Paring Quantitative Easing Policy and Peaking Valuations of Risk Financial Assets, World Inflation Waves, Collapse of United States Dynamism of Income Growth and Employment Creation, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation, United States Industrial Production, United States Commercial Banks Assets and Liabilities, World Economic Slowdown and Global Recession Risk: Part II

 

Paring Quantitative Easing Policy and Peaking Valuations of Risk Financial Assets, World Inflation Waves, Collapse of United States Dynamism of Income Growth and Employment Creation, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation, United States Industrial Production, United States Commercial Banks Assets and Liabilities, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013

Executive Summary

I World Inflation Waves

IA Appendix: Transmission of Unconventional Monetary Policy

IA1 Theory

IA2 Policy

IA3 Evidence

IA4 Unwinding Strategy

IB United States Inflation

IC Long-term US Inflation

ID Current US Inflation

IE Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation

IB Collapse of United States Dynamism of Income Growth and Employment Creation

IIA United States Industrial Production

IIB United States Commercial Banks Assets and Liabilities

IIB1 Transmission of Monetary Policy

IIB2 Functions of Banks

IIB3 United States Commercial Banks Assets and Liabilities

IIB4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

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

IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are four major approaches to the analysis of the depth of the financial crisis and global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and the subpar recovery from IIIQ2009 (Jul) to the present IVQ2012:

(1) Deeper contraction and slower recovery in recessions with financial crises

(2) Counterfactual of avoiding deeper contraction by fiscal and monetary policies

(3) Counterfactual that the financial crises and global recession would have been avoided had economic policies been different

(4) Evidence that growth rates are higher after deeper recessions with financial crises.

A counterfactual consists of theory and measurements of what would have occurred otherwise if economic policies or institutional arrangements had been different. This task is quite difficult because economic data are observed with all effects as they actually occurred while the counterfactual attempts to evaluate how data would differ had policies and institutional arrangements been different (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008b), 125, 136; Pelaez 1979, 26-8). Counterfactual data are unobserved and must be calculated using theory and measurement methods. The measurement of costs and benefits of projects or applied welfare economics (Harberger 1971, 1997) specifies and attempts to measure projects such as what would be economic welfare with or without a bridge or whether markets would be more or less competitive in the absence of antitrust and regulation laws (Winston 2006). Counterfactuals were used in the “new economic history” of the United States to measure the economy with or without railroads (Fishlow 1965, Fogel 1964) and also in analyzing slavery (Fogel and Engerman 1974). A critical counterfactual in economic history is how Britain surged ahead of France (North and Weingast 1989). These four approaches are discussed below in turn followed with comparison of the two recessions of the 1980s from IQ1980 (Jan) to IIIQ1980 (Jul) and from IIIQ1981 (Jul) to IVQ1982 (Nov) as dated by the National Bureau of Economic Research (NBER http://www.nber.org/cycles.html). These comparisons are not idle exercises, defining the interpretation of history and even possibly critical policies and institutional arrangements. There is active debate on these issues (Bordo 2012Oct 21 http://www.bloomberg.com/news/2012-10-21/why-this-u-s-recovery-is-weaker.html Reinhart and Rogoff, 2012Oct14 http://www.economics.harvard.edu/faculty/rogoff/files/Is_US_Different_RR_3.pdf Taylor 2012Oct 25 http://www.johnbtaylorsblog.blogspot.co.uk/2012/10/an-unusually-weak-recovery-as-usually.html, Wolf 2012Oct23 http://www.ft.com/intl/cms/s/0/791fc13a-1c57-11e2-a63b-00144feabdc0.html#axzz2AotsUk1q).

(1) Lower Growth Rates in Recoveries from Recessions with Financial Crises. A monumental effort of data gathering, calculation and analysis by Professors Carmen M. Reinhart and Kenneth Rogoff at Harvard University is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). See http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html. The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time periods:

“Our results incorporate data on 44 countries spanning about 200 years. Taken together, the data incorporate over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements and historic circumstances. We also employ more recent data on external debt, including debt owed by government and by private entities.”

Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average is for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the United States: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90.

For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).

An important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):

“The ignorance, of course, stems from the belief that financial crises happen to other people at other time in other places. Outside a small number of experts, few people fully appreciate the universality of financial crises. The arrogance is of those who believe they have figured out how to do things better and smarter so that the boom can long continue without a crisis.”

There is sober warning by Reinhart and Rogoff (2011CEPR, 42) based on the momentous effort of their scholarly data gathering, calculation and analysis:

“Despite considerable deleveraging by the private financial sector, total debt remains near its historic high in 2008. Total public sector debt during the first quarter of 2010 is 117 percent of GDP. It has only been higher during a one-year stint at 119 percent in 1945. Perhaps soaring US debt levels will not prove to be a drag on growth in the decades to come. However, if history is any guide, that is a risky proposition and over-reliance on US exceptionalism may only be one more example of the “This Time is Different” syndrome.”

As both sides of the Atlantic economy maneuver around defaults, the experience on debt and growth deserves significant emphasis in research and policy. The world economy is slowing with high levels of unemployment in advanced economies. Countries do not grow themselves out of unsustainable debts but rather through de facto defaults by means of financial repression and in some cases through inflation. The conclusion is that this time is not different.

Professor Alan M. Taylor (2012) at the University of Virginia analyzes own and collaborative research on 140 years of history with data from 14 advanced economies in the effort to elucidate experience preceding, during and after financial crises. The conclusion is (Allan M. Taylor 2012, 8):

“Recessions might be painful, but they tend to be even more painful when combined with financial crises or (worse) global crises, and we already know that post-2008 experience will not overturn this conclusion. The impact on credit is also very strong: financial crises lead to strong setbacks in the rate of growth of loans as compared to what happens in normal recessions, and this effect is strong for global crises. Finally, inflation generally falls in recessions, but the downdraft is stronger in financial crisis times.”

Alan M. Taylor (2012) also finds that advanced economies entered the global recession with the largest financial sector in history. There was doubling after 1980 of the ratio of loans to GDP and tripling of the size of bank balance sheets. In contrast, in the period from 1950 to 1970 there was high investment, savings and growth in advanced economies with firm regulation of finance and controls of foreign capital flows.

(2) Counterfactual of the Global Recession. There is a difficult decision on when to withdraw the fiscal stimulus that could have adverse consequences on current growth and employment analyzed by Krugman (2011Jun18). CBO (2011JunLTBO, Chapter 2) considers the timing of withdrawal as well as the equally tough problems that result from not taking prompt action to prevent a possible debt crisis in the future. Krugman (2011Jun18) refers to Eggertsson and Krugman (2010) on the possible contractive effects of debt. The world does not become poorer as a result of debt because an individual’s asset is another’s liability. Past levels of credit may become unacceptable by credit tightening, such as during a financial crisis. Debtors are forced into deleveraging, which results in expenditure reduction, but there may not be compensatory effects by creditors who may not be in need of increasing expenditures. The economy could be pushed toward the lower bound of zero interest rates, or liquidity trap, remaining in that threshold of deflation and high unemployment.

Analysis of debt can lead to the solution of the timing of when to cease stimulus by fiscal spending (Krugman 2011Jun18). Excessive debt caused the financial crisis and global recession and it is difficult to understand how more debt can recover the economy. Krugman (2011Jun18) argues that the level of debt is not important because one individual’s asset is another individual’s liability. The distribution of debt is important when economic agents with high debt levels are encountering different constraints than economic agents with low debt levels. The opportunity for recovery may exist in borrowing by some agents that can adjust the adverse effects of past excessive borrowing by other agents. As Krugman (2011Jun18, 20) states:

“Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.”

Besides operational issues, the consideration of this argument would require specifying and measuring two types of gains and losses from this policy: (1) the benefits in terms of growth and employment currently; and (2) the costs of postponing the adjustment such as in the exercise by CBO (2011JunLTO, 28-31) in Table 11. It may be easier to analyze the costs and benefits than actual measurement.

An analytical and empirical approach is followed by Blinder and Zandi (2010), using the Moody’s Analytics model of the US economy with four different scenarios: (1) baseline with all policies used; (2) counterfactual including all fiscal stimulus policies but excluding financial stimulus policies; (3) counterfactual including all financial stimulus policies but excluding fiscal stimulus; and (4) a scenario excluding all policies. The scenario excluding all policies is an important reference or the counterfactual of what would have happened if the government had been entirely inactive. A salient feature of the work by Blinder and Zandi (2010) is the consideration of both fiscal and financial policies. There was probably more activity with financial policies than with fiscal policies. Financial policies included the Fed balance sheet, 11 facilities of direct credit to illiquid segments of financial markets, interest rate policy, the Financial Stability Plan including stress tests of banks, the Troubled Asset Relief Program (TARP) and others (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 157-67; Regulation of Banks and Finance (2009a), 224-7).

Blinder and Zandi (2010, 4) find that:

“In the scenario that excludes all the extraordinary policies, the downturn con­tinues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010 (see Table 3). The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemploy­ment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fis­cal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.”

The conclusion by Blinder and Zandi (2010) is that if the US had not taken massive fiscal and financial measures the economy could have suffered far more during a prolonged period. There are still a multitude of questions that cloud understanding of the impact of the recession and what would have happened without massive policy impulses. Some effects are quite difficult to measure. An important argument by Blinder and Zandi (2010) is that this evaluation of counterfactuals is relevant to the need of stimulus if economic conditions worsened again.

(3) Counterfactual of Policies Causing the Financial Crisis and Global Recession. The counterfactual of avoidance of deeper and more prolonged contraction by fiscal and monetary policies is not the critical issue. As Professor John B. Taylor (2012Oct25) argues the critically important counterfactual is that the financial crisis and global recession would have not occurred in the first place if different economic policies had been followed. The counterfactual intends to verify that a combination of housing policies and discretionary monetary policies instead of rules (Taylor 1993) caused, deepened and prolonged the financial crisis (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB; see http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html) and that the experience resembles that of the Great Inflation of the 1960s and 1970s with stop-and-go growth/inflation that coined the term stagflation (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html 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 explanation of the sharp contraction of United States housing 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 used in purchasing 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 intended 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 of skills of the relationship banker converts 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 because 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 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. Bank charters were the source of profits 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 based on 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.”

Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US, the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:

“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”

Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.

In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):

“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”

The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. Congress established the Federal Home Loan Bank (FHLB) system in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.

According to Pinto (2008) in testimony to Congress:

“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”

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 Germany. 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.

(4) Historically Sharper Recoveries from Deeper Contractions and Financial Crises. Professor Michael D. Bordo (2012Sep27), at Rutgers University, is providing clear thought on the correct comparison of the current business cycles in the United States with those in United States history. There are two issues raised by Professor Bordo: (1) lumping together countries with different institutions, economic policies and financial systems; and (2) the conclusion that growth is mediocre after financial crises and deep recessions, which is repeated daily in the media, but that Bordo and Haubrich (2012DR) persuasively demonstrate to be inconsistent with United States experience.

Depriving economic history of institutions is perilous as is illustrated by the economic history of Brazil. Douglass C. North (1994) emphasized the key role of institutions in explaining economic history. Rondo E. Cameron (1961, 1967, 1972) applied institutional analysis to banking history. Friedman and Schwartz (1963) analyzed the relation of money, income and prices in the business cycle and related the monetary policy of an important institution, the Federal Reserve System, to the Great Depression. Bordo, Choudhri and Schwartz (1995) analyze the counterfactual of what would have been economic performance if the Fed had used during the Great Depression the Friedman (1960) monetary policy rule of constant growth of money (for analysis of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). Alan Meltzer (2004, 2010a,b) analyzed the Federal Reserve System over its history. The reader would be intrigued by Figure 5 in Reinhart and Rogoff (2010FCDC, 15) in which Brazil is classified in external default for seven years between 1828 and 1834 but not again until 64 years later in 1989, above the 50 years of incidence for “serial default”. William R. Summerhill, Jr. (2007SC, 2007IR) has filled this void in scholarly research on nineteenth-century Brazil. There are important conclusions by Summerhill on the exceptional sample of institutional change or actually lack of change, public finance and financial repression in Brazil between 1822 and 1899, combining tools of economics, political science and history. During seven continuous decades, Brazil did not miss a single interest payment with government borrowing without repudiation of debt or default. What is surprising is that Brazil borrowed by means of long-term bonds and, even more surprising, interest rates fell over time. The external debt of Brazil in 1870 was ₤41,275,961 and the domestic debt in the internal market was ₤25,708,711, or 62.3 percent of the total (Summerhill 2007IR, 73).

The experience of Brazil differed from that of Latin America (Summerhill 2007IR). During the six decades when Brazil borrowed without difficulty, Latin American countries becoming independent after 1820 engaged in total defaults, suffering hardship in borrowing abroad. The countries that borrowed again fell again in default during the nineteenth century. Venezuela defaulted in four occasions. Mexico defaulted in 1827, rescheduling its debt eight different times and servicing the debt sporadically. About 44 percent of Latin America’s sovereign debt was in default in 1855 and approximately 86 percent of total government loans defaulted in London originated in Spanish American borrowing countries.

External economies of commitment to secure private rights in sovereign credit would encourage development of private financial institutions, as postulated in classic work by North and Weingast (1989), Summerhill (2007IR, 22). This is how banking institutions critical to the Industrial Revolution were developed in England (Cameron 1967). The obstacle in Brazil found by Summerhill (2007IR) is that sovereign debt credibility was combined with financial repression. There was a break in Brazil of the chain of effects from protecting public borrowing, as in North and Weingast (1989), to development of private financial institutions.

Nicia Villela Luz and Carlos Manuel Peláez (1972, 276) find that:

“The lack of interest on historical moments by economists may explain their emphasis on secular trends in their research on the past instead of changes in the historical process. This may be the origin of why they fill gaps in documentation with their extrapolations.”

According to Pelaez 1976, 283) following Cameron:

“The banking law of 1860 placed severe restrictions on two basic modern economic institutions—the corporation and the commercial bank. The growth of the volume of bank credit was one of the most significant factors of financial intermediation and economic growth in the major trading countries of the gold standard group. But Brazil placed strong restrictions on the development of banking and intermediation functions, preventing the channeling of coffee savings into domestic industry at an earlier date.”

Brazil actually abandoned the gold standard during multiple financial crises in the nineteenth century, as it should have to protect domestic economic activity. Pelaez (1975, 447) finds similar experience in the first half of nineteenth-century Brazil:

“Brazil’s experience is particularly interesting in that in the period 1808-1851 there were three types of monetary systems. Between 1808 and 1829, there was only one government-related Bank of Brazil, enjoying a perfect monopoly of banking services. No new banks were established in the 1830s after the liquidation of the Bank of Brazil in 1829. During the coffee boom in the late 1830s and 1840s, a system of banks of issue, patterned after similar institutions in the industrial countries [Cameron 1967], supplied the financial services required in the first stage of modernization of the export economy.”

Financial crises in the advanced economies were transmitted to nineteenth-century Brazil by the arrival of a ship (Pelaez and Suzigan 1981). The explanation of those crises and the economy of Brazil requires knowledge and roles of institutions, economic policies and the financial system chosen by Brazil, in agreement with Bordo (2012Sep27).

The departing theoretical framework of Bordo and Haubrich (2012DR) is the plucking model of Friedman (1964, 1988). Friedman (1988, 1) recalls “I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuation in money and income reflect primarily the influence of money on income or of income on money?” Friedman (1964, 1988) finds useful for this purpose to analyze the relation between expansions and contractions. Analyzing the business cycle in the United States between 1870 and 1961, Friedman (1964, 15) found that “a large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion.” The depth of the contraction opens up more room in the movement toward full employment (Friedman 1964, 17):

“Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities and prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction.”

Kim and Nelson (1999) test the asymmetric plucking model of Friedman (1964, 1988) relative to a symmetric model using reference cycles of the NBER and find evidence supporting the Friedman model. Bordo and Haubrich (2012DR) analyze 27 cycles beginning in 1872, using various measures of financial crises while considering different regulatory and monetary regimes. The revealing conclusion of Bordo and Haubrich (2012DR, 2) is that:

“Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength. For many configurations, the evidence for a robust bounce-back is stronger for cycles with financial crises than those without.”

The average rate of growth of real GDP in expansions after recessions with financial crises was 8 percent but only 6.9 percent on average for recessions without financial crises (Bordo 2012Sep27). Real GDP declined 12 percent in the Panic of 1907 and increased 13 percent in the recovery, consistent with the plucking model of Friedman (Bordo 2012Sep27). Bordo (2012Sep27) finds two probable explanations for the weak recovery during the current economic cycle: (1) collapse of United States housing; and (2) uncertainty originating in fiscal policy, regulation and structural changes. There are serious doubts if monetary policy is adequate to recover the economy under these conditions.

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare and regulatory state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in USD fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in Japan and France within the G7 in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. The key indicator of growth of real income per capita, or what is earned per person after inflation, measures long-term economic growth and prosperity. A refined concept would include real disposable income per capita, or what a person earns after inflation and taxes.

Table IB-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IIIQ1986 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IQ1986: GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.9 percent at the annual equivalent rate of 4.4 percent; RDPI per capita increased 11.9 percent at the annual equivalent rate of 3.5 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. In the 15 quarters from IQ1983 to IQ1II986: GDP increased 21.3 percent at the annual equivalent rate of 5.3 percent; real disposable personal income (RDPI) increased 16.9 percent at the annual equivalent rate of 4.2 percent; RDPI per capita increased 13.3 percent at the annual equivalent rate of 3.4 percent; and population increased 3.2 percent at the annual equivalent rate of 0.8 percent Second, in the 15 quarters of the current cyclical expansion from IIIQ2009 to IQ2013, GDP increased 8.2 percent at the annual equivalent rate of 2.1 percent. In the 15 quarters of cyclical expansion: real disposable personal income (RDPI) increased 5.3 percent at the annual equivalent rate of 1.4 percent; RDPI per capita increased 2.6 percent at the annual equivalent rate of 0.7 percent; and population increased 2.6 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IQ2013, GDP increased 3.2 percent, or barely above the level before the recession, at the annual equivalent rate of 0.6 percent. Since the beginning of the recession in IVQ2007 to IQ2013, real disposable personal income increased 3.2 percent at the annual equivalent rate of 0.6 percent; population increased 4.2 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 0.8 percent lower than the level before the recession. 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. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2012, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15
GDP IQ1983 to IVQ1985 IQ1983 to IIIQ1986	13 15	19.6 21.3	5.7 5.3
RDPI IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	14.9 16.9	4.4 4.2
RDPI Per Capita IQ1983 to IVQ1986 IQ1983 to IIIQ1986	13 15	11.9 13.3	3.5 3.4
Population IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	2.7 3.2	0.8 0.8
IIIQ2009 to IQ2013	15
GDP		8.2	2.1
RDPI		5.3	1.4
RDPI per Capita		2.6	0.7
Population		2.6	0.7
IVQ2007 to IQ2013	22
GDP		3.2	0.6
RDPI		3.4	0.6
RDPI per Capita		-0.8	NA
Population		4.2	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

There are seven basic facts illustrating the current economic disaster of the United States: (1) GDP maintained trend growth in the entire business cycle from IQ1980 to IV1985 and IIIQ1986, including contractions and expansions, but is well below trend in the entire business cycle from IVQ2007 to IQ2013, including contractions and expansions; (2) per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IQ2013; (3) the number of employed persons increased in the 1980s but declined into IQ2013; (4) the number of full-time employed persons increased in the 1980s but declined into IQ2013; (5) the number unemployed, unemployment rate and number employed part-time for economic reasons fell in the recovery from the recessions of the 1980s but not substantially in the recovery after IIQ2009; (6) wealth of households and nonprofit organizations soared in the 1980s but declined in real terms into IQ2013; and (7) gross private domestic investment increased sharply from IQ1980 to IVQ1985 and IIIQ1986 but gross private domestic investment and private fixed investment have fallen sharply from IVQ2007 to IQ2013. There is a critical issue of whether the United States economy will be able in the future to attain again the level of activity and prosperity of projected trend growth. Growth at trend during the entire business cycles built the largest economy in the world but there may be an adverse, permanent weakness in United States economic performance and prosperity. Table IB-2 provides data for analysis of these seven basic facts. The seven blocks of Table IB-2 are separated initially after individual discussion of each one followed by the full Table IB-2.

1. Trend Growth.

i. As shown in Table IB-2, actual GDP grew cumulatively 20.5 percent from IQ1980 to IIIQ1986, which is relatively close to what trend growth would have been at 22.9 percent. Rapid growth at 5.7 percent annual rate on average per quarter during the expansion from IQ1983 to IQ1986 erased the loss of GDP of 4.8 percent during the contraction and maintained trend growth at 3 percent over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IQ2013 was 3.2 percent while trend growth would have been 17.7 percent. GDP in IQ2013 at seasonally adjusted annual rate is estimated at $13,746.2 billion by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,684.7 billion, or $1,939 billion higher, had the economy grown at trend over the entire business cycle as it happened during the 1980s and throughout most of US history. There is $1.9 trillion of foregone GDP that would have been created as it occurred during past cyclical expansions, which explains why employment has not rebounded to even higher than before. There would not be recovery of full employment even with growth of 3 percent per year beginning immediately because the opportunity was lost to grow faster during the expansion from IIIQ2009 to IQ2013 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 27.8 million people or 17.1 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html) that will not be significantly diminished even with return to growth of GDP of 3 percent per year because of growth of the labor force by new entrants. The US labor force grew from 142.583 million in 2000 to 153.124 million in 2007 or by 7.4 percent at the average yearly rate of 1.0 percent per year. The civilian noninstitutional population increased from 212.577 million in 2000 to 231.867 million in 2007 or 9.1 percent at the average yearly rate of 1.3 percent per year (data from http://www.bls.gov/data/). Data for the past five years cloud accuracy because of the number of people discouraged from seeking employment. The noninstitutional population of the United States increased from 231.867 million in 2007 to 243.284 million in 2012 or by 4.9 percent while the labor force increased from 153.124 million in 2007 to 154.975 million in 2012 or by 1.2 percent and only by 0.3 percent to 153.617 million in 2011 while population increased 3.3 percent from 231.867 million in 2007 to 239.618 million in 2011 (data from http://www.bls.gov/data/). People ceased to seek jobs because they do not believe that there is a job available for them (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html). Structural change in demography occurs over relatively long periods and not suddenly as shown by Edward P. Lazear and James R. Spletzer (2012JHJul22).

Period IQ1980 to IIIQ1986
GDP SAAR USD Billions
IQ1980	5,903.4
IIIQ1986	7,112.9
∆% IQ1980 to IIIQ1986 (21.3 percent from IVQ1982 $5866.0 billion)	20.5
∆% Trend Growth IQ1980 to IIIQ1986	22.9

Period IVQ2007 to IQ2013
GDP SAAR USD Billions
IVQ2007	13,326.0
IVQ2012	13,746.2
∆% IVQ2007 to IVQ2012 Actual	3.2
∆% IVQ2007 to IQ2013 Trend	17.7

2. Decline of Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IIIQ1986, as shown in Table IB-2 trend growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 17.0 percent, which is close to what would have been trend growth of 14.9 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IQ2013, per capita real disposable income fell 0.8 percent while trend growth would have been 11.5 percent. Income available after inflation and taxes is about the same or lower as before the contraction after 15 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions. In IQ2013, personal income fell at the SAAR of minus 4.6 percent; real personal income excluding current transfer receipts at minus 7.5 percent; and real disposable personal income at minus 5.1 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0413.pdf). The BEA explains as follows (page 3 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0313.pdf):

“The February and January changes in disposable personal income (DPI) mainly reflected the effect of special factors in January, such as the expiration of the “payroll tax holiday” and the acceleration of bonuses and personal dividends to November and to December in anticipation of changes in individual tax rates.”

Period IQ1980 to IIIQ1986

Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IQ1II986 Chained 2005 USD	22,165
∆% IQ1980 to IIIQ1986	17.0
∆% Trend Growth	14.9

Period IVQ2007 to IQ2013

Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IQ2013 Chained 2005 USD	32,570
∆% IVQ2007 to IQ2013	-0.8
∆% Trend Growth	11.5

3. Number of Employed Persons

i. As shown in Table IB-2, the number of employed persons increased over the entire business cycle from 98.527 million not seasonally adjusted (NSA) in IQ1980 to 110.229 million NSA in IIIQ1986 or by 11.9 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 142.698 million in IQ2013 or by 2.5 percent. There are 27.8 million persons unemployed or underemployed, which is 17.1 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html).

Period IQ1980 to IIIQ1986

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IIIQ1986 NSA End of Quarter	110.229
∆% Employed IQ1980 to IIIQ1986	11.9

Period IVQ2007 to IQ2013

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IQ2013 NSA End of Quarter	142.698
∆% Employed IVQ2007 to IQ2013	-2.5

4. Number of Full-Time Employed Persons

i. As shown in Table IB-2, during the entire business cycle in the 1980s, including contractions and expansion, the number of employed full-time rose from 81.280 million NSA in IQ1980 to 91.579 million NSA in IIIQ1986 or 12.7 percent.

ii. In contrast, during the entire current business cycle, including contraction and expansion, the number of persons employed full-time fell from 121.042 million in IVQ2007 to 114.796 million in IQ2013 or by minus 5.2 percent.

Period IQ1980 to IIIQ1986

Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IIIQ1986 NSA End of Quarter	91.579
∆% Full-time Employed IQ1980 to IIIQ1986	12.7

Period IVQ2007 to IQ2013

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IQ2013 NSA End of Quarter	114.796
∆% Full-time Employed IVQ2007 to IQ2013	-5.2

5. Unemployed, Unemployment Rate and Employed Part-time for Economic Reasons.

i. As shown in Table IB-2 and in the following block, in the cycle from IQ1980 to IIIQ1986: (a) the rate of unemployment was virtually the same at 6.8 percent in IIIQ1986 relative to 6.6 percent in IQ1980; (b) the number unemployed increased from 6.983 million in IQ1980 to 8.015 million in IIIQ1986 or 14.8 percent; and (c) the number employed part-time for economic reasons increased 44.7 percent from 3.624 million in IQ1980 to 5.245 million in IIIQ1986.

ii. In contrast, in the economic cycle from IVQ2007 to IVQ2012: (a) the rate of unemployment increased from 4.8 percent in IVQ2007 to 7.6 percent in IQ2013; (b) the number unemployed increased 60.3 percent from 7.371 million in IVQ2007 to 11.815 million in IQ2013; (c) the number employed part-time for economic reasons increased 62.8 percent from 4.750 million in IVQ2007 to 7.734 million in IQ2013; and (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 13.9 percent in IQ2013.

Period IQ1980 to IIIQ1986

Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IIIQ1986 NSA End of Quarter	6.8
Unemployed IQ1980 Millions End of Quarter	6.983
Unemployed IIIQ1986 Millions End of Quarter	8.015
Employed Part-time Economic Reasons Millions IQ1980 End of Quarter	3.624
Employed Part-time Economic Reasons Millions IIIQ1986 End of Quarter	5.245
∆%	44.7

Period IVQ2007 to IQ2013

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IQ2013 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IQ2013 Millions End of Quarter	11.815
∆%	60.3
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IQ2013 End of Quarter	7.734
∆%	62.8
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IQ2013	13.9

6. Wealth of Households and Nonprofit Organizations.

i. The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIIQ2012 is provided in the following block and in Table IB-2. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980.

ii. In contrast, as shown in Table IB-2, net worth of households and nonprofit organizations increased from $66,861.7 billion in IVQ2007 to $70,439.1 billion in IQ2013 by $3487.4 billion or 5.2 percent. The US consumer price index was 210.036 in Dec 2007 and 232.773 in Mar 2013 for increase of 10.8 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 5.2 percent in Mar 2013 relative to IVQ2007 when the recession began after 15 consecutive quarters of expansion from IIIQ2009 to IQ2013. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IVQ2012 has been 2.1 percent, which is substantially lower than the average of 5.7 percent in the expansion from IQ1983 to IQ1986 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The US missed the opportunity of high growth rates that has been available in past cyclical expansions. US wealth of households and nonprofit organizations grew from IVQ1945 at $710,125.9 million to IVQ2012 at $67.346.450.1 million or increase of 9,383.7 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 229.601 in Dec 2012 or 1,161.5 percent. There was a gigantic increase of US net worth of households and nonprofit organizations over 67 years with inflation-adjusted increase of 651.8 percent. Net worth of households and nonprofit organizations increased at the average annual average rate of 3.1 percent in the 67 years from 1945 to 2012 while GDP increased at the annual average rate of 2.9 percent. The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of US household and nonprofit net worth. There is extraordinary contrast between the mediocre average annual equivalent growth rate of 2.1 percent of the US economy in the fifteen quarters of the current cyclical expansion from IIIQ2009 to IQ2013 and the average of 5.7 percent in the first thirteen quarters of expansion from IQ1983 to IQ1986 and 5.3 percent in the first fifteen quarters of expansion from IQ1983 to IIIQ1986 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). The average growth rate of 7.8 percent is derived from 7.9 percent from IIIQ1954 to IIQ1955, 9.5 percent from IIIQ1958 to IIQ1959, 6.1 percent from IIIQ1975 to IIQ1976 and 7.7 percent from IQ1983 to IVQ1983. The United States missed this opportunity of high growth in the initial phase of recovery. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The average of 7.8 percent in the first four quarters of major cyclical expansions is more than twice higher than the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 3.2 percent obtained by diving GDP of $13,103.5 billion in IIIQ2010 by GDP of $12,701.0 billion in IIQ2009 {[$13.103.5/$12,701.0 -1]100 = 3.2%], or accumulating the quarter on quarter growth rates. As a result, there are 27.8 million unemployed or underemployed in the United States for an effective unemployment rate of 17.1 percent (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html). BEA data show the US economy in standstill with annual growth of 2.4 percent in 2010 decelerating to 1.8 percent annual growth in 2011, 2.2 percent in 2012.

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Period IVQ2007 to IIIQ2012
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,861.7
IVQ2012	70,349.1
∆ USD Billions	3,487.2

7. Gross Private Domestic Investment.

i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IIIIQ1986 and from IVQ2007 to IQ2013 is provided in the following block and in Table IB-2. Gross private domestic investment increased from $778.3 billion in IQ1980 to $913.0 billion in IIIQ1986 or by 17.3 percent.

ii In the current cycle, gross private domestic investment decreased from $2,123.6 billion in IVQ2007 to $1,977.2 billion in IQ2013, or decline by 6.9 percent. Private fixed investment fell from $2,111.5 billion in IVQ2007 to $1,925.6 billion in IQ2013, or decline by 8.8 percent.

Period IQ1980 to IIIQ1986
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IIIQ1986	913.0
∆%	17.3
Period IVQ2007 to IQ2013
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IQ2013	1,977.2
∆%	-6.9
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IQ2013	1,925.6
∆%	-8.8

Table IB-2, US, GDP and Real Disposable Personal Income per Capita Actual and Trend Growth and Employment, 1980-1985 and 2007-2012, SAAR USD Billions, Millions of Persons and ∆%

Period IQ1980 to IIIQ1986
GDP SAAR USD Billions
IQ1980	5,903.4
IIIQ1986	7,112.9
∆% IQ1980 to IIIQ1986 (21.3 percent from IVQ1982 $5866.0 billion)	20.5
∆% Trend Growth IQ1980 to IIIQ1986	22.9
Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IIIQ1986 Chained 2005 USD	22,165
∆% IQ1980 to IIIQ1986	17.0
∆% Trend Growth	14.9
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions III1986 NSA End of Quarter	110.229
∆% Employed IQ1980 to IIIQ1986	11.9
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IIIIQ1986 NSA End of Quarter	91.579
∆% Full-time Employed IQ1980 to IIIQ1986	12.7
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate  IIIQ1986 NSA End of Quarter	6.8
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IIIQ1986 Millions NSA End of Quarter	8.015
∆%	16.3
Employed Part-time Economic Reasons IQ1980 Millions NSA End of Quarter	3.624
Employed Part-time Economic Reasons Millions IIIQ1986 NSA End of Quarter	5.245
∆%	44.7
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IQ1986	913.0
∆%	17.3
Period IVQ2007 to IQ2013
GDP SAAR USD Billions
IVQ2007	13,326.0
IQ2013	13,746.2
∆% IVQ2007 to IQ2013	3.2
∆% IVQ2007 to IQ2013 Trend Growth	17.7
Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IQ2013 Chained 2005 USD	32,570
∆% IVQ2007 to IQ2013	-0.8
∆% Trend Growth	11.5
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IQ2013 NSA End of Quarter	142.698
∆% Employed IVQ2007 to IQ2013	-2.5
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IQ2013 NSA End of Quarter	114.796
∆% Full-time Employed IVQ2007 to IQ2013	-5.2
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IQ2013 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IQ2013 Millions NSA End of Quarter	11.815
∆%	60.3
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IQ2013 NSA End of Quarter	7.734
∆%	62.8
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IQ2013	13.9
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,861.7
IQ2013	70,349.1
∆ USD Billions	3,487.4
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IQ2013	1,977.2
∆%	-6.9
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IQ2013	1,925.6
∆%	-8.8

Note: GDP trend growth used is 3.0 percent per year and GDP per capita is 2.0 percent per year as estimated by Lucas (2011May) on data from 1870 to 2010.

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm US Bureau of Labor Statistics http://www.bls.gov/data/. Board of Governors of the Federal Reserve System. 2013Jun6. Flow of funds, balance sheets and integrated macroeconomic accounts. Washington, DC, Federal Reserve System, Jun 6.

The Congressional Budget Office (CBO 2013BEOFeb5) estimates potential GDP, potential labor force and potential labor productivity provided in Table IB-3. The average rate of growth of potential GDP from 1950 to 2012 is estimated at 3.3 percent per year. The projected path is

significantly lower at 2.2 percent per year from 2012 to 2023. The legacy of the economic cycle with expansion from IIIQ2009 to IQ2013 at 2.1 percent on average in contrast with 5.7 percent on average in the expansion from IQ1983 to IVQ1985 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html) may perpetuate unemployment and underemployment estimated at 27.8 million or 17.1 percent of the effective labor force in May 2013 (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/06/recovery-without-hiring-seven-million.html).

Table IB-3, US, Congressional Budget Office History and Projections of Potential GDP of US Overall Economy, ∆%

	Potential GDP	Potential Labor Force	Potential Labor Productivity*
Average Annual ∆%
1950-1973	3.9	1.6	2.3
1974-1981	3.3	2.5	0.8
1982-1990	3.1	1.6	1.5
1991-2001	3.1	1.3	1.8
2002-2012	2.2	0.8	1.4
Total 1950-2012	3.3	1.5	1.7
Projected Average Annual ∆%
2013-2018	2.2	0.6	1.6
2019-2023	2.3	0.5	1.8
2012-2023	2.2	0.5	1.7

*Ratio of potential GDP to potential labor force

Source: CBO (2013BEOFeb5).

Chart IB-1 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.1 percent on average from IIIQ2009 to IVQ2012 during the current economic expansion in contrast with 5.7 percent on average in the cyclical expansion from IQ1983 to IVQ1985 (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states.html) cannot be explained by the contraction of 4.7 of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 27.8 million or 17.1 percent of the labor as estimated for May 2013 (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html) and the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/06/recovery-without-hiring-seven-million.html).

Chart IB-1, US, Congressional Budget Office, Actual and Projections of Potential GDP, 2000-2024, Trillions of Dollars

Source: Congressional Budget Office, CBO (2013BEOFeb5).

II United States Industrial Production. Industrial production changed 0.0 percent in May 2013 after falling 0.4 percent in Apr 2013, as shown in Table II-1, with all data seasonally adjusted. The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

“Industrial production was unchanged in May after having decreased 0.4 percent in April. In May, manufacturing production rose 0.1 percent after falling in each of the previous two months, and the output at mines increased 0.7 percent. The gains in manufacturing and mining were offset by a decrease of 1.8 percent in the output of utilities. At 98.7 percent of its 2007 average, total industrial production in May was 1.6 percent above its year-earlier level.”

In the six months ending in May 2013, United States national industrial production accumulated increase of 0.5 percent at the annual equivalent rate of 1.0 percent, which is lower than growth of percent in 12 months. Excluding growth of 0.7 in Feb 2013, growth in the remaining five months from Dec 2012 to May 2013 accumulated to minus 0.2 percent or minus 0.5 percent annual equivalent. Industrial production stagnated in three of the past six months and fell in one. Business equipment accumulated growth of 0.9 percent in the six months from Dec 2012 to May 2013 at the annual equivalent rate of 1.8 percent, which is much lower than growth of 3.3 percent in 12 months. The Fed analyzes capacity utilization of total industry in its report (http://www.federalreserve.gov/releases/g17/Current/default.htm): “The rate of capacity utilization for total industry edged down 0.1 percentage point to 77.6 percent, a rate 0.2 percentage point below its level of a year earlier and 2.6 percentage points below its long-run (1972–2012) average.” United States industry is apparently decelerating.

Table II-1, US, Industrial Production and Capacity Utilization, SA, ∆% 

2012-2013	May  13	Apr 13	Mar 13	Feb 13	Jan 13	Dec 12	Mar  13/ Mar  12
Total	0.0	-0.4	0.2	0.7	0.0	0.0	1.6
Market Groups
Final Products	0.0	-0.5	0.4	1.0	-0.3	0.0	1.5
Consumer Goods	-0.1	-0.7	0.6	0.8	0.2	-0.1	1.2
Business Equipment	0.2	-0.3	0.0	1.8	-1.2	0.4	3.3
Non Industrial Supplies	-0.3	-1.0	0.0	0.9	0.5	0.0	0.3
Construction	-0.2	-1.2	-1.2	2.3	1.0	0.7	2.6
Materials	0.2	-0.2	0.1	0.4	0.1	0.1	2.1
Industry Groups
Manufacturing	0.1	-0.4	-0.3	0.7	-0.1	0.9	1.7
Mining	0.7	1.1	-0.5	0.8	-0.8	-0.4	4.8
Utilities	-1.8	-3.2	5.0	0.9	2.5	-5.4	-3.6
Capacity	77.6	77.7	78.1	78.1	77.7	77.8	1.9

Sources: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing increased 0.1 percent in May 2013 after decreasing 0.4 percent in Apr 2013 seasonally adjusted, increasing 1.7 percent not seasonally adjusted in 12 months. Manufacturing grew cumulatively 0.9 percent in the six months ending in May 2013 or at the annual equivalent rate of 1.8 percent. Excluding the increase of 0.9 percent in Dec 2012 perhaps partly because of recovery from hurricane Sandy, manufacturing accumulated growth of 0.0 percent from Jan 2013 to May 2013 or at the annual equivalent rate of 0.0 percent. A longer perspective of manufacturing in the US is provided by Table II-2. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 into more recent months as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.2 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily in the past six months with some strength at the margin. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 22, 2013 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization. Measured from fourth quarter to fourth quarter, total IP is now reported to have increased 0.7 percentage point less in 2011 than was previously published. The revisions to IP for other years were smaller: Compared to the previous estimates, industrial production fell slightly less in 2008 and 2009 and increased slightly less in 2010 and 2012. At 97.7 percent of its 2007 average, the index in the fourth quarter of 2012 now stands 0.4 percent below its previous estimate. With these revisions, IP is still estimated to have advanced about 6 percent in 2010, the first full year following the trough in June 2009 of the most recent recession, but it is now estimated to have risen about 3 percent both in 2011 and in 2012. Since the trough of the recession, total IP has reversed about 90 percent of its peak-to-trough decline.”

The bottom part of Table II-2 shows decline of manufacturing by 21.9 from the peak in Jun 2007 to the trough in Apr 2009 and increased 16.8 percent from the trough in Apr 2009 to Dec 2012. Manufacturing fell 7.3 percent from the peak in Jun 2007 to May 2013 and increased 18.6 from the trough in Apr 2008 to May 2013. Manufacturing grew 18.6 percent from the trough in Apr 2009 to Apr 2013. Manufacturing output in May 2013 is 7.3 percent below the peak in Jun 2007.

Table II-2, US, Monthly and 12-Month Rates of Growth of Manufacturing ∆%

	Month SA ∆%	12-Month NSA ∆%
May 2013	0.1	1.7
Apr	-0.4	2.2
Mar	-0.3	1.8
Feb	0.7	2.0
Jan	-0.1	2.4
Dec 2012	0.9	3.0
Nov	1.4	3.3
Oct	-0.4	2.1
Sep	0.1	3.1
Aug	-0.7	3.5
Jul	0.2	4.0
Jun	0.3	5.0
May	-0.3	4.8
Apr	0.6	5.1
Mar	-0.5	3.9
Feb	0.6	5.3
Jan	1.0	4.2
Dec 2011	1.0	3.8
Nov	0.0	3.2
Oct	0.6	3.1
Sep	0.4	3.0
Aug	0.4	2.4
Jul	0.7	2.5
Jun	0.1	2.1
May	0.3	1.9
Apr	-0.7	3.1
Mar	0.7	4.9
Feb	0.0	5.4
Jan	0.2	5.6
Dec 2010	0.6	6.2
Nov	0.2	5.3
Oct	0.1	6.6
Sep	0.1	7.0
Aug	0.1	7.4
Jul	0.7	7.8
Jun	0.0	9.3
May	1.4	8.9
Apr	0.9	7.1
Mar	1.3	4.9
Feb	0.0	1.3
Jan	1.0	1.2
Dec 2009	0.0	-3.1
Nov	1.1	-6.1
Oct	0.1	-9.1
Sep	0.8	-10.6
Aug	1.1	-13.6
Jul	1.2	-15.2
Jun	-0.3	-17.6
May	-1.1	-17.6
Apr	-0.8	-18.2
Mar	-1.9	-17.3
Feb	-0.2	-16.1
Jan	-2.9	-16.4
Dec 2008	-3.4	-14.0
Nov	-2.2	-11.3
Oct	-0.6	-9.0
Sep	-3.4	-8.6
Aug	-1.3	-5.1
Jul	-1.1	-3.5
Jun	-0.5	-3.1
May	-0.5	-2.4
Apr	-1.1	-1.1
Mar	-0.3	-0.5
Feb	-0.6	0.9
Jan	-0.4	2.3
Dec 2007	0.2	2.0
Nov	0.5	3.4
Oct	-0.4	2.8
Sep	0.5	3.0
Aug	-0.4	2.6
Jul	0.1	3.4
Jun	0.3	2.9
May	-0.1	3.1
Apr	0.7	3.6
Mar	0.7	2.4
Feb	0.4	1.6
Jan	-0.5	1.3
Dec 2006		2.7
Dec 2005		3.4
Dec 2004		4.0
Dec 2003		1.7
Dec 2002		2.4
Dec 2001		-5.5
Dec 2000		0.4
Dec 1999		5.4
Average ∆% Dec 1986-Dec 2012		2.3
Average ∆% Dec 1986-Dec 1999		4.3
Average ∆% Dec 1999-Dec 2006		1.3
Average ∆% Dec 1999-Dec 2012		0.4
∆% Peak 103.0005 in 06/2007 to 93.9456 in 12/2012		-8.8
∆% Peak 103.0005 on 06/2007 to Trough 80.4617 in 4/2009		-21.9
∆% Trough  80.4617 in 04/2009 to 93.9456 in 12/2012		16.8
∆% Trough  80.4617 in 04/2009 to 95.4491 in 5/2013		18.6
∆% Peak 103.0005 on 06/2007 to Trough 95.4491 in 5/2013		-7.3

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart II-1 of the Board of Governors of the Federal Reserve System provides industrial production, manufacturing and capacity since the 1970s. There was acceleration of growth of industrial production, manufacturing and capacity in the 1990s because of rapid growth of productivity in the US (Cobet and Wilson (2002); see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). The slopes of the curves flatten in the 2000s. Production and capacity have not recovered to the levels before the global recession.

Chart II-1, US, Industrial Production, Capacity and Utilization

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg1.gif

The modern industrial revolution of Jensen (1993) is captured in Chart II-2 of the Board of Governors of the Federal Reserve System (for the literature on M&A and corporate control see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 143-56, Globalization and the State, Vol. I (2008a), 49-59, Government Intervention in Globalization (2008c), 46-49). The slope of the curve of total industrial production accelerates in the 1990s to a much higher rate of growth than the curve excluding high-technology industries. Growth rates decelerate into the 2000s and output and capacity utilization have not recovered fully from the strong impact of the global recession. Growth in the current cyclical expansion has been more subdued than in the prior comparably deep contractions in the 1970s and 1980s. Chart II-2 shows that the past recessions after World War II are the relevant ones for comparison with the recession after 2007 instead of common comparisons with the Great Depression (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). The bottom left-hand part of Chart II-2 shows the strong growth of output of communication equipment, computers and semiconductor that continued from the 1990s into the 2000s. Output of semiconductors has already surpassed the level before the global recession.

Chart II-2, US, Industrial Production, Capacity and Utilization of High Technology Industries

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg3.gif

Additional detail on industrial production and capacity utilization is provided in Chart II-3 of the Board of Governors of the Federal Reserve System. Production of consumer durable goods fell sharply during the global recession by more than 30 percent and is still around the level before the contraction. Output of nondurable consumer goods fell around 10 percent and is some 5 percent below the level before the contraction. Output of business equipment fell sharply during the contraction of 2001 but began rapid growth again after 2004. An important characteristic is rapid growth of output of business equipment in the cyclical expansion after sharp contraction in the global recession. Output of defense and space only suffered reduction in the rate of growth during the global recession and surged ahead of the level before the contraction. Output of construction supplies collapsed during the global recession and is well below the level before the contraction. Output of energy materials was stagnant before the contraction but has recovered sharply above the level before the contraction.

Chart II-3, US, Industrial Production and Capacity Utilization

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/ipg2.gif

United States manufacturing output from 1919 to 2012 on a monthly basis is in Chart II-4 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is losing momentum at the margin.

Chart II-4, US, Manufacturing Output, 1919-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Manufacturing jobs fell 8,000 in May 2013 relative to Apr 2013, seasonally adjusted, as shown in Table II-3 (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/05/twenty-nine-million-unemployed-or.html). Manufacturing jobs not seasonally adjusted increased 47,000 from May 2012 to May 2013 or at the average monthly rate of 3,917. There are effects of the weaker economy and international trade together with the yearly adjustment of labor statistics. In the six months ending in Apr 2013, United States national industrial production accumulated increase of 2.0 percent at the annual equivalent rate of 4.1 percent, which is higher than 1.9 percent growth in 12 months. Excluding 1.3 percent growth in Nov 2012 in the rebound from hurricane Sandy, growth in the five months from Dec 2012 to Apr 2013 accumulated to 0.7 percent or 1.7 percent annual equivalent. Business equipment decreased 0.5 percent in Apr 2013, growing 3.4 percent in the 12 months ending in Apr 2013 and at the annual equivalent rate of 5.6 percent in the six months ending in Apr 2013 and 0.9 percent annual equivalent in the five months ending in Apr 2013. The Fed analyzes capacity utilization of total industry in its report (http://www.federalreserve.gov/releases/g17/Current/default.htm): “The rate of capacity utilization for total industry edged down 0.1 percentage point to 77.6 percent, a rate 0.2 percentage point below its level of a year earlier and 2.6 percentage points below its long-run (1972–2012) average.” United States industry is apparently decelerating with some strength at the margin.

Manufacturing increased 0.1 percent in May 2013 after decreasing 0.4 percent in Apr 2013 seasonally adjusted, increasing 1.7 percent not seasonally adjusted in 12 months. Manufacturing grew cumulatively 0.9 percent in the six months ending in May 2013 or at the annual equivalent rate of 1.8 percent. Excluding the increase of 0.9 percent in Dec 2012 perhaps partly because of recovery from hurricane Sandy, manufacturing accumulated growth of 0.0 percent from Jan 2013 to May 2013 or at the annual equivalent rate of 0.0 percent. Manufacturing fell 7.3 percent from the peak in Jun 2007 to May 2013 and increased 18.6 from the trough in Apr 2008 to May 2013. Manufacturing grew 18.6 percent from the trough in Apr 2009 to Apr 2013. Manufacturing output in May 2013 is 7.3 percent below the peak in Jun 2007.

Table II-3 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 86.4 percent in US national income in IVQ2012 and 86.4 percent in IQ2013. Most of US national income is in the form of services. In May 2013, there were 136.367 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 114.128 million NSA in May 2013 accounted for 83.7 percent of total nonfarm jobs of 136.367 million, of which 11.954 million, or 10.5 percent of total private jobs and 8.8 percent of total nonfarm jobs, were in manufacturing. Private service-producing jobs were 95.459 million NSA in May 2013, or 70.0 percent of total nonfarm jobs and 83.6 percent of total private-sector jobs. Manufacturing has share of 11.2 percent in US national income in IVQ2012, as shown in Table II-3. Most income in the US originates in services. Subsidies and similar measures designed to increase manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table II-3, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

	SAAR IVQ2012	% Total	SAAR IQ2013	% Total
National Income WCCA	14,230.5	100.0	14,300.3	100.0
Domestic Industries	13,963.9	97.9	14,068.1	98.3
Private Industries	12,300.8	86.4	12,406.5	86.4
Agriculture	138.6	1.0
Mining	221.7	1.6
Utilities	211.7	1.5
Construction	606.9	4.3
Manufacturing	1599.8	11.2
Durable Goods	921.3	6.5
Nondurable Goods	678.4	4.8
Wholesale Trade	857.2	6.0
Retail Trade	973.3	6.8
Transportation & WH	417.9	2.9
Information	496.2	3.5
Finance, Insurance, RE	2377.2	16.7
Professional, BS	2042.5	14.4
Education, Health Care	1402.0	9.9
Arts, Entertainment	548.3	3.9
Other Services	406.6	2.9
Government	1663.0	11.7	1661.6	11.9
Rest of the World	266.6	1.9	232.2	1.7

Notes: SSAR: Seasonally-Adjusted Annual Rate; WCCA: Without Capital Consumption Adjustment by Industry; WH: Warehousing; RE, includes rental and leasing: Real Estate; Art, Entertainment includes recreation, accommodation and food services; BS: business services

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart II-5 of the Board of Governors of the Federal Reserve provides output of motor vehicles and parts in the United States from 1972 to 2013. Output has stagnated since the late 1990s.

Chart II-5, US, Motor Vehicles and Parts Output, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Motor vehicle sales and production in the US have been in long-term structural change. Table II-4 provides the data on new motor vehicle sales and domestic car production in the US from 1990 to 2010. New motor vehicle sales grew from 14,137 thousand in 1990 to the peak of 17,806 thousand in 2000 or 29.5 percent. In that same period, domestic car production fell from 6,231 thousand in 1990 to 5,542 thousand in 2000 or -11.1 percent. New motor vehicle sales fell from 17,445 thousand in 2005 to 11,772 in 2010 or 32.5 percent while domestic car production fell from 4,321 thousand in 2005 to 2,840 thousand in 2010 or 34.3 percent. In Jan-May 2013, light vehicle sales accumulated to 6,424,707, which is higher by 7.3 percent relative to 5,986,605 a year earlier (http://motorintelligence.com/m_frameset.html). The seasonally adjusted annual rate of light vehicle sales in the US reached 15.31 million in May 2013, higher than 14.92 million in Apr 2013 and higher than 13.95 million in May 2012 (http://motorintelligence.com/m_frameset.html).

Table II-4, US, New Motor Vehicle Sales and Car Production, Thousand Units

	New Motor Vehicle Sales	New Car Sales and Leases	New Truck Sales and Leases	Domestic Car Production
1990	14,137	9,300	4,837	6,231
1991	12,725	8,589	4,136	5,454
1992	13,093	8,215	4,878	5,979
1993	14,172	8,518	5,654	5,979
1994	15,397	8,990	6,407	6,614
1995	15,106	8,536	6,470	6,340
1996	15,449	8,527	6,922	6,081
1997	15,490	8,273	7,218	5,934
1998	15,958	8,142	7,816	5,554
1999	17,401	8,697	8,704	5,638
2000	17,806	8,852	8,954	5,542
2001	17,468	8,422	9,046	4,878
2002	17,144	8,109	9,036	5,019
2003	16,968	7,611	9,357	4,510
2004	17,298	7,545	9,753	4,230
2005	17,445	7,720	9,725	4,321
2006	17,049	7,821	9,228	4,367
2007	16,460	7,618	8,683	3,924
2008	13,494	6,814	6.680	3,777
2009	10,601	5,456	5,154	2,247
2010	11,772	5,729	6,044	2,840

Source: US Census Bureau http://www.census.gov/compendia/statab/cats/wholesale_retail_trade/motor_vehicle_sales.html

Chart II-6 of the Board of Governors of the Federal Reserve System provides output of computers and electronic products in the United States from 1972 to 2013. Output accelerated sharply in the 1990s and 2000s and has surpassed the level before the global recession beginning in IVQ2007.

Chart II-6, US, Output of Computers and Electronic Products, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart II-7 of the Board of Governors of the Federal Reserve System shows that output of durable manufacturing accelerated in the 1980s and 1990s with slower growth in the 2000s perhaps because processes matured. Growth was robust after the major drop during the global recession but appears to vacillate in the final segment.

Chart II-7, US, Output of Durable Manufacturing, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

Chart II-8 of the Board of Governors of the Federal Reserve System provides output of aerospace and miscellaneous transportation equipment from 1972 to 2013. There is long-term upward trend with oscillations around the trend and cycles of large amplitude.

Chart II-8, US, Output of Aerospace and Miscellaneous Transportation Equipment, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/g17/Current/default.htm

The Empire State Manufacturing Survey Index in Table II-5 provides continuing deterioration that started in Jun 2012 well before Hurricane Sandy in Oct 2012. The current general index has been in negative contraction territory from minus 3.78 in Aug 2012 to minus 7.78 in Jan 2012 and minus 1.43 in May 2013. The current general index improved to 7,84 in Jun 2013, which is again in expansion territory. The index of current orders has also been in negative contraction territory from minus 4.63 in Aug 2012 to minus 7.18 in Jan 2013 and minus 6.69 in Jun 2013. Number of workers and hours worked have registered negative or declining readings since Sep 2012 with no expansion at 0.00 for number of workers in Jun 2013 but sharp contraction in the average workweek at minus 11.29 in Jun 2013. There is moderate expansion in the general index for the next six months at 11.29 in Jun 2013 and relative but declining strength in new orders at 19.77 in Jun 2013.

Table II-5, US, New York Federal Reserve Bank Empire State Manufacturing Survey Index SA

	General Index	New Orders	Shipments	# Workers	Average Work-week
Current
Jun 2013	7.84	-6.69	-11.77	0.00	-11.29
May	-1.43	-1.17	-0.02	5.68	-1.14
Apr	3.05	2.20	0.75	6.82	5.68
Mar	9.24	8.18	7.76	3.23	0.00
Feb	10.04	13.31	13.08	8.08	-4.04
Jan	-7.78	-7.18	-3.08	-4.30	-5.38
Dec 2012	-7.30	-3.44	11.93	-9.68	-10.75
Nov	-4.31	2.93	14.18	-14.61	-7.87
Oct	-6.75	-7.21	-6.48	-1.08	-4.30
Sep	-7.54	-10.60	7.30	4.26	-1.06
Aug	-3.78	-4.63	6.37	16.47	3.53
Jul	7.08	-2.27	11.52	18.52	0.00
Jun	4.15	2.28	6.34	12.37	3.09
May	14.52	8.99	23.11	20.48	12.05
Apr	6.40	4.81	4.51	19.28	6.02
Mar	18.00	6.55	15.97	13.58	18.52
Feb	18.31	7.93	19.90	11.76	7.06
Jan	12.12	11.21	18.94	12.09	6.59
Dec 2011	9.6	6.35	23.77	2.33	-2.33
Nov	1.82	-0.97	11.34	-3.66	2.44
Oct	-7.39	1.51	2.46	3.37	-4.49
Sep	-4.75	-4.31	-4.48	-5.43	-2.17
Six Months
Jun 2013	11.29	19.77	20.21	1.61	-9.68
May	4.55	28.84	25.18	11.36	1.14
Apr 2013	5.68	36.23	39.28	25.00	7.95
Mar	2.15	34.94	41.60	19.35	2.15
Feb	8.08	29.11	26.82	15.15	11.11
Jan	10.75	25.11	23.86	7.53	3.23
Dec 2012	1.08	17.19	22.46	10.75	5.38
Nov	5.62	15.96	25.67	-1.12	0.00
Oct	4.30	22.79	17.39	0.00	-11.83
Sep	5.32	27.85	23.35	8.51	2.13
Aug	2.35	14.34	21.16	3.53	-8.24
Jul	3.70	19.85	21.60	6.17	-4.94
Jun	1.03	26.02	22.18	16.49	2.06
May	12.05	31.26	26.00	12.05	8.43
Apr	19.28	38.95	40.75	27.71	10.84
Mar	13.58	39.18	41.64	32.10	20.99
Feb	15.29	39.25	40.92	29.41	18.82
Jan	23.08	45.70	44.12	28.57	17.58
Dec 2011	3.49	42.20	40.36	24.42	22.09
Nov	6.10	30.89	33.01	14.63	8.54
Oct	4.49	19.71	22.65	6.74	-2.25
Sep	8.70	23.52	22.89	0.00	-6.52

Source: http://www.newyorkfed.org/survey/empire/empiresurvey_overview.html

The Business Outlook Survey Diffusion Index of the Federal Reserve Bank of Philadelphia in Table II-6 also shows improvement after prior deterioration. The general index moved out contraction to 12.5 in Jun 2013 together with renewed expansion at 16.6 for new orders. Employment segments still show weakness in Jun 2013: minus 5.4 for number of workers and 0.8 for hours worked. Expectations for the next six months are brighter with the general index at 41.5 in Jun 2013 and the index of new orders at 37.6.

Table II-6, FRB of Philadelphia Business Outlook Survey Diffusion Index SA

	General Index	New Orders	Ship- ments	# of Workers	Average Workweek
11-Jan	15.0	19.1	11.1	13.9	8.0
11-Feb	25.6	15.7	24	19.6	6.9
11-Mar	36.1	33.2	28.1	16.1	7.3
11-Apr	13.7	12.6	23.0	9.9	15.1
11-May	4.0	6.8	5.4	22.2	2.8
11-Jun	-1.1	-1.2	5.7	3.4	3.7
11-Jul	9.4	4.7	9.0	12.6	-0.8
11-Aug	-19.0	-18.6	-4.7	-0.5	-7.6
11-Sep	-10.0	-4.5	-7.4	9.4	-2.8
11-Oct	9.7	8.8	11.2	7.8	5.2
11-Nov	5.0	3.6	6.9	10.9	6.8
11-Dec	4.2	5.9	6.2	8.0	-0.3
12-Jan	4.7	9.0	4.4	9.6	3.9
12-Feb	5.0	5.3	8.6	0.9	5.7
12-Mar	8.6	-0.7	0.2	5.9	-0.6
12-Apr	6.5	-0.8	0.5	13.4	-3.4
12-May	-4.9	-0.6	2.7	-0.2	-6.4
12-Jun	-12.8	-13.1	-13.8	2.3	-16.9
12-Jul	-9.1	-2.1	-7.5	-4.7	-13.9
12-Aug	-1.7	-0.8	-5.9	-7.6	-9.9
12-Sep	1.4	2.5	-10.4	-4.9	-2.9
12-Oct	4.2	-0.5	-3.5	-7.6	-6.5
12-Nov	-8.9	-4.7	-6.3	-6.9	-7.4
12-Dec	4.6	4.9	14.7	-0.2	0.4
13-Jan	-5.8	-4.3	0.4	-5.2	-8.3
13-Feb	-12.5	-7.8	2.4	0.9	-1.6
13-Mar	2.0	0.5	3.5	2.7	-12.9
13-Apr	1.3	-1.0	9.1	-6.8	-2.1
13-May	-5.2	-7.9	-8.5	-8.7	-12.4
13-Jun	12.5	16.6	4.1	-5.4	0.8

Future	General Index	New Orders	Ship- ments	# of Workers	Average Workweek
10-Dec	42.1	41.9	14.5	28.0	22.0
11-Jan	35.9	39.8	10.3	29.1	19.6
11-Feb	38.6	42.7	14.2	22.6	11.8
11-Mar	53.6	52.3	12.6	25.2	13.0
11-Apr	26.6	33.5	8.8	32.3	15.9
11-May	22.4	26.1	3.8	20.9	12.5
11-Jun	9.6	7.7	-4.7	7.2	4.2
11-Jul	35.0	31.0	8.0	16.2	6.6
11-Aug	26.4	22.8	3.5	13.9	2.4
11-Sep	26.6	27.0	6.0	13.4	5.7
11-Oct	29.8	31.0	5.3	17.5	8.2
11-Nov	36.2	34.0	8.9	27.9	4.5
11-Dec	37.7	31.6	4.4	7.9	2.0
12-Jan	43.9	46.1	13.0	17.8	6.8
12-Feb	32.2	26.3	5.7	20.2	8.7
12-Mar	34.4	28.6	6.0	19.2	8.0
12-Apr	34.8	29.6	5.6	23.6	6.9
12-May	30.2	26	10.1	11.8	1.2
12-Jun	35.5	35.6	6.0	19.1	5.0
12-Jul	30.8	24.7	6.5	15.3	14.6
12-Aug	25.3	17.3	4.8	14.5	8.8
12-Sep	52.0	42.8	12.6	21.2	13.8
12-Oct	22.6	22.7	8.6	9.8	10.5
12-Nov	23.2	24.9	2.7	7.0	8.2
12-Dec	28.3	28.0	2.7	11.2	14.4
13-Jan	32.5	38.9	2.9	10.7	8.9
13-Feb	38	30.3	4.3	14.9	6.5
13-Mar	34.5	31.2	6.6	8.1	3.4
13-Apr	24.3	26.5	-2.1	8.2	6.6
13-May	34.5	31.7	16.9	10.0	14.1
13-Jun	41.5	37.6	17.8	27.3	7.5

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

Chart II-9 of the Federal Reserve Bank of Philadelphia is very useful, providing current and future general activity indexes from Jan 1995 to Jun 2013. The shaded areas are the recession cycle dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles.html). The Philadelphia Fed index dropped during the initial period of recession and then led the recovery, as industry overall. There was a second decline of the index into 2011 followed now by what hopefully appeared as renewed strength from late 2011 into Jan 2012 with decline to negative territory of the current activity index in Nov 2012 and return to positive territory in Dec 2012 with decline of current conditions into contraction in Jan-Feb 2013 and rebound to mild expansion in Mar-Apr 2013. The index of current activity moved into expansion in Jun 2013.

Chart II-9, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Activity Indexes

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

The index of current new orders of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia in Chart II-10 illustrates the weakness of the cyclical expansion. The index weakened in 2006 and 2007 and then fell sharply into contraction during the global recession. There have been twelve readings into contraction from Jan 2012 to May 2013 and generally weak readings with some exceptions. The index of new orders moved into expansion in Jun 2013.

Chart II-10, Federal Reserve Bank of Philadelphia Current New Orders Diffusion Index

Source: Federal Reserve Bank of Philadelphia

http://www.philadelphiafed.org/index.cfm

IIB United States Commercial Banks Assets and Liabilities. Subsection IIB1 Transmission of Monetary Policy recapitulates the mechanism of transmission of monetary policy. Subsection IIB2 Functions of Banking analyzes the functions of banks in modern banking theory. Subsection IIB3 United States Commercial Bank Assets and Liabilities provides data and analysis of US commercial bank balance sheets in report H.8 of the Board of Governors of the Federal Reserve System on Assets and Liabilities of Commercial Banks in the United States (http://www.federalreserve.gov/releases/h8/current/default.htm). Subsection IIB4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation analyzes and compares unconventional monetary policy.

IIB1 Transmission of Monetary Policy. The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists primarily of reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Fixing policy rates at zero is the strongest measure of monetary policy with collateral effects of inducing carry trades from zero interest rates to exposures in risk financial assets such as commodities, exchange rates, stocks and higher yielding fixed income. Second, unconventional monetary policy also includes a battery of measures in also reducing long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

When inflation is low, the central bank lowers interest rates to stimulate aggregate demand in the economy, which consists of consumption and investment. When inflation is subdued and unemployment high, monetary policy would lower interest rates to stimulate aggregate demand, reducing unemployment. When interest rates decline to zero, unconventional monetary policy would consist of policies such as large-scale purchases of long-term securities to lower their yields. Long-term asset-backed securities finance a major portion of credit in the economy. Loans for purchasing houses, automobiles and other consumer products are bundled in securities that in turn are sold to investors. Corporations borrow funds for investment by issuing corporate bonds. Loans to small businesses are also financed by bundling them in long-term bonds. Securities markets bridge the needs of higher returns by savers obtaining funds from investors that are channeled to consumers and business for consumption and investment. Lowering the yields of these long-term bonds could lower costs of financing purchases of consumer durables and investment by business. The essential mechanism of transmission from lower interest rates to increases in aggregate demand is portfolio rebalancing. Withdrawal of bonds in a specific maturity segment or directly in a bond category such as currently mortgage-backed securities causes reductions in yields that are equivalent to increases in the prices of the bonds. There can be secondary increases in purchases of those bonds in private portfolios in pursuit of their increasing prices. Lower yields translate into lower costs of buying homes and consumer durables such as automobiles and also lower costs of investment for business. There are two additional intended routes of transmission.

1. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.

2. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial instability. During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from events such as collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets. More technical discussion is in IA Appendix: Transmission of Unconventional Monetary Policy.

Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even with the economy growing at or close to potential output. Monetary easing by unconventional measures, including zero interest rates and outright purchases of securities for the portfolio of the central bank, is now open ended in perpetuity, or QE→∞, as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):

“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 agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

Charles Evans, President of the Federal Reserve Bank of Chicago, proposed an “economic state-contingent policy” or “7/3” approach (Evans 2012 Aug 27):

“I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance. There are many ways of doing this, including setting a target for the level of nominal GDP. But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent. Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.

Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation. But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong. Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.

The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low. In addition, I would indicate that clear and steady progress toward stronger growth is essential.”

Evans (2012Nov27) modified the “7/3” approach to a “6.5/2.5” approach:

“I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Price Index) inflation over the next two to three years, would be appropriate.”

The Federal Open Market Committee (FOMC) decided at its meeting on Dec 12, 2012 to implement the “6.5/2.5” approach (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm):

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

The actual objective is attempting to bring the unemployment rate to 5.2 percent but because of the lag in effect of monetary policy impulses on income and prices policy uses “projections” such that the target of monetary policy is a forecast of unemployment and inflation. Unconventional monetary policy will remain in perpetuity, or QE→∞, changing to a “growth mandate.” There are two reasons explaining unconventional monetary policy of QE→∞: insufficiency of job creation to reduce unemployment/underemployment at current rates of job creation; and growth of GDP at 1.6 to 2.1 percent, which is well below 3.0 percent estimated by Lucas (2011May) from 1870 to 2010. Unconventional monetary policy interprets the dual mandate of low inflation and maximum employment as mainly a “growth mandate” of forcing economic growth in the US at a rate that generates full employment. A hurdle to this “growth mandate” is that US economic growth has been at only 2.1 percent on average in the cyclical expansion in the 15 quarters from IIIQ2009 to IQ2013. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). The average of 7.8 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 3.2 percent obtained by diving GDP of $13,103.5 billion in IIIQ2010 by GDP of $12,701.0 billion in IIQ2009 {[$13.103.5/$12,701.0 -1]100 = 3.2%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.7 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/04/mediocre-and-decelerating-united-states_28.html). Zero interest rates and quantitative easing have not provided the impulse for growth and were not required in past successful cyclical expansions.

First, total nonfarm payroll employment seasonally adjusted (SA) increased 175,000 in May 2013 and private payroll employment rose 178,000. The average number of nonfarm jobs created in Jan-May 2012 was 204,800 while the average number of nonfarm jobs created in Jan-May 2013 was 189,200, or decline by 7.6 percent. The average number of private jobs created in the US in Jan-May 2012 was 213,600 while the average in Jan-May 2013 was 194,400, or decline by 9.0 percent. The US labor force increased from 153.617 million in 2011 to 154.975 million in 2012 by 1.358 million or 113,167 per month. The average increase of nonfarm jobs in the five months from Jan to May 2013 was 189,200, which is an inadequate rate of job creation to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 27.8 million unemployed or underemployed. The difference between the average increase of 189,200 new private nonfarm jobs per month in the US from Jan to May 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 76,033 monthly new jobs net of absorption of new entrants in the labor force. There are 27.8 million in job stress in the US currently. Creation of 76,033 new jobs per month net of absorption of new entrants in the labor force would require 365 months to provide jobs for the unemployed and underemployed (27.780 million divided by 76,033) or 30.4 years (365 divided by 12). The civilian labor force of the US in May 2013 not seasonally adjusted stood at 155.734 million with 11.302 million unemployed or effectively 17.998 million unemployed in this blog’s calculation by inferring those who are not searching because they believe there is no job for them for effective labor force of 162.430 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.1 years (1 million divided by product of 76,033 by 12, which is 912,396). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.787 million (0.05 times labor force of 155.734 million) for new net job creation of 3.515 million (11.302 million unemployed minus 7.787 million unemployed at rate of 5 percent) that at the current rate would take 3.9 years (3.515 million divided by 0.912396). Under the calculation in this blog, there are 17.998 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.430 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.876 million jobs net of labor force growth that at the current rate would take 10.8 years (17.998 million minus 0.05(162.430 million) = 9.876 million divided by 0.912396, using LF PART 66.2% and Total UEM in Table I-4). These calculations assume that there are no more recessions, defying United States economic history with periodic contractions of economic activity when unemployment increases sharply. The number employed in the US fell from 147.315 million in Jul 2007 to 144.432 million in May 2013, by 2.883 million, or decline of 2.0 percent, while the noninstitutional population increased from 231.958 million in Jul 2007 to 245.363 million in May 2013, by 13.405 million or increase of 5.8 percent, using not seasonally adjusted data. There is actually not sufficient job creation in merely absorbing new entrants in the labor force because of those dropping from job searches, worsening the stock of unemployed or underemployed in involuntary part-time jobs.

Second, the economy of the US can be summarized in growth of economic activity or GDP as decelerating from mediocre growth of 2.4 percent on an annual basis in 2010 and 1.8 percent in 2011 to 2.2 percent in 2012. Calculations below show that actual growth is around 1.9 percent per year. This rate is well below 3 percent per year in trend from 1870 to 2010, which has been always recovered after events such as wars and recessions (Lucas 2011May). United States real GDP grew at the rate of 3.2 percent between 1929 and 2012 and at 3.2 percent between 1947 and 2012 (http://www.bea.gov/iTable/index_nipa.cfm see http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html). Growth is not only mediocre but also sharply decelerating to a rhythm that is not consistent with reduction of unemployment and underemployment of 27.8 million people corresponding to 17.1 percent of the effective labor force of the United States (http://cmpassocregulationblog.blogspot.com/2013/06/twenty-eight-million-unemployed-or.html). In the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013, US real GDP grew at the seasonally-adjusted annual equivalent rates of 0.1 percent in the first quarter of 2011 (IQ2011), 2.5 percent in IIQ2011, 1.3 percent in IIIQ2011, 4.1 percent in IVQ2011, 2.0 percent in IQ2012, 1.3 percent in IIQ2012, revised 3.1 percent in IIIQ2012, 0.4 percent in IVQ2012 and revised 2.4 percent in IQ2013. The annual equivalent rate of growth of GDP for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 percent, obtained as follows. Discounting 0.1 percent to one quarter is 0.025 percent {[(1.001)^1/4 -1]100 = 0.025}; discounting 2.5 percent to one quarter is 0.62 percent {[(1.025)^1/4 – 1]100}; discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 – 1]100}; discounting 4.1 percent to one quarter is 1.0 {[(1.04)^1/4 -1]100; discounting 2.0 percent to one quarter is 0.50 percent {[(1.020)^1/4 -1]100); discounting 1.3 percent to one quarter is 0.32 percent {[(1.013)^1/4 -1]100}; discounting 3.1 percent to one quarter is 0.77 {[(1.031)^1/4 -1]100); discounting 0.4 percent to one quarter is 0.1 percent {[(1.004)^1/4 – 1]100}; and discounting 2.4 percent to one quarter is 0.59 percent {[(1.024)^1/4 -1}100}. Real GDP growth in the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 accumulated to 4.3 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0059) - 1]100 = 4.3%}. This is equivalent to growth from IQ2011 to IQ2013 obtained by dividing the seasonally-adjusted annual rate (SAAR) of IQ2013 of $13,746.2 billion by the SAAR of IVQ2010 of $13,181.2 (http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1 and Table I-6 below) and expressing as percentage {[($13,746.2/$13,181.2) - 1]100 = 4.3%}. The growth rate in annual equivalent for the four quarters of 2011, the four quarters of 2012 and the first quarter of 2013 is 1.9 percent {[(1.00025 x 1.0062 x 1.0032 x 1.010 x 1.005 x 1.0032 x 1.0077 x 1.001 x 1.0059)^4/9 -1]100 = 1.9%], or {[($13,746.2/$13,181.2)]^4/9-1]100 = 1.9%} dividing the SAAR of IVQ2012 by the SAAR of IVQ2010 in Table I-6 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html), obtaining the average for nine quarters and the annual average for one year of four quarters. Growth in the four quarters of 2012 accumulates to 1.7 percent {[(1.02)^1/4(1.013)^1/4(1.031)^1/4(1.004)^1/4 -1]100 = 1.7%}. This is equivalent to dividing the SAAR of $13,665.4 billion for IVQ2012 in Table I-6 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html) by the SAAR of $13,441.0 billion in IVQ2011 except for a rounding discrepancy to obtain 1.7 percent {[($13,665.4/$13,441.0) – 1]100 = 1.7%}. The US economy is still close to a standstill especially considering the GDP report in detail.

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is concern of the production and employment costs of controlling future inflation. Even if there is no inflation, QE→∞ cannot be abandoned because of the fear of rising interest rates. The economy would operate in an inferior allocation of resources and suboptimal growth path, or interior point of the production possibilities frontier where the optimum of productive efficiency and wellbeing is attained, because of the distortion of risk/return decisions caused by perpetual financial repression. Not even a second-best allocation is feasible with the shocks to efficiency of financial repression in perpetuity.

The major reason and channel of transmission of unconventional monetary policy is through expectations of inflation. Fisher (1930) provided theoretical and historical relation of interest rates and inflation. Let i_n be the nominal interest rate, i_r the real or inflation-adjusted interest rate and π^e the expectation of inflation in the time term of the interest rate, which are all expressed as proportions. The following expression provides the relation of real and nominal interest rates and the expectation of inflation:

(1 + i_r) = (1 + i_n)/(1 + π^e) (1)

That is, the nominal interest rate equals the real interest rate discounted by the expectation of inflation in time term of the interest rate. Fisher (1933) analyzed the devastating effect of deflation on debts. Nominal debt contracts remained at original principal interest but net worth and income of debtors contracted during deflation. Real interest rates increase during declining inflation. For example, if the interest rate is 3 percent and prices decline 0.2 percent, equation (1) calculates the real interest rate as:

(1 +0.03)/(1 – 0.02) = 1.03/(0.998) = 1.032

That is, the real rate of interest is (1.032 – 1) 100 or 3.2 percent. If inflation were 2 percent, the real rate of interest would be 0.98 percent, or about 1.0 percent {[(1.03/1.02) -1]100 = 0.98%}.

The yield of the one-year Treasury security was quoted in the Wall Street Journal at 0.114 percent on Fri May 17, 2013 (http://online.wsj.com/mdc/page/marketsdata.html?mod=WSJ_topnav_marketdata_main). The expected rate of inflation π^e in the next twelve months is not observed. Assume that it would be equal to the rate of inflation in the past twelve months estimated by the Bureau of Economic Analysis (BLS) at 1.1 percent (http://www.bls.gov/cpi/). The real rate of interest would be obtained as follows:

(1 + 0.00114)/(1 + 0.011) = (1 + r_r) = 0.9902

That is, i_r is equal to 1 – 0.9902 or minus 0.98 percent. Investing in a one-year Treasury security results in a loss of 0.98 percent relative to inflation. The objective of unconventional monetary policy of zero interest rates is to induce consumption and investment because of the loss to inflation of riskless financial assets. Policy would be truly irresponsible if it intended to increase inflationary expectations or π^e. The result could be the same rate of unemployment with higher inflation (Kydland and Prescott 1977).

Friedman (1953) analyzed the effects of full-employment economic policy on economic stability. There are two critical issues. First, there are lags in effect of monetary policy on aggregate income and prices (Friedman 1961, Culbertson 1960, 1961, Batini and Nelson 2002, Romer and Romer 2004). Second, concrete knowledge on the functioning of the economy is inadequate. The result of shocking the economy with policies at the wrong time could be an increase in instability in the form of higher volatility of prices, or σ_p (standard deviation of prices), and higher volatility of real income, or σ_y (standard deviation of real income.

Carry trades from zero interest rates to highly leveraged exposures in risk financial assets characterize the current environment. Some analytical aspects of the carry trade are instructive (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 101-5, Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4), Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-4). Consider the following symbols: R_t is the exchange rate of a country receiving carry trade denoted in units of domestic currency per dollars at time t of initiation of the carry trade; R_t+τ is the exchange of the country receiving carry trade denoted in units of domestic currency per dollars at time t+τ when the carry trade is unwound; i_f is the domestic interest rate of the high-yielding country where investment will be made; i_usd is the interest rate on short-term dollar debt assumed to be 0.5 percent per year; i_f >i_usd, which expresses the fact that the interest rate on the foreign country is much higher than that in short-term USD (US dollars); S_t is the dollar value of the investment principal; and π is the dollar profit from the carry trade. The investment of the principal S_t in the local currency debt of the foreign country provides a profit of:

π = (1 + i_f)(R_tS_t)(1/R_t+τ) – (1 + i_usd)S_t (2)

The profit from the carry trade, π, is nonnegative when:

(1 + i_f)/ (1 + i_usd) ≥ R_t+τ/R_t (3)

In words, the difference in interest rate differentials, left-hand side of inequality (3), must exceed the percentage devaluation of the currency of the host country of the carry trade, right hand side of inequality (3). The carry trade must earn enough in the host-country interest rate to compensate for depreciation of the host-country at the time of return to USD. A simple example explains the vulnerability of the carry trade in fixed-income. Let i_f be 0.10 (10 percent), i_usd 0.005 (0.5 percent), S_t USD100 and R_t CUR 1.00/USD. Adopt the fixed-income rule of months of 30 days and years of 360 days. Consider a strategy of investing USD 100 at 10 percent for 30 days with borrowing of USD 100 at 0.5 percent for 30 days. At time t, the USD 100 are converted into CUR 100 and invested at [(30/360)10] equal to 0.833 percent for thirty days. At the end of the 30 days, assume that the rate R_t+30 is still CUR 1/USD such that the return amount from the carry trade is USD 0.833. There is still a loan to be paid [(0.005)(30/360)USD100] equal to USD 0.042. The investor receives the net amount of USD 0.833 minus USD 0.042 or US 0.791. The rate of return on the investment of the USD 100 is 0.791 percent, which is equivalent to the annual rate of return of 9.49 percent {(0.791)(360/30)}. This is incomparably better than earning 0.5 percent. There are alternatives of hedging by buying forward the exchange for conversion back into USD.

What really matters in the statement of the Federal Open Market Committee (FOMC) on Jun 19, 2013, is interest rates of fed funds at 0 to ¼ percent for the foreseeable future, even with paring of purchases of longer term bonds for the portfolio of the Fed (http://www.federalreserve.gov/newsevents/press/monetary/20130619a.htm):

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent” (emphasis added).

It may be quite painful to exit QE∞ or use of the balance sheet of the central bank together with zero interest rates forever. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that discount rates increase without bound, then V → 0, or

declines.

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 (Friedman 1957, 10). 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→∞. Equally, as r→∞, W→0. Monetary policy is constrained in a QE∞ trap with all adverse effects of financial repression and resource misallocation because an increase in interest rates causes contraction of wealth, which in the United States is concentrated in home ownership and stocks in own investment portfolios and pension funds that decline during interest rate increases.

IA2 Functions of Banks. Modern banking theory analyzes three important functions provided by banks: monitoring of borrowers, provision of liquidity services and transformation of illiquid assets into immediately liquid assets (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 51-60). These functions require valuation of alternative investment projects that may be distorted by zero interest rates of monetary policy and artificially low long-term interest rates. The QE∞ trap frustrates essential banking functions.

1. Monitoring. Banks monitor projects to ensure that funds are allocated to their intended projects (Diamond 1984, 1996). Banks issue deposits, which are secondary assets, to acquire loans, which are primary assets. Monitoring reduces costs of participating in business projects. Acting as delegated monitor, banks obtain information on the borrower, allowing less costly participation through the issue of unmonitored deposits. Monitoring of borrowers provides enhanced less costly participation by investors through the issue of deposits. There is significant reduction of monitoring costs by delegating to a bank. If there are many potential investors, monitoring by the bank of a credit name is less costly than the sum of individual monitoring of the same credit name by all potential investors. Banks permit borrowers to reach many investors for their projects while affording investors less costly participation in the returns of projects of bank borrowers.
2. Transformation of Illiquid Loans into Liquid Deposits. Diamond and Dybvig (1986) analyze bank services through bank balance sheets.

i. Assets. Banks provide loans to borrowers. The evaluation of borrowers prevents “adverse selection,” which consists of banks choosing unsound projects and failing to finance sound projects. Monitoring of loans prevents “moral hazard,” which consists of borrowers using the funds of the loan for purposes other than the project for which they were lent, as for example, using borrowed bank funds for speculative real estate instead of for the intended industrial project. Relationship banking improves the information on borrowers and the monitoring function.

ii. Liabilities. Banks provide numerous services to their clients such as holding deposits, clearing transactions, currency inventory and payments for goods, services and obligations.

iii. Assets and Liabilities: Transformation Function. The transformation function operates through both sides of the balance sheet: banks convert illiquid loans in the asset side into liquid deposits in the liability side. There is rich theory of banking (Diamond and Rajan 2000, 2001a,b). Securitized banking provides the same transformation function by bundling mortgage and other consumer loans into securities that are then sold to investors who finance them in short-dated sale and repurchase agreements (Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 61-6).

Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Personal consumptions expenditures have share of 71.1 percent of GDP in IQ2013 (Table I-10 http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). Most consumers rely on their banks for real estate loans, credit cards and personal consumer loans. Thus, it should be expected that success of monetary policy in stimulating the economy would be processed through bank balance sheets.

IIB3 United States Commercial Banks Assets and Liabilities. Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table IIB-1. Data are not seasonally adjusted to permit comparison between May 2012 and May 2013. Total assets of US commercial banks grew 5.9 percent from $12,712.7 billion in May 2012 to $13,457.8 billion in May 2013. US GDP in 2012 is estimated at $15,684.8 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 85 percent of US GDP. Bank credit grew 3.8 percent from $9648.7 billion in May 2012 to $10,010.9 billion in May 2013. Securities in bank credit increased 5.5 percent from $2597.8 billion in May 2012 to $2741.7 billion in May 2013. A large part of securities in banking credit consists of US Treasury and agency securities, growing 3.0 percent from $1803.3 billion in May 2012 to $1857.3 billion in May 2013. Credit to the government that issues or backs Treasury and agency securities of $1857.3 billion in May 2013 is about 18.6 percent of total bank credit of US commercial banks of $10,010.9 billion. Mortgage-backed securities, providing financing of home loans, grew 2.3 percent, from $1331.2 billion in May 2012 to $1362.0 billion in May 2013. Loans and leases were less dynamic, growing 3.1 percent from $7050.9 billion in May 2012 to $7269.5 billion in May 2013. The only dynamic class is commercial and industrial loans, growing 9.7 percent from May 2012 to May 2013 and providing $1553.6 billion or 21.4 percent of total loans and leases of $7269.2 billion in May 2013. Real estate loans increased only 0.3 percent, providing $3538.8 billion in Apr 2013 or 48.7 percent of total loans and leases. Consumer loans increased only 2.4 percent, providing $1125.2 billion in May 2013 or 15.5 percent of total loans. Cash assets are measured to “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks increased 26.5 percent from $1651.3 billion in May 2012 to $2088.1 billion in May 2013 but a single year of the series masks exploding cash in banks because of unconventional monetary policy, which is discussed below. Bank deposits increased 8.1 percent from $8619.2 billion to $9316.7 billion. The difference between bank deposits and total loans and leases in banks increased from $1568.3 billion in May 2012 to $2047.5 billion in May 2013 or by $479.2 billion, which is similar to the increase in securities in bank credit by $143.9 billion from $2597.8 billion in May 2012 to $2741.7 billion in May 2013 and to the increase in Treasury and agency securities by $54.0 billion from $1803.3 billion in May 2012 to $1857.3 billion in May 2013. Loans and leases increased $218.3 billion from $7050.9 billion in May 2012 to $7269.2 billion in May 2013. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IQ2013 lower by 0.8 percent than in IVQ2007 (Table IB-2 IX Conclusion and extended analysis in IB Collapse of United States Dynamism of Income Growth and Employment Creation) in contrast with 11.5 percent higher if the economy had performed in long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May). In contrast, growth of real disposable income grew cumulatively 17.0 percent in the cycle from IQ1980 to IIIQ1986 that was higher than trend growth of 14.9 percent.

Table IIB-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars

	May 2012	May 2013	∆%
Total Assets	12,712.7	13,457.8	5.9
Bank Credit	9648.7	10,010.9	3.8
Securities in Bank Credit	2597.8	2741.7	5.5
Treasury & Agency Securities	1803.3	1857.3	3.0
Mortgage-Backed Securities	1331.2	1362.0	2.3
Loans & Leases	7050.9	7269.2	3.1
Real Estate Loans	3531.5	3535.0	0.1
Consumer Loans	1098.5	1125.2	2.4
Commercial & Industrial Loans	1415.6	1553.6	9.7
Other Loans & Leases	1005.4	1055.4	5.0
Cash Assets*	1651.3	2088.1	26.5
Total Liabilities	11,244.5	11,940.1	6.2
Deposits	8619.2	9316.7	8.1

Note: balancing item of residual assets less liabilities not included

*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are provided in Table IIB-2 annually from 2008 to 2012 and for Apr 2013 and May 2013. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.8 percent in 2010. Commercial and industrial loans fell 18.6 percent in 2009 and 9.0 percent in 2010. Unconventional monetary policy caused an increase of cash assets of banks of 158.3 percent in 2008, 48.2 percent in 2009, 47.9 percent in 2011 followed by decline by 2.4 percent in 2012. Cash assets of banks increased at the SAAR of 22.4 percent in Aug 2012 but contraction by 49.6 percent in Sep 2012 and 6.3 percent in Oct 2012 followed by increase of 56.0 percent in Nov 2012, minus 7.8 percent in Dec 2012, 38.8 percent in Jan 2013, 66.2 percent in Feb 2013, 85.6 percent in Mar 2013 and 9.2 percent in Apr 2013. Cash assets of banks increased at the SAAR of 73.5 percent in May 2013. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that were held as cash and reserves at the central bank because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit: growing at the SAAR of 15.4 percent in Jul 2012, 2.6 percent in Aug 2012, 5.3 percent in Sep 2012, 4.7 percent in Oct 2012, 1.7 percent in Nov 2012 and 20.5 percent in Dec 2012 with declines at 1.1 percent in Jan 2013, 3.2 percent in Feb 2013 and 4.3 percent in Mar 2013 but growth of 0.6 percent in Apr 2013 followed by decline at 3.1 percent in May 2013. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit: with growth of 14.5 percent in 2009 and 15.3 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 3.4 percent in Aug 2012, 2.1 percent in Sep 2012 and 0.7 percent in Oct 2012 but falling at the rate of 0.8 percent in Nov 2012, increasing at 17.2 percent in Dec 2012 but falling at 5.9 percent in Jan 2013, 3.1 percent in Feb 2013, 9.0 percent in Mar 2013, 6.8 percent in Apr 2013 and 9.9 percent in May 2013. Increases in yield result in capital losses that may explain less interest in holding securities with higher duration. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 6.2 percent in Aug 2012 but increasing to 7.2 percent in Sep 2012, 8.4 percent in Oct 2012, 5.7 percent in Nov 2012, 18.7 percent in Dec 2012, 2.7 percent in Jan 2013, 4.4 percent in Feb 2013, 7.5 percent in Mar 2013, 2.3 percent in Apr 2013 and 1.6 percent in May 2013. The credit intermediation function of banks is broken because of adverse expectations on future business and is not easily mended simply by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.

Table IIB-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%

	2008	2009	2010	2011	2012	Apr   2013	May  2013
Total Assets	7.9	-6.0	-2.7	5.4	2.5	4.1	8.8
Bank Credit	2.2	-6.7	-2.7	1.8	4.0	4.0	-1.8
Securities in Bank Credit	-1.8	6.4	6.9	1.8	7.5	1.1	-3.1
Treasury & Agency Securities	3.5	14.5	15.3	3.1	8.6	-6.1	-9.8
Other Securities	-8.3	-4.9	-7.2	-0.8	5.0	16.5	11.5
Loans & Leases	3.3	-10.2	-5.8	1.8	2.7	5.1	-1.4
Real Estate Loans	-0.2	-5.6	-5.5	-3.7	-1.1	2.6	-2.9
Consumer Loans	5.1	-3.3	-7.1	-0.7	1.1	6.1	6.9
Commercial & Industrial Loans	12.9	-18.6	-9.0	9.5	11.4	6.5	-1.1
Other Loans & Leases	1.8	-23.3	0.3	19.4	6.3	10.3	-5.5
Cash Assets	158.3	48.2	-7.9	47.9	-2.4	9.0	73.4
Total Liabilities	10.6	-7.2	-3.4	5.5	2.2	3.9	14.1
Deposits	5.4	5.2	2.4	6.6	7.1	2.4	1.6

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-1-1 of the Board of Governors of the Federal Reserve System provides quarterly seasonally adjusted annual rates (SAAR) of cash assets in US commercial banks from 1973 to 2013. Unconventional monetary policy caused an increase in cash assets in late 2008 of close to 500 percent at SAAR and also in following policy impulses. Such aggressive policies were not required for growth of GDP at the average rate of 5.7 percent in 13 quarters of cyclical expansion from IQ1983 to IV1985 while the average rate in 15 quarters of cyclical expansion from IIIQ2009 to IQ2013 has been at the rate of 2.1 percent (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). The difference in magnitude of the recessions is not sufficient to explain weakness of the current cyclical expansion. Bordo (2012Sep27) and Bordo and Haubrich (2012DR) find that growth is higher after deeper contractions and contractions with financial crises. There were two consecutive contractions in the 1980s with decline of 2.2 percent in two quarters from IQ1980 to IIIQ1980 and 2.7 percent from IIIQ1981 to IVQ1982 that are almost identical to the contraction of 4.7 percent from IVQ2007 to IIQ2009. There was also a decade-long financial and banking crisis during the 1980s. The debt crisis of 1982 (Pelaez 1986) wiped out a large part of the capital of large US money-center banks. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.74 percent of GDP in a year. US GDP in 2012 is estimated at $15,684.8 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the bailout would be equivalent to cost to taxpayers of about $429.8 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery.

Chart IIB-1, US, Cash Assets, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-2 of the Board of Governors of the Federal Reserve System provides quarterly SAARs of bank credit at US commercial banks from 1973 to 2013. Rates collapsed sharply during the global recession as during the recessions of the 1980s and then rebounded. In both episodes, rates of growth of bank credit did not return to earlier magnitudes.

Chart IIB-2, US, Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-3 of the Board of Governors of the Federal Reserve System provides deposits at US commercial banks from 1973 to 2013. Deposits fell sharp during and after the global recession but then rebounded in the cyclical expansion.

Chart IIB-3, US, Deposits, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is similar behavior in the 1980s and in the current cyclical expansion of SAARs holdings of Treasury and agency securities in US commercial banks provided in Chart IIB-4 of the Board of Governors of the Federal Reserve System for the period 1973 to 2013. Sharp reductions of holdings during the contraction were followed by sharp increases.

Chart IIB-4, US, Treasury and Agency Securities in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-5 of the Board of Governors of the Federal Reserve System provides SAARs of change of total loans and leases in US commercial banks from 1973 to 2013. The decline in the current cycle of SAARs was much sharper and the rebound did not recover earlier growth rates. Part of the explanation originates in demand for loans that was high during rapid economic growth at 5.7 percent per year on average in the cyclical expansion of the 1980s in contrast with lower demand during tepid economic growth at 2.1 percent per year on average in the current weak expansion.

Chart IIB-5, US, Loans and Leases in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in the two cycles of the 1980s and the current one in quarterly SAARs of real estate loans in US commercial banks provided in Chart IIB-6 of the Board of Governors of the Federal Reserve System. The difference is explained by the debacle in real estate after 2006 compared to expansion during the 1980s even in the midst of the crisis of savings and loans and real estate credit. In both cases, government policy tried to influence recovery and avoid market clearing.

Chart IIB-6, US, Real Estate Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1947-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in quarterly SAARs of change of consumer loans in US commercial banks in the 1980s and during the current cycle as shown in Chart IIB-7 of the Board of Governors of the Federal Reserve System. Quarterly SAARs of consumer loans in US commercial banks fell sharply during the contraction of 1980 and oscillated with upward trend during the contraction of 1983-1984 but increased sharply in the cyclical expansion. In contrast, SAARs of consumer loans in US commercial banks collapsed to high negative magnitudes during the contraction and have increased at very low magnitudes during the current cyclical expansion.

Chart IIB-7, US, Consumer Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1958-2013, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare and regulatory state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in USD fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in Japan and France within the G7 in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. The key indicator of growth of real income per capita, or what is earned per person after inflation, measures long-term economic growth and prosperity. A refined concept would include real disposable income per capita, or what a person earns after inflation and taxes.

Table IIB-3 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IIIQ1986 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IQ1986: GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.9 percent at the annual equivalent rate of 4.4 percent; RDPI per capita increased 11.9 percent at the annual equivalent rate of 3.5 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. In the 15 quarters from IQ1983 to IQ1II986: GDP increased 21.3 percent at the annual equivalent rate of 5.3 percent; real disposable personal income (RDPI) increased 16.9 percent at the annual equivalent rate of 4.2 percent; RDPI per capita increased 13.3 percent at the annual equivalent rate of 3.4 percent; and population increased 3.2 percent at the annual equivalent rate of 0.8 percent. Second, in the 15 quarters of the current cyclical expansion from IIIQ2009 to IQ2013, GDP increased 8.2 percent at the annual equivalent rate of 2.1 percent. In the 15 quarters of cyclical expansion: real disposable personal income (RDPI) increased 5.3 percent at the annual equivalent rate of 1.4 percent; RDPI per capita increased 2.6 percent at the annual equivalent rate of 0.7 percent; and population increased 2.6 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IQ2013, GDP increased 3.2 percent, or barely above the level before the recession, at the annual equivalent rate of 0.6 percent. Since the beginning of the recession in IVQ2007 to IQ2013, real disposable personal income increased 3.2 percent at the annual equivalent rate of 0.6 percent; population increased 4.2 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 0.8 percent lower than the level before the recession. 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. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table IIB-3, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2012, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15
GDP IQ1983 to IVQ1985 IQ1983 to IIIQ1986	13 15	19.6 21.3	5.7 5.3
RDPI IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	14.9 16.9	4.4 4.2
RDPI Per Capita IQ1983 to IVQ1986 IQ1983 to IIIQ1986	13 15	11.9 13.3	3.5 3.4
Population IQ1983 to IQ1986 IQ1983 to IIIQ1986	13 15	2.7 3.2	0.8 0.8
IIIQ2009 to IQ2013	15
GDP		8.2	2.1
RDPI		5.3	1.4
RDPI per Capita		2.6	0.7
Population		2.6	0.7
IVQ2007 to IQ2013	22
GDP		3.2	0.6
RDPI		3.4	0.6
RDPI per Capita		-0.8	NA
Population		4.2	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart IIB-8 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2013. Increases in bank cash reserves processed acquisitions of securities for the portfolio of the central bank. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Discovery of such painless and fast adjustment by gigantic impulses of monetary policy of zero interest rates and trillions of dollars of bond buying would have occurred earlier with prior cases of successful implementation. Selective incentives to the private sector of a long-term nature could have been more effective.

Chart IIB-8, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-9 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from Dec 18, 2002 to Jun 19, 2013. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart IIB-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.

Chart IIB-9, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, Dec 18, 2002 to Jun 19, 2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1

Chart IIB-10 of the Board of Governors of the Federal Reserve System provides deposits in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2013. Deposit growth clearly accelerated after 2001 and continued during the current cyclical expansion after bumps during the global recession.

Chart IIB-10, US, Deposits in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-11 of the Board of Governors of the Federal Reserve System provides Treasury and agency securities in US commercial banks, not seasonally adjusted, in billions of dollars from 1947 to 2013. Holdings stabilized between the recessions of 2001 and after IVQ2007. There was rapid growth during the global contraction especially after unconventional monetary policy in 2008 and nearly vertical increase without prior similar historical experience during the various bouts of unconventional monetary policy. Banks hoard cash and less risky Treasury and agency securities instead of risky lending because of the weakness of the economy and the lack of demand for financing sound business projects.

Chart IIB-11, US, Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-12 of the Board of Governors of the Federal Reserve System provides total loans and leases in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Total loans and leases of US commercial banks contracted sharply and have stalled during the cyclical expansion.

Chart IIB-12, US, Loans and Leases in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-13 of the Board of Governors of the Federal Reserve System provides real estate loans in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Housing subsidies and low interest rates caused a point of inflexion to higher, nearly vertical growth until 2007. Real estate loans have contracted in downward trend partly because of adverse effects of uncertainty on the impact on balance sheets of the various mechanisms of resolution imposed by policy. Nick Timiraos, writing on “Push for cheaper credit hits wall,” on Dec 24, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324660404578197782701079650.html), provides important information and analysis on housing finance. Quantitative easing consists of withdrawing supply of mortgage-backed securities by acquiring them as assets in the Fed balance sheet. Lending banks obtain funds for mortgages by bundling them according to risk and other characteristics and selling them to investors, using the proceeds from the sale to provide the loans to homebuyers or refinancing homeowners. Banks earn net revenue to remunerate capital required for operations from the spread between the rate received from mortgage debtors and the rate implicit in the yield of the mortgage-backed securities. Nick Timiraos (Ibid) finds that the spread was around 0.5 percentage points before the financial crisis of 2007, widening to 1 percentage point after the crisis but jumping to 1.6 percentage points after the Fed engaged in another program of buying mortgage-backed securities, oscillating currently around 1.3 percentage points. The spread has widened because banks have higher costs originating in regulation, litigation on repurchasing defaulted mortgages, loss in case of default and more prudent but more costly scrutiny of property appraisals and income verification. As a result, even if quantitative easing does lower yields of mortgage-backed securities there would not be proportionate reduction in mortgage rates and even less likely construction and sales of houses.

Chart IIB-13, US, Real Estate Loans in Bank Credit, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-14 of the Board of Governors of the Federal Reserve System provides consumer loans in US commercial banks not seasonally adjusted in billions of dollars from 1947 to 2013. Consumer loans even increased during the contraction then declined and increased vertically to decline again. There was high demand for reposition of durable goods that exhausted and limited consumption again with increase in savings rates in recent periods.

Chart IIB-14, US, Consumer Loans in Bank Credit, Not Seasonally Adjusted, US Commercial Banks, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-15 of the Board of Governors of the Federal Reserve System provides commercial and industrial loans not seasonally adjusted in billions of dollars from 1947 to 2013. Commercial and industrial loans fell sharply during both contractions in 2001 and after IVQ2007 and then rebounded with accelerated growth. Commercial and industrial loans have not reached again the peak during the global recession.

Chart IIB-15, US, Commercial and Industrial Loans in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1947-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart IIB-16 is quite revealing in analyzing the state of bank credit in the US economy. The upper curves are deposits and loans and leases in bank credit. Historically since 1973, the level and rate of change of deposits and loans and leases in bank credit were almost identical. The lower two curves are Treasury and agency securities in bank credit and cash assets with treasury and agency securities moving closely with cash assets until the 1990s when Treasury and agency securities exceeded cash assets. The shaded area of the recession from IV2007 to IIQ2009 shows a break in the level and rate of movement of the series. Deposits continued to expand rapidly through the recession and the following expansion period. Loans and leases fell and barely recovered the level before the recession while deposits moved nearly vertically well above the level before the recession. While Treasury and agency securities in bank credit continued to expand at a higher rate, reaching a level well above that before the recession, cash assets jumped as the counterpart of excess reserves in banks that financed quantitative easing or massive outright purchases of securities for the balance sheet of the Fed. Unconventional monetary policy of zero interest rates and outright purchases of securities has result in sharp increases of deposits, cash assets and Treasury and agency securities in bank credit but not in loans and leases. Much is said about the almost impossible task of evaluating monetary policy in terms of costs and benefits. Before the financial crisis, Chairman Greenspan (2004) analyzes monetary policy and its limitations (see Pelaez and Pelaez, The Global Recession Risk (2007), 13-4, 212-13) that do not differ from those of private financial institutions:

“The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision making.

This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy's dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions.

However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis.

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”

“Whale” trades at official institutions causing wide swings of financial and economic variables do not receive the same media attention as those in large private banking institutions such as the teapot storm over JP Morgan Chase.

Chart IIB-16, US, Deposits, Treasury and Government Securities in Bank Credit, Loans and Leases in Bank Credit and Cash Assets, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2013, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

IA4 Theory and Reality of Economic History and Monetary Policy Based on Fear of Deflation. Fear of deflation as had occurred during the Great Depression and in Japan was used as an argument for the first round of unconventional monetary policy with 1 percent interest rates from Jun 2003 to Jun 2004 and quantitative easing in the form of withdrawal of supply of 30-year securities by suspension of the auction of 30-year Treasury bonds with the intention of reducing mortgage rates (for fear of deflation see Pelaez and Pelaez, International Financial Architecture (2005), 18-28, and Pelaez and Pelaez, The Global Recession Risk (2007), 83-95). The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

If the forecast of the central bank is of recession and low inflation with controlled inflationary expectations, monetary policy should consist of lowering the short-term policy rate of the central bank, which in the US is the fed funds rate. The intended effect is to lower the real rate of interest (Svensson 2003LT, 146-7). The real rate of interest, r, is defined as the nominal rate, i, adjusted by expectations of inflation, π*, with all variables defined as proportions: (1+r) = (1+i)/(1+π*) (Fisher 1930). If i, the fed funds rate, is lowered by the Fed, the numerator of the right-hand side is lower such that if inflationary expectations, π*, remain unchanged, the left-hand (1+r) decreases, that is, the real rate of interest, r, declines. Expectations of lowering short-term real rates of interest by policy of the Federal Open Market Committee (FOMC) fixing a lower fed funds rate would lower long-term real rates of interest, inducing with a lag investment and consumption, or aggregate demand, that can lift the economy out of recession. Inflation also increases with a lag by higher aggregate demand and inflation expectations (Fisher 1933). This reasoning explains why the FOMC lowered the fed funds rate in Dec 2008 to 0 to 0.25 percent and left it unchanged.

The fear of the Fed is expected deflation or negative π*. In that case, (1+ π*) < 1, and (1+r) would increase because the right-hand side of the equation would be divided by a fraction. A simple numerical example explains the effect of deflation on the real rate of interest. Suppose that the nominal rate of interest or fed funds rate, i, is 0.25 percent, or in proportion 0.25/100 = 0.0025, such that (1+i) = 1.0025. Assume now that economic agents believe that inflation will remain at 1 percent for a long period, which means that π* = 1 percent, or in proportion 1/100 =0.01. The real rate of interest, using the equation, is (1+0.0025)/(1+0.01) = (1+r) = 0.99257, such that r = 0.99257 - 1 = -0.00743, which is a proportion equivalent to –(0.00743)100 = -0.743 percent. That is, Fed policy has created a negative real rate of interest of 0.743 percent with the objective of inducing aggregate demand by higher investment and consumption. This is true if expected inflation, π*, remains at 1 percent. Suppose now that expectations of deflation become generalized such that π* becomes -1 percent, that is, the public believes prices will fall at the rate of 1 percent in the foreseeable future. Then the real rate of interest becomes (1+0.0025) divided by (1-0.01) equal to (1.0025)/(0.99) = (1+r) = 1.01263, or r = (1.01263-1) = 0.01263, which results in positive real rate of interest of (0.01263)100 = 1.263 percent.

Irving Fisher also identified the impact of deflation on debts as an important cause of deepening contraction of income and employment during the Great Depression illustrated by an actual example (Fisher 1933, 346):

“By March, 1933, liquidation had reduced the debts about 20 percent, but had increased the dollar about 75 percent, so that the real debt, that is the debt measured in terms of commodities, was increased about 40 percent [100%-20%)X(100%+75%) =140%]. Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized”

The nominal rate of interest must always be nonnegative, that is, i ≥ 0 (Hick 1937, 154-5):

“If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall”

The interpretation by Hicks of the General Theory of Keynes is the special case in which at interest rates close to zero liquidity preference is infinitely or perfectly elastic, that is, the public holds infinitely large cash balances at that near zero interest rate because there is no opportunity cost of foregone interest. Increases in the money supply by the central bank would not decrease interest rates below their near zero level, which is called the liquidity trap. The only alternative public policy would consist of fiscal policy that would act similarly to an increase in investment, increasing employment without raising the interest rate.

An influential view on the policy required to steer the economy away from the liquidity trap is provided by Paul Krugman (1998). Suppose the central bank faces an increase in inflation. An important ingredient of the control of inflation is the central bank communicating to the public that it will maintain a sustained effort by all available policy measures and required doses until inflation is subdued and price stability is attained. If the public believes that the central bank will control inflation only until it declines to a more benign level but not sufficiently low level, current expectations will develop that inflation will be higher once the central bank abandons harsh measures. During deflation and recession the central bank has to convince the public that it will maintain zero interest rates and other required measures until the rate of inflation returns convincingly to a level consistent with expansion of the economy and stable prices. Krugman (1998, 161) summarizes the argument as:

“The ineffectuality of monetary policy in a liquidity trap is really the result of a looking-glass version of the standard credibility problem: monetary policy does not work because the public expects that whatever the central bank may do now, given the chance, it will revert to type and stabilize prices near their current level. 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”

This view is consistent with results of research by Christina Romer that “the rapid rates of growth of real output in the mid- and late 1930s were largely due to conventional aggregate demand stimulus, primarily in the form of monetary expansion. My calculations suggest that in the absence of these stimuli the economy would have remained depressed far longer and far more deeply than it actually did” (Romer 1992, 757-8, cited in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 210-2). The average growth rate of the money supply in 1933-1937 was 10 percent per year and increased in the early 1940s. Romer calculates that GDP would have been much lower without this monetary expansion. The growth of “the money supply was primarily due to a gold inflow, which was in turn due to the devaluation in 1933 and to capital flight from Europe because of political instability after 1934” (Romer 1992, 759). Gold inflow coincided with the decline in real interest rates in 1933 that remained negative through the latter part of the 1930s, suggesting that they could have caused increases in spending that was sensitive to declines in interest rates. Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (Bernanke 2002):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US 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 US 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. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”

Fed policy is seeking what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher 1933, 350).

The President of the Federal Reserve Bank of Chicago argues that (Charles Evans 2010):

“I believe the US economy is best described as being in a bona fide liquidity trap. Highly plausible projections are 1 percent for core Personal Consumption Expenditures (PCE) inflation at the end of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual mandate misses are too large to shrug off, and there is currently no policy conflict between improving employment and inflation outcomes”

There are two types of monetary policies that could be used in this situation. First, the Fed could announce a price-level target to be attained within a reasonable time frame (Evans 2010):

“For example, if the slope of the price path is 2 percent and inflation has been underunning the path for some time, monetary policy would strive to catch up to the path. Inflation would be higher than 2 percent for a time until the path was reattained”

Optimum monetary policy with interest rates near zero could consist of “bringing the price level back up to a level even higher than would have prevailed had the disturbance never occurred” (Gauti Eggertsson and Michael Woodford 2003, 207). Bernanke (2003JPY) explains as follows:

“Failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods—greater quantities of assets purchased on the open market for example. So even if the central bank is reluctant to provide a time frame for meetings its objective, the structure of the price-level objective provides a means for the bank to commit to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and Woodford show, the expectations that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank’s own objectives by lowering the current real rate of interest”

Second, the Fed could use its balance sheet to increase purchases of long-term securities together with credible commitment to maintain the policy until the dual mandates of maximum employment and price stability are attained.

In the restatement of the liquidity trap and large-scale policies of monetary/fiscal stimulus, Krugman (1998, 162) finds:

“In the traditional open economy IS-LM model developed by Robert Mundell [1963] and Marcus Fleming [1962], and also in large-scale econometric models, monetary expansion unambiguously leads to currency depreciation. But there are two offsetting effects on the current account balance. On one side, the currency depreciation tends to increase net exports; on the other side, the expansion of the domestic economy tends to increase imports. For what it is worth, policy experiments on such models seem to suggest that these effects very nearly cancel each other out.

Krugman (1998) uses a different dynamic model with expectations that leads to similar conclusions.

The central bank could also be pursuing competitive devaluation of the national currency in the belief that it could increase inflation to a higher level and promote domestic growth and employment at the expense of growth and unemployment in the rest of the world. An essay by Chairman Bernanke in 1999 on Japanese monetary policy received attention in the press, stating that (Bernanke 2000, 165):

“Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and experiment—in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”

Quantitative easing has never been proposed by Chairman Bernanke or other economists as certain science without adverse effects. What has not been mentioned in the press is another suggestion to the Bank of Japan (BOJ) by Chairman Bernanke in the same essay that is very relevant to current events and the contentious issue of ongoing devaluation wars (Bernanke 2000, 161):

“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all 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. A yen trading at 100 to the dollar is in no one’s interest”

Chairman Bernanke is referring to the argument by Joan Robinson based on the experience of the Great Depression that: “in times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others” (Robinson 1947, 156). Devaluation is one of the tools used in these policies (Robinson 1947, 157). Banking crises dominated the experience of the United States, but countries that recovered were those devaluing early such that competitive devaluations rescued many countries from a recession as strong as that in the US (see references to Ehsan Choudhri, Levis Kochin and Barry Eichengreen in Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 205-9; for the case of Brazil that devalued early in the Great Depression recovering with an increasing trade balance see Pelaez, 1968, 1968b, 1972; Brazil devalued and abandoned the gold standard during crises in the historical period as shown by Pelaez 1976, Pelaez and Suzigan 1981). Beggar-my-neighbor policies did work for individual countries but the criticism of Joan Robinson was that it was not optimal for the world as a whole.

Chairman Bernanke (2013Mar 25) reinterprets devaluation and recovery from the Great Depression:

“The uncoordinated abandonment of the gold standard in the early 1930s gave rise to the idea of "beggar-thy-neighbor" policies. According to this analysis, as put forth by important contemporary economists like Joan Robinson, exchange rate depreciations helped the economy whose currency had weakened by making the country more competitive internationally. Indeed, the decline in the value of the pound after 1931 was associated with a relatively early recovery from the Depression by the United Kingdom, in part because of some rebound in exports. However, according to this view, the gains to the depreciating country were equaled or exceeded by the losses to its trading partners, which became less internationally competitive--hence, ‘beggar thy neighbor.’ Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression. However, modern research on the Depression, beginning with the seminal 1985 paper by Barry Eichengreen and Jeffrey Sachs, has changed our view of the effects of the abandonment of the gold standard. Although it is true that leaving the gold standard and the resulting currency depreciation conferred a temporary competitive advantage in some cases, modern research shows that the primary benefit of leaving gold was that it freed countries to use appropriately expansionary monetary policies. By 1935 or 1936, when essentially all major countries had left the gold standard and exchange rates were market-determined, the net trade effects of the changes in currency values were certainly small. Yet the global economy as a whole was much stronger than it had been in 1931. The reason was that, in shedding the strait jacket of the gold standard, each country became free to use monetary policy in a way that was more commensurate with achieving full employment at home.”

Nurkse (1944) raised concern on the contraction of trade by competitive devaluations during the 1930s. Haberler (1937) dwelled on the issue of flexible exchange rates. Bordo and James (2001) provide perceptive exegesis of the views of Haberler (1937) and Nurkse (1944) together with the evolution of thought by Haberler. Policy coordination among sovereigns may be quite difficult in practice even if there were sufficient knowledge and sound forecasts. Friedman (1953) provided strong case in favor of a system of flexible exchange rates.

Eichengreen and Sachs (1985) argue theoretically with measurements using a two-sector model that it is possible for series of devaluations to improve the welfare of all countries. There were adverse effects of depreciation on other countries but depreciation by many countries could be beneficial for all. The important counterfactual is if depreciations by many countries would have promoted faster recovery from the Great Depression. Depreciation in the model of Eichengreen and Sachs (1985) affected domestic and foreign economies through real wages, profitability, international competitiveness and world interest rates. Depreciation causes increase in the money supply that lowers world interest rates, promoting growth of world output. Lower world interest rates could compensate contraction of output from the shift of demand away from home goods originating in neighbor’s exchange depreciation. Eichengreen and Sachs (1985, 946) conclude:

“This much, however, is clear. We do not present a blanket endorsement of the competitive devaluations of the 1930s. Though it is indisputable that currency depreciation conferred macroeconomic benefits on the initiating country, because of accompanying policies the depreciations of the 1930s had beggar-thy-neighbor effects. Though it is likely that currency depreciation (had it been even more widely adopted) would have worked to the benefit of the world as a whole, the sporadic and uncoordinated approach taken to exchange-rate policy in the 1930s tended, other things being equal, to reduce the magnitude of the benefits.”

There could major difference in the current world economy. The initiating impulse for depreciation originates in zero interest rates on the fed funds rate. The dollar is the world’s reserve currency. Risk aversion intermittently channels capital flight to the safe haven of the dollar and US Treasury securities. In the absence of risk aversion, zero interest rates induce carry trades of short positions in dollars and US debt (borrowing) together with long leveraged exposures in risk financial assets such as stocks, emerging stocks, commodities and high-yield bonds. Without risk aversion, the dollar depreciates against every currency in the world. The dollar depreciated against the euro by 39.3 percent from USD 1.1423/EUR con Jun 26, 2003 to USD 1.5914/EUR on Jun 14, 2008 during unconventional monetary policy before the global recession (Table VI-1). Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can increases net exports of the US that increase aggregate economic activity (Yellen 2011AS). The country issuing the world’s reserve currency appropriates the advantage from initiating devaluation that in policy intends to generate net exports that increase domestic output.

Pelaez and Pelaez (Regulation of Banks and Finance (2009b), 208-209) summarize the experience of Brazil as follows:

“During 1927–9, Brazil accumulated ￡30 million of foreign exchange of which ￡20 million were deposited at its stabilization fund (Pelaez 1968, 43–4). After the decline in coffee prices and the first impact of the Great Depression in Brazil a hot money movement wiped out foreign exchange reserves. In addition, capital inflows stopped entirely. The deterioration of the terms of trade further complicated matters, as the value of exports in foreign currency declined abruptly. Because of this exchange crisis, the service of the foreign debt of Brazil became impossible. In August 1931, the federal government was forced to cancel the payment of principal on certain foreign loans. The balance of trade in 1931 was expected to yield ￡20 million whereas the service of the foreign debt alone amounted to ￡22.6 million. Part of the solution given to these problems was typical of the 1930s. In September 1931, the government of Brazil required that all foreign transactions were to be conducted through the Bank of Brazil. This monopoly of foreign exchange was exercised by the Bank of Brazil for the following three years. Export permits were granted only after the exchange derived from sales abroad was officially sold to the Bank, which in turn allocated it in accordance with the needs of the economy. An active black market in foreign exchange developed. Brazil was in the first group of countries that abandoned early the gold standard, in 1931, and suffered comparatively less from the Great Depression. The Brazilian federal government, advised by the BOE, increased taxes and reduced expenditures in 1931 to compensate a decline in custom receipts (Pelaez 1968, 40). Expenditures caused by a revolution in 1932 in the state of Sao Paulo and a drought in the northeast explain the deficit. During 1932–6, the federal government engaged in strong efforts to stabilize the budget. Apart from the deliberate efforts to balance the budget during the 1930s, the recovery in economic activity itself may have induced a large part of the reduction of the deficit (Ibid, 41). Brazil’s experience is similar to that of the United States in that fiscal policy did not promote recovery from the Great Depression.”

Is depreciation of the dollar the best available tool currently for achieving the dual mandate of higher inflation and lower unemployment? Bernanke (2002) finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“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.”

Should the US devalue following Roosevelt? Or has monetary policy intended devaluation? Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher, 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment.

The producer price index of the US from 1947 to 2013 in Chart IB-17 shows various periods of more rapid or less rapid inflation but no bumps. The major event is the decline in 2008 when risk aversion because of the global recession caused the collapse of oil prices from $148/barrel to less than $80/barrel with most other commodity prices also collapsing. The event had nothing in common with explanations of deflation but rather with the concentration of risk exposures in commodities after the decline of stock market indexes. Eventually, there was a flight to government securities because of the fears of insolvency of banks caused by statements supporting proposals for withdrawal of toxic assets from bank balance sheets in the Troubled Asset Relief Program (TARP), as explained by Cochrane and Zingales (2009). The bump in 2008 with decline in 2009 is consistent with the view that zero interest rates with subdued risk aversion induce carry trades into commodity futures.

Chart IIB-17, US, Producer Price Index, Finished Goods, NSA, 1947-2013

Source: US Bureau of Labor Statistics

http://www.bls.gov/ppi/

Chart IB-18 provides 12-month percentage changes of the producer price index from 1948 to 2013. The distinguishing event in Chart I-18 is the Great Inflation of the 1970s. The shape of the two-hump Bactrian camel of the 1970s resembles the double hump from 2007 to 2013.

Chart IIB-18, US, Producer Price Index, Finished Goods, 12-Month Percentage Change, NSA, 1948-2013

Source: US Bureau of Labor Statistics

http://www.bls.gov/ppi/

Annual percentage changes of the producer price index from 1948 to 2012 are shown in Table IIB-4. The producer price index fell 2.8 percent in 1949 following the adjustment to World War II and fell 0.6 percent in 1952 and 1.0 percent in 1953 around the Korean War. There are two other mild decline of 0.3 percent in 1959 and 0.3 percent in 1963. There are only few subsequent and isolated declines of the producer price index of 1.4 percent in 1986, 0.8 percent in 1998, 1.3 percent in 2002 and 2.6 percent in 2009. The decline of 2009 was caused by unwinding of carry trades in 2008 that had lifted oil prices to $140/barrel during deep global recession because of the panic of probable toxic assets in banks that would be removed with the Troubled Asset Relief Program (TARP) (Cochrane and Zingales 2009). There is no evidence in this history of 65 years of the US producer price index suggesting that there is frequent and persistent deflation shock requiring aggressive unconventional monetary policy. The design of such anti-deflation policy could provoke price and financial instability because of lags in effect of monetary policy, model errors, inaccurate forecasts and misleading analysis of current economic conditions.

Table IIB-4 US, Annual PPI Inflation ∆% 1948-2012

Year	Annual
1948	8.0
1949	-2.8
1950	1.8
1951	9.2
1952	-0.6
1953	-1.0
1954	0.3
1955	0.3
1956	2.6
1957	3.8
1958	2.2
1959	-0.3
1960	0.9
1961	0.0
1962	0.3
1963	-0.3
1964	0.3
1965	1.8
1966	3.2
1967	1.1
1968	2.8
1969	3.8
1970	3.4
1971	3.1
1972	3.2
1973	9.1
1974	15.4
1975	10.6
1976	4.5
1977	6.4
1978	7.9
1979	11.2
1980	13.4
1981	9.2
1982	4.1
1983	1.6
1984	2.1
1985	1.0
1986	-1.4
1987	2.1
1988	2.5
1989	5.2
1990	4.9
1991	2.1
1992	1.2
1993	1.2
1994	0.6
1995	1.9
1996	2.7
1997	0.4
1998	-0.8
1999	1.8
2000	3.8
2001	2.0
2002	-1.3
2003	3.2
2004	3.6
2005	4.8
2006	3.0
2007	3.9
2008	6.3
2009	-2.6
2010	4.2
2011	6.0
2012	1.9

Source: US Bureau of Labor Statistics

http://www.bls.gov/ppi/

Chart IIB-19 provides the consumer price index NSA from 1914 to 2013. The dominating characteristic is the increase in slope during the Great Inflation from the middle of the 1960s through the 1970s. There is long-term inflation in the US and no evidence of deflation risks.

Chart IIB-19, US, Consumer Price Index, NSA, 1914-2013

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

Chart IIB-20 provides 12-month percentage changes of the consumer price index from 1914 to 2013. The only episode of deflation after 1950 is in 2009, which is explained by the reversal of speculative commodity futures carry trades that were induced by interest rates driven to zero in a shock of monetary policy in 2008. The only persistent case of deflation is from 1930 to 1933, which has little if any relevance to the contemporary United States economy. There are actually three waves of inflation in the second half of the 1960s, in the mid 1970s and again in the late 1970s. Inflation rates then stabilized in a range with only two episodes above 5 percent.

Chart IIB-20, US, Consumer Price Index, All Items, 12- Month Percentage Change 1914-2013

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

Table IIB-5 provides annual percentage changes of United States consumer price inflation from 1914 to 2013. There have been only cases of annual declines of the CPI after wars: (1) World War I minus 10.5 percent in 1921 and minus 6.1 percent in 1922 following cumulative increases of 83.5 percent in four years from 1917 to 1920 at the average of 16.4 percent per year; (2) World War II: minus 1.2 percent in 1949 following cumulative 33.9 percent in three years from 1946 to 1948 at average 10.2 percent per year (3) minus 0.4 percent in 1955 two years after the end of the Korean War; and (4) minus 0.4 percent in 2009. The decline of 0.4 percent in 2009 followed increase of 3.8 percent in 2008 and is explained by the reversal of speculative carry trades into commodity futures that were created in 2008 as monetary policy rates were driven to zero. The reversal occurred after misleading statement on toxic assets in banks in the proposal for TARP (Cochrane and Zingales 2009). There were declines of 1.7 percent in both 1927 and 1928 during the episode of revival of rules of the gold standard. The only persistent deflationary period since 1914 was during the Great Depression in the years from 1930 to 1933 and again in 1938-1939. Fear of deflation on the basis of that experience does not justify unconventional monetary policy of zero interest rates that has failed to stop deflation in Japan. Financial repression causes far more adverse effects on allocation of resources by distorting the calculus of risk/returns than alleged employment-creating effects or there would not be current recovery without jobs and hiring after zero interest rates since Dec 2008 and intended now forever in a self-imposed forecast growth and employment mandate of monetary policy.

Table IIB-5, US, Annual CPI Inflation ∆% 1914-2012

Year	Annual
1914	1.0
1915	1.0
1916	7.9
1917	17.4
1918	18.0
1919	14.6
1920	15.6
1921	-10.5
1922	-6.1
1923	1.8
1924	0.0
1925	2.3
1926	1.1
1927	-1.7
1928	-1.7
1929	0.0
1930	-2.3
1931	-9.0
1932	-9.9
1933	-5.1
1934	3.1
1935	2.2
1936	1.5
1937	3.6
1938	-2.1
1939	-1.4
1940	0.7
1941	5.0
1942	10.9
1943	6.1
1944	1.7
1945	2.3
1946	8.3
1947	14.4
1948	8.1
1949	-1.2
1950	1.3
1951	7.9
1952	1.9
1953	0.8
1954	0.7
1955	-0.4
1956	1.5
1957	3.3
1958	2.8
1959	0.7
1960	1.7
1961	1.0
1962	1.0
1963	1.3
1964	1.3
1965	1.6
1966	2.9
1967	3.1
1968	4.2
1969	5.5
1970	5.7
1971	4.4
1972	3.2
1973	6.2
1974	11.0
1975	9.1
1976	5.8
1977	6.5
1978	7.6
1979	11.3
1980	13.5
1981	10.3
1982	6.2
1983	3.2
1984	4.3
1985	3.6
1986	1.9
1987	3.6
1988	4.1
1989	4.8
1990	5.4
1991	4.2
1992	3.0
1993	3.0
1994	2.6
1995	2.8
1996	3.0
1997	2.3
1998	1.6
1999	2.2
2000	3.4
2001	2.8
2002	1.6
2003	2.3
2004	2.7
2005	3.4
2006	3.2
2007	2.8
2008	3.8
2009	-0.4
2010	1.6
2011	3.2
2012	2.1

Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/data.htm

Friedman (1969) finds that the optimal rule for the quantity of money is deflation at a rate that results in a zero nominal interest rate (see Ireland 2003 and Cole and Kocherlakota 1998). Atkeson and Kehoe (2004) argue that central bankers are not inclined to implement policies that could result in deflation because of the interpretation of the Great Depression as closely related to deflation. They use panel data on inflation and growth of real output for 17 countries over more than 100 years. The time-series data for each individual country are broken into five-year events with deflation measured as average negative inflation and depression as average negative growth rate of real output. Atkeson and Kehoe (2004) find that the Great Depression from 1929 to 1934 is the only case of association between deflation and depression without any evidence whatsoever of such relation in any other period. Their conclusion is (Atkeson and Kehoe 2004, 99): “Our finding thus suggests that policymakers’ fear of anticipated policy-induced deflation that would result from following, say, the Friedman rule is greatly overblown.” Their conclusion on the experience of Japan is (Atkeson and Kehoe 2004, 99):

“Since 1960, Japan’s average growth rates have basically fallen monotonically, and since 1970, its average inflation rates have too. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think, is that much of the slowdown is the natural pattern for a country that was far behind the world leaders and had begun to catch up.”

In the sample of Atkeson and Kehoe (2004), there are only eight five-year periods besides the Great Depression with both inflation and depression. Deflation and depression is shown in 65 cases with 21 of depression without deflation. There is no depression in 65 of 73 five-year periods and there is no deflation in 29 episodes of depression. There is a remarkable result of no depression in 90 percent of deflation episodes. Excluding the Great Depression, there is virtually no relation of deflation and depression. Atkeson and Kehoe (2004, 102) find that the average growth rate of Japan of 1.41 percent in the 1990s is “dismal” when compared with 3.20 percent in the United States but is not “dismal” when compared with 1.61 percent for Italy and 1.84 percent for France, which are also catch-up countries in modern economic growth (see Atkeson and Kehoe 1998). The conclusion of Atkeson and Kehoe (2004), without use of controls, is that there is no association of deflation and depression in their dataset.

Benhabib and Spiegel (2009) use a dataset similar to that of Atkeson and Kehoe (2004) but allowing for nonlinearity and inflation volatility. They conclude that in cases of low and negative inflation an increase of average inflation of 1 percent is associated with an increase of 0.31 percent of average annual growth. The analysis of Benhabib and Spiegel (2009) leads to the significantly different conclusion that inflation and economic performance are strongly associated for low and negative inflation. There is no claim of causality by Atkeson and Kehoe (2004) and Benhabib and Spiegel (2009).

Delfim Netto (1959) partly reprinted in Pelaez (1973) conducted two classical nonparametric tests (Mann 1945, Wallis and Moore 1941; see Kendall and Stuart 1968) with coffee-price data in the period of free markets from 1857 to 1906 with the following conclusions (Pelaez, 1976a, 280):

“First, the null hypothesis of no trend was accepted with high confidence; secondly, the null hypothesis of no oscillation was rejected also with high confidence. Consequently, in the nineteenth century international prices of coffee fluctuated but without long-run trend. This statistical fact refutes the extreme argument of structural weakness of the coffee trade.”

In his classic work on the theory of international trade, Jacob Viner (1937, 563) analyzed the “index of total gains from trade,” or “amount of gain per unit of trade,” denoted as T:

T= (∆P^e/∆Pⁱ)∆Q

Where ∆P^e is the change in export prices, ∆Pⁱ is the change in import prices and ∆Q is the change in export volume. Dorrance (1948, 52) restates “Viner’s index of total gain from trade” as:

“What should be done is to calculate an index of the value (quantity multiplied by price) of exports and the price of imports for any country whose foreign accounts are to be analysed. Then the export value index should be divided by the import price index. The result would be an index which would reflect, for the country concerned, changes in the volume of imports obtainable from its export income (i.e. changes in its "real" export income, measured in import terms). The present writer would suggest that this index be referred to as the ‘income terms of trade’ index to differentiate it from the other indexes at present used by economists.”

What really matters for an export activity especially during modernization is the purchasing value of goods that it exports in terms of prices of imports. For a primary producing country, the purchasing power of exports in acquiring new technology from the country providing imports is the critical measurement. The barter terms of trade of Brazil improved from 1857 to 1906 because international coffee prices oscillated without trend (Delfim Netto 1959) while import prices from the United Kingdom declined at the rate of 0.5 percent per year (Imlah 1958). The accurate measurement of the opportunity afforded by the coffee exporting economy was incomparably greater when considering the purchasing power in British prices of the value of coffee exports, or Dorrance’s (1948) income terms of trade.

The conventional theory that the terms of trade of Brazil deteriorated over the long term is without reality (Pelaez 1976a, 280-281):

“Moreover, physical exports of coffee by Brazil increased at the high average rate of 3.5 per cent per year. Brazil's exchange receipts from coffee-exporting in sterling increased at the average rate of 3.5 per cent per year and receipts in domestic currency at 4.5 per cent per year. Great Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 per cent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 per cent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quality of coffee remained relatively constant, the quality of manufactured products improved significantly during the fifty-year period considered. The trade data and the non-parametric tests refute conclusively the long-run hypothesis. The valid historical fact is that the tropical export economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the "workshop" countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil.”

Imlah (1958) provides decline of British export prices at 0.5 percent in the nineteenth century and there were no lost decades, depressions or unconventional monetary policies in the highly dynamic economy of England that drove the world’s growth impulse. Inflation in the United Kingdom between 1857 and 1906 is measured by the composite price index of O’Donoghue and Goulding (2004) at minus 7.0 percent or average rate of decline of 0.2 percent per year.

Simon Kuznets (1971) analyzes modern economic growth in his Lecture in Memory of Alfred Nobel:

“The major breakthroughs in the advance of human knowledge, those that constituted dominant sources of sustained growth over long periods and spread to a substantial part of the world, may be termed epochal innovations. And the changing course of economic history can perhaps be subdivided into economic epochs, each identified by the epochal innovation with the distinctive characteristics of growth that it generated. Without considering the feasibility of identifying and dating such economic epochs, we may proceed on the working assumption that modern economic growth represents such a distinct epoch - growth dating back to the late eighteenth century and limited (except in significant partial effects) to economically developed countries. These countries, so classified because they have managed to take adequate advantage of the potential of modern technology, include most of Europe, the overseas offshoots of Western Europe, and Japan—barely one quarter of world population.”

Cameron (1961) analyzes the mechanism by which the Industrial Revolution in Great Britain spread throughout Europe and Cameron (1967) analyzes the financing by banks of the Industrial Revolution in Great Britain. O’Donoghue and Goulding (2004) provide consumer price inflation in England since 1750 and MacFarlane and Mortimer-Lee (1994) analyze inflation in England over 300 years. Lucas (2004) estimates world population and production since the year 1000 with sustained growth of per capita incomes beginning to accelerate for the first time in English-speaking countries and in particular in the Industrial Revolution in Great Britain. The conventional theory is unequal distribution of the gains from trade and technical progress between the industrialized countries and developing economies (Singer 1950, 478):

“Dismissing, then, changes in productivity as a governing factor in changing terms of trade, the following explanation presents itself: the fruits of technical progress may be distributed either to producers (in the form of rising incomes) or to consumers (in the form of lower prices). In the case of manufactured commodities produced in more developed countries, the former method, i.e., distribution to producers through higher incomes, was much more important relatively to the second method, while the second method prevailed more in the case of food and raw material production in the underdeveloped countries. Generalizing, we may say -that technical progress in manufacturing industries showed in a rise in incomes while technical progress in the production of food and raw materials in underdeveloped countries showed in a fall in prices”

Temin (1997, 79) uses a Ricardian trade model to discriminate between two views on the Industrial Revolution with an older view arguing broad-based increases in productivity and a new view concentration of productivity gains in cotton manufactures and iron:

“Productivity advances in British manufacturing should have lowered their prices relative to imports. They did. Albert Imlah [1958] correctly recognized this ‘severe deterioration’ in the net barter terms of trade as a signal of British success, not distress. It is no surprise that the price of cotton manufactures fell rapidly in response to productivity growth. But even the price of woolen manufactures, which were declining as a share of British exports, fell almost as rapidly as the price of exports as a whole. It follows, therefore, that the traditional ‘old-hat’ view of the Industrial Revolution is more accurate than the new, restricted image. Other British manufactures were not inefficient and stagnant, or at least, they were not all so backward. The spirit that motivated cotton manufactures extended also to activities as varied as hardware and haberdashery, arms, and apparel.”

Phyllis Deane (1968, 96) estimates growth of United Kingdom gross national product (GNP) at around 2 percent per year for several decades in the nineteenth century. The facts that the terms of trade of Great Britain deteriorated during the period of epochal innovation and high rates of economic growth while the income terms of trade of the coffee economy of nineteenth-century Brazil improved at the average yearly rate of 4.0 percent from 1857 to 1906 disprove the hypothesis of weakness of trade as an explanation of relatively lower income and wealth. As Temin (1997) concludes, Britain did pass on lower prices and higher quality the benefits of technical innovation. Explanation of late modernization must focus on laborious historical research on institutions and economic regimes together with economic theory, data gathering and measurement instead of grand generalizations of weakness of trade and alleged neocolonial dependence (Stein and Stein 1970, 134-5):

“Great Britain, technologically and industrially advanced, became as important to the Latin American economy as to the cotton-exporting southern United States. [After Independence in the nineteenth century] Latin America fell back upon traditional export activities, utilizing the cheapest available factor of production, the land, and the dependent labor force.”

The experience of the United Kingdom with deflation and economic growth is relevant and rich. Table IA-6 provides yearly percentage changes of the composite index of prices of the United Kingdom of O’Donoghue and Goulding (2004). There are 73 declines of inflation in the 145 years from 1751 to 1896. Prices declined in 50.3 percent of 145 years. Some price declines were quite sharp and many occurred over several years. Table IA-6 also provides yearly percentage changes of the UK composite price index of O’Donoghue and Goulding (2004) from 1929 to 1934. Deflation was much sharper in continuous years in earlier periods than during the Great Depression. The United Kingdom could not have led the world in modern economic growth if there were meaningful causality from deflation to depression.

Table IA-6, United Kingdom, Negative Percentage Changes of Composite Price Index, 1751-1896, 1929-1934, Yearly ∆%

Year	∆%	Year	∆%	Year	∆%	Year	∆%
1751	-2.7	1797	-10.0	1834	-7.8	1877	-0.7
1753	-2.7	1798	-2.2	1841	-2.3	1878	-2.2
1755	-6.0	1802	-23.0	1842	-7.6	1879	-4.4
1758	-0.3	1803	-5.9	1843	-11.3	1881	-1.1
1759	-7.9	1806	-4.4	1844	-0.1	1883	-0.5
1760	-4.5	1807	-1.9	1848	-12.1	1884	-2.7
1761	-4.5	1811	-2.9	1849	-6.3	1885	-3.0
1768	-1.1	1814	-12.7	1850	-6.4	1886	-1.6
1769	-8.2	1815	-10.7	1851	-3.0	1887	-0.5
1770	-0.4	1816	-8.4	1857	-5.6	1893	-0.7
1773	-0.3	1819	-2.5	1858	-8.4	1894	-2.0
1775	-5.6	1820	-9.3	1859	-1.8	1895	-1.0
1776	-2.2	1821	-12.0	1862	-2.6	1896	-0.3
1777	-0.4	1822	-13.5	1863	-3.6	1929	-0.9
1779	-8.5	1826	-5.5	1864	-0.9	1930	-2.8
1780	-3.4	1827	-6.5	1868	-1.7	1931	-4.3
1785	-4.0	1828	-2.9	1869	-5.0	1932	-2.6
1787	-0.6	1830	-6.1	1874	-3.3	1933	-2.1
1789	-1.3	1832	-7.4	1875	-1.9	1934	0.0
1791	-0.1	1833	-6.1	1876	-0.3

Source:

O’Donoghue, Jim and Louise Goulding, 2004. Consumer Price Inflation since 1750. UK Office for National Statistics Economic Trends 604, Mar 2004, 38-46.

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. If deflation causes depressions as embedded in the theory of unconventional monetary policy, the United Kingdom would not have been a growth leader in the nineteenth century while staying almost half of the time in deflation.

Nicholas Georgescu-Rogen (1960, 1) reprinted in Pelaez (1973) argues that “the agrarian economy has to this day remained a reality without theory.” The economic history of Latin America shares with the relation of deflation and unconventional monetary policy a more frustrating intellectual misfortune: theory without reality. MacFarlane and Mortimer-Lee (1994, 159) quote in a different context a phrase by Thomas Henry Huxley in the President’s Address to the British Association for the Advancement of Science on Sep 14, 1870 that is appropriate to these issues: “The great tragedy of science—the slaying of a beautiful hypothesis by an ugly fact.”

III World Financial Turbulence. Financial markets are being shocked by multiple factors including:

(1) world economic slowdown; (2) slowing growth in China with political development and slowing growth in Japan and world trade; (3) slow growth propelled by savings/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse, contraction of real private fixed investment, decline of wealth of households over the business cycle by 5.2 percent adjusted for inflation while growing 651.8 percent adjusted for inflation from IVQ1945 to IVQ2012 and unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes; and (4) 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 financial assets during the week. There are various appendixes for convenience of reference of material related to the debt crisis of the euro area. 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 and is available in the Appendixes section at the end of the blog comment. 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 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. 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 and is available in the Appendixes section at the end of the blog comment.

IIIA Financial Risks. Financial turbulence, attaining unusual magnitude in recent months, characterized the expansion from the global recession since IIIQ2009. Table III-1, updated with every comment in this blog, provides beginning values on Fri Jun 14 and daily values throughout the week ending on Jun 21, 2013 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 14 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jun 14, 2013”, first row “USD/EUR 1.3345 -0.9%,” provides the information that the US dollar (USD) depreciated 0.9 percent to USD 1.3345/EUR in the week ending on Fri Jun 14 relative to the exchange rate on Fri Jun 7. 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) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3345/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jun 14, depreciating to USD 1.3366/EUR on Mon Jun 17, 2013, or by 0.2 percent. The dollar depreciated because more dollars, $1.3366, were required on Mon Jun 17 to buy one euro than $1.3345 on Jun 14. 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 such as 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 1.3345/EUR on Jun 14; 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 14, to the last business day of the current week, in this case Fri Jun 21, such as appreciation to USD 1.3122/EUR by Jun 21; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (denoted by positive sign) by 1.7 percent from the rate of USD 1.3345/EUR on Fri Jun 14 to the rate of USD 1.3122/EUR on Fri Jun 21 {[(1.3122/1.3345) – 1]100 = -1.7%} and appreciated (denoted by positive sign) by 0.7 percent from the rate of USD 1.3219 on Thu Jun 20 to USD 1.3122/EUR on Fri Jun 21 {[(1.3122/1.3219) -1]100 = -0.7%}. 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 assets to the safety of dollar-denominated assets during risk aversion and return to higher yielding risk assets during risk appetite.

III-I, Weekly Financial Risk Assets Jun 17 to Jun 21, 2013

Fri Jun 14, 2013	M 17	Tue 18	Wed 19	Thu 20	Fri 21
USD/EUR 1.3345 -0.9%	1.3366 -0.2% -0.2%	1.3394 -0.4% -0.2%	1.3296 0.4% 0.7%	1.3219 0.9% 0.6%	1.3122 1.7% 0.7%
JPY/  USD 94.08 3.5%	94.49 -0.4% -0.4%	95.34 -1.3% -0.9%	96.45 -2.5% -1.2%	97.28 -3.4% -0.9%	97.90 -4.1% -0.6%
CHF/  USD 0.9211 1.6%	0.9226 -0.2% -0.2%	0.9199 0.1% 0.3%	0.9280 -0.7% -0.9%	0.9275 -0.7% 0.1%	0.9345 -1.5% -0.8%
CHF/ EUR 1.2290 0.7%	1.2331 -0.3% -0.3%	1.2322 -0.1% 0.1%	1.2343 -0.4% -0.2%	1.2270 0.2% 0.6%	1.2261 0.2% 0.1%
USD/  AUD 0.9570 1.0449 0.8%	0.9550 1.0471 -0.2% -0.2%	0.9486 1.0542 -0.9% -0.7%	0.9297 1.0756 -2.9% -2.0%	0.9197 1.0873 -4.1% -1.1%	0.9218 1.0848 -3.8% 0.2%
10 Year  T Note 2.125	2.18	2.188	2.333	2.424	2.542
2 Year     T Note 0.276	0.264	0.264	0.304	0.329	0.366
German Bond 2Y 0.12 10Y 1.51	2Y 0.13 10Y 1.52	2Y 0.17 10Y 1.57	2Y 0.16 10Y 1.56	2Y 0.25 10Y 1.67	2Y 0.26 10Y 1.72
DJIA 15070.18 -1.2%	15179.85 0.7% 0.7%	15318.23 1.6% 0.9%	15112.19 0.3% -1.3%	14758.32 -2.1% -2.3%	14799.40 -1.8% 0.3%
DJ Global 2148.22 -0.8%	2169.34 1.0% 1.0%	2178.74 1.4% 0.4%	2170.86 1.1% -0.4%	2092.30 -2.6% -3.6%	2087.03 -2.8% -0.3%
DJ Asia Pacific 1338.27 0.3%	1354.72 1.2% 1.2%	1348.23 0.7% -0.5%	1362.41 1.8% 1.1%	1307.66 -2.3% -4.0%	1308.86 -2.2% 0.1%
Nikkei 12686.52 -1.5%	13033.12 2.7% 2.7%	13007.28 2.5% -0.2%	13245.22 4.4% 1.8%	13014.58 2.6% -1.7%	13230.13 4.3% 1.7%
Shanghai 2162.04 -2.2%	2156.21 0.3% -0.3%	2159.29 -0.1% 0.1%	2143.45 -0.9% -0.7%	2084.02 -3.6% -2.8%	2073.10 -4.1% -0.5%
DAX 8127.96 -1.5%	8215.73 1.1% 1.1%	8229.51 1.2% 0.2%	8197.08 0.9% -0.4%	7928.48 -2.5% -3.3%	7789.24 -4.2% -1.8%
DJ UBS Comm. 130.37 -0.7%	130.76 0.3% 0.3%	130.90 0.4% 0.1%	131.97 1.2% 0.8%	128.060 -1.8% -3.0%	127.28 -2.4% -0.6%
WTI $ B 97.89 1.7%	97.65 -0.2% -0.2%	98.54 0.7% 0.9%	97.92 0.0% -0.6%	95.40 -2.5% -2.6%	93.86 -4.1% -1.6%
Brent    $/B 105.88 1.1%	105.62 -0.2% -0.2%	106.08 0.2% 0.4%	105.69 -0.2% -0.4%	101.89 -3.8% -3.6%	100.94 -4.7% -0.9%
Gold  $/OZ 1381.2 0.6%	1384.9 0.3% 0.3%	1368.2 -0.9% -1.2%	1350.3 -2.2% -1.3%	1275.9 -7.6% -5.5%	1294.9 -6.2% 1.5%

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

There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.

First, risk determining events. Prior risk determining events are in an appendix below following Table III-1A. Current focus is on “paring” of quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Market are overreacting to the so-called “paring” of outright purchases of $85 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Jun 19, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130619a.htm):

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent” (emphasis added).

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2013/01/peaking-valuation-of-risk-financial.html). Matt Jarzemsky, writing on Dow industrials set record,” on Mar 5, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324156204578275560657416332.html), analyzes that the DJIA broke the closing high of 14,164.53 set on Oct 9, 2007, and subsequently also broke the intraday high of 14,198.10 reached on Oct 11, 2007. The DJIA closed at 14,799.40

on Fri Jun 14, 2013, which is higher by 4.5 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 4.2 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

The key policy is maintaining fed funds rate between 0 and ¼ percent. An increase in fed funds rates could cause flight out of risk financial markets worldwide. There is no exit from this policy without major financial market repercussions. There are high costs and risks of this policy because indefinite financial repression induces carry trades with high leverage, risks and illiquidity.

Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 10, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 4.873 percent on Jun 21, 2013, and that of the ten-year sovereign bond of Italy at 4.591 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes 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 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Jun 21, 2013, the yield of the two-year Treasury jumped to 0.366 percent and that of the ten-year Treasury to 2.542 percent while the two-year bond of Germany increased to 0.26 percent and the ten-year to 1.72 percent; and the dollar appreciated to USD 1.3122/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that 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 higher than consumer price inflation of 1.4 percent in the 12 months ending in May 2013 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/05/word-inflation-waves-squeeze-of.html) and the expectation of higher inflation if risk aversion diminishes. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. 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
6/21/13	0.366	2.542	0.26	1.72	1.3122
6/14/13	0.276	2.125	0.12	1.51	1.3345
6/7/13	0.304	2.174	0.18	1.54	1.3219
5/31/13	0.299	2.132	0.06	1.50	1.2996
5/24/13	0.249	2.009	0.00	1.43	1.2932
5/17/13	0.248	1.952	-0.03	1.32	1.2837
5/10/13	0.239	1.896	0.05	1.38	1.2992
5/3/13	0.22	1.742	0.00	1.24	1.3115
4/26/13	0.209	1.663	0.00	1.21	1.3028
4/19/13	0.232	1.702	0.02	1.25	1.3052
4/12/13	0.228	1.719	0.02	1.26	1.3111
4/5/13	0.228	1.706	0.01	1.21	1.2995
3/29/13	0.244	1.847	-0.02	1.29	1.2818
3/22/13	0.242	1.931	0.03	1.38	1.2988
3/15/13	0.246	1.992	0.05	1.46	1.3076
3/8/13	0.256	2.056	0.09	1.53	1.3003
3/1/13	0.236	1.842	0.03	1.41	1.3020
2/22/13	0.252	1.967	0.13	1.57	1.3190
2/15/13	0.268	2.007	0.19	1.65	1.3362
2/8/13	0.252	1.949	0.18	1.61	1.3365
2/1/13	0.26	2.024	0.25	1.67	1.3642
1/25/13	0.278	1.947	0.26	1.64	1.3459
1/18/13	0.252	1.84	0.18	1.56	1.3321
1/11/13	0.247	1.862	0.13	1.58	1.3343
1/4/13	0.262	1.898	0.08	1.54	1.3069
12/28/12	0.252	1.699	-0.01	1.31	1.3218
12/21/12	0.272	1.77	-0.01	1.38	1.3189
12/14/12	0.232	1.704	-0.04	1.35	1.3162
12/7/12	0.256	1.625	-0.08	1.30	1.2926
11/30/12	0.248	1.612	0.01	1.39	1.2987
11/23/12	0.273	1.691	0.00	1.44	1.2975
11/16/12	0.24	1.584	-0.03	1.33	1.2743
11/9/12	0.256	1.614	-0.03	1.35	1.2711
11/2/12	0.274	1.715	0.01	1.45	1.2838
10/26/12	0.299	1.748	0.05	1.54	1.2942
10/19/12	0.296	1.766	0.11	1.59	1.3023
10/12/12	0.264	1.663	0.04	1.45	1.2953
10/5/12	0.26	1.737	0.06	1.52	1.3036
9/28/12	0.236	1.631	0.02	1.44	1.2859
9/21/12	0.26	1.753	0.04	1.60	1.2981
9/14/12	0.252	1.863	0.10	1.71	1.3130
9/7/12	0.252	1.668	0.03	1.52	1.2816
8/31/12	0.225	1.543	-0.03	1.33	1.2575
8/24/12	0.266	1.684	-0.01	1.35	1.2512
8/17/12	0.288	1.814	-0.04	1.50	1.2335
8/10/12	0.267	1.658	-0.07	1.38	1.2290
8/3/12	0.242	1.569	-0.02	1.42	1.2387
7/27/12	0.244	1.544	-0.03	1.40	1.2320
7/20/12	0.207	1.459	-0.07	1.17	1.2158
7/13/12	0.24	1.49	-0.04	1.26	1.2248
7/6/12	0.272	1.548	-0.01	1.33	1.2288
6/29/12	0.305	1.648	0.12	1.58	1.2661
6/22/12	0.309	1.676	0.14	1.58	1.2570
6/15/12	0.272	1.584	0.07	1.44	1.2640
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

Appendix: Prior Risk Determining Events. Current risk analysis concentrates on deciphering what the Federal Open Market Committee (FOMC) may decide on quantitative easing. The week of May 24 was dominated by the testimony of Chairman Bernanke to the Joint Economic Committee of the US Congress on May 22, 2013 (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm), followed by questions and answers and the release on May 22, 2013 of the minutes of the meeting of the Federal Open Market Committee (FOMC) from Apr 30 to May 1, 2013 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm). Monetary policy emphasizes communication of policy intentions to avoid that expectations reverse outcomes in reality (Kydland and Prescott 1977). Jon Hilsenrath, writing on “In bid for clarity, Fed delivers opacity,” on May 23, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath), analyzes discrepancies in communication by the Fed. The annotated chart of values of the Dow Jones Industrial Average (DJIA) during trading on May 23, 2013 provided by Hinselrath, links the prepared testimony of Chairman Bernanke at 10:AM, following questions and answers and the release of the minutes of the FOMC at 2PM. Financial markets strengthened between 10 and 10:30AM on May 23, 2013, perhaps because of the statement by Chairman Bernanke in prepared testimony (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm):

“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.”

In that testimony, Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm) also analyzes current weakness of labor markets:

“Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers' skills and--particularly relevant during this commencement season--by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.”

Hilsenrath (op. cit. http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath) analyzes the subsequent decline of the market from 10:30AM to 10:40AM as Chairman Bernanke responded questions with the statement that withdrawal of stimulus would be determined by data but that it could begin in one of the “next few meetings.” The DJIA recovered part of the losses between 10:40AM and 2PM. The minutes of the FOMC released at 2PM on May 23, 2013, contained a phrase that troubled market participants (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm): “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.” The DJIA closed at 15,387.58 on May 21, 2013 and fell to 15,307.17 at the close on May 22, 2013, with the loss of 0.5 percent occurring after release of the minutes of the FOMC at 2PM when the DJIA stood at around 15,400. The concern about exist of the Fed from stimulus affected markets worldwide as shown in declines of equity indexes in Table III-1 with delays because of differences in trading hours. This behavior shows the trap of unconventional monetary policy with no exit from zero interest rates without risking financial crash and likely adverse repercussions on economic activity.

Financial markets worldwide were affected by the reduction of policy rates of the European Central Bank (ECB) on May 2, 2013. (http://www.ecb.int/press/pr/date/2013/html/pr130502.en.html):

“2 May 2013 - Monetary policy decisions

At today’s meeting, which was held in Bratislava, the Governing Council of the ECB took the following monetary policy decisions:

1. The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.50%, starting from the operation to be settled on 8 May 2013.
2. The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
3. The interest rate on the deposit facility will remain unchanged at 0.00%.”

Financial markets in Japan and worldwide were shocked by new bold measures of “quantitative and qualitative monetary easing” by the Bank of Japan (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The objective of policy is to “achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The main elements of the new policy are as follows:

1. Monetary Base Control. Most central banks in the world pursue interest rates instead of monetary aggregates, injecting bank reserves to lower interest rates to desired levels. The Bank of Japan (BOJ) has shifted back to monetary aggregates, conducting money market operations with the objective of increasing base money, or monetary liabilities of the government, at the annual rate of 60 to 70 trillion yen. The BOJ estimates base money outstanding at “138 trillion yen at end-2012) and plans to increase it to “200 trillion yen at end-2012 and 270 trillion yen at end 2014” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
2. Maturity Extension of Purchases of Japanese Government Bonds. Purchases of bonds will be extended even up to bonds with maturity of 40 years with the guideline of extending the average maturity of BOJ bond purchases from three to seven years. The BOJ estimates the current average maturity of Japanese government bonds (JGB) at around seven years. The BOJ plans to purchase about 7.5 trillion yen per month (http://www.boj.or.jp/en/announcements/release_2013/rel130404d.pdf). Takashi Nakamichi, Tatsuo Ito and Phred Dvorak, wiring on “Bank of Japan mounts bid for revival,” on Apr 4, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323646604578401633067110420.html ), find that the limit of maturities of three years on purchases of JGBs was designed to avoid views that the BOJ would finance uncontrolled government deficits.
3. Seigniorage. The BOJ is pursuing coordination with the government that will take measures to establish “sustainable fiscal structure with a view to ensuring the credibility of fiscal management” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
4. Diversification of Asset Purchases. The BOJ will engage in transactions of exchange traded funds (ETF) and real estate investment trusts (REITS) and not solely on purchases of JGBs. Purchases of ETFs will be at an annual rate of increase of one trillion yen and purchases of REITS at 30 billion yen.

The European sovereign debt crisis continues to shake financial markets and the world economy. Debt resolution within the international financial architecture requires that a country be capable of borrowing on its own from the private sector. Mechanisms of debt resolution have included participation of the private sector (PSI), or “bail in,” that has been voluntary, almost coercive, agreed and outright coercive (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Creditors and Debtors (2005), Chapter 4, 187-202). Private sector involvement requires losses by the private sector in bailouts of highly indebted countries. The essence of successful private sector involvement is to recover private-sector credit of the highly indebted country. Mary Watkins, writing on “Bank bailouts reshuffle risk hierarchy,” published on Mar 19, 2013, in the Financial Times (http://www.ft.com/intl/cms/s/0/7666546a-9095-11e2-a456-00144feabdc0.html#axzz2OSpbvCn8) analyzes the impact of the bailout or resolution of Cyprus banks on the hierarchy of risks of bank liabilities. Cyprus banks depend mostly on deposits with less reliance on debt, raising concerns in creditors of fixed-income debt and equity holders in banks in the euro area. Uncertainty remains as to the dimensions and structure of losses in private sector involvement or “bail in” in other rescue programs in the euro area. Alkman Granitsas, writing on “Central bank details losses at Bank of Cyprus,” on Mar 30, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324000704578392502889560768.html), analyzes the impact of the agreement with the €10 billion agreement with IMF and the European Union on the banks of Cyprus. The recapitalization plan provides for immediate conversion of 37.5 percent of all deposits in excess of €100,000 to shares of special class of the bank. An additional 22.5 percent will be frozen without interest until the plan is completed. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):

“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.

Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans.

Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.

An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):

“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.

The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”

Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.

The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.

First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:

“The European Council called for work to proceed on the proposals on the Single Supervisory Mechanism as a matter of priority with the objective of agreeing on the legislative framework by 1st January 2013 and agreed on a number of orientations to that end. It also took note of issues relating to the integrated budgetary and economic policy frameworks and democratic legitimacy and accountability which should be further explored. It agreed that the process towards deeper economic and monetary union should build on the EU's institutional and legal framework and be characterised by openness and transparency towards non-euro area Member States and respect for the integrity of the Single Market. It looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based.”

Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. The Bank of Spain released new data on doubtful debtors in Spain’s credit institutions (http://www.bde.es/bde/en/secciones/prensa/Agenda/Datos_de_credit_a6cd708c59cf931.html). In 2006, the value of doubtful credits reached €10,859 million or 0.7 percent of total credit of €1,508,626 million. In Aug 2012, doubtful credit reached €178,579 million or 10.5 percent of total credit of €1,698,714 million.

There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):

“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 agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.

(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):

“6 September 2012 - Technical features of Outright Monetary Transactions

As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:

Conditionality

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.

Coverage

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

Sterilisation

The liquidity created through Outright Monetary Transactions will be fully sterilised.

Transparency

Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

Securities Markets Programme

Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”

Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):

“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.

Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):

“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.

The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”

Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).

Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year, one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for July 31, 2001, are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one month at 4.95 percent, the two-year at 4.59 percent and the ten year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Jun 20, 2013, with the one-month yield at 0.03 percent, the two-year at 0.33 percent, the ten-year at 2.41 percent, the fed funds rate at 0.10 percent and the corporate Baa bond at 5.34 percent.

Chart III-1A, US, Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields, Overnight Fed Funds Rate and Yield of Moody’s Baa Corporate Bond, Jul 31, 2001-Jun 20, 2013

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Alexandra Scaggs, writing on “Tepid profits, roaring stocks,” on May 16, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323398204578487460105747412.html), analyzes stabilization of earnings growth: 70 percent of 458 reporting companies in the S&P 500 stock index reported earnings above forecasts but sales fell 0.2 percent relative to forecasts of increase of 0.5 percent. Paul Vigna, writing on “Earnings are a margin story but for how long,” on May 17, 2013, published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2013/05/17/earnings-are-a-margin-story-but-for-how-long/), analyzes that corporate profits increase with stagnating sales while companies manage costs tightly. More than 90 percent of S&P components reported moderate increase of earnings of 3.7 percent in IQ2013 relative to IQ2012 with decline of sales of 0.2 percent. Earnings and sales have been in declining trend. In IVQ2009, growth of earnings reached 104 percent and sales jumped 13 percent. Net margins reached 8.92 percent in IQ2013, which is almost the same at 8.95 percent in IIIQ2006. Operating margins are 9.58 percent. There is concern by market participants that reversion of margins to the mean could exert pressure on earnings unless there is more accelerated growth of sales. Vigna (op. cit.) finds sales growth limited by weak economic growth. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. Future company cash flows derive from investment projects. Real private fixed investment fell 8.8 percent from $2,111.5 billion in IVQ2007 to $1925.6 billion in IQ2013 or by 8.8 percent compared with growth of 24.1 percent of gross private domestic investment from IQ1980 to IVQ1985 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). Undistributed profits of US corporations swelled 205 percent from $118.0 billion IQ2007 to $359.9 billion in IQ2013 and minus $22.1 billion in billion in IVQ2007 (http://cmpassocregulationblog.blogspot.com/2013/06/mediocre-united-states-economic-growth.html). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $43.8 billion relative to IVQ2012 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp1q13_2nd.pdf), from $2013.0 billion to $1969.2 billion at the quarterly rate of minus 2.2 percent. The investment decision of US business is fractured. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines.

There was mostly weak performance in equity indexes with several indexes in Table III-1 decreasing in the week ending on Jun 21, 2013. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.3 percent on Jun 21, decreasing 1.8 percent in the week. Germany’s Dax decreased 1.8 percent on Fri Jun 21 and decreased 4.2 percent in the week. Dow Global decreased 0.3 percent on Jun 21 and decreased 2.8 percent in the week. Japan’s Nikkei Average increased 1.7 percent on Fri Jun 21 and increased 4.3 percent in the week as the yen continues to be oscillating but relatively weaker and the stock market gains in expectations of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM increased 0.1 percent on Jun 21 and decreased 2.2 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2073.10 on Fri Jun 21 for decrease of 0.5 percent and decrease of 4.1 percent in the week of Jun 21. There is evident trend of deceleration of the world economy that could affect corporate revenue and equity valuations, causing oscillation in equity markets with increases during favorable risk appetite.

Commodities were mostly weaker in the week of Jun 21, 2013. The DJ UBS Commodities Index decreased 0.6 percent on Fri Jun 21 and decreased 2.4 percent in the week, as shown in Table III-1. WTI decreased 4.1 percent in the week of Jun 21 while Brent decreased 4.7 percent in the week. Gold increased 1.5 percent on Fri Jun 21 and decreased 6.2 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €821,785 million on Jun 14, 2013 with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €1,427,741 million in the statement of Jun 7, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €89,754 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Jun 14, 2013
1 Gold and other Receivables	367,402	419,822	435,315
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	255,616
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	29,320
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,339
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	821,785
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	94,982
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	605,956
8 General Government Debt Denominated in Euro	34,954	33,928	29,012
9 Other Assets	278,719	336,574	260,359
TOTAL ASSETS	2,004, 432	2,733,235	2,550,684
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,427,741
Capital and Reserves	78,143	85,748	89,754

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/2013/html/fs130618.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would ensure that success. 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 surpluses 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), or euro area, are only 40.5 percent of the total. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at 5.3 percent in Jan-Apr 2013 relative to Jan-Apr 2012 while those to EMU are growing at minus 3.8 percent.

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

Apr 2013	Exports % Share	∆% Jan-Apr 2013/ Jan-Apr 2012	Imports % Share	∆% Jan-Apr 2013/ Jan-Apr 2012
EU	53.7	-3.2	52.9	-2.2
EMU 17	40.5	-3.8	42.7	-2.1
France	11.1	-2.1	8.3	-4.5
Germany	12.5	-4.6	14.6	-6.0
Spain	4.7	-9.0	4.4	-1.2
UK	4.9	-0.2	2.5	-0.9
Non EU	46.3	5.3	47.1	-10.8
Europe non EU	13.9	3.0	11.3	8.0
USA	6.8	0.3	3.3	-21.0
China	2.3	3.4	6.5	-5.7
OPEC	5.7	14.7	10.8	-23.8
Total	100.0	0.5	100.0	-6.3

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/93481

Table VG-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €570 million with the 17 countries of the euro zone (EMU 17) in Apr 2013 and cumulative deficit of €1726 million in Jan-Apr 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €1948 million in Jan-Apr 2013 with Europe non European Union, the trade surplus of €4443 million with the US and trade surplus with non-European Union of €2521 million in Jan-Apr 2013. There is significant rigidity in the trade deficits in Jan-Apr 2013 of €4705 million with China and €3619 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

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

Regions and Countries	Trade Balance Apr 2013 Millions of Euro	Trade Balance Cumulative Jan-Apr 2013 Millions of Euro
EU	441	2,105
EMU 17	-570	-1,726
France	853	3,973
Germany	-282	-1,708
Spain	8	316
UK	805	2,836
Non EU	1,466	2,521
Europe non EU	780	1,948
USA	1,213	4,443
China	-913	-4,705
OPEC	-520	-3,619
Total	1,907	4,626

Notes: EU: European Union; EMU: European Monetary Union (euro zone) http://www.istat.it/it/archivio/93481

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/93481

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Apr 2013 relative to Jan-Apr 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 18.5 percent and minus 10.9 percent for durable goods. The higher rate of growth of exports of 0.5 percent in Jan-Apr 2013/Jan-Apr 2012 relative to imports of minus 6.3 percent may reflect weak demand in Italy with GDP declining during seven consecutive quarters from IIIQ2011 through IQ2013 together with softening commodity prices.

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

	Exports Share %	Exports ∆% Jan-Apr 2013/ Jan-Apr 2012	Imports Share %	Imports ∆% Jan-Apr 2013/ Jan-Apr 2012
Consumer Goods	29.3	7.2	25.6	0.9
Durable	5.8	2.0	2.9	-10.9
Non-Durable	23.5	8.5	22.7	2.4
Capital Goods	31.6	0.4	19.5	-6.5
Inter- mediate Goods	33.6	-2.2	32.6	-2.8
Energy	5.5	-16.3	22.3	-18.5
Total ex Energy	94.5	1.5	77.7	-2.6
Total	100.0	0.5	100.0	-6.3

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/93481

Table III-6 provides Italy’s trade balance by product categories in Apr 2013 and cumulative Jan-Apr 2013. Italy’s trade balance excluding energy generated surplus of €6467 million in Apr 2013 and €23,446 million cumulative in Jan-Apr 2013 but the energy trade balance created deficit of €4559 million in Apr 2013 and cumulative €18,820 million in Jan-Apr 2013. The overall surplus in Apr 2013 was €1907 million with cumulative surplus of €4626 million in Jan-Apr 2013. 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

	Apr 2013	Cumulative Jan-Apr 2013
Consumer Goods	1,483	6,530
Durable	1,003	4,044
Nondurable	480	2,487
Capital Goods	4,385	15,274
Intermediate Goods	599	1,642
Energy	-4,559	-18,820
Total ex Energy	6,467	23,446
Total	1,907	4,626

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/93481

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

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF 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, 2011, 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 exceeding 100 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/2013/01/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 2013.

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

	GDP 2013 USD Billions	Primary Net Lending Borrowing % GDP 2013	General Government Net Debt % GDP 2013
World	74,172
Euro Zone	12,752	-0.04	73.9
Portugal	218	-1.4	115.0
Ireland	222	-3.2	106.2
Greece	244	--	155.4
Spain	1,388	-3.5	79.1
Major Advanced Economies G7	34,068	-3.8	91.5
United States	16,238	-4.6	89.0
UK	2,423	-5.0	86.1
Germany	3,598	1.8	54.1
France	2,739	-1.4	86.5
Japan	5,150	-9.0	143.4
Canada	1,844	-2.4	35.9
Italy	2,076	2.7	102.3
China	9,020	-2.1*	21.3**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2013” to the column “GDP USD Billions.” The total debt of France and Germany in 2013 is $4315.7 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 $4087.3 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 $8403.0 billion, which would be equivalent to 132.6 percent of their combined GDP in 2013. 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 233.5 percent if including debt of France and 167.7 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	9,423.7
B Germany	1,946.5		$8403.0 as % of $3598 =233.5% $6033.8 as % of $3598 =167.7%
C France	2,369.2
B+C	4,315.7	GDP $6,337.0 Total Debt $8403.0 Debt/GDP: 132.6%
D Italy	2,123.7
E Spain	1,097.9
F Portugal	250.7
G Greece	379.2
H Ireland	235.8
Subtotal D+E+F+G+H	4,087.3

Source: calculation with IMF data IMF World Economic Outlook databank http://www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx

There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Apr 2013. German exports to other European Union (EU) members are 55.9 percent of total exports in Apr 2013 and 57.4 percent in cumulative Jan-Apr 2013. Exports to the euro area are 34.5 percent in Apr and 37.6 percent cumulative in Jan-Apr. Exports to third countries are 41.7 percent of the total in Apr and 42.6 percent cumulative in Jan-Apr. There is similar distribution for imports. Exports to non-euro countries are increasing 5.6 percent in Apr 2013, increasing 1.7 percent cumulative in Jan-Apr 2013 while exports to the euro area are increasing 4.3 percent in Apr 2013, and decreasing 2.0 percent cumulative in Jan-Apr 2013. Exports to third countries, accounting for 44.1 percent of the total in Apr 2013, are increasing 13.6 percent in Apr 2013 and increasing 3.1 percent cumulative in Jan-Apr 2013, accounting for 42.6 percent of the cumulative total in Jan-Apr 2013. Price competitiveness through devaluation could improve export performance and growth. 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 high share in its 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 2013  € Billions	Apr 12-Month ∆%	Cumulative Jan-Apr 2012 € Billions	Cumulative Jan-Apr 2013/ Jan-Apr 2012 ∆%
Total Exports	94.5	8.5	366.3	0.2
A. EU Members	52.8 % 55.9	4.7	210.1 % 57.4	-0.8
Euro Area	34.5 % 36.5	4.3	137.7 % 37.6	-2.0
Non-euro Area	18.4 % 19.5	5.6	72.3 % 19.7	1.7
B. Third Countries	41.7 % 44.1	13.6	156.2 % 42.6	3.1
Total Imports	76.4	5.2	298.9	-1.4
C. EU Members	49.4 % 64.7	6.8	193.0 % 64.6	0.5
Euro Area	34.5 % 45.2	5.4	134.4 % 44.9	-0.7
Non-euro Area	14.9 % 19.5	10.1	58.6 % 19.6	3.5
D. Third Countries	27.1 % 35.5	2.4	105.9 % 35.4	-4.8

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2013/06/PE13_189_51.html

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.

© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013