Rules versus Discretionary Authorities in Monetary Policy, United States Trade, World Financial Turbulence and Economic Slowdown: Part I

 

Rules versus Discretionary Authorities in Monetary Policy, United States Trade, World Financial Turbulence and Economic Slowdown

Carlos M. Pelaez

© Carlos M. Pelaez, 2010, 2011, 2012

Executive Summary

I Rules versus Discretionary Authorities in Monetary Policy

IA Monetary Policy Rules

IA1 Origins of Rules versus Discretion

IA2 Monetary Policy Rules

IA3 The Taylor Rule

IB Unconventional Monetary Policy

II United States Trade

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

Executive Summary

ESI Rules versus Discretionary Authorities in Monetary Policy. Current distinction between rules and discretion in monetary policy is provided by Professor John B. Taylor (2012JMCB, 2). There are characteristics of both rules and discretion.

1. Characteristics of rules

· More predictable and systematic decisions by the central bank on policy instruments

· Dynamic analysis of effects of current decisions on future outcomes

· Decisions based or guided by formulas and equations

· Use of stable relation of policy instruments to outcomes such as inflation and growth

2. Characteristics of discretion

· Decisions on monetary policy instruments are “less predictable,” focusing on short-term events such as “fine tuning” or policy actions in response to ad hoc movements in economic and financial variables

· Little or no interest by policymakers in agreeing on alternative strategies for fixing magnitudes of instruments of policy

· Evolution of policy instruments over time cannot be captured by equations

Taylor (1993,1998LB, 1999, 2012JMCB) argues that economic performance has been enhanced during periods of long-term focus of monetary policy in the form of guidance under monetary policy rules. Periods of discretion such as the Great Inflation from the second half of the 1960s to the beginning of the 1980s (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 the past decade since 2003 have been characterized by instability and mediocre economic performance.

Table ESI-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 11 quarters of the current cyclical expansion from IIIQ2009 to IQ2012, GDP increased 6.7 percent at the annual equivalent rate of 2.4 percent; real disposable personal income (RDPI) increased 2.5 percent at the annual equivalent rate of 0.9 percent; RDPI per capita increased 0.3 percent at the annual equivalent rate of 0.1 percent; and population increased 2.1 percent at the annual equivalent rate of 0.8 percent. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing.

Table ESI-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1985	13
GDP		19.6	5.7
RDPI		14.5	4.3
RDPI Per Capita		11.5	3.4
Population		2.7	0.8
IIIQ2009 to IQ2012	11
GDP		6.7	2.4
RDPI		2.5	0.9
RDPI per Capita		0.3	0.1
Population		2.1	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

There are around 30 million people in the US unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). Real wages are falling. There is no exit from unemployment, underemployment and falling real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html). The euro is fighting for survival. Inflation has occurred in three waves in 2011 and now 2012 with higher inflation induced by carry trades from zero interest rates to commodity futures when there is subdued risk aversion. Inflation declines in periods of unwinding carry trades as a result of financial risk aversion originating in the sovereign debt crisis of Europe (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html). Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources.

ESII Bailout of Spanish Banks. The International Monetary Fund (IMF) provides the Financial Sector Assessment Program (FSAP) (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62; Globalization and the State, Vol. II (2008b) 114-25), which is a major tool of analysis of the financial sector of its members (http://www.imf.org/external/np/fsap/fssa.aspx):

“The Financial Sector Assessment Program (FSAP), established in 1999, is a comprehensive and in-depth assessment of a country’s financial sector. It is a key instrument of the Fund’s surveillance and provides input to the Article IV consultation. In jurisdictions with financial sectors deemed by the Fund to be systemically important, financial stability assessments under the FSAP are a mandatory part of Article IV surveillance, and are supposed to take place every five years; for all other jurisdictions, participation in the program is voluntary.”

IMF (2012FSAPJun8) provides the important FSAP for Spain. Current problems originated significantly in floods of money at very low interest rates. IMF (2012FSAPJun8, 10) informs that construction and real estate loans increased from 10 percent of GDP in 1992 to 43 percent in 2009 and declined to 37 percent of GDP in 2011. Discretionary monetary policy, as argued in I Rules versus Discretionary Authorities in Monetary Policy attempted to manage the rate of economic growth with near zero interest rates from Jun 2003 to Jun 2004 and then increased them by 25 basis points increments in all meetings of the Federal Open Market Committee (FOMC) until reaching 5.25 percent in Jun 2006. There was quantitative easing by the suspension of auctions of 30-year bonds to increase the demand and prices of long-dated mortgage backed securities (MBS), which was equivalent to lowering mortgage rates to induce home buying and construction. IMF (2012FSAPJun8, 10) explains the source of funding for excessive construction in Spain and subsequent collapse:

“Spanish banks funded their increasing exposures largely from external sources during the period of high global liquidity and low interest rates, rather than through the mobilization of savings. The freezing of wholesale markets and the onset of the euro-area debt crisis exposed Spain’s vulnerabilities from accumulated domestic and external imbalances.”

Spain’s economy has fallen back into recession with expected decline of GDP of 1.8 percent in 2012 while the rate of unemployment at 24 percent continues to increase (IMF 2012FAP Jun 8, 15). The IMF (2012FSAPJun8, 17) baseline or central growth scenario is recession in 2012 with moderate recovery in 2013. The outlook for the long-term could be more favorable with GDP growth moving to a path of 1.8 percent driven by exports supported by recent labor market reforms. The FSAP of the IMF conducted stress tests of 96 percent of the domestic banking sector of Spain in the horizon of 2012-13. In order to comply with Basel III capital requirements, Spanish banks would have to raise their “minimum core Tier I capital ratio from 3.5 percent in 2013 to 7 percent by the end of 2018,” complying “with a 7 percent core Tier 1 ratio would amount to an aggregate €37 billion” (IMF 2012FSAPJun8, 19). About 80 percent of these funds are required for smaller savings banks because there is no need for support of the two largest Spanish international banks, which are well capitalized and account for about one half of the consolidated banking assets of Spain.

Jonathan House, Matina Stevis and Gabrielle Steinhauser, writing on “Spain to request EU aid for banks,” on Jun 9, 2012, published in the Wall Street Journal ({Spain to request EU aid for banks WSJ 060912}), inform that the European Union will provide Spain with up to €100 billion, about $125 billion, to be used in supporting the capital needs of its banks. A safety margin has been added to guarantee the estimated capital requirements of Spanish banks.

The President of the European Commission Jose Manuel Barroso and Vice-President Oli Rhen released the following statement (http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/12/436&format=HTML&aged=0&language=EN&guiLanguage=en):

“We welcome today’s communication by Spain of its intention to request the support of the euro area for the restructuring of its financial sector, and the Eurogroup’s positive response to this. The Commission is ready to proceed swiftly with the necessary assessment on the ground, in close liaison with the ECB, EBA and the IMF, and to propose appropriate conditionality for the financial sector. With this thorough restructuring of the banking sector, together with the on-going determined implementation of structural reforms and fiscal consolidation, we are certain that Spain can gradually regain the confidence of investors and market participants and create the conditions for a return to sustainable growth and job creation.”

Christine Lagarde, Managing Director of the IMF, provided the following statement on Jun 9, 2012, on the decision by the Eurogroup to extend financial support to Spain (http://www.imf.org/external/np/sec/pr/2012/pr12215.htm):

“I strongly welcome the statement by the Eurogroup, which complements the measures taken by the Spanish authorities in recent weeks to strengthen the banking system. Providing a credible back stop to recapitalize weaker segments of the banking system has been a key recommendation of the IMF's recent Financial Sector Assessment Program (FSAP) conducted in Spain. The willingness of Spain’s Euro Area partners to financially support the Fund for Orderly Bank Restructuring (FROB) with up to EUR 100 billion is a crucial step for the success of the Spanish authorities’ strategy. This scale of proposed financing, which is consistent with the capital needs identified in the FSAP, gives assurance that the financing needs of Spain's banking system will be fully met.

“The IMF stands ready, at the invitation of the Eurogroup members, to support the implementation and monitoring of this financial assistance through regular reporting."

Charles Forelle and Gabrielle Steinhauser, writing on “Spain is banking on a limited bailout,” on Jun 10, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303768104577458562351966868.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the issue of whether the bailout of Spanish banks could be followed by sovereign bailout of Spain. The borrowing requirements of Spain in 2012 are €86 billion, of which the country has raised €48 billion, leaving €38 billion that must be raised in international debt markets. The bailout of banks implies difficult evaluation of available funding. The reaction of markets is difficult to anticipate. The yield of the ten-year government bond of Spain was 6.25 percent on Fri Jun 8, below the peak of 6.70 percent on May 30. After deep haircuts in the recent bailout of Greece, investors could be cautious in building debt assets in Spain. The lowest rates for a bailed out member of the euro zone are over 7 percent for eight-year government bonds of Ireland. Spain would require maintaining confidence and credibility in its adjustment program to continue accessing international debt markets.

ESIII 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. Increasing aversion is captured by decrease of the yield of the ten-year Treasury and the two- and ten-year government bonds of Germany. Table ESIII-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 of Germany 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 Aug 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 combination of multiple risks in the world economy and finance caused heightened risk aversion in the week of Jun 1, 2012, with the ten-year Treasury yield collapsing to 1.454, level experienced during the Treasury-Fed agreement of the 1940s, while the two-year government bond of Germany fell to 0.01 percent and even negative and 0.00 percent and the ten-year government bond of Germany collapsing to 1.17 percent. There was relaxation of risk aversion in the week of Jun 8 with increase of the yield of the ten-year Treasury to 1.635 percent and of the two-year government bond of Germany to 0.04 percent and the ten-year to 1.33 percent, which are still at levels of extreme flight from risk. 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, and further to USD 1.2435/EUR on Jun 1, 2012, or by 14.2 percent. The USD revalued by 0.7 percent to USD 1.2517 on Jun 8, 2012. 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 1.2517/EUR on Jun 8, 2012. Under zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates 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).

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 IV at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html) 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, 0.01 percent on Jun 1, 2012 and 0.04 percent on Jun 8, while the ten-year yield fell from 2.202 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012 and then to 1.454 percent on Jun 1, 2012 and 1.635 percent on Jun 8, as shown in Table ESIII-1. The lower part of Table ESIII-1 provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

Table ESIII-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
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
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
5/4/12	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
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

Source:

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

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

http://www.federalreserve.gov/releases/h15/data.htm

http://www.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

ESIV Decline in Productivity. Productivity jumped in the recovery after the recession from Mar IQ2001 to Nov IVQ2001 (http://www.nber.org/cycles.html). Table ESIV-1 provides quarter on quarter and annual percentage changes in nonfarm business output per hour, or productivity, from 1999 to 2012. The annual average jumped from 2.9 percent in 2001 to 4.6 percent in 2002. Nonfarm business productivity increased at the SAAE rate of 8.8 percent in the first quarter after the recession in IQ2002. Productivity increases decline later in the expansion period. Productivity increases were mediocre during the recession from Dec IVQ2007 to Jun IIQ2009 (http://www.nber.org/cycles.html) and increased during the first phase of expansion from IIQ2009 to IQ2010, trended lower and collapsed in 2011 and 2012.

Table ESIV-1, US, Nonfarm Business Output per Hour, Percent Change from Prior Quarter at Annual Rate, 1999-2012

Year	Qtr1	Qtr2	Qtr3	Qtr4	Annual
1999	3.9	0.3	3.3	7.1	3.3
2000	-1.5	9.4	0.1	4.0	3.4
2001	-1.3	7.4	2.5	5.8	2.9
2002	8.8	0.5	3.8	-0.2	4.6
2003	3.7	5.5	9.5	1.5	3.7
2004	0.6	3.3	0.7	0.5	2.6
2005	4.2	-0.8	3.1	-0.2	1.6
2006	2.5	0.4	-2.2	2.7	0.9
2007	-0.2	3.4	4.8	1.9	1.5
2008	-2.6	2.4	-0.8	-3.4	0.6
2009	1.3	8.3	6.4	5.3	2.3
2010	4.5	1.2	1.8	1.8	4.0
2011	-1.0	-0.3	1.8	1.2	0.4
2012	-0.9

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart ESIV-1 of the Bureau of Labor Statistics (BLS) provides SAAE rates of nonfarm business productivity from 1999 to 2012. There is a clear pattern in both episodes of economic cycles in 2001 and 2007 of rapid expansion of productivity in the transition from contraction to expansion followed by more subdued productivity expansion. Part of the explanation is the reduction in labor utilization resulting from adjustment of business to the sudden shock of collapse of sales. Productivity rose briefly in the expansion after 2009 but then collapsed and moved to negative change.

Chart ESIV-1, US, Nonfarm Business Output per Hour, Percent Change from Prior Quarter at Annual Rate, 1999-2012

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

ESV Decline in Real Hourly Compensation. Table ESV-1 provides percentage change from prior quarter at annual rates for nonfarm business real hourly worker compensation. The expansion after the contraction of 2001 was followed by strong recovery of real hourly compensation. Real hourly compensation increased at the rate of 0.5 percent in IQ2011 but fell at annual rates of 4.7 percent in IIQ2011, 1.6 percent in IVQ2011 and at 2.0 percent in IQ2012. In 2011, real hourly compensation fell 0.9 percent.

Table ESV-1, Nonfarm Business Real Hourly Compensation, Percent Change from Prior Quarter at Annual Rate 1999-2012

Year	Qtr1	Qtr2	Qtr3	Qtr4	Annual
1999	5.4	-2.0	0.2	5.6	2.2
2000	11.4	-1.8	4.7	-0.4	4.0
2001	5.4	-1.5	0.2	4.5	1.6
2002	2.8	0.6	0.0	-0.6	1.5
2003	2.4	7.7	2.5	1.8	2.4
2004	-5.2	2.6	3.7	-1.1	0.6
2005	1.3	-0.1	-0.3	-1.3	0.6
2006	3.1	-1.8	-2.6	11.6	0.5
2007	-0.2	-3.0	0.3	1.3	1.1
2008	1.4	-6.1	-2.8	12.2	-0.4
2009	-0.3	5.2	-1.4	-2.0	2.1
2010	0.4	3.0	0.2	-2.8	0.3
2011	0.5	-4.7	2.5	-1.6	-0.9
2012	-2.0

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

Chart ESV-1 provides percentage change from prior quarter at annual rate of nonfarm business real hourly compensation from 1999 to 2012. There are significant fluctuations in quarterly percentage changes oscillating between positive and negative. There is no clear pattern in the two contractions in the 2000s.

Chart ESV-1, US, Nonfarm Business Real Hourly Compensation, Percent Change from Prior Quarter at Annual Rate 2001-2011

Source: US Bureau of Labor Statistics

http://www.bls.gov/lpc/home.htm

ESVI 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 ESVI-1 provides the CNY/USD rate from Oct 28, 2011 to Jun 8, 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. After depreciation of 0.5 percent in the week of Jun 1 and 0.1 percent in the week of Jun 8, the CNY has depreciated 0.3 percent to Jun 8, 2012 relative to Oct 28, 2011, as shown in Table ESVI-1.

Table ESVI-1, Renminbi Yuan US Dollar Rate

	CNY/USD	∆% from 10/28/2011
6/8/2012	6.3752	-0.3
6/1/2012	6.3708	-0.2
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

ESVII Global Economic Slowdown. Table ESVII-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 1.2 percent in IQ2012 and 2.8 percent relative to a year earlier but part of the jump could be the low level a year earlier because of 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 fell 0.1 percent 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 0.5 percent in IQ2012 and 2.0 percent relative to a year earlier (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html) but with substantial underemployment and underemployment (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html) and weak hiring (http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html).

Table ESVII-1, Percentage Changes of GDP Quarter on Prior Quarter and on Same Quarter Year Earlier, ∆%

	IQ2012/IVQ2011	IQ2012/IQ2011
United States	0.5	2.0
Japan	1.2	2.8
China	1.8	8.1
Euro Area	0.0	-0.1
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

ESVIII 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 28.4 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 VI-1 in the text 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 ESVIII-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 6/8/12,” 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 and exploded in the week of Jun 1. Expectations of stimulus by central banks caused valuation of risk financial assets in the week of Jun 8. The highest valuations in column “∆% Trough to 6/8/12” are by US equities indexes: DJIA 29.6 percent and S&P 500 29.6 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 6/8/12” 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 4.3 percent below the trough; STOXX 50 of Europe is 0.7 percent below the trough; Japan’s Nikkei Average is 4.1 percent below the trough; DJ Asia Pacific TSM is 0.4 percent below the trough; Dow Global is 3.3 percent above the trough; and NYSE Financial is 0.6 percent above the trough. DJ UBS Commodities is 3.9 percent above the trough. DAX is 8.1 percent above the trough. Japan’s Nikkei Average is 4.1 percent below the trough on Aug 31, 2010 and 25.8 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 8459.26 on Fri Jun 8, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 17.5 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 6/8/12” in Table ESVIII-1 shows that there were increases of several valuations of risk financial assets in the week of Jun 8, 2012 such as 0.1 percent for DJ Asia Pacific, 0.2 percent for Nikkei Average, 2.6 percent for STOXX 50 and 1.6 percent for DJ UBS Commodities. Other valuations also increased such as 3.6 percent for DJIA, 3.7 percent for S&P 500, 4.9 percent for NYSE Financial, 3.0 percent for Dow Global and 1.3 percent for Dax. The only decline is 3.9 percent for the Shanghai Composite. 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 ESVIII-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 6/8/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Jun 8, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 6/8/12” but also relative to the peak in column “∆% Peak to 6/8/12.” There are now only two equity indexes above the peak in Table ESVIII-1: DJIA 12.0 percent and S&P 500 8.9 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 19.8 percent, Nikkei Average by 25.8 percent, Shanghai Composite by 27.9 percent, DJ Asia Pacific by 12.8 percent, STOXX 50 by 15.9 percent, Dax by 3.2 percent and Dow Global by 15.7 percent. DJ UBS Commodities Index is now 11.2 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 ESVIII-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury  

	Peak	Trough	∆% to Trough	∆% Peak to 6/8 /12	∆% Week 6/8/ 12	∆% Trough to 6/8 12
DJIA	4/26/ 10	7/2/10	-13.6	12.0	3.6	29.6
S&P 500	4/23/ 10	7/20/ 10	-16.0	8.9	3.7	29.6
NYSE Finance	4/15/ 10	7/2/10	-20.3	-19.8	4.9	0.6
Dow Global	4/15/ 10	7/2/10	-18.4	-15.7	3.0	3.3
Asia Pacific	4/15/ 10	7/2/10	-12.5	-12.8	0.1	-0.4
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-25.8	0.2	-4.1
China Shang.	4/15/ 10	7/02 /10	-24.7	-27.9	-3.9	-4.3
STOXX 50	4/15/10	7/2/10	-15.3	-15.9	2.6	-0.7
DAX	4/26/ 10	5/25/ 10	-10.5	-3.2	1.3	8.1
Dollar Euro	11/25 2009	6/7 2010	21.2	17.3	-0.7	-5.0
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-11.2	1.6	3.9
10-Year T Note	4/5/ 10	4/6/10	3.986	1.635

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

I Rules versus Discretionary Authorities in Monetary Policy. The objective of this section is to place the alternatives of monetary policy into two perspectives of (1) emphasis on long-term policy in contrast with (2) current emphasis on short-term impulses of unusual magnitude to respond immediately to deviations perceived with significant lags and measurement errors because of the deficiencies of the state of the art. IA Monetary Policy Rules considers the use of long-term rules or guidance for optimization of policy over many periods in contrast with discretion or immediate optimization of every perceived deviation from desired paths by policymakers. Section IB Unconventional Monetary Policy raises the issue if excessive short-term impulses cause instability instead of the prime objective of monetary policy of fostering stability together with adverse effects on resource allocation that prevent an efficient dynamic path of the economy at the time when real disposable income per capita, or what is left per person after taxes and inflation, has stagnated.

IA Monetary Policy Rules. The discussion of monetary policy rules is divided into three subsections: IA1 Origins of Rules versus Discretion, IA2 Monetary Policy Rules and IA3 The Taylor Rule.

IA1 Origins of Rules versus Discretion. A classic proposal for rules instead of “authorities” in monetary policy is by Simons (1936, 29-30):

“A democratic, free-enterprise system implies, and requires for its effective functioning and survival, a stable framework of definite rules, laid down in legislation and subject to change only gradually and with careful regard for the vested interests of participants in the economic game. It is peculiarly essential economically that there should be a minimum of uncertainty for enterprisers and investors as to monetary conditions in the future and, politically, that the plausible expedient of setting up "authorities" instead of rules, with respect to matters of such fundamental importance, be avoided, or accepted only as a very temporary arrangement. The most important objective of a sound liberal policy, apart from the establishment of highly competitive conditions in industry and the narrow limitation of political control over relative prices, should be that of securing a monetary system governed by definite rule. The responsibility for carrying out the monetary rules should be lodged in a federal authority, endowed with large administrative powers but closely controlled in their exercise by a sharply defined policy. The powers of the monetary authority should have to do primarily or exclusively with fiscal arrangements with the issue and retirement of paper money (open-market operations in government securities) and perhaps with the relation between government revenues and expenditures; in other words, the monetary rules should be implemented entirely by, and in turn should largely determine, fiscal policy. A monetary rule of maintaining the constancy of some price-index, preferably an index of prices of competitively produced commodities, appears to afford the only promising escape from present monetary chaos and uncertainties.”

The working system of Simons (1936, 1948) consisted of 100 percent reserve requirements on banks (see Allen 1993, Fisher 1936, Graham 1936) to avoid fluctuations from bank runs and fixed quantity of money. Friedman (1967) finds that the monetary reforms proposed by Simons (1948) were not required and moving against desired directions by restricting financial intermediation that would raise costs of capital, inhibiting capital formation. The value in the proposals of Simons (1948) as viewed by Friedman (1967) would be in providing more flexibility for banks that were restricted in the 1960s by regulation inherited from the Great Depression. There are contemporary proposals that resemble the 100 percent reserve requirement in what is known as “narrow banking” (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 71-72).

Historical evolution of monetary policy rules is analyzed by Asso, Khan and Leeson (2007, 2010). In the United States, Irving Fisher and Milton Friedman proposed price and monetary rules (see Bordo and Rockoff 2011). An important departure for considering rules is the existence of three lags of macroeconomic policy (Friedman 1953):

1. The lag between the need for action and the recognition of the need

2. The lag between recognition of the need and taking action

3. The lag between taking action and effects on prices and income

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.

Friedman (1968) restated his proposal for fixed setting of monetary policy in terms of a fixed rate of increase of the money stock:

“My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only. But it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced. Short of the adoption of such a publicly stated policy of a steady rate of monetary growth, it would constitute a major improvement if the monetary authority followed the self-denying ordinance of avoiding wide swings. It is a matter of record that periods of relative stability in the rate of monetary growth have also been periods of relative stability in economic activity, both in the United States and other countries. Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity.”

This was Friedman’s presidential address to the American Economic Association at the onset of wide swings in monetary policy, output and employment in the period of United States economic history known as “the Great Inflation.”

There are three “tactics” in monetary policy identified by Friedman (1982, 100-1):

1. Interest rates as both targets and instruments

2. Monetary targets as instruments and interest rates as targets

3. Base money as instrument and monetary aggregates as targets

The specific policy proposal of Friedman (1982, 101) consists of five ingredients:

“A monetarist policy has five points: first, the target should be growth in some monetary aggregate just which monetary aggregate is a separate question; second, monetary authorities should adopt long-run targets for monetary growth that are consistent with no inflation; third, present rates of growth of monetary aggregates should be modified to achieve the long-run target in a gradual, systematic, and preannounced fashion; fourth, monetary authorities should avoid fine-tuning; fifth, monetary authorities should avoid trying to manipulate either interest rates or exchange rates. Internationally, those countries that have broadly followed the five-point monetarist policy have succeeded in controlling inflation and have done so while achieving relatively satisfactory economic growth.”

The fourth of eight specific proposals for Fed monetary policy at the time states (Friedman, 1982, 117): “set a target path for several years ahead for a single aggregate—for example, M2 or the base. It is less important which aggregate is chosen than that a single aggregate be designated as the target.”

IA2 Monetary Policy Rules. The essence of rules versus discretion monetary policy is posed by McCallum (1999) as follows:

1. Rules attempt to optimize by using a policy-contingent rule or formula that is implemented every period and is designed such as to apply indefinitely

2. Discretion consist of re-optimization in every period in accordance with existing conditions assessed by monetary authorities

A rules-based policy optimizes over a long-term period while discretionary policy optimizes individually in every period in accordance with short-term information. A practical definition of monetary policy rule by McCallum (1999) is systematic policy that does not use expectations to cause temporary gains in output.

McCallum (1999) finds that Barro and Gordon (1983b) opened the inclusion of activist policy within a monetary policy rule. The rule provides a reaction function of the central bank that depends on available information. Barro and Gordon (1983b, 606) differentiate as follows: “the presence or absence of precomitment is the most important distinction between rules and discretion.” The reaction function of the central bank h(I_t-1) depends on information available in the past period, I_t-1, that would be more restrictive under rules-based policy than under discretion, would include many more variables in the argument. As McCallum (1999) argues a rule could specify the conditions for activism instead of fixed settings for policy. For example, constant rate of growth of the money stock would be a fixed setting that the central bank would implement indefinitely. A policy in which the interest rate depends on inflation and the divergence of actual and potential output would be activist but under certain guidance.

Current distinction between rules and discretion is provided by Taylor (2012JMCB, 2). There are characteristics of both rules and discretion.

3. Characteristics of rules

· More predictable and systematic decisions by the central bank on policy instruments

· Dynamic analysis of effects of current decisions on future outcomes

· Decisions based or guided by formulas and equations

· Use of stable relation of policy instruments to outcomes such as inflation and growth

4. Characteristics of discretion

· Decisions on monetary policy instruments are “less predictable,” focusing on short-term events such as “fine tuning” or policy actions in response to ad hoc movements in economic and financial variables

· Little or no interest by policymakers in agreeing on alternative strategies for fixing magnitudes of instruments of policy

· Evolution of policy instruments over time cannot be captured by equations

IA3 The Taylor Rule. The definition of policy rule by Taylor (1993, 199) is: “Technically, a policy rule is a contingency plan that lasts forever unless there is an explicit cancellation clause.” “Forever” means here “a reasonably long period of time” (Taylor 1993, 1999). The departing theory of Taylor (1993, 1999) is the quantity theory of money equation:

MV = PY (1)

Where M is the money stock V is income velocity of money, P the price level and Y real output. Velocity depends on the interest rate r and real output or income Y with functional form V(r, Y). The substitution of V(r, Y) in equation (1) yields a relation between the interest rate, r, the price level, P, and real output Y. Taylor (1999) assumes a linear relation of interest rates and the logarithms of the price level P and real output Y. Assuming no lags, deviation of output from stochastic trend and the inflation rate as the first difference of the logarithms of the price level, Taylor (1999) obtains:

r = π + gy + h(π – π*) + r^r = (r^f – hπ*) + (1 + h)π + gy (2)

Where r is the short-term interest rate, π the inflation rate or percent change in the price level P, y the percentage difference of real output Y from trend and g, h, π* and r^f are constants. The settings of monetary policy are the response coefficients g of the deviation of actual output from potential output and (1+h), the response to inflation.

Taylor (1993, 202) provides the simple formula, known as the Taylor Rule, as follows:

r = p + .5y + .5(p-2) + 2 (3)

Where r is the federal funds rate or policy rate of the Fed, p is the rate of inflation in the past four quarters and y is the percentage deviation of actual output from potential output. The fed funds rate increases if the gap between actual and potential output y increases to prevent lower growth below potential and resulting unemployment; and increases if inflation p increases above maximum tolerable inflation of 2 percent. Thus, the policy is guidance on fixing the fed funds rate in response to growth and inflation. Taylor (1993, 202) states: “if both the inflation rate and real GDP are on target, then the federal funds rate would equal 4 percent, or 2 percent in real terms.” If real economic growth is around trend, y is zero, and inflation is around the maximum desired of 2 percent, (p-2) is zero, such that the fed funds rate r is equal to 4 or 2 percent by deducting inflation of 2 percent.

IB Unconventional Monetary Policy. Taylor (1998LB, 1999, 2012JMCB) argues that economic performance has been enhanced during periods of long-term focus of monetary policy in the form of guidance under monetary policy rules. Periods of discretion such as the Great Inflation from the second half of the 1960s to the beginning of the 1980s and the past decade since 2003 have been characterized by instability and mediocre economic performance.

The objective of Levin and Taylor (2009) is to reveal the primary cause of the persistence of inflation drift during the Great Inflation by focusing on the path of inflationary expectations to model monetary policy from 1965 to 1980. They derive three stylized facts by use of measurements of inflation expectations. (1) Inflation began in the mid 1960 while it had been contained since the late 1950s at around 1 percent but inflation expectations accelerate beginning in 1965. (2) Long-term inflation expectations stabilized at a high level in the first half of the 1970s but catapulted toward the end of the decade. (3) Long-run inflation expectations only began to decline at the end of 1980. The central bank reaction function analyzed by Taylor (1993, 202, equation (1)) on the basis of prior research is:

r = p +0.5y + 0.5(p-2) + 2 (3)

In equation (3), the federal funds rate, r, is expressed in terms of the rate of inflation over the previous four quarters, the percentage output gap, y, defined as 100(Y-Y*)/Y*, where Y is actual GDP, Y* is trend real GDP (2.2 percent from IQ1984 to IIIQ1992), and the deviation of inflation from the target of 2 percent, 0.5(p-2). The Taylor policy rule in equation (3) triggers an increase in the fed funds rate when inflation exceeds 2 percent or when GDP exceeds trend GDP. If GDP is equal to target, y = 0, and inflation is also equal to target, p = 2, then the real rate of interest as measured by prior inflation, r-p, equal 2 percent. The fed funds rate calculated with this simple policy rule fits remarkably well the actual fed funds rate in 1987-1992 (Taylor 1993, 204, Figure 1).

The simple rule is restated by Levin and Taylor (2010, 16, equation (1)) to account for discrete shifts in the intercept:

r_t = ­r’ + γ_π(π_t – π*) + γ_y(y_t – y*_t) (5)

Equation (5) expresses the short-term real interest rate, r_t, in terms of an effect, γ_π(π_t – π*), of the difference between actual inflation, π_t, and the central’s bank objective for inflation, π*, and an effect, γ_y(y_t – y*_t), of the deviation of actual output, y_t, from trend or steady-state output, y*_t, and r’ stands for the steady-state value of the real rate of interest.

Equation (5) is shown by Levy and Taylor (2009) to provide a good fit of experience during the Great Inflation by allowing for shifts in the central bank’s inflation objective π*. Monetary policy during the Great Inflation can be interpreted by three stop-start events occurring in 1968-70, 1974-76 and 1979-80. Levy and Taylor (2009) conclude that in all three “stop and go” episodes monetary policy “fell behind the curve,” permitting rising inflation before belated tightening and abandoning tightening because of the contraction before inflation was reduced to the level before the event. Lags in effect of monetary policy have been amply discussed in the literature and may have proved important in falling behind the curve (see Culbertson 1960, Friedman 1961, Culbertson 1961, Batini and Nelson 2002 and Romer and Romer 2004).

Detailed discussion of the analysis of the Great Inflation is provided in past 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). Unconventional monetary policy played a major role in the financial crisis and global recession as discussed in the balance of this section.

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.”

Table I-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 11 quarters of the current cyclical expansion from IIIQ2009 to IQ2012, GDP increased 6.7 percent at the annual equivalent rate of 2.4 percent; real disposable personal income (RDPI) increased 2.5 percent at the annual equivalent rate of 0.9 percent; RDPI per capita increased 0.3 percent at the annual equivalent rate of 0.1 percent; and population increased 2.1 percent at the annual equivalent rate of 0.8 percent. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing.

Table II-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1985	13
GDP		19.6	5.7
RDPI		14.5	4.3
RDPI Per Capita		11.5	3.4
Population		2.7	0.8
IIIQ2009 to IQ2012	11
GDP		6.7	2.4
RDPI		2.5	0.9
RDPI per Capita		0.3	0.1
Population		2.1	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

There are around 30 million people in the US unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html). Real wages are falling. There is no exit from unemployment, underemployment and falling real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-hiring-ten-million.html). The euro is fighting for survival. Inflation has occurred in three waves in 2011 and now 2012 with higher inflation induced by carry trades from zero interest rates to commodity futures when there is subdued risk aversion. Inflation declines in periods of unwinding carry trades as a result of financial risk aversion originating in the sovereign debt crisis of Europe (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html). Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources.

II United States International Trade. The United States Census Bureau has released revisions of trade statistics from Jan 2009 to Mar 2012 (http://www.census.gov/foreign-trade/Press-Release/2011pr/final_revisions/). Table II-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted. The US trade balance improved from deficit of $52,617 million in Mar 2012 to deficit of $50,062 billion in Apr 2012 with growth of exports of minus 0.8 percent better than growth of imports of minus 1.7 percent. The deterioration of the trade deficit from $45,433 million in Feb to $52,617 million in Mar resulted from growth of exports of 2.5 percent while imports jumped 5.2 percent. The US trade balance had improved from deficit of $52,947 million in Jan 2012 to lower deficit of $45,433 million in Feb 2012 mostly because of decline of imports by 2.6 percent while exports increased only 0.8 percent. The US trade balance deteriorated sharply from Nov 2011 to Jan 2012 with growth of imports by cumulative 3.2 percent and cumulative decline of exports of 0.1 percent, resulting in deficits of $48,835 million in Nov, $51,748 million in Dec and $52,947 million in Jan, which are the highest since $50,234 million in Jun 2011. In the months of Jun to Oct, exports increased 1.8 percent while imports increased 0.5 percent, resulting in improvement of the trade deficit from $50,234 million in Jun to $45,703 million in Oct. The trade balance deteriorated from cumulative deficit of $493,737 million in Jan-Dec 2010 to deficit of $559,880 million in Jan-Dec 2011.

Table II-1, US, Trade Balance of Goods and Services Seasonally Adjusted Millions of Dollars and ∆%  

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Apr 2012	-50,062	182,910	-0.8	232,972	-1.7
Mar	-52,617	184,443	2.5	237,061	5.2
Feb	-45,433	179,969	0.8	225,402	-2.6
Jan	-52,947	178,509	0.4	231,455	0.9
Dec 2011	-51,748	177,751	0.6	229,499	1.8
Nov	-48,835	176,710	-1.1	225,545	0.5
Oct	-45,703	178,742	-1.0	224,445	-0.3
Sep	-44,467	180,629	1.3	225,096	0.9
Aug	-44,775	178,382	0.0	223,157	-0.3
Jul	-45,580	178,339	3.3	223,919	0.4
Jun	-50,234	172,664	-1.7	222,988	-0.2
May	-47,669	175,673	0.0	223,343	1.9
Apr	-43,556	175,662	0.9	219,218	0.1
Mar	-44,902	174,169	4.6	219,071	3.7
Feb	-44,801	166,545	-0.9	211,346	-2.0
Jan	-47,523	168,098	1.6	215,621	4.6
Dec 2010	-40,677	165,499	1.7	206,176	2.2
Jan-Dec 2011	-559,880	2,103,367		2,663,247
Jan-Dec 2010	-494,737	1,842,485		2,337,222

Note: Trade Balance of Goods and Services = Exports of Goods and Services less Imports of Goods and Services. Trade balance may not add exactly because of errors of rounding and seasonality.

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

Table II-2 provides the US international trade balance, exports and imports on an annual basis from 1992 to 2011. The trade balance deteriorated sharply over the long term. The current account deficit of the US declined from $123.4 billion in IIQ2010, or 3.3 percent of GDP to $107.6 billion in IIIQ2011, or 2.8 percent of GDP, but increased to $124.1 billion in IVQ2011, or 3.2 percent of GDP. In IVQ2010, the deficit reached $112.2 billion or 3.3 percent of GDP (for the balance of payments in IVQ2011 see http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html). The balance of international transactions or balance of payments of the US for IQ2012 will be released on Jun 14, 2012 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm).

In IVQ2010, “the deficit decreased to 3.0 percent of current-dollar GDP from 3.4 percent, the first decrease after five straight quarterly increases” (http://www.bea.gov/scb/pdf/2011/04%20April/0411_itaq-text.pdf 1). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The current account deficit reached 6.1 percent of GDP in 2006. The external imbalance of the US measured by the current account deficit must be financed with foreign borrowings. The US borrows heavily from other countries. China is the largest holder of US Treasury securities with $1169.9 billion in Mar 2012, increasing 2.2 percent from $1144.9 billion in Mar 2011. Japan increased its holdings from $908.1 billion in Mar 2011 to $1083.0 billion in Mar 2012. Oil exporters increased their holdings from $222.5 billion in Mar 2011 to $254.5 billion in Mar 2012. Total foreign holdings of Treasury securities rose from $4477.6 billion in Mar 2011 to $5117.6 billion in Mar 2012, or 14.3 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Table VA-13 at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy_20.html).

Table II-2, US, International Trade Balance, Exports and Imports SA, Millions of Dollars

Period	Balance	Exports	Imports
Total
Annual
1992	-39,212	616,882	656,094
1993	-70,311	642,863	713,174
1994	-98,493	703,254	801,747
1995	-96,384	794,387	890,771
1996	-104,065	851,602	955,667
1997	-108,273	934,453	1,042,726
1998	-166,140	933,174	1,099,314
1999	-263,160	967,008	1,230,168
2000	-376,749	1,072,783	1,449,532
2001	-361,771	1,007,726	1,369,496
2002	-417,432	980,879	1,398,311
2003	-490,984	1,023,519	1,514,503
2004	-605,357	1,163,146	1,768,502
2005	-708,624	1,287,441	1,996,065
2006	-753,288	1,459,823	2,213,111
2007	-696,728	1,654,561	2,351,289
2008	-698,338	1,842,682	2,541,020
2009	-379,154	1,578,945	1,958,099
2010	-494,737	1,842,485	2,337,222
2011	-559,880	2,103,367	2,663,247

Source: http://www.census.gov/foreign-trade/

Chart II-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. There was slight improvement at the margin from Jul to Oct 2011 but new increase in the gap from Nov to Jan and again in Mar as exports grow less rapidly than imports. There is improvement in Apr with imports declining at a faster rate of 1.7 percent than decline of exports by 0.8 percent. Weaker world and internal demand and fluctuating commodity price increases explain the declining or less dynamic changes in exports and imports in Chart II-1.

Chart II-1, US Balance, Exports and Imports of Goods and Services $ Billions

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr042.html

The balance of international trade in goods of the US seasonally-adjusted is shown in Table II-3. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The balance in international trade of goods deteriorated from $58.6 billion in Apr 2011 to $64.8 billion in Apr 2012. Deterioration of the goods balance in Apr 2012 relative to Apr 2011 occurred mostly in the non petroleum balance, exports less imports of goods other than petroleum, while there was very mild deterioration in the sizeable petroleum balance, exports less imports of petroleum goods. Exports rose 4.0 percent with non-petroleum exports growing 3.5 percent. Total imports rose 6.2 percent with petroleum imports increasing 5.6 percent and non-petroleum imports increasing 9.9 percent.

Table II-3, US, International Trade in Goods Balance, Exports and Imports $ Millions and ∆% SA

	Apr 2012	Apr 2011	∆%
Total Balance	-64,838	-58,557
Petroleum	-27,989	-26,753
Non Petroleum	-36,527	-30,985
Total Exports	130,668	125,586	4.0
Petroleum	10,510	9,701	8.3
Non Petroleum	118,504	114,446	3.5
Total Imports	195,507	184,143	6.2
Petroleum	38,499	36,454	5.6
Non Petroleum	159,162	144,869	9.9

Details may not add because of rounding and seasonal adjustment

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

US exports and imports of goods not seasonally adjusted in Jan-Apr 2012 and Jan-Apr 2011 are shown in Table II-4. The rate of growth of exports was 7.0 percent and 7.9 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that fell 6.8 percent and of mineral fuels that increased 14.9 percent both because of higher prices of raw materials and commodities that are falling again currently because of shocks of risk aversion. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose 8.2 percent while imports rose 8.5 percent. Significant part of the US trade imbalance originates in imports of mineral fuels growing by 5.6 percent and crude oil increasing 9.8 percent. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates.

Table II-4, US, Exports and Imports of Goods, Not Seasonally Adjusted Millions of Dollars and %

	Jan-Apr 2012 $ Millions	Jan-Apr 2011 $ Millions	∆%
Exports	509,016	475,513	7.0
Manufactured	336,590	311,093	8.2
Agricultural Commodities	45,972	49,343	-6.8
Mineral Fuels	44,339	38,584	14.9
Crude Oil	531	432	22.9
Imports	741,751	687,630	7.9
Manufactured	543,841	501,380	8.5
Agricultural Commodities	35,696	32,723	9.1
Mineral Fuels	148,520	140,638	5.6
Crude Oil	111,597	101,617	9.8

Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf

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 Jun 1 and daily values throughout the week ending on Fri Jun 8 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 Jun 1 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jun 1, 2012”, first row “USD/EUR 1.2435 0.7%,” provides the information that the US dollar (USD) appreciated 0.7 percent to USD 1.2435/EUR in the week ending on Fri Jun 1 relative to the exchange rate on Fri May 25. 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 1.2435/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jun 1, depreciating to USD 1.2493/EUR on Mon Jun 4, or by 0.5 percent. The dollar depreciated because more dollars, $1.2493, were required on Mon Jun 4 to buy one euro than $1.2435 on Jun 1. 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 1.2493/EUR on Jun 4; 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 Jun 1, to the last business day of the current week, in this case Fri Jun 8, such as depreciation by 0.7 percent to USD 1.2517/EUR by Jun 8; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.7 percent from the rate of USD 1.2435/EUR on Fri Jun 1 to the rate of USD 1.2517/EUR on Fri Jun 8 {[(1.2517/1.2435) – 1]100 = 0.7%} and appreciated (denoted by positive sign) by 0.3 percent from the rate of USD 1.2560 on Thu Jun 7 to USD 1.2517/EUR on Fri Jun 8 {[(1.2517/1.2560) -1]100 = -0.3%}. 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 Jun 4 to Jun 8, 2012

Fri Jun 1, 2012	M 4	Tue 5	W 6	Thu 7	Fr 8
USD/EUR 1.2435 0.7%	1.2493 -0.5% -0.5%	1.2448 -0.1% 0.4%	1.2577 -1.1% -1.0%	1.2560 -1.0% 0.1%	1.2517 -0.7% 0.3%
JPY/  USD 77.99 2.1%	78.38 -0.5% -0.5%	78.78 -1.0% -0.5%	79.25 -1.6% -0.6%	79.62 -2.1% -0.5%	79.48 -1.9% 0.2%
CHF/  USD 0.9661 -0.7%	0.9613 0.5% 0.5%	0.9648 0.1% -0.4%	0.9547 1.2% 1.0%	0.9562 1.0% -0.2%	0.9596 0.7% -0.3%
CHF/ EUR 1.2012 0.0%	1.2010 0.0% 0.0%	1.2010 0.0% 0.0%	1.2007 0.0% 0.0%	1.2010 0.0% 0.0%	1.2012 0.0% 0.0%
USD/  AUD 0.9697 1.0313 -0.6%	0.9726 1.0282 0.3% 0.3%	0.9743 1.0264 0.5% 0.2%	0.9929 1.0072 2.3% 1.9%	0.9894 1.0107 2.0% -0.3%	0.9916 1.0085 2.2% 0.2%
10 Year  T Note 1.454	1.52	1.57	1.66	1.64	1.635
2 Year     T Note 0.248	0.25	0.25	0.26	0.27	0.268
German Bond 2Y 0.01 10Y 1.17	2Y 0.01 10Y 1.21	2Y 0.01 10Y 1.21	2Y 0.07 10Y 1.33	2Y 0.07 10Y 1.37	2Y 0.04 10Y 1.33
DJIA 12118.57 -2.7%	12101.46 -0.1% -0.1%	12127.95 0.1% 0.2%	12414.79 2.4% 2.4%	12460.96 2.8% 0.4%	12554.20 3.6% 0.8%
DJ Global 1708.51 -2.9%	1704.93 -0.2% -0.2%	1714.39 0.3% 0.6%	1752.10 2.6% 2.2%	1764.17 3.3% 0.7%	1759.55 3.0% -0.3%
DJ Asia Pacific 1139.47 -0.3%	1116.21 -2.0% -2.0%	1128.23 -1.0% 1.1%	1142.73 0.3% 1.3%	1156.41 1.5% 1.2%	1140.59 0.1% -1.4%
Nikkei 8440.25 -1.6%	8295.63 -1.7% -1.7%	8382.00 -0.7% 1.0%	8533.53 1.1% 1.8%	8639.72 2.4% 1.2%	8459.26 0.2% -2.1%
Shanghai 2373.44 1.7%	2308.55 -2.7% -2.7%	2311.92 -2.6% 0.1%	2309.55 -2.7% -0.1%	2293.13 -3.4% -0.7%	2281.45 -3.9% -0.5%
DAX 6050.29 -4.6%	5978.23 -1.2% -1.2%	5969.40 -1.4% -0.2%	6093.99 0.7% 2.1%	6144.22 1.6% 0.8%	6130.82 1.3% -0.2%
DJ UBS Comm. 126.81 -4.4%	127.55 0.6% 0.6%	127.67 0.7% 0.1%	129.44 2.1% 1.4%	129.24 1.9% -0.1%	128.80 1.6% -0.3%
WTI $ B 83.24 -8.4%	84.21 1.2% 1.2%	84.24 1.2% 0.0%	85.47 2.7% 1.5%	83.50 0.3% -2.3%	84.39 1.4% 1.1%
Brent    $/B 98.71 -7.6%	98.86 0.2% 0.2%	98.79 0.1% -0.1%	100.91 2.2% 2.1%	99.12 0.4% -1.8%	99.91 1.2% 0.8%
Gold  $/OZ 1625.0 3.4%	1620.0 -0.3% -0.3%	1619.5 -0.3% 0.0%	1619.4 -0.3% 0.0%	1591.8 -2.0% -1.7%	1594.9 -1.9% 0.2%

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

The International Monetary Fund (IMF) provides the Financial Sector Assessment Program (FSAP) (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62; Globalization and the State, Vol. II (2008b) 114-25), which is a major tool of analysis of the financial sector of its members (http://www.imf.org/external/np/fsap/fssa.aspx):

“The Financial Sector Assessment Program (FSAP), established in 1999, is a comprehensive and in-depth assessment of a country’s financial sector. It is a key instrument of the Fund’s surveillance and provides input to the Article IV consultation. In jurisdictions with financial sectors deemed by the Fund to be systemically important, financial stability assessments under the FSAP are a mandatory part of Article IV surveillance, and are supposed to take place every five years; for all other jurisdictions, participation in the program is voluntary.”

IMF (2012FSAPJun8) provides the important FSAP for Spain. Current problems originated significantly in floods of money at very low interest rates. IMF (2012FSAPJun8, 10) informs that construction and real estate loans increased from 10 percent of GDP in 1992 to 43 percent in 2009 and declined to 37 percent of GDP in 2011. Discretionary monetary policy, as argued in I Rules versus Discretionary Authorities in Monetary Policy attempted to manage the rate of economic growth with near zero interest rates from Jun 2003 to Jun 2004 and then increased them by 25 basis points increments in all meetings of the Federal Open Market Committee (FOMC) until reaching 5.25 percent in Jun 2006. There was quantitative easing by the suspension of auctions of 30-year bonds to increase the demand and prices of long-dated mortgage backed securities (MBS), which was equivalent to lowering mortgage rates to induce home buying and construction. IMF (2012FSAPJun8, 10) explains the source of funding for excessive construction in Spain and subsequent collapse:

“Spanish banks funded their increasing exposures largely from external sources during the period of high global liquidity and low interest rates, rather than through the mobilization of savings. The freezing of wholesale markets and the onset of the euro-area debt crisis exposed Spain’s vulnerabilities from accumulated domestic and external imbalances.”

Spain’s economy has fallen back into recession with expected decline of GDP of 1.8 percent in 2012 while the rate of unemployment at 24 percent continues to increase (IMF 2012FAP Jun 8, 15). The IMF (2012FSAPJun8, 17) baseline or central growth scenario is recession in 2012 with moderate recovery in 2013. The outlook for the long-term could be more favorable with GDP growth moving to a path of 1.8 percent driven by exports supported by recent labor market reforms. The FSAP of the IMF conducted stress tests of 96 percent of the domestic banking sector of Spain in the horizon of 2012-13. In order to comply with Basel III capital requirements, Spanish banks would have to raise their “minimum core Tier I capital ratio from 3.5 percent in 2013 to 7 percent by the end of 2018,” complying “with a 7 percent core Tier 1 ratio would amount to an aggregate €37 billion” (IMF 2012FSAPJun8, 19). About 80 percent of these funds are required for smaller savings banks because there is no need for support of the two largest Spanish international banks, which are well capitalized and account for about one half of the consolidated banking assets of Spain.

Jonathan House, Matina Stevis and Gabrielle Steinhauser, writing on “Spain to request EU aid for banks,” on Jun 9, 2012, published in the Wall Street Journal ({Spain to request EU aid for banks WSJ 060912}), inform that the European Union will provide Spain with up to €100 billion, about $125 billion, to be used in supporting the capital needs of its banks. A safety margin has been added to guarantee the estimated capital requirements of Spanish banks.

The President of the European Commission Jose Manuel Barroso and Vice-President Oli Rhen released the following statement (http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/12/436&format=HTML&aged=0&language=EN&guiLanguage=en):

“We welcome today’s communication by Spain of its intention to request the support of the euro area for the restructuring of its financial sector, and the Eurogroup’s positive response to this. The Commission is ready to proceed swiftly with the necessary assessment on the ground, in close liaison with the ECB, EBA and the IMF, and to propose appropriate conditionality for the financial sector. With this thorough restructuring of the banking sector, together with the on-going determined implementation of structural reforms and fiscal consolidation, we are certain that Spain can gradually regain the confidence of investors and market participants and create the conditions for a return to sustainable growth and job creation.”

Christine Lagarde, Managing Director of the IMF, provided the following statement on Jun 9, 2012, on the decision by the Eurogroup to extend financial support to Spain (http://www.imf.org/external/np/sec/pr/2012/pr12215.htm):

“I strongly welcome the statement by the Eurogroup, which complements the measures taken by the Spanish authorities in recent weeks to strengthen the banking system. Providing a credible back stop to recapitalize weaker segments of the banking system has been a key recommendation of the IMF's recent Financial Sector Assessment Program (FSAP) conducted in Spain. The willingness of Spain’s Euro Area partners to financially support the Fund for Orderly Bank Restructuring (FROB) with up to EUR 100 billion is a crucial step for the success of the Spanish authorities’ strategy. This scale of proposed financing, which is consistent with the capital needs identified in the FSAP, gives assurance that the financing needs of Spain's banking system will be fully met.

“The IMF stands ready, at the invitation of the Eurogroup members, to support the implementation and monitoring of this financial assistance through regular reporting."

Charles Forelle and Gabrielle Steinhauser, writing on “Spain is banking on a limited bailout,” on Jun 10, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303768104577458562351966868.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the issue of whether the bailout of Spanish banks could be followed by sovereign bailout of Spain. The borrowing requirements of Spain in 2012 are €86 billion, of which the country has raised €48 billion, leaving €38 billion that must be raised in international debt markets. The bailout of banks implies difficult evaluation of available funding. The reaction of markets is difficult to anticipate. The yield of the ten-year government bond of Spain was 6.25 percent on Fri Jun 8, below the peak of 6.70 percent on May 30. After deep haircuts in the recent bailout of Greece, investors could be cautious in building debt assets in Spain. The lowest rates for a bailed out member of the euro zone are over 7 percent for eight-year government bonds of Ireland. Spain would require maintaining confidence and credibility in its adjustment program to continue accessing international debt markets.

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 and the two- and ten-year government bonds of Germany. 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 of Germany 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 Aug 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 combination of multiple risks in the world economy and finance caused heightened risk aversion in the week of Jun 1, 2012, with the ten-year Treasury yield collapsing to 1.454, level experienced during the Treasury-Fed agreement of the 1940s, while the two-year government bond of Germany fell to 0.01 percent and even negative and 0.00 percent and the ten-year government bond of Germany collapsing to 1.17 percent. There was relaxation of risk aversion in the week of Jun 8 with increase of the yield of the ten-year Treasury to 1.635 percent and of the two-year government bond of Germany to 0.04 percent and the ten-year to 1.33 percent, which are still at levels of extreme flight from risk. 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, and further to USD 1.2435/EUR on Jun 1, 2012, or by 14.2 percent. The USD revalued by 0.7 percent to USD 1.2517 on Jun 8, 2012. 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 1.2517/EUR on Jun 8, 2012. Under zero interest rates for the monetary policy rate of the US, or fed funds rate, carry trades ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates 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).

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 IV at http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html) 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, 0.01 percent on Jun 1, 2012 and 0.04 percent on Jun 8, while the ten-year yield fell from 2.202 percent on Aug 26, 2011 to 1.37 percent on May 25, 2012 and then to 1.454 percent on Jun 1, 2012 and 1.635 percent on Jun 8, as shown in Table III-1A. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.

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
6/8/12	0.268	1.635	0.04	1.33	1.2517
6/1/12	0.248	1.454	0.01	1.17	1.2435
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
5/4/12	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
6/7/10	0.74	3.17	0.49	2.56	1.192
3/5/09	0.89	2.83	1.19	3.01	1.254
12/17/08	0.73	2.20	1.94	3.00	1.442
10/27/08	1.57	3.79	2.61	3.76	1.246
7/14/08	2.47	3.88	4.38	4.40	1.5914
6/26/03	1.41	3.55	NA	3.62	1.1423

Note: DE: Germany

Source:

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

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

http://www.federalreserve.gov/releases/h15/data.htm

http://www.bundesbank.de/Navigation/EN/Statistics/Time_series_databases/Macro_economic_time_series/macro_economic_time_series_node.html?anker=GELDZINS

http://www.ecb.int/stats/money/long/html/index.en.html

Equity indexes in Table III-1 mostly increased in the week of Jun 8 under expectations of further monetary stimulus by central banks. Germany’s Dax gained 1.3 percent while DJIA jumped 3.6 percent in the week of Jun 8 and Dow Global jumped 3.0 percent. Japan’s Nikkei Average increased 0.2 percent. Dow Asia Pacific TSM increased 0.1 percent in the week of Jun 8 while Shanghai Composite fell 3.9 percent.

Commodities gained during the week of Jun 8, 2012, as shown in Table III-1. The DJ UBS Commodities Index increased 1.6 percent. WTI increased 1.2 percent while Brent increased 1.2 percent. Gold lost 1.9 percent mostly by decline of 1.7 percent on Jun 7.

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 €1,115,517 million on Jun 1, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,720,630 million in the statement of Jun 1.

Table III-1B, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	Jun 1, 2012
1 Gold and other Receivables	367,402	419,822	432,703
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	243,598
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	49,077
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	17,590
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,115,517
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	250,592
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	605,113
8 General Government Debt Denominated in Euro	34,954	33,928	30,583
9 Other Assets	278,719	336,574	257,820
TOTAL ASSETS	2,004, 432	2,733,235	3,002,593
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,720,630
Capital and Reserves	78,143	81,481	85,363

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/fs120605.en.html

There is extremely important information in Table III-1C for the current sovereign risk crisis in the euro zone. Table III-1C provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Apr 2012. German exports to other European Union (EU) members are 57.9 percent of total exports in Apr 2012 and 58.3 percent in Jan-Apr 2012. Exports to the euro area are 38.0 percent in Apr and 38.8 percent in Jan-Apr. Exports to third countries are 42.1 percent of the total in Apr and 41.7 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-1C, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Apr 2012  € Billions	Apr 12-Month ∆%	Jan–Apr 2012 € Billions	Jan-Apr 2012/ Jan-Apr 2011 ∆%
Total Exports	87.1	3.4	363.1	5.2
A. EU Members	50.5 % 57.9	-1.1	211.6 % 58.3	1.4
Euro Area	33.1 % 38.0	-3.6	140.7 % 38.8	-0.1
Non-euro Area	17.3 % 19.9	4.1	70.9 % 19.5	4.6
B. Third Countries	36.7 % 42.1	10.3	151.4 % 41.7	11.0
Total Imports	72.7	-1.0	303.2	3.3
C. EU Members	46.3 % 63.7	-1.1	192.0 % 63.3	3.4
Euro Area	32.8 % 45.1	-0.6	135.1 % 44.6	3.3
Non-euro Area	13.5 % 18.6	-2.3	56.9 % 18.8	3.7
D. Third Countries	26.5 % 36.5	-0.7	113.3 % 37.4	3.1

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

Source:

Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/06/PE12_195_51.html;jsessionid=9AA93AFFD978CD2C25BE7CA368BD0690.cae1

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-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 €1,115,517 million on Jun 1, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,720,630 million in the statement of Jun 1.

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	Jun 1, 2012
1 Gold and other Receivables	367,402	419,822	432,703
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	243,598
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	49,077
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	17,590
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,115,517
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	250,592
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	605,113
8 General Government Debt Denominated in Euro	34,954	33,928	30,583
9 Other Assets	278,719	336,574	257,820
TOTAL ASSETS	2,004, 432	2,733,235	3,002,593
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,720,630
Capital and Reserves	78,143	81,481	85,363

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/fs120605.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 % Share	∆% Mar 2012/ Mar 2011	Imports % Share	Imports ∆% Mar 2012/ Mar 2011
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 Share %	Exports ∆% Mar 2012/ Mar 2011	Imports Share %	Imports ∆% Mar 2012/ Mar 2011
Consumer Goods	28.9	5.4	25.0	-8.4
Durable	5.9	2.1	3.0	-17.0
Non Durable	23.0	6.4	22.0	-7.2
Capital Goods	32.2	4.2	20.8	-20.7
Inter- mediate Goods	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 USD Billions	Primary Net Lending Borrowing % GDP 2012	General Government Net Debt % GDP 2012
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-1C 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 Apr 2012. German exports to other European Union (EU) members are 57.9 percent of total exports in Apr 2012 and 58.3 percent in Jan-Apr 2012. Exports to the euro area are 38.0 percent in Apr and 38.8 percent in Jan-Apr. Exports to third countries are 42.1 percent of the total in Apr and 41.7 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 ∆%

	Apr 2012  € Billions	Apr 12-Month ∆%	Jan–Apr 2012 € Billions	Jan-Apr 2012/ Jan-Apr 2011 ∆%
Total Exports	87.1	3.4	363.1	5.2
A. EU Members	50.5 % 57.9	-1.1	211.6 % 58.3	1.4
Euro Area	33.1 % 38.0	-3.6	140.7 % 38.8	-0.1
Non-euro Area	17.3 % 19.9	4.1	70.9 % 19.5	4.6
B. Third Countries	36.7 % 42.1	10.3	151.4 % 41.7	11.0
Total Imports	72.7	-1.0	303.2	3.3
C. EU Members	46.3 % 63.7	-1.1	192.0 % 63.3	3.4
Euro Area	32.8 % 45.1	-0.6	135.1 % 44.6	3.3
Non-euro Area	13.5 % 18.6	-2.3	56.9 % 18.8	3.7
D. Third Countries	26.5 % 36.5	-0.7	113.3 % 37.4	3.1

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

Source:

Statistiche Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2012/06/PE12_195_51.html;jsessionid=9AA93AFFD978CD2C25BE7CA368BD0690.cae1

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

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.ft.com/intl/cms/s/0/778eb1ce-7288-11e1-9c23-00144feab49a.html#axzz1pexRlsiQ), 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 19^th 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.

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, 1947-1971

	GDP ∆%	GDP per Capita ∆%	Base Money ∆%	Prices ∆%	Current Account BOP 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: Análise das Reformas Monetárias do Brasil e da Argentina. 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: Análise das Reformas Monetárias do Brasil e da Argentina. 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

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: Análise das Reformas Monetárias do Brasil e da Argentina. 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	2.0	2.3	1.9	8.2
Japan	2.8	0.4	-0.2	4.6
China	8.9	3.4	-0.7
UK	-0.1	3.0* RPI 3.5	2.8* output 0.1** input 1.1*	8.3
Euro Zone	-0.1	2.6	2.6	11.0
Germany	1.2	2.2	2.4	5.4
France	0.3	2.4	2.7	10.2
Nether-lands	-1.3	2.8	3.0	5.2
Finland	1.7	3.0	2.3	7.6
Belgium	0.5	2.9	2.0	7.4
Portugal	-2.2	2.9	3.6	15.2
Ireland	NA	1.9	3.1	14.2
Italy	-1.3	3.7	2.5	10.2
Greece	-6.2	1.5	5.2	NA
Spain	-0.4	2.0	3.1	24.3

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/may-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 2.0 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 II Mediocre Economic Growth at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.html). Japan’s GDP fell 0.6 percent in IVQ2011 relative to IVQ2010 and contracted 1.8 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 7.8 percent in IIIQ2011, increasing at the SAAR of 0.1 percent in IVQ 2011 and 4.7 percent in IQ2012 (see Section VB); the UK grew at minus 0.1 percent in IQ2012 relative to IQ2011 and GDP fell 0.3 percent in IQ2012 relative to IVQ2011 (see Section VB http://cmpassocregulationblog.blogspot.com/2012/05/world-financial-turbulence-global_27.html); and the Euro Zone grew at 0.0 percent in both IQ2012 relative to IVQ2011 and fell 0.1 percent in IQ2012 relative to IQ2011 (see Section VD and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06062012-AP/EN/2-06062012-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: 8.2 percent in the US but 17.6 percent for unemployment/underemployment or job stress of 28.4 million (see Table I-4 in Section I at http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier 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), 4.6 percent for Japan (see Section VB http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html and earlier 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 11.0 percent in the Euro Zone (section VD http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs_04.html and earlier http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight_06.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 http://cmpassocregulationblog.blogspot.com/2012/05/world-financial-turbulence-global_27.html 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-financial-turbulence-global.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 and earlier http://cmpassocregulationblog.blogspot.com/2012/04/mediocre-growth-with-high-unemployment.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 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 http://cmpassocregulationblog.blogspot.com/2012/06/mediocre-recovery-without-jobs.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/05/recovery-without-jobs-twenty-eight.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 Tendency
2012  Jan PR	2.4 to 2.9 2.2 to 2.7	7.2 to 8.0 8.2 to 8.5	1.9 to 2.0 1.4 to 1.8	1.8 to 2.0 1.5 to 1.8
2013  Jan PR	2.7 to 3.1 2.8 to 3.2	7.3 to 7.7 7.4 to 8.1	1.6 to 2.0 1.4 to 2.0	1.7 to 2.0 1.5 to 2.0
2014  Jan PR	3.1 to 3.6 3.3 to 4.0	6.7 to 7.4 6.7 to 7.6	1.7 to 2.0 1.6 to 2.0	1.8 to 2.0 1.6 to 2.0
Longer Run Jan PR	2.3 to 2.6 2.3 to 2.6	5.2 to 6.0 5.2 to 6.0	2.0 2.0
Range
2012 Jan PR	2.1 to 3.0 2.1 to 3.0	7.2 to 8.2 7.8 to 8.6	1.8 to 2.3 1.3 to 2.5	1.7 to 2.0 1.3 to 2.0
2013 Jan PR	2.4 to 3.8 2.4 to 3.8	7.0 to 8.1 7.0 to 8.2	1.5 to 2.1 1.4 to 2.3	1.6 to 2.1 1.4 to 2.0
2014 Jan PR	2.9 to 4.3 2.8 to 4.3	6.3 to 7.7 6.3 to 7.7	1.5 to 2.2 1.5 to 2.1	1.7 to 2.2 1.4 to 2.0
Longer Run Jan PR	2.2 to 3.0 2.2 to 3.0	4.9 to 6.0 4.9 to 6.0	2.0 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

The producer price index of the euro zone was flat in Apr after increasing 0.5 percent in Mar, as shown in Table IV-5. Producer price inflation has moderated since May 2011. Energy inflation has oscillated with the shocks of risk aversion that cause unwinding of carry trade positions from zero interest rates to commodity futures. Energy prices fell 0.1 percent in Apr 2012, increased 1.4 percent in Mar, 1.2 percent in Feb, 2.7 percent in Jan and 6.5 percent from Oct to Apr, which is equivalent to 11.5 percent per year but is 23.4 percent annual equivalent in Jan-Mar 2012. During periods of relaxed risk aversion, carry trades from zero interest rates to commodity exposures drive high inflation waves. Prices of capital goods have barely moved. Prices of durable consumer goods have accelerated in Oct 2011-Feb 2012 at annual equivalent rate of 2.7 percent compared but were flat in Mar and Apr 2012.

Table IV-5, Euro Zone, Industrial Producer Prices Month ∆%

	Apr  2012	Mar 2012	Feb  2012	Jan 2012	Dec  2011	Nov 2011	Oct 2011
Industry ex Construction	0.0	0.5	0.6	0.9	-0.2	0.3	0.1
Industry ex Construction & Energy	0.2	0.2	0.4	0.3	-0.1	-0.1	-0.1
Intermediate Goods	0.3	0.3	0.5	0.4	-0.2	-0.4	-0.5
Energy	-0.1	1.4	1.2	2.7	-0.5	1.0	0.7
Capital Goods	0.1	0.1	0.1	0.3	-0.1	0.0	0.1
Durable Consumer Goods	0.0	0.0	0.3	0.4	0.0	0.2	0.2
Nondurable Consumer Goods	0.1	0.3	0.3	0.3	0.1	0.3	0.2

Source: EUROSTAT

http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-04062012-AP/EN/4-04062012-AP-EN.PDF

Although moderating significantly in recent months, 12-month rates of increase of producer prices in the euro zone continue at relatively high levels in some segments, as shown in Table IV-6. The 12-month percentage change of industrial prices excluding construction fell from 5.5 percent in Oct 2011 to 3.3 percent in Feb 2012. Industrial prices excluding construction and energy increased 1.3 percent in the 12 months ending in Apr while energy prices increased 6.8 percent. There is major vulnerability in producer price inflation that can return together with long positions in commodity futures with carry trades from zero interest during relaxation of risk aversion.

Table IV-6, Euro Zone, Industrial Producer Prices 12-Month ∆%

	Apr  2012	Mar 2012	Feb 2012	Jan 2012	Dec  2011	Nov 2011	Oct 2011
Industry ex Construction	2.6	3.5	3.7	3.9	4.3	5.4	5.5
Industry ex Construction & Energy	1.3	1.6	1.7	2.0	2.5	3.0	3.2
Intermediate Goods	0.6	0.9	1.1	1.6	2.7	3.5	4.1
Energy	6.8	9.0	9.8	9.7	9.5	12.4	12.3
Capital Goods	1.1	1.2	1.2	1.3	1.4	1.4	1.6
Durable Consumer Goods	2.0	2.3	2.4	2.3	2.3	2.5	2.5
Nondurable Consumer Goods	2.4	2.9	3.0	3.1	3.3	3.6	3.5

Source: EUROSTAT

http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-04062012-AP/EN/4-04062012-AP-EN.PDF

Industrial producer prices in the euro area are following similar inflation waves as in the rest of the world (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy_20.html), as shown in Table IV-7. In the first wave in Jan-Apr 2011, annual equivalent producer price inflation was 12.0 percent driven by carry trades from zero interest rates into commodity futures. In the second wave in May-Jun 2011, annual equivalent producer price inflation declined at minus 1.2 percent. In the third wave in Jul-Sep 2011, annual equivalent inflation increased at 2.0 percent. In the third wave in Oct-Dec, risk aversion resulting from the European sovereign debt crisis interrupted commodity carry trades, resulting in annual equivalent inflation of only 0.8 percent. In the fifth wave in Jan-Mar 2012, annual equivalent inflation jumped to 8.3 percent with a high annual equivalent rate of 9.4 percent in Jan-Feb 2012. Producer price inflation in the euro zone excluding construction was flat in Apr and 2.6 percent in 12 months, in what appears to be another subdued wave caused by reversal of carry trade positions during unusual risk aversion. The bottom part of Table IV-7 provides 12-month percentage changes from 1999 to 2010. The final row of Table IV-7 provides the average annual rate of producer-price inflation in the euro area at 2.6 percent in Dec from 1999 to 2011.

Table IV-7, Euro Area, Industrial Producer Prices Excluding Construction, Month and 12-Month ∆%

	Month ∆%	12-Month ∆%
Apr 2012	0.0	2.6
Mar	0.5	3.5
Feb	0.6	3.7
Jan	0.9	3.9
AE ∆% Jan-Mar	8.3
Dec	-0.2	4.3
Nov	0.3	5.4
Oct	0.1	5.5
AE ∆% Oct-Dec	0.8
Sep	0.3	5.8
Aug	-0.2	5.8
Jul	0.4	6.1
AE ∆% Jul-Sep	2.0
Jun	0.0	5.9
May	-0.2	6.2
AE ∆% May-Jun	-1.2
Apr	0.9	6.8
Mar	0.8	6.8
Feb	0.8	6.6
Jan	1.3	5.9
AE ∆% Jan-Apr	12.0
Dec 2010	0.8	5.4
Dec 2009		-2.9
Dec 2008		1.1
Dec 2007		4.7
Dec 2006		3.8
Dec 2005		4.5
Dec 2004		3.8
Dec 2003		0.8
Dec 2002		1.5
Dec 2001		-0.6
Dec 2000		4.6
Dec 1999		2.6
Average ∆% 1999-2011		2.6

Source: EUROSTAT

http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database

Inflation in the UK is somewhat higher than in many advanced economies, deserving more detailed analysis. Table IV-8 provides 12-month percentage changes of UK output prices for all manufactured products, excluding food, beverage and petroleum and excluding duty. The 12-month rates rose significantly in 2011 in all three categories, reaching 6.3 percent for all manufactured products in Sep 2011 but declining to 5.7 percent in Oct, 5.4 in Nov and down to 32.8 percent in May 2012. Output price inflation is highly sensitive to commodity prices as shown by the increase by 6.7 percent in 2008 when oil prices rose over $140/barrel even in the midst of a global recession driven by the carry trade from zero interest rates to oil futures. The mirage episode of false deflation in 2001 and 2002 is also captured by the output prices for the UK, which was originated in decline of commodity prices but was used as an argument for the unconventional monetary policy of zero interest rates and quantitative easing during the past decade.

Table IV-8, UK Output Prices 12 Months ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
May 2012	2.8	2.1	2.7
Apr	3.2	2.3	3.1
Mar	3.7	2.5	3.5
Feb	4.1	3.0	4.1
Jan	4.0	2.4	4.0
Dec 2011	4.8	3.0	4.8
Nov	5.4	3.1	5.6
Oct	5.7	3.3	5.9
Sep	6.3	3.7	6.4
Aug	6.0	3.5	6.2
Jul	6.1	3.4	6.2
Jun	5.8	3.2	5.9
May	5.4	3.4	5.5
Apr	5.6	3.6	5.8
Mar	5.6	3.1	5.5
Feb	5.3	3.1	5.2
Jan	5.0	3.3	5.0
Dec 2010	4.2	2.7	4.0
Year ∆%		Ex Food
2011	5.6	3.4	5.7
2010	4.2	3.0	3.9
2009	1.6	2.5	1.0
2008	6.7	3.7	6.7
2007	2.3	1.4	2.1
2006	2.0	1.5	2.0
2005	1.9	1.0	1.9
2004	1.0	-0.3	0.6
2003	0.6	0.1	0.5
2002	-0.1	-0.4	-0.1
2001	-0.3	-0.6	-0.3
2000	1.4	-0.5	0.8
1999	0.6	-1.0	-0.3
1998	0.0	-0.8	-0.9
1997	0.9	0.3	0.1

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

Monthly and annual equivalent rates of change of output prices are shown in Table IV-9. There are waves of inflation similar to those in other countries (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html). In the first wave, annual equivalent inflation was 12.0 percent in Jan-Apr with relaxed risk aversion in commodity markets. In the second wave, intermittent risk aversion resulted in annual equivalent inflation of 2.0 percent in May-Oct. In the third wave, alternation of risk aversion resulted in annual equivalent inflation of 1.6 percent in Nov-Jan. In the fourth wave, the energy commodity shock caused by carry trades caused the jump of annual equivalent inflation to 7.4 percent in Feb-Apr 2012. A fifth wave has begun in May with decline of output inflation by 0.2 percent in an environment of risk aversion that is causing decline of commodity prices.

Table IV-9, UK Output Prices Month ∆% NSA

	All Manufactured Products	Excluding Food, Beverage and Petroleum	All Excluding Duty
May 2012	-0.2	0.0	-0.2
Apr	0.6	0.6	0.5
Mar	0.6	0.1	0.5
Feb	0.6	0.5	0.6
∆% AE Feb-Apr	7.4	4.9	6.6
Jan	0.4	0.3	0.3
Dec 2011	-0.2	-0.1	-0.2
Nov	0.2	-0.1	0.2
∆% AE Nov-Jan	1.6	0.4	1.2
Oct	0.0	-0.1	0.1
Sep	0.3	0.3	0.2
Aug	0.0	0.1	0.1
Jul	0.3	0.4	0.3
Jun	0.2	0.2	0.2
May	0.2	0.2	0.2
∆% AE May-Oct	2.0	2.2	2.2
Apr	1.1	0.8	0.9
Mar	1.1	0.5	1.1
Feb	0.5	0.0	0.5
Jan	1.1	0.8	1.1
Jan-Apr ∆% AE	12.0	6.5	11.4
Dec 2010	0.5	0.0	0.6

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

Input prices in the UK have been more dynamic than output prices, as shown by Table IV-10. The 12-month rates of increase of input prices, even excluding food, tobacco, beverages and petroleum, are very high, reaching 18.1 percent in Sep 2011 for materials and fuels purchased and 13.3 percent excluding food, beverages and petroleum. Inflation in 12 months of materials and fuels purchased moderated to 5.4 percent in Mar 2012 and 4.1 percent excluding food, tobacco, beverages and petroleum with the rates falling further in Apr to 1.0 percent for materials and fuels purchased and 2.2 percent excluding food, tobacco, beverages and petroleum. Input-price inflation collapsed to only 0.1 percent in the 12 months ending in May 2012 and 1.1 percent excluding food, tobacco, beverages and petroleum. There is only comparable experience with 22.2 percent inflation of materials and fuels purchased in 2008 and 16.9 percent excluding food, beverages and petroleum followed by decline of 3.8 percent by materials and fuels purchased and increase of 1.6 percent for the index excluding items. UK input and output inflation is sensitive to commodity price increases driven by carry trades from zero interest rates. The mirage of false deflation is also observed in input prices in 1997-9 and then again from 2001 to 2003.

Table IV-10, UK Input Prices 12-Month ∆% NSA

	Materials and Fuels Purchased	Excluding Food, Tobacco, Beverages and Petroleum
May 2012	0.1	1.1
Apr	1.0	2.2
Mar	5.4	4.1
Feb	7.7	5.7
Jan	6.5	5.6
Dec 2011	8.9	7.2
Nov	13.8	10.2
Oct	14.5	11.0
Sep	18.1	13.3
Aug	16.3	13.0
Jul	18.5	13.3
Jun	16.8	12.6
May	16.3	11.4
Apr	17.9	12.2
Mar	14.8	10.3
Feb	14.9	10.7
Jan	14.2	10.5
Dec 2010	13.1	9.0
Year ∆%
2011	15.4	11.4
2010	9.9	5.7
2009	-3.8	1.6
2008	22.2	16.9
2007	2.9	2.3
2006	9.8	7.3
2005	10.9	6.9
2004	3.3	1.6
2003	1.2	-0.6
2002	-4.4	-4.8
2001	-1.2	-1.2
2000	7.4	3.7
1999	-1.3	-3.6
1998	-9.1	-4.6
1997	-8.2	-6.3

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

Table IV-11 provides monthly percentage changes of UK input prices for materials and fuels purchased and excluding food, tobacco, beverages and petroleum. There are strong waves of inflation of input prices in the UK similar to those worldwide (http://cmpassocregulationblog.blogspot.com/2012/05/world-inflation-waves-monetary-policy.html). In the first wave, input prices rose at the high annual equivalent rate of 35.6 percent in Jan-Apr 2011, driven by carry trades from unconventional monetary policy into commodity exposures. In the second wave, alternating risk aversion caused annual equivalent inflation of minus 3.1 percent in May-Oct. In the third wave, renewed risk aversion resulted in annual equivalent inflation of minus 1.2 percent in Nov-Dec. In the fourth wave, annual equivalent inflation of input prices in the UK surged at 17.6 percent in Jan-Mar under relaxed risk aversion. In the fifth wave, annual equivalent inflation was minus 21.1 percent in Apr-May because of collapse of commodity prices during increasing risk aversion.

Table IV-11, UK Input Prices Month ∆% 

	Materials and Fuels Purchased NSA	Excluding Food, Tobacco, Beverages and Petroleum SA
May 2012	-2.5	-0.7
Apr	-1.4	0.1
∆% Apr-May	-21.1	-3.6
Mar	1.5	-0.6
Feb	2.5	1.0
Jan	0.1	-0.1
∆% AE Jan-Mar	17.6	1.2
Dec 2011	-0.6	-0.7
Nov	0.4	0.1
∆% AE Nov-Dec	-1.2	-3.6
Oct	-0.8	-0.4
Sep	2.1	0.7
Aug	-1.9	0.2
Jul	0.6	0.8
Jun	0.1	0.8
May	-1.6	-0.1
∆% AE May-Oct	-3.1	4.3
Apr	2.8	2.0
Mar	3.8	1.0
Feb	1.4	1.0
Jan	2.3	1.5
∆% AE Jan-Apr	35.6	17.8
Dec 2010	3.9	1.9

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of manufactured products, shown in Table IV-12. There are high contributions of 0.53 percentage points by food products, 0.70 percentage points by tobacco and alcohol, 0.28 percentage points by computer, electrical and optical and 0.57 percentage points by other manufactured products. There are diversified sources of contributions to 12 months output price inflation such as 0.22 percentage points by clothing, textile and leather and 0.17 percentage points by chemical and pharmaceutical. In general, contributions by products rich in commodities are the drivers of inflation. There were diversified contributions in percentage points to monthly inflation: 0.06 by food products, 0.03 by tobacco and alcohol and 0.02 percentage points by clothing textile and leather. The collapse of petroleum prices by 3.0 percent deducted 0.31 percentage points from monthly inflation of manufactured products.

Table IV-12, Contributions to Month and 12-Month Change in Prices of All Manufactured Products, Percentage Points

May 2012	12 Months % Points	12 Months ∆%	Month  % Points	Month ∆%
Total %	2.8	2.8	-0.2	-0.2
Food Products	0.53	3.3	0.06	0.4
Tobacco & Alcohol	0.70	6.6	0.03	0.3
Clothing, Textile & Leather	0.22	2.0	0.02	0.3
Paper and Printing	0.03	0.9	0.00	0.1
Petroleum	0.13	1.1	-0.31	-3.0
Chemical & Pharmaceutical	0.17	2.0	-0.01	-0.1
Metal, Machinery & Equipment	0.05	1.5	0.00	0.1
Computer, Electrical & Optical	0.28	3.3	0.00	0.0
Transport Equipment	0.12	1.2	-0.01	0.0
Other Manufactured Products	0.57	3.4	0.00	0.0

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

The UK Office for National Statistics also provides contributions in percentage points to the monthly and 12-month rates of inflation of input prices, shown in Table IV-13. Fuel is the large contributor with 1.03 percentage points to the 12-month rate but minus 0.14 percentage points to the monthly rate in May. Inflation also transfers to the domestic economy through the prices of imported inputs: other imported materials contributed 0.67 percentage points to the 12-month rate but deducted 0.04 percentage points to the May rate. Crude oil price fell 7.7 percent in May and deducted 2.20 percentage points to the monthly rate. Reversals of commodity exposures in carry trades during risk aversion are a major source of financial instability.

Table IV-13, UK, Contributions to Month and 12-Month Change in Prices of Inputs, Percentage Points

May 2012	12 Months % Points	12 Months ∆%	Month % Points	Month ∆%
Total	0.1	0.1	-2.5	-2.5
Fuel	1.03	7.1	-0.14	-1.4
Crude Oil	-0.37	-0.9	-2.20	-7.7
Domestic Food Materials	-0.32	-1.9	0.08	0.8
Imported Food Materials	0.32	3.8	0.01	0.2
Other Domestic Produced Materials	0.15	2.4	0.03	0.9
Imported Metals	-1.24	-9.2	-0.21	-2.7
Imported Chemicals	0.01	0.0	0.06	0.6
Imported Parts and Equipment	-0.14	-0.5	-0.10	-0.6
Other Imported Materials	0.67	4.3	-0.04	-0.5

Source: http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/may-2012/index.html

 

© Carlos M. Pelaez, 2010, 2011, 2012