World Financial Turbulence, Global Economic Slowdown and United States Housing
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011, 2012
Executive Summary
I United States Housing Collapse
IA United States New House Sales
II United States House Prices
IIA United States House Prices
IIB Factors of US Housing Collapse
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
IIIG Appendix on Deficit Financing of Growth and the Debt Crisis
IIIGA Monetary Policy with Deficit Financing of Economic Growth
IIIGB Adjustment during the Debt Crisis of the 1980s
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
There are major economic and financial risks in the world economy and international financial system. This preamble summarizes major risks covered more extensively in this Executive Summary and in the text.
· ES1 The Flight to Government Securities of the United States, Germany and Japan. The financial panic of 2008 manifested in flight to the dollar and US government securities because of fears about the soundness of the international financial system aggravated by statements proposing the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). Reversal of the panic occurred in IQ2009 when financial markets were assessed as more sound than previously represented. Multiple risk factors have caused flight of money to the safety of the government obligations of Germany, the United States and Japan with strengthening of the US dollar and the Japanese yen.
· ESII World Economic Slowdown. The rate of growth of advanced economies has moderated with declines of GDP in some countries while unemployment continues at high levels and hiring has collapsed.
· ESIII Exchange Wars. Regulation, trade and devaluation wars should be expected during a global recession (Pelaez and Pelaez (2008a), Government Intervention in Globalization: Regulation, Trade and Devaluation Wars). Unconventional monetary policy of zero interest rates and quantitative easing induces devaluation of the dollar still in its role as international reserve currency.
· ESIV Global Financial and Economic Risk. There are multiple economic and financial risks in the world economy and international financial system. Zero interest rates induced carry trades that caused higher valuations of risk financial assets in worldwide hunt for yields. Excessive valuations face risks of sharp corrections in this environment of weak world economy and financial turbulence.
· ESV United States Housing Collapse. While it is true that that are some improvements at the margin, US housing continues at depressed levels. The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. There is catastrophic data: sales of new houses in Jan-Apr 2012 of 117 thousand units are lower by 32.4 percent relative to 173 thousand units houses sold in Jan-Apr 1963, the first year when data become available, while population increased 72.2 percent.
· ESA Appendix Monetary Policy with Deficit Financing of Economic Growth. There are proposals to increase the inflation target of the US to 4 percent per year while stimulating the economy with fiscal deficits. There is more sober approach to increase fiscal deficits in countries with lower ratios of government debt to GDP and not tighten budgets in countries with higher ratios of government debt to GDP. Fiscal consolidation would be committed now and implemented in the “medium term.” Monetary policy would continue with zero interest rates and quantitative easing as needed. Two episodes from economic history are not kind to these views. There is in addition the experience of the Great Inflation in the US or stagflation of the 1960s and 1970s analyzed in various comments of this blog (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) and in Appendix I).
ESI The Flight to Government Securities of the United States, Germany and Japan. Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. The panic of 2008 manifested in flight to the dollar and US government securities because of the fear of toxic assets in banks that would have to be removed with one trillion dollars for Congressional funding of the Troubled Assets Relief Program (TARP) or the world would fall into repetition of the Great Depression (Cochrane and Zingales (2009). Risk aversion ameliorated in IQ2009 when the claims of toxic assets were disproved as exaggerated by normal functioning of the US financial system and subsequently by stress tests of US banks. Increasing risk aversion currently is captured by decrease of the yield of the ten-year Treasury. Table ESI-1 provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.738 percent on May 25, 2012 while the yield of the ten-year government bond fell from 2.16 percent to 1.37 percent. The yield of the two-year government bond of Germany fell from 0.65 percent on May 26, 2011, to 0.05 percent on May 25, 2012, as investors fled euro area risks to the safety of liabilities of the government of Germany. There is perception of safety in the liabilities of the government of Germany because of sound fiscal management and strength of the economy attained by reforms that enhanced productivity in the beginning of the past decade. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2518/EUR on May 25, 2919, or by 13.7 percent. The dollar peaked at USD 1.192/EUR on Jun 7, 2010, during the first round of the European sovereign risk crisis, but is now only 5.0 percent weaker at USD 1.2518/EUR. Under zero interest rates for the monetary policy rate of the US, fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciate in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.3 percent in the 12 months ending in Apr (see subsection IB United States Inflation at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The latest statement of the Federal Open Market Committee (FOMC) on Apr 25, 2012 does not have sufficient changes suggesting that it contributed to the rise in Treasury yields (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm). The statement continues to consider inflation low, unemployment high and growth at a moderate pace. Because of the “slack” in the economy, the FOMC anticipates maintaining the zero interest rate policy until 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm):
“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.”
A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.6 percent for the 12 months ending in Apr 2012 but jumping 1.3 percent in the month of Mar (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16052012-BP/EN/2-16052012-BP-EN.PDF; see Section VD) yet the yield of the two-year German government bond fell from 0.65 percent on Aug 19, 2011 to 0.05 percent on May 25, 2012, while the ten-year yield fell from 2.16 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012, as shown in Table ESI-1.
Table ESI-1, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 5/25/12 | 0.291 | 1.738 | 0.05 | 1.37 | 1.2518 |
| 5/18/12 | 0.292 | 1.714 | 0.05 | 1.43 | 1.2780 |
| 5/11/12 | 0.248 | 1.845 | 0.09 | 1.52 | 1.2917 |
| 5/14/12 | 0.256 | 1.876 | 0.08 | 1.58 | 1.3084 |
| 4/6/12 | 0.31 | 2.058 | 0.14 | 1.74 | 1.3096 |
| 3/30/12 | 0.335 | 2.214 | 0.21 | 1.79 | 1.3340 |
| 3/2/12 | 0.29 | 1.977 | 0.16 | 1.80 | 1.3190 |
| 2/24/12 | 0.307 | 1.977 | 0.24 | 1.88 | 1.3449 |
| 1/6/12 | 0.256 | 1.957 | 0.17 | 1.85 | 1.2720 |
| 12/30/11 | 0.239 | 1.871 | 0.14 | 1.83 | 1.2944 |
| 8/26/11 | 0.20 | 2.202 | 0.65 | 2.16 | 1.450 |
| 8/19/11 | 0.192 | 2.066 | 0.65 | 2.11 | 1.4390 |
Note: DE: Germany
Source:
http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
ESII World Economic Slowdown. Table ESII-1 provides the latest available estimates of GDP for the regions and countries followed in this blog. Growth is weak throughout most of the world. Japan’s GDP increased 1.0 percent in IQ2012 and 2.7 percent relative to a year earlier but part of the jump could be the low level a year earlier because disruption of the economy caused by the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Japan is experiencing difficulties with the overvalued yen because of worldwide capital flight originating in zero interest rates with risk aversion in an environment of softer growth of world trade. China grew at 1.8 percent in IQ2012, which annualizes to 7.4 percent. Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). GDP was flat in the euro area in IQ2012 and relative to a year earlier. Germany’s GDP increased 0.5 percent in IQ2012 and 1.7 percent relative to a year earlier. US GDP increased 0.4 percent in IQ2012 and 2.1 percent relative to a year earlier (http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html) but with substantial underemployment and underemployment (http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html) and weak hiring (http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html).
Table ESII-1, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%
| IQ2012/IVQ2011 | IQ2012/IQ2011 | |
| United States | 0.4 | 2.1 |
| Japan | 1.0 | 2.7 |
| China | 1.8 | 8.1 |
| Euro Area | 0.0 | 0.0 |
| Germany | 0.5 | 1.7 |
| France | 0.0 | 0.0 |
| Italy | -0.8 | -1.3 |
| United Kingdom | -0.3 | -0.1 |
Source: Country Statistical Agencies
http://www.bea.gov/national/index.htm#gdp http://www.esri.cao.go.jp/en/sna/sokuhou/sokuhou_top.html http://www.stats.gov.cn/enGliSH/ http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/ https://www.destatis.de/EN/FactsFigures/Indicators/ShortTermIndicators/ShortTermIndicators.html http://www.insee.fr/en/ http://www.istat.it/en/ http://www.ons.gov.uk/ons/rel/naa2/second-estimate-of-gdp/q1-2012/index.html
ESIII Exchange Wars. The Dow Jones Newswires informs on Oct 15 that the premier of China Wen Jiabao announced that the Chinese yuan will not be further appreciated to prevent adverse effects on exports (http://professional.wsj.com/article/SB10001424052970203914304576632790881396896.html?mod=WSJ_hp_LEFTWhatsNewsCollection). Table ESIII-1 provides the CNY/USD rate from Oct 28, 2011 to May 25, 2012 in selected intervals. The CNY/USD revalued by 0.9 percent from Oct 28, 2012 to Apr 27, 2012 but the magnitude of the revaluation declined to 0.3 percent by May 25, 2012. Meanwhile, the Senate of the US is proceeding with a bill on China’s trade that could create a confrontation but may not be approved by the entire Congress. An important statement by the People’s Bank of China (PBC), China’s central bank, on Apr 14, 2012, announced the widening of the daily maximum band of fluctuation of the renminbi (RMB) yuan (http://www.pbc.gov.cn/publish/english/955/2012/20120414090756030448561/20120414090756030448561_.html).
Table ESIII-1, Renminbi Yuan US Dollar Rate
| CNY/USD | ∆% from 10/28/2011 | |
| 5/25/2012 | 6.3372 | 0.3 |
| 4/27/2012 | 6.3016 | 0.9 |
| 3/23/2012 | 6.3008 | 0.9 |
| 2/3/2012 | 6.3030 | 0.9 |
| 12/30/2011 | 6.2940 | 1.0 |
| 11/25/2011 | 6.3816 | -0.4 |
| 10/28/2011 | 6.3588 | - |
Source:
http://professional.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm
ESIV Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/update/01/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.
Economic risks include the following:
1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the first quarter of 2012 of 1.8 percent is equivalent to 7.4 percent per year.
2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 30.5 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.
3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
4. World Inflation Waves. Inflation continues in repetitive waves globally (see Section I Inflation Waves at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html).
A list of financial uncertainties includes:
1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion
It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table ESIV-1 after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII). Table ESIV-1, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 5/25/12,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values have fluctuated with events such as the surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23 but renewed risk appetite in the week of Mar 30 because of the end of the quarter and the increase in the firewall of support of sovereign debts in the euro area. New risks developed in the week of Apr 6 with increase of yields of sovereign bonds of Spain and Italy, doubts on Fed policy and weak employment report. Asia and financial entities are experiencing their own risk environments. Financial markets were under stress in the week of Apr 13 because of the large exposure of Spanish banks to lending by the European Central Bank and the annual equivalent growth rate of China’s GDP of 7.4 percent in IQ2012 [(1.018)4]. There was strength again in the week of Apr 20 because of the enhanced IMF firewall and Spain placement of debt, continuing into the week of Apr 27. Risk aversion returned in the week of May 4 because of the expectation of elections in Europe and the new trend of deterioration of job creation in the US. Europe’s sovereign debt crisis and the fractured US job market continued to influence risk aversion in the week of May 11. Politics in Greece and banking issues in Spain were important factors of sharper risk aversion in the week of May 18. Risk aversion continued during the week of May 25. The highest valuations in column “∆% Trough to 5/25/12” are by US equities indexes: DJIA 28.6 percent and S&P 500 28.9 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. The DJIA reached 13,331.77 in intraday trading on Mar 16, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 5/25/12” had double digit gains relative to the trough around Jul 2, 2010 but now most valuations of equity indexes show increase of less than 10 percent: China’s Shanghai Composite is 2.1 percent below the trough; STOXX 50 of Europe is 0.5 percent below the trough; Japan’s Nikkei Average is 2.8 percent below the trough; DJ Asia Pacific TSM is 0.2 percent below the trough; Dow Global is 3.4 percent above the trough; and NYSE Financial is 0.5 percent below the trough. DJ UBS Commodities is 6.9 percent above the trough. DAX is 11.8 percent above the trough. Japan’s Nikkei Average is 2.8 percent below the trough on Aug 31, 2010 and 24.7 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 8580.39 on Fri May 25, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 16.3 percent lower than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 5.0 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 5/25/12” in Table ESIV-1 shows that there were decreases of several valuations of risk financial assets in the week of May 25, 2012 such as 0.8 percent for DJ Asia Pacific, 0.4 percent for Nikkei Average, 0.5 percent for Shanghai Composite, 1.6 percent for STOXX 50 and 2.5 percent for DJ UBS Commodities. Some valuations increased such as 0.7 percent for DJIA, 1.7 percent for S&P 500, 1.4 percent for NYSE Financial, 0.4 for Dow Global and 1.1 percent for Dax. There are still high uncertainties on European sovereign risks, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ESIV-1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 5/25/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to May 25, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 5/25/12” but also relative to the peak in column “∆% Peak to 5/25/12.” There are now only three equity indexes above the peak in Table ESIV-1: DJIA 11.2 percent, S&P 500 8.3 percent and Dax 0.1 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 20.8 percent, Nikkei Average by 24.7 percent, Shanghai Composite by 26.3 percent, DJ Asia Pacific by 12.6 percent, STOXX 50 by 15.8 percent, Dax by 15.8 percent and Dow Global by 15.6 percent. DJ UBS Commodities Index is now 8.6 percent below the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.
Table ESIV-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 5/25 /12 | ∆% Week 5/25/ 12 | ∆% Trough to 5/25 12 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 11.2 | 0.7 | 28.6 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 8.3 | 1.7 | 28.9 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -20.8 | 1.4 | -0.5 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -15.6 | 0.4 | 3.4 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | -12.6 | -0.8 | -0.2 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -24.7 | -0.4 | -2.8 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -26.3 | -0.5 | -2.1 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -15.8 | -1.6 | -0.5 |
| DAX | 4/26/ | 5/25/ | -10.5 | 0.1 | 1.1 | 11.8 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 17.3 | 2.1 | 5.0 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -8.6 | -2.5 | 6.9 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 1.738 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
ESV United Housing Collapse. The depressed level of residential construction and new house sales in the US is evident in Table ESV-1 providing new house sales not seasonally adjusted in Jan-Apr of various years. Sales of new houses in Jan-Apr 2012 are substantially lower than in any year between 1995 and 2012. There are only two increases of 15.8 percent between Jan-Apr 2011 and Jan-Apr 2012 and 0.9 percent between Jan-Apr 2009 and Jan-Apr 2012. Sales of new houses in 2012 are lower by 8.6 percent in relation to 2010, 38.4 percent relative to 2008, 60.6 percent relative to 2007, 69.6 percent relative to 2006 and 73.6 percent relative to 2005. 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-Mar 2012 relative to the same period in 2005 fell 73.6 percent and 69.6 percent relative to the same period in 2006. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Mar 2012 fell 46.1 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 ESV-1 reveals catastrophic data: sales of new houses in Jan-Apr 2012 of 117 thousand units are lower by 32.4 percent relative to 173 thousand units houses sold in Jan-Apr 1963, the first year when data become available, while population increased 72.2 percent.
Table ESV-1, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %
| Not Seasonally Adjusted Thousands | |
| Jan-Apr 2012 | 117 |
| Jan-Apr 2011 | 101 |
| ∆% | 15.8 |
| Jan-Apr 2010 | 128 |
| ∆% Jan-Apr 2012/ | -8.6 |
| Jan-Apr 2009 | 116 |
| ∆% Jan-Apr 2012/ | 0.9 |
| Jan-Apr 2008 | 190 |
| ∆% Jan-Apr 2012/ | -38.4 |
| Jan-Apr 2007 | 297 |
| ∆% Jan-Apr 2012/ | -60.6 |
| Jan-Apr 2006 | 385 |
| ∆% Jan-Apr 2012/Jan-Apr 2006 | -69.6 |
| Jan-Apr 2005 | 444 |
| ∆% Jan-Apr 2012/Jan-Apr 2005 | -73.6 |
| Jan-Apr 2004 | 423 |
| ∆% Jan-Apr 2012/Jan-Apr 2004 | -72.3 |
| Jan-Apr 2003 | 347 |
| ∆% Jan-Apr 2012/ | -66.3 |
| Jan-Apr 2002 | 326 |
| ∆% Jan-Apr 2012/ | -64.1 |
| Jan-Apr 2001 | 335 |
| ∆% Jan-Apr 2012/ | -65.1 |
| Jan-Apr 2000 | 311 |
| ∆% Jan-Apr 2012/ | -62.4 |
| Jan-Apr 1995 | 212 |
| ∆% Jan-Apr 2012/ | -44.8 |
| Jan-Apr 1963 | 173 |
| ∆% Jan-Apr 2012/ | -32.4 |
Source: http://www.census.gov/construction/nrs/
Table ESV-2 provides the entire available annual series of new house sales from 1963 to 2011. The revised level of 306 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 ESV-2 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009 and 2010.
Table ESV-2, 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 | 306 |
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 ESV-3. The percentage change of new house sales from 1963 to 2011 is minus 45.4 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 54.1 percent relative to the same period in 1995.
Table ESV-3, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses
| ∆% | Average Yearly % Rate | |
| 1963-2011 | -45.4 | NA |
| 1991-2001 | 78.4 | 5.9 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2011 | -54.1 | NA |
| 2000-2011 | -65.1 | NA |
| 2005-2011 | -76.1 | NA |
NA: Not Applicable
Source: http://www.census.gov/construction/nrs/
ESA Appendix Monetary Policy with Deficit Financing of Economic Growth. The advice of Bernanke (2000, 159-161, 165) to the Bank of Japan (BOJ) to reignite growth and employment in the economy consisted of zero interest rates and commitment to a high inflation target as proposed by Krugman (1999):
“I agree that this approach would be helpful, in that it would give private decision makers more information about the objectives of monetary policy. In particular, a target in the 3-4 percent range for inflation to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime but also that it intends to make up some of the ‘price-level gap’ created by 8 years of zero or negative inflation. In stating an inflation target of, say, 3-4 percent, the BOJ would be giving the direction in which it will attempt to move the economy. The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the period of very low interest rates in the 1930s, in which a central bank has been unable to devaluate its currency. There is strong presumption that vigorous intervention by the BOJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly. Further, there seems little reason not to try this strategy. The ‘worst’ that could happen would be that the BOJ would greatly increase its holdings of reserve assets. Perhaps not all of those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. Franklin D. Roosevelt was elected president of the United States in 1932 with the mandate to get the country out of the Depression. In the end, his most effective actions were the same ones that Japan needs to take—namely, rehabilitation of the banking system and devaluation of the currency.”
Bernanke (2002) also finds devaluation to be a powerful policy instrument to move the economy away from deflation and weak economic and financial conditions:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
Krugman (2012Apr24) finds that this advice of then Professor Bernanke (2000) is relevant to current monetary policy in the US. The relevance would be in a target of inflation in the US of 4 percent, which was the rate prevailing in the late years of the Reagan Administration. The liquidity trap is defined by Krugman (1998, 141) “as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.” The adversity of the liquidity trap in terms of weakness in output and employment can be viewed as an economy experiencing deflation that cannot be contained by increases in the monetary base, or currency held by the public plus reserves held by banks at the central bank. The argument of monetary neutrality is that an increase in money throughout all future periods will increase prices by the same proportion. According to Krugman (1998, 142), the liquidity trap occurs because the public does not expect that the central bank will continue the monetary expansion once inflation returns to a certain level. Expectations are critical in explaining the liquidity trap and have been shaped by the continued fight against inflation by central banks during several decades with the possible exception of Japan beginning with the lost decade when deflation became the relevant policy concern. In this framework, monetary policy is ineffectual if perceived by the public as temporary. Credible monetary policy is perceived by the public as permanent deliberate increase in prices or output: “if the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap” (Krugman 1998, 161).
Fed Chairman Bernanke (2012Apr25, 7-8) argues that there is no conflict between his advice to the Bank of Japan as Princeton Professor Bernanke (2000) and current monetary policy by the Federal Open Market Committee (FOMC):
“So there’s this view circulating [Princeton Professor Paul Krugman at http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?pagewanted=all] that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. Our—my views and our policies today are completely consistent with the views that I held at that time. I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation—that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer—are not exhausted, there are still other things that the central bank can do to create additional accommodation. Now, looking at the current situation in United States, we are not in deflation. When deflation became a significant risk in late 2010, or at least a modest risk in late 2010, we used additional balance sheet tools to help return inflation close to the 2 percent target. Likewise, we have been aggressive and creative in using non-federal-funds-rate-centered tools to achieve additional accommodation for the U.S. economy. So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation, and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative. We—and I won’t go through the list again, but you know all the things that we have done to try to provide support to the economy. I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate? The view of the Committee is that that would be very reckless. We have—we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been be able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”
Chairman Bernanke (2012Apr 25, 10-11) explains current FOMC policy:
“So it’s not a ceiling, it’s a symmetric objective, and we attempt to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason—and we don’t have, obviously don’t have perfect control of inflation—we’ll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment. The risk of higher inflation—you say 2½ percent; well, 2½ percent expected change might involve a distribution of outcomes, some of which might be much higher than 2½ percent. And the concern we have is that if inflation were to run well above 2 percent for a protracted period, that the credibility and the well-anchored inflation expectations, which are such a valuable asset of the Federal Reserve, might become eroded, in which case we would in fact have less rather than more flexibility to use accommodative monetary policy to achieve our employment goals. I would cite to you, just as an example, if you look at Vice Chair Yellen’s paper, which she gave—or speech, which she gave a couple of weeks ago, where she described a number of ways of looking at the late 2014 guidance. She showed there some so-called optimal policy rules that come from trying to get the best possible outcomes from our quantitative econometric models, and what you see, if you look at that, is that the best possible outcomes, assuming perfect certainty, assuming perfect foresight—very unrealistic assumptions—still involve inflation staying quite close to 2 percent. So there is no presumption even in our econometric models that you need inflation well above target in order to make progress on unemployment.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
Proposals for higher inflation target of 4 percent for FOMC monetary policy are based on the view that interest rates are too high in real terms because the nominal rate is already at zero and cannot be lowered further. Rajan (2012May8) argues that higher inflation targets by the FOMC need not increase aggregate demand as proposed in those policies because of various factors:
· Pension Crisis. Baby boomers close to retirement calculate that their savings are not enough at current interest rates and may simply save more. Many potential retirees are delaying retirement in order to save what is required to provide for comfortable retirement.
· Regional Income and Debt Disparities. Unemployment, indebtedness and income growth differ by regions in the US. It is not feasible to relocate demand around the country such that decreases in real interest rates may not have aggregate demand effects.
· Inflation Expectations. Rajan (2012May) argues that there is not much knowledge about how people form expectations. Increasing the FOMC target to 4 percent could erode control of monetary policy by the central bank. More technical analysis of this issue, which could be merely repetition of inflation surprise in the US Great Inflation of the 1970s, is presented in Appendix IIA.
· Frictions. Keynesian economics is based on rigidities of wages and benefits in economic activities but there may be even more important current inflexibilities such as moving when it is not possible to sell and buy a house.
Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf ), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see 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 and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20), is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. Further analysis is provided in Appendix IIA Inflation Surprise and Appendix IIB Unpleasant Monetarist Arithmetic at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html.
According to an influential school of thought, the interrelation of growth and inflation in Latin America is complex, preventing analysis of whether inflation promotes or restricts economic growth (Seers 1962, 191). In this view, there are multiple structural factors of inflation. Successful economic policy requires a development program that ameliorates structural weaknesses. Policy measures in developed countries are not transferable to developing economies.
In extensive research and analysis, Kahil (1973) finds no evidence of the role of structural factors in Brazilian inflation from 1947 to 1963. In fact, Kahil (1973, 329) concludes:
“The immediate causes of the persistent and often violent rise in prices, with which Brazil was plagued from the last month of 1948 to the early months of 1964, are pretty obvious: large and generally growing public deficits, together with too rapid an expansion of bank credit in the first years and, later, exaggerated and more and more frequent increases in the legal minimum wages.”
Kahil (1973, 334) analyzes the impact of inflation on the economy and society of Brazil:
“The real incomes of the various social classes alternately suffered increasingly frequent and sharp fluctuations: no sooner had a group succeeded in its struggle to restore its real income to some previous peak than it witnessed its erosion with accelerated speed; and it soon became apparent to all that the success of any important group in raising its real income, through government actions or by other means, was achieved only by reducing theirs. Social harmony, the general climate of euphoria, and also enthusiasm for government policies, which had tended to prevail until the last months of 1958, gave way in the following years of galloping inflation to intense political and social conflict and to profound disillusionment with public policies. By 1963 when inflation reached its runaway stage, the economy had ceased to grow, industry and transport were convulsed by innumerable strikes, and peasants were invading land in the countryside; and the situation further worsened in the first months of 1964.”
Professor Nathiel H. Leff (1975) at Columbia University identified another important contribution of Kahil (1975, Chapter IV“The supply of capital,” 127-185) of key current relevance to current proposals to promote economic growth and employment by raising inflation targets:
“Contrary to the assertions of some earlier writers on this topic, Kahil concludes that inflation did not lead to accelerated capital formation in Brazil.”
In econometric analysis of Brazil’s inflation from 1947 to 1980, Barbosa (1987) concludes:
“The most important result, based on the empirical evidence presented here, is that in the long run inflation is a monetary phenomenon. It follows that the most challenging task for Brazilian society in the near future is to shape a monetary-fiscal constitution that precludes financing much of the budget deficits through the inflation tax.”
Experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table ESA-1 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable. Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.
Table ESA-1, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)
| M1 | M2 | Y | y | y/N | P | |
| 1861-1970 | 9.3 | 6.2 | 10.2 | 4.6 | 2.4 | 5.8 |
| 1861-1900 | 5.4 | 5.9 | 5.9 | 4.4 | 2.6 | 1.6 |
| 1861-1913 | 4.7 | 4.7 | 5.3 | 4.4 | 2.4 | 0.1 |
| 1861-1929 | 5.5 | 5.6 | 6.4 | 4.3 | 2.3 | 2.1 |
| 1900-1970 | 13.9 | 13.9 | 15.2 | 4.9 | 2.6 | 10.3 |
| 1900-1929 | 8.9 | 8.9 | 10.8 | 4.2 | 2.1 | 6.6 |
| 1900-1945 | 8.6 | 9.1 | 9.2 | 4.3 | 2.2 | 4.9 |
| 1920-1970 | 17.8 | 17.3 | 19.4 | 5.3 | 2.8 | 14.1 |
| 1920-1945 | 8.3 | 8.7 | 7.5 | 4.3 | 2.2 | 3.2 |
| 1920-1929 | 5.4 | 6.9 | 11.1 | 5.3 | 3.3 | 5.8 |
| 1929-1939 | 8.9 | 8.1 | 11.7 | 6.3 | 4.1 | 5.4 |
| 1945-1970 | 30.3 | 29.2 | 33.2 | 6.1 | 3.1 | 27.1 |
Note: growth rates are obtained by regressions of the natural logarithms on time. M1 and M2 definitions of the money stock; Y nominal GDP; y real GDP; y/N real GDP per capita; P prices.
Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.
Chart ESA-1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income.
Chart ESA-1, Brazil, Money, Income and Prices 1861-1970.
Source: © Carlos Manuel Pelaez and Wilson Suzigan. 1981. História Monetária do Brasil Segunda Edição. Coleção Temas Brasileiros. Brasília: Universidade de Brasília, 21.
Table ESA-2 provides yearly percentage changes of GDP, GDP per capita, base money, prices and the current account in millions of dollars during the acceleration of inflation after 1947. There was an explosion of base money or the issue of money and three waves of inflation identified by Kahil (1973). Inflation accelerated together with issue of money and political instability from 1960 to 1964. There must be a role for expectations in inflation but there is not much sound knowledge and measurement as Rajan (2012May8) argues. There have been inflation waves documented in periodic comments in this blog (see Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). The risk is ignition of adverse expectations at the crest of one of worldwide inflation waves. Lack of credibility of the commitment by the FOMC to contain inflation could ignite such perverse expectations. Deficit financing of economic growth can lead to inflation and financial instability.
Table ESA-2, Brazil, GDP, GDP per Capita, Base Money, Prices and Current Account of the Balance of Payments, ∆% and USD Millions
| GDP ∆% | GDP per Capita ∆% | Base Money ∆% | Prices ∆% | Current USD Millions | |
| 1947 | 2.4 | 0.1 | -1.4 | 14.0 | 162 |
| 1948 | 7.4 | 4.9 | 4.6 | 7.6 | -24 |
| 1949 | 6.6 | 4.2 | 14.5 | 4.0 | -74 |
| 1950 | 6.5 | 4.0 | 23.0 | 10.0 | 52 |
| 1951 | 5.9 | 2.9 | 15.3 | 21.9 | -291 |
| 1952 | 8.7 | 5.6 | 17.7 | 10.2 | -615 |
| 1953 | 2.5 | -0.5 | 15.5 | 12.1 | 16 |
| 1954 | 10.1 | 6.9 | 23.4 | 31.0 | -203 |
| 1955 | 6.9 | 3.8 | 18.0 | 14.0 | 17 |
| 1956 | 3.2 | 0.2 | 16.9 | 21.6 | 194 |
| 1957 | 8.1 | 4.9 | 30.5 | 13.9 | -180 |
| 1958 | 7.7 | 4.6 | 26.1 | 10.4 | -253 |
| 1959 | 5.6 | 2.5 | 32.3 | 37.7 | -154 |
| 1960 | 9.7 | 6.5 | 42.4 | 27.6 | -410 |
| 1961 | 10.3 | 7.1 | 54.4 | 36.1 | 115 |
| 1962 | 5.3 | 2.2 | 66.4 | 54.1 | -346 |
| 1963 | 1.6 | -1.4 | 78.4 | 75.2 | -244 |
| 1964 | 2.9 | -0.1 | 82.5 | 89.7 | 40 |
| 1965 | 2.7 | -0.6 | 67.6 | 62.0 | 331 |
| 1966 | 4.4 | 1.5 | 25.8 | 37.9 | 153 |
| 1967 | 4.9 | 2.0 | 33.9 | 28.7 | -245 |
| 1968 | 11.2 | 8.1 | 31.4 | 25.2 | 32 |
| 1969 | 9.9 | 6.9 | 22.4 | 18.2 | 549 |
| 1970 | 8.9 | 5.8 | 20.2 | 20.7 | 545 |
| 1971 | 13.3 | 10.2 | 29.8 | 22.0 | 530 |
Sources: Fundação Getúlio Vargas, Banco Central do Brasil and Pelaez and Suzigan (1981). Carlos Manuel Pelaez, História Econômica do Brasil: Um Elo entre a Teoria e a Realidade Econômica. São Paulo: Editora Atlas, 1979, 94.
ESA Adjustment during the Debt Crisis of the 1980s. Economic and financial risks in the euro area are increasingly being dominated by analytical and political disagreement on conflicts of fiscal adjustment, financial stability, economic growth and employment. Political development is beginning to push for alternative paths of policy. Blanchard (2012WEOApr) and Draghi (2012May3) provide analysis of appropriate directions of policy.
Blanchard (2012WEOApr) finds that interest rates close to zero in advanced economies have not induced higher economic growth because of two main factors—fiscal consolidation and deleveraging—that restrict economic growth in the short-term. First, Blanchard (2012WEOApr, XIII) finds that assuming a multiplier of unity of the fiscal deficit on GDP, decrease of the cyclically-adjusted deficit of advanced economies by 1 percent would reduce economic growth by one percentage point. Second, deleveraging by banks, occurring mainly in Europe, tightens credit supply with similar reduction of euro area economic growth by one percentage point in 2012. The baseline of the World Economic Outlook (WEO) of the IMF (2012WEOApr) for Apr 2012 incorporates both effects, which results in weak economic growth, in particular in Europe, and prolonged unemployment. An important analysis by Blanchard (2012WEOApr, XIII) is that “financial uncertainty, together with sharp shifts in risk appetite, has led to volatile capital flows.” Blanchard (2012WEOApr) still finds that the greatest vulnerability is another profound crisis in Europe (ECB). Crisis prevention should buttress the resilience of affected countries during those shifts in risk appetite. The role of the enhanced firewall of the IMF, European Union (EU) and European Central Bank is gaining time during which countries could engage in fiscal consolidation and structural reforms that would diminish the shifts in risk appetite, preventing devastating effects of financial crises. Volatility in capital flows is equivalent to volatility of valuations of risk financial assets. The challenge to the policy mix consists in balancing the adverse short-term effects of fiscal consolidation and deleveraging with the beneficial long-term effects of eliminating the vulnerability to shocks of risk aversion. Blanchard (2012WEOApr) finds that policy should seek short-term credibility while implementing measures that restrict the path of expenditures together with simultaneous development of institutions and rules that constrain deficits and spending in the future. There is similar policy challenge in deleveraging banks, which is required for sound lending institutions, but without causing an adverse credit crunch. Advanced economies face a tough policy challenge of increasing demand and potential growth.
The President of the European Central Bank (ECB) Mario Draghi (2012May3) also outlines the appropriate policy mix for successful adjustment:
“It is of utmost importance to ensure fiscal sustainability and sustainable growth in the euro area. Most euro area countries made good progress in terms of fiscal consolidation in 2011. While the necessary comprehensive fiscal adjustment is weighing on near-term economic growth, its successful implementation will contribute to the sustainability of public finances and thereby to the lowering of sovereign risk premia. In an environment of enhanced confidence in fiscal balances, private sector activity should also be fostered, supporting private investment and medium-term growth.
At the same time, together with fiscal consolidation, growth and growth potential in the euro area need to be enhanced by decisive structural reforms. In this context, facilitating entrepreneurial activities, the start-up of new firms and job creation is crucial. Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.
In this context, let me make a few remarks on the adjustment process within the euro area. As we know from the experience of other large currency areas, regional divergences in economic developments are a normal feature. However, considerable imbalances have accumulated in the last decade in several euro area countries and they are now in the process of being corrected.
As concerns the monetary policy stance of the ECB, it has to be focused on the euro area. Our primary objective remains to maintain price stability over the medium term. This is the best contribution of monetary policy to fostering growth and job creation in the euro area.
Addressing divergences among individual euro area countries is the task of national governments. They must undertake determined policy actions to address major imbalances and vulnerabilities in the fiscal, financial and structural domains. We note that progress is being made in many countries, but several governments need to be more ambitious. Ensuring sound fiscal balances, financial stability and competitiveness in all euro area countries is in our common interest.”
Economic policy during the debt crisis of 1983 may be useful in analyzing the options of the euro area. Brazil successfully combined fiscal consolidation, structural reforms to eliminate subsidies and devaluation to parity. Brazil’s terms of trade, or export prices relative to import prices, deteriorated by 47 percent from 1977 to 1983 (Pelaez 1986, 46). Table ESA-3 provides selected economic indicators of the economy of Brazil from 1970 to 1985. In 1983, Brazil’s inflation was 164.9 percent, GDP fell 3.2 percent, idle capacity in manufacturing reached 24.0 percent and Brazil had an unsustainable foreign debt. US money center banks would have had negative capital if loans to emerging countries could have been marked according to loss given default and probability of default (for credit risk models see Pelaez and Pelaez (2005), International Financial Architecture, 134-54). Brazil’s current account of the balance of payments shrank from $16,310 million in 1982 to $6,837 million in 1983 because of the abrupt cessation of foreign capital inflows with resulting contraction of Brazil’s GDP by 3.2 percent. An important part of adjustment consisted of agile coordination of domestic production to cushion the impact of drastic reduction in imports. In 1984, Brazil had a surplus of $45 million in current account, the economy grew at 4.5 percent and inflation was stabilized at 232.9 percent.
Table ESA-3, Brazil, Selected Economic Indicators 1970-1985
| Inflation ∆% | GDP Growth ∆% | Idle Capacity in MFG % | BOP Current Account USD MM | |
| 1985 | 223.4 | 7.4 | 19.8 | -630 |
| 1984 | 232.9 | 4.5 | 22.6 | 45 |
| 1983 | 164.9 | -3.2 | 24.0 | -6,837 |
| 1982 | 94.0 | 0.9 | 15.2 | -16,310 |
| 1981 | 113.0 | -1.6 | 12.3 | -11,374 |
| 1980 | 109.2 | 7.2 | 3.5 | -12,886 |
| 1979 | 55.4 | 6.4 | 4.1 | -10,742 |
| 1978 | 38.9 | 5.0 | 3.3 | -6,990 |
| 1977 | 40.6 | 5.7 | 3.2 | -4,037 |
| 1976 | 40.4 | 9.7 | 0.0 | -6,013 |
| 1975 | 27.8 | 5.4 | 3.0 | -6,711 |
| 1974 | 29.1 | 9.7 | 0.1 | -7,122 |
| 1973 | 15.4 | 13.6 | 0.3 | -1,688 |
| 1972 | 17.7 | 11.1 | 6.5 | -1,489 |
| 1971 | 21.5 | 12.0 | 9.8 | -1,307 |
| 1970 | 19.3 | 8.8 | 12.2 | -562 |
Source: Carlos 21.5Manuel Pelaez, O Cruzado e o Austral: São Paulo, Editora Atlas, 1986, 86.
Chart ESA-2 provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart III-2 used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.
Chart ESA-2, Brazil, Phillips Circuit 1963-1987
Source:
©Carlos Manuel Pelaez, O Cruzado e o Austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.
A key to success in stabilizing an economy with significant risk aversion is finding parity of internal and external interest rates. Brazil implemented fiscal consolidation and reforms that are advisable in explosive foreign debt environments. In addition, Brazil had the capacity to find parity in external and internal interest rates to prevent capital flight and disruption of balance sheets (for analysis of balance sheets, interest rates, indexing, devaluation, financial instruments and asset/liability management in that period see Pelaez and Pelaez (2007), The Global Recession Risk: Dollar Devaluation and the World Economy, 178-87). Table ESA-4 provides monthly percentage changes of inflation, devaluation and indexing and the monthly percent overnight interest rate. Parity was attained by means of a simple inequality:
Cost of Domestic Loan ≥ Cost of Foreign Loan
This ordering was attained in practice by setting the domestic interest rate of the overnight interest rate plus spread higher than indexing of government securities with lower spread than loans in turn higher than devaluation plus spread of foreign loans. Interest parity required equality of inflation, devaluation and indexing. Brazil devalued the cruzeiro by 30 percent in 1983 because the depreciation of the German mark DM relative to the USD had eroded the competitiveness of Brazil’s products in Germany and in competition with German goods worldwide. The database of the Board of Governors of the Federal Reserve System quotes DM 1.7829/USD on Mar 3 1980 and DM 2.4425/USD on Mar 15, 1983 (http://www.federalreserve.gov/releases/h10/hist/dat89_ge.htm) for devaluation of 37.0 percent. Parity of costs and rates of domestic and foreign loans and assets required ensuring that there would not be appreciation of the exchange rate, inducing capital flight in expectation of future devaluation that would have reversed stabilization. One of the main problems of adjustment of members of the euro area with high debts is that they cannot adjust the exchange rate because of the common euro currency. This is not an argument in favor of breaking the euro area because there would be also major problems of adjustment such as exiting the euro in favor of a new Drachma in the case of Greece. Another hurdle of adjustment in the euro area is that Brazil could have moved swiftly to adjust its economy in 1983 but the euro area has major sovereignty and distribution of taxation hurdles in moving rapidly.
Table ESA-4, Brazil, Inflation, Devaluation, Overnight Interest Rate and Indexing, Percent Per Month
| 1984 | Inflation IGP ∆% | Devaluation ∆% | Overnight Interest Rate % | Indexing ∆% |
| Jan | 9.8 | 9.8 | 10.0 | 9.8 |
| Feb | 12.3 | 12.3 | 12.2 | 12.3 |
| Mar | 10.0 | 10.1 | 11.3 | 10.0 |
| Apr | 8.9 | 8.8 | 10.1 | 8.9 |
| May | 8.9 | 8.9 | 9.8 | 8.9 |
| Jun | 9.2 | 9.2 | 10.2 | 9.2 |
| Jul | 10.3 | 10.2 | 11.9 | 10.3 |
| Aug | 10.6 | 10.6 | 11.0 | 10.6 |
| Sep | 10.5 | 10.5 | 11.9 | 10.5 |
| Oct | 12.6 | 12.6 | 12.9 | 12.6 |
| Nov | 9.9 | 9.9 | 10.9 | 9.9 |
| Dec | 10.5 | 10.5 | 11.5 | 10.5 |
Source: Carlos Manuel Pelaez, O Cruzado e o Austral. São Paulo, Editora Atlas, 1986, 86.
I United States Housing Collapse. The objective of this section is to provide the latest data and analysis of US housing. Subsection IA United New House Sales analyzes the collapse of US new house sales.
IA United States New House Sales. Data and other information continue to provide depressed conditions in the US housing market with improvement at the margin. Table I-1 shows sales of new houses in the US at seasonally-adjusted annual equivalent rate (SAAR). House prices fell in seven of sixteen months from Jan 2011 to Apr 2012. Revisions show flat house in Jan and increase of house sales by 5.6 percent in Feb, which is partly the cause of decline of upwardly revised 7.3 percent in Mar. The annual equivalent rate in the first four months of 2012 is 3.4 percent. There was significant strength in Sep-Dec with annual equivalent rate of 56.4 percent. The annual equivalent rate in May-Aug was minus 18.1 percent and minus 12.2 percent in Jan-Apr but after increase of 13.6 percent in Dec 2010.
Table I-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate | ∆% | |
| Apr | 343 | 3.3 |
| Mar | 332 | -7.3 |
| Feb | 358 | 5.6 |
| Jan | 339 | 0.0 |
| AE ∆% Jan-Apr | 3.4 | |
| Dec 2011 | 339 | 3.7 |
| Nov | 327 | 4.1 |
| Oct | 314 | 2.6 |
| Sep | 306 | 4.8 |
| AE ∆% Sep-Dec | 56.4 | |
| Aug | 292 | -1.7 |
| Jul | 297 | -2.3 |
| Jun | 304 | -1.3 |
| May | 308 | -1.3 |
| AE ∆% May-Aug | -18.1 | |
| Apr | 312 | 3.7 |
| Mar | 301 | 10.3 |
| Feb | 273 | -11.4 |
| Jan | 308 | -5.5 |
| AE ∆% Jan-Apr | -12.2 | |
| Dec 2010 | 326 | 13.6 |
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 2011 at average 6.6 monthly equivalent sales at current sales rates and then dropped to 5.1 in Apr 2012. Median and average house prices oscillate. In Apr 2012, median prices of new houses sold not seasonally adjusted (NSA) increased 0.7 but after decreasing revised 1.6 percent in Mar and increasing 7.2 percent in Feb. Average prices fell 1.1 percent in Apr but after consecutive increases of 3.9 percent in Mar and 3.6 percent in Feb. There are only six months with price increases in both median and average house prices: Apr with 1.9 percent in median prices and 3.1 percent in average prices, Jun with 8.2 percent in median prices and 3.9 percent in average prices, Oct with 3.6 percent in median prices and 1.1 percent in average prices, Dec with 2.0 percent in median prices and 5.2 percent in average prices, Jan 2012 with 1.4 percent in median prices and 1.1 percent in average prices and Feb 2012 with 7.2 percent in median prices and 3.6 percent in average prices. Median prices of new houses sold in the US fell in eight of the 16 months from Jan 2011 to Apr 2012 and average prices fell in nine months.
Table I-2, US, New House Stocks and Median and Average New Homes Sales Price
| Unsold* | Median | Month | Average New House Sales Price USD | Month | |
| Apr 2012 | 5.1 | 235,700 | 0.7 | 282,600 | -1.1 |
| Mar | 5.2 | 234,000 | -1.6 | 285,800 | 3.9 |
| Feb | 4.9 | 237,700 | 7.2 | 275,200 | 3.6 |
| Jan | 5.3 | 221,700 | 1.4 | 265,700 | 1.1 |
| Dec 2011 | 5.4 | 218,600 | 2.0 | 262,900 | 5.2 |
| Nov | 5.7 | 214,300 | -4.7 | 250,000 | -3.2 |
| Oct | 6.1 | 224,800 | 3.6 | 258,300 | 1.1 |
| Sep | 6.3 | 217,000 | -1.2 | 255,400 | -1.5 |
| Aug | 6.6 | 219,600 | -4.5 | 259,300 | -4.1 |
| Jul | 6.7 | 229,900 | -4.3 | 270,300 | -1.0 |
| Jun | 6.6 | 240,200 | 8.2 | 273,100 | 3.9 |
| May | 6.6 | 222,000 | -1.2 | 262,700 | -2.3 |
| Apr | 6.7 | 224,700 | 1.9 | 268,900 | 3.1 |
| Mar | 7.1 | 220,500 | 0.2 | 260,800 | -0.8 |
| Feb | 8.0 | 220,100 | -8.3 | 262,800 | -4.7 |
| Jan | 7.3 | 240,100 | -0.5 | 275,700 | -5.5 |
| Dec 2010 | 7.0 | 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-Apr of various years. Sales of new houses in Jan-Apr 2012 are substantially lower than in any year between 1995 and 2012. There are only two increases of 15.8 percent between Jan-Apr 2011 and Jan-Apr 2012 and 0.9 percent between Jan-Apr 2009 and Jan-Apr 2012. Sales of new houses in 2012 are lower by 8.6 percent in relation to 2010, 38.4 percent relative to 2008, 60.6 percent relative to 2007, 69.6 percent relative to 2006 and 73.6 percent relative to 2005. 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-Mar 2012 relative to the same period in 2005 fell 73.6 percent and 69.6 percent relative to the same period in 2006. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Mar 2012 fell 46.1 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-Apr 2012 of 117 thousand units are lower by 32.4 percent relative to 173 thousand units houses sold in Jan-Apr 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-Apr 2012 | 117 |
| Jan-Apr 2011 | 101 |
| ∆% | 15.8 |
| Jan-Apr 2010 | 128 |
| ∆% Jan-Apr 2012/ | -8.6 |
| Jan-Apr 2009 | 116 |
| ∆% Jan-Apr 2012/ | 0.9 |
| Jan-Apr 2008 | 190 |
| ∆% Jan-Apr 2012/ | -38.4 |
| Jan-Apr 2007 | 297 |
| ∆% Jan-Apr 2012/ | -60.6 |
| Jan-Apr 2006 | 385 |
| ∆% Jan-Apr 2012/Jan-Apr 2006 | -69.6 |
| Jan-Apr 2005 | 444 |
| ∆% Jan-Apr 2012/Jan-Apr 2005 | -73.6 |
| Jan-Apr 2004 | 423 |
| ∆% Jan-Apr 2012/Jan-Apr 2004 | -72.3 |
| Jan-Apr 2003 | 347 |
| ∆% Jan-Apr 2012/ | -66.3 |
| Jan-Apr 2002 | 326 |
| ∆% Jan-Apr 2012/ | -64.1 |
| Jan-Apr 2001 | 335 |
| ∆% Jan-Apr 2012/ | -65.1 |
| Jan-Apr 2000 | 311 |
| ∆% Jan-Apr 2012/ | -62.4 |
| Jan-Apr 1995 | 212 |
| ∆% Jan-Apr 2012/ | -44.8 |
| Jan-Apr 1963 | 173 |
| ∆% Jan-Apr 2012/ | -32.4 |
Source: http://www.census.gov/construction/nrs/
Table I-4 provides the entire available annual series of new house sales from 1963 to 2011. The revised level of 306 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 II-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009 and 2010.
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 | 306 |
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 45.4 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 54.1 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 | -45.4 | NA |
| 1991-2001 | 78.4 | 5.9 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2011 | -54.1 | NA |
| 2000-2011 | -65.1 | NA |
| 2005-2011 | -76.1 | 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 | $227,200 | $267,900 |
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 7.8 percent and average prices fell 12.4 percent. Between 2010 and 2011, median prices increased 2.4 percent and average prices fell 1.8 percent.
Table I-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%
| Median New | Average New Home Sales Prices ∆% | |
| ∆% 2000 to 2003 | 15.4 | 18.9 |
| ∆% 2000 to 2005 | 42.5 | 43.5 |
| ∆% 2000 to 2011 | 34.4 | 29.4 |
| ∆% 2005 to 2011 | -5.7 | -9.8 |
| ∆% 2000 to 2006 | 45.9 | 47.8 |
| ∆% 2006 to 2011 | -7.8 | -12.4 |
| ∆% 2009 to 2011 | 4.8 | -1.1 |
| ∆% 2010 to 2011 | 2.4 | -1.8 |
Source: http://www.census.gov/construction/nrs/
II United States House Prices. Section IIA United States House Prices considers the latest available data on house prices. Section IIB Factors of US Housing Collapse provides the analysis of the causes of the housing crisis of the US.
IIA 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 IQ2000 to IQ2006, the index for the US as a whole rose 60.4 percent, higher than 80 percent for New England and Middle Atlantic, 73.8 for South Atlantic but only by 30.4 percent for East South Central. Prices fell relative to 2012 from all years since 2005 with some exceptions for 2011. From IQ2000 to IQ2011, 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 | |
| 1Q2000 | 22.9 | 42.7 | 33.9 | 23.9 | 9.8 |
| 1Q2000 | 46.8 | 74.9 | 65.6 | 53.8 | 21.0 |
| 1Q2000 to | 60.4 | 82.3 | 81.5 | 73.8 | 30.4 |
| 1Q2005 t0 | -10.5 | -12.0 | -0.2 | -14.2 | 2.3 |
| 1Q2006 | -18.1 | -15.6 | -8.9 | -24.1 | -5.0 |
| 1Q2007 to | -19.8 | -10.4 | -10.2 | -23.3 | -9.1 |
| 1Q2010 to | -5.1 | -4.6 | -4.8 | -6.2 | -3.4 |
| 1Q2011 to | 0.4 | -1.3 | -0.9 | 0.9 | 0.9 |
| 1Q2000 to | 31.4 | 53.9 | 62.3 | 32.0 | 23.8 |
Source: http://fhfa.gov/webfiles/23967/Q12012HPI_Report52312F.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-10 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 2012, 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 | |
| 1Q2000 | 12.9 | 18.8 | 14.7 | 17.2 | 39.6 |
| 1Q2000 | 22.1 | 31.6 | 24.9 | 45.1 | 98.0 |
| 1Q2000 to 1Q2006 | 31.0 | 38.3 | 28.5 | 68.6 | 127.7 |
| 1Q2005 t0 | 14.5 | -3.2 | -15.5 | -15.9 | -30.2 |
| 1Q2006 | 6.7 | -7.9 | -17.9 | -27.6 | -39.3 |
| 1Q2007 to | 0.7 | -9.7 | -17.8 | -30.8 | -38.7 |
| 1Q2010 to | 0.2 | -2.5 | -4.9 | -8.3 | -9.6 |
| 1Q2011 to | 2.6 | 2.3 | 0.2 | 0.4 | -1.6 |
| 1Q2000 to 1Q2012 | 39.8 | 27.4 | 5.5 | 22.0 | 38.2 |
Source: http://fhfa.gov/webfiles/23967/Q12012HPI_Report52312F.pdf
Chart II-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IQ2001 to IQ2012. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IQ2008 but there was another decline after IQ2010. The rate of decline improved in the second half of 2011 and into 2012.
Chart II-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change
Source: Federal Housing Finance Agency
http://fhfa.gov/Default.aspx?Page=14
Monthly and 12-month 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 or equal to 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 3.4 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 0.1 percent in Dec and the 12-month percentage change fell to minus 1.5 percent. There was further improvement with revised decline 0.5 percent in Jan 2012 and decline of the 12-month percentage change to minus 1.3 percent. The index changed to positive change of 0.3 percent in Feb 2012 and increase of 0.3 percent in the 12 months ending in Feb 2012. There was strong improvement in Mar 2012 with gain in prices of 1.8 percent and 2.7 percent in 12 months.
Table II-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%
| Month ∆% SA | 12 Month ∆% NSA | |
| Mar 2012 | 1.8 | 2.7 |
| Feb | 0.3 | 0.3 |
| Jan | -0.5 | -1.3 |
| Dec 2011 | 0.2 | -1.5 |
| Nov | 0.7 | -2.2 |
| Oct | -0.9 | -3.4 |
| Sep | 0.3 | -2.6 |
| Aug | -0.3 | -3.9 |
| Jul | 0.1 | -3.7 |
| Jun | 0.6 | -4.3 |
| May | 0.2 | -6.0 |
| Apr | 0.3 | -6.0 |
| Mar | -0.6 | -6.0 |
| Feb | -1.3 | -5.4 |
| Jan | -0.7 | -4.6 |
| Dec 2010 | -3.9 | |
| Dec 2009 | -1.9 | |
| Dec 2008 | -9.7 | |
| Dec 2007 | -3.0 | |
| Dec 2006 | 2.5 | |
| Dec 2005 | 9.8 | |
| 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 | 2.8 | |
| Dec 1994 | 2.6 | |
| Dec 1993 | 3.1 | |
| Dec 1992 | 2.4 |
Source: http://fhfa.gov/Default.aspx?Page=87
Table II-4 provides 12-month percentage changes of the FHFA house price index since 1992 when data become available for 1991. Table II-4 provides percentage changes and average rates of percent change per year for various periods. Between 1992 and 2011, the FHFA house price index increased 74.4 percent at the yearly average rate of 3.0 percent. In the period 1992-2000, the FHFA house price index increased 39.0 percent at the average yearly rate of 4.2 percent. The rate of price increase accelerated to 7.5 percent in the period 2000-2003 and to 8.5 percent in 2000-2005 and 7.5 percent in 2000-2006. At the margin the average rate jumped to 10.0 percent in 2003-2005 and 7.5 percent in 2003-2006. House prices measured by the FHFA house price index declined 18.6 percent between 2006 and 2011 and 16.6 percent between 2005 and 2011.
Table II-4, US, FHFA House Price Index, Percentage Change and Average Rate of Percentage Change per Year, Selected Dates 1992-2011
| Dec | ∆% | Average ∆% per Year |
| 1992-2011 | 74.4 | 3.0 |
| 1992-2000 | 39.0 | 4.2 |
| 2000-2003 | 24.2 | 7.5 |
| 2000-2005 | 50.3 | 8.5 |
| 2003-2005 | 21.0 | 10.0 |
| 2005-2011 | -16.6 | NA |
| 2000-2006 | 54.1 | 7.5 |
| 2003-2006 | 24.1 | 7.5 |
| 2006-2011 | -18.6 | NA |
Source: http://fhfa.gov/Default.aspx?Page=87
IIB Factors of US Housing Collapse. 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:
“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.”
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→∞.
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).
There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.
In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection skills of the relationship banker convert an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.
Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by the financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.
The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):
“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”
III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China with political development, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment, falling wages and hiring collapse; 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. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil.
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 May 18 and daily values throughout the week ending on Fri May 25 of various 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 May 18 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri May 18, 2012”, first row “USD/EUR 1.2780 1.1%,” provides the information that the US dollar (USD) appreciated 1.1 percent to USD 1.2780/EUR in the week ending on Fri May 18 relative to the exchange rate on Fri May 11. 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 1.2780/EUR in the first row, first column in the block for currencies in Table III-1 for Fri May 18, depreciating to USD 1.2814/EUR on Mon May 21, or by 0.3 percent. The dollar depreciated because more dollars, $1.2814, were required on Mon May 21 to buy one euro than $1.2780 on May 18. 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 1.2814/EUR on May 21; 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 May 18, to the last business day of the current week, in this case Fri May 25, such as appreciation by 2.1 percent to USD 1.2518/EUR by May 25; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 2.1 percent from the rate of USD 1.2780/EUR on Fri May 18 to the rate of USD 1.2518/EUR on Fri May 25 {[(1.2518/1.2780) – 1]100 = -2.1%} and appreciated (denoted by positive sign) by 0.1 percent from the rate of USD 1.2532 on Thu May 24 to USD 1.2518/EUR on Fri May 25 {[(1.2518/1.2532) -1]100 = -0.1%}. 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.
Table III-I, Weekly Financial Risk Assets May 21 to May 25, 2012
| Fri May 18, 2012 | M 21 | Tue 22 | W 23 | Thu 24 | Fr 25 |
| USD/EUR 1.2780 1.1% | 1.2814 -0.3% -0.3% | 1.2683 0.8% 1.0% | 1.2581 1.6% 0.8% | 1.2532 1.9% 0.4% | 1.2518 2.1% 0.1% |
| JPY/ USD 79.01 1.2% | 79.35 -0.4% -0.4% | 79.97 -1.2% -0.8% | 79.49 -0.6% 0.6% | 79.59 -0.7% -0.1% | 79.68 -0.8% -0.1% |
| CHF/ USD 0.9398 -1.1% | 0.9374 0.3% 0.3% | 0.9471 -0.8% -1.0% | 0.9546 -1.6% -0.8% | 0.9585 -2.0% -0.4% | 0.9595 -2.1% -0.1% |
| CHF/ EUR 1.2011 0.0% | 1.2012 0.0% 0.0% | 1.2011 0.0% 0.0% | 1.2010 0.0% 0.0% | 1.2013 0.0% 0.0% | 1.2012 0.0% 0.0% |
| USD/ AUD 0.9843 1.0160 -1.8% | 0.9913 1.0088 0.7% 0.7% | 0.9810 1.0194 -0.3% -1.1% | 0.9766 1.0240 -0.8% -0.5% | 0.9760 1.0246 -0.8% -0.1% | 0.9759 1.0247 -0.8% 0.0% |
| 10 Year T Note 1.714 | 1.74 | 1.77 | 1.74 | 1.78 | 1.738 |
| 2 Year T Note 0.292 | 0.29 | 0.29 | 0.29 | 0.30 | 0.291 |
| German Bond 2Y 0.05 10Y 1.43 | 2Y 0.05 10Y 1.43 | 2Y 0.06 10Y 1.47 | 2Y 0.05 10Y 1.38 | 2Y 0.07 10Y 1.39 | 2Y 0.05 10Y 1.37 |
| DJIA 12369.38 -3.5% | 12504.48 1.1% 1.1% | 12502.81 1.1% 0.0 | 12496.15 1.0% -0.1% | 12529.75 1.3% 0.3% | 12454.83 0.7% -0.6% |
| DJ Global 1754.30 -5.4% | 1769.31 0.9% 0.9% | 1781.49 1.5% 0.7% | 1756.79 0.1% -1.4% | 1764.80 0.6% 0.5% | 1760.51 0.4% -0.2% |
| DJ Asia Pacific 1152.04 -5.0% | 1154.08 0.2% 0.2% | 1163.59 1.0% 0.8% | 1145.93 -0.5% -1.5% | 1145.57 -0.6% 0.0% | 1142.84 -0.8% -0.2% |
| Nikkei 8611.31 -3.8% | 8633.89 0.3% 0.3% | 8729.29 1.4% 1.1% | 8556.60 -0.6% -2.0% | 8563.38 -0.6% 0.1% | 8580.39 -0.4% 0.2% |
| Shanghai 2344.52 -2.1% | 2348.30 0.2% 0.2% | 2373.31 1.2% 1.1% | 2363.44 0.8% -0.4% | 2350.97 0.3% -0.5% | 2333.55 -0.5% -0.7% |
| DAX 6271.22 -4.7% | 6331.04 0.9% 0.9% | 6435.60 2.6% 1.7% | 6285.75 0.2% -2.3% | 6315.89 0.7% 0.5% | 6339.94 1.1% 0.4% |
| DJ UBS Comm. 136.00 0.9% | 135.72 -0.2% -0.2% | 134.45 -1.1% -0.9% | 132.36 -2.7% -1.6% | 132.39 -2.7% 0.0% | 132.61 -2.5% 0.2% |
| WTI $ B 91.02 -4.9% | 92.83 2.0% 2.0% | 91.57 0.6% -1.4% | 90.37 -0.7% -1.3% | 90.88 -0.2% 0.6% | 90.86 -0.2% 0.0% |
| Brent $/B 106.85 -4.6% | 109.33 2.3% 2.3% | 108.05 1.1% -1.2% | 106.02 -0.8% -1.9% | 106.73 -0.1% 0.7% | 106.83 0.0% 0.1% |
| Gold $/OZ 1591.1 0.7% | 1593.0 0.1% 0.1% | 1567.6 -1.5% -1.6% | 1560.3 -1.9% -0.5% | 1560.9 -1.9% 0.0% | 1571.2 -1.3% 0.7% |
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
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. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.738 percent on May 25, 2012 while the yield of the ten-year government bond fell from 2.16 percent to 1.37 percent. The yield of the two-year government bond of Germany fell from 0.65 percent on May 26, 2011, to 0.05 percent on May 25, 2012, as investors fled euro area risks to the safety of liabilities of the government of Germany. The US dollar strengthened significantly from USD 1.450/EUR on Aug 26, 2011, to USD 1.2518/EUR on May 25, 2919, or by 13.7 percent. The dollar peaked at USD 1.192/EUR on Jun 7, 2010, during the first round of the European sovereign risk crisis, but is now only 5.0 percent weaker at USD 1.2518/EUR. Under zero interest rates for the monetary policy rate of the US, fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciate in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.3 percent in the 12 months ending in Apr (see subsection IB United States Inflation http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The latest statement of the Federal Open Market Committee (FOMC) on Apr 25, 2012 does not have sufficient changes suggesting that it contributed to the rise in Treasury yields (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm). The statement continues to consider inflation low, unemployment high and growth at a moderate pace. Because of the “slack” in the economy, the FOMC anticipates maintaining the zero interest rate policy until 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm):
“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.”
A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.6 percent for the 12 months ending in Apr 2012 but jumping 1.3 percent in the month of Mar (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16052012-BP/EN/2-16052012-BP-EN.PDF; see Section VD) but the yield of the two-year German government bond fell from 0.65 percent on Aug 19, 2011 to 0.05 percent on May 25, 2012, while the ten-year yield fell from 2.16 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012, as shown in Table III-1A.
Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
| US 2Y | US 10Y | DE 2Y | DE 10Y | USD/ EUR | |
| 5/25/12 | 0.291 | 1.738 | 0.05 | 1.37 | 1.2518 |
| 5/18/12 | 0.292 | 1.714 | 0.05 | 1.43 | 1.2780 |
| 5/11/12 | 0.248 | 1.845 | 0.09 | 1.52 | 1.2917 |
| 5/14/12 | 0.256 | 1.876 | 0.08 | 1.58 | 1.3084 |
| 4/6/12 | 0.31 | 2.058 | 0.14 | 1.74 | 1.3096 |
| 3/30/12 | 0.335 | 2.214 | 0.21 | 1.79 | 1.3340 |
| 3/2/12 | 0.29 | 1.977 | 0.16 | 1.80 | 1.3190 |
| 2/24/12 | 0.307 | 1.977 | 0.24 | 1.88 | 1.3449 |
| 1/6/12 | 0.256 | 1.957 | 0.17 | 1.85 | 1.2720 |
| 12/30/11 | 0.239 | 1.871 | 0.14 | 1.83 | 1.2944 |
| 8/26/11 | 0.20 | 2.202 | 0.65 | 2.16 | 1.450 |
| 8/19/11 | 0.192 | 2.066 | 0.65 | 2.11 | 1.4390 |
Note: DE: Germany
Source:
http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
Equity indexes in Table III-1 were mixed in the week of May 25 under stress from the European debt crisis. Germany’s Dax gained 1.1 percent while DJIA increased 0.7 percent in the week of May 25 and Dow Global increased 0.4 percent. Japan’s Nikkei Average continued recent declines with loss of 0.4 percent in the week of May 25. Dow Asia Pacific TSM dropped 0.8 percent in the week of May 25 while Shanghai Composite dropped 0.5 percent.
Commodities were weak during the week of May 25, as shown in Table III-1. The DJ UBS Commodities Index decreased 2.5 percent. WTI dropped 0.2 percent while Brent was flat. Gold decreased 1.3 percent.
Risk aversion during the week of Mar 2, 2012, was dominated by the long-term refinancing operations (LTRO) of the European Central Bank. LTROs and related principles are analyzed in subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort. First, as analyzed by David Enrich, writing on “ECB allots €529.5 billion in long-term refinancing operations,” published on Feb 29, 2012 by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203986604577252803223310964.html?mod=WSJ_hp_LEFTWhatsNewsCollection), the ECB provided a second round of three-year loans at 1.0 percent to about 800 banks. The earlier round provided €489 billion to more than 500 banks. Second, the ECB sets the fixed-rate for main refinancing operations at 1.00 percent and the overnight deposit facility at 0.25 percent (http://www.ecb.int/home/html/index.en.html) for negative spread of 75 basis points. That is, if a bank borrows at 1.0 percent for three years through the LTRO and deposits overnight at the ECB, it incurs negative spread of 75 basis points. An alternative allocation could be to lend for a positive spread to other banks. Richard Milne, writing on “Banks deposit record cash with ECB,” on Mar 2, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/9798fd36-644a-11e1-b30e-00144feabdc0.html#axzz1nxeicB6H), provides important information and analysis that banks deposited a record €776.9 billion at the ECB on Fri Mar 2 at interest receipt of 0.25 percent, just two days after receiving €529.5 billion of LTRO loans at interest cost of 1.0 percent. The main issue here is whether there is ongoing perceptions of high risks in counterparties in financial transactions that froze credit markets in 2008 (see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 57-60, 217-27, Financial Regulation after the Global Recession (2009b), 155-67). Richard Milne and Mary Watkins, writing on “European finance: the leaning tower of perils,” on Mar 27, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/82205f6e-7735-11e1-baf3-00144feab49a.html#axzz1qOqWaqF2), raise concerns that the large volume of LTROs can create future problems for banks and the euro area. An important issue is if the cheap loans at 1 percent for three-year terms finance the carry trade into securities of the governments of banks. Balance sheets of banks may be stressed during future sovereign-credit events. Sam Jones, writing on “ECB liquidity fuels high stakes hedging,” on Apr 4, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/cb74d63a-7e75-11e1-b009-00144feab49a.html#axzz1qyDYxLjS), analyzes unusually high spreads in government bond markets in Europe that could have been caused by LTROs. There has been active relative value arbitrage of these spreads similar to the strategies of Long-Term Capital Management (LTCM) of capturing high spreads in mortgage-backed securities jointly with hedges in Treasury securities (on LTCM see Pelaez and Pelaez, International Financial Architecture (2005), 108-12, 87-9, The Global Recession Risk (2007) 12-3, 102, 176, Globalization and the State, Vol. I (2008a), 59-64).
Table III-1B provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,127,017 million on May 18, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,731,705 million in the statement of May 18.
Table III-1B, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | May 18, 2012 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 432,704 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 242,223 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 50,962 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 18,992 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,127,017 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 212,494 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 604,688 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 30,589 |
| 9 Other Assets | 278,719 | 336,574 | 255,592 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,975,261 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,731,705 |
| Capital and Reserves | 78,143 | 81,481 | 85,539 |
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/fs120522.en.html
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.
The members of the European Monetary Union (EMU), or euro area, established the European Financial Stability Facility (EFSF), on May 9, 2010, to (http://www.efsf.europa.eu/about/index.htm):
- “Provide loans to countries in financial difficulties
- Intervene in the debt primary and secondary markets. Intervention in the secondary market will be only on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability
- Act on the basis of a precautionary programme
- Finance recapitalisations of financial institutions through loans to governments”
The EFSF will be replaced by the permanent European Stability Mechanism (ESM) in 2013. On Mar 30, 2012, members of the euro area reached an agreement providing for sufficient funding required in rescue programs of members countries facing funding and fiscal difficulties and the transition from the EFSF to the ESM. The agreement of Mar 30, 2012 of the euro area members provides for the following (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf):
· Acceleration of ESM paid-in capital. The acceleration of paid-in capital for the ESM provides for two tranches paid in 2012, in July and Oct; another two tranches in 2013; and a final tranche in the first half of 2014. There could be acceleration of paid-in capital is required to maintain a 15 percent relation of paid-in capital and the outstanding issue of the ESM
· ESM Operation and EFSF transition. ESM will assume all new rescue programs beginning in Jul 2012. EFSF will administer programs begun before initiation of ESM activities. There will be a transition period for the EFSF until mid 2013 in which it can engage in new programs if required to maintain the full lending limit of €500 billion.
· Increase of ESM/EFSF lending limit. The combined ceiling of the ESM and EFSF will be increased to €700 billion to facilitate operation of the transition of the EFSF to the ESM. The ESM lending ceiling will be €500 billion by mid 2013. The combined lending ceiling of the ESM and EFSF will continue to €700 billion
· Prior lending. The bilateral Greek loan facility of €53 billion and €49 billion of the EFSF have been paid-out in supporting programs of countries: “all together the euro area is mobilizing an overall firewall of approximately EUR 800 billion, more than USD 1 trillion” (http://www.consilium.europa.eu/media/1513204/eurogroup_statement_30_march_12.pdf)
· Bilateral IMF contributions. Members of the euro area have made commitments of bilateral contributions to the IMF of €150 billion
A key development in the bailout of Greece is the approval by the Executive Board of the International Monetary Fund (IMF) on Mar 15, 2012, of a new four-year financing in the value of €28 billion to be disbursed in equal quarterly disbursements (http://www.imf.org/external/np/tr/2012/tr031512.htm). The sovereign debt crisis of Europe has moderated significantly with the elimination of immediate default of Greece. New economic and financial risk factors have developed, which are covered in VI Valuation of Risk Financial Assets and V World Economic Slowdown.
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 an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increasing from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,127,017 million on May 18, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,731,705 million in the statement of May 18.
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 | May 18, 2012 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 432,704 |
| 2 Claims on Non Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 242,223 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 50,962 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 18,992 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 1,127,017 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 212,494 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 604,688 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 30,589 |
| 9 Other Assets | 278,719 | 336,574 | 255,592 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 2,975,261 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 1,731,705 |
| Capital and Reserves | 78,143 | 81,481 | 85,539 |
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/fs120522.en.html
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 euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate 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 42.7 percent of the total. Exports to the non-European Union area are growing at 12.4 percent in Mar 2012 relative to Mar 2011 while those to EMU are falling at 1.8 percent.
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Mar 2012 | Exports | ∆% Mar 2012/ Mar 2011 | Imports | Imports |
| EU | 56.0 | -0.5 | 53.3 | -11.4 |
| EMU 17 | 42.7 | -1.8 | 43.2 | -11.5 |
| France | 11.6 | 0.2 | 8.3 | -9.0 |
| Germany | 13.1 | 2.9 | 15.6 | -17.1 |
| Spain | 5.3 | -10.3 | 4.5 | -12.6 |
| UK | 4.7 | 12.4 | 2.7 | -12.1 |
| Non EU | 44.0 | 12.4 | 46.7 | -10.3 |
| Europe non EU | 13.3 | 11.5 | 11.1 | -7.1 |
| USA | 6.1 | 23.5 | 3.3 | 7.0 |
| China | 2.7 | -12.3 | 7.3 | -33.3 |
| OPEC | 4.7 | 32.0 | 8.6 | 5.5 |
| Total | 100.0 | 4.9 | 100.0 | -10.9 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: http://www.istat.it/it/archivio/61853
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €216 million with the 17 countries of the euro zone (EMU 17) in Mar and deficit of €346 million in Jan-Mar. Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €1863 million in Jan-Mar with Europe non European Union and of €2135 million with the US. There is significant rigidity in the trade deficits in Jan-Mar of €4111 million with China and €6162 million with members of the Organization of Petroleum Exporting Countries (OPEC).
Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro
| Regions and Countries | Trade Balance Mar 2012 Millions of Euro | Trade Balance Cumulative Jan-Mar 2012 Millions of Euro |
| EU | 1,554 | 2,729 |
| EMU 17 | 216 | -346 |
| France | 1,173 | 2,972 |
| Germany | -491 | -1,361 |
| Spain | 271 | 741 |
| UK | 836 | 2,141 |
| Non EU | 510 | -6,148 |
| Europe non EU | 1,165 | 1,863 |
| USA | 1,043 | 2,135 |
| China | -902 | -4,111 |
| OPEC | -1,690 | -6,162 |
| Total | 2,064 | -3,418 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: http://www.istat.it/it/archivio/61853
Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Mar 2012 relative to Mar 2011. Growth rates of imports are negative with the exception of energy. The higher rate of growth of exports of 4.9 percent relative to imports of minus 10.9 percent may reflect weak demand in Italy with GDP declining during three consecutive quarters from IIIQ2011 through IQ2012.
Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 28.9 | 5.4 | 25.0 | -8.4 |
| Durable | 5.9 | 2.1 | 3.0 | -17.0 |
| Non | 23.0 | 6.4 | 22.0 | -7.2 |
| Capital Goods | 32.2 | 4.2 | 20.8 | -20.7 |
| Inter- | 34.3 | 3.0 | 34.5 | -16.3 |
| Energy | 4.7 | 20.7 | 19.7 | 8.8 |
| Total ex Energy | 95.3 | 4.1 | 80.3 | -15.2 |
| Total | 100.0 | 4.9 | 100.0 | -4.6 |
Source: http://www.istat.it/it/archivio/61853
Table III-6 provides Italy’s trade balance by product categories in Mar 2012 and cumulative Jan-Mar 2012. Italy’s trade balance excluding energy generated surplus of €7571 million in Mar 2012 and €14,022 million in Jan-Mar 2012 but the energy trade balance created deficit of €5507 million in Mar 2012 and €17,441 million in Jan-Mar 2012. The overall surplus in Mar 2012 was €2064 million but there was an overall deficit of €3418 million in Jan-Mar 2012. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.
Table III-6, Italy, Trade Balance by Product Categories, € Millions
| Mar 2012 | Cumulative Jan-Mar 2012 | |
| Consumer Goods | 2,076 | 3,483 |
| Durable | 1,214 | 2,642 |
| Nondurable | 862 | 842 |
| Capital Goods | 4,461 | 9,622 |
| Intermediate Goods | 1,034 | 916 |
| Energy | -5,507 | -17,441 |
| Total ex Energy | 7,571 | 14,022 |
| Total | 2,064 | -3,418 |
Source: http://www.istat.it/it/archivio/61853
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. 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 (http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/index.aspx) 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 2012 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 69,660 | ||
| Euro Zone | 12,586 | -0.5 | 70.3 |
| Portugal | 221 | 0.1 | 110.9 |
| Ireland | 210 | -4.4 | 102.9 |
| Greece | 271 | -1.0 | 153.2 |
| Spain | 1,398 | -3.6 | 67.0 |
| Major Advanced Economies G7 | 34,106 | -4.8 | 88.3 |
| United States | 15,610 | -6.1 | 83.7 |
| UK | 2,453 | -5.3 | 84.2 |
| Germany | 3,479 | 1.0 | 54.1 |
| France | 2,712.0 | -2.2 | 83.2 |
| Japan | 5,981 | -8.9 | 135.2 |
| Canada | 1,805 | -3.1 | 35.4 |
| Italy | 2,067 | 2.9 | 102.3 |
| China | 7992 | -1.3* | 22.0** |
*Net Lending/borrowing**Gross Debt
Source: http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselgr.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 2012 is $4138.5 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 $3927.8 billion, adding rows D+E+F+G+H in column “Net Debt USD billions.” 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 $8066.3 billion, which would be equivalent to 130.3 percent of their combined GDP in 2012. 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 231.9 percent if including debt of France and 167.0 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 | 8,847.9 | ||
| B Germany | 1,882.1 | $8066.3 as % of $3479 =231.9% $5809.9 as % of $3479 =167.0% | |
| C France | 2,256.4 | ||
| B+C | 4,138.5 | GDP $6,191.0 Total Debt $8066.3 Debt/GDP: 130.3% | |
| D Italy | 2,114.5 | ||
| E Spain | 936.7 | ||
| F Portugal | 245.3 | ||
| G Greece | 415.2 | ||
| H Ireland | 216.1 | ||
| Subtotal D+E+F+G+H | 3,927.8 |
Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2012/01/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 Mar 2012. German exports to other European Union (EU) members are 57.6 percent of total exports in Mar 2012 and 58.4 percent in Jan-Mar 2012. Exports to the euro area are 38.5 percent in Mar and 39.0 percent in Jan-Mar. Exports to third countries are 42.4 percent of the total in Mar and 41.6 percent in Jan-Mar. 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 ∆%
| Mar 2012 | Mar 12-Month | Jan–Mar 2012 € Billions | Jan-Mar 2012/ | |
| Total | 98.9 | 0.7 | 276.1 | 5.8 |
| A. EU | 57.0 % 57.6 | -2.8 | 161.3 % 58.4 | 2.3 |
| Euro Area | 38.1 % 38.5 | -3.6 | 107.7 % 39.0 | 1.1 |
| Non-euro Area | 18.9 % 19.1 | -1.4 | 53.6 % 19.4 | 4.7 |
| B. Third Countries | 41.9 % 42.4 | 6.1 | 114.8 % 41.6 | 11.2 |
| Total Imports | 81.5 | 2.6 | 230.6 | 4.8 |
| C. EU Members | 52.4 % 64.3 | 2.1 | 145.8 % 63.2 | 5.0 |
| Euro Area | 37.0 % 45.4 | 2.3 | 102.4 % 44.4 | 4.7 |
| Non-euro Area | 15.4 % 18.9 | 1.7 | 43.4 % 18.8 | 5.8 |
| D. Third Countries | 29.1 % 35.7 | 3.5 | 84.8 % 36.8 | 4.3 |
Notes: Total Exports = A+B; Total Imports = C+D
Source:
Statistiche Bundesamt Deutschland
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:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+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 Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (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.
IIIG Appendix on Deficit Financing of Growth and the Debt Crisis. This section is divided into two subsections. Subsection IIIGA Monetary Policy with Deficit Financing of Economic Growth analyzes proposals to promote economic growth with government deficits financed by monetary policy. Subsection IIIGB Adjustment during the Debt Crisis of the 1980s provides the routes of adjustment of Brazil during the debt crisis after 1983.
IIIGA Monetary Policy with Deficit Financing of Economic Growth. The advice of Bernanke (2000, 159-161, 165) to the Bank of Japan (BOJ) to reignite growth and employment in the economy consisted of zero interest rates and commitment to a high inflation target as proposed by Krugman (1999):
“I agree that this approach would be helpful, in that it would give private decision makers more information about the objectives of monetary policy. In particular, a target in the 3-4 percent range for inflation to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime but also that it intends to make up some of the ‘price-level gap’ created by 8 years of zero or negative inflation. In stating an inflation target of, say, 3-4 percent, the BOJ would be giving the direction in which it will attempt to move the economy. The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode, including the period of very low interest rates in the 1930s, in which a central bank has been unable to devaluate its currency. There is strong presumption that vigorous intervention by the BOJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly. Further, there seems little reason not to try this strategy. The ‘worst’ that could happen would be that the BOJ would greatly increase its holdings of reserve assets. Perhaps not all of those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. Franklin D. Roosevelt was elected president of the United States in 1932 with the mandate to get the country out of the Depression. In the end, his most effective actions were the same ones that Japan needs to take—namely, rehabilitation of the banking system and devaluation of the currency.”
Bernanke (2002) also finds devaluation to be a powerful policy instrument to move the economy away from deflation and weak economic and financial conditions:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
Krugman (2012Apr24) finds that this advice of then Professor Bernanke (2000) is relevant to current monetary policy in the US. The relevance would be in a target of inflation in the US of 4 percent, which was the rate prevailing in the late years of the Reagan Administration. The liquidity trap is defined by Krugman (1998, 141) “as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.” The adversity of the liquidity trap in terms of weakness in output and employment can be viewed as an economy experiencing deflation that cannot be contained by increases in the monetary base, or currency held by the public plus reserves held by banks at the central bank. The argument of monetary neutrality is that an increase in money throughout all future periods will increase prices by the same proportion. According to Krugman (1998, 142), the liquidity trap occurs because the public does not expect that the central bank will continue the monetary expansion once inflation returns to a certain level. Expectations are critical in explaining the liquidity trap and have been shaped by the continued fight against inflation by central banks during several decades with the possible exception of Japan beginning with the lost decade when deflation became the relevant policy concern. In this framework, monetary policy is ineffectual if perceived by the public as temporary. Credible monetary policy is perceived by the public as permanent deliberate increase in prices or output: “if the central bank can credibly promise to be irresponsible—that is, convince the market that it will in fact allow prices to rise sufficiently—it can bootstrap the economy out of the trap” (Krugman 1998, 161).
Fed Chairman Bernanke (2012Apr25, 7-8) argues that there is no conflict between his advice to the Bank of Japan as Princeton Professor Bernanke (2000) and current monetary policy by the Federal Open Market Committee (FOMC):
“So there’s this view circulating [Princeton Professor Paul Krugman at http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?pagewanted=all] that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. Our—my views and our policies today are completely consistent with the views that I held at that time. I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation—that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer—are not exhausted, there are still other things that the central bank can do to create additional accommodation. Now, looking at the current situation in United States, we are not in deflation. When deflation became a significant risk in late 2010, or at least a modest risk in late 2010, we used additional balance sheet tools to help return inflation close to the 2 percent target. Likewise, we have been aggressive and creative in using non-federal-funds-rate-centered tools to achieve additional accommodation for the U.S. economy. So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation, and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative. We—and I won’t go through the list again, but you know all the things that we have done to try to provide support to the economy. I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate? The view of the Committee is that that would be very reckless. We have—we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been be able to take strong accommodative actions in the last four or five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.”
Chairman Bernanke (2012Apr 25, 10-11) explains current FOMC policy:
“So it’s not a ceiling, it’s a symmetric objective, and we attempt to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason—and we don’t have, obviously don’t have perfect control of inflation—we’ll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment. The risk of higher inflation—you say 2½ percent; well, 2½ percent expected change might involve a distribution of outcomes, some of which might be much higher than 2½ percent. And the concern we have is that if inflation were to run well above 2 percent for a protracted period, that the credibility and the well-anchored inflation expectations, which are such a valuable asset of the Federal Reserve, might become eroded, in which case we would in fact have less rather than more flexibility to use accommodative monetary policy to achieve our employment goals. I would cite to you, just as an example, if you look at Vice Chair Yellen’s paper, which she gave—or speech, which she gave a couple of weeks ago, where she described a number of ways of looking at the late 2014 guidance. She showed there some so-called optimal policy rules that come from trying to get the best possible outcomes from our quantitative econometric models, and what you see, if you look at that, is that the best possible outcomes, assuming perfect certainty, assuming perfect foresight—very unrealistic assumptions—still involve inflation staying quite close to 2 percent. So there is no presumption even in our econometric models that you need inflation well above target in order to make progress on unemployment.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
Proposals for higher inflation target of 4 percent for FOMC monetary policy are based on the view that interest rates are too high in real terms because the nominal rate is already at zero and cannot be lowered further. Rajan (2012May8) argues that higher inflation targets by the FOMC need not increase aggregate demand as proposed in those policies because of various factors:
· Pension Crisis. Baby boomers close to retirement calculate that their savings are not enough at current interest rates and may simply save more. Many potential retirees are delaying retirement in order to save what is required to provide for comfortable retirement.
· Regional Income and Debt Disparities. Unemployment, indebtedness and income growth differ by regions in the US. It is not feasible to relocate demand around the country such that decreases in real interest rates may not have aggregate demand effects.
· Inflation Expectations. Rajan (2012May) argues that there is not much knowledge about how people form expectations. Increasing the FOMC target to 4 percent could erode control of monetary policy by the central bank. More technical analysis of this issue, which could be merely repetition of inflation surprise in the US Great Inflation of the 1970s, is presented in Appendix IIA.
· Frictions. Keynesian economics is based on rigidities of wages and benefits in economic activities but there may be even more important current inflexibilities such as moving when it is not possible to sell and buy a house.
Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf ), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see 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 and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20), is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. Further analysis is provided in Appendix IIA Inflation Surprise and Appendix IIB Unpleasant Monetarist Arithmetic at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html.
According to an influential school of thought, the interrelation of growth and inflation in Latin America is complex, preventing analysis of whether inflation promotes or restricts economic growth (Seers 1962, 191). In this view, there are multiple structural factors of inflation. Successful economic policy requires a development program that ameliorates structural weaknesses. Policy measures in developed countries are not transferable to developing economies.
In extensive research and analysis, Kahil (1973) finds no evidence of the role of structural factors in Brazilian inflation from 1947 to 1963. In fact, Kahil (1973, 329) concludes:
“The immediate causes of the persistent and often violent rise in prices, with which Brazil was plagued from the last month of 1948 to the early months of 1964, are pretty obvious: large and generally growing public deficits, together with too rapid an expansion of bank credit in the first years and, later, exaggerated and more and more frequent increases in the legal minimum wages.”
Kahil (1973, 334) analyzes the impact of inflation on the economy and society of Brazil:
“The real incomes of the various social classes alternately suffered increasingly frequent and sharp fluctuations: no sooner had a group succeeded in its struggle to restore its real income to some previous peak than it witnessed its erosion with accelerated speed; and it soon became apparent to all that the success of any important group in raising its real income, through government actions or by other means, was achieved only by reducing theirs. Social harmony, the general climate of euphoria, and also enthusiasm for government policies, which had tended to prevail until the last months of 1958, gave way in the following years of galloping inflation to intense political and social conflict and to profound disillusionment with public policies. By 1963 when inflation reached its runaway stage, the economy had ceased to grow, industry and transport were convulsed by innumerable strikes, and peasants were invading land in the countryside; and the situation further worsened in the first months of 1964.”
Professor Nathiel H. Leff (1975) at Columbia University identified another important contribution of Kahil (1975, Chapter IV“The supply of capital,” 127-185) of key current relevance to current proposals to promote economic growth and employment by raising inflation targets:
“Contrary to the assertions of some earlier writers on this topic, Kahil concludes that inflation did not lead to accelerated capital formation in Brazil.”
In econometric analysis of Brazil’s inflation from 1947 to 1980, Barbosa (1987) concludes:
“The most important result, based on the empirical evidence presented here, is that in the long run inflation is a monetary phenomenon. It follows that the most challenging task for Brazilian society in the near future is to shape a monetary-fiscal constitution that precludes financing much of the budget deficits through the inflation tax.”
Experience with continuing fiscal deficits and money creation tend to show accelerating inflation. Table III-10 provides average yearly rates of growth of two definitions of the money stock, M1, and M2 that adds also interest-paying deposits. The data were part of a research project on the monetary history of Brazil using the NBER framework of Friedman and Schwartz (1963, 1970) and Cagan (1965) as well as the institutional framework of Rondo E. Cameron (1967, 1972) who inspired the research (Pelaez 1974, 1975, 1976a,b, 1977, 1979, Pelaez and Suzigan 1978, 1981). The data were also used to test the correct specification of money and income following Sims (1972; see also Williams et al. 1976) as well as another test of orthogonality of money demand and supply using covariance analysis. The average yearly rates of inflation are high for almost any period in 1861-1970, even when prices were declining at 1 percent in 19th century England, and accelerated to 27.1 percent in 1945-1970. There may be concern in an uncontrolled deficit monetized by sharp increases in base money. The Fed may have desired to control inflation at 2 percent after lowering the fed funds rate to 1 percent in 2003 but inflation rose to 4.1 percent in 2007. There is not “one hundred percent” confidence in controlling inflation because of the lags in effects of monetary policy impulses and the equally important lags in realization of the need for action and taking of action and also the inability to forecast any economic variable. Romer and Romer (2004) find that a one percentage point tightening of monetary policy is associated with a 4.3 percent decline in industrial production. There is no change in inflation in the first 22 months after monetary policy tightening when it begins to decline steadily, with decrease by 6 percent after 48 months (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 102). Even if there were one hundred percent confidence in reducing inflation by monetary policy, it could take a prolonged period with adverse effects on economic activity. Certainty does not occur in economic policy, which is characterized by costs that cannot be anticipated.
Table III-10, Brazil, Yearly Growth Rates of M1, M2, Nominal Income (Y), Real Income (y), Real Income per Capita (y/n) and Prices (P)
| M1 | M2 | Y | y | y/N | P | |
| 1861-1970 | 9.3 | 6.2 | 10.2 | 4.6 | 2.4 | 5.8 |
| 1861-1900 | 5.4 | 5.9 | 5.9 | 4.4 | 2.6 | 1.6 |
| 1861-1913 | 4.7 | 4.7 | 5.3 | 4.4 | 2.4 | 0.1 |
| 1861-1929 | 5.5 | 5.6 | 6.4 | 4.3 | 2.3 | 2.1 |
| 1900-1970 | 13.9 | 13.9 | 15.2 | 4.9 | 2.6 | 10.3 |
| 1900-1929 | 8.9 | 8.9 | 10.8 | 4.2 | 2.1 | 6.6 |
| 1900-1945 | 8.6 | 9.1 | 9.2 | 4.3 | 2.2 | 4.9 |
| 1920-1970 | 17.8 | 17.3 | 19.4 | 5.3 | 2.8 | 14.1 |
| 1920-1945 | 8.3 | 8.7 | 7.5 | 4.3 | 2.2 | 3.2 |
| 1920-1929 | 5.4 | 6.9 | 11.1 | 5.3 | 3.3 | 5.8 |
| 1929-1939 | 8.9 | 8.1 | 11.7 | 6.3 | 4.1 | 5.4 |
| 1945-1970 | 30.3 | 29.2 | 33.2 | 6.1 | 3.1 | 27.1 |
Note: growth rates are obtained by regressions of the natural logarithms on time. M1 and M2 definitions of the money stock; Y nominal GDP; y real GDP; y/N real GDP per capita; P prices.
Source: See Pelaez and Suzigan (1978), 143; M1 and M2 from Pelaez and Suzigan (1981); money income and real income from Contador and Haddad (1975) and Haddad (1974); prices by the exchange rate adjusted by British wholesale prices until 1906 and then from Villela and Suzigan (1973); national accounts after 1947 from Fundação Getúlio Vargas.
Chart III-1 shows in semi-logarithmic scale from 1861 to 1970 in descending order two definitions of income velocity, money income, M1, M2, an indicator of prices and real income.
![clip_image001[1]](file:///C:\Users\cmpelaez\AppData\Local\Temp\WindowsLiveWriter1264636800\supfiles11B1421\image13.png "clip_image001[1]")
Chart III-1, Brazil, Money, Income and Prices 1861-1970.
Source: © Carlos Manuel Pelaez and Wilson Suzigan. 1981. História Monetária do Brasil Segunda Edição. Coleção Temas Brasileiros. Brasília: Universidade de Brasília, 21.
Table III-11 provides yearly percentage changes of GDP, GDP per capita, base money, prices and the current account in millions of dollars during the acceleration of inflation after 1947. There was an explosion of base money or the issue of money and three waves of inflation identified by Kahil (1973). Inflation accelerated together with issue of money and political instability from 1960 to 1964. There must be a role for expectations in inflation but there is not much sound knowledge and measurement as Rajan (2012May8) argues. There have been inflation waves documented in periodic comments in this blog (see Section I and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html). The risk is ignition of adverse expectations at the crest of one of worldwide inflation waves. Lack of credibility of the commitment by the FOMC to contain inflation could ignite such perverse expectations. Deficit financing of economic growth can lead to inflation and financial instability.
Table III-11, Brazil, GDP, GDP per Capita, Base Money, Prices and Current Account of the Balance of Payments, ∆% and USD Millions
| GDP ∆% | GDP per Capita ∆% | Base Money ∆% | Prices ∆% | Current USD Millions | |
| 1947 | 2.4 | 0.1 | -1.4 | 14.0 | 162 |
| 1948 | 7.4 | 4.9 | 4.6 | 7.6 | -24 |
| 1949 | 6.6 | 4.2 | 14.5 | 4.0 | -74 |
| 1950 | 6.5 | 4.0 | 23.0 | 10.0 | 52 |
| 1951 | 5.9 | 2.9 | 15.3 | 21.9 | -291 |
| 1952 | 8.7 | 5.6 | 17.7 | 10.2 | -615 |
| 1953 | 2.5 | -0.5 | 15.5 | 12.1 | 16 |
| 1954 | 10.1 | 6.9 | 23.4 | 31.0 | -203 |
| 1955 | 6.9 | 3.8 | 18.0 | 14.0 | 17 |
| 1956 | 3.2 | 0.2 | 16.9 | 21.6 | 194 |
| 1957 | 8.1 | 4.9 | 30.5 | 13.9 | -180 |
| 1958 | 7.7 | 4.6 | 26.1 | 10.4 | -253 |
| 1959 | 5.6 | 2.5 | 32.3 | 37.7 | -154 |
| 1960 | 9.7 | 6.5 | 42.4 | 27.6 | -410 |
| 1961 | 10.3 | 7.1 | 54.4 | 36.1 | 115 |
| 1962 | 5.3 | 2.2 | 66.4 | 54.1 | -346 |
| 1963 | 1.6 | -1.4 | 78.4 | 75.2 | -244 |
| 1964 | 2.9 | -0.1 | 82.5 | 89.7 | 40 |
| 1965 | 2.7 | -0.6 | 67.6 | 62.0 | 331 |
| 1966 | 4.4 | 1.5 | 25.8 | 37.9 | 153 |
| 1967 | 4.9 | 2.0 | 33.9 | 28.7 | -245 |
| 1968 | 11.2 | 8.1 | 31.4 | 25.2 | 32 |
| 1969 | 9.9 | 6.9 | 22.4 | 18.2 | 549 |
| 1970 | 8.9 | 5.8 | 20.2 | 20.7 | 545 |
| 1971 | 13.3 | 10.2 | 29.8 | 22.0 | 530 |
Sources: Fundação Getúlio Vargas, Banco Central do Brasil and Pelaez and Suzigan (1981). Carlos Manuel Pelaez, História Econômica do Brasil: Um Elo entre a Teoria e a Realidade Econômica. São Paulo: Editora Atlas, 1979, 94.
IIIGB Adjustment during the Debt Crisis of the 1980s. Economic and financial risks in the euro area are increasingly being dominated by analytical and political disagreement on conflicts of fiscal adjustment, financial stability, economic growth and employment. Political development is beginning to push for alternative paths of policy. Blanchard (2012WEOApr) and Draghi (2012May3) provide analysis of appropriate directions of policy.
Blanchard (2012WEOApr) finds that interest rates close to zero in advanced economies have not induced higher economic growth because of two main factors—fiscal consolidation and deleveraging—that restrict economic growth in the short-term. First, Blanchard (2012WEOApr, XIII) finds that assuming a multiplier of unity of the fiscal deficit on GDP, decrease of the cyclically-adjusted deficit of advanced economies by 1 percent would reduce economic growth by one percentage point. Second, deleveraging by banks, occurring mainly in Europe, tightens credit supply with similar reduction of euro area economic growth by one percentage point in 2012. The baseline of the World Economic Outlook (WEO) of the IMF (2012WEOApr) for Apr 2012 incorporates both effects, which results in weak economic growth, in particular in Europe, and prolonged unemployment. An important analysis by Blanchard (2012WEOApr, XIII) is that “financial uncertainty, together with sharp shifts in risk appetite, has led to volatile capital flows.” Blanchard (2012WEOApr) still finds that the greatest vulnerability is another profound crisis in Europe (ECB). Crisis prevention should buttress the resilience of affected countries during those shifts in risk appetite. The role of the enhanced firewall of the IMF, European Union (EU) and European Central Bank is gaining time during which countries could engage in fiscal consolidation and structural reforms that would diminish the shifts in risk appetite, preventing devastating effects of financial crises. Volatility in capital flows is equivalent to volatility of valuations of risk financial assets. The challenge to the policy mix consists in balancing the adverse short-term effects of fiscal consolidation and deleveraging with the beneficial long-term effects of eliminating the vulnerability to shocks of risk aversion. Blanchard (2012WEOApr) finds that policy should seek short-term credibility while implementing measures that restrict the path of expenditures together with simultaneous development of institutions and rules that constrain deficits and spending in the future. There is similar policy challenge in deleveraging banks, which is required for sound lending institutions, but without causing an adverse credit crunch. Advanced economies face a tough policy challenge of increasing demand and potential growth.
The President of the European Central Bank (ECB) Mario Draghi (2012May3) also outlines the appropriate policy mix for successful adjustment:
“It is of utmost importance to ensure fiscal sustainability and sustainable growth in the euro area. Most euro area countries made good progress in terms of fiscal consolidation in 2011. While the necessary comprehensive fiscal adjustment is weighing on near-term economic growth, its successful implementation will contribute to the sustainability of public finances and thereby to the lowering of sovereign risk premia. In an environment of enhanced confidence in fiscal balances, private sector activity should also be fostered, supporting private investment and medium-term growth.
At the same time, together with fiscal consolidation, growth and growth potential in the euro area need to be enhanced by decisive structural reforms. In this context, facilitating entrepreneurial activities, the start-up of new firms and job creation is crucial. Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.
In this context, let me make a few remarks on the adjustment process within the euro area. As we know from the experience of other large currency areas, regional divergences in economic developments are a normal feature. However, considerable imbalances have accumulated in the last decade in several euro area countries and they are now in the process of being corrected.
As concerns the monetary policy stance of the ECB, it has to be focused on the euro area. Our primary objective remains to maintain price stability over the medium term. This is the best contribution of monetary policy to fostering growth and job creation in the euro area.
Addressing divergences among individual euro area countries is the task of national governments. They must undertake determined policy actions to address major imbalances and vulnerabilities in the fiscal, financial and structural domains. We note that progress is being made in many countries, but several governments need to be more ambitious. Ensuring sound fiscal balances, financial stability and competitiveness in all euro area countries is in our common interest.”
Economic policy during the debt crisis of 1983 may be useful in analyzing the options of the euro area. Brazil successfully combined fiscal consolidation, structural reforms to eliminate subsidies and devaluation to parity. Brazil’s terms of trade, or export prices relative to import prices, deteriorated by 47 percent from 1977 to 1983 (Pelaez 1986, 46). Table III-12 provides selected economic indicators of the economy of Brazil from 1970 to 1985. In 1983, Brazil’s inflation was 164.9 percent, GDP fell 3.2 percent, idle capacity in manufacturing reached 24.0 percent and Brazil had an unsustainable foreign debt. US money center banks would have had negative capital if loans to emerging countries could have been marked according to loss given default and probability of default (for credit risk models see Pelaez and Pelaez (2005), International Financial Architecture, 134-54). Brazil’s current account of the balance of payments shrank from $16,310 million in 1982 to $6,837 million in 1983 because of the abrupt cessation of foreign capital inflows with resulting contraction of Brazil’s GDP by 3.2 percent. An important part of adjustment consisted of agile coordination of domestic production to cushion the impact of drastic reduction in imports. In 1984, Brazil had a surplus of $45 million in current account, the economy grew at 4.5 percent and inflation was stabilized at 232.9 percent.
Table III-12, Brazil, Selected Economic Indicators 1970-1985
| Inflation ∆% | GDP Growth ∆% | Idle Capacity in MFG % | BOP Current Account USD MM | |
| 1985 | 223.4 | 7.4 | 19.8 | -630 |
| 1984 | 232.9 | 4.5 | 22.6 | 45 |
| 1983 | 164.9 | -3.2 | 24.0 | -6,837 |
| 1982 | 94.0 | 0.9 | 15.2 | -16,310 |
| 1981 | 113.0 | -1.6 | 12.3 | -11,374 |
| 1980 | 109.2 | 7.2 | 3.5 | -12,886 |
| 1979 | 55.4 | 6.4 | 4.1 | -10,742 |
| 1978 | 38.9 | 5.0 | 3.3 | -6,990 |
| 1977 | 40.6 | 5.7 | 3.2 | -4,037 |
| 1976 | 40.4 | 9.7 | 0.0 | -6,013 |
| 1975 | 27.8 | 5.4 | 3.0 | -6,711 |
| 1974 | 29.1 | 9.7 | 0.1 | -7,122 |
| 1973 | 15.4 | 13.6 | 0.3 | -1,688 |
| 1972 | 17.7 | 11.1 | 6.5 | -1,489 |
| 1971 | 21.5 | 12.0 | 9.8 | -1,307 |
| 1970 | 19.3 | 8.8 | 12.2 | -562 |
Source: Carlos 21.5Manuel Pelaez, O Cruzado e o Austral: São Paulo, Editora Atlas, 1986, 86.
Chart III-2 provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart III-2 used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.
Chart III-2, Brazil, Phillips Circuit 1963-1987
Source:
©Carlos Manuel Pelaez, O Cruzado e o Austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.
A key to success in stabilizing an economy with significant risk aversion is finding parity of internal and external interest rates. Brazil implemented fiscal consolidation and reforms that are advisable in explosive foreign debt environments. In addition, Brazil had the capacity to find parity in external and internal interest rates to prevent capital flight and disruption of balance sheets (for analysis of balance sheets, interest rates, indexing, devaluation, financial instruments and asset/liability management in that period see Pelaez and Pelaez (2007), The Global Recession Risk: Dollar Devaluation and the World Economy, 178-87). Table III-13 provides monthly percentage changes of inflation, devaluation and indexing and the monthly percent overnight interest rate. Parity was attained by means of a simple inequality:
Cost of Domestic Loan ≥ Cost of Foreign Loan
This ordering was attained in practice by setting the domestic interest rate of the overnight interest rate plus spread higher than indexing of government securities with lower spread than loans in turn higher than devaluation plus spread of foreign loans. Interest parity required equality of inflation, devaluation and indexing. Brazil devalued the cruzeiro by 30 percent in 1983 because the depreciation of the German mark DM relative to the USD had eroded the competitiveness of Brazil’s products in Germany and in competition with German goods worldwide. The database of the Board of Governors of the Federal Reserve System quotes DM 1.7829/USD on Mar 3 1980 and DM 2.4425/USD on Mar 15, 1983 (http://www.federalreserve.gov/releases/h10/hist/dat89_ge.htm) for devaluation of 37.0 percent. Parity of costs and rates of domestic and foreign loans and assets required ensuring that there would not be appreciation of the exchange rate, inducing capital flight in expectation of future devaluation that would have reversed stabilization. One of the main problems of adjustment of members of the euro area with high debts is that they cannot adjust the exchange rate because of the common euro currency. This is not an argument in favor of breaking the euro area because there would be also major problems of adjustment such as exiting the euro in favor of a new Drachma in the case of Greece. Another hurdle of adjustment in the euro area is that Brazil could have moved swiftly to adjust its economy in 1983 but the euro area has major sovereignty and distribution of taxation hurdles in moving rapidly.
Table III-13, Brazil, Inflation, Devaluation, Overnight Interest Rate and Indexing, Percent Per Month
| 1984 | Inflation IGP ∆% | Devaluation ∆% | Overnight Interest Rate % | Indexing ∆% |
| Jan | 9.8 | 9.8 | 10.0 | 9.8 |
| Feb | 12.3 | 12.3 | 12.2 | 12.3 |
| Mar | 10.0 | 10.1 | 11.3 | 10.0 |
| Apr | 8.9 | 8.8 | 10.1 | 8.9 |
| May | 8.9 | 8.9 | 9.8 | 8.9 |
| Jun | 9.2 | 9.2 | 10.2 | 9.2 |
| Jul | 10.3 | 10.2 | 11.9 | 10.3 |
| Aug | 10.6 | 10.6 | 11.0 | 10.6 |
| Sep | 10.5 | 10.5 | 11.9 | 10.5 |
| Oct | 12.6 | 12.6 | 12.9 | 12.6 |
| Nov | 9.9 | 9.9 | 10.9 | 9.9 |
| Dec | 10.5 | 10.5 | 11.5 | 10.5 |
Source: Carlos Manuel Pelaez, O Cruzado e o Austral. São Paulo, Editora Atlas, 1986, 86.
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 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 | 2.1 | 2.3 | 1.9 | 8.1 |
| Japan | 2.7 | 0.4 | -0.2 | 4.5 |
| China | 8.9 | 3.4 | -0.7 | |
| UK | -0.1 | 3.0* | 3.3* output | 8.3 |
| Euro Zone | 0.0 | 2.6 | 3.3 | 10.9 |
| Germany | 1.7 | 2.2 | 3.4 | 5.6 |
| France | 0.3 | 2.4 | 3.7 | 10.0 |
| Nether-lands | -1.3 | 2.8 | 3.6 | 5.0 |
| Finland | 2.9 | 3.0 | 2.7 | 7.5 |
| Belgium | 0.5 | 2.9 | 2.8 | 7.3 |
| Portugal | -2.2 | 2.9 | 3.5 | 15.3 |
| Ireland | NA | 1.9 | 3.1 | 14.5 |
| Italy | -1.3 | 3.7 | 2.7 | 9.8 |
| Greece | -6.2 | 1.5 | 6.7 | NA |
| Spain | -0.4 | 2.0 | 3.3 | 24.1 |
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/april-2012/index.html**Core
PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/april-2012/index.html
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 2.1 percent in IQ2012 relative to IQ2011 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp1q12_adv.pdf See Section I Mediocre Economic Growth at http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html). Japan’s GDP fell 0.5 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 7.6 percent in IIIQ2011, increasing at the SAAR of 0.7 percent in IVQ 2011 and 4.1 percent in IQ2012 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy_20.html); the UK grew at 0.0 percent in IQ2012 relative to IQ2011 and GDP fell 0.2 percent in IQ2012 relative to IVQ2011 (see Section VB and http://www.ons.gov.uk/ons/rel/naa2/second-estimate-of-gdp/q1-2012/index.html); and the Euro Zone grew at 0.0 percent in both IQ2012 relative to IVQ2011 and IQ2012 relative to IQ2011 (see Section VD at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy_20.html and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-15052012-AP/EN/2-15052012-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive or about nil growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.1 percent in the US but 17.3 percent for unemployment/underemployment or job stress of 27.8 million (see Table I-4 in Section I at http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/thirty-million-unemployed-or.html), 4.5 percent for Japan (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment_29.html), 8.3 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/2012/05/world-inflation-waves-monetary-policy_20.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/imf-view-of-world-economy-and-finance_22.html) and 10.9 percent in the Euro Zone (section VD at http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight_06.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/thirty-million-unemployed-or_08.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 2.3 percent in the US, 0.4 percent for Japan, 3.4 percent for China, 2.6 percent for the Euro Zone and 3.0 percent for the UK (see Section IV and http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2012/index.html). 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/2012/05/world-inflation-waves-monetary-policy.html); (2) the tradeoff of growth and inflation in China now with change in growth strategy to domestic consumption instead of investment and political developments in a decennial transition; (3) slow growth by repression of savings with de facto interest rate controls (see section I at http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html and earlier http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-economic-growth-falling-real.html), weak hiring with the loss of 10 million full-time jobs (see http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html and earlier in http://cmpassocregulationblog.blogspot.com/2012/04/fractured-labor-market-with-hiring.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html and http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html) and continuing job stress of 24 to 30 million people in the US and stagnant wages in a fractured job market (see Section I Twenty Eight Million Unemployed or Underemployed at http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/04/thirty-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 Apr 25, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm):
“Release Date: April 25, 2012
For immediate release
Information received since the Federal Open Market Committee met in March suggests that the economy has been expanding moderately. Labor market conditions have improved in recent months; the unemployment rate has declined but remains elevated. Household spending and business fixed investment have continued to advance. Despite some signs of improvement, the housing sector remains depressed. Inflation has picked up somewhat, mainly reflecting higher prices of crude oil and gasoline. However, 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 to remain moderate over coming quarters and then to pick up gradually. Consequently, the Committee anticipates that the unemployment rate will decline gradually toward levels that it judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The increase in oil and gasoline prices earlier this year is expected to affect inflation only temporarily, and the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its 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 Apr 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. Policy now focuses on improving conditions in real estate by attempting to reduce mortgage rates: “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.”
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/fomcprojtabl20120425.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 IQ2012 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 IQ2012 to be released on May 31 (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 Apr 30. 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 Apr will be released on May 4, 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/fomcprojtabl20120425.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 2.2 to 2.7 percent at the Jan 25 meeting but increased it to 2.4 to 2.9 percent at the Apr 25, 2012 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 and further down to 7.2 to 8.0 percent at the Apr 25, 2012 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 but increased it to 1.9 to 2.0 percent at the Apr 25, 2012 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 but increased to 1.5 to 1.8 percent at the Apr 25, 2012 meeting.
Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, January 2012 and April 2012
| ∆% GDP | UNEM % | ∆% PCE Inflation | ∆% Core PCE Inflation | |
| Central | ||||
| 2012 | 2.4 to 2.9 | 7.2 to 8.0 | 1.9 to 2.0 | 1.8 to 2.0 |
| 2013 | 2.7 to 3.1 | 7.3 to 7.7 | 1.6 to 2.0 | 1.7 to 2.0 |
| 2014 | 3.1 to 3.6 | 6.7 to 7.4 | 1.7 to 2.0 | 1.8 to 2.0 |
| Longer Run Jan PR | 2.3 to 2.6 | 5.2 to 6.0 | 2.0 | |
| Range | ||||
| 2012 | 2.1 to 3.0 | 7.2 to 8.2 | 1.8 to 2.3 | 1.7 to 2.0 |
| 2013 | 2.4 to 3.8 | 7.0 to 8.1 | 1.5 to 2.1 | 1.6 to 2.1 |
| 2014 | 2.9 to 4.3 | 6.3 to 7.7 | 1.5 to 2.2 | 1.7 to 2.2 |
| Longer Run Jan PR | 2.2 to 3.0 | 4.9 to 6.0 | 2.0 |
Notes: UEM: unemployment; PR: Projection
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120425.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/fomcprojtabl20120425.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 four participants with three expecting the rate to be in the range of 0.5 to 1 percent and three participants expecting rates from 1 to 2.0 percent but only 7 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, April 25, 2012
| 0 to 0.25 | 0.5 to 1.0 | 1.0 to 1.5 | 1.0 to 2.0 | 2.0 to 2.75 | 3.5 to 4.5 | |
| 2012 | 14 | 1 | 2 | |||
| 2013 | 11 | 1 | 3 | 2 | ||
| 2014 | 4 | 3 | 3 | 7 | ||
| Longer Run | 17 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120425.pdf
Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2015. 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, Apr 25, 2012
| Appropriate Year of Increasing Target Fed Funds Rate | Number of Participants |
| 2012 | 3 |
| 2013 | 3 |
| 2014 | 7 |
| 2015 | 4 |
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120425.pdf
Unconventional monetary policy of zero interest rates and quantitative easing has been used in Japan and now also in the US. Table IV-5 provides the consumer price index of Japan, with inflation of 0.4 percent in 12 months ending in Apr and 0.1 percent NSA (not-seasonally-adjusted) and 0.0 percent SA (seasonally-adjusted) in the month of Apr. Inflation of consumer prices in the first four months of 2012 annualizes at 2.1 percent SA and 3.0 percent NSA. Annual equivalent inflation in the first three months of 2012 is 2.8 percent SA and 3.7 percent NSA. There are negative percentage changes in most of the 12-month rates in 2011 with the exception of Jul and Aug both with 0.2 percent and stability in Sep. All monthly and 12-month rates of inflation are positive in the first quarter of 2012. There are eight years of deflation and one of zero inflation in the 12-month rate of inflation in Dec from 1995 to 2010. This experience is entirely different from that of the US that shows long-term inflation. It is difficult to justify unconventional monetary policy because of risks of deflation similar to that experienced in Japan.
Table IV-5, Japan, Consumer Price Index, All Items ∆%
| ∆% Month SA | ∆% Month NSA | ∆% 12-Month NSA | |
| Apr 2012 | 0.0 | 0.1 | 0.4 |
| Mar | 0.1 | 0.5 | 0.5 |
| Feb | 0.3 | 0.2 | 0.3 |
| Jan | 0.3 | 0.2 | 0.1 |
| Dec 2011 | 0.1 | 0.0 | -0.2 |
| Nov | -0.1 | -0.6 | -0.5 |
| Oct | 0.0 | 0.1 | -0.2 |
| Sep | -0.1 | 0.0 | 0.0 |
| Aug | -0.2 | 0.1 | 0.2 |
| Jul | 0.3 | 0.0 | 0.2 |
| Jun | -0.1 | -0.2 | -0.4 |
| May | -0.1 | 0.0 | -0.4 |
| Apr | -0.1 | 0.1 | -0.4 |
| Mar | 0.0 | 0.3 | -0.5 |
| Feb | 0.1 | 0.0 | -0.5 |
| Jan | 0.0 | -0.1 | -0.6 |
| Dec 2010 | -0.2 | –0.3 | 0.0 |
| Dec 2009 | -1.7 | ||
| Dec 2008 | 0.4 | ||
| Dec 2007 | 0.7 | ||
| Dec 2006 | 0.3 | ||
| Dec 2005 | -0.1 | ||
| Dec 2004 | 0.2 | ||
| Dec 2003 | -0.4 | ||
| Dec 2002 | -0.3 | ||
| Dec 2001 | -1.2 | ||
| Dec 2000 | -0.2 | ||
| Dec 1999 | -1.1 | ||
| Dec 1998 | 0.6 | ||
| Dec 1997 | 1.8 | ||
| Dec 1996 | 0.6 | ||
| Dec 1995 | -0.3 | ||
| Dec 1994 | 0.7 | ||
| Dec 1993 | 1.0 | ||
| Dec 1992 | 1.2 | ||
| Dec 1991 | 2.7 | ||
| Dec 1990 | 3.8 | ||
| Dec 1989 | 2.6 | ||
| Dec 1988 | 1.0 | ||
| Dec 1987 | 0.8 | ||
| Dec 1986 | -0.3 | ||
| Dec 1985 | 1.9 | ||
| Dec 1984 | 2.6 | ||
| Dec 1983 | 1.7 | ||
| Dec 1982 | 2.0 | ||
| Dec 1981 | 4.3 | ||
| Dec 1980 | 6.9 | ||
| Dec 1979 | 5.6 | ||
| Dec 1978 | 3.9 | ||
| Dec 1977 | 5.0 | ||
| Dec 1976 | 10.5 | ||
| Dec 1975 | 7.8 | ||
| Dec 1974 | 21.0 | ||
| Dec 1973 | 18.3 | ||
| Dec 1972 | 5.7 | ||
| Dec 1971 | 4.8 |
Source: http://www.stat.go.jp/english/data/cpi/1581.htm
Chart IV-1 provides the US consumer price index NSA from 1960 to 2012. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.
Chart IV-1, US, Consumer Price Index, All Items, NSA, 1960-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart IV-2 provides 12-month percentage changes of the US consumer price index from 1960 to 2012. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Table IV-5 provides similar inflation waves in the economy of Japan with 18.3 percent in 1973 and 21.0 percent in 1974. Inflation rates then stabilized in the US in a range with only two episodes above 5 percent.
Chart IV-2, US, Consumer Price Index, All Items, NSA, 12-Month Percentage Change 1960-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart IV-3 provides the US consumer price index excluding food and energy from 1960 to 2012. There is long-term inflation in the US without episodes of deflation.
IV-3, US, Consumer Price Index Excluding Food and Energy, NSA, 1960-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
Chart IV-4 provides 12-month percentage changes of the consumer price index excluding food and energy from 1960 to 2012. There are three waves of inflation in the 1970s during the Great Inflation. There is no episode of deflation.
Chart IV-4, US, Consumer Price Index Excluding Food and Energy, 12-Month Percentage Change, NSA, 1960-2012
Source: US Bureau of Labor Statistics
http://www.bls.gov/cpi/data.htm
More detail on the consumer price index of Japan in Apr is shown in Table IV-6. Inflation in the 12 months ending in Apr has been driven by items rich in commodities such as 4.7 percent in fuel, light and water charges with monthly increase of 0.6 percent in the month of Apr. There is similar behavior in the preliminary estimate for May for the Ku Area of Tokyo with increase of 0.2 percent of fuel, light and water charges and increase of 5.5 percent in 12 months but decline of 0.1 percent in Apr. There is inflation in all items in the consumer price index with flat prices in Apr in goods but increase of 0.8 percent in 12 months, which is still high for Japan. There is mild deflation in the CPI excluding food, alcoholic beverages and energy with minus 0.3 percent in the 12 months ending in Apr but increase of 0.2 percent in the month of Apr. The CPI excluding imputed rent increased 0.1 percent in Apr but only 0.6 percent in 12 months. The all-items CPI estimate for May of the Ku-Area of Tokyo remained stable fell 0.3 percent in May and fell 0.5 percent in 12 months.
Table IV-6, Japan, Consumer Price Index, ∆%
| 2012 | Apr 2012/Mar 2012 ∆% | Year ∆% |
| CPI All Items | 0.1 | 0.4 |
| CPI Excluding Fresh Food | 0.2 | 0.2 |
| CPI Excluding Food, Alcoholic Beverages and Energy | 0.2 | -0.3 |
| CPI Goods | 0.0 | 0.8 |
| CPI Services | 0.1 | 0.1 |
| CPI Excluding Imputed Rent | 0.1 | 0.6 |
| CPI Fuel, Light, Water Charges | 0.6 | 4.7 |
| CPI Transport Communications | 0.4 | 0.9 |
| CPI Ku-Area Tokyo All Items | -0.3 | -0.5 |
| Fuel, Light, Water Charges Ku Area Tokyo | -0.1 | 5.5 |
Note: Ku-area Tokyo CPI data preliminary for May 2012
Source: http://www.stat.go.jp/english/data/cpi/1581.htm
Consumer price inflation in the UK is shown in Table IV-7. The CPI index increased 0.6 percent in Apr after 0.3 percent in Mar and 0.6 percent in Feb Feb. The same inflation waves (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html) are present in UK CPI inflation. In the first wave in Jan-Apr 2011, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul, annual equivalent inflation fell to only 0.4 percent. In the third wave in Aug-Dec, annual equivalent inflation returned at 4.6 percent. In the fourth wave in Dec to Jan, annual equivalent inflation was minus 0.6 percent because of decline of 0.5 percent in Jan. In the fifth wave, annual equivalent inflation increased to 6.2 percent in Feb-Apr.
Table IV-7, UK, Consumer Price Index All Items, Month and 12-Month ∆%
| Month ∆% | 12 Months ∆% | |
| Apr 2012 | 0.6 | 3.0 |
| Mar | 0.3 | 3.5 |
| Feb | 0.6 | 3.4 |
| AE ∆% Feb-Apr | 6.2 | |
| Jan | -0.5 | 3.6 |
| Dec 2011 | 0.4 | 4.2 |
| AE ∆% Dec-Jan | -0.6 | |
| Nov | 0.2 | 4.8 |
| Oct | 0.1 | 5.0 |
| Sep | 0.6 | 5.2 |
| Aug | 0.6 | 4.5 |
| AE ∆% Aug-Dec | 4.6 | |
| Jul | 0.0 | 4.4 |
| Jun | -0.1 | 4.2 |
| May | 0.2 | 4.5 |
| May-Jul | 0.4 | |
| Apr | 1.0 | 4.5 |
| Mar | 0.3 | 4.0 |
| Feb | 0.7 | 4.4 |
| Jan | 0.1 | 4.0 |
| AE ∆% Jan-Apr | 6.5 | |
| Dec 2010 | 1.0 | 3.7 |
| Nov | 0.4 | 3.3 |
| Oct | 0.3 | 3.2 |
| Sep | 0.0 | 3.1 |
| Aug | 0.5 | 3.1 |
| Jul | -0.2 | 3.1 |
| Jun | 0.1 | 3.2 |
| May | 0.2 | 3.4 |
| Apr | 0.6 | 3.7 |
| Mar | 0.6 | 3.4 |
| Feb | 0.4 | 3.0 |
| Jan | -0.2 | 3.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2012/index.html
Inflation has been unusually high in the UK since 2006, as shown in Table IV-8. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010 and 4.5 percent in 2011.
Table IV-8, UK, Consumer Price Index, Annual ∆%
| 1997 | 1.8 |
| 1998 | 1.6 |
| 1999 | 1.3 |
| 2000 | 0.8 |
| 2001 | 1.2 |
| 2002 | 1.3 |
| 2003 | 1.4 |
| 2004 | 1.3 |
| 2005 | 2.1 |
| 2006 | 2.3 |
| 2007 | 2.3 |
| 2008 | 3.6 |
| 2009 | 2.2 |
| 2010 | 3.3 |
| 2011 | 4.5 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2012/index.html
Table IV-9 provides the analysis of inflation in Apr 2012 by the UK Office for National Statistics. The drivers of monthly inflation are 0.20 percentage points of transportation, 0.13 percentage points of housing and household services, 0.12 percentage points of alcohol and tobacco, 0.11 percentage points of restaurants and hotels and 0.06 percentage points of recreation and culture. Contributions of percentage points to the 12-month rate of consumer price inflation of 3.0 percent are provided by the final two columns in Table IV-11. Housing and household services rose 6.2 percent in 12 months, contributing 0.81 percentage points. Food and nonalcoholic beverages increased 4.3 percent, contributing 0.49 percentage points. Transportation rose 3.3 percent in 12 months, contributing 0.28 percentage points. Restaurant and hotels increased 3.3 percent, contributing 0.39 percentage points. There is only negative change of 0.5 percent in recreation and culture but with negligible impact on the index of deducting 0.07 percentage points.
Table IV-9, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components
| Apr 2012 | Month ∆% | Percentage Point Contribution | 12 Months ∆% | Percentage Point Contribution |
| CPI All Items | 0.6 | 3.0 | ||
| Food & Non-Alcoholic Beverages | -0.1 | -0.01 | 4.3 | 0.49 |
| Alcohol & Tobacco | 2.9 | 0.12 | 5.5 | 0.23 |
| Clothing & Footwear | 0.2 | 0.01 | 2.1 | 0.15 |
| Housing & Household Services | 0.9 | 0.13 | 6.2 | 0.81 |
| Furniture & Household Goods | -1.2 | -0.07 | 3.7 | 0.23 |
| Health | 1.1 | 0.03 | 3.1 | 0.08 |
| Transport | 1.2 | 0.20 | 1.7 | 0.28 |
| Communication | 0.4 | 0.01 | 4.2 | 0.11 |
| Recreation & Culture | 0.4 | 0.06 | -0.5 | -0.07 |
| Education | 0.0 | 0.00 | 5.1 | 0.09 |
| Restaurants & Hotels | 1.0 | 0.11 | 3.3 | 0.39 |
| Miscellaneous Goods & Services | 0.1 | 0.01 | 2.7 | 0.26 |
Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/april-2012/index.html
© Carlos M. Pelaez, 2010, 2011, 2012
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