CMP Associates Regulation Blog

Broader perspective is provided by Chart I-12c of the US Bureau of Labor Statistics. The United States civilian noninstitutional population has increased along a consistent trend since 1948 that continued through earlier recessions and the global recession from IVQ2007 to IIQ2009 and the cyclical expansion after IIIQ2009.

Chart I-12c, US, Civilian Noninstitutional Population, Thousands, NSA, 1948-2013

Sources: US Bureau of Labor Statistics

The labor force of the United States in Chart I-12d has increased along a trend similar to that of the civilian noninstitutional population in Chart I-12c. There is an evident stagnation of the civilian labor force in the final segment of Chart I-12d during the current economic cycle. This stagnation is explained by cyclical factors similar to those analyzed by Lazear and Spletzer (2012JHJul22) that motivated an increasing population to drop out of the labor force instead of structural factors. Large segments of the potential labor force are not observed, constituting unobserved unemployment and of more permanent nature because those afflicted have been seriously discouraged from working by the lack of opportunities.

Chart I-12d, US, Labor Force, Thousands, NSA, 1948-2013

Sources: US Bureau of Labor Statistics

The civilian labor force in Chart I-24 grew steadily on an upward trend in the 2000s until it contracted together with the economy after 2007. There has not been recovery during the expansion but rather decline and marginal turn of the year 2011 into expansion in 2012 followed by stability and oscillation into 2013. The ratio of the labor force of 154.871 million in Jul 2007 to the noninstitutional population of 231.958 million in Jul 2007 was 66.8 percent while the ratio of the labor force of 154.408 million in Dec 2013 to the noninstitutional population of 246.745 million in Dec 2013 was 62.6 percent. The labor force of the US in Dec 2013 corresponding to 66.8 percent of participation in the population would be 164.826 million (0.668 x 246.745). The difference between the measured labor force in Dec 2013 of 154.408 million and the labor force in Dec 2013 with participation rate of 66.8 percent (as in Jul 2007) of 164.826 million is 10.418 million. The level of the labor force in the US has stagnated and is 10.418 million lower than what it would have been had the same participation rate been maintained. Millions of people have abandoned their search for employment because they believe there are no jobs available for them. The key issue is whether the decline in participation of the population in the labor force is the result of people giving up on finding another job.

Chart I-24, US, Civilian Labor Force, Thousands, 2001-2013

Source: US Bureau of Labor Statistics

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

The theory of secular stagnation cannot explain sudden collapse of the US economy and labor markets. There are accentuated cyclic factors for both the entire population and the young population of ages 16 to 24 years. Table Summary provides the total noninstitutional population (ICP) of the US, full-time employment level (FTE), employment (EMP), civilian labor force (CLF), civilian labor force participation rate (CLFP), employment/population ratio (EPOP) and unemployment level (UNE). Secular stagnation would not be secular but immediate. All indicators of the labor market weakened sharply during the contraction and did not recover. Population continued to grow but all other variables collapsed and did not recover. The theory of secular stagnation departs from an aggregate production function in which output grows with the use of labor, capital and technology (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 11-6). Hansen (1938, 1939) finds secular stagnation in lower growth of an aging population and disincentive to innovation because of imperfect competition in product and labor markets. In the current US economy, Table Summary Total shows that population is dynamic while the labor market is fractured. There is key explanation in the behavior of the civilian labor force participation rate (CLFP) and the employment population ratio (EPOP) that collapsed during the global recession with inadequate recovery. Abandoning job searches are difficult to capture in labor statistics but likely explain the decline in the participation of the population in the labor force. Allowing for abandoning job searches, the total number of people unemployed or underemployed is 28.1 million or 17.2 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html).

Table Summary Total, US, Total Noninstitutional Civilian Population, Full-time Employment, Employment, Civilian Labor Force, Civilian Labor Force Participation Rate, Employment Population Ratio, Unemployment, NSA, Millions and Percent

	ICP	FTE	EMP	CLF	CLFP	EPOP	UNE
2006	288.8	119.7	144.4	151.4	66.2	63.1	7.0
2009	235.8	112.6	139.9	154.1	65.4	59.3	14.3
2012	243.3	114.8	142.5	155.0	63.7	58.6	12.5
12/07	233.2	121.0	146.3	153.7	65.9	62.8	7.4
9/09	236.3	112.0	139.1	153.6	65.0	58.9	14.5
11/13	246.6	116.9	144.8	155.0	62.9	58.7	10.3

ICP: Total Noninstitutional Civilian Population; FT: Full-time Employment Level, EMP: Total Employment Level; CLF: Civilian Labor Force; CLFP: Civilian Labor Force Participation Rate; EPOP: Employment Population Ratio; UNE: Unemployment

Source: Bureau of Labor Statistics

The same situation is present in the labor market for young people in ages 16 to 24 years with data in Table Summary Youth. The youth noninstitutional civilian population (ICP) continued to increase during and after the global recession. There is the same disastrous labor market with decline for young people in employment (EMP), civilian labor force (CLF), civilian labor force participation rate (CLFP) and employment population ratio (EPOP). There are only increases for unemployment of young people (UNE) and youth unemployment rate (UNER). If aging were a factor of secular stagnation, growth of population of young people would attract a premium in remuneration in labor markets. The sad fact is that young people are also facing tough labor markets. The application of the theory of secular stagnation to the US economy and labor markets is void of reality in the form of key facts.

Table Summary Youth, US, Youth, Ages 16 to 24 Years, Noninstitutional Civilian Population, Full-time Employment, Employment, Civilian Labor Force, Civilian Labor Force Participation Rate, Employment Population Ratio, Unemployment, NSA, Millions and Percent

	ICP	EMP	CLF	CLFP	EPOP	UNE	UNER
2006	36.9	20.0	22.4	60.6	54.2	2.4	10.5
2009	37.6	17.6	21.4	56.9	46.9	3.8	17.6
2012	38.8	17.8	21.3	54.9	46.0	3.5	16.2
12/07	37.5	19.4	21.7	57.8	51.6	2.3	10.7
9/09	37.6	17.0	20.7	55.2	45.1	3.8	18.2
11/13	38.8	18.1	20.8	53.7	46.7	2.7	13.1

ICP: Youth Noninstitutional Civilian Population; EMP: Youth Employment Level; CLF: Youth Civilian Labor Force; CLFP: Youth Civilian Labor Force Participation Rate; EPOP: Youth Employment Population Ratio; UNE: Unemployment; UNER: Youth Unemployment Rate

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

The theory of secular stagnation cannot explain sudden collapse of the US economy and labor markets. The theory of secular stagnation departs from an aggregate production function in which output grows with the use of labor, capital and technology (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 11-6). Simon Kuznets (1971) analyzes modern economic growth in his Lecture in Memory of Alfred Nobel:

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

Chart VA-7 provides nonfarm-business labor productivity, measured by output per hour, from 1947 to 2013. The rate of productivity increase continued in the early part of the 2000s but then softened and fell during the global recession. The interruption of productivity increases occurred exclusively in the current business cycle. Lazear and Spletzer (2012JHJul22) find “primarily cyclic” factors in explaining the frustration of currently depressed labor markets in the United States. Stagnation of productivity is another cyclic event and not secular trend. The theory and application of secular stagnation to current US economic conditions is void of reality.

Chart VA-7, US, Nonfarm Business Labor Productivity, Output per Hour, 1947-2013, Index 2005=100

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

Unit labor costs increased sharply during the Great Inflation from the late 1960s to 1981 as shown by sharper slope in Chart VA-8. Unit labor costs continued to increase but at a lower rate because of cyclic factors and not because of imaginary secular stagnation.

Chart VA-8, US, Nonfarm Business, Unit Labor Costs, 1947-2013, Index 2005=100

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

Real hourly compensation increased at relatively high rates after 1947 to the early 1970s but reached a plateau that lasted until the early 1990s, as shown in Chart VA-9. There were rapid increases until the global recession. Cyclic factors and not alleged secular stagnation explain the interruption of increases in real hourly compensation.

Chart VA-6, US, Nonfarm Business, Real Hourly Compensation, 1947-2013, Index 2005=100

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

The current application of Hansen’s (1938, 1939, 1941) proposition argues that secular stagnation occurs because full employment equilibrium can be attained only with negative real interest rates between minus 2 and minus 3 percent. Taylor (2014Jan1) finds major contradictions between the theory of secular stagnation and the behavior of the US economy. “Equilibrium” consists of market clearing that occurs in markets without government intervention. Negative real interest rates have not occurred in a market without intervention in conditions of full employment. In fact, monetary policy has consisted of unconventional measures of injecting bank reserves to maintain the fed funds rate close to zero and attempting to lower medium-term yields of securities at very low levels. The allegation of full employment equilibrium only with negative real rates of interest is theoretically deficient because monetary policy caused the negative real rates of interest. Disproving a weak theoretical argument is quite difficult because it requires measurement of counterfactuals. Conclusive evidence would require contrasting what actually happened with the counterfactual of what would have happened in the absence of unconventional monetary policy and other effects (on counterfactuals see Pelaez and Pelaez, Globalization and the State Vol I (2008a), 125, 136, Harberger (1971, 1997), Fishlow 1965, Fogel 1964, Fogel and Engerman 1974, North and Weingast 1989, Pelaez 1979, 26-7). Employment is observed only with the effects of unconventional monetary policy. The counterfactual would require measuring employment in the absence of unconventional monetary policy. There is no valid measurement of what monetary policy would have promoted full employment. An important alternative to unconventional monetary policy is that rules instead of discretionary authorities would have better promoted employment and price/financial stability (Taylor 1993, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012FP, 2012JMCB, 2014Jan3).

There is a strong case on the collateral effects of unconventional monetary policy. Chart VIII-1 of the Board of Governors of the Federal Reserve System provides the rate on the overnight fed funds rate and the yields of the 10-year constant maturity Treasury and the Baa seasoned corporate bond. Table VIII-3 provides the data for selected points in Chart VIII-1. There are two important economic and financial events, illustrating the ease of inducing carry trade with extremely low interest rates and the resulting financial crash and recession of abandoning extremely low interest rates.

The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. 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. 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 interest rates close to zero, 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 with the objective of 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 was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity by the penalty in the form of low interest rates and unsound credit decisions. 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). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VIII-1. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession.
On Dec 16, 2008, the policy determining committee of the Fed decided (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm): “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.” Policymakers emphasize frequently that there are tools to exit unconventional monetary policy at the right time. At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states that: “The Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.” Perception of withdrawal of $2490 billion, or $2.5 trillion, of bank reserves (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), would cause Himalayan increase in interest rates that would provoke another recession. There is no painless gradual or sudden exit from zero interest rates because reversal of exposures created on the commitment of zero interest rates forever.

In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):

“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differ from each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”

Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. 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 statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption 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→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.

Chart VIII-1, Fed Funds Rate and Yields of Ten-year Treasury Constant Maturity and Baa Seasoned Corporate Bond, Jan 2, 2001 to Jan 9, 2014

Source: Board of Governors of the Federal Reserve System

Table VIII-3, Selected Data Points in Chart VIII-1, % per Year

	Fed Funds Overnight Rate	10-Year Treasury Constant Maturity	Seasoned Baa Corporate Bond
1/2/2001	6.67	4.92	7.91
10/1/2002	1.85	3.72	7.46
7/3/2003	0.96	3.67	6.39
6/22/2004	1.00	4.72	6.77
6/28/2006	5.06	5.25	6.94
9/17/2008	2.80	3.41	7.25
10/26/2008	0.09	2.16	8.00
10/31/2008	0.22	4.01	9.54
4/6/2009	0.14	2.95	8.63
4/5/2010	0.20	4.01	6.44
2/4/2011	0.17	3.68	6.25
7/25/2012	0.15	1.43	4.73
5/1/13	0.14	1.66	4.48
9/5/13	0.08	2.98	5.53
11/21/2013	0.09	2.79	5.44
11/27/13	0.09	2.74	5.34 (11/26/13)
12/6/13	0.09	2.88	5.47
12/12/13	0.09	2.89	5.42
12/19/13	0.09	2.94	5.36
12/26/13	0.08	3.00	5.37
1/2/2014	0.08	3.00	5.34
1/9/2014	0.07	2.97	5.28

Source: Board of Governors of the Federal Reserve System

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

(4) 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 (Ingersoll 1987, 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 caused by 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.

(5) 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) 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 2012 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 contractions 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 1989 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. Table IB-1 illustrates the contradiction of long-term growth with the proposition of secular stagnation (Hansen 1938, 1938, 1941 with early critique by Simons (1942). Secular stagnation would occur over long periods. Table IB-1 also provides the corresponding rates of population growth that is only marginally lower at 0.8 to 0.9 percent recently from 1.1 percent over the long-term. GDP growth fell abruptly from 2.6 percent on average from 2000 to 2006 to 0.9 percent from 2006 to 2012 and real disposable income growth fell from 2.9 percent from 2000 to 2006 to 1.4 percent from 2006 to 2012. The decline of real per capita disposable income is even sharper from average 2.0 percent from 2000 to 2006 to 0.6 percent from 2006 to 2012 while population growth was 0.8 percent on average. Lazear and Spletzer (2012JHJul122) provide theory and measurements showing that cyclic factors explain currently depressed labor markets. This is also the case of the overall economy. 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 0.3 percent and real disposable income per capita decreased 0.5 percent. Third, first 17 quarters of expansion. In the expansion from IQ1983 to IQ1987: GDP grew 23.1 percent at the annual equivalent rate of 5.0 percent; real disposable income grew 19.5 percent at the annual equivalent rate of 4.3 percent; and real disposable income per capita grew 15.1 percent at the annual equivalent rate of 3.4 percent. In the expansion from IIIQ2009 to IIIQ2013: GDP grew 10.3 percent at the annual equivalent rate of 2.3 percent; real disposable income grew 6.3 percent at the annual equivalent rate of 1.4 percent; and real disposable personal income per capita grew 2.9 percent at the annual equivalent rate of 0.7 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IQ1987: GDP grew 22.9 percent at the annual equivalent rate of 2.8 percent; real disposable personal income 26.4 percent at the annual equivalent rate of 3.2 percent; and real disposable personal income per capita 18.1 percent at the annual equivalent rate of 2.2 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IIIQ2013: GDP grew 5.6 percent at the annual equivalent rate of 0.9 percent; real disposable personal income 7.9 percent at the annual equivalent rate of 1.3 percent; and real disposable personal income per capita 3.1 percent at the annual equivalent rate of 0.5 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. The proposition of secular stagnation should explain a long-term process of decay and not the actual abrupt collapse of the economy and labor markets currently.

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

Long-term Average ∆% per Year	GDP	Population
1929-2012	3.3	1.1
1947-2012	3.2	1.2
1947-1999	3.6	1.3
2000-2012	1.7	0.9
2000-2006	2.6	0.9
2006-2012	0.9	0.8
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita	Population
1929-2012	3.2	2.0	1.1
1947-1999	3.7	2.3	1.3
2000-2012	2.2	1.3	0.9
2000-2006	2.9	2.0	0.9
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6	0.9
2006-2012	1.4	0.6	0.8
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
GDP
I83 to IV83 IQ83 to IQ87	4 17
I83 to IV83 I83 to IQ87	4 17	7.8 23.1	7.8 5.0
RDPI
I83 to IV83 I83 to I87	4 17	5.3 19.5	5.3 4.3
RDPI Per Capita
I83 to IV83 I83 to I87	4 17	4.4 15.1	4.4 3.4
Whole Cycle IQ1980 to IQ1987
GDP	30	22.9	2.8
RDPI	30	26.4	3.2
RDPI per Capita	30	18.1	2.2
Population	30	7.0	0.9
GDP
III09 to II10 III09 to III13	4 17	2.7 10.3	2.7 2.3
RDPI
III09 to II10 III09 to III13	4 17	0.3 6.3	0.3 1.4
RDPI per Capita
III09 to II10 II09 to IIIQ13	4 17	-0.5 2.9	-0.5 0.7
Population
II09 to II010 II09 to III13	4 17	0.9 3.2	0.8 0.8
IVQ2007 to IIIQ2013	23
GDP	24	5.6	0.9
RDPI	24	7.9	1.3
RDPI per Capita	24	3.1	0.5
Population	24	4.6	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 IQ1987, including contractions and expansions. GDP is well below trend in the entire business cycle from IVQ2007 to IIIQ2013, including contractions and expansions
Per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIIQ2013
Level of employed persons increased in the 1980s but declined into IIIQ2013
Level of full-time employed persons increased in the 1980s but declined into IIIQ2013
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 stagnated in real terms into IIIQ2013
Gross private domestic investment increased sharply from IQ1980 to IQ1987 but gross private domestic investment stagnated and private fixed investment fell from IVQ2007 into IIIQ2013

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 22.5 percent from IQ1980 to IQ1987, which is relatively close to what trend growth would have been at 24.8 percent. Real GDP grew 22.9 percent from IVQ1979 to IQ1987. Rapid growth at the average annual rate of 5.0 percent per quarter during the expansion from IQ1983 to IQ1987 erased the loss of GDP of 4.6 percent during the contraction and maintained trend growth at 2.8 percent for GDP and 3.2 percent for real disposable personal income over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIIQ2013 was 5.6 percent while trend growth would have been 19.4 percent. GDP in IIIQ2013 at seasonally adjusted annual rate is $15,839.3 billion as estimated by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $17,905.3 billion, or $2066.0 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 IIIQ2013 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.1 million people or 17.2 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.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 or those able to work, increased from 212.577 million in 2000 to 231.867 million in 2007 or 9.1 percent at the average yearly rate of 1.2 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 0.9 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/2013/12/risks-of-zero-interest-rates-mediocre.html). Structural change in demography occurs over relatively long periods and not suddenly as shown by Edward P. Lazear and James R. Spletzer (2012JHJul22). There is an abrupt cyclical event and no evidence for secular stagnation and similar propositions.

Period IQ1980 to IQ1987
GDP SAAR USD Billions
IQ1980	6,517.9
IQ1987	7,986.4
∆% IQ1980 to IQ1987 (22.9 percent from IVQ1979 $6496.8 billion)	22.5
∆% Trend Growth IQ1980 to IQ1987	24.8

Period IVQ2007 to IIIQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIIQ2013	15,839.3
∆% IVQ2007 to IIIQ2013 Actual	5.6
∆% IVQ2007 to IIIQ2013 Trend	19.4

2. Stagnating Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IQ1987, 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 18.0 percent, which is close to what would have been trend growth of 16.0 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IIIQ2013, per capita real disposable income increased 3.1 percent while trend growth would have been 12.6 percent. Income available after inflation and taxes is about the same or lower as before the contraction after 17 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 4.7 percent after falling at 4.1 percent in IQ2013. In IIQ2013, real personal income excluding current transfer receipts grew at 5.6 percent after falling at 7.2 percent in IQ2013. In IIQ2013, real disposable personal income grew at 4.1 percent after falling at minus 7.9 percent in IQ2013 percent (Table 6 at http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi1113.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.”

Nominal personal income grew at 4.0 percent in IIIQ2013 and real personal income excluding current transfer receipts at 2.0 percent while real disposable income grew at 3.0 percent (http://www.bea.gov/newsreleases/national/pi/2013/pdf/pi1113.pdf).

Period IQ1980 to IQ1987

Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,242
Real Disposable Personal Income per Capita IQ1987 Chained 2009 USD	23,891
∆% IQ1980 to IQ1987 (18.1 percent from IVQ1982 $20,230)	18.0
∆% Trend Growth	16.0

Period IVQ2007 to IIIQ2013

Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIIQ2013 Chained 2009 USD	36,943
∆% IVQ2007 to IIIQ2013	3.1
∆% Trend Growth	12.6

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 IQ1987 or by 11.9 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 144,651 million in IIIQ2013 or by 1.2 percent. There are 28.1 million persons unemployed or underemployed, which is 17.2 percent of the effective labor force (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html).

Period IQ1980 to IQ1987

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IQ1987 NSA End of Quarter	110.229
∆% Employed IQ1980 to IQ1987	11.9

Period IVQ2007 to IIIQ2013

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2013 NSA End of Quarter	144.651
∆% Employed IVQ2007 to IIIQ2013	-1.2

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 90.270 million NSA in IQ1987 or 11.1 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 117.308 million in IIIQ2013 or by minus 3.1 percent.

4. Number of Full-time Employed Persons

Period IQ1980 to IQ1987

Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IQ1987 NSA End of Quarter	90,270
∆% Full-time Employed IQ1980 to IQ1987	11.1

Period IVQ2007 to IIIQ2013

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2013 NSA End of Quarter	117.308
∆% Full-time Employed IVQ2007 to IIIQ2013	-3.1

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 IQ1987: (a) The rate of unemployment was virtually the same at 6.9 percent in IQ1987 relative to 6.6 percent in IQ1980. (b) The number unemployed increased from 6.983 million in IQ1980 to 8.124 million in IQ1987 or 16.3 percent. (c) The number employed part-time for economic reasons increased 44.4 percent from 3.624 million in IQ1980 to 5.232 million in IQ1987.

ii. In contrast, in the economic cycle from IVQ2007 to IIIQ2013: (a) The rate of unemployment increased from 4.8 percent in IVQ2007 to 7.0 percent in IIIQ2013. (b) The number unemployed increased 47.7 percent from 7.371 million in IVQ2007 to 10.885 million in IIIQ2013. (c) The number employed part-time for economic reasons because they could not find any other job increased 58.4 percent from 4.750 million in IVQ2007 to 7.522 million in IIIQ2013. (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 13.1 percent in IIIQ2013.

Period IQ1980 to IQ1987

Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate IQ1987 NSA End of Quarter	6.9
Unemployed IQ1980 Millions End of Quarter	6.983
Unemployed IQ1987 Millions End of Quarter	8.124
∆%	16.3
Employed Part-time Economic Reasons Millions IQ1980 End of Quarter	3.624
Employed Part-time Economic Reasons Millions IQ1987 End of Quarter	5.232
∆%	44.4

Period IVQ2007 to IIIQ2013

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2013 NSA End of Quarter	7.0
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIIQ2013 Millions End of Quarter	10.885
∆%	47.7
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2013 End of Quarter	7.522
∆%	58.4
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
IIIQ2013	13.1

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 IQ1987 and from IVQ2007 to IIIQ2012 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 IQ1987. Net worth increased 94.1 percent from IVQ1979 to IQ1987, the all items CPI index increased 46.2 percent from 76.7 in Dec 1979 to 112.1 in Mar 1987 and real net worth increased 32.8 percent.
IQ1980 to IVQ1985. Net worth increased 65.7 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 21.4 percent.
IVQ1979 to IVQ1985. Net worth increased 69.4 percent, 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 18.8 percent.
IQ1980 to IQ1987. Net worth increased 89.9 percent, the all items CPI index increased 39.9 percent from 80.1 in Mar 1980 to 112.1 in Mar 1987 and real net worth increased 35.7 percent.

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

IVQ2007 to IIIQ2013. Net worth increased 13.6 percent, the all items CPI increased 11.5 percent from 210.036 in Dec 2007 to 234.149 in Sep 2013 and real or inflation adjusted net worth increased 1.9 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 2.3 percent on average in the cyclical expansion in the 17 quarters from IIIQ2009 to IIIQ2013. 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) and the third estimate of GDP for IIIQ2013 (http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp3q13_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/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html).The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.4 percent from IQ1983 to IVQ1986 and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html and earlier http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). As a result, there are 28.1 million unemployed or underemployed in the United States for an effective unemployment rate of 17.2 percent (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html http://cmpassocregulationblog.blogspot.com/2013/11/global-financial-risk-mediocre-united.html). The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May).

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ1979 IQ1980	9,021.2 9,220.3
IVQ1985 IIIQ1986 IVQ1986 IQ1987	15,278.5 16,292.9 16,845,1 17,509.1
∆ USD Billions IVQ1985 IQ1987 IQ1980-IVQ1985 IQ1980-IIIQ1986 IQ1980-IVQ1986 IQ1980-IQ1987	+6,257.3 ∆%69.4 R∆%18.8 +8,487.9 ∆%94.1 R∆%32.8 +6,058.2 ∆%65.7 R∆%21.4 +7,072.6 ∆%76.7 R∆%28.4 +7,624.8 ∆%82.7 R∆%32.4 +8,288.8 ∆%89.9 R∆%35.7
Period IVQ2007 to IQ2013
Net Worth of Households and Nonprofit Organizations USD Millions
IVQ2007	67,990.3
IIIQ2013	77,259.3
∆ USD Billions	9,269.0 ∆%13.6 R∆%1.9

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: third quarter 2013. Washington, DC, Federal Reserve System, Dec 9.

7. Gross Private Domestic Investment.

i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IQ1987 and from IVQ2007 to IIIQ2013 is in the following block and in Table IB-2. Gross private domestic investment increased from $951.6 billion in IQ1980 to $1,173.8 billion in IQ1987 or by 23.4 percent.

ii In the current cycle, gross private domestic investment increased from $2,605.2 billion in IVQ2007 to $2,627.2 billion in IIIQ2013, or 0.8 percent. Private fixed investment fell from $2,586.3 billion in IVQ2007 to $2,494.0 billion in IIIQ2013, or decline by 3.6 percent.

Period IQ1980 to IQ1987
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IQ1987	1,173.8
∆%	23.4
Period IVQ2007 to IIIQ2013
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIQ2013	2,627.2
∆%	0.8
Private Fixed Investment USD 2009 Billions
IVQ2007	2,586.3
IIIQ2013	2,494.0
∆%	-3.6

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 IQ1987
GDP SAAR USD Billions
IQ1980	6,517.9
IQ1987	7,986.4
∆% IQ1980 to IQ1987 (22.9 percent from IVQ1982 $6496.8 billion)	21.1
∆% Trend Growth IQ1980 to IQ1987	24.8
Real Disposable Personal Income per Capita IQ1980 Chained 2009 USD	20,242
Real Disposable Personal Income per Capita IQ1987 Chained 2009 USD	23,891
∆% IQ1980 to IQ1987 (18.1 percent from IVQ1982 $20,230 billion)	18.0
∆% Trend Growth	16.0
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IQ1987 NSA End of Quarter	110.229
∆% Employed IQ1980 to IQ1987	11.9
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IQ1987 NSA End of Quarter	90.270
∆% Full-time Employed IQ1980 to IQ1987	11.1
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate IQ1987 NSA End of Quarter	6.9
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IQ1987 Millions NSA End of Quarter	8.124
∆%	16.3
Employed Part-time Economic Reasons IQ1980 Millions NSA End of Quarter	3.624
Employed Part-time Economic Reasons Millions IQ1987 NSA End of Quarter	5.232
∆%	44.4
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	9,021.4
IQ1987	17,509.1
∆ USD Billions	+8,487.9
∆% CPI Adjusted	32.8
Gross Private Domestic Investment USD 2009 Billions
IQ1980	951.6
IQ1987	1173.8
∆%	23.4
Period IVQ2007 to IIQ2013
GDP SAAR USD Billions
IVQ2007	14,996.1
IIIQ2013	15,839.3
∆% IVQ2007 to IIIQ2013	5.6
∆% IVQ2007 to IIIQ2013 Trend Growth	19.4
Real Disposable Personal Income per Capita IVQ2007 Chained 2009 USD	35,823
Real Disposable Personal Income per Capita IIIQ2013 Chained 2009 USD	36,943
∆% IVQ2007 to IIIQ2013	3.1
∆% Trend Growth	12.6
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2013 NSA End of Quarter	144.651
∆% Employed IVQ2007 to IIIQ2013	-1.2
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2013 NSA End of Quarter	117.308
∆% Full-time Employed IVQ2007 to IIIQ2013	-3.1
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2013 NSA End of Quarter	7.0
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIIQ2013 Millions NSA End of Quarter	10.885
∆%	47.7
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2013 NSA End of Quarter	7.522
∆%	58.4
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
IIIQ2013	13.1
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	67,990.3
IIIQ2013	77.259.3
∆ USD Billions	9,269 ∆%13.6 R∆%1.9
Gross Private Domestic Investment USD Billions
IVQ2007	2,605.2
IIIQ2013	2,627.2
∆%	0.8
Private Fixed Investment USD 2005 Billions
IVQ2007	2,586.3
IIIQ2013	2,494.0
∆%	-3.6

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 IIIQ2013 at 2.3 percent on average is in contrast with 5.0 percent on average in the expansion from IQ1983 to IQ1987 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 28.1 million or 17.2 percent of the effective labor force in Nov 2013 (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html) with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.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 2.3 percent on average from IIIQ2009 to IIIQ2013 during the current economic expansion in contrast with 5.0 percent on average in the cyclical expansion from IQ1983 to IQ1987 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.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 28.1 million or 17.2 percent of the labor force as estimated for Nov 2013 (http://cmpassocregulationblog.blogspot.com/2013/12/risks-of-zero-interest-rates-mediocre.html). There is no exit from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2013/12/theory-and-reality-of-secular.html). The US economy and labor markets collapsed without recovery. Abrupt collapse of economic conditions can be explained only with cyclic factors (Lazear and Spletzer 2012Jul22) and not by secular stagnation (Hansen 1938, 1939, 1941 with early dissent by Simons 1942).

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

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

II United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html). The Census Bureau revised data for 2012 and 2013. The US trade balance improved from deficit of $39,328 million in Oct 2013 to deficit of $34,252 million in Nov 2013 but higher deficit of $42,969 million in Sep 2013. Exports and imports did not change in Aug 2013. Exports decreased 0.1 percent in Sep 2012 while imports increased 1.6 percent. Exports increased 2.0 percent in Oct 2013 while imports increased 0.1 percent. Exports increased 0.9 percent in Nov 2013 while imports fell 1.4 percent. The trade balance deteriorated from cumulative deficit of $499,379 million in Jan-Dec 2010 to deficit of $556,838 million in Jan-Dec 2011 and improved to marginally lower deficit of $534,656 million in Jan-Dec 2012.

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

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Nov 2013	-34,252	194,857	0.9	229,108	-1.4
Oct	-39,328	193,136	2.0	232,464	0.1
Sep	-42,969	189,312	-0.1	232,281	1.6
Aug	-38,945	189,579	0.0	228,524	0.0
Jul	-38,824	189,630	-0.7	228,455	1.3
Jun	-34,637	190,875	2.2	225,512	-2.2
May	-43,886	186,727	-0.2	230,613	1.7
Apr	-39,599	187,126	1.4	226,725	2.4
Mar	-36,787	184,578	-1.1	221,365	-3.8
Feb	-43,481	186,698	0.0	230,180	0.5
Jan	-42,364	186,607	-1.1	228,971	0.9
Dec 2012	-38,307	188,686	1.9	226,994	-2.0
Nov	-46,422	185,220	1.4	231,641	2.8
Oct	-42,650	182,655	-2.2	225,304	-1.4
Sep	-41,570	186,829	2.6	228,400	1.0
Aug	-44,007	182,071	-0.7	226,078	-0.3
Jul	-43,451	183,375	-1.0	226,826	-0.4
Jun	-42,430	185,218	0.5	227,648	-1.2
May	-46,247	184,217	0.0	230,464	-0.2
Apr	-46,625	184,267	-1.2	230,892	-1.5
Mar	-47,790	186,505	2.4	234,295	3.7
Feb	-43,763	182,064	1.4	225,827	-2.2
Jan	-51,393	179,477	0.2	230,871	0.2
Jan-Dec 2012	-534,656	2,210,585		2,745,240
Jan-Dec 2011	-556,838	2,112,825		2,669,663
Jan-Dec 2010	-499,379	1,844,468		2,343,847

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

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

Table IIA-2 provides the US international trade balance, exports and imports on an annual basis from 1992 to 2012. The trade balance deteriorated sharply over the long term. The US has a large deficit in goods or exports less imports of goods but it has a surplus in services that helps to reduce the trade account deficit or exports less imports of goods and services. The current account deficit of the US decreased from $122.5 billion in IIIQ2012, or 2.6 percent of GDP to $110.1 billion in IIIQ2013, or 2.2 percent of GDP (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre_24.html). The ratio of the current account deficit to GDP has stabilized around 3 percent of GDP compared with much higher percentages before the recession (see Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State, Vol. II (2008b), 183-94, Government Intervention in Globalization (2008c), 167-71). The last row of Table IIA-2 shows marginal improvement of the trade deficit from $556,838 million in 2011 to lower $534,656 million in 2012 with exports growing 4.6 percent and imports 2.8 percent. Growth and commodity shocks under alternating inflation waves (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html) have deteriorated the trade deficit from the low of $383,657 million in 2009.

Table IIA-2, US, International Trade Balance of Goods and Services, Exports and Imports of Goods and Services, SA, Millions of Dollars

Period	Balance	Exports	Imports
1960	3,508	25,940	22,432
1961	4,195	26,403	22,208
1962	3,370	27,722	24,352
1963	4,210	29,620	25,410
1964	6,022	33,341	27,319
1965	4,664	35,285	30,621
1966	2,939	38,926	35,987
1967	2,604	41,333	38,729
1968	250	45,543	45,293
1969	91	49,220	49,129
1970	2,254	56,640	54,386
1971	-1,302	59,677	60,979
1972	-5,443	67,222	72,665
1973	1,900	91,242	89,342
1974	-4,293	120,897	125,190
1975	12,404	132,585	120,181
1976	-6,082	142,716	148,798
1977	-27,246	152,301	179,547
1978	-29,763	178,428	208,191
1979	-24,565	224,131	248,696
1980	-19,407	271,834	291,241
1981	-16,172	294,398	310,570
1982	-24,156	275,236	299,391
1983	-57,767	266,106	323,874
1984	-109,072	291,094	400,166
1985	-121,880	289,070	410,950
1986	-138,538	310,033	448,572
1987	-151,684	348,869	500,552
1988	-114,566	431,149	545,715
1989	-93,141	487,003	580,144
1990	-80,864	535,233	616,097
1991	-31,135	578,344	609,479
1992	-39,212	616,882	656,094
1993	-70,311	642,863	713,174
1994	-98,493	703,254	801,747
1995	-96,384	794,387	890,771
1996	-104,065	851,602	955,667
1997	-108,273	934,453	1,042,726
1998	-166,140	933,174	1,099,314
1999	-263,755	967,008	1,230,764
2000	-377,337	1,072,782	1,450,119
2001	-362,339	1,007,725	1,370,065
2002	-418,165	980,879	1,399,044
2003	-490,545	1,023,937	1,514,482
2004	-604,897	1,163,724	1,768,622
2005	-707,914	1,288,257	1,996,171
2006	-752,399	1,460,792	2,213,191
2007	-699,065	1,652,859	2,351,925
2008	-702,302	1,840,332	2,542,634
2009	-383,657	1,578,187	1,961,844
2010	-499,379	1,844,468	2,343,847
2011	-556,838	2,112,825	2,669,663
2012	-534,656	2,210,585	2,745,240

Source: US Census Bureau

Chart IIA-1 of the US Census Bureau of the Department of Commerce shows that the trade deficit (gap between exports and imports) fell during the economic contraction after 2007 but has grown again during the expansion. The low average rate of growth of GDP of 2.3 percent during the expansion beginning in IIIQ2009 does not deteriorate further the trade balance. Higher rates of growth may cause sharper deterioration.

Chart IIA-1, US, International Trade Balance, Exports and Imports of Goods and Services USD Billions

Source: US Census Bureau

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

Chart IIA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Nov 2013. There is long-term trend of deterioration of the US trade deficit shown vividly by Chart IIA-2. The global recession from IVQ2007 to IIQ2009 reversed the trend of deterioration. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4 http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Nov 2013

Source: US Census Bureau

Chart IIA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Nov 2013. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Nov 2013

Source: US Census Bureau

Chart IIA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Nov 2013. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion.

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Nov 2013

Source: US Census Bureau

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

The balance of international trade in goods of the US seasonally adjusted is in Table IIA-3. The US has a dynamic surplus in services that reduces the large deficit in goods for a still very sizeable deficit in international trade of goods and services. The deficit in the balance in international trade of goods decreased from deficit of $64,862 million in Nov 2012 to $53,938 million in Nov 2013. The relative improvement of the goods balance in Nov 2013 relative to Nov 2012 occurred mostly in the petroleum balance, exports less imports of petroleum goods, in the magnitude of decreasing the deficit by $7593 million, while there was improvement in the nonpetroleum balance, exports less imports of nonpetroleum goods, in the magnitude of decreasing the deficit by $3222 million. US terms of trade, export prices relative to import prices, and the US trade account fluctuate in accordance with the carry trade from zero interest rates to commodity futures exposures, especially oil futures. Exports increased 5.7 percent with nonpetroleum exports increasing 4.1 percent. Total imports decreased 1.8 percent with petroleum imports decreasing 15.1 percent and nonpetroleum imports increasing 1.0 percent. Details do not add because of seasonal adjustment and rounding.

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

	Nov 2013	Nov 2012	∆%
Total Balance	-53,938	-64,862
Petroleum	-15,172	-22,765
Non Petroleum	-37,847	-41,069
Total Exports	137,065	129,667	5.7
Petroleum	13,313	10,790	23.4
Non Petroleum	122,528	117,740	4.1
Total Imports	191,003	194,529	-1.8
Petroleum	28,485	33,555	-15.1
Non Petroleum	160,375	158,809	1.0

Details may not add because of rounding and seasonal adjustment

Source: US Census Bureau http://www.census.gov/foreign-trade/

US exports and imports of goods not seasonally adjusted in Jan-Nov 2013 and Jan-Nov 2012 are in Table IIA-4. The rate of growth of exports was 2.4 percent and minus 0.6 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that increased 1.1 percent and of mineral fuels that increased 7.5 percent both because prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion and portfolio reallocations. The US exports an insignificant amount of crude oil. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports rose 2.0 percent while manufactured imports rose 1.2 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 10.9 percent and petroleum decreasing 11.7 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html).

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

	Jan-Nov 2013 $ Millions	Jan-Nov 2012 $ Millions	∆%
Exports	1,448,209	1,414,952	2.4
Manufactured	1,086,420	1,064,832	2.0
Agricultural Commodities	129,715	128,308	1.1
Mineral Fuels	132,307	123,025	7.5
Petroleum	110,140	100,959	9.1
Imports	2,084,928	2,098,345	-0.6
Manufactured	1,681,537	1,662,110	1.2
Agricultural Commodities	95,927	94,889	1.1
Mineral Fuels	350,900	393,863	-10.9
Petroleum	335,596	379,880	-11.7

Source: US Census Bureau http://www.census.gov/foreign-trade/

In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

“Imagine that fiscal policy dominates monetary policy. The fiscal authority independently sets its budgets, announcing all current and future deficits and surpluses and thus determining the amount of revenue that must be raised through bond sales and seignorage. Under this second coordination scheme, the monetary authority faces the constraints imposed by the demand for government bonds, for it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public. Suppose that the demand for government bonds implies an interest rate on bonds greater than the economy’s rate of growth. Then if the fiscal authority runs deficits, the monetary authority is unable to control either the growth rate of the monetary base or inflation forever. If the principal and interest due on these additional bonds are raised by selling still more bonds, so as to continue to hold down the growth of base money, then, because the interest rate on bonds is greater than the economy’s growth rate, the real stock of bonds will growth faster than the size of the economy. This cannot go on forever, since the demand for bonds places an upper limit on the stock of bonds relative to the size of the economy. Once that limit is reached, the principal and interest due on the bonds already sold to fight inflation must be financed, at least in part, by seignorage, requiring the creation of additional base money.”

The alternative fiscal scenario of the CBO (2012NovCDR, 2013Sep17) resembles an economic world in which eventually the placement of debt reaches a limit of what is proportionately desired of US debt in investment portfolios. This unpleasant environment is occurring in various European countries.

The current real value of government debt plus monetary liabilities depends on the expected discounted values of future primary surpluses or difference between tax revenue and government expenditure excluding interest payments (Cochrane 2011Jan, 27, equation (16)). There is a point when adverse expectations about the capacity of the government to generate primary surpluses to honor its obligations can result in increases in interest rates on government debt.

This analysis suggests that there may be a point of saturation of demand for United States financial liabilities without an increase in interest rates on Treasury securities. A risk premium may develop on US debt. Such premium is not apparent currently because of distressed conditions in the world economy and international financial system. Risk premiums are observed in the spread of bonds of highly indebted countries in Europe relative to bonds of the government of Germany.

The issue of global imbalances centered on the possibility of a disorderly correction (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). Such a correction has not occurred historically but there is no argument proving that it could not occur. The need for a correction would originate in unsustainable large and growing United States current account deficits (CAD) and net international investment position (NIIP) or excess of financial liabilities of the US held by foreigners net relative to financial liabilities of foreigners held by US residents. The IMF estimated that the US could maintain a CAD of two to three percent of GDP without major problems (Rajan 2004). The threat of disorderly correction is summarized by Pelaez and Pelaez, The Global Recession Risk (2007), 15):

“It is possible that foreigners may be unwilling to increase their positions in US financial assets at prevailing interest rates. An exit out of the dollar could cause major devaluation of the dollar. The depreciation of the dollar would cause inflation in the US, leading to increases in American interest rates. There would be an increase in mortgage rates followed by deterioration of real estate values. The IMF has simulated that such an adjustment would cause a decline in the rate of growth of US GDP to 0.5 percent over several years. The decline of demand in the US by four percentage points over several years would result in a world recession because the weakness in Europe and Japan could not compensate for the collapse of American demand. The probability of occurrence of an abrupt adjustment is unknown. However, the adverse effects are quite high, at least hypothetically, to warrant concern.”

The United States could be moving toward a situation typical of heavily indebted countries, requiring fiscal adjustment and increases in productivity to become more competitive internationally. The CAD and NIIP of the United States are not observed in full deterioration because the economy is well below potential. There are two complications in the current environment relative to the concern with disorderly correction in the first half of the past decade. In the release of Jun 14, 2013, the Bureau of Economic Analysis (http://www.bea.gov/newsreleases/international/transactions/2013/pdf/trans113.pdf) informs of revisions of US data on US international transactions since 1999:

“The statistics of the U.S. international transactions accounts released today have been revised for the first quarter of 1999 to the fourth quarter of 2012 to incorporate newly available and revised source data, updated seasonal adjustments, changes in definitions and classifications, and improved estimating methodologies.”

Table VI-IIIB provides data on the US fiscal and balance of payments imbalances. In 2007, the federal deficit of the US was $161 billion corresponding to 1.1 percent of GDP while the Congressional Budget Office (CBO 2013Sep11) estimates the federal deficit in 2012 at $1087 billion or 6.8 percent of GDP. The combined record federal deficits of the US from 2009 to 2012 are $5090 billion or 31.6 percent of the estimate of GDP for fiscal year 2012 implicit in the CBO (CBO 2013Sep11) estimate of debt/GDP. The deficits from 2009 to 2012 exceed one trillion dollars per year, adding to $5.090 trillion in four years, using the fiscal year deficit of $1087 billion for fiscal year 2012, which is the worst fiscal performance since World War II. Federal debt in 2007 was $5035 billion, less than the combined deficits from 2009 to 2012 of $5090 billion. Federal debt in 2012 was 70.1 percent of GDP (CBO 2013Sep11). This situation may worsen in the future (CBO 2013Sep17):

“Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73 percent of the economy’s annual output, or gross domestic product (GDP). That percentage is higher than at any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007. If current laws generally remained in place, federal debt held by the public would decline slightly relative to GDP over the next several years, CBO projects. After that, however, growing deficits would ultimately push debt back above its current high level. CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

The gap between federal spending and revenues would widen steadily after 2015 under the assumptions of the extended baseline, CBO projects. By 2038, the deficit would be 6½ percent of GDP, larger than in any year between 1947 and 2008, and federal debt held by the public would reach 100 percent of GDP, more than in any year except 1945 and 1946. With such large deficits, federal debt would be growing faster than GDP, a path that would ultimately be unsustainable.

Incorporating the economic effects of the federal policies that underlie the extended baseline worsens the long-term budget outlook. The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. With those effects included, debt under the extended baseline would rise to 108 percent of GDP in 2038.”

Table VI-3B, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011	2012
Goods & Services	-699	-702	-384	-499	-557	-535
Income	101	146	124	178	233	224
UT	-115	-125	-122	-128	-134	-130
Current Account	-713	-681	-382	-449	-458	-440
NGDP	14480	14720	14418	14958	15534	16245
Current Account % GDP	-4.9	-4.6	-2.6	-3.0	-2.9	-2.7
NIIP	-1796	-3260	-2275	-2250	-3730	-3863
US Owned Assets Abroad	18400	19464	18558	20555	21636	21638
Foreign Owned Assets in US	20196	22724	20833	22805	25366	25501
NIIP % GDP	-12.4	-22.1	-15.8	-15.0	-24.0	-23.8
Exports Goods Services Income	2487	2654	2185	2523	2874	2987
NIIP % Exports Goods Services Income	-72	-123	-104	-89	-130	-129
DIA MV	5274	3102	4322	4809	4514	5249
DIUS MV	3551	2486	2995	3422	3510	3924
Fiscal Balance	-161	-459	-1413	-1294	-1296	-1087
Fiscal Balance % GDP	-1.1	-3.1	-9.8	-8.7	-8.4	-6.8
Federal Debt	5035	5803	7545	9019	10128	11281
Federal Debt % GDP	35.1	39.3	52.3	61.0	65.8	70.1
Federal Outlays	2729	2983	3518	3456	3598	3537
∆%	2.8	9.3	17.9	-1.8	4.1	-1.7
% GDP	19.0	20.2	24.4	23.4	23.4	22.0
Federal Revenue	2568	2524	2105	2162	2302	2450
∆%	6.7	-1.7	-16.6	2.7	6.5	6.4
% GDP	17.9	17.1	14.6	14.6	15.0	15.2

Sources:

Notes: UT: unilateral transfers; NGDP: nominal GDP or in current dollars; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. There are minor discrepancies in the decimal point of percentages of GDP between the balance of payments data and federal debt, outlays, revenue and deficits in which the original number of the CBO source is maintained. These discrepancies do not alter conclusions. Budget http://www.cbo.gov/ Balance of Payments and NIIP http://www.bea.gov/international/index.htm#bop Gross Domestic Product, Bureau of Economic Analysis (BEA). http://www.bea.gov/iTable/index_nipa.cfm

Table VI-IIIC provides quarterly estimates NSA of the external and internal imbalances of the United States. The current account deficit seasonally adjusted falls from 3.0 percent of GDP in IQ2012 to 2.5 percent in IQ2013 and 2.3 percent of GDP in IIQ2013. The net international investment position increases from $3.9 trillion in IQ2012 to $4.3 trillion in IQ2013 and $4.5 trillion in IIQ2013.

Table VI-IIIC, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and % NSA

	IIQ2012	IIIQ2012	IVQ2012	IQ2013	IIQ2013
Goods & Services	-145	-145	-122	-100	-126
Income	58	55	55	52	57
UT	-31	-33	-32	-34	-33
Current Account	-118	-123	-99	-82	-102
Current Account % GDP	-2.7	-2.6	-2.5	-2.5	-2.3
NIIP	-4332	-4109	-3863	-4236	-4504
US Owned Assets Abroad	20948	21551	21638	21590	20984
Foreign Owned Assets in US	-25280	-25660	-25501	-25826	-25488
DIA MV	4679	5059	5249	5501	5430
DIUS MV	3765	3962	3924	4251	4343

Sources:

Notes: UT: unilateral transfers; NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value.

Sources: US Bureau of Economic Analysis http://www.bea.gov/international/index.htm#bop

Chart IIA-5 of the Bureau of Economic Analysis shows the US balance on current account from 1960 to 2012. The sharp devaluation of the dollar resulting from unconventional monetary policy of zero interest rates and suspension of auctions of 30-year Treasury bonds did not adjust the US balance of payments. Adjustment only occurred after the contraction of economic activity during the global recession.

Chart IIA-5, US, Balance on Current Account, 1960-2012, Millions of Dollars

Source: Bureau of Economic Analysis

Chart IIA-6 of the Bureau of Economic Analysis provides real GDP in the US from 1960 to 2012. The contraction of economic activity during the global recession was a major factor in the reduction of the current account deficit as percent of GDP.

Chart IIA-6, US, US Real GDP in 2009 Chained Dollars

Source: Bureau of Economic Activity

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

Chart IIA-7 provides the US balance of current account quarterly from 1979 to 2013. The contraction of the economy from IVQ2007 to IIQ2009 improved the deficit in current account. There is no resolution of the external or balance of payments imbalance of the US that could widen in any growth of the economy toward potential output.

Chart IIA-7, US, Balance on Current Account, Quarterly 1979-2013, Millions of Dollars, NSA

Source: Bureau of Economic Analysis

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

Risk aversion channels funds toward US long-term and short-term securities that finance the US balance of payments and fiscal deficits benefitting at the moment from risk flight to US dollar denominated assets. Net foreign purchases of US long-term securities (row C in Table IIB-5) decreased from $3.2 billion in Sep 2012 to $1.3 billion in Oct 2012. Foreign (residents) purchases minus sales of US long-term securities (row A in Table IIB-5) in Sep of $17.8 billion increased to $28.4 billion in Oct 2012. Net US (residents) purchases of long-term foreign securities (row B in Table IIB-5) decreased from minus $14.6 billion in Sep to minus $27.1 billion in Oct. In Oct,

C = A + B = $28.4 billion - $27.1 billion = $1.3 billion

There is increasing demand in Table IIB-5 in Oct in A1 private purchases by residents overseas of US long-term securities of $22.3 billion of which increases in A11 Treasury securities of $7.6 billion, increase in A12 of $12.5 billion in agency securities, increase by $2.8 billion of corporate bonds and decrease of $0.6 billion in equities. Worldwide risk aversion causes flight into US Treasury obligations with significant oscillations. Official purchases of securities in row A2 increased $6.2 billion with increase of Treasury securities of $8.2 billion in Oct, which is higher than $0.9 billion in Sep. Official purchases of agency securities decreased $4.1 billion in Oct and increased $9.9 billion in Sep. Row D shows decrease in Oct in purchases of short-term dollar denominated obligations. Foreign private holdings of US Treasury bills decreased $5.5 billion (row D11) with foreign official holdings decreasing $4.4 billion while the category other increased $8.0 billion. Risk aversion of default losses in foreign securities dominates decisions to accept zero interest rates in Treasury securities with no perception of principal losses. In the case of long-term securities, investors prefer to sacrifice inflation and possible duration risk to avoid principal losses.

Table IIB-5, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Oct 2011 12 Months	Oct 2012 12 Months	Oct 2012	Oct 2012
A Foreign Purchases less Sales of US LT Securities	611.5	459.8	17.8	28.4
A1 Private	415.8	248.3	3.7	22.3
A11 Treasury	327.5	179.4	-18.3	7.6
A12 Agency	50.3	100.5	8.0	12.5
A13 Corporate Bonds	-21.2	-60.2	-9.3	2.8
A14 Equities	59.3	28.6	23.3	-0.6
A2 Official	195.6	211.5	14.1	6.2
A21 Treasury	171.2	197.5	0.9	8.2
A22 Agency	21.3	2.2	9.9	-4.1
A23 Corporate Bonds	-0.8	4.5	2.9	0.8
A24 Equities	4.0	7.2	0.4	1.2
B Net US Purchases of LT Foreign Securities	-185.6	34.6	-14.6	-27.1
B1 Foreign Bonds	-85.1	52.1	-21.6	-26.7
B2 Foreign Equities	-100.5	-17.5	7.0	-0.4
C Net Foreign Purchases of US LT Securities	425.8	494.4	3.2	1.3
D Increase in Foreign Holdings of Dollar Denominated Short-term	-195.9	83.4	17.0	-1.9
D1 US Treasury Bills	-140.5	45.4	23.6	-9.8
D11 Private	16.2	40.6	12.8	-5.5
D12 Official	-156.7	4.7	10.8	-4.4
D2 Other	-55.4	38.0	-6.6	8.0

C = A + B;

A = A1 + A2

A1 = A11 + A12 + A13 + A14

A2 = A21 + A22 + A23 + A24

B = B1 + B2

D = D1 + D2

Sources: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticpress.aspx

Table IIB-6 provides major foreign holders of US Treasury securities. China is the largest holder with $1161.5 billion in Oct 2012, decreasing 7.5 percent from $1256.0 billion in Oct 2011. Japan increased its holdings from $1006.1 billion in Oct 2011 to $1134.7 billion in Oct 2012 or by 12.8 percent likely in part by intervention to buy dollars against the yen to depreciate the overvalued yen/dollar rate that diminishes the competitiveness of Japan. Total foreign holdings of Treasury securities rose from $4918.3 billion in Oct 2011 to $5482.2 billion in Oct 2012, or 11.5 percent. The US continues to finance its fiscal and balance of payments deficits with foreign savings (see Pelaez and Pelaez, The Global Recession Risk (2007)). A point of saturation of holdings of US Treasury debt may be reached as foreign holders evaluate the threat of reduction of principal by dollar devaluation and reduction of prices by increases in yield, including possibly risk premium. Shultz et al (2012) find that the Fed financed three-quarters of the US deficit in fiscal year 2011, with foreign governments financing significant part of the remainder of the US deficit while the Fed owns one in six dollars of US national debt. Concentrations of debt in few holders are perilous because of sudden exodus in fear of devaluation and yield increases and the limit of refinancing old debt and placing new debt. In their classic work on “unpleasant monetarist arithmetic,” Sargent and Wallace (1981, 2) consider a regime of domination of monetary policy by fiscal policy (emphasis added):

Table IIB-6, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Oct 2012	Sep 2012	Oct 2011
Total	5482.2	5476.2	4918.3
China	1161.5	1153.6	1256.0
Japan	1134.7	1129.5	1006.1
Oil Exporters	266.2	267.0	248.4
Caribbean Banking Centers	258.5	261.1	212.1
Brazil	255.2	251.2	229.4
Taiwan	201.6	201.7	167.4
Switzerland	194.4	193.5	143.9
Russia	165.4	163.5	147.5
Luxembourg	139.4	147.6	126.5
Hong Kong	137.2	137.1	113.3
Belgium	133.3	133.2	132.4
United Kingdom	117.3	137.9	106.5
Foreign Official Holdings	3962.0	3958.1	3600.9
A. Treasury Bills	379.4	383.8	374.6
B. Treasury Bonds and Notes	3582.6	3574.3	3226.2

Source: http://www.treasury.gov/resource-center/data-chart-center/tic/Pages/ticsec2.aspx#ussecs

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 1.9 percent adjusted for inflation while growing 635.2 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 Jan 3 and daily values throughout the week ending on Jan 10, 2014 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 Jan 3 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jan 3, 2014”, first row “USD/EUR 1.3588 1.1% 0.6 %,” provides the information that the US dollar (USD) appreciated 1.1 percent to USD 1.3588/EUR in the week ending on Fri Jan 3 relative to the exchange rate on Fri Dec 27 and depreciated 0.6 percent relative to Thu Jan 2. 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 1.3588/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jan 3, depreciating to USD 1.3628/EUR on Mon Jan 6, 2014, or by 0.3 percent. The dollar depreciated because more dollars, $1.3628, were required on Mon Jan 6 to buy one euro than $1.3588 on Fri Jan 3. 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 1.3588/EUR on Jan 3. 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 Jan 3, to the last business day of the current week, in this case Fri Jan 10, such as depreciation of 0.6 percent to USD 1.3670/EUR by Jan 10. 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 0.6 percent from the rate of USD 1.3588/EUR on Fri Jan 3 to the rate of USD 1.3670/EUR on Fri Jan 10 {[(1.3670/1.3588) – 1]100 = 0.6%}. The dollar depreciated (denoted by negative sign) by 0.5 percent from the rate of USD 1.3608 on Jan 9 to USD 1.3670/EUR on Fri Jan 10 {[(1.3670/1.3608) -1]100 = 0.5%}. 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 to Jan 6 to Jan 10, 2014

Fri Jan 3 2014

Mon 6

Tue 7

Wed 8

Thu 9

Fri 10

USD/ EUR

1.3588

1.1%

0.6%

1.3628

-0.3%

1.3616

-0.2%

0.1%

1.3575

0.1%

0.3%

1.3608

-0.1%

-0.2%

1.3670

-0.6%

-0.5%

JPY/ USD

104.85

0.3%

0.0%

104.22

0.6%

104.60

0.2%

-0.4%

104.87

0.0%

-0.3%

104.83

0.0%

104.17

0.6%

CHF/ USD

0.9054

-1.5%

-0.7%

0.9040

0.2%

0.9092

-0.4%

-0.6%

0.9112

-0.6%

-0.2%

0.9071

-0.2%

0.4%

0.9027

0.3%

0.5%

CHF/ EUR

1.2301

-0.4%

-0.1%

1.2321

-0.2%

1.2380

-0.6%

-0.5%

1.2369

-0.6%

0.1%

1.2342

-0.3%

0.2%

1.2336

-0.3%

0.0%

USD/ AUD

0.8947

1.1177

0.9%

0.4%

0.8968

1.1151

0.2%

0.8928

1.1201

-0.2%

-0.4%

0.8901

1.1235

-0.5%

-0.3%

0.8900

1.1236

-0.5%

0.0%

0.8996

1.1116

0.5%

1.1%

10Y Note

2.999

2.961

2.942

2.99

2.960

2.858

2Y Note

0.398

0.399

0.43

0.423

0.372

German Bond

2Y 0.20 10Y 1.94

2Y 0.21 10Y 1.91

2Y 0.21 10Y 1.88

2Y 0.22 10Y 1.90

2Y 0.21 10Y 1.91

2Y 0.18 10Y 1.84

DJIA

16469.99

-0.1%

0.2%

16425.10

-0.3%

16530.94

0.4%

0.6%

16462.64

0.0%

-0.4%

16444.76

-0.2%

-0.1%

16437.05

-0.2%

0.0%

Dow Global

2461.03

-0.7%

0.0%

2455.56

-0.2%

2464.74

0.2%

0.4%

2472.28

0.5%

0.3%

2461.33

0.0%

-0.4%

2475.84

0.6%

DJ Asia Pacific

1440.42

0.2%

-0.3%

1430.60

-0.7%

1424.30

-1.1%

-0.4%

1438.52

-0.1%

1.0%

1430.24

-0.7%

-0.6%

1437.19

-0.2%

0.5%

Nikkei

16291.31

0.7%

0.0%

15908.88

-2.3%

15814.37

-2.9%

-0.6%

16121.45

-1.0%

1.9%

15880.33

-2.5%

-1.5%

15912.06

-2.3%

0.2%

Shanghai

2083.14

-0.9%

-1.2%

2045.71

-1.8%

2047.32

-1.7%

0.1%

2044.34

-1.9%

-0.1%

2027.62

-2.7%

-0.8%

2013.30

-3.4%

-0.7%

DAX

9435.15

-1.6%

0.4%

9428.00

-0.1%

9506.20

0.8%

9497.84

0.7%

-0.1%

9421.61

-0.1%

-0.8%

9473.24

0.4%

0.5%

DJ UBS Comm.

124.91

-2.1%

-0.4%

125.05

0.1%

124.87

0.0%

-0.1%

123.68

-1.0%

-0.9%

122.33

-2.1%

-1.1%

123.64

-1.0%

1.1%

WTI $/B

94.20

-5.9%

-1.4%

93.67

-0.6%

93.85

-0.4%

0.2%

92.52

-1.8%

-1.4%

92.36

-2.0%

-0.2%

92.72

-1.6%

0.4%

Brent $/B

107.05

-4.5%

-0.7%

107.02

0.0%

107.50

0.4%

107.42

0.3%

-0.1%

106.50

-0.5%

-0.9%

107.25

0.2%

0.7%

Gold $/OZ

1236.2

1.9%

0.9%

1237.9

0.1%

1231.0

-0.4%

-0.6%

1225.2

-0.9%

-0.5%

1227.2

-0.7%

0.2%

1246.9

0.9%

1.6%

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.

1 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). At the meeting on Dec 18, 2013, the FOMC decided tapering monthly bond purchases. Earlier programs are continued with an additional lower open-ended $75 billion of bond purchases per month, increasing the stock of $2,739,919 million securities held outright and bank reserves deposited at the Fed of $2,465,932 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) (http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm): “In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month. The Committee 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 and of rolling over maturing Treasury securities at auction. The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.”

At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:

“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.

For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”

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 Oct 30, 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/20131218a.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. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent 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).

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).

Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?

“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differfrom each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”

W = Y/r (10

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 European Central Bank (ECB) lowered the policy rates on Nov 7, 2013 (http://www.ecb.europa.eu/press/pr/date/2013/html/pr131107.en.html):

“PRESS RELEASE

7 November 2013 - Monetary policy decisions

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
The interest rate on the deposit facility will remain unchanged at 0.00%.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”

Mario Draghi, President of the ECB, explained as follows (http://www.ecb.europa.eu/press/pressconf/2013/html/is131107.en.html):

“Based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%. These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.”

The ECB decision together with the employment situation report on Fri Nov 8, 2013, influenced revaluation of the dollar. Market expectations were of relatively easier monetary policy in the euro area.

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 16,437.05 on Fri Jan 10, 2014, which is higher by 16.0 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 15.8 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.

In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows.

Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.

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 3.810 percent on Jan 10, 2014, and that of the ten-year sovereign bond of Italy at 3.921 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 Jan 10, 2014, the yield of the two-year Treasury decreased to 0.372 percent and that of the ten-year Treasury decreased to 2.858 percent while the two-year bond of Germany decreased to 0.10 percent and the ten-year to 1.84 percent; and the dollar depreciated to USD 1.3670/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 2.858 percent is higher than consumer price inflation of 1.2 percent in the 12 months ending in Nov 2013 (http://cmpassocregulationblog.blogspot.com/2013/12/tapering-quantitative-easing-mediocre.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.122 percent (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3002) is well below the 12-month consumer price inflation of 1.2 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
1/10/14	0.372	2.858	0.18	1.84	1.3670
1/3/14	0.398	2.999	0.20	1.94	1.3588
12/27/13	0.393	3.004	0.24	1.95	1.3746
12/20/13	0.377	2.891	0.22	1.87	1.3673
12/13/13	0.328	2.865	0.24	1.83	1.3742
12/6/13	0.304	2.858	0.21	1.84	1.3705
11/29/13	0.283	2.743	0.11	1.69	1.3592
11/22/13	0.280	2.746	0.13	1.74	1.3557
11/15/13	0.292	2.704	0.10	1.70	1.3497
11/8/13	0.316	2.750	0.10	1.76	1.3369
11/1/13	0.311	2.622	0.11	1.69	1.3488
10/25/13	0.305	2.507	0.18	1.75	1.3804
10/18/13	0.321	2.588	0.17	1.83	1.3686
10/11/13	0.344	2.688	0.18	1.86	1.3543
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://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

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

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:

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.
The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
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:

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).
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.
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).
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 Jan 9, 2014, with the one-month yield at 0.01 percent, the two-year at 0.44 percent, the ten-year at 2.97 percent, the fed funds rate at 0.07 percent and the corporate Baa bond at 5.28 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-Jan 9, 2014

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System