus 45.7 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2004. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2011 fell 54.4 percent relative to the same period in 1995.

Table ES3, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses

	∆%	Average Yearly % Rate
1963-2011	-45.7	NA
1991-2001	78.4	5.9
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2011	-54.4	NA
2000-2011	-65.3	NA
2005-2011	-76.3	NA

NA: Not Applicable

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

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply the analysis of Merton (1974) to the US housing market in 2005-2006 concluding:

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

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

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

I United States New House Sales. Data and other information continue to provide depressed conditions in the US housing market. Table I-1 shows sales of new houses in the US at seasonally-adjusted annual equivalent rate (SAAR). House prices fell in eight of thirteen months from Jan 2011 to Jan 2012. The four months Sep to Dec 2011 were quite strong with annual equivalent percentage change of 39.6 percent. There was significant weakness in the annual equivalent rate of percentage change of minus 13.1 in Jan-Apr and the annual equivalent rate of minus 22.5 percent in May-Aug. The SAAR for Jan 2012 fell 0.9 percent relative to Dec.

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

	SA Annual Rate Thousands	∆%
Jan 2012	321	-0.9
Dec 2011	324	1.9
Nov	318	2.3
Oct	311	3.0
Sep	302	4.1
AE ∆% Sep-Dec		39.6
Aug	290	-1.7
Jul	295	-2.6
Jun	303	-1.6
May	308	-2.5
AE ∆% May-Aug		-22.5
Apr	316	3.6
Mar	305	8.5
Feb	281	-9.4
Jan	310	-6.3
AE ∆% Jan-Apr		-13.1
Dec 2010	331	15.3

AE: Annual Equivalent

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

There is additional information of the report of new house sales in Table I-2. The stock of unsold houses stabilized in Apr-Aug at 6.6 monthly equivalent sales at current sales rates and then dropped to 6.4 in Sep, 6.1 in Oct, 5.9 in Nov and 5.7 in Dec, increasing slightly to 5.8 in Jan. Median and average house prices oscillate. In Jan 2012, median prices of new houses sold not seasonally adjusted (NSA) increased 0.3 percent and average prices fell 1.2 percent. There are only three months with price increases in both median and average house prices: Oct with 1.9 percent in median prices and 1.1 in average prices, Jun with 8.2 percent in median prices and 3.9 percent in average prices and Apr with 1.9 percent in median prices and 3.1 percent in average prices. Median and average prices of new houses sold in the US fell in nine of the 12 months from Jan 2011 to Jan 2012.

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

	Unsold* Stocks in Equiv. Months of Sales SA %	Median New House Sales Price USD NSA	Month ∆%	Average New House Sales Price USD NSA	Month ∆%
Jan 2012	5.8	217,100	0.3	261,600	-1.2
Dec 2011	5.7	216,500	-2.5	264,900	6.3
Nov	5.9	213,100	-2.4	249,200	-3.5
Oct	6.1	224,800	1.9	258,300	1.1
Sep	6.4	217,000	-1.2	255,400	-1.5
Aug	6.7	219,600	-4.5	259,300	-4.1
Jul	6.8	229,900	-4.3	270,300	-1.0
Jun	6.6	240,200	8.2	273,100	3.9
May	6.5	222,000	-1.2	262,700	-2.3
Apr	6.6	224,700	1.9	268,900	3.1
Mar	7.0	220,500	0.2	260,800	-0.8
Feb	7.8	220,100	-8.3	262,800	-4.7
Jan	7.2	240,100	-0.5	275,700	-5.5
Dec 2010	6.9	241,200	9.8	291,700	3.5

*Percent of new houses for sale relative to houses sold

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

The depressed level of residential construction and new house sales in the US is evident in Table I-3 providing new house sales not seasonally adjusted in Jan of various years. Sales of new houses in Jan 2012 are substantially lower than in any year between 1995 and 2010. There is only an increase of 4.8 percent between Jan 2011 and Jan 2012 that will likely disappear as the year proceeds. Sales of new houses in 2012 are lower by 8.3 percent in relation to 2010 and also 8.3 percent below the level in 2009. The housing boom peaked in 2005 and 2006 when increases in fed funds rates affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan 2011 relative to the same period in 2005 fell 76.1 percent and 75.3 percent relative to the same period in 2006. Similar percentage declines are also observed for 2011 relative to years from 2000 to 2004. Sales of new houses in Jan 2012 fell 53.2 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hoobs and Snoops 2012, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table I-3 reveals catastrophic data: sales of new houses in Jan 2012 of 22 thousand units are lower by 47.6 percent relative to 42 thousand units houses sold in Jan 1963, the first year when data become available, while population increased 72.2 percent.

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

	Not Seasonally Adjusted Thousands
Jan 2012	22
Jan 2011	21
∆%	4.8
Jan 2010	24
∆% Jan 2012/ Jan 2010	-8.3
Jan 2009	24
∆% Jan 2012/ Jan 2009	-8.3
Jan 2008	44
∆% Jan 2012/ Jan 2008	-50.0
Jan 2007	66
∆% Jan 2012/ Jan 2007	-66.7
Jan 2006	89
∆% Jan 2012/Jan 2006	-75.3
Jan 2005	92
∆% Jan 2012/Jan 2005	-76.1
Jan 2004	89
∆% Jan 2012/Jan 2004	-75.3
Jan-Dec 2003	76
∆% Jan 2012/ Jan 2003	-71.1
Jan 2002	66
∆% Jan 2012/ Jan 2001	-66.7
Jan 2001	72
∆% Jan 2012/ Jan 2001	-69.4
Jan-Dec 2000	67
∆% Jan 2012/ Jan 2000	-67.2
Jan 1995	47
∆% Jan 2012/ Jan 1995	-53.2
Jan 1963	42
∆% Jan 2012/ Jan 1963	-47.6

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

Table I-4 provides the entire available series of new house sales from 1963 to 2011. The level of 304 thousand new houses sold in 2011 is the lowest since 560,000 in 1963 in the 48 years of available data. In that period, the population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. In fact, there is no year from 1963 to 2010 in Table I-4 with sales of new houses below 400 thousand.

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

1963	560
1964	565
1965	575
1966	461
1967	487
1968	490
1969	448
1970	485
1971	656
1972	718
1973	634
1974	519
1975	549
1976	646
1977	819
1978	817
1979	709
1980	545
1981	436
1982	412
1983	623
1984	639
1985	688
1986	750
1987	671
1988	676
1989	650
1990	534
1991	509
1992	610
1993	666
1994	670
1995	667
1996	757
1997	804
1998	886
1999	880
2000	877
2001	908
2002	973
2003	1,086
2004	1,203
2005	1,283
2006	1,051
2007	776
2008	485
2009	375
2010	323
2011	304

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

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

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

Source: US Census Bureau

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

Percentage changes and average rates of growth of new house sales for selected periods are shown in Table I-5. The percentage change of new house sales from 1963 to 2011 is minus 45.7 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2004. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2011 fell 54.4 percent relative to the same period in 1995.

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

	∆%	Average Yearly % Rate
1963-2011	-45.7	NA
1991-2001	78.4	5.9
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2011	-54.4	NA
2000-2011	-65.3	NA
2005-2011	-76.3	NA

NA: Not Applicable

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

The available historical data of median and average prices of new houses sold in the US between 1963 and 2010 is provided in Table I-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially.

Table I-6, US, Median and Average Prices of New Houses Sold, Annual Data

Period	Median	Average
1963	$18,000	$19,300
1964	$18,900	$20,500
1965	$20,000	$21,500
1966	$21,400	$23,300
1967	$22,700	$24,600
1968	$24,700	$26,600
1969	$25,600	$27,900
1970	$23,400	$26,600
1971	$25,200	$28,300
1972	$27,600	$30,500
1973	$32,500	$35,500
1974	$35,900	$38,900
1975	$39,300	$42,600
1976	$44,200	$48,000
1977	$48,800	$54,200
1978	$55,700	$62,500
1979	$62,900	$71,800
1980	$64,600	$76,400
1981	$68,900	$83,000
1982	$69,300	$83,900
1983	$75,300	$89,800
1984	$79,900	$97,600
1985	$84,300	$100,800
1986	$92,000	$111,900
1987	$104,500	$127,200
1988	$112,500	$138,300
1989	$120,000	$148,800
1990	$122,900	$149,800
1991	$120,000	$147,200
1992	$121,500	$144,100
1993	$126,500	$147,700
1994	$130,000	$154,500
1995	$133,900	$158,700
1996	$140,000	$166,400
1997	$146,000	$176,200
1998	$152,500	$181,900
1999	$161,000	$195,600
2000	$169,000	$207,000
2001	$175,200	$213,200
2002	$187,600	$228,700
2003	$195,000	$246,300
2004	$221,000	$274,500
2005	$240,900	$297,000
2006	$246,500	$305,900
2007	$247,900	$313,600
2008	$232,100	$292,600
2009	$216,700	$270,900
2010	$221,800	$272,900
2011	$226,100	$267,100

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

Percentage changes of median and average prices of new houses sold in selected years are shown in Table I-7. Prices rose sharply between 2000 and 2005. In fact, prices in 2011 are higher than in 2000. Between 2006 and 2011, median prices of new houses sold fell 8.3 percent and average prices fell 12.7 percent. Between 2010 and 2011, median prices increased 1.9 percent and average prices fell 2.1 percent.

Table I-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%

	Median New Home Sales Prices ∆%	Average New Home Sales Prices ∆%
∆% 2000 to 2003	15.4	18.9
∆% 2000 to 2005	42.5	43.5
∆% 2000 to 2011	33.8	29.0
∆% 2005 to 2011	-6.1	-10.1
∆% 2000 to 2006	45.9	47.8
∆% 2006 to 2011	-8.3	-12.7
∆% 2009 to 2011	4.3	-1.4
∆% 2010 to 2011	1.9	-2.1

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

Weakness in the housing sector is being considered as an important factor of the financial crisis, global recession and slow growth recession. Chairman Bernanke (2011Oct4JEC, 2-3) states:

“Other sectors of the economy are also contributing to the slower-than-expected rate of expansion. The housing sector has been a significant driver of recovery from most recessions in the United States since World War II. This time, however, a number of factors--including the overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and the large number of “underwater” mortgages (on which homeowners owe more than their homes are worth)--have left the rate of new home construction at only about one-third of its average level in recent decades.”

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

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

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

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

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

W = Y/r (1)

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

II United States House Prices. The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae- and Freddie Mac-acquired mortgages” (http://www.fhfa.gov/webfiles/22558/2q2011HPI.pdf). Table II-1 provides the FHFA HPI for purchases only, which shows behavior similar to that of the Case-Shiller index but with lower magnitudes. House prices catapulted from 2000 to 2003, 2005 and 2006. From IVQ2000 to IVQ2006, the index for the US as a whole rose 55.0 percent and by close or higher than 70 percent for New England, Middle Atlantic and South Atlantic but only by 33.2 percent for East South Central. Prices fell relative to 2011 from all years since 2005. From IVQ2000 to IVQ2011, prices rose for the US and the four regions in Table II-1.

Table II-1, US, FHFA House Price Index Purchases Only NSA ∆%

	United States	New England	Middle Atlantic	South Atlantic	East South Central
4Q2000 to 4Q2003	24.6	40.7	35.9	25.8	11.1
4Q2000 to 4Q2005	50.3	65.2	67.9	62.4	25.5
4Q2000 to 4Q2006	55.0	62.3	72.6	70.6	33.2
4Q2005 t0 4Q2011	-16.3	-13.6	-7.3	-22.0	-1.6
4Q2006 to 4Q2011	-18.9	-12.1	-9.8	-25.8	-7.3
4Q2007 to 4Q2011	-16.9	-10.4	-10.2	-23.3	-9.1
4Q2009 to 4Q2011	-6.4	-3.6	-4.9	-8.3	-5.2
4Q2010 to 4Q2011	-2.4	-2.0	-3.4	-2.7	-0.7
4Q2000 to 4Q2011	25.8	42.7	55.6	26.6	23.5

Source: http://www.fhfa.gov/webfiles/23396/4Q2011hpi.pdf

Data of the FHFA HPI for the remaining US regions are provided in Table II-2. Behavior is not very different than in Table II-1 with the exception of East North Central. House prices in the Pacific region doubled between 2000 and 2006. Although prices of houses declined sharply from 2005 to 2011, there was still appreciation relative to 2000.

Table II-2, US, FHFA House Price Index Purchases Only NSA ∆%

	West South Central	West North Central	East North Central	Mountain	Pacific
4Q2000 to 4Q2003	11.2	18.4	14.8	18.9	44.2
4Q2000 to 4Q2005	23.8	31.2	24.0	57.6	106.9
4Q2000 to 4Q2006	31.7	34.1	23.9	68.8	107.8
4Q2005 t0 4Q2011	8.2	-6.9	-16.4	-26.2	-37.8
4Q2006 to 4Q2011	1.7	-8.9	-16.4	-31.1	-38.1
4Q2007 to 4Q2011	-1.7	-8.5	-13.5	-28.8	-31.5
4Q2009 to 4Q2011	-1.2	-4.7	-5.5	-10.9	-10.3
4Q2010 to 4Q2011	1.2	-1.2	-2.7	-3.5	-4.8
4Q2000 to 4Q2011	33.9	22.1	3.6	16.3	28.6

Source: http://www.fhfa.gov/webfiles/23396/4Q2011hpi.pdf

Chart II-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IVQ2001 to IVQ2011. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IVQ2008 but there was another decline after IIIQ2010. The rate of decline improved in the second half of 2011.

Chart II-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change

Source: Federal Housing Finance Agency

http://www.fhfa.gov/Default.aspx?Page=14

Monthly and 12 months percentage changes of the FHFA House Price Index are provided in Table II-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul while 12 months percentage changes improved steadily from more than minus 6 percent in Mar to May to minus 4.3 percent in Jun. The FHFA house price index fell 0.9 percent in Oct and fell 3.5 percent in the 12 months ending in Oct. There was significant recovery in Nov with increase in the house price index of 0.7 percent and reduction of the 12-month rate of decline to 2.2 percent. The house price index rose 0.7 percent in Dec and the 12-month percentage change fell to minus 0.7 percent.

Table II-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12 Months ∆%

2011	Month ∆% SA	12 Month ∆% NSA
Dec	0.7	-0.7
Nov	0.7	-2.2
Oct	-0.9	-3.5
Sep	0.4	-2.7
Aug	-0.3	-4.0
Jul	0.1	-3.9
Jun	0.6	-4.3
May	0.2	-6.0
Apr	0.3	-6.1
Mar	-0.3	-6.0
Feb	-1.6	-5.4
Jan	-0.7	-4.6
Dec 2010		-3.8
Dec 2009		-1.9
Dec 2008		-9.6
Dec 2007		-3.0
Dec 2006		2.5
Dec 2005		9.9
Dec 2004		10.1
Dec 2003		7.9
Dec 2002		7.8
Dec 2001		6.8
Dec 2000		7.1
Dec 1999		6.1
Dec 1998		5.9
Dec 1997		3.4
Dec 1996		2.8
Dec 1995		2.7
Dec 1994		2.6
Dec 1993		3.1
Dec 1992		2.4

Source: http://www.fhfa.gov/Default.aspx?Page=87

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment; and (3) the outcome of the sovereign debt crisis in Europe. This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. There are various appendixes at the end of this section for convenience of reference of material related to the euro area debt crisis. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis.

IIIA Financial Risks. The past half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr Feb 17 and daily values throughout the week ending on Fri Feb 24 of several financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Feb 17 and the percentage change in that prior week below the label of the financial risk asset. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. The most important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3140/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Feb 17, depreciating to USD 1.3241/EUR on Mon Feb 20, or by 0.8 percent. The dollar depreciated because more dollars, $1.3241, were required on Feb 20 to buy one euro than $1.3140 on Feb 17. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3241/EUR on Feb 20; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Feb 17, to the last business day of the current week, in this case Fri Feb 24, such as depreciation by 2.4 percent to USD 1.3449/EUR by Feb 24; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 2.4 percent from the rate of USD 1.3140/EUR on Fri Feb 17 to the rate of USD 1.3449/EUR on Fri Feb 24 {[(1.3449/1.314) – 1]100 = 2.4%} and depreciated (denoted by negative sign) by 0.6 percent from the rate of USD 1.3365 on Thus Feb 23 to USD 1.3449/EUR on Fri Feb 24 {[(1.3449/1.3365) -1]100 = 0.6%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets, depreciating the dollar.

III-I, Weekly Risk Financial Assets Feb 20 to Feb 24, 2012

Fri Feb 17, 2012

Mon 20

Tue 21

W 22

Thu 23

Fr 24

USD/EUR

1.3140

0.4%

1.3241

-0.8%

1.3236

-0.7%

-0.1%

1.3251

-0.8%

-0.1%

1.3365

-1.7%

-0.9%

1.3449

-2.4%

-0.6%

JPY/ USD

79.52

-2.5%

79.6350

-0.1%

79.7115

-0.2%

-0.1%

80.3055

-0.9%

-0.7%

79.8950

-0.5%

0.5%

81.199

-2.1%

-1.6%

CHF/ USD

0.918

-0.1%

0.9117

0.7%

0.9123

0.6%

-0.1%

0.9102

0.8%

0.2%

0.9020

1.7%

0.9%

0.895

2.5%

0.8%

CHF/ EUR

1.2089

0.0%

1.2072

0.1%

1.2076

0.1%

0.0%

1.2061

0.2%

0.1%

1.2056

0.3%

0.0%

1.2048

0.4%

0.1%

USD/ AUD

1.071

0.9337

1.0756

0.9297

0.4%

1.0663

0.9378

-0.4%

-0.9%

1.0635

0.9403

-0.7%

-0.3%

1.07050

0.9341

0.0%

0.7%

1.069

0.9355

-0.2%

-0.1%

10 Year T Note

2.00

2.06

2.00

1.99

1.977

2 Year T Note

0.292

0.29

0.30

0.29

0.30

0.307

German Bond

2Y 0.25 10Y 1.92

2Y 0.26 10Y 1.96

2Y 0.26 10Y 1.98

2Y 0.26 10Y 1.89

2Y 0.26 10Y 1.88

2Y 0.24 10Y 1.88

DJIA

12949.87

1.2%

12949.87

CLOSED

0.4%

12965.69

0.1%

12938.67

-0.1%

-0.2%

12984.91

0.2%

0.4%

12982.95

0.3%

0.0%

DJ Global

1989.39

1.3%

2003.12

0.7%

1999.70

0.5%

-0.2%

1986.12

-0.2%

-0.7%

1987.88

-0.1%

0.1%

2000.96

0.3%

0.7%

DJ Asia Pacific

1298.19

1.5%

1308.39

0.8%

1305.19

0.5%

-0.2%

1306.54

0.6%

0.1%

1306.33

0.6%

0.0%

1309.12

0.8%

0.2%

Nikkei

9384.17

4.9%

9485.09

1.1%

9463.02

0.8%

-0.2%

9554.00

1.8%

1.0%

9595.57

2.2%

0.4%

9647.38

2.8%

0.5%

Shanghai

2357.18

0.2%

2363.60

0.3%

2381.43

1.0%

0.8%

2403.59

2.0%

0.9%

2409.55

2.2%

0.2%

2439.63

3.5%

1.3%

DAX

6848.03

2.3%

6948.25

1.5%

6908.18

0.9%

-0.6%

6843.87

-0.1%

-0.9%

6809.46

-0.6%

-0.5%

6864.43

0.2%

0.8%

DJ UBS

Comm.

145.76

0.6%

145.76

CLOSED

0.4%

147.72

1.3%

148.29

1.7%

0.4%

148.59

1.9%

0.2%

149.35

2.5%

0.5%

WTI $ B

104.06

5.2%

104.92

106.04

1.9%

105.91

1.8%

-0.1%

108.06

3.8%

2.0%

109.71

5.4%

1.5%

Brent $/B

119.94

2.0%

119.92

0.0%

121.20

1.1%

122.60

2.2%

1.2%

123.92

3.3%

1.1%

125.40

4.6%

1.2%

Gold $/OZ

1725.2

0.1%

1735.5

1760.7

2.1%

1778.0

3.1%

1.0%

1781.6

3.3%

0.2%

1775.6

2.9%

-0.3%

Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss

Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce

Sources: http://www.bloomberg.com/markets/

http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

Table III-1 shows changes in valuations of risk financial assets in the week of Feb 20 to Feb 24, which were affected by the continuing impasse on the negotiation of the bailout for Greece. Risk aversion returned in earlier weeks because of the uncertainties on rapidly moving political development in Greece, Italy, Spain and perhaps even in France and Germany. Most currency movements in Table III-1 reflect alternating bouts of risk aversion because of continuing doubts on the success of the new agreement on Europe reached in the week of Dec 9, 2011 and the new agreement reached on Jan 30, 2012. Risk aversion is observed in foreign exchange markets with daily trading of around $4 trillion. The dollar had fluctuated in a tight range with hardly any changes but depreciated after advanced guidance by the Federal Open Market Committee (FOMC) that fed funds rates may remain at 0 to ¼ percent until the latter part of 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

The JPY depreciated an additional 2.5 percent during the week largely because of strong new measures by the Bank of Japan. The Policy Board of the Bank of Japan decided three important measures of enhancing monetary easing at the meeting held on Feb 14, 2012 (Bank of Japan 2012EME, 2012PSG and 2012APP). First, the Bank of Japan (2012Feb14EME, 2012Feb14PSG) adopted a “price stability goal” for the “medium term” of 2 percent of the “year-on-year rate of change of the CPI” with the immediate goal of inflation of 1 percent. Japan’s CPI inflation in the 12 months ending in Dec was minus 0.2 percent. Second, the Bank of Japan (2012Feb14EME, 1-2) will conduct “virtually zero interest rate policy” by maintaining “the uncollateralized overnight call rate at around 0 to 0.1 percent.” Third, the Bank of Japan (20012Feb13EME, 2014Feb14APP) is increasing the size of its quantitative easing:

“The Bank increases the total size of the Asset Purchase Program by about 10 trillion yen, from about 55 trillion yen to about 65 trillion yen. The increase in the Program is earmarked for the purchase of Japanese government bonds. By fully implementing the Program including the additional expansion decided today, by the end of 2012, the amount outstanding of the Program will be increased by about 22 trillion yen from the current level of around 43 trillion yen.”

IIIB Appendix on Safe Haven Currencies analyzes the burden on the Japanese economy of yen appreciation. Policy rates close to zero by major central banks in the world together with quantitative easing tend to depreciate currencies. Monetary policy is an indirect form of currency intervention.

The Swiss franc appreciated 2.5 percent to USD 0.895/USD relative to the dollar and appreciated 0.4 percent relative to the euro at CHF 1.2089/EUR. The Australian dollar appreciated to USD 1.069/AUD on Feb 24 for cumulative appreciation of 0.2 percent relative to the USD. The AUD is considered a carry trade commodity currency.

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing aversion is captured by decrease of the yield of the ten-year Treasury note from 2.326 percent on Oct 28 to 1.964 percent on Fri Nov 25, 2.065 on Dec 9 and collapse to 1.847 percent by Fr Dec 16. The yield of the ten-year Treasury rose from 1.81 percent on Mon Dec 19 to 2.027 percent on Fri Dec 23, falling to 1.871 percent on Fri Dec 30 and increasing to 1.957 percent on Jan 6 but falling again to 1.869 on Jan 13. More relaxed risk aversion is shown in the increase of the yield of the ten-year Treasury to 2.026 percent on Fri Jan 20 but renewed aversion with decline to 1.893 percent on Jan 27 and 1.923 on Feb 3 but increase to 1.974 on Fri Feb 10. As shown in Table III-1, the ten-year Treasury yield rose to 2.000 on Fri Feb 17 and fell marginally to 1.977 percent on Feb 24. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.9 percent in the 12 months ending in Dec (see section II United States Inflation at http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with stable low yield of 0.226 percent on Dec 16 but rising to 0.28 percent on Dec 23 and then falling to 0.239 percent on Fri Dec 30, increasing to 0.256 on Fri Jan 6 but falling to 0.225 on Jan 13. The yield of the two-year Treasury rose to 0.242 percent on Fri Jan 20 in an environment of more relaxed risk aversion but fell to 0.215 on Fri Jan 27 in another shock of aversion, standing at 0.234 on Feb 3 and 0.274 on Feb 10. As shown in Table III-1, the two-year Treasury yield rose to 0.292 percent on Fri Feb 17 and marginally to 0.307 on Fri Feb 24. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities.

A similar risk aversion phenomenon occurred in Germany. The flash estimate of euro zone CPI inflation is at 2.7 percent for the 12 months ending in Jan 2012 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-01022012-AP/EN/2-01022012-AP-EN.PDF) but the yield of the two-year German government bond fell from 0.32 percent on Dec 9 to 0.22 percent on Dec 16, virtually equal to the yield of the two-year Treasury note of the US and settled at 0.23 percent on Fri Dec 23, collapsing to 0.14 percent on Fri Dec 30 and rising to 0.17 percent on Jan 6 and 0.15 percent on Jan 13. The yield of the two-year government bond of Germany increased to 0.21 percent in an environment of marginally more relaxed risk aversion on Jan 20 but fell to 0.19 percent on Jan 27 and 0.20 percent on Feb 3, increasing to 0.24 on Feb 10. As shown in Table III-1, the yield of the two-year German government bond increased to 0.25 percent on Fri Feb 17 and fell marginally to 0.24 percent on Fri Feb 24. The yield of the ten-year German government bond has also collapsed from 2.15 percent on Dec 9 to 1.85 percent on Dec 16, rising to 1.96 percent on Dec 23, falling to 1.83 percent on Dec 30, which was virtually equal to the yield of 1.871 percent of the US ten-year Treasury note. The ten-year government bond of Germany traded at 1.85 percent on Jan 6 and at 1.77 percent on Jan 13, increasing to 1.93 percent on Jan 20 but falling to 1.86 percent on Jan 27 and rising to 1.93 percent on Feb 10. As shown in Table III-1, the yield of the ten-year government bond of Germany settled at 1.92 percent on Fri Feb 17 and remained almost unchanged at 1.88 percent on Fri Feb 24. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds.

Equity indexes in Table III-1 increased mildly during the week of Feb 24 with remaining doubts on the execution of the bailout of Greece. Germany’s Dax rose 0.2 percent. DJIA gained 0.3 percent in the week of Feb 24 and Dow Global gained 0.3 percent. Japan’s Nikkei Average jumped 4.9 percent in the week of Feb 17 and an additional 2.8 percent in the week of Feb 24 because of measures of enhancing monetary easing by the Bank of Japan and expectations of further intervention to weaken the JPY. Dow Asia Pacific rose 0.8 percent.

IIIB Appendix on Safe Haven Currencies. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation but also remained relatively unchanged. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.

1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent. The pain of Japan from dollar devaluation continues as illustrated by Table VI-6 in Section VII Valuation of Risk Financial Assets: The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 78.08/USD on Dec 23, 2011, for cumulative appreciation of 29.1 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Dec 23, 2011 (JPY 78.08) was 6.0 percent.

2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.

There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. The JPY was virtually unchanged in the week of Dec 16 with depreciation of 0.1 percent but depreciated by 0.5 percent in the week of Dec 23, appreciating by 1.5 percent in the week of Dec 30. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:

· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.

· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”

Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc remained unchanged relative to the USD in the week of Dec 23 and appreciated 0.2 percent in the week of Dec 30 relative to the USD and 0.5 percent relative to the euro, as shown in Table II-1. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.5 percent in the week of Fr Dec 16 after no change in the week of Dec 9. In the week of Dec 23, the Australian dollar appreciated 1.9 percent, appreciating another 0.5 percent in the week of Dec 30 as shown in Table II-1. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).

IIIC Appendix on Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.

1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.

i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with adjustment of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.

ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.

2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.

i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.

ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in Mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Matthew Dalton and Matina Stevis, writing on Dec 20, 2011, on “Euro Zone Agrees to New IMF Loans,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204791104577107974167166272.html?mod=WSJPRO_hps_MIDDLESecondNews), inform that at a meeting on Dec 20, finance ministers of the euro-zone developed plans to contribute €150 billion in bilateral loans to the IMF as provided in the agreement of Dec 9. Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).

3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.

IIID Appendix on European Central Bank Large Scale Lender of Last Resort. European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”

An important statement of Draghi (2011Dec15) focuses on the role of central banking: “You all know that the statutes of the ECB inherited this important principle and that central bank independence and the credible pursuit of price stability go hand in hand.”

Draghi (2011Dec19) explains measures to ensure “access to funding markets” by euro zone banks:

§ “We have decided on three-year refinancing operations to support the supply of credit to the euro area economy. These measures address the risk that persistent financial markets tensions could affect the capacity of euro area banks to obtain refinancing over longer horizons.

§ Earlier, in October, the Governing Council had already decided to have two more refinancing operations with a maturity of around one year.

§ Also, it was announced then that in all refinancing operations until at least the first half of 2012 all liquidity demand by banks would be fully allotted at fixed rate.

§ Funding via the covered bonds market was also facilitated by the ECB deciding in October to introduce a new Covered Bond Purchase Programme of €40 billion.

§ Funding in US dollar is facilitated by lowering the pricing on the temporary US dollar liquidity swap arrangements.”

Lionel Barber and Ralph Atkins interviewed Mario Draghi on Dec 14 with the transcript published in the Financial Times on Dec 18 (http://www.ft.com/intl/cms/s/0/25d553ec-2972-11e1-a066-00144feabdc0.html#axzz1gzoHXOj6) as “FT interview transcript: Mario Draghi.” A critical question in the interview is if the new measures are a European version of quantitative easing. Draghi analyzes the difference between the measures of the European Central Bank (ECB) and quantitative easing such as in Japan, US and UK:

1. The measures are termed “non-standard” instead of “unconventional.” While quantitative easing attempts to lower the yield of targeted maturities, the three-year facility operates through the “bank channel.” Quantitative easing would not be feasible because the ECB is statutorily prohibited of funding central governments. The ECB would comply with its mandate of medium-term price stability.

2. There is a critical difference in the two programs. Quantitative easing has been used as a form of financial repression known as “directed lending.” For example, the purchase of mortgage-backed securities more recently or the suspension of the auctions of 30-year bonds in response to the contraction early in the 2000s has the clear objective of directing spending to housing. The ECB gives the banks entire discretion on how to use the funding within their risk/return decisions, which could include purchase of government bonds.

The question on the similarity of the ECB three-year lending facility and quantitative easing is quite valid. Tracy Alloway, writing on Oct 10, 2011, on “Investors worry over cheap ECB money side effects,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d2f87d16-f339-11e0-8383-00144feab49a.html#axzz1hAqMH1vn), analyzes the use of earlier long-term refinancing operations (LTRO) of the ECB. LTROs by the ECB in Jun, Sep and Dec 2009 lent €614 billion at 1 percent. Alloway quotes estimates of Deutsche Bank that banks used €442billion to acquire assets with higher yields. Carry trades developed from LTRO funds at 1 percent into liquid investments at a higher yield to earn highly profitable spreads. Alloway quotes estimates of Morgan Stanley that European debt of GIIPS (Greece, Ireland, Italy, Portugal and Spain) in European bank balance sheets is €700 billion. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. Three such LTROs could add to $1.9 trillion, which is not far from the value of quantitative easing in the US of $2.5 trillion. Fairless and Cottle find that there could be renewed hopes that banks could use the LTROs to support euro zone bond markets. It is possible that there could be official moral suasion by governments on banks to increase their holdings of government bonds or at least not to sell existing holdings. Banks are not free to choose assets in evaluation of risk and returns. Floods of cheap money at 1 percent per year induce carry trades to high-risk assets and not necessarily financing of growth with borrowing and lending decisions constrained by shocks of confidence.

The LTROs of the ECB are not very different from the liquidity facilities of the Fed during the financial crisis. Kohn (2009Sep10) finds that the trillions of dollars in facilities provided by the Fed (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-64, Regulation of Banks and Finance (2009b), 224-7) could fall under normal principles of “lender of last resort” of central banks:

“The liquidity measures we took during the financial crisis, although unprecedented in their details, were generally consistent with Bagehot's principles and aimed at short-circuiting these feedback loops. The Federal Reserve lends only against collateral that meets specific quality requirements, and it applies haircuts where appropriate. Beyond the collateral, in many cases we also have recourse to the borrowing institution for repayment. In the case of the TALF, we are backstopped by the Treasury. In addition, the terms and conditions of most of our facilities are designed to be unattractive under normal market conditions, thus preserving borrowers' incentives to obtain funds in the market when markets are operating normally. Apart from a very small number of exceptions involving systemically important institutions, such features have limited the extent to which the Federal Reserve has taken on credit risk, and the overall credit risk involved in our lending during the crisis has been small.

In Ricardo's view, if the collateral had really been good, private institutions would have lent against it. However, as has been recognized since Bagehot, private lenders, acting to protect themselves, typically severely curtail lending during a financial crisis, irrespective of the quality of the available collateral.The central bank--because it is not liquidity constrained and has the infrastructure in place to make loans against a variety of collateral--is well positioned to make those loans in the interest of financial stability, and can make them without taking on significant credit risk, as long as its lending is secured by sound collateral. A key function of the central bank is to lend in such circumstances to contain the crisis and mitigate its effects on the economy.”

The Bagehot (1873) principle is that central banks should provide a safety net, lending to temporarily illiquid but solvent banks and not to insolvent banks (see Cline 2001, 2002; Pelaez and Pelaez, International Financial Architecture (2005), 175-8). Kohn (2009Apr18) characterizes “quantitative easing” as “large scale purchases of assets:”

“Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt. We initially announced our intention to undertake large-scale asset purchases last November, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. These purchases are intended to reduce intermediate- and longer-term interest rates on mortgages and other credit to households and businesses; those rates influence decisions about investments in long-lived assets like houses, consumer durable goods, and business capital. In ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. However, the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates. These preferences are likely to be especially strong in current circumstances, so that long-term asset prices rise and yields fall as the Federal Reserve acquires a significant portion of the outstanding stock of securities held by the public.”

Non-standard ECB policy and unconventional Fed policy have a common link in the scale of implementation or policy doses. Direct lending by the central bank to banks is the function “large scale lender of last resort.” If there is moral suasion by governments to coerce banks into increasing their holdings of government bonds, the correct term would be financial repression.

An important additional measure discussed by Draghi (2011Nov19) is relaxation on the collateral pledged by banks in LTROs:

“Some banks’ access to refinancing operations may be restricted by lack of eligible collateral. To overcome this, a temporary expansion of the list of collateral has been decided. Furthermore, the ECB intends to enhance the use of bank loans as collateral in Eurosystem operations. These measures should support bank lending, by increasing the amount of assets on euro area banks’ balance sheets that can be used to obtain central bank refinancing.”

There are collateral concerns about European banks. David Enrich and Sara Schaefer Muñoz, writing on Dec 28, on “European bank worry: collateral,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203899504577126430202451796.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the strain on bank funding from a squeeze in the availability of high-quality collateral as guarantee in funding. High-quality collateral includes government bonds and investment-grade non-government debt. There could be difficulties in funding for a bank without sufficient available high-quality collateral to offer in guarantee of loans. It is difficult to assess from bank balance sheets the availability of sufficient collateral to support bank funding requirements. There has been erosion in the quality of collateral as a result of the debt crisis and further erosion could occur. Perceptions of counterparty risk among financial institutions worsened the credit/dollar crisis of 2007 to 2009. The banking theory of Diamond and Rajan (2000, 2001a, 2001b) and the model of Diamond Dybvig (1983, 1986) provide the analysis of bank functions that explains the credit crisis of 2007 to 2008 (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7, 48-52, Regulation of Banks and Finance (2009b), 52-66, 217-24). In fact, Rajan (2005, 339-41) anticipated the role of low interest rates in causing a hunt for yields in multiple financial markets from hedge funds to emerging markets and that low interest rates foster illiquidity. Rajan (2005, 341) argued:

“The point, therefore, is that common factors such as low interest rates—potentially caused by accommodative monetary policy—can engender excessive tolerance for risk on both sides of financial transactions.”

A critical function of banks consists of providing transformation services that convert illiquid risky loans and investment that the bank monitors into immediate liquidity such as unmonitored demand deposits. Credit in financial markets consists of the transformation of asset-backed securities (SRP) constructed with monitoring by financial institutions into unmonitored immediate liquidity by sale and repurchase agreements (SRP). In the financial crisis financial institutions distrusted the quality of their own balance sheets and those of their counterparties in SRPs. The financing counterparty distrusted that the financed counterparty would not repurchase the assets pledged in the SRP that could collapse in value below the financing provided. A critical problem was the unwillingness of banks to lend to each other in unsecured short-term loans. Emse Bartha, writing on Dec 28, on “Deposits at ECB hit high,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577125913779446088.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that banks deposited €453.034 billion, or $589.72 billion, at the ECB on Dec 28, which is a record high in two consecutive days. The deposit facility is typically used by banks when they do prefer not to extend unsecured loans to other banks. In addition, banks borrowed €6.225 billion from the overnight facility on Dec 28, when in normal times only a few hundred million euro are borrowed. The collateral issues and the possible increase in counterparty risk occurred a week after large-scale lender of last resort by the ECB in the value of €489 billion in the prior week. The ECB may need to extend its lender of last resort operations.

The financial reform of the United States around the proposal of a national bank by Alexander Hamilton (1780) to develop the money economy with specialization away from the barter economy is credited with creating the financial system that brought prosperity over a long period (see Pelaez 2008). Continuing growth and prosperity together with sound financial management earned the US dollar the role as reserve currency and the AAA rating of its Treasury securities. McKinnon (2011Dec18) analyzes the resolution of the European debt crisis by comparison with the reform of Alexander Hamilton. Northern states of the US had financed the revolutionary war with the issue of paper notes that were at risk of default by 1890. Alexander Hamilton proposed the purchase of the states’ paper notes by the Federal government without haircuts. McKinnon (2011Dec18) describes the conflicts before passing the assumption bill in 1790 for federal absorption of the debts of states. Other elements in the Hamilton reform consisted of creation of a market for US Treasury bonds by their use as paid-in capital in the First Bank of the United States. McKinnon (2011Dec18) finds growth of intermediation in the US by the branching of the First Bank of the United States throughout several states, accepting deposits to provide commercial short-term credit. The reform consolidated the union of states, fiscal credibility for the union and financial intermediation required for growth. The reform also introduced low tariffs and an excise tax on whisky to service the interest on the federal debt. Trade relations among members of the euro zone are highly important to economic activity. There are two lessons drawn by McKinnon (2011Dec18) from the experience of Hamilton for the euro zone currently. (1) The reform of Hamilton included new taxes for the assumption of debts of states with concrete provisions for their credibility. (2) Commercial lending was consolidated with a trusted bank both for accepting private deposits and for commercial lending, creating the structure of financial intermediation required for growth.

IIIE Appendix Euro Zone Survival Risk. Markets have been dominated by rating actions of Standard & Poor’s Ratings Services (S&PRS) (2012Jan13) on 16 members of the European Monetary Union (EMU) or eurozone. The actions by S&PRS (2012Jan13) are of several types:

1. Downgrades by two notches of long-term credit ratings of Cyprus (from BBB/Watch/NegA-3+ to BB+/Neg/B), Italy (from A/Watch Neg/A-1 to BBB+/Neg/A-2), Portugal (from BBB-/Watch Neg/A-3 to BB/Neg/B) and Spain (from AA-/Watch Neg/A-1+ to A/Neg/A-1).

2. Downgrades by one notch of long-term credit ratings of Austria (from AAA/Watch Neg/A-1+ to AA+/Neg/A-1+), France (from AAA/Watch Neg/A-1+ to AA+/Neg A-1+), Malta (from A/Watch, Neg/A-1 to A-/Neg/A-2), Slovakia (from A+/Watch Neg/A-1 to A/Stable/A-1) and Slovenia (AA-/Watch Neg/A-1+ to A+/Neg/A-1).

3. Affirmation of long-term ratings of Belgium (AA/Neg/A-1+), Estonia (AA-/Neg/A-1+), Finland (AAA/Neg/A-1+), Germany (AAA/Stable/A-1+), Ireland (BBB+/Neg/A-2), Luxembourg (AAA/Neg/A-1+) and the Netherlands (AAA/Neg/A-1+) with removal from CreditWatch.

4. Negative outlook on the long-term credit ratings of Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain, meaning that S&PRS (2012Jan13) finds that the ratings of these sovereigns have a chance of at least 1-to-3 of downgrades in 2012 or 2013.

S&PRS (2012Jan13) finds that measures by European policymakers may not be sufficient to contain sovereign risks in the eurozone. The sources of stress according to S&PRS (2012Jan13) are:

1. Worsening credit environment

2. Increases in risk premiums for many eurozone borrowers

3. Simultaneous attempts at reducing debts by both eurozone governments and households

4. More limited perspectives of economic growth

5. Deepening and protracted division among Europe’s policymakers in agreeing to approaches to resolve the European debt crisis

There is now only one major country in the eurozone with AAA rating of its long-term debt by S&PRS (2012Jan13): Germany. IIIE Appendix Euro Zone Survival Risk analyzes the hurdle of financial bailouts of euro area members by the strength of the credit of Germany alone. The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is abouy $3531.6 billion. There is some simple “unpleasant bond arithmetic.” Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is about $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. Debt as percent of Germany’s GDP would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Charles Forelle, writing on Jan 14, 2012, on “Downgrade hurts euro rescue fund,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204409004577159210191567778.html), analyzes the impact of the downgrades on the European Financial Stability Facility (EFSF). The EFSF is a special purpose vehicle that has not capital but can raise funds to be used in bailouts by issuing AAA-rated debt. S&P may cut the rating of the EFSF to the new lowest rating of the six countries with AAA rating, which are now down to four with the downgrades of France and Austria. The other rating agencies Moody’s and Fitch have not taken similar action. On Jan, S&PRS (2012Jan16) did cut the long-term credit rating of the EFSF to AA+ and affirmed the short-term credit rating at A-+. The decision is derived from the reduction in credit rating of the countries guaranteeing the EFSF. In the view of S&PRS (2012Jan16), there are not sufficient credit enhancements after the reduction in the creditworthiness of the countries guaranteeing the EFSF. The decision could be reversed if credit enhancements were provided.

The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.

Bond auctions are also critical in episodes of risk aversion. David Oakley, writing on Jan 3, 2012, on “Sovereign issues draw euro to crunch point,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/63b9d7ca-2bfa-11e1-98bc-00144feabdc0.html#axzz1iLNRyEbs), estimates total euro area sovereign issues in 2012 at €794 billion, much higher than the long-term average of €670 billion. Oakley finds that the sovereign issues are: Italy €220 billion, France €197 billion, Germany €178 billion and Spain €81 billion. Bond auctions will test the resilience of the euro. Victor Mallet and Robin Wigglesworth, writing on Jan 12, 2012, on “Spain and Italy raise €22bn in debt sales,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/e22c4e28-3d05-11e1-ae07-00144feabdc0.html#axzz1j4euflAi), analyze debt auctions during the week. Spain placed €10 billion of new bonds with maturities in 2015 and 2016, which was twice the maximum planned for the auction. Italy placed €8.5 billion of one-year bills at average yield of 2.735 percent, which was less than one-half of the yield of 5.95 percent a month before. Italy also placed €3.5 billion of 136-day bills at 1.64 percent. There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20.

A combination of strong economic data in China analyzed in subsection VC and the realization of the widely expected downgrade could explain the strength of the European sovereign debt market. Emese Bartha, Art Patnaude and Nick Cawley, writing on January 17, 2012, on “European T-bills see solid demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204555904577166363369792848.html?mod=WSJPRO_hpp_LEFTTopStories), analyze successful auctions treasury bills by Spain and Greece. A day after the downgrade, the EFSF found strong demand on Jan 17 for its six-month debt auction at the yield of 0.2664 percent, which is about the same as sovereign bills of France with the same maturity.

There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20. Paul Dobson, Emma Charlton and Lucy Meakin, writing on Jan 20, 2012, on “Bonds show return of crisis once ECB loans expire,” published in Bloomberg (http://www.bloomberg.com/news/2012-01-20/bonds-show-return-of-crisis-once-ecb-loans-expire-euro-credit.html), analyze sovereign debt and analysis of market participants. Large-scale lending of last resort by the European Central Bank, considered in VD Appendix on European Central Bank Large Scale Lender of Last Resort, provided ample liquidity in the euro zone for banks to borrow at 1 percent and lend at higher rates, including to government. Dobson, Charlton and Meakin trace the faster decline of yields of short-term sovereign debt relative to decline of yields of long-term sovereign debt. The significant fall of the spread of short relative to long yields could signal concern about the resolution of the sovereign debt while expanding lender of last resort operations have moderated relative short-term sovereign yields. Normal conditions would be attained if there is definitive resolution of long-term sovereign debt that would require fiscal consolidation in an environment of economic growth.

Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.

Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).

Improving equity markets and strength of the euro appear related to developments in sovereign debt negotiations and markets. Alkman Granitsas and Costas Paris, writing on Jan 29, 2012, on “Greek debt deal, new loan agreement to finish next week,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204573704577189021923288392.html?mod=WSJPRO_hpp_LEFTTopStories), inform that Greece and its private creditors were near finishing a deal of writing off €100 billion, about $132 billion, of Greece’s debt depending on the conversations between Greece, the euro area and the IMF on the new bailout. An agreement had been reached in Oct 2011 for a new package of fresh money in the amount of €130 billion to fill needs through 2015 but was contingent on haircuts reducing Greece’s debt from 160 percent of GDP to 120 percent of GDP. The new bailout would be required to prevent default by Greece of €14.4 billion maturing on Mar 20, 2012. There has been increasing improvement of sovereign bond yields. Italy’s ten-year bond yield fell from over 6.30 percent on Jan 20, 2012 to slightly above 5.90 percent on Jan 27. Spain’s ten-year bond yield fell from slightly above 5.50 percent on Jan 20 to just below 5 percent on Jan 27.

An important difference, according to Beim (2011Oct9), between large-scale buying of bonds by the central bank between the Federal Reserve of the US and the European Central Bank (ECB) is that the Fed and most banks do not buy local and state government obligations with lower creditworthiness. The European Monetary Union (EMU) that created the euro and the ECB did not include common fiscal policy and affairs. Thus, EMU cannot issue its own treasury obligations. The line “Reserve bank credit” in the Fed balance sheet for Jan 25, 2012, is $2902 billion of which $2570 billion consisting of $1565 billion US Treasury notes and bonds, $68 billion inflation-indexed bonds and notes, $101 billion Federal agency debt securities and $836 billion mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed has been careful in avoiding credit risk in its portfolio of securities. The 11 exceptional liquidity facilities of several trillion dollars created during the financial crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62) have not resulted in any losses. The Fed has used unconventional monetary policy without credit risk as in classical central banking.

Beim (2011Oct9, 6) argues:

“In short, the ECB system holds more than €1 trillion of debt of the banks and governments of the 17 member states. The state-by-state composition of this debt is not disclosed, but the events of the past year suggest that a disproportionate fraction of these assets are likely obligations of stressed countries. If a significant fraction of the €1 trillion were to be restructured at 40-60% discounts, the ECB would have a massive problem: who would bail out the ECB?

This is surely why the ECB has been so shrill in its antagonism to the slightest mention of default and restructuring. They need to maintain the illusion of risk-free sovereign debt because confidence in the euro itself is built upon it.”

Table III-2 provides the consolidated financial statement of the Eurosystem on Dec 31, 2010 and Dec 28, 2011 and an update for Feb 10, 2012. Memo items provide the sum of lines 5, “lending to euro area credit institutions related to monetary policy operations denominated in euro,” and 7, “securities of euro area residents denominated in euro,” which has increased from €1,004,174 million on Dec 31, 2010 to €1,489,759 million on Dec 28, 2011. This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF. There is a recurring issue of whether the ECB should accept a haircut on its portfolio of Greek bonds of €40 billion acquired at discounts from face value. An article on “Haircut for the ECB? Not so fast,” published by the Wall Street Journal on Jan 28, 2012 (http://blogs.wsj.com/davos/2012/01/28/haircut-for-the-ecb-not-so-fast/), informs of the remarks by Mark Carney, Governor of the Bank of Canada and President of the Financial Stability Board (FSB) (http://www.financialstabilityboard.org/about/overview.htm), expressing what appears to be correct doctrine that there could conceivably be haircuts for official debt but that such a decision should be taken by governments and not by central banks.

Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	Feb 10, 2012
1 Gold and other Receivables	367,402	419,822	423,446
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	245,107
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	100,629
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	23,936
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	787,255
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	70,338
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	624,299
8 General Government Debt Denominated in Euro	34,954	33,928	31,176
9 Other Assets	278,719	336,574	349,598
TOTAL ASSETS	2,004, 432	2,733,235	2,665,784
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,411,554
Capital and Reserves	78,143	81,481	81,877

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

http://www.ecb.int/press/pr/wfs/2012/html/fs120214.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common currency prevents Italy from devaluation to parity or the exchange rate that would permit export growth to promote internal economic activity that generates fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 43.6 percent of the total. Exports to the non-European Union area are growing at 14.9 percent in Jan-Dec 2011 relative to Jan-Dec 2010 while those to EMU are growing at 8.7 percent.

Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%

	Exports % Share	∆% Jan-Dec 2011/ Jan-Dec 2010	Imports % Share	Imports ∆% Jan-Dec 2011/ Jan-Dec 2010
EU	57.3	8.8	54.8	5.8
EMU 17	43.6	8.7	44.6	5.4
France	11.6	11.2	8.8	3.7
Germany	13.0	12.4	16.1	5.7
Spain	5.8	1.4	4.6	6.0
UK	5.2	-0.2	2.7	6.8
Non EU	42.7	14.9	45.2	12.6
Europe non EU	12.0	23.3	10.3	18.0
USA	6.0	12.4	3.0	17.0
China	2.6	16.2	7.8	1.8
OPEC	5.3	-1.1	9.5	-1.4
Total	100.0	11.4	100.0	8.9

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Source: http://www.istat.it/it/archivio/53289

Table III-4 provides Italy’s trade balance by regions and countries. Italy has a trade deficit of €12,461 million with the 17 countries of the euro zone (EMU 17). Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €5505 million with Europe non European Union and of €9823 million with the US. There is significant rigidity in the trade deficits of €19,302 million with China and €16,701 million with oil exporting countries (OPEC).

Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro

Regions and Countries	Trade Balance Dec 2011 Millions of Euro	Trade Balance Jan-Dec 2011 Millions of Euro
EU	-577	-2,747
EMU 17	-1,565	-12,461
France	703	10,284
Germany	-1,451	-12,999
Spain	145	2,130
UK	703	6,848
Non EU	2,024	-21,586
Europe non EU	1,042	5,505
USA	1,082	9,823
China	-853	-19,302
OPEC	-1,014	-16,701
Total	1,447	-24,333

Notes: EU: European Union; EMU: European Monetary Union (euro zone)

Source: http://www.istat.it/it/archivio/53289

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan-Dec 2011 relative to Jan-Dec 2010. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 6.0 percent. Capital goods exports increased 10.7 percent relative to a year earlier and intermediate products 13.9 percent.

Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%

	Exports Share %	Exports ∆% Jan-Dec 2011/ Jan-Dec 2010	Imports Share %	Imports ∆% Jan-De 2011/ Jan-Nov 2010
Consumer Goods	29.5	9.1	25.3	7.8
Durable	6.3	4.2	3.5	-6.0
Non Durable	23.2	10.4	21.8	6.2
Capital Goods	32.4	10.7	22.4	0.8
Inter- mediate Goods	33.5	13.9	33.9	10.8
Energy	4.6	12.8	18.4	16.8
Total ex Energy	95.4	11.3	81.6	7.1
Total	100.0	11.4	100.0	8.9

Source: http://www.istat.it/it/archivio/53289

Table III-6 provides Italy’s trade balance by product categories in Dec and Jan-De 2011. Italy’s trade balance excluding energy is a surplus of €37,060 in Jan-Dec 2011 but the energy trade balance is a deficit of €61,394 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Dec 2011	Jan-Dec 2011
Consumer Goods	935	8,305
Durable	950	10,205
Nondurable	-15	-1,900
Capital Goods	4,358	37,927
Intermediate Goods	1,255	-9,172
Energy	-5,102	-61,394
Total ex Energy	6,549	37,060
Total	1,447	-24,333

Source: http://www.istat.it/it/archivio/53289

Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection IIID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30 the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent (see Table III-1). There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.

Table III-7, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2010 USD Billions	Primary Net Lending Borrowing % GDP 2010	General Government Net Debt % GDP 2010
World	62,911.2
Euro Zone	12,167.8	-3.6	65.9
Portugal	229.2	-6.3	88.7
Ireland	206.9	-28.9	78.0
Greece	305.4	-4.9	142.8
Spain	1,409.9	-7.8	48.8
Major Advanced Economies G7	31,716.9	-6.5	76.5
United States	14,526.6	-8.4	68.3
UK	2,250.2	-7.7	67.7
Germany	3,286.5	-1.2	57.6
France	2,562.7	-4.9	76.5
Japan	5,458.8	-8.1	117.2
Canada	1,577.0	-4.9	32.2
Italy	2,055.1	-0.3	99.4
China	5,878.3	-2.3	33.8*
Cyprus	23.2	-5.3	61.6

*Gross Debt

Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.

Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,018.6
B Germany	1,893.0		$7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1%
C France	1,960.5
B+C	3,853.5	GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3%
D Italy	2,042.8
E Spain	688.0
F Portugal	203.3
G Greece	436.1
H Ireland	161.4
Subtotal D+E+F+G+H	3,531.6

Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Dec. German exports to other European Union members are 47.4 percent of total exports in Dec and 59.2 percent in Jan-Dec. Exports to the euro area are 31.8 percent in Dec and 39.7 percent in Jan-Dec. Exports to third countries are 44.3 percent of the total in Dec and 40.8 percent in Jan-Dec. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of its high share in exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Dec 2011 € Billions	12 Months ∆%	Jan-Dec 2011 € Billions	Jan-Dec 2011/ Jan-Dec 2010 ∆%
Total Exports	85.1	5.0	1,060.1	11.4
A. EU Members	47.4 % 55.7	-1.6	627.3 % 59.2	9.9
Euro Area	31.8 % 37.4	-3.3	420.9 % 39.7	8.6
Non-euro Area	15.5 % 18.2	2.2	206.4 % 19.5	12.6
B. Third Countries	37.7 % 44.3	14.7	432.8 % 40.8	13.6
Total Imports	72.1	5.4	902.0	13.2
C. EU Members	45.9 % 63.7	5.1	572.6 % 63.5	13.8
Euro Area	31.9 % 44.2	3.5	401.5 % 44.5	12.9
Non-euro Area	14.0 % 19.4	8.8	171.1 % 18.9	16.1
D. Third Countries	26.2 % 36.3	6.1	329.4 % 36.5	12.0

Notes: Total Exports = A+B; Total Imports = C+D

Source: http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/02/PE12__044__51,templateId=renderPrint.psml

IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.

First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:

D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)

Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,

{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:

N(t+1) = (1+n)N(t), n>-1 (2)

The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:

B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)

On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.

Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:

(M_t + B_t)/P_t = E_t∫(1/R_t_{, t+τ})s_t_+τdτ (4)

Equation (4) expresses the monetary, M_t, and debt, B_t, liabilities of the government, divided by the price level, P_t, in terms of the expected value discounted by the ex-post rate on government debt, R_t_{, t+τ}, of the future primary surpluses s_t_+τ, which are equal to T_t_+τ – G_t_+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post R_t_{, t+τ}. The second equation of Cochrane (2011Jan, 5) is:

M_tV(i_t, ·) = P_tY_t (5)

Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):

“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”

An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.

There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:

(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress

(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality

(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.

IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.

Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	1.6	2.9	4.1	8.3
Japan	-1.0	-0.2	0.5	4.6
China	8.9	4.5	0.7
UK	0.7	4.2* RPI 4.8	4.1* output 2.4** input 7.0*	8.4
Euro Zone	0.7	2.7	4.3	10.4
Germany	2.0	2.8	4.0	5.5
France	0.2	2.7	4.6	9.9
Nether-lands	-0.7	2.7	5.0	4.9
Finland	1.2	3.2	2.8	7.6
Belgium	0.9	3.7	4.5	7.2
Portugal	-2.7	3.8	4.4	13.6
Ireland	NA	1.7	4.4	14.5
Italy	-0.5	3.7	4.0	8.9
Greece	-7.0	2.8	5.7	19.2
Spain	0.3	2.9	5.2	22.9

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/january-2012/stb---consumer-price-indices---january-2012.html

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/january-2012/stb-producer-price-index---january-2012.html

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IVQ2011 relative to IVQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf). Japan’s GDP fell 1.0 percent in IVQ2011 relative to IVQ2010 and contracted 1.7 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 7.0 percent in IIIQ2011 to decline at the SAAR of 2.3 percent in IVQ 2011 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states_19.html and http://www.esri.cao.go.jp/en/sna/sokuhou/qe/main_1e.pdf); the UK grew at 0.7 percent in IVQ2011 relative to IVQ2010 and GDP fell 0.2 percent in IVQ2011 relative to IIIQ2011 (http://www.ons.gov.uk/ons/rel/naa2/second-estimate-of-gdp/q4-2011/index.html); and the Euro Zone grew at 0.7 percent in IVQ2011 relative to IVQ2010 but declined 0.3 percent in IVQ2011 relative to IIIQ2011 (see Section VD at http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states_19.html and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-15022012-AP/EN/2-15022012-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.3 percent in the US but 19.5 percent for unemployment/underemployment (see Table I-4 in I Thirty-One Million Unemployed or Underemployed and http://cmpassocregulationblog.blogspot.com/2012/01/thirty-million-unemployed-or.html), 4.6 percent for Japan, 8.4 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH at http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states_19.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states_22.html) and 10.4 percent in the Euro Zone. Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 2.9 percent in the US, minus 0.2 percent for Japan, 4.5 percent for China, 2.7 percent for the Euro Zone and 4.2 percent for the UK. Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html) (2) the tradeoff of growth and inflation in China; (3) slow growth by repression of savings with de facto interest rate controls (http://cmpassocregulationblog.blogspot.com/2012/01/mediocre-economic-growth-financial.html), weak hiring with the loss of 10 million full-time jobs (http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html) and continuing job stress of 24 to 31 million people in the US and stagnant wages in a fractured job market (see Section I Thirty-One Million Unemployed or Underemployed at http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see IV Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.

In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.

The statement of the FOMC at the conclusion of its meeting on Jan 25, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm):

“Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. ”

There are several important issues in this statement.

1. Mandate. The FOMC pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

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

2. Extending Average Maturity of Holdings of Securities. The statement of Jan 25, 2012, invokes the mandate that inflation is subdued but employment below maximum such that further accommodation is required. Accommodation consists of low interest rates. The new “Operation Twist” (http://cmpassocregulationblog.blogspot.com/2011_09_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html) or restructuring the portfolio of securities of the Fed by selling short-dated securities and buying long-term securities has the objective of reducing long-term interest rates. Lower interest rates would stimulate consumption and investment, or aggregate demand, increasing the rate of economic growth and thus reducing stress in job markets.

3. Target of Fed Funds Rate. The FOMC continues to maintain the target of fed funds rate at 0 to ¼ percent.

4. Advance Guidance. The FOMC increases transparency by advising on the expectation of the future path of fed funds rate. This guidance is the view that conditions such as “low rates of resource utilization and a subdued outlook for inflation over the medium run are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

5. Monitoring and Policy Focus. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.”

These policy statements are carefully crafted to express the intentions of the FOMC. The main objective of the statements is to communicate as clearly and firmly as possible the intentions of the FOMC to fulfill its dual mandate. During periods of low inflation and high unemployment and underemployment such as currently the FOMC may be more biased toward measures that stimulate the economy to reduce underutilization of workers and other productive resources. The FOMC also is vigilant about inflation and ready to change policy in the effort to attain its dual mandate.

The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table IV-2. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2011 is analyzed in the current post of this blog in section I. The Bureau of Economic Analysis (BEA) provides the GDP report with the second estimate for IVQ2011 to be released on Feb 29 and the third estimate on Mar 29 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/national/index.htm#personal), which is analyzed in this blog as soon as available. The next report will be released at 8:30 AM on Jan 30, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog. The report for February will be released on Feb 3, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jan 25 and the second row “Nov PR” the projection of the Nov meeting. There are three major changes in the view.

1. Growth “GDP ∆.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun to 2.5 to 2.9 percent in Nov and now to 2.2 to 2.7 percent at the Jan 25 meeting.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun to 8.5 to 8.7 percent in Nov but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun to virtually the same of 1.4 to 2.0 percent in Nov but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun of 1.4 to 2.0 percent and the Nov projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal

Reserve Bank Presidents in FOMC, January 2012 and November 2011

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012 Nov PR	2.2 to 2.7 2.5 to 2.9	8.2 to 8.5 8.5 to 8.7	1.4 to 1.8 1.4 to 2.0	1.5 to 1.8 1.5 to 2.0
2013 Nov PR	2.8 to 3.2 3.0 to 3.5	7.4 to 8.1 7.8 to 8.2	1.4 to 2.0 1.5 to 2.0	1.5 to 2.0 1.4 to 1.9
2014 Nov PR	3.3 to 4.0 3.0 to 3.9	6.7 to 7.6 6.8 to 7.7	1.6 to 2.0 1.5 to 2.0	1.6 to 2.0 1.5 to 2.0
Longer Run	2.3 to 2.6 2.4 to 2.7	5.2 to 6.0 5.2 to 6.0	2.0 1.7 to 2.0
Range
2012 Nov PR	2.1 to 3.0 2.3 to 3.5	7.8 to 8.6 8.1 to 8.9	1.3 to 2.5 1.4 to 2.8	1.3 to 2.0 1.3 to 2.1
2013 Nov PR	2.4 to 3.8 2.7 to 4.0	7.0 to 8.2 7.5 to 8.4	1.4 to 2.3 1.4 to 2.5	1.4 to 2.0 1.4 to 2.1
2014 Nov PR	2.8 to 4.3 2.7 to 4.5	6.3 to 7.7 6.5 to 8.0	1.5 to 2.1 1.5 to 2.4	1.4 to 2.0 1.4 to 2.2
Longer Run	2.2 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.0	2.0 1.5 to 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):

“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. The table is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). There are 14 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 11 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and two participants expecting rates from 1 to 1.5 percent but only 4 with rates exceeding 2.5 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.

Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2016. It is evident from Table IV-4 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2.

Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2012	3
2013	3
2014	5
2015	4
2016	2

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Table IV-5 provides monthly and 12 months consumer price inflation in France. There are the same four waves as in inflation worldwide (http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states.html). In the first wave, annual equivalent inflation in Jan-Apr was 4.3 percent driven by the carry trade from zero interest rates to commodity futures positions in an environment of risk appetite. In the second wave, risk aversion caused the reversal of carry trades into commodity futures, resulting in the fall of the annual equivalent inflation rate to minus 1.2 percent in May-Jul. In the third wave, annual equivalent inflation rose to 3.4 percent in Aug-Dec with alternations of risk aversion and risk appetite. In the fourth wave, risk aversion originating in the European debt crisis caused annual equivalent inflation of 0.0 from Dec 2011 to Jan 2012.

Table IV-5, France, Consumer Price Index, Month and 12-Month ∆%

	Month ∆%	12-Month ∆%
Jan 2012	-0.4	2.4
Dec 2011	0.4	2.5
AE ∆% Dec-Jan	0.0
Nov	0.3	2.5
Oct	0.3	2.4
Sep	-0.1	2.2
Aug	0.5	2.2
AE ∆% Aug-Dec	3.4
Jul	-0.5	1.9
Jun	0.1	2.1
May	0.1	2.0
AE ∆% May-Jul	-1.2
Apr	0.3	2.1
Mar	0.8	2.0
Feb	0.5	1.6
Jan	-0.2	1.8
AE ∆% Jan-Apr	4.3
Dec 2010	0.4	1.8
Nov	0.1	1.6
Oct	0.1	1.6
Sep	-0.1	1.5
Aug	0.2	1.4
Jul	-0.3	1.7
Jun	0.0	1.5
May	0.1	1.6
Apr	0.3	1.7
Mar	0.5	1.6
Feb	0.6	1.3
Jan	-0.3	1.1

AE: Annual Equivalent

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120222

Table IV-6 provides the estimates of inflation by the Institut National de la Statistique et des Études Économiques (INSEE) for the years from 1999 to 2011. Inflation has been relatively moderate in France. The rise of inflation to 2.8 percent in 2008 was caused by the commodity price shock as investment funds shifted from other risk financial assets into carry trades driven by interest rates falling toward zero. INSEE estimates 2011 inflation at 2.1 percent.

Table IV-6, France, Consumer Price Index Year ∆%

Year	∆%
2011	2.1
2010	1.5
2009	0.1
2008	2.8
2007	1.5
2006	1.6
2005	1.8
2004	2.1
2003	2.1
2002	1.9
2001	1.7
2000	1.7
1999	0.5

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120222

Chart IV-1 of the Institut National de la Statistique et des Études Économiques of France shows headline and core consumption price inflation of France. Inflation rose during the commodity price shock of unconventional monetary policy. Risk aversion in late 2008 and beginning of 2009 caused collapse of valuation of commodity futures with resulting decline in inflation. Unconventional monetary policy with alternations of risk aversion resulted in higher inflation in France that stabilized in recent months until the increase of 0.3 percent in both Oct and Nov and 0.4 percent in Dec that were followed by decline of 0.4 percent in Jan 2012.

Chart IV-1, France, Consumer Price Index (IPC) and Core Consumer Price Index (ISJ) 12 Months Rates of Change

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=29&date=20120222

The Istituto Nazionale di Statistica of Italy confirmed the estimate of Jan 2012 inflation of 0.3 percent and 3.2 percent in 12 months. There are the same four waves of inflation (http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states.html). The first wave of commodity price increases in the first four months of 2011 also influenced the surge of consumer price inflation in Italy shown in Table IV-7. Annual equivalent inflation in the first four months of 2011 was 4.9 percent. The crisis of confidence or risk aversion resulted in reversal of carry trades on commodity positions. Consumer price inflation in Italy was subdued in the second wave in Jun and May at 0.1 percent for annual equivalent 1.2 percent. In the third wave in Jul-Sep, annual equivalent inflation increased to 2.4 percent. In the fourth wave, annual equivalent inflation in the six months Jul-Jan jumped again at 3.7 percent.

Table IV-7, Italy, Consumer Price Index

	Month	12 Months
Jan 2012	0.3	3.2
Dec 2011	0.4	3.3
Nov	-0.1	3.3
Oct	0.6	3.4
AE ∆% Oct-Jan	3.7
Sep	0.0	3.0
Aug	0.3	2.8
Jul	0.3	2.7
AE ∆% Jul-Sep	2.4
Jun	0.1	2.7
May	0.1	2.6
AE ∆% May-Jun	1.2
Apr	0.5	2.6
Mar	0.4	2.5
Feb	0.3	2.4
Jan	0.4	2.1
AE ∆% Jan-Apr	4.9
Dec 2010	0.4	1.9

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/54459

Consumer price inflation in Italy by segments in Jan 2012 is provided in Table VI-8. Total consumer price inflation in Jan was 0.3 percent and 3.2 percent in 12 months. Inflation of goods was 0.8 percent and 3.9 percent in 12 months. Prices of durable goods rose 0.2 percent in Jan and increased only revised 1.0 percent in 12 months, as typical in most countries. Prices of energy goods jumped revised 3.9 percent in Jan and 15.5 percent in 12 months. Food prices increased only 0.2 percent in Jan and 2.3 percent in 12 months. Prices of services decreased 0.2 percent and rose 2.3 percent in 12 months. Transport prices, also influenced by commodity prices, decreased 0.9 percent in Jan and revised 4.8 percent in 12 months. Carry trades from zero interest rates to positions in commodity futures cause increases in commodity prices. Waves of inflation originate in periods when there is no risk aversion and commodity prices decline during periods of risk aversion.

Table IV-8, Italy, Consumer Price Index and Segments, Month and 12-Month ∆%

Jan 2012	Month ∆%	12-Months ∆%
Total	0.3	3.2
I Goods	0.8	3.9
Food	0.2	2.3
Energy	3.9	15.5
Durable	0.1	1.0
Nondurable	0.2	0.7
II Services	-0.2	2.3
Housing	0.8	2.5
Communications	0.1	2.0
Transport	-0.9	4.8

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/54459

Chart IV-2 of the Istituto Nazionale di Statistica shows moderation in 12-month percentage changes of the consumer price index of Italy.

Chart, IV-2, Italy, Consumer Price Index, 12-Month Percentage Changes

Source: Istituto Nazionale di Statistica

http://www.istat.it/en/

1.75 to 2.0

2.5 to 2.75

3.75 to 4.5

Longer Run