Collapse of United States Dynamism of Income Growth and Employment Creation, Private Sector Jobs, Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and Global Financial and Economic Risk, World Economic Slowdown and Global Recession Risk: Part I

 

Collapse of United States Dynamism of Income Growth and Employment Creation, Private Sector Jobs, Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and Global Financial and Economic Risk, World Economic Slowdown and Global Recession Risk

Carlos M. Pelaez

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

Executive Summary

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

II Private Sector Jobs

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

Executive Summary

Contents of Executive Summary

ESI Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and Global Financial and Economic Risk

ESII Private Sector Jobs

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

ESI Increasing Interest Rate Risk, Tapering Quantitative Easing, Duration Dumping, Steepening Yield Curve and Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task for both theory and measurement. The IMF (2012WEOOct) provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (IMF 2012GFSROct) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (IMF 2012FMOct) (http://www.imf.org/external/pubs/ft/fm/2012/02/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. China’s GDP growth decelerated significantly from annual equivalent 10.4 percent in IIQ2011 to 7.4 percent in IVQ2011 and 6.2 percent in IQ2012, rebounding to 8.7 percent in IIQ2012, 8.2 percent in IIIQ2012 and 7.8 percent in IVQ2012. Annual equivalent growth in IQ2013 fell to 6.6 percent and to 7.0 percent in IIQ2013 (See Subsection VC and earlier at http://cmpassocregulationblog.blogspot.com/2013/07/tapering-quantitative-easing-policy-and_7005.html and earlier at http://cmpassocregulationblog.blogspot.com/2013/01/recovery-without-hiring-world-inflation.html and earlier at http://cmpassocregulationblog.blogspot.com/2012/10/world-inflation-waves-stagnating-united_21.html).
2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.3 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining/stagnating real wages.
3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
4. World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2013/09/duration-dumping-and-peaking-valuations.html).

A list of financial uncertainties includes:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.
3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.
4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).
6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion

Professionals use a variety of techniques in measuring interest rate risk (Fabozzi, Buestow and Johnson, 2006, Chapter Nine, 183-226):

• Full valuation approach in which securities and portfolios are shocked by 50, 100, 200 and 300 basis points to measure their impact on asset values
• Stress tests requiring more complex analysis and translation of possible events with high impact even if with low probability of occurrence into effects on actual positions and capital
• Value at Risk (VaR) analysis of maximum losses that are likely in a time horizon
• Duration and convexity that are short-hand convenient measurement of changes in prices resulting from changes in yield captured by duration and convexity
• Yield volatility

Analysis of these methods is in Pelaez and Pelaez (International Financial Architecture (2005), 101-162) and Pelaez and Pelaez, Globalization and the States, Vol. (I) (2008a), 78-100). Frederick R. Macaulay (1938) introduced the concept of duration in contrast with maturity for analyzing bonds. Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from change of 100 basis points in yield. The mathematical formula is the negative of the yield elasticity of the bond price or –[dB/d(1+y)]((1+y)/B), where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (Hallerbach 2001). The duration trap of unconventional monetary policy is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are historically low because of unconventional monetary policy. Duration dumping during a rate increase may trigger the same crossfire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in multiple segments (Brunnermeier and Pedersen 2009; see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 217-24). Financial markets are currently experiencing fear of duration resulting from the debate within and outside the Fed on tapering quantitative easing. Table VIII-2 provides the yield curve of Treasury securities on Oct 4, 2013, Sep 5, 2013, May 1, 2013, Oct 4, 2012 and Oct 4, 2006. There is ongoing steepening of the yield curve for longer maturities, which are also the ones with highest duration. The 10-year yield increased from 1.45 percent on Jul 26, 2012 to 2.98 percent on Sep 5, 2013, as measured by the United States Treasury. Assume that a bond with maturity in 10 years were issued on Sep 5, 2013 at par or price of 100 with coupon of 1.45 percent. The price of that bond would be 86.8530 with instantaneous increase of the yield to 2.98 percent for loss of 13.1 percent and far more with leverage. Losses absorb capital available for positioning, triggering crossfire sales in multiple asset classes (Brunnermeier and Pedersen 2009). Chris Dieterich, writing on “Bond investors turn to cash,” on Jul 25, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323971204578625900935618178.html), uses data of the Investment Company Institute (http://www.ici.org/) in showing withdrawals of $43 billion in taxable mutual funds in Jun, which is the largest in history, with flows into cash investments such as $8.5 billion in the week of Jul 17 into money-market funds.

Table VIII-2, United States, Treasury Yields

	10/4/13	9/05/13	5/01/13	10/4/12	10/4/06
1 M	0.11	0.03	0.03	0.10	4.78
3 M	0.03	0.02	0.06	0.10	4.93
6 M	0.04	0.06	0.08	0.14	5.00
1 Y	0.11	0.16	0.11	0.18	4.87
2 Y	0.33	0.52	0.20	0.23	4.60
3 Y	0.66	0.97	0.30	0.32	4.53
5 Y	1.41	1.85	0.65	0.63	4.50
7 Y	2.05	2.45	1.07	1.07	4.52
10 Y	2.66	2.98	1.66	1.70	4.57
20 Y	3.43	3.64	2.44	2.48	4.79
30 Y	3.73	3.88	2.83	2.89	4.72

Source: United States Treasury http://www.treasury.gov/resource-center/data-chart-center/Pages/index.aspx

Interest rate risk is increasing in the US. Chart VI-13 of the Board of Governors provides the conventional mortgage rate for a fixed-rate 30-year mortgage. The rate stood at 5.87 percent on Jan 8, 2004, increasing to 6.79 percent on Jul 6, 2006. The rate bottomed at 3.35 percent on May 2, 2013. Fear of duration risk in longer maturities such as mortgage-backed securities caused continuing increases in the conventional mortgage rate that rose to 4.51 percent on Jul 11, 2013, 4.58 percent on Aug 22, 2013 and 4.22 percent on Oct 3, 2013, which is the last data point in Chart VI-13.

Chart VI-13, US, Conventional Mortgage Rate, Jan 8, 2004 to Oct 3, 2013

Source: Board of Governors of the Federal Reserve System

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

Chart VA-2 of the Board of Governors of the Federal Reserve System provides the finance rate on a loan for buying new autos with terms of 48 months. In contrast with mortgage rates, analyzed in Chart VI-13 in Section VI, financing rates on autos declined during and after the global recession with continuing downward trend. The initial data point in Chart VA-15 is for Feb 1972 with the rate at 10.20 percent. The rate rose to 17.36 percent in in Nov 1981, falling to 7.4 percent in Feb 1994. The rate increased to 9.62 percent in Aug 2000, falling to 6.43 percent in Jun 2004. The rate increased to 7.95 percent in Aug 2006, 7.92 percent in May 2007 and 6.84 percent in May 2008. The rate fell to 4.13 percent in May 2013, which is the final point in Chart VA-2. Bankrate quotes the rate on 48-month new car loan at 3.9 percent on Oct 2, 2013, 4.01 percent for a 60-month loan for a new car and 4.47 percent for a 36-month loan of a used car (http://www.bankrate.com/finance/auto/current-interest-rates.aspx).

Chart VA-2, US, Finance Rates on New Autos 48 Month Loan, 1972-2013

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/G19/default.htm

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 real interest rate equals the nominal 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).

Current focus is on tapering 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 Sep 18, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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” (emphasis added).

There is a critical phrase in the statement of Sep 19, 2013 (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm): “but mortgage rates have risen further.” Did the increase of mortgage rates influence the decision of the FOMC not to taper? Is FOMC “communication” and “guidance” successful?

In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:

“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.

The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”

Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σ_y and prices σ_p. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).

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. Indefinite financial repression induces carry trades with high leverage, risks and illiquidity.

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 15072.58

on Fri Oct 4, 2013, which is higher by 6.4 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 6.2 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs.

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.

The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. The DJIA has increased 55.6 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Oct 4, 2013; S&P 500 has gained 65.3 percent and DAX 52.1 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 10/4/13” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior: China’s Shanghai Composite is 8.7 percent below the trough. Japan’s Nikkei Average is 58.9 percent above the trough. DJ Asia Pacific TSM is 24.5 percent above the trough. Dow Global is 36.8 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 20.4 percent above the trough. NYSE Financial Index is 41.5 percent above the trough. DJ UBS Commodities is 2.6 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 52.1 percent above the trough. Japan’s Nikkei Average is 58.9 percent above the trough on Aug 31, 2010 and 23.1 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 14,024.31 Fri Oct 4, 2013 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 36.8 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 13.7 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 10/4/13” in Table VI-4 shows increase of 0.7 percent in the week for China’s Shanghai Composite. DJ Asia Pacific decreased 1.1 percent. NYSE Financial increased 0.1 percent in the week. DJ UBS Commodities decreased 0.6 percent. Dow Global decreased 0.1 percent in the week of Oct 4, 2013. The DJIA decreased 1.2 percent and S&P 500 decreased 0.1 percent. DAX of Germany decreased 0.4 percent. STOXX 50 decreased 0.9 percent. The USD depreciated 0.3 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 10/4/13” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Oct 4, 2013. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 10/4/13” but also relative to the peak in column “∆% Peak to 10/4/13.” There are now several equity indexes above the peak in Table VI-4: DJIA 34.5 percent, S&P 500 38.9 percent, DAX 36.2 percent, Dow Global 11.6 percent, DJ Asia Pacific 9.0 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 12.7 percent, Nikkei Average 23.1 percent and STOXX 50 2.0 percent. There is only one equity index below the peak: Shanghai Composite by 31.3 percent. DJ UBS Commodities Index is now 12.3 percent below the peak. The US dollar strengthened 10.4 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. 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. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,143.0 billion in IVQ1986 or 20.1 percent. Real gross private domestic investment in the US decreased 3.1 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,524.9 billion in IIQ2013. Real private fixed investment fell 4.9 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,458.4 billion in IIQ2013. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits of US corporations swelled 263.4 percent from $107.7 billion IQ2007 to $391.4 billion in IIQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured.

It may be quite painful to exit QE→∞ or use of the balance sheet of the central 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 interest rates increase without bound, then V → 0, or

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.

Table VI-4, Stock Indexes, Commodities, Dollar and 10-Year Treasury  

	Peak	Trough	∆% to Trough	∆% Peak to 10/4/ /13	∆% Week 10/4/13	∆% Trough to 10/4/ 13
DJIA	4/26/ 10	7/2/10	-13.6	34.5	-1.2	55.6
S&P 500	4/23/ 10	7/20/ 10	-16.0	38.9	-0.1	65.3
NYSE Finance	4/15/ 10	7/2/10	-20.3	12.7	0.1	41.5
Dow Global	4/15/ 10	7/2/10	-18.4	11.6	-0.1	36.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	9.0	-1.1	24.5
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	23.1	-5.0	58.9
China Shang.	4/15/ 10	7/02 /10	-24.7	-31.3	0.7	-8.7
STOXX 50	4/15/10	7/2/10	-15.3	2.0	-0.9	20.4
DAX	4/26/ 10	5/25/ 10	-10.5	36.2	-0.4	52.1
Dollar Euro	11/25 2009	6/7 2010	21.2	10.4	-0.3	-13.7
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-12.3	-0.6	2.6
10-Year T Note	4/5/ 10	4/6/10	3.986	2.784	2.645

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

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

ESII Private Sector Jobs. The Bureau of Labor Statistics (BLS) of the US Department of Labor releases the employment situation report in the first Fri of every month. The BLS is delaying the release of the report for Sep 2013 due on Fri Oct 4 because of the lapse in appropriations (http://www.opm.gov/). There are no revisions of data and new estimates for Sep. This section focuses on private sector jobs provided by ADP after brief recapitulation of job creation for Aug 2013. What is striking about the data in Table II-1 is that the numbers of monthly increases in jobs in 1983 and 1984 are several times higher than in 2010 to 2013. The civilian noninstitutional population growing by 39.6 percent from 174.215 million in 1983 to 243.284 million in 2012 and labor force higher by 38.9 percent, growing from 111.550 million in 1983 to 154.975 million in 2012. Total nonfarm payroll employment seasonally adjusted (SA) increased 169,000 in Aug 2013 and private payroll employment rose 152,000. The average number of nonfarm jobs created in Jan-Aug 2012 was 178,625 while the average number of private jobs created in Jan-Aug 2013 was 180,250, or increase by 0.9 percent. The average number of private jobs created in the US in Jan-Aug 2012 was 181,750 while the average in Jan-Aug 2013 was 185,625, or increase by 2.1 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 eight months from Jan to Aug 2013 was 178,625, which is a rate of job creation inadequate to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 28.3 million unemployed or underemployed. The difference between the average increase of 178,625 new private nonfarm jobs per month in the US from Jan to Aug 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 65,458 monthly new jobs net of absorption of new entrants in the labor force. There are 28.3 million in job stress in the US currently. Creation of 65,458 new jobs per month net of absorption of new entrants in the labor force would require 433 months to provide jobs for the unemployed and underemployed (28.348 million divided by 65,458) or 36 years (433 divided by 12). The civilian labor force of the US in Aug 2013 not seasonally adjusted stood at 155.971 million with 11.462 million unemployed or effectively 18.316 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 162.825 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.3 years (1 million divided by product of 65,458 by 12, which is 785,496). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.799 million (0.05 times labor force of 155.971 million) for new net job creation of 3.663 million (11.462 million unemployed minus 7.799 million unemployed at rate of 5 percent) that at the current rate would take 4.7 years (3.663 million divided by 0.785496). Under the calculation in this blog, there are 18.316 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.825 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.586 million jobs net of labor force growth that at the current rate would take 12.9 years (18.316 million minus 0.05(162.825 million) = 10.175 million divided by 0.785596, 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 144.509 million in Aug 2013, by 2.806 million, or decline of 1.9 percent, while the civilian noninstitutional or economically active population increased from 231.958 million in Jul 2007 to 245.959 million in Aug 2013, by 14.001 million or increase of 6.0 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. The United States economy has grown at the average yearly rate of 3 percent per year and 2 percent per year in per capita terms from 1870 to 2010, as measured by Lucas (2011May). An important characteristic of the economic cycle in the US has been rapid growth in the initial phase of expansion after recessions.

Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design. Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 16 quarters from IIIQ2009 to IIQ2013. 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). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) and the second estimate of GDP for IIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). The average of 7.7 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 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). As a result, there are 28.3 million unemployed or underemployed in the United States for an effective unemployment rate of 17.4 percent (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html).

Table II-1, US, Monthly Change in Jobs, Number SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	14	-794	-13	-17
Feb	67	-6	-78	-85	-695	-40	-26
Mar	104	-129	173	-79	-830	154	111
Apr	74	-281	276	-215	-704	229	170
May	10	-45	277	-186	-352	521	102
Jun	196	-243	378	-169	-472	-130	94
Jul	112	-343	418	-216	-351	-86	103
Aug	-36	-158	-308	-270	-210	-37	129
Sep	-87	-181	1114	-459	-233	-43	113
Oct	-100	-277	271	-472	-170	228	188
Nov	-209	-124	352	-775	-21	144	154
Dec	-278	-14	356	-705	-220	95	114
			1984			2011	Private
Jan			447			69	80
Feb			479			196	243
Mar			275			205	223
Apr			363			304	303
May			308			115	183
Jun			379			209	177
Jul			312			78	206
Aug			241			132	129
Sep			311			225	256
Oct			286			166	174
Nov			349			174	197
Dec			127			230	249
			1985			2012	Private
Jan			266			311	323
Feb			124			271	265
Mar			346			205	208
Apr			195			112	120
May			274			125	152
Jun			145			87	78
Jul			189			153	177
Aug			193			165	131
Sep			204			138	118
Oct			187			160	217
Nov			209			247	256
Dec			168			219	224
			1985			2013	Private
Jan			123			148	164
Feb			107			332	319
Mar			93			142	154
Apr			188			199	188
May			125			176	187
Jun			-93			172	194
Jul			318			104	127
Aug			113			169	152
Sep			346
Oct			187
Nov			186
Dec			204

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

Automatic Data Processing (ADP) provides the ADP National Employment Report in collaboration with Moody’s Analytics. The sample consists of about 20 percent of US private-sector workers derived from the processing of payrolls of close to half a million establishments. The sample is not exactly corresponding to that used by the Bureau of Labor Statistics (BLS) in generating the Current Employment Survey (CES). Moody’s Analytics adjusts the ADP sample to conform to the CES establishment sample (http://www.adpemploymentreport.com/common/docs/ADP-NER-Methodology-Full-Detail.pdf). The ADP National Employment Report for Sep 2013 shows creation of 166,000 jobs in the US with 74,000 new jobs created by small business. Table II-2 provides monthly job creation in the US. The ADP report provides total job creation distributed in services and goods. There is significant detail in the BLS of goods producing, service providing and government (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). Table II-2 provides aggregate total and private employment in the BLS report. Both reports show acceleration of job creation in late 2012 but at a slower rate in 2013. There are 28.3 million unemployed or underemployment in involuntary part-time jobs in the BLS report for Aug 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). Even with return to historical trend growth of GDP of 3.0 percent, the pace of job creation in the US is insufficient for return to full employment.

Table II-2, US, Monthly Change in Jobs, Number SA

Month	ADP Total	ADP Services	ADP Goods	BLS Total	BLS Private
2010
Jan	-6	-27	21	-13	-17
Feb	-12	-33	21	-40	-26
Mar	66	-13	80	154	111
Apr	160	27	134	229	170
May	214	39	175	521	102
Jun	146	28	118	-130	94
Jul	89	-11	100	-86	103
Aug	109	-1	109	-37	129
Sep	92	-3	95	-43	113
Oct	120	11	108	228	188
Nov	156	46	110	144	154
Dec	125	1	124	95	114
2011
Jan	173	36	137	69	80
Feb	129	29	99	196	243
Mar	202	29	173	205	223
Apr	198	46	152	304	303
May	202	44	158	115	183
Jun	186	31	154	209	177
Jul	241	43	198	78	206
Aug	195	44	151	132	129
Sep	262	30	232	225	256
Oct	157	23	133	166	174
Nov	262	48	214	174	197
Dec	290	61	229	230	249
2012
Jan	255	44	211	311	323
Feb	294	57	237	271	265
Mar	129	9	120	205	208
Apr	152	20	133	112	120
May	99	-9	108	125	152
Jun	88	12	76	87	78
Jul	128	3	125	153	177
Aug	73	-14	87	165	131
Sep	104	-4	108	138	118
Oct	148	16	132	160	217
Nov	276	44	232	247	256
Dec	209	47	163	219	224
2013
Jan	177	27	150	148	164
Feb	198	31	167	332	319
Mar	154	2	152	142	154
Apr	124	2	122	199	188
May	141	-5	146	176	187
Jun	190	27	164	172	194
Jul	161	22	139	104	127
Aug	159	7	152	169	152
Sep	166	19	147
Oct
Nov
Dec

BLS: Bureau of Labor Statistics, Department of Labor; ADP: ADP National Employment Report

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

ADP http://www.adpemploymentreport.com/

ESII Collapse of United States Dynamism of Income Growth and Employment Creation. 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. Lucas sharpens this analysis 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, which is what a person earns after inflation and taxes.

Table IB-1 provides the data required for broader comparison of long-term and cyclical performance of the United States economy. Revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0713.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0813.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) provide important information on long-term growth and cyclical behavior. First, Long-term performance. Using annual data, US GDP grew at the average rate of 3.3 percent per year from 1929 to 2012 and at 3.2 percent per year from 1947 to 2012. Real disposable income grew at the average yearly rate of 3.2 percent from 1929 to 2013 and at 3.7 percent from 1947 to 1999. Real disposable income per capita grew at the average yearly rate of 2.0 percent from 1929 to 2012 and at 2.3 percent from 1947 to 1999. US economic growth was much faster during expansions, compensating for the contraction in maintaining trend growth for whole cycles. Using annual data, US real disposable income grew at the average yearly rate of 3.5 percent from 1980 to 1980 and real disposable income per capita at 2.6 percent. The US economy has lost its dynamism in the current cycle: real disposable income grew at the yearly average rate of 1.4 percent from 2006 to 2012 and real disposable income per capita at 0.6 percent. Second, first four quarters of expansion. Growth in the first four quarters of expansion is critical in recovering loss of output and employment occurring during the contraction. In the first four quarters of expansion from IQ1983 to IVQ1983: GDP increased 7.8 percent, real disposable personal income 5.3 percent and real disposable income per capita 4.4 percent. In the first four quarters of expansion from IIIQ2009 to IIQ2010: GDP increased 2.7 percent, real disposable personal income 1.4 percent and real disposable income per capita 0.8 percent. Third, first 16 quarters of expansion. In the expansion from IQ1983 to IIIQ1986: GDP grew 22.3 percent at the annual equivalent rate of 5.2 percent; real disposable income grew 17.3 percent at the annual equivalent rate of 4.1 percent; and real disposable income per capita grew 13.7 percent at the annual equivalent rate of 3.3 percent. In the expansion from IIIQ2009 to IIQ2013: GDP grew 9.0 percent at the annual equivalent rate of 2.2 percent; real disposable income grew 6.4 percent at the annual equivalent rate of 1.6 percent; and real disposable personal income per capita grew 3.5 percent at the annual equivalent rate of 0.9 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IIIQ1986: GDP grew 21.1 percent at the annual equivalent rate of 2.8 percent; real disposable personal income 24.7 percent at the annual equivalent rate of 3.2 percent; and real disposable personal income per capita 17.4 percent at the annual equivalent rate of 2.3 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IIQ2013: GDP grew 4.4 percent at the annual equivalent rate of 0.7 percent; real disposable personal income 6.9 percent at the annual equivalent rate of 1.2 percent; and real disposable personal income per capita 2.4 percent at the annual equivalent rate of 0.4 percent. 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 of 4.3 percent from IVQ2007 to IIQ2009 and the financial crisis.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2013, %

Long-term GDP	Average ∆% per Year
1929-2012	3.3
1947-2012	3.2
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita
1929-2012	3.2	2.0
1947-1999	3.7	2.3
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6
2006-2012	1.4	0.6
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1986 IQ1983 to IIIQ1986	4 16
GDP IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	7.8 22.3	7.8 5.2
RDPI IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	5.3 17.3	5.3 4.1
RDPI Per Capita IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	4.4 13.7	4.4 3.3
Whole Cycle IQ1980 to IIIQ1986
GDP	28	21.1	2.8
RDPI	28	24.7	3.2
RDPI per Capita	28	17.4	2.3
Population	28	6.3	0.9
GDP First Four Quarters IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	2.7 9.0	2.7 2.2
RDPI IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	1.4 6.4	1.4 1.6
RDPI per Capita IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	0.8 3.5	0.8 0.9
Population IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	0.6 2.8	0.6 0.7
IVQ2007 to IIQ2013	23
GDP	23	4.4	0.7
RDPI	23	6.9	1.2
RDPI per Capita	23	2.4	0.4
Population	23	4.4	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:

• GDP maintained trend growth in the entire business cycle from IQ1980 to IVQ1985 and IIIQ1986, including contractions and expansions. GDP is well below trend in the entire business cycle from IVQ2007, including contractions and expansions
• Per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIQ2013
• Level of employed persons increased in the 1980s but declined into IIQ2013
• Level of full-time employed persons increased in the 1980s but declined into IIQ2013
• Level unemployed, unemployment rate and employed part-time for economic reasons fell in the recovery from the recessions in the 1980s but not substantially in the recovery since IIIQ2009
• Wealth of households and nonprofit organizations soared in the 1980s but declined in real terms into IQ2013
• Gross private domestic investment increased sharply from IQ1980 to IVQ1985 and IIIQ1986 but gross private domestic investment and private fixed investment fell from IVQ2007 into IIQ2013

There is a critical issue of 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 21.1 percent from IQ1980 to IIIQ1986, which is relatively close to what trend growth would have been at 22.9 percent. Rapid growth at the average annual rate of 5.7 percent annual per quarter during the expansion from IQ1983 to IQ1986 erased the loss of GDP of 4.6 percent during the contraction and maintained trend growth at 2.8 percent for GDP and 3.0 percent for real disposable personal income over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIQ2013 was 4.6 percent while trend growth would have been 18.5 percent. GDP in IIQ2013 at seasonally adjusted annual rate is $15,679.7 billion as estimated by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $17,770.4 billion, or $2090.7 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 $2.1 trillion of foregone GDP that the economy would have created as it occurred during past cyclical expansions, which explains why employment net of population growth 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 IIQ2013 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.3 million people or 17.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/09/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. In the same period, 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/2013/09/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	6,517.9
IIIQ1986	7,890.1
∆% IQ1980 to IIIQ1986 (21.4 percent from IVQ1979 $6496.8 billion)	21.1
∆% Trend Growth IQ1980 to IIIQ1986	22.9

Period IVQ2007 to IQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIQ2013	15,679.7
∆% IVQ2007 to IIQ2013 Actual	4.6
∆% IVQ2007 to IIQ2013 Trend	18.5

2. Stagnating 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 16.4 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 IIQ2013, per capita real disposable income increased 2.4 percent while trend growth would have been 12.1 percent. Income available after inflation and taxes is about the same or lower as before the contraction after 16 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions. In IIQ2013, personal income grew at the SAAR of 4.1 percent after falling at 4.1 percent in IQ2013. In IIQ2013, real personal income excluding current transfer receipts grew at 4.9 percent after falling at 7.2 percent in IQ2013. In IIQ2013, real disposable personal income grew at 3.5 percent after falling at minus 7.9 percent in IQ2013 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0813.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 2009 USD	20,413
Real Disposable Personal Income per Capita IQ1II986 Chained 2005 USD	23,756
∆% IQ1980 to IIIQ1986	16.4
∆% Trend Growth	14.9

Period IVQ2007 to IQ2013

Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIQ2013 Chained 2009 USD	36,692
∆% IVQ2007 to IIQ2013	2.4
∆% Trend Growth	12.1

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 144,841 million in IIQ2013 or by 1.0 percent. There are 28.3 million persons unemployed or underemployed, which is 17.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/09/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 IIQ2013 NSA End of Quarter	144.841
∆% Employed IVQ2007 to IIQ2013	-1.0

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 117.400 million in IIQ2013 or by minus 3.0 percent.

4. Number of Full-time Employed Persons

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 IIQ2013 NSA End of Quarter	117.400
∆% Full-time Employed IVQ2007 to IIQ2013	-3.0

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. (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 IIQ2013: (a) The rate of unemployment increased from 4.8 percent in IVQ2007 to 7.8 percent in IIQ2013. (b) The number unemployed increased 66.2 percent from 7.371 million in IVQ2007 to 12.248 million in IIQ2013. (c) The number employed part-time for economic reasons because they could not find any other job increased 77.7 percent from 4.750 million in IVQ2007 to 8.440 million in IQ2013. (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 14.6 percent in IIQ2013.

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 IIQ2013 NSA End of Quarter	7.8
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIQ2013 Millions End of Quarter	12.248
∆%	66.2
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2013 End of Quarter	8.440
∆%	77.7
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
IIQ2013	14.6

6. Wealth of Households and Nonprofit Organizations.

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and from IVQ1979) to IVQ1985 and from IVQ2007 to IQ2012 is provided in Table IB-2 and in the following block. i. The data reveal the following facts for the cycles in the 1980s:

• IVQ1979 to IVQ1985. Net worth increased 68.2 percent from IVQ1979 to IVQ1985, the all items CPI index increased 42.5 percent from 76.7 in Dec 1979 to 109.3 in Dec 1985 and real net worth increased 18.0 percent.
• IQ1980 to IVQ1985. Net worth increased 64.6 percent, the all items CPI index increased 36.5 percent from 80.1 in Mar 1980 to 109.3 in Dec 1985 and real net worth increased 20.6 percent.
• IVQ1979 to IIIQ1986. Net worth increased 79.4 percent, the all items CPI index increased 43.7 percent from 76.7 in Dec 1979 to 110.2 in Sep 1986 and real net worth increased 24.9 percent.
• IQ1980 to IIIQ1986. Net worth increased 75.5 percent, the all items CPI index increased 37.6 percent from 80.1 in Mar 1980 to 110.2 in Sep 1986 and real net worth increased 27.6 percent.

ii. There is disastrous performance in the current economic cycle:

• IVQ2007 to IIQ2013. Net worth increased 10.2 percent, the all items CPI increased 11.2 percent from 210.036 in Dec 2007 to 233.504 in Jun 2013 and real or inflation adjusted net worth fell 0.9 percent.

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. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 16 quarters from IIIQ2009 to IIQ2013. 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). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) and the second estimate of GDP for IIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). The average of 7.7 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 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). As a result, there are 28.3 million unemployed or underemployed in the United States for an effective unemployment rate of 17.4 percent (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html).

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	9,021.4 9,220.7
IVQ1985 III1986	15,174.7 16,182.9
∆ USD Billions IVQ1985 IIIQ1986 IQ1980-IVQ1985 IQ1980-IIIQ1986	+6,153.3  ∆%68.2 R∆%18.0 +7,161.5  ∆%79.4 R∆%24.9 +5,954.0 ∆%64.6 R∆%20.6 +6,962.2 ∆%75.5 R∆%27.6
Period IVQ2007 to IQ2013
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	67,918.6
IIQ2013	74,820.9
∆ USD Billions	6,902.3 ∆%10.2 R∆%-0.9

Net Worth = Assets – Liabilities. : R∆% real percentage change or adjusted for CPI percentage change.

Source: Board of Governors of the Federal Reserve System. 2013. Flow of funds, balance sheets and integrated macroeconomic accounts: second quarter 2013. Washington, DC, Federal Reserve System, Sep 25.

http://www.federalreserve.gov/releases/Z1/Current/

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 IIQ2013 is in the following block and in Table IB-2. Gross private domestic investment increased from $951.6 billion in IQ1980 to $1,139.5 billion in IIIQ1986 or by 19.7 percent.

ii In the current cycle, gross private domestic investment decreased from $2,605.2 billion in IVQ2007 to $2,524.9 billion in IIQ2013, or decline by 3.1 percent. Private fixed investment fell from $2,586.3 billion in IVQ2007 to $2,458.4 billion in IIQ2013, or decline by 4.9 percent.

Period IQ1980 to IIIQ1986
Gross Private Domestic Investment USD 2005 Billions
IQ1980	951.6
IIIQ1986	1,139.5
∆%	19.7
Period IVQ2007 to IIQ2013
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIQ2013	2,524.9
∆%	-3.1
Private Fixed Investment USD 2009 Billions
IVQ2007	2,586.3
IIQ2013	2,458.4
∆%	-4.9

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	6,517.9
IIIQ1986	7,890.1
∆% IQ1980 to IIIQ1986 (21.4 percent from IVQ1982 $6496.8 billion)	21.1
∆% Trend Growth IQ1980 to IIIQ1986	22.9
Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,413
Real Disposable Personal Income per Capita IIIQ1986 Chained 2009 USD	23,756
∆% IQ1980 to IIIQ1986	16.4
∆% 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 IIIQ1986 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
∆%	14.8
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	9,021.4
IIIQ1986	16,182.9
∆ USD Billions	+7,161.5
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IIIQ1986	1139.5
∆%	19.7
Period IVQ2007 to IIQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIQ2013	15,679.7
∆% IVQ2007 to IIQ2013	4.6
∆% IVQ2007 to IIQ2013 Trend Growth	18.5
Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIQ2013 Chained 2009 USD	36,692
∆% IVQ2007 to IIQ2013	2.4
∆% Trend Growth	12.1
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIQ2013 NSA End of Quarter	144.841
∆% Employed IVQ2007 to IIQ2013	-1.0
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIQ2013 NSA End of Quarter	117.400
∆% Full-time Employed IVQ2007 to IIQ2013	-3.0
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIQ2013 NSA End of Quarter	7.8
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIQ2013 Millions NSA End of Quarter	12.248
∆%	66.2
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2013 NSA End of Quarter	8.440
∆%	77.7
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
IIQ2013	14.6
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	67,918.6
IQ2013	74,820.9
∆ USD Billions	6,902.3
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIQ2013	2,524.9
∆%	-3.1
Private Fixed Investment USD 2005 Billions
IVQ2007	2,586.3
IIQ2013	2,458.4
∆%	-4.9

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 CBO estimates average rate of growth of potential GDP from 1950 to 2012 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 expansion from IIIQ2009 to IIQ2013 at 2.2 percent on average is in contrast with 5.2 percent on average in the expansion from IQ1983 to IIIQ1986 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 28.3 million or 17.4 percent of the effective labor force in Aug 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-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 2.2 percent on average from IIIQ2009 to IIQ2013 during the current economic expansion in contrast with 5.7 percent on average in the cyclical expansion from IQ1983 to IQ1986 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html) cannot be explained by the contraction of 4.3 percent of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 28.3 million or 17.4 percent of the labor force as estimated for Jul 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). There is no exist from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-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).

I 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:

(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 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 Vilela 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.”

Vilela Luz (1960) provides classic research on the struggle for industrialization of Brazil from 1808 to 1930. 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 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. Lucas sharpens this analysis 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, which is what a person earns after inflation and taxes.

Table IB-1 provides the data required for broader comparison of long-term and cyclical performance of the United States economy. Revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_2nd.pdf http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0713.pdf http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0813.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) provide important information on long-term growth and cyclical behavior. First, Long-term performance. Using annual data, US GDP grew at the average rate of 3.3 percent per year from 1929 to 2012 and at 3.2 percent per year from 1947 to 2012. Real disposable income grew at the average yearly rate of 3.2 percent from 1929 to 2013 and at 3.7 percent from 1947 to 1999. Real disposable income per capita grew at the average yearly rate of 2.0 percent from 1929 to 2012 and at 2.3 percent from 1947 to 1999. US economic growth was much faster during expansions, compensating for the contraction in maintaining trend growth for whole cycles. Using annual data, US real disposable income grew at the average yearly rate of 3.5 percent from 1980 to 1980 and real disposable income per capita at 2.6 percent. The US economy has lost its dynamism in the current cycle: real disposable income grew at the yearly average rate of 1.4 percent from 2006 to 2012 and real disposable income per capita at 0.6 percent. Second, first four quarters of expansion. Growth in the first four quarters of expansion is critical in recovering loss of output and employment occurring during the contraction. In the first four quarters of expansion from IQ1983 to IVQ1983: GDP increased 7.8 percent, real disposable personal income 5.3 percent and real disposable income per capita 4.4 percent. In the first four quarters of expansion from IIIQ2009 to IIQ2010: GDP increased 2.7 percent, real disposable personal income 1.4 percent and real disposable income per capita 0.8 percent. Third, first 16 quarters of expansion. In the expansion from IQ1983 to IIIQ1986: GDP grew 22.3 percent at the annual equivalent rate of 5.2 percent; real disposable income grew 17.3 percent at the annual equivalent rate of 4.1 percent; and real disposable income per capita grew 13.7 percent at the annual equivalent rate of 3.3 percent. In the expansion from IIIQ2009 to IIQ2013: GDP grew 9.0 percent at the annual equivalent rate of 2.2 percent; real disposable income grew 6.4 percent at the annual equivalent rate of 1.6 percent; and real disposable personal income per capita grew 3.5 percent at the annual equivalent rate of 0.9 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IIIQ1986: GDP grew 21.1 percent at the annual equivalent rate of 2.8 percent; real disposable personal income 24.7 percent at the annual equivalent rate of 3.2 percent; and real disposable personal income per capita 17.4 percent at the annual equivalent rate of 2.3 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IIQ2013: GDP grew 4.4 percent at the annual equivalent rate of 0.7 percent; real disposable personal income 6.9 percent at the annual equivalent rate of 1.2 percent; and real disposable personal income per capita 2.4 percent at the annual equivalent rate of 0.4 percent. 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 of 4.3 percent from IVQ2007 to IIQ2009 and the financial crisis.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2013, %

Long-term GDP	Average ∆% per Year
1929-2012	3.3
1947-2012	3.2
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita
1929-2012	3.2	2.0
1947-1999	3.7	2.3
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6
2006-2012	1.4	0.6
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1986 IQ1983 to IIIQ1986	4 16
GDP IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	7.8 22.3	7.8 5.2
RDPI IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	5.3 17.3	5.3 4.1
RDPI Per Capita IQ1983 to IVQ1983 IQ1983 to IIIQ1986	4 16	4.4 13.7	4.4 3.3
Whole Cycle IQ1980 to IIIQ1986
GDP	28	21.1	2.8
RDPI	28	24.7	3.2
RDPI per Capita	28	17.4	2.3
Population	28	6.3	0.9
GDP First Four Quarters IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	2.7 9.0	2.7 2.2
RDPI IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	1.4 6.4	1.4 1.6
RDPI per Capita IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	0.8 3.5	0.8 0.9
Population IIIQ2009 to IIQ2010 IIIQ2009 to IIQ2013	4 16	0.6 2.8	0.6 0.7
IVQ2007 to IIQ2013	23
GDP	23	4.4	0.7
RDPI	23	6.9	1.2
RDPI per Capita	23	2.4	0.4
Population	23	4.4	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:

• GDP maintained trend growth in the entire business cycle from IQ1980 to IVQ1985 and IIIQ1986, including contractions and expansions. GDP is well below trend in the entire business cycle from IVQ2007, including contractions and expansions
• Per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIQ2013
• Level of employed persons increased in the 1980s but declined into IIQ2013
• Level of full-time employed persons increased in the 1980s but declined into IIQ2013
• Level unemployed, unemployment rate and employed part-time for economic reasons fell in the recovery from the recessions in the 1980s but not substantially in the recovery since IIIQ2009
• Wealth of households and nonprofit organizations soared in the 1980s but declined in real terms into IQ2013
• Gross private domestic investment increased sharply from IQ1980 to IVQ1985 and IIIQ1986 but gross private domestic investment and private fixed investment fell from IVQ2007 into IIQ2013

There is a critical issue of 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 21.1 percent from IQ1980 to IIIQ1986, which is relatively close to what trend growth would have been at 22.9 percent. Rapid growth at the average annual rate of 5.7 percent annual per quarter during the expansion from IQ1983 to IQ1986 erased the loss of GDP of 4.6 percent during the contraction and maintained trend growth at 2.8 percent for GDP and 3.0 percent for real disposable personal income over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIQ2013 was 4.6 percent while trend growth would have been 18.5 percent. GDP in IIQ2013 at seasonally adjusted annual rate is $15,679.7 billion as estimated by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $17,770.4 billion, or $2090.7 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 $2.1 trillion of foregone GDP that the economy would have created as it occurred during past cyclical expansions, which explains why employment net of population growth 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 IIQ2013 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.3 million people or 17.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/09/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. In the same period, 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/2013/09/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	6,517.9
IIIQ1986	7,890.1
∆% IQ1980 to IIIQ1986 (21.4 percent from IVQ1979 $6496.8 billion)	21.1
∆% Trend Growth IQ1980 to IIIQ1986	22.9

Period IVQ2007 to IQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIQ2013	15,679.7
∆% IVQ2007 to IIQ2013 Actual	4.6
∆% IVQ2007 to IIQ2013 Trend	18.5

2. Stagnating 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 16.4 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 IIQ2013, per capita real disposable income increased 2.4 percent while trend growth would have been 12.1 percent. Income available after inflation and taxes is about the same or lower as before the contraction after 16 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions. In IIQ2013, personal income grew at the SAAR of 4.1 percent after falling at 4.1 percent in IQ2013. In IIQ2013, real personal income excluding current transfer receipts grew at 4.9 percent after falling at 7.2 percent in IQ2013. In IIQ2013, real disposable personal income grew at 3.5 percent after falling at minus 7.9 percent in IQ2013 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi0813.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 2009 USD	20,413
Real Disposable Personal Income per Capita IQ1II986 Chained 2005 USD	23,756
∆% IQ1980 to IIIQ1986	16.4
∆% Trend Growth	14.9

Period IVQ2007 to IQ2013

Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIQ2013 Chained 2009 USD	36,692
∆% IVQ2007 to IIQ2013	2.4
∆% Trend Growth	12.1

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 144,841 million in IIQ2013 or by 1.0 percent. There are 28.3 million persons unemployed or underemployed, which is 17.4 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/09/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 IIQ2013 NSA End of Quarter	144.841
∆% Employed IVQ2007 to IIQ2013	-1.0

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 117.400 million in IIQ2013 or by minus 3.0 percent.

4. Number of Full-time Employed Persons

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 IIQ2013 NSA End of Quarter	117.400
∆% Full-time Employed IVQ2007 to IIQ2013	-3.0

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. (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 IIQ2013: (a) The rate of unemployment increased from 4.8 percent in IVQ2007 to 7.8 percent in IIQ2013. (b) The number unemployed increased 66.2 percent from 7.371 million in IVQ2007 to 12.248 million in IIQ2013. (c) The number employed part-time for economic reasons because they could not find any other job increased 77.7 percent from 4.750 million in IVQ2007 to 8.440 million in IQ2013. (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 14.6 percent in IIQ2013.

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 IIQ2013 NSA End of Quarter	7.8
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIQ2013 Millions End of Quarter	12.248
∆%	66.2
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2013 End of Quarter	8.440
∆%	77.7
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
IIQ2013	14.6

6. Wealth of Households and Nonprofit Organizations.

The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and from IVQ1979) to IVQ1985 and from IVQ2007 to IQ2012 is provided in Table IB-2 and in the following block. i. The data reveal the following facts for the cycles in the 1980s:

• IVQ1979 to IVQ1985. Net worth increased 68.2 percent from IVQ1979 to IVQ1985, the all items CPI index increased 42.5 percent from 76.7 in Dec 1979 to 109.3 in Dec 1985 and real net worth increased 18.0 percent.
• IQ1980 to IVQ1985. Net worth increased 64.6 percent, the all items CPI index increased 36.5 percent from 80.1 in Mar 1980 to 109.3 in Dec 1985 and real net worth increased 20.6 percent.
• IVQ1979 to IIIQ1986. Net worth increased 79.4 percent, the all items CPI index increased 43.7 percent from 76.7 in Dec 1979 to 110.2 in Sep 1986 and real net worth increased 24.9 percent.
• IQ1980 to IIIQ1986. Net worth increased 75.5 percent, the all items CPI index increased 37.6 percent from 80.1 in Mar 1980 to 110.2 in Sep 1986 and real net worth increased 27.6 percent.

ii. There is disastrous performance in the current economic cycle:

• IVQ2007 to IIQ2013. Net worth increased 10.2 percent, the all items CPI increased 11.2 percent from 210.036 in Dec 2007 to 233.504 in Jun 2013 and real or inflation adjusted net worth fell 0.9 percent.

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. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 16 quarters from IIIQ2009 to IIQ2013. 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). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) and the second estimate of GDP for IIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). The average of 7.7 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 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). As a result, there are 28.3 million unemployed or underemployed in the United States for an effective unemployment rate of 17.4 percent (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html).

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	9,021.4 9,220.7
IVQ1985 III1986	15,174.7 16,182.9
∆ USD Billions IVQ1985 IIIQ1986 IQ1980-IVQ1985 IQ1980-IIIQ1986	+6,153.3  ∆%68.2 R∆%18.0 +7,161.5  ∆%79.4 R∆%24.9 +5,954.0 ∆%64.6 R∆%20.6 +6,962.2 ∆%75.5 R∆%27.6
Period IVQ2007 to IQ2013
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	67,918.6
IIQ2013	74,820.9
∆ USD Billions	6,902.3 ∆%10.2 R∆%-0.9

Net Worth = Assets – Liabilities. : R∆% real percentage change or adjusted for CPI percentage change.

Source: Board of Governors of the Federal Reserve System. 2013. Flow of funds, balance sheets and integrated macroeconomic accounts: second quarter 2013. Washington, DC, Federal Reserve System, Sep 25.

http://www.federalreserve.gov/releases/Z1/Current/

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 IIQ2013 is in the following block and in Table IB-2. Gross private domestic investment increased from $951.6 billion in IQ1980 to $1,139.5 billion in IIIQ1986 or by 19.7 percent.

ii In the current cycle, gross private domestic investment decreased from $2,605.2 billion in IVQ2007 to $2,524.9 billion in IIQ2013, or decline by 3.1 percent. Private fixed investment fell from $2,586.3 billion in IVQ2007 to $2,458.4 billion in IIQ2013, or decline by 4.9 percent.

Period IQ1980 to IIIQ1986
Gross Private Domestic Investment USD 2005 Billions
IQ1980	951.6
IIIQ1986	1,139.5
∆%	19.7
Period IVQ2007 to IIQ2013
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIQ2013	2,524.9
∆%	-3.1
Private Fixed Investment USD 2009 Billions
IVQ2007	2,586.3
IIQ2013	2,458.4
∆%	-4.9

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	6,517.9
IIIQ1986	7,890.1
∆% IQ1980 to IIIQ1986 (21.4 percent from IVQ1982 $6496.8 billion)	21.1
∆% Trend Growth IQ1980 to IIIQ1986	22.9
Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,413
Real Disposable Personal Income per Capita IIIQ1986 Chained 2009 USD	23,756
∆% IQ1980 to IIIQ1986	16.4
∆% 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 IIIQ1986 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
∆%	14.8
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	9,021.4
IIIQ1986	16,182.9
∆ USD Billions	+7,161.5
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IIIQ1986	1139.5
∆%	19.7
Period IVQ2007 to IIQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIQ2013	15,679.7
∆% IVQ2007 to IIQ2013	4.6
∆% IVQ2007 to IIQ2013 Trend Growth	18.5
Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIQ2013 Chained 2009 USD	36,692
∆% IVQ2007 to IIQ2013	2.4
∆% Trend Growth	12.1
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIQ2013 NSA End of Quarter	144.841
∆% Employed IVQ2007 to IIQ2013	-1.0
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIQ2013 NSA End of Quarter	117.400
∆% Full-time Employed IVQ2007 to IIQ2013	-3.0
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIQ2013 NSA End of Quarter	7.8
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIQ2013 Millions NSA End of Quarter	12.248
∆%	66.2
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2013 NSA End of Quarter	8.440
∆%	77.7
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
IIQ2013	14.6
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	67,918.6
IQ2013	74,820.9
∆ USD Billions	6,902.3
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIQ2013	2,524.9
∆%	-3.1
Private Fixed Investment USD 2005 Billions
IVQ2007	2,586.3
IIQ2013	2,458.4
∆%	-4.9

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 CBO estimates average rate of growth of potential GDP from 1950 to 2012 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 expansion from IIIQ2009 to IIQ2013 at 2.2 percent on average is in contrast with 5.2 percent on average in the expansion from IQ1983 to IIIQ1986 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 28.3 million or 17.4 percent of the effective labor force in Jul 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-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 2.2 percent on average from IIIQ2009 to IIQ2013 during the current economic expansion in contrast with 5.7 percent on average in the cyclical expansion from IQ1983 to IQ1986 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html) cannot be explained by the contraction of 4.3 percent of GDP from IVQ2007 to IIQ2009 and the financial crisis. Weakness of growth in the expansion is perpetuating unemployment and underemployment of 28.3 million or 17.4 percent of the labor force as estimated for Jul 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). There is no exist from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/09/recovery-without-hiring-ten-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 Private Sector Jobs. The Bureau of Labor Statistics (BLS) of the US Department of Labor releases the employment situation report in the first Fri of every month. The BLS is delaying the release of the report for Sep 2013 due on Fri Oct 4 because of the lapse in appropriations (http://www.opm.gov/). There are no revisions of data and new estimates for Sep. This section focuses on private sector jobs provided by ADP after brief recapitulation of job creation for Aug 2013. What is striking about the data in Table II-1 is that the numbers of monthly increases in jobs in 1983 and 1984 are several times higher than in 2010 to 2013. The civilian noninstitutional population growing by 39.6 percent from 174.215 million in 1983 to 243.284 million in 2012 and labor force higher by 38.9 percent, growing from 111.550 million in 1983 to 154.975 million in 2012. Total nonfarm payroll employment seasonally adjusted (SA) increased 169,000 in Aug 2013 and private payroll employment rose 152,000. The average number of nonfarm jobs created in Jan-Aug 2012 was 178,625 while the average number of private jobs created in Jan-Aug 2013 was 180,250, or increase by 0.9 percent. The average number of private jobs created in the US in Jan-Aug 2012 was 181,750 while the average in Jan-Aug 2013 was 185,625, or increase by 2.1 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 eight months from Jan to Aug 2013 was 178,625, which is a rate of job creation inadequate to reduce significantly unemployment and underemployment in the United States because of 113,167 new entrants in the labor force per month with 28.3 million unemployed or underemployed. The difference between the average increase of 178,625 new private nonfarm jobs per month in the US from Jan to Aug 2013 and the 113,167 average monthly increase in the labor force from 2011 to 2012 is 65,458 monthly new jobs net of absorption of new entrants in the labor force. There are 28.3 million in job stress in the US currently. Creation of 65,458 new jobs per month net of absorption of new entrants in the labor force would require 433 months to provide jobs for the unemployed and underemployed (28.348 million divided by 65,458) or 36 years (433 divided by 12). The civilian labor force of the US in Aug 2013 not seasonally adjusted stood at 155.971 million with 11.462 million unemployed or effectively 18.316 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 162.825 million. Reduction of one million unemployed at the current rate of job creation without adding more unemployment requires 1.3 years (1 million divided by product of 65,458 by 12, which is 785,496). Reduction of the rate of unemployment to 5 percent of the labor force would be equivalent to unemployment of only 7.799 million (0.05 times labor force of 155.971 million) for new net job creation of 3.663 million (11.462 million unemployed minus 7.799 million unemployed at rate of 5 percent) that at the current rate would take 4.7 years (3.663 million divided by 0.785496). Under the calculation in this blog, there are 18.316 million unemployed by including those who ceased searching because they believe there is no job for them and effective labor force of 162.825 million. Reduction of the rate of unemployment to 5 percent of the labor force would require creating 9.586 million jobs net of labor force growth that at the current rate would take 12.9 years (18.316 million minus 0.05(162.825 million) = 10.175 million divided by 0.785596, 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 144.509 million in Aug 2013, by 2.806 million, or decline of 1.9 percent, while the civilian noninstitutional or economically active population increased from 231.958 million in Jul 2007 to 245.959 million in Aug 2013, by 14.001 million or increase of 6.0 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. The United States economy has grown at the average yearly rate of 3 percent per year and 2 percent per year in per capita terms from 1870 to 2010, as measured by Lucas (2011May). An important characteristic of the economic cycle in the US has been rapid growth in the initial phase of expansion after recessions.

Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design. Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 16 quarters from IIIQ2009 to IIQ2013. 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). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm http://bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf http://bea.gov/newsreleases/national/pi/2013/pdf/pi0613.pdf) and the second estimate of GDP for IIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). The average of 7.7 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 2.7 percent obtained by diving GDP of $14,738.0 billion in IIQ2010 by GDP of $14,356.9 billion in IIQ2009 {[$14,738.0/$14,356.9 -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/09/mediocre-and-decelerating-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). As a result, there are 28.3 million unemployed or underemployed in the United States for an effective unemployment rate of 17.4 percent (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html).

Table II-1, US, Monthly Change in Jobs, Number SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	14	-794	-13	-17
Feb	67	-6	-78	-85	-695	-40	-26
Mar	104	-129	173	-79	-830	154	111
Apr	74	-281	276	-215	-704	229	170
May	10	-45	277	-186	-352	521	102
Jun	196	-243	378	-169	-472	-130	94
Jul	112	-343	418	-216	-351	-86	103
Aug	-36	-158	-308	-270	-210	-37	129
Sep	-87	-181	1114	-459	-233	-43	113
Oct	-100	-277	271	-472	-170	228	188
Nov	-209	-124	352	-775	-21	144	154
Dec	-278	-14	356	-705	-220	95	114
			1984			2011	Private
Jan			447			69	80
Feb			479			196	243
Mar			275			205	223
Apr			363			304	303
May			308			115	183
Jun			379			209	177
Jul			312			78	206
Aug			241			132	129
Sep			311			225	256
Oct			286			166	174
Nov			349			174	197
Dec			127			230	249
			1985			2012	Private
Jan			266			311	323
Feb			124			271	265
Mar			346			205	208
Apr			195			112	120
May			274			125	152
Jun			145			87	78
Jul			189			153	177
Aug			193			165	131
Sep			204			138	118
Oct			187			160	217
Nov			209			247	256
Dec			168			219	224
			1985			2013	Private
Jan			123			148	164
Feb			107			332	319
Mar			93			142	154
Apr			188			199	188
May			125			176	187
Jun			-93			172	194
Jul			318			104	127
Aug			113			169	152
Sep			346
Oct			187
Nov			186
Dec			204

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

Automatic Data Processing (ADP) provides the ADP National Employment Report in collaboration with Moody’s Analytics. The sample consists of about 20 percent of US private-sector workers derived from the processing of payrolls of close to half a million establishments. The sample is not exactly corresponding to that used by the Bureau of Labor Statistics (BLS) in generating the Current Employment Survey (CES). Moody’s Analytics adjusts the ADP sample to conform to the CES establishment sample (http://www.adpemploymentreport.com/common/docs/ADP-NER-Methodology-Full-Detail.pdf). The ADP National Employment Report for Sep 2013 shows creation of 166,000 jobs in the US with 74,000 new jobs created by small business. Table II-2 provides monthly job creation in the US. The ADP report provides total job creation distributed in services and goods. There is significant detail in the BLS of goods producing, service providing and government (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). Table II-2 provides aggregate total and private employment in the BLS report. Both reports show acceleration of job creation in late 2012 but at a slower rate in 2013. There are 28.3 million unemployed or underemployment in involuntary part-time jobs in the BLS report for Aug 2013 (http://cmpassocregulationblog.blogspot.com/2013/09/twenty-eight-million-unemployed-or.html). Even with return to historical trend growth of GDP of 3.0 percent, the pace of job creation in the US is insufficient for return to full employment.

Table II-2, US, Monthly Change in Jobs, Number SA

Month	ADP Total	ADP Services	ADP Goods	BLS Total	BLS Private
2010
Jan	-6	-27	21	-13	-17
Feb	-12	-33	21	-40	-26
Mar	66	-13	80	154	111
Apr	160	27	134	229	170
May	214	39	175	521	102
Jun	146	28	118	-130	94
Jul	89	-11	100	-86	103
Aug	109	-1	109	-37	129
Sep	92	-3	95	-43	113
Oct	120	11	108	228	188
Nov	156	46	110	144	154
Dec	125	1	124	95	114
2011
Jan	173	36	137	69	80
Feb	129	29	99	196	243
Mar	202	29	173	205	223
Apr	198	46	152	304	303
May	202	44	158	115	183
Jun	186	31	154	209	177
Jul	241	43	198	78	206
Aug	195	44	151	132	129
Sep	262	30	232	225	256
Oct	157	23	133	166	174
Nov	262	48	214	174	197
Dec	290	61	229	230	249
2012
Jan	255	44	211	311	323
Feb	294	57	237	271	265
Mar	129	9	120	205	208
Apr	152	20	133	112	120
May	99	-9	108	125	152
Jun	88	12	76	87	78
Jul	128	3	125	153	177
Aug	73	-14	87	165	131
Sep	104	-4	108	138	118
Oct	148	16	132	160	217
Nov	276	44	232	247	256
Dec	209	47	163	219	224
2013
Jan	177	27	150	148	164
Feb	198	31	167	332	319
Mar	154	2	152	142	154
Apr	124	2	122	199	188
May	141	-5	146	176	187
Jun	190	27	164	172	194
Jul	161	22	139	104	127
Aug	159	7	152	169	152
Sep	166	19	147
Oct
Nov
Dec

BLS: Bureau of Labor Statistics, Department of Labor; ADP: ADP National Employment Report

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

ADP http://www.adpemploymentreport.com/

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

(4) 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 Sep 27 and daily values throughout the week ending on Oct 4, 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 Sep 27 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Sep 27, 2013”, first row “USD/EUR 1.3523 0.0% -0.3 %,” provides the information that the US dollar (USD) changed 0.0 percent to USD 1.3523/EUR in the week ending on Fri Sep 27 relative to the exchange rate on Fri Sep 20 and depreciated 0.3 percent relative to Thu Sep 26. 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. An 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 most important source of financial turbulence is shifting toward increasing interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3523/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Sep 27, depreciating to USD 1.3578/EUR on Wed Oct 2, 2013, or by 0.4 percent. The dollar depreciated because more dollars, $1.3578, were required on Wed Oct 2 to buy one euro than $1.3523 on Fri Sep 27. 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 1.3523/EUR on Sep 27. 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 Sep 27, to the last business day of the current week, in this case Fri Oct 4, such as depreciation of 0.3 percent to USD 1.3557/EUR by Oct 4. The third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.3 percent from the rate of USD 1.3523/EUR on Fri Sep 27 to the rate of USD 1.3557/EUR on Fri Oct 4 {[(1.3557/1.3523) – 1]100 = 0.3%}. The dollar appreciated (denoted by positive sign) by 0.4 percent from the rate of USD 1.3618 on Thu Oct 3 to USD 1.3557/EUR on Fri Oct 4 {[(1.3557/1.3618) -1]100 = -0.4%}. 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.

Table III-I, Weekly Financial Risk Assets Sep 30 to Oct 4, 2013

Fri Sep 27	Mon 30	Tue 1	Wed 2	Thu 3	Fri 4
USD/ EUR 1.3523 0.0% -0.3%	1.3526 0.0% 0.0%	1.3526 0.0% 0.0%	1.3578 -0.4% -0.4%	1.3618 -0.7% -0.3%	1.3557 -0.3% 0.4%
JPY/USD 98.24 1.0% 0.8%	98.23 0.0% 0.0%	98.00 0.2% 0.2%	97.36 0.9% 0.7%	97.26 1.0% 0.1%	97.47 0.8% -0.2%
CHF/USD 0.9059 0.5% 0.5%	0.9047 0.1% 0.1%	0.9055 0.0% -0.1%	0.9028 0.3% 0.3%	0.8994 0.7% 0.4%	0.9072 -0.1% -0.9%
CHF/EUR 1.2251 0.5% 0.2%	1.2237 0.1% 0.1%	1.2249 0.0% -0.1%	1.2260 -0.1% -0.1%	1.2253 0.0% 0.1%	1.2298 -0.4% -0.4%
USD/ AUD 0.9317 1.0733 -0.9% -0.5%	0.9321 1.0729 0.0% 0.0%	0.9398 1.0641 0.9% 0.8%	0.9385 1.0655 0.7% -0.1%	0.9393 1.0646 0.8% -0.1%	0.9432 1.0602 1.2% 0.4%
10Y T Note 2.626	2.612	2.647	2.618	2.602	2.645
2 Year T Note 0.335	0.315	0.331	0.319	0.315	0.335
German Bond 2Y 0.16 10Y 1.78	2Y 0.16 10Y 1.78	2Y 0.17 10Y 1.80	2Y 0.16 10Y 1.81	2Y 0.16 10Y 1.81	2Y 0.17 10Y 1.84
DJIA 15258.24 -1.2% -0.5%	15129.67 -0.8% -0.8%	15191.70 -0.4% 0.4%	15133.14 -0.8% -0.4%	14996.48 -1.7% -0.9%	15072.58 -1.2% 0.5%
DJ Global 2332.38 -0.7% -0.1%	2311.15 -0.9% -0.9%	2328.08 -0.2% 0.7%	2325.40 -0.3% -0.1%	2320.22 -0.5% -0.2%	2329.05 -0.1% 0.4%
DJ Asia Pacific 1441.40 0.2% 0.2%	1420.95 -1.4% -1.4%	1423.60 -1.2% 0.2%	1421.64 -1.4% -0.1%	1428.62 -0.9% 0.5%	1425.18 -1.1% -0.2%
Nikkei 14760.07 0.1% -0.3%	14455.80 -2.1% -2.1%	14484.72 -1.9% 0.2%	14170.49 -4.0% -2.2%	14157.25 -4.1% -0.1%	14024.31 -5.0% -0.9%
Shanghai 2160.03 -1.5% 0.2%	2174.66 0.7% 0.7%	2174.66 0.7% 0.0%	2174.66 0.7% 0.0%	2174.66 0.7% 0.0%	2174.66 0.7% 0.0%
DAX 8661.51 -0.2% 0.0%	8594.40 -0.8% -0.8%	8689.14 0.3% 1.1%	8629.42 -0.4% -0.7%	8597.91 -0.7% -0.4%	8622.97 -0.4% 0.3%
DJ UBS Comm. 128.01 -0.2% 0.2%	127.11 -0.7% -0.7%	126.28 -1.4% -0.7%	127.22 -0.6% 0.7%	126.91 -0.9% -0.2%	127.26 -0.6% 0.3%
WTI $B 102.78 -1.8% 0.1%	102.24 -0.5% -0.5%	101.80 -0.9% -0.4%	103.84 1.0% 2.0%	103.07 0.3% -0.7%	103.63 0.8% 0.5%
Brent $/B 108.35 -0.9% -0.8%	108.27 -0.1% -0.1%	107.73 -0.6% -0.5%	109.07 0.7% 1.2%	108.63 0.3% -0.4%	109.32 0.9% 0.6%
Gold $/OZ 1336.9 0.8% 1.0%	1328.9 -0.6% -0.6%	1288.9 -3.6% -3.0%	1316.6 -1.5% 2.1%	1318.6 -1.4% 0.2%	1310.7 -2.0% -0.6%

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 “tapering” 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 “tapering” 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. What really matters in the statement of the Federal Open Market Committee (FOMC) on Sep 18, 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/20130918a.htm):

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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).

Another critical concern in the statement of the FOMC on Sep 18, 2013, is on the effects of tapering expectations on interest rates (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):

“Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth” (emphasis added).

In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:

“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.

The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”

Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σ_y and prices σ_p. Policy attempts to circumvent the lags by policy impulses based on forecasts. We are all naïve about forecasting. Data are available with lags and revised to maintain high standards of estimation. Policy simulation models estimate economic relations with structures prevailing before simulations of policy impulses such that parameters change as discovered by Lucas (1977). Economic agents adjust their behavior in ways that cause opposite results from those intended by optimal control policy as discovered by Kydland and Prescott (1977). Advance guidance attempts to circumvent expectations by economic agents that could reverse policy impulses but is of dubious effectiveness. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities).

The President of the European Central Bank (ECB) Mario Draghi explained the indefinite period of low policy rates during the press conference following the meeting on Jul 4, 2013 (http://www.ecb.int/press/pressconf/2013/html/is130704.en.html):

“Yes, that is why I said you haven’t listened carefully. The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney [Governor of the Bank of England] said in London is just a coincidence.”

The statement of the meeting of the Monetary Policy Committee of the Bank of England on Jul 4, 2013, may be leading toward the same forward guidance (http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx):

“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report.  The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”

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 15072.58

on Fri Oct 4, 2013, which is higher by 6.4 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 6.2 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 4.213 percent on Oct 4, 2013, and that of the ten-year sovereign bond of Italy at 4.162 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 Oct 4, 2013, the yield of the two-year Treasury remained at 0.335 percent and that of the ten-year Treasury increased to 2.645 percent while the two-year bond of Germany increased to 0.17 percent and the ten-year increased to 1.84 percent; and the dollar depreciated to USD 1.3557/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 of 2.743 is higher than consumer price inflation of 1.5 percent in the 12 months ending in Aug 2013 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/08/duration-dumping-and-peaking-valuations_18.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.102 percent is well below the 12-month consumer price inflation of 1.5 percent. 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
10/4/13	0.335	2.645	0.17	1.84	1.3557
9/27/13	0.335	2.626	0.16	1.78	1.3523
9/20/13	0.333	2.734	0.21	1.94	1.3526
9/13/13	0.433	2.890	0.22	1.97	1.3297
9/6/13	0.461	2.941	0.26	1.95	1.3179
8/23/13	0.401	2.784	0.23	1.85	1.3221
8/23/13	0.374	2.818	0.28	1.93	1.3380
8/16/13	0.341	2.829	0.22	1.88	1.3328
8/9/13	0.30	2.579	0.16	1.68	1.3342
8/2/13	0.299	2.597	0.15	1.65	1.3281
7/26/13	0.315	2.565	0.15	1.66	1.3279
7/19/13	0.300	2.480	0.08	1.52	1.3141
7/12/13	0.345	2.585	0.10	1.56	1.3068
7/5/13	0.397	2.734	0.11	1.72	1.2832
6/28/13	0.357	2.486	0.19	1.73	1.3010
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

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 and 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 Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A 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 Oct 3, 2013, with the one-month yield at 0.12 percent, the two-year at 0.33 percent, the ten-year at 2.62 percent, the fed funds rate at 0.08 percent and the corporate Baa bond at 5.40 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with marginal reduction.

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, Jan 2, 1962-Oct 3, 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. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,143.0 billion in IVQ1986 or 20.1 percent. Real gross private domestic investment in the US decreased 3.1 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,524.9 billion in IIQ2013. Real private fixed investment fell 4.9 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,458.4 billion in IIQ2013. Growth of real private investment in is mediocre for all but four quarters from IIQ2011 to IQ2012 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2013/09/increasing-interest-rate-risk.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits of US corporations swelled 263.4 percent from $107.7 billion IQ2007 to $391.4 billion in IIQ2013 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the quarterly rate of 3.3 percent (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_3rd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. 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 weak performance in equity indexes with several indexes in Table III-1 decreasing in the week ending on Oct 4, 2013, after wide swings caused by reallocations of investment portfolios worldwide. 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 0.5 percent on Oct, decreasing 1.2 percent in the week. Germany’s Dax increased 0.3 percent on Fri Oct 4 and decreased 0.4 percent in the week. Dow Global increased 0.4 percent on Oct 4 and decreased 0.1 percent in the week. Japan’s Nikkei Average decreased 0.9 percent on Oct 4 and decreased 5.0 percent in the week as the yen continues 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 decreased 0.2 percent on Oct 4 and decreased 1.1 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 2174.66 on Oct 4 for change of 0.0 percent and increase of 0.7 percent in the week of Oct 4. There is 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 mixed in the week of Oct 4, 2013. The DJ UBS Commodities Index increased 0.3 percent on Fri Oct 4 and decreased 0.6 percent in the week, as shown in Table III-1. WTI increased 0.8 percent in the week of Oct 4 while Brent increased 0.9 percent in the week. Gold decreased 0.6 percent on Fri Oct 4 and decreased 2.0 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 €767,304 million on Sep 27, 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 €1,367,418 million in the statement of Sep 27, 2013, with marginal reduction. There is high credit risk in these transactions with capital of only €90,419 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Sep 27, 2013
1 Gold and other Receivables	367,402	419,822	319,969
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	249,991
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	22,701
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	23,256
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	767,304
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	81,277
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	600,114
8 General Government Debt Denominated in Euro	34,954	33,928	28,361
9 Other Assets	278,719	336,574	245,072
TOTAL ASSETS	2,004, 432	2,733,235	2,338,044
Memo Items
Sum of 5 and  7	1,004,174	1,489,759	1,367,418
Capital and Reserves	78,143	81,481	90,419

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.europa.eu/press/pr/wfs/2013/html/fs131001.en.html

IIIE Appendix Euro Zone Survival Risk. Resolution of the European sovereign debt crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common euro currency prevents Italy from devaluing the exchange 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. 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 in Jan-Jul 2013. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at 3.2 percent in Jan-Jul 2013 relative to Jan-Jul 2012 while those to EMU are growing at minus 3.2 percent.

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

Jul 2013	Exports % Share	∆% Jan-Jul 2013/ Jan-Jul 2012	Imports % Share	∆% Jan-Jul 2013/ Jan-Jul 2012
EU	54.2	-2.3	53.2	-2.4
EMU 17	40.5	-3.2	42.7	-2.7
France	11.1	-2.4	8.3	-6.0
Germany	12.5	-3.5	14.6	-6.5
Spain	4.7	-7.7	4.4	-2.5
UK	4.9	1.6	2.5	-0.2
Non EU	46.3	3.2	46.8	-10.0
Europe non EU	13.4	0.3	11.0	7.7
USA	6.8	-2.0	3.3	-14.6
China	2.3	9.3	6.5	-9.9
OPEC	5.7	10.7	10.8	-27.5
Total	100.0	0.2	100.0	-6.0

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade surplus of €1335 million with the 17 countries of the euro zone (EMU 17) in Jul 2013 and cumulative deficit of €1058 million in Jan-Jul 2013. Depreciation to parity could permit greater competitiveness in improving the trade surplus of 4657 million in Jan-Jul 2013 with Europe non European Union, the trade surplus of €8930 million with the US and trade surplus with non-European Union of €10,497 million in Jan-Jul 2013. There is significant rigidity in the trade deficits in Jan-Jul 2013 of €8066 million with China and €4366 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 Jul 2013 Millions of Euro	Trade Balance Cumulative Jan-Jul 2013 Millions of Euro
EU	3,152	7,739
EMU 17	1,335	-1,058
France	1,640	7,846
Germany	151	-2,286
Spain	153	544
UK	1,083	5,756
Non EU	2,796	10,497
Europe non EU	1,224	4,657
USA	1,336	8,930
China	-1,339	-8,066
OPEC	-368	-4,366
Total	5,948	18,237

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Jul 2013 relative to Jan-Jul 2012. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 15.2 percent and minus 9.9 percent for durable goods. The higher rate of growth of exports of 0.2 percent in Jan-Jul 2013/Jan-Jul 2012 relative to imports of minus 6.0 percent may reflect weak demand in Italy with GDP declining during eight consecutive quarters from IIIQ2011 through IIQ2013 together with softening commodity prices.

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

	Exports Share %	Exports ∆% Jan-Jul 2013/ Jan-Jul 2012	Imports Share %	Imports ∆% Jan-Jul 2013/ Jan-Jul 2012
Consumer Goods	29.3	6.4	25.6	1.2
Durable	5.8	1.4	2.9	-9.9
Non-Durable	23.5	7.7	22.7	2.7
Capital Goods	31.6	1.3	19.5	-7.2
Inter- mediate Goods	33.6	-3.3	32.6	-4.6
Energy	5.5	-18.0	22.3	-15.2
Total ex Energy	94.5	1.2	77.7	-3.4
Total	100.0	0.2	100.0	-6.0

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

Table III-6 provides Italy’s trade balance by product categories in Jul 2013 and cumulative Jan-Jul 2013. Italy’s trade balance excluding energy generated surplus of €10,928 million in Jul 2013 and €50,616 million cumulative in Jan-Jul 2013 but the energy trade balance created deficit of €4980 million in Jul 2013 and cumulative €32,379 million in Jan-Jul 2013. The overall surplus in Jul 2013 was €5948 million with cumulative surplus of €18,237 million in Jan-Jul 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

	Jul 2013	Cumulative Jan-Jul 2013
Consumer Goods	2,899	13,160
Durable	1,374	7,697
Nondurable	1,524	5,463
Capital Goods	6,255	32,428
Intermediate Goods	1,775	5,028
Energy	-4,980	-32,379
Total ex Energy	10,928	50,616
Total	5,948	18,237

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/98796

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 Jul 2013. German exports to other European Union (EU) members are 56.0 percent of total exports in Jul 2013 and 57.3 percent in cumulative Jan-Jul 2013. Exports to the euro area are 36.0 percent in Jul and 37.2 percent cumulative in Jan-Jul. Exports to third countries are 44.1 percent of the total in Jul and 42.7 percent cumulative in Jan-Jul. There is similar distribution for imports. Exports to non-euro countries are increasing 3.6 percent in the 12 months ending in Jul 2013, increasing 1.5 percent cumulative in Jan-Jul 2013 while exports to the euro area are decreasing 0.7 percent in the 12 months ending in Jul 2013 and decreasing 2.9 percent cumulative in Jan-Jul 2013. Exports to third countries, accounting for 44.1 percent of the total in Jun 2013, are decreasing 1.0 percent in the 12 months ending in Jul 2013 and decreasing 0.7 percent cumulative in Jan-Jul 2013, accounting for 42.7 percent of the cumulative total in Jan-Jul 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 ∆%

	Jul 2013  € Billions	Jun 12-Month ∆%	Cumulative Jan-Jul 2012 € Billions	Cumulative Jan-Jul 2013/ Jan-Jul 2012 ∆%
Total Exports	93.4	0.0	640.8	-0.5
A. EU Members	52.3 % 56.0	0.8	367.1 % 57.3	-1.4
Euro Area	33.6 % 36.0	-0.7	238.5 % 37.2	-2.9
Non-euro Area	18.6 % 19.9	3.6	128.6 % 20.1	1.5
B. Third Countries	41.2 % 44.1	-1.0	273.8 % 42.7	0.7
Total Imports	77.3	0.9	526.8	-1.3
C. EU Members	49.6 % 64.2	0.6	340.8 % 64.7	0.1
Euro Area	35.3 % 45.7	1.5	238.8 % 45.3	-0.4
Non-euro Area	14.3 % 18.5	-1.7	102.0 % 19.4	1.4
D. Third Countries	27.7 % 35.8	1.6	186.1 % 35.3	-3.7

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

Source: Statistisches Bundesamt Deutschland https://www.destatis.de/EN/PressServices/Press/pr/2013/09/PE13_298_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