CMP Associates Regulation Blog: Valuation Risks, World Inflation Waves, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, United States Industrial Production, Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities, World Cyclical Slow Growth and Global Recession Risk: Part III

Valuation Risks, World Inflation Waves, Squeeze of Economic Activity by Carry Trades Induced by Zero Interest Rates, United States Industrial Production, Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

Executive Summary

I World Inflation Waves

IA Appendix: Transmission of Unconventional Monetary Policy

IB1 Theory

IB2 Policy

IB3 Evidence

IB4 Unwinding Strategy

IB United States Inflation

IC Long-term US Inflation

ID Current US Inflation

IE Theory and Reality of Economic History, Cyclical Slow Growth Not Secular Stagnation and Monetary Policy Based on Fear of Deflation

IIA Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities

IIB United States Industrial Production

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

IIA Unresolved US Balance of Payments Deficits and Fiscal Imbalance Threatening Risk Premium on Treasury Securities. There are two subsection: IIA1 United States Unsustainable Deficit/debt and IIA2 Unresolved US Balance of Payments Deficits.

IIA1 United States Unsustainable Fiscal Deficit/Debt. Table IIA1-1 of the CBO (2012NovMBR, 2013BEOFeb5, 2013HBDFFeb5, 2013MEFFeb5, 2013Aug12, CBO, Feb 2014, CBO, Apr 2014) shows the significant worsening of United States fiscal affairs from 2007-2008 to 2009-2012 with marginal improvement in 2013 but with much higher debt relative to GDP. The deficit of $1.1 trillion in fiscal year 2012 was the fourth consecutive federal deficit exceeding one trillion dollars. All four deficits are the highest in share of GDP since 1946 (CBO 2012MBR, 2013HBDFeb5, 2013Aug12, 2013AugHBD).

Table IAI-1, US, Budget Fiscal Year Totals, Billions of Dollars and % GDP

	2007	2008	2009	2010	2011	2012	2013
Receipts	2568	2524	2105	2163	2304	2450	2775
Outlays	2729	2983	3518	3457	3603	3537	3455
Deficit	-161	-459	1413	1294	1300	1087	680
% GDP	-1.1	-3.1	-9.8	-8.8	-8.4	-6.8	-4.1

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO (2013HBDFeb5), CBO (2013Aug12). CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical Budget Data—April 2014, Washington DC, Congressional Budget Office, Apr 14.

Table IA1-2 provides additional information required for understanding the deficit/debt situation of the United States. The table is divided into four parts: Treasury budget in the 2014 fiscal year beginning on Oct 1, 2013 and ending on Sep 30, 2014; federal fiscal data for the years from 2009 to 2013; federal fiscal data for the years from 2005 to 2008; and Treasury debt held by the public from 2005 to 2013. Receipts increased 7.5 percent in the cumulative fiscal year 2014 ending in May 2014 relative to the cumulative in fiscal year 2013. Individual income taxes increased 3.3 percent relative to the same fiscal period a year earlier. Outlays decreased 2.3 percent relative to a year earlier. There are also receipts, outlays, deficit and debt for fiscal year 2013. Total revenues of the US from 2009 to 2012 accumulate to $9021 billion, or $9.0 trillion, while expenditures or outlays accumulate to $14,109 billion, or $14.1 trillion, with the deficit accumulating to $5090 billion, or $5.1 trillion. Revenues decreased 6.5 percent from $9653 billion in the four years from 2005 to 2008 to $9021 billion in the years from 2009 to 2012. Decreasing revenues were caused by the global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and also by growth of only 2.2 percent on average in the cyclical expansion from IIIQ2009 to IQ2014. In contrast, the expansion from IQ1983 to IIIQ1987 was at the average annual growth rate of 4.9 percent and at 7.8 percent from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html). Because of mediocre GDP growth, there are 26.6 million unemployed or underemployed in the United States for an effective unemployment rate of 16.2 percent (http://cmpassocregulationblog.blogspot.com/2014/06/financial-risks-rules-discretionary.html

and earlier http://cmpassocregulationblog.blogspot.com/2014/05/financial-volatility-mediocre-cyclical.html). Weakness of growth and employment creation is analyzed in II Collapse of United States Dynamism of Income Growth and Employment Creation (http://cmpassocregulationblog.blogspot.com/2014/05/united-states-commercial-banks-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2014/04/financial-fluctuations-united-states.html). In contrast with the decline of revenue, outlays or expenditures increased 30.2 percent from $10,839 billion, or $10.8 trillion, in the four years from 2005 to 2008, to $14,109 billion, or $14.1 trillion, in the four years from 2009 to 2012. Increase in expenditures by 30.2 percent while revenue declined by 6.5 percent caused the increase in the federal deficit from $1186 billion in 2005-2008 to $5090 billion in 2009-2012. Federal revenue was 14.9 percent of GDP on average in the years from 2009 to 2012, which is well below 17.4 percent of GDP on average from 1973 to 2012. Federal outlays were 23.3 percent of GDP on average from 2009 to 2012, which is well above 20.4 percent of GDP on average from 1973 to 2012. The lower part of Table VI-7C shows that debt held by the public swelled from $5803 billion in 2008 to $11,982 billion in 2013, by $5478 billion or 106.5 percent. Debt held by the public as percent of GDP or economic activity jumped from 39.3 percent in 2008 to 72.1 percent in 2013, which is well above the average of 38.0 percent from 1973 to 2012. The United States faces tough adjustment because growth is unlikely to recover, creating limits on what can be obtained by increasing revenues, while continuing stress of social programs restricts what can be obtained by reducing expenditures.

Table IA1-2, US, Treasury Budget in Fiscal Year to Date Million Dollars

May 2014	Fiscal Year 2014	Fiscal Year 2013	∆%
Receipts	1,934,919	1,800,515	7.5
Outlays	2,371,301	2,426,840	-2.3
Deficit	-436,382	-626,325
Individual Income Tax	903,024	873,862	3.3
Corporation Income Tax	164,840	142,632	15.6
Social Insurance	493,716	439,239	12.4
	Receipts	Outlays	Deficit (-), Surplus (+)
$ Billions
Fiscal Year 2013	2,775	3,455	-680
% GDP	16.7	20.8	-4.1
Fiscal Year 2012	2,450	3,537	-1,087
% GDP	15.2	22.0	-6.8
Fiscal Year 2011	2,304	3,603	-1,300
% GDP	15.0	23.4	-8.4
Fiscal Year 2010	2,163	3,457	-1,294
% GDP	14.6	23.4	-8.8
Fiscal Year 2009	2,105	3,518	-1,413
% GDP	14.6	24.4	-9.8
Total 2009-2012	9,021	14,109	-5,090
Average % GDP 2009-2012	14.9	23.3	-8.4
Fiscal Year 2008	2,524	2,983	-459
% GDP	17.1	20.2	-3.1
Fiscal Year 2007	2,568	2,729	-161
% GDP	17.9	19.0	-1.1
Fiscal Year 2006	2,407	2,655	-248
% GDP	17.6	19.4	-1.8
Fiscal Year 2005	2,154	2,472	-318
% GDP	16.7	19.2	-2.5
Total 2005-2008	9,653	10,839	-1,186
Average % GDP 2005-2008	17.3	19.5	-2.1
Debt Held by the Public	Billions of Dollars	Percent of GDP
2005	4,592	35.6
2006	4,829	35.3
2007	5,035	35.1
2008	5,803	39.3
2009	7,545	52.3
2010	9,019	61.0
2011	10,128	65.8
2012	11,281	70.1
2013	11,982	72.1

Source: http://www.fms.treas.gov/mts/index.html CBO (2012NovMBR). CBO (2011AugBEO); Office of Management and Budget 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO (2013Aug12). 2013AugHBD. Historical budget data—August 2013. Washington, DC, Congressional Budget Office, Aug. CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr.

Unusually low economic growth of average 2.2 percent of GDP in the current expansion from IIIQ2009 to IVQ2013 and 2.7 percent in the first four quarters from IIIQ2009 to IIQ2010 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html) has had adverse impact on revenue generation. The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.7 percent and at 7.8 percent in the first four quarters from IQ1983 to IVQ1983 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html). Because of mediocre GDP growth, there are 26.6 million unemployed or underemployed in the United States for an effective unemployment rate of 16.2 percent (http://cmpassocregulationblog.blogspot.com/2014/06/financial-risks-rules-discretionary.html). The impact of low growth on employment creation and labor market hiring is discussed in Subsection IB Collapse of United States Dynamism of Income Growth and Employment (http://cmpassocregulationblog.blogspot.com/2014/05/united-states-commercial-banks-assets.html). Table IIAI-3 provides total United States federal receipts from 2010 to 2013. Individual income taxes of $1132 billion, or $1.1 trillion, increased 25.9 percent from 2010 to 2012 and account for 46.2 percent of US total receipts in 2012. Individual income taxes increased 16.3 percent from $1132 billion in 2012 to $1316 billion in 2013, contributing 47.4 percent of total receipts. Total receipts stood at 15.2 percent of GDP in 2012, which is lower than 17.4 percent in the past 40 years (CBO 2013Aug12Av). Total receipts increased to 16.7 percent of GDP in 2013.

Table IIA1-3, United States, Total Receipts, Billions of Dollars and ∆%

Major Source	2010	2011	2012	2013	∆% 2012-2013
Individual Income Taxes	899	1092	1132	1316	16.3
Corporate Income Taxes	191	181	242	274	13.2
Social Insurance	865	819	845	948	12.2
Other	208	212	231	236	10.0
Total	2163	2304	2450	2775	13.3
% of GDP	14.6	15.0	15.2	16.7	NA

Source: CBO (2012NovMBR), CBO (2013BEOFeb5), CBO 2013HBDFeb5), CBO (2013Aug12). CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr.

Total outlays of the federal government of the United States have grown to extremely high levels. Table IIA1-4 of the CBO (2014Feb, Apr 2014) provides total outlays in 2006 and 2013. Total outlays of $3454.6 billion in 2013, or $3.5 trillion, are higher by $799.5 billion, or $0.8 trillion, relative to $2655.1 billion in 2006, or $2.7 trillion. Outlays have grown from 19.4 percent of GDP in 2007 to 20.8 percent of GDP in 2013. Outlays as percent of GDP were on average 20.4 percent from 1973 to 2012 and receipts as percent of GDP were on average 17.4 percent of GDP. It has proved extremely difficult to increase receipts above 19 percent of GDP. Mandatory outlays increased from $1411.8 billion in 2006 to $2031.8 billion in 2013, by $620 billion. The first to the final row shows that the total of social security, Medicare, Medicaid, Income Security, net interest and defense absorbs 82.3 percent of US total outlays, which is equal to 17.1 percent of GDP. There has been no meaningful constraint of spending, which is quite difficult because of the rigid structure of social programs.

Table IIA1-4, US, Central Government Total Revenue and Outlays, Billions of Dollars and Percent

	2006	% Total	2013	% Total
I TOTAL REVENUE $B	2406.9	100.0	2775	100.0
% GDP	17.6		16.7
Individual Income Taxes $B	1043.9		1316.4
% GDP	7.6		7.9
Corporate Income Taxes $B	353.9		273.5
% GDP	2.6		5.7
Social Insurance Taxes	837.8		947.8
% GDP	6.1		1.6
II TOTAL OUTLAYS	2655.1		3454.6
% GDP	19.4		20.8
Discretionary	1016.6		1202.2
% GDP	7.4		7.2
Defense	520.0		625.8
% GDP	3.8		3.8
Nondefense	496.7		576.4
% GDP	3.6		3.5
Mandatory	1411.8		2031.8
% GDP	10.3		12.2
Social Security	543.9		807.8
% GDP	4.0		4.9
Medicare	376.8		585.2
% GDP	2.8		3.5
Medicaid	180.6		265.4
% GDP	1.3		1.6
Income Security	200.0		339.5
% GDP	1.5		2.0
Offsetting Receipts	-144.3		-304.8
% GDP	-1.1		-1.8
Net Interest	226.6		220.9
% GDP	1.7		1.3
Defense +Social Security +Medicare +Medicaid +Income Security +Net interest	2047.9	77.1*	2844.6	82.3*
% GDP	15.1		17.1

*Percent of Total Outlays

Source: CBO (2013Aug12). 2013AugHBD. Historical budget data—August 2013. Washington, DC, Congressional Budget Office, Aug. CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr.

The US is facing a major fiscal challenge. Table IIA1-5 provides federal revenues, expenditures, deficit and debt as percent of GDP and the yearly change in GDP in the more than eight decades from 1930 to 2013. The most recent period of debt exceeding 90 percent of GDP based on yearly observations in Table IIA1-5 is between 1944 and 1948. The data in Table IIA-15 use the earlier GDP estimates of the Bureau of Economic Analysis (BEA) until 1972 for the ratios to GDP of revenue, expenditures, deficit and debt and the revised CBO (2013Aug12) after 1973 that incorporate the new BEA GDP estimates (http://www.bea.gov/iTable/index_nipa.cfm). The percentage change of GDP is based on the new BEA estimates for all years. The debt/GDP ratio actually rose to 106.2 percent of GDP in 1945 and to 108.7 percent of GDP in 1946. GDP fell revised 11.6 percent in 1946, which is only matched in Table I-5 by the decline of revised 12.9 percent in 1932. Part of the decline is explained by the bloated US economy during World War II, growing at revised 17.7 percent in 1941, 18.9 percent in 1942 and 17.0 percent in 1943. Expenditures as a share of GDP rose to their highest in the series: 43.6 percent in 1943, 43.6 percent in 1944 and 41.9 percent in 1945. The repetition of 43.6 percent in 1943 and 1944 is in the original source of Table IIA1-5. During the Truman administration from Apr 1945 to Jan 1953, the federal debt held by the public fell systematically from the peak of 108.7 percent of GDP in 1946 to 61.6 percent of GDP in 1952. During the Eisenhower administration from Jan 1953 to Jan 1961, the federal debt held by the public fell from 58.6 percent of GDP in 1953 to 45.6 percent of GDP in 1960. The Truman and Eisenhower debt reductions were facilitated by diverse factors such as low interest rates, lower expenditure/GDP ratios that could be attained again after lowering war outlays and less rigid structure of mandatory expenditures than currently. There is no subsequent jump of debt as the one from revised 39.3 percent of GDP in 2008 to 65.8 percent of GDP in 2011, 70.1 percent in 2012 and 72.1 percent in 2013.

Table IIA1-5, United States Central Government Revenue, Expenditure, Deficit, Debt and GDP Growth 1930-2011

	Rev % GDP	Exp % GDP	Deficit % GDP	Debt % GDP	GDP ∆%
1930	4.2	3.4	0.8		-8.5
1931	3.7	4.3	-0.6		-6.4
1932	2.8	6.9	-4.0		-12.9
1933	3.5	8.0	-4.5		-1.3
1934	4.8	10.7	-5.9		10.8
1935	5.2	9.2	-4.0		8.9
1936	5.0	10.5	-5.5		12.9
1937	6.1	8.6	-2.5		5.1
1938	7.6	7.7	-0.1		-3.3
1939	7.1	10.3	-3.2		8.0
1940s
1940	6.8	9.8	-3.0	44.2	8.8
1941	7.6	12.0	-4.3	42.3	17.7
1942	10.1	24.3	-14.2	47.0	18.9
1943	13.3	43.6	-30.3	70.9	17.0
1944	20.9	43.6	-22.7	88.3	8.0
1945	20.4	41.9	-21.5	106.2	-1.0
1946	17.7	24.8	-7.2	108.7	-11.6
1947	16.5	14.8	1.7	96.2	-1.1
1948	16.2	11.6	4.6	84.3	4.1
1949	14.5	14.3	0.2	79.0	-0.5
1950s
1950	14.4	15.6	-1.1	80.2	8.7
1951	16.1	14.2	1.9	66.9	8.1
1952	19.0	19.4	-0.4	61.6	4.1
1953	18.7	20.4	-1.7	58.6	4.7
1954	18.5	18.8	-0.3	59.5	-0.6
1955	16.5	17.3	-0.8	57.2	7.1
1956	17.5	16.5	0.9	52.0	2.1
1957	17.7	17.0	0.8	48.6	2.1
1958	17.3	17.9	-0.6	49.2	-0.7
1959	16.2	18.8	-2.6	47.9	6.9
1960s
1960	17.8	17.8	0.1	45.6	2.6
1961	17.8	18.4	-0.6	45.0	2.6
1962	17.6	18.8	-1.3	43.7	6.1
1963	17.8	18.6	-0.8	42.4	4.4
1964	17.6	18.5	-0.9	40.0	5.8
1965	17.0	17.2	-0.2	37.9	6.5
1966	17.3	17.8	-0.5	34.9	6.6
1967	18.4	19.4	-1.1	32.9	2.7
1968	17.6	20.5	-2.9	33.9	4.9
1969	19.7	19.4	0.3	29.3	3.1
1970s
1970	19.0	19.3	-0.3	28.0	0.2
1971	17.3	19.5	-2.1	28.1	3.3
1972	17.6	19.6	-2.0	27.4	5.2
1973	17.0	18.1	-1.1	25.1	5.6
1974	17.7	18.1	-0.4	23.1	-0.5
1975	17.3	20.6	-3.3	24.5	-0.2
1976	16.6	20.8	-4.1	26.7	5.4
1977	17.5	20.2	-2.6	27.1	4.6
1978	17.5	20.1	-2.6	26.6	5.6
1979	18.0	19.6	-1.6	24.9	3.2
1980s
1980	18.5	21.1	-2.6	25.5	-0.2
1981	19.1	21.6	-2.5	25.2	2.6
1982	18.6	22.5	-3.9	27.9	-1.9
1983	17.0	22.8	-5.9	32.1	4.6
1984	16.9	21.5	-4.7	33.1	7.3
1985	17.2	22.2	-5.0	35.3	4.2
1986	17.0	21.8	-4.9	38.4	3.5
1987	17.9	21.0	-3.1	39.5	3.5
1988	17.6	20.6	-3.0	39.8	4.2
1989	17.8	20.5	-2.7	39.3	3.7
1990s
1990	17.4	21.2	-3.7	40.8	1.9
1991	17.3	21.7	-4.4	44.0	-0.1
1992	17.0	21.5	-4.5	46.6	3.6
1993	17.0	20.7	-3.8	47.8	2.7
1994	17.5	20.3	-2.8	47.7	4.0
1995	17.8	20.0	-2.2	47.5	2.7
1996	18.2	19.6	-1.3	46.8	3.8
1997	18.6	18.9	-0.3	44.5	4.5
1998	19.2	18.5	0.8	41.6	4.4
1999	19.2	17.9	1.3	38.2	4.8
2000s
2000	19.9	17.6	2.3	33.6	4.1
2001	18.8	17.6	1.2	31.4	1.0
2002	17.0	18.5	-1.5	32.5	1.8
2003	15.7	19.1	-3.3	34.5	2.8
2004	15.6	19.0	-3.4	35.5	3.8
2005	16.7	19.2	-2.5	35.6	3.4
2006	17.6	19.4	-1.8	35.3	2.7
2007	17.9	19.0	-1.1	35.1	1.8
2008	17.1	20.2	-3.1	39.3	-0.3
2009	14.6	24.4	-9.8	52.3	-2.8
2010s
2010	14.6	23.4	-8.8	61.0	2.5
2011	15.0	23.4	-8.4	65.8	1.8
2012	15.2	22.0	-6.8	70.1	2.8
2013	16.7	20.8	-4.1	72.1	1.9

Sources:

Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB. CBO (2012JanBEO). CBO (2012Jan31). CBO (2012AugBEO). CBO (2013BEOFeb5). CBO2013HBDFeb5), CBO (2013Aug12). CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr 14, 2014.

Table IIA1-6 provides 40-year average ratios of fiscal variables to GDP before and after the revision by the Bureau of Economic Analysis (BEA) in Aug 2013 (http://www.bea.gov/iTable/index_nipa.cfm). The ratios are equal or slightly higher because of the addition of intellectual property to GDP estimates. There are no major changes.

Table IIA1-6, US, Congressional Budget Office, 40-Year Averages of Revenues and Outlays Before and After Update of the US National Income Accounts by the Bureau of Economic Analysis, % of GDP

	Before Update	After Update
Revenues
Individual Income Taxes	8.2	7.9
Social Insurance Taxes	6.2	6.0
Corporate Income Taxes	1.9	1.9
Other	1.6	1.6
Total Revenues	17.9	17.4
Outlays
Mandatory	10.2	9.9
Discretionary	8.6	8.4
Net Interest	2.2	2.2
Total Outlays	21.0	20.4
Deficit	-3.1	-3.0
Debt Held by the Public	39.2	38.0

Source: CBO (2013Aug12Av). Kim Kowaleski and Amber Marcellino.

Table IIA1-7 provides the latest exercise by the CBO (2013BEOFeb5, 2012AugBEO, CBO2012NovCDR, 2013Sep11, CBO Feb2014, CBO Apr2014) of projecting the fiscal accounts of the US. Table IIA1-7 extends data back to 1995 with the projections of the CBO from 2014 to 2024, using the new estimates of the Bureau of Economic Analysis of US GDP (http://www.bea.gov/iTable/index_nipa.cfm). Budget analysis in the US uses a ten-year horizon. The significant event in the data before 2011 is the budget surpluses from 1998 to 2001, from 0.8 percent of GDP in 1998 to 2.3 percent of GDP in 2000 and 1.2 percent of GDP in 2001. Debt held by the public fell from 47.5 percent of GDP in 1995 to 31.4 percent of GDP in 2001.

Table IIA1-7, US, CBO Baseline Budget Outlook 2014-2024

	Out $B	Out % GDP	Deficit $B	Deficit % GDP	Debt	Debt % GDP
1995	1,516	20.0	-164	-2.2	3,604	47.5
1996	1,560	19.6	-107	-1.3	3,734	46.8
1997	1,601	18.9	-22	-0.3	3,772	44.5
1998	1,652	18.5	+69	+0.8	3,721	41.6
1999	1,702	17.9	+126	+1.3	3,632	38.2
2000	1,789	17.6	+236	+2.3	3,410	33.6
2001	1,863	17.6	+128	+1.2	3,320	31.4
2002	2,011	18.5	-158	-1.5	3,540	32.5
2003	2,159	19.1	-378	-3.3	3,913	34.5
2004	2,293	19.0	-413	-3.4	4,295	35.5
2005	2,472	19.2	-318	-2.5	4,592	35.6
2006	2,655	19.4	-248	-1.8	4,829	35.3
2007	2,729	19.0	-161	-1.1	5,035	35.1
2008	2,983	20.2	-459	-3.1	5,803	39.3
2009	3,518	24.4	-1,413	-9.8	7,545	52.3
2010	3,457	23.4	-1,294	-8.7	9,019	61.0
2011	3,603	23.4	-1,300	-8.4	10,128	65.8
2012	3,537	22.0	-1,087	-6.8	11,281	70.1
2013	3,455	20.8	-680	-4.1	11,983	72.1
2014	3,523	20.4	-492	-2.8	12,740	73.8
2015	3,774	20.8	-469	-2.6	13,285	73.3
2016	4,011	21.0	-536	-2.8	13,884	72.8
2017	4,197	20.9	-576	-2.9	14,523	72.4
2018	4,391	21.0	-627	-3.0	15,202	72.5
2019	4,649	21.3	-722	-3.3	15,977	73.1
2020	4,903	21.5	-804	-3.5	16,835	73.8
2021	5,162	21.7	-878	-3.7	17,769	74.8
2022	5,484	22.2	-998	-4.0	18,823	76.1
2023	5,701	22.1	-1,005	-3.9	19,885	77.1
2024	5,920	22.1	-1,003	-3.7	20,947	78.1
2015 to 2019	21,022	21.0	-2,930	-2.9	NA	NA
2015 to 2024	48,192	21.5	-7,618	-3.4	NA	NA

Note: Out = outlays

Sources: CBO (2011AugBEO); Office of Management and Budget. 2011. Historical Tables. Budget of the US Government Fiscal Year 2011. Washington, DC: OMB; CBO. 2011JanBEO. Budget and Economic Outlook. Washington, DC, Jan. CBO. 2012AugBEO. Budget and Economic Outlook. Washington, DC, Aug 22. CBO. 2012Jan31. Historical budget data. Washington, DC, Jan 31. CBO. 2012NovCDR. Choices for deficit reduction. Washington, DC. Nov. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO. 2013HBDFeb5. Historical budget data—February 2013 baseline projections. Washington, DC, Congressional Budget Office, Feb 5. CBO (2013Sep11). CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, The Budget and Economic Outlook 2014 to 2024. Washington, DC, Congressional Budget Office, Feb 2014. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr 14, 2014. CBO, Updated Budget Projections: 2014 to 2024. Washington, DC, Congressional Budget Office, Apr 14, 2014.

Chart IIA1-1 of the Congressional Budget Office (CBO) provides the deficits of the US as percent of GDP from 1974 to 2013 followed on the right with the projections of the CBO in Feb 2014. Large deficits from 2009 to 2013, all above the average from 1974 to 2013, doubled the debt held by the public. Fiscal adjustment is now more challenging with rigidities in revenues and expenditures. The projections of the CBO in Apr 2014 for the years from 2014 to 2024 show lower deficits in proportion of GDP in the initial years that eventually become larger than the average in the second half of the ten-year window.

Chart IIA1-1, US, Total Federal Deficits and Surpluses

Source: Congressional Budget Office

CBO, Updated Budget Projections: 2014 to 2024. Washington, DC, Congressional Budget Office, Apr 14, 2014. http://www.cbo.gov/publication/45229

The Budget and Economic Outlook 2014 to 2024. Washington, DC, Congressional Budget Office, Feb 2014.

http://www.cbo.gov/publication/45073

Table IIA1-8 provides baseline CBO projections of federal revenues, outlays, deficit and debt as percent of GDP. The adjustment depends on increasing revenues from 15.0 percent of GDP in 2011 and 16.7 percent in 2013 to 18.3 percent of GDP in 2024, which is above the 40-year average of 17.4 percent of GDP. Outlays fall from 23.4 percent of GDP in 2011 and 20.8 percent of GDP in 2013 to 22.1 percent of GDP in 2024. The last row of Table IIA1-8 provides the CBO estimates of averages for 1973 to 2012 of 17.4 percent for revenues/GDP, 20.4 percent for outlays/GDP and 38.0 percent for debt/GDP. The debt/GDP ratio increases to 78.1 percent of GDP. The United States faces tough adjustment of its fiscal accounts. There is an additional source of pressure on financing the current account deficit of the balance of payments.

Table IIA1-8, US, Baseline CBO Projections of Federal Government Revenues, Outlays, Deficit and Debt as Percent of GDP

	Revenues % GDP	Outlays % GDP	Deficit % GDP	Debt GDP
2011	15.0	23.4	-8.4	65.8
2012	15.2	22.0	-6.8	70.1
2013	16.7	20.8	-4.1	72.1
2014	17.6	20.4	-2.8	73.8
2015	18.2	20.8	-2.6	73.3
2016	18.2	21.0	-2.8	72.8
2017	18.1	20.9	-2.9	72.4
2018	18.0	21.0	-3.0	72.5
2019	18.0	21.3	-3.3	73.1
2020	18.0	21.5	-3.5	73.8
2021	18.0	21.7	-3.7	74.8
2022	18.1	22.2	-4.0	76.1
2023	18.2	22.1	-3.9	77.1
2024	18.3	22.1	-3.7	78.1
Total 2015-2019	18.1	21.0	-2.9	NA
Total 2015-2024	18.1	21.5	-3.4	NA
Average 1973-2012	17.4	20.4	-3.0	38.0

Source: CBO (2012AugBEO). CBO (2012NovCDR). CBO (2013BEOFeb5). CBO 2013HBDFeb5), CBO (2013Sep11), CBO (2013Aug12Av). Kim Kowaleski and Amber Marcellino. CBO, Historical Budget Data—February 2014, Washington, DC, Congressional Budget Office, Feb. CBO, The Budget and Economic Outlook 2014 to 2024. Washington, DC, Congressional Budget Office, Feb 2014. CBO, Historical budget data—April 2014 release. Washington, DC, Congressional Budget Office, Apr 14, 2014. CBO, Updated Budget Projections: 2014 to 2024. Washington, DC, Congressional Budget Office, Apr 14, 2014.

Chart IIA1-2 of the Congressional Budget Office (CBO) provides the actual federal debt as percent of GDP from 1940 to 2013 and the projected path by the CBO from 2014 to 2024. The federal debt exceeded 100 percent of GDP because of the war effort during World War II. Adjustment was swift and continuous during rapid economic growth in large part because of less rigid structures of expenditures and revenues. The jump of the federal debt from 35.1 percent of GDP in 2007 to 72.1 percent of GDP in 2013 with CBO projection of 78.1 percent of GDP in 2024 poses a major challenge of fiscal adjustment.

Chart IIA1-2, US, Federal Debt Held by the Public

Source: Congressional Budget Office

CBO, Updated Budget Projections: 2014 to 2024. Washington, DC, Congressional Budget Office, Apr 14, 2014. http://www.cbo.gov/publication/45229

The Budget and Economic Outlook 2014 to 2024. Washington, DC, Congressional Budget Office, Feb 2014.

http://www.cbo.gov/publication/45073

Table IIA1-9 provides the long-term budget outlook of the CBO for 2013, 2023 and 2038. Revenues increase from 17.0 percent of GDP in 2013 to 19.7 percent in 2038. The growing stock of debt raises net interest spending from 1.3 percent of GDP in 2013 to 3.1 percent in 2023 and 4.9 percent 2038. Total spending increases from 20.8 percent of GDP in 2013 to 26.2 percent in 2038. Federal debt held by the public rises to 100.0 percent of GDP in 2038. US fiscal affairs are in an unsustainable path with tough rigidities in spending and revenues.

Table IIA1-9, Congressional Budget Office, Long-term Budget Outlook, % of GDP

	2013	2023	2038
Revenues	17.0	18.5	19.7
Total Noninterest Spending	19.5	18.8	21.3
Social Security	4.9	5.3	6.2
Medicare	3.0	3.3	4.9
Medicaid, CHIP and Exchange Subsidies	1.7	2.6	3.2
Other	10.0	7.6	7.1
Net Interest	1.3	3.1	4.9
Total Spending	20.8	21.8	26.2
Revenues Minus Total Noninterest Spending	-2.5	-0.3	-1.6
Revenues Minus Total Spending	-3.9	-3.3	-6.4
Federal Debt Held by the Public	73.0	71.0	100.0

Source: CBO (2013Sep17). The 2013 long-term budget outlook. Washington, DC, Congressional Budget Office, Sep 17.

Chart IIA1-3 provides actual federal debt held by the public as percent of GDP from 1790 to 2012 and projected by the CBO (2013Sep17) from 2013 to 2038. The ratio of debt to GDP climbed from 42.3 percent in 1941 to a peak of 108.7 percent in 1946 because of the Second World War. The ratio of debt to GDP declined to 80.2 percent in 1950 and 66.9 percent in 1951 because of unwinding war effort, economy growing to capacity and less rigid mandatory expenditures. The ratio of debt to GDP of 70.1 percent in 2012 is the highest in the United States since 1950. The CBO (2013BEOFeb5) projects the ratio of debt of GDP of the United States to reach 100.0 percent in 2038, which will be more than double the average ratio of 38.0 percent in 1973-2012. The misleading debate on the so-called “fiscal cliff” has disguised the unsustainable path of United States fiscal affairs.

Chart IIA1-3, Congressional Budget Office, Federal Debt Held by the Public, Extended Baseline Projection, % of GDP

Source: CBO. 2013Sep17. The 2013 long-term budget outlook. Washington, DC, Congressional Budget Office, Sep 17.

IIA2 Unresolved US Balance of Payments Deficits. The current account of the US balance of payments is provided in Table IIA2-1 for IQ2013 and IQ2014. 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 not seasonally adjusted increased from $81.0 billion in IQ2013 to $86.1 billion in IQ2014. The current account deficit seasonally adjusted at annual rate fell from 2.6 percent of GDP in IQ2013 to 2.0 percent of GDP in IVQ2013, increasing to 2.6 percent of GDP in IQ2014. The ratio of the current account deficit to GDP has stabilized below 3 percent of GDP compared with much higher percentages before the recession but is combined now with much higher imbalance in the Treasury budget (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).

Table IIA2-1, US, Balance of Payments, Millions of Dollars NSA

	IQ2013	IQ2014	Difference
Goods Balance	-156,922	-158,746	-1,824
X Goods	386,924	396,135	2.4 ∆%
M Goods	-543,846	-554,881	2.0 ∆%
Services Balance	58,560	57,565	-995
X Services	166,192	170,588	2.6 ∆%
M Services	-107,632	-113,023	5.0 ∆%
Balance Goods and Services	-98,362	-101,181	-2,819
Exports of Goods and Services and Income Receipts	772,204	794,134
Imports of Goods and Services and Income Payments	-853,226	-880,265
Current Account Balance	-81,022	-86,131	-5,109
% GDP	IQ2013	IQ2014	IVQ2013
	2.6	2.6	2.0

X: exports; M: imports

Balance on Current Account = Exports of Goods and Services – Imports of Goods and Services and Income Payments

Source: Bureau of Economic Analysis

http://www.bea.gov/international/index.htm#bop

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 trend. 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.”

The BEA introduced new concepts and methods (http://www.bea.gov/international/concepts_methods.htm) in comprehensive restructuring on Jun 18, 2014 (http://www.bea.gov/international/modern.htm):

“BEA introduced a new presentation of the International Transactions Accounts on June 18, 2014 and will introduce a new presentation of the International Investment Position on June 30, 2014. These new presentations reflect a comprehensive restructuring of the international accounts that enhances the quality and usefulness of the accounts for customers and bring the accounts into closer alignment with international guidelines.”

Table IIA2-2 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 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 IIA2-2, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and %

	2007	2008	2009	2010	2011	2012
Goods & Services	-705	-709	-384	-495	-549	-538
Primary Income	101	146	124	178	221	203
Secondary Income	-114	-124	-121	-127	-132	-126
Current Account	-719	-687	-381	-444	-459	-461
NGDP	14480	14720	14418	14958	15534	16245
Current Account % GDP	-4.9	-4.7	-2.6	-3.0	-2.9	-2.8
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 and Income	2569	2751	2286	2631	2988	3085
NIIP % Exports Goods, Services and Income	-70	-119	-100	-86	-125	-125
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	-8.8	-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	3457	3603	3537
∆%	2.8	9.3	17.9	-1.7	4.2	-1.8
% GDP	19.0	20.2	24.4	23.4	23.4	22.0
Federal Revenue	2568	2524	2105	2163	2304	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: 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. See Bureau of Economic Analysis, US International Economic Accounts: Concepts and Methods. 2014. Washington, DC: BEA, Department of Commerce, Jun 2014 http://www.bea.gov/international/concepts_methods.htm 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 IIA2-3 provides quarterly estimates NSA of the external imbalance of the United States. The current account deficit seasonally adjusted falls from 2.6 percent of GDP in IVQ2012 to 2.5 percent in IIQ2013, 2.4 percent of GDP in IIIQ2013 and 2.0 percent of GDP in IVQ2013. The net international investment position increases from $3.9 trillion in IVQ2012 to $4.2 trillion in IQ2013 and $4.6 trillion in IIQ2013, decreasing to $4.2 trillion in IIIQ2013 but increasing to $4.6 trillion in IVQ2013.

Table IIA2-3, US, Current Account, NIIP, Fiscal Balance, Nominal GDP, Federal Debt and Direct Investment, Dollar Billions and % NSA

	IVQ2012	IQ2013	IIQ2013	IIIQ2013	IVQ2013
Goods & Services	-122	-98	-130	-137	-111
Primary Income	48	48	47	51	53
Secondary Income	-29	-31	-30	-33	-29
Current Account	-103	-81	-113	-119	-87
Current Account % GDP	-2.6	-2.6	-2.5	-2.4	-2.0
NIIP	-3863	-4236	-4555	-4171	-4577
US Owned Assets Abroad	21638	21590	20969	21591	21963
Foreign Owned Assets in US	-25501	-25826	-25424	-25763	-26541
DIA MV	5249	5501	5435	5973	6349
DIUS MV	3924	4251	4333	4515	4935

Notes: NIIP: Net International Investment Position; DIA MV: US Direct Investment Abroad at Market Value; DIUS MV: Direct Investment in the US at Market Value. See Bureau of Economic Analysis, US International Economic Accounts: Concepts and Methods. 2014. Washington, DC: BEA, Department of Commerce, Jun 2014 http://www.bea.gov/international/concepts_methods.htm

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

Chart VI-10 of the Board of Governors of the Federal Reserve System provides the overnight Fed funds rate on business days from Jul 1, 1954 at 1.13 percent through Jan 10, 1979, at 9.91 percent per year, to Jun 19, 2014, at 0.10 percent per year. US recessions are in shaded areas according to the reference dates of the NBER (http://www.nber.org/cycles.html). In the Fed effort to control the “Great Inflation” of the 1930s (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation; see Taylor 1993, 1997, 1998LB, 1999, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB and http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html), the fed funds rate increased from 8.34 percent on Jan 3, 1979 to a high in Chart VI-10 of 22.36 percent per year on Jul 22, 1981 with collateral adverse effects in the form of impaired savings and loans associations in the United States, emerging market debt and money-center banks (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7; Pelaez 1986, 1987). Another episode in Chart VI-10 is the increase in the fed funds rate from 3.15 percent on Jan 3, 1994, to 6.56 percent on Dec 21, 1994, which also had collateral effects in impairing emerging market debt in Mexico and Argentina and bank balance sheets in a world bust of fixed income markets during pursuit by central banks of non-existing inflation (Pelaez and Pelaez, International Financial Architecture (2005), 113-5). Another interesting policy impulse is the reduction of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of equally non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85), followed by increments of 25 basis points from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006 in Chart VI-10. 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 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 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 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). A final episode in Chart VI-10 is the reduction of the fed funds rate from 5.41 percent on Aug 9, 2007, to 2.97 percent on October 7, 2008, to 0.12 percent on Dec 5, 2008 and close to zero throughout a long period with the final point at 0.10 percent on Jun 19, 2014. Evidently, this behavior of policy would not have occurred had there been theory, measurements and forecasts to avoid these violent oscillations that are clearly detrimental to economic growth and prosperity without inflation. Current policy consists of forecast mandate of maintaining policy accommodation until the forecast of the rate of unemployment reaches 6.5 percent and the rate of personal consumption expenditures excluding food and energy reaches 2.5 percent (http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm). The FOMC dropped the numbers but affirmed guidance (http://www.federalreserve.gov/newsevents/press/monetary/20140319a.htm): “With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements.” It is a forecast mandate because of the lags in effect of monetary policy impulses on income and prices (Romer and Romer 2004). The intention is to reduce unemployment close to the “natural rate” (Friedman 1968, Phelps 1968) of around 5 percent and inflation at or below 2.0 percent. If forecasts were reasonably accurate, there would not be policy errors. A commonly analyzed risk of zero interest rates is the occurrence of unintended inflation that could precipitate an increase in interest rates similar to the Himalayan rise of the fed funds rate from 9.91 percent on Jan 10, 1979, at the beginning in Chart VI-10, to 22.36 percent on Jul 22, 1981. There is a less commonly analyzed risk of the development of a risk premium on Treasury securities because of the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2014/02/theory-and-reality-of-cyclical-slow.html and earlier (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). There is not a fiscal cliff or debt limit issue ahead but rather free fall into a fiscal abyss. The combination of the fiscal abyss with zero interest rates could trigger the risk premium on Treasury debt or Himalayan hike in interest rates.

Chart VI-10, US, Fed Funds Rate, Business Days, Jul 1, 1954 to Jun 19, 2014, Percent per Year

Source: Board of Governors of the Federal Reserve System

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

Chart VI-14 provides the overnight fed funds rate, the yield of the 10-year Treasury constant maturity bond, the yield of the 30-year constant maturity bond and the conventional mortgage rate from Jan 1991 to Dec 1996. In Jan 1991, the fed funds rate was 6.91 percent, the 10-year Treasury yield 8.09 percent, the 30-year Treasury yield 8.27 percent and the conventional mortgage rate 9.64 percent. Before monetary policy tightening in Oct 1993, the rates and yields were 2.99 percent for the fed funds, 5.33 percent for the 10-year Treasury, 5.94 for the 30-year Treasury and 6.83 percent for the conventional mortgage rate. After tightening in Nov 1994, the rates and yields were 5.29 percent for the fed funds rate, 7.96 percent for the 10-year Treasury, 8.08 percent for the 30-year Treasury and 9.17 percent for the conventional mortgage rate.

Chart VI-14, US, Overnight Fed Funds Rate, 10-Year Treasury Constant Maturity, 30-Year Treasury Constant Maturity and Conventional Mortgage Rate, Monthly, Jan 1991 to Dec 1996

Source: Board of Governors of the Federal Reserve System

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

Chart VI-15 of the Bureau of Labor Statistics provides the all items consumer price index from Jan 1991 to Dec 1996. There does not appear acceleration of consumer prices requiring aggressive tightening.

Chart VI-15, US, Consumer Price Index All Items, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

Chart IV-16 of the Bureau of Labor Statistics provides 12-month percentage changes of the all items consumer price index from Jan 1991 to Dec 1996. Inflation collapsed during the recession from Jul 1990 (III) and Mar 1991 (I) and the end of the Kuwait War on Feb 25, 1991 that stabilized world oil markets. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). Policy tightening had adverse collateral effects in the form of emerging market crises in Mexico and Argentina and fixed income markets worldwide.

Chart VI-16, US, Consumer Price Index All Items, Twelve-Month Percentage Change, Jan 1991 to Dec 1996

Source: Bureau of Labor Statistics

http://www.bls.gov/cpi/data.htm

The Congressional Budget Office (CBO 2014BEOFeb4) 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 2.1 percent per year from 2013 to 2024. The legacy of the economic cycle expansion from IIIQ2009 to IVQ2013 at 2.2 percent on average is in contrast with 5.0 percent on average in the expansion from IQ1983 to IIQ1987 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html). Subpar economic growth may perpetuate unemployment and underemployment estimated at 26.6 million or 16.2 percent of the effective labor force in May 2014 () with much lower hiring than in the period before the current cycle (http://cmpassocregulationblog.blogspot.com/2014/06/financialgeopolitical-risks-recovery.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	3.2	2.5	0.8
1982-1990	3.2	1.6	1.6
1991-2001	3.2	1.3	1.9
2002-2012	2.2	0.8	1.4
2007-2012	1.7	0.6	1.1
Total 1950-2012	3.3	1.5	1.8
Projected Average Annual ∆%
2013-2018	2.1	0.6	1.5
2019-2024	2.1	0.5	1.6
2013-2024	2.1	0.5	1.6

*Ratio of potential GDP to potential labor force

Source: CBO (2014BEOFeb4), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

Chart IB-1 of the Congressional Budget Office (CBO 2013BEOFeb5) provides actual and potential GDP of the United States from 2000 to 2011 and projected to 2024. Lucas (2011May) estimates trend of United States real GDP of 3.0 percent from 1870 to 2010 and 2.2 percent for per capita GDP. The United States successfully returned to trend growth of GDP by higher rates of growth during cyclical expansion as analyzed by Bordo (2012Sep27, 2012Oct21) and Bordo and Haubrich (2012DR). Growth in expansions following deeper contractions and financial crises was much higher in agreement with the plucking model of Friedman (1964, 1988). The unusual weakness of growth at 2.2 percent on average from IIIQ2009 to IQ2014 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/2014/06/financial-instability-mediocre-cyclical.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 26.6 million or 16.2 percent of the labor force as estimated for May 2014 (http://cmpassocregulationblog.blogspot.com/2014/06/financial-risks-rules-discretionary.html). There is no exit from unemployment/underemployment and stagnating real wages because of the collapse of hiring (http://cmpassocregulationblog.blogspot.com/2014/06/financialgeopolitical-risks-recovery.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). The last year in common in both projections is 2017. The revision lowers potential output in 2017 by 7.3 percent relative to the projection in 2007.

Chart IB-2 provides differences in the projections of potential output by the CBO in 2007 and more recently on Feb 4, 2014, which the CBO explains in CBO (2014Feb28).

Chart IB-2, Congressional Budget Office, Revisions of Potential GDP

Source: Congressional Budget Office, 2014Feb 28. Revisions to CBO’s Projection of Potential Output since 2007. Washington, DC, CBO, Feb 28, 2014.

Chart IB-3 provides actual and projected potential GDP from 2000 to 2024. The gap between actual and potential GDP disappears at the end of 2017 (CBO2014Feb4). GDP increases in the projection at 2.5 percent per year.

Chart IB-3, Congressional Budget Office, GDP and Potential GDP

Source: CBO (2013BEOFeb5), CBO, Key assumptions in projecting potential GDP—February 2014 baseline. Washington, DC, Congressional Budget Office, Feb 4, 2014.

Chart IIA2-3 of the Bureau of Economic Analysis of the Department of Commerce shows on the lower negative panel the sharp increase in the deficit in goods and the deficits in goods and services from 1960 to 2012. The upper panel shows the increase in the surplus in services that was insufficient to contain the increase of the deficit in goods and services. The adjustment during the global recession has been in the form of contraction of economic activity that reduced demand for goods.

Chart IIA2-3, US, Balance of Goods, Balance on Services and Balance on Goods and Services, 1960-2013, Millions of Dollars

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

Chart IIA2-4 of the Bureau of Economic Analysis shows exports and imports of goods and services from 1960 to 2012. Exports of goods and services in the upper positive panel have been quite dynamic but have not compensated for the sharp increase in imports of goods. The US economy apparently has become less competitive in goods than in services.

Chart IIA2-4, US, Exports and Imports of Goods and Services, 1960-2013, Millions of Dollars

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

Chart IIA2-5 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 elimination 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 IIA2-5, US, Balance on Current Account, 1960-2013, Millions of Dollars

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

Chart IIA2-6 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 IIA2-6, US, Real GDP, 1960-2013, Billions of Chained 2009 Dollars

Source: Bureau of Economic Analysis

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

Chart IIA-7 provides the US current account deficit on a quarterly basis from 1980 to IQ1983. The deficit is at a lower level because of growth below potential not only in the US but worldwide. The combination of high government debt and deficit with external imbalance restricts potential prosperity in the US.

Chart IIA-7, US, Balance on Current Account, Quarterly, 1980-2013

Source: Bureau of Economic Analysis

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

Risk aversion channels funds toward US long-term and short-term securities that finance the US balance of payments and fiscal deficits benefitting from risk flight to US dollar denominated assets. There are now temporary interruptions because of fear of rising interest rates that erode prices of US government securities because of mixed signals on monetary policy and exit from the Fed balance sheet of four trillion dollars of securities held outright. Net foreign purchases of US long-term securities (row C in Table VA-4) decreased from $4.1 billion in Mar 2014 to minus $24.2 billion in Apr 2014. Foreign (residents) purchases minus sales of US long-term securities (row A in Table VA-4) in Mar 2014 of $9.4 billion decreased to minus $14.0 billion in Apr 2014. Net US (residents) purchases of long-term foreign securities (row B in Table VA-4) deteriorated from minus $5.3 billion in Mar 2014 to minus $10.2 billion in Apr 2014. In Apr 2014,

C = A + B = -$14.0 billion - $10.2 billion = -$24.2 billion

There are minor rounding errors. There is weakening demand in Table VA-4 in Apr in A1 private purchases by residents overseas of US long-term securities of minus $31.9 billion of which deterioration in A11 Treasury securities of minus $32.4 billion, improvement in A12 of minus $2.4 billion in agency securities, deterioration of $8.2 billion of corporate bonds and improvement of $11.0 billion in equities. Worldwide risk aversion causes flight into US Treasury obligations with significant oscillations. Official purchases of securities in row A2 increased $18.0 billion with increase of Treasury securities of $18.8 billion in Apr 2014. Official purchases of agency securities increased $0.3 billion in Apr. Row D shows decrease in Apr 2014 of $17.1 billion in purchases of short-term dollar denominated obligations. Foreign private holdings of US Treasury bills decreased $22.2 billion (row D11) with foreign official holdings decreasing $19.4 billion while the category “other” increased $24.5 billion. Foreign private holdings of US Treasury bills decreased $22.2 billion in what could be arbitrage of duration exposures. 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 with significant oscillations in risk perceptions.

Table VA-4, Net Cross-Borders Flows of US Long-Term Securities, Billion Dollars, NSA

	Mar 2013 12 Months	Mar 2014 12 Months	Mar 2014	Apr 2014
A Foreign Purchases less Sales of US LT Securities	494.3	105.3	9.4	-14.0
A1 Private	308.9	58.0	3.0	-31.9
A11 Treasury	120.0	146.0	13.8	-32.4
A12 Agency	105.6	-25.9	-7.7	-2.4
A13 Corporate Bonds	-15.5	-4.8	6.0	-8.2
A14 Equities	98.7	-57.2	-9.1	11.0
A2 Official	185.4	47.2	6.4	18.0
A21 Treasury	115.5	17.0	12.1	18.8
A22 Agency	44.9	35.2	-1.4	0.3
A23 Corporate Bonds	12.4	10.7	1.0	-0.3
A24 Equities	12.6	-15.6	-5.2	-0.9
B Net US Purchases of LT Foreign Securities	-118.0	-125.6	-5.3	-10.2
B1 Foreign Bonds	-11.5	-3.2	2.1	0.8
B2 Foreign Equities	-106.5	-122.4	-7.3	-11.0
C Net Foreign Purchases of US LT Securities	376.2	-20.3	4.1	-24.2
D Increase in Foreign Holdings of Dollar Denominated Short-term	80.6	-78.7	-2.7	-17.1
D1 US Treasury Bills	86.2	-59.3	9.8	-41.6
D11 Private	34.9	-24.4	14.5	-22.2
D12 Official	51.3	-34.8	-4.7	-19.4
D2 Other	-5.6	-19.5	-12.5	24.5

C = A + B;

A = A1 + A2

A1 = A11 + A12 + A13 + A14

A2 = A21 + A22 + A23 + A24

B = B1 + B2

D = D1 + D2

Sources: United States Treasury

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

Table VA-5 provides major foreign holders of US Treasury securities. China is the largest holder with $1253.2 billion in Apr 2014, decreasing 2.1 percent from $1290.7 billion in Apr 2013 while decreasing $8.9 billion from Mar 2014 or 0.7 percent. Japan increased its holdings from $1105.3 billion in Feb 2013 to $1210.5 billion in Feb 2014 or by 9.5 percent. Japan increased its holdings from $1112.7 billion in Apr 2014 to $1209.7 billion in Apr 2014 by $97.0 billion or 8.7 percent. Total foreign holdings of Treasury securities rose from $5709.7 billion in Apr 2013 to $5960.9 billion in Apr 2014, or 4.4 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 VA-5, US, Major Foreign Holders of Treasury Securities $ Billions at End of Period

	Apr 2014	Mar 2014	Apr 2013
Total	5960.9	5949.5	5709.7
China	1263.2	1272.1	1290.7
Japan	1209.7	1200.2	1112.7
Belgium	366.4	381.4	185.5
Caribbean Banking Centers	308.4	312.5	285.0
Oil Exporters	255.5	247.4	271.7
Brazil	245.8	245.3	253.1
United Kingdom	185.5	176.4	160.2
Switzerland	177.6	175.8	185.8
Taiwan	175.7	176.4	185.7
Hong Kong	155.1	155.7	141.2
Luxembourg	141.3	145.1	149.7
Russia	116.4	100.4	149.4
Ireland	112.1	113.3	120.5
Foreign Official Holdings	4067.5	4053.7	4080.0
A. Treasury Bills	364.4	383.8	399.2
B. Treasury Bonds and Notes	3703.1	3670.0	3680.8

Source: United States Treasury

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

IIB United States Industrial Production. Industrial production increased 0.6 percent in May 2014 after decreasing 0.3 percent in Apr 2014 and increasing 0.8 percent in Mar 2014, as shown in Table I-1, with all data seasonally adjusted. The Federal Reserve completed its annual revision of industrial production and capacity utilization on Mar 28, 2014 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm). The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

“Industrial production rose 0.6 percent in May after having declined 0.3 percent in April. The decrease in April was previously reported to have been 0.6 percent. Manufacturing output increased 0.6 percent in May after having moved down 0.1 percent in the previous month. In May, the output of mines gained 1.3 percent and the production of utilities decreased 0.8 percent. At 103.7 percent of its 2007 average, total industrial production in May was 4.3 percent above its level of a year earlier. The capacity utilization rate for total industry increased 0.2 percentage point in May to 79.1 percent, a rate that is 1.0 percentage point below its long-run (1972–2013) average.”

In the six months ending in May 2014, United States national industrial production accumulated increase of 2.2 percent at the annual equivalent rate of 4.5 percent, which is higher than growth of 4.3 percent in the 12 months ending in May 2014. Excluding growth of 1.1 percent in Feb 2014, growth in the remaining five months from Dec to May 2014 accumulated to 1.1 percent or 2.7 percent annual equivalent. Industrial production fell in two of the past six months. Business equipment accumulated growth of 3.7 percent in the six months from Dec 2013 to May 2014 at the annual equivalent rate of 7.6 percent, which is higher than growth of 5.3 percent in the 12 months ending in May 2014. The Fed analyzes capacity utilization of total industry in its report (http://www.federalreserve.gov/releases/g17/Current/default.htm): “The capacity utilization rate for total industry increased 0.2 percentage point in May to 79.1 percent, a rate that is 1.0 percentage points below its long-run (1972–2013) average.” United States industry apparently decelerated to a lower growth rate with possible acceleration in past months.

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

2013-2014	May 14	Apr 14	Mar 14	Feb 14	Jan 14	Dec 13	May 14/ May
Total	0.6	-0.3	0.8	1.1	-0.2	0.2	4.3
Market Groups
Final Products	0.3	-0.7	0.7	1.9	-0.6	0.5	3.7
Consumer Goods	0.1	-1.1	0.5	1.8	-0.7	0.9	3.1
Business Equipment	0.8	0.1	1.0	2.5	-0.1	-0.6	5.3
Non Industrial Supplies	0.3	-0.4	0.3	0.8	0.0	0.1	3.1
Construction	0.8	-0.6	0.8	0.9	-0.3	-0.5	4.4
Materials	0.9	0.1	1.1	0.5	0.1	-0.1	5.1
Industry Groups
Manufacturing	0.6	-0.1	0.8	1.4	-0.9	0.2	3.6
Mining	1.3	1.6	1.9	0.2	1.0	0.2	9.7
Utilities	-0.8	-4.5	-0.5	-0.3	3.3	0.1	0.6
Capacity	79.1	78.9	79.3	78.8	78.1	78.5	2.4

Sources: Board of Governors of the Federal Reserve System

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

Manufacturing increased 0.6 percent in May 2014 after decreasing 0.1 percent in Feb 2014 and increasing 0.8 percent in Mar 2014 seasonally adjusted, increasing 3.6 percent not seasonally adjusted in the 12 months ending in May 2014, as shown in Table I-2. Manufacturing grew cumulatively 2.0 percent in the six months ending in May 2014 or at the annual equivalent rate of 4.0 percent. Excluding the increase of 1.4 percent in Feb 2014, manufacturing accumulated growth of 0.6 percent from Dec 2013 to May 2014 or at the annual equivalent rate of 1.2 percent. Table I-2 provides a longer perspective of manufacturing in the US. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 into more recent months as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.2 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily in the past six months with some strength at the margin. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 28, 2014 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

“The Federal Reserve has revised its index of industrial production (IP) and the related measures of capacity and capacity utilization. The annual revision for 2014 was more limited than in recent years because the source data required to extend the annual benchmark indexes of production into 2012 were mostly unavailable. Consequently, the IP indexes published with this revision are very little changed from previous estimates. Measured from fourth quarter to fourth quarter, total IP is now reported to have increased about 3 1/3 percent in each year from 2011 to 2013. Relative to the rates of change for total IP published earlier, the new rates are 1/2 percentage point higher in 2012 and little changed in any other year. Total IP still shows a peak-to-trough decline of about 17 percent for the most recent recession, and it still returned to its pre-recession peak in the fourth quarter of 2013.”

The bottom part of Table I-2 shows decline of manufacturing by 21.9 from the peak in Jun 2007 to the trough in Apr 2009 and increase by 19.9 percent from the trough in Apr 2009 to Dec 2013. Manufacturing grew 23.8 percent from the trough in Apr 2009 to May 2014. Manufacturing output in May 2014 is 3.3 percent below the peak in Jun 2007.

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

	Month SA ∆%	12-Month NSA ∆%
May 2014	0.6	3.6
Apr	-0.1	2.8
Mar	0.8	3.7
Feb	1.4	2.7
Jan	-0.9	1.6
Dec 2013	0.2	2.2
Nov	0.3	2.8
Oct	0.4	3.7
Sep	0.3	2.8
Aug	0.7	2.9
Jul	-0.4	1.7
Jun	0.3	2.3
May	0.3	2.4
Apr	-0.2	2.7
Mar	0.1	2.6
Feb	0.6	2.5
Jan	-0.2	2.9
Dec 2012	0.7	3.8
Nov	1.3	3.8
Oct	-0.4	2.6
Sep	0.2	3.5
Aug	-0.5	3.8
Jul	0.4	4.3
Jun	0.4	5.0
May	-0.2	4.9
Apr	0.8	5.1
Mar	-0.3	3.8
Feb	0.6	5.1
Jan	1.0	4.0
Dec 2011	0.7	3.5
Nov	-0.1	2.9
Oct	0.5	3.0
Sep	0.4	2.9
Aug	0.3	2.3
Jul	0.8	2.6
Jun	0.1	2.1
May	0.2	1.9
Apr	-0.6	3.2
Mar	0.7	4.9
Feb	0.0	5.4
Jan	0.2	5.7
Dec 2010	0.4	6.3
Nov	0.2	5.4
Oct	0.1	6.6
Sep	0.1	6.9
Aug	0.1	7.4
Jul	0.8	7.8
Jun	0.0	9.3
May	1.5	8.8
Apr	0.9	7.0
Mar	1.3	4.8
Feb	-0.1	1.3
Jan	1.1	1.2
Dec 2009	-0.1	-3.1
Nov	1.0	-6.0
Oct	0.2	-9.1
Sep	0.8	-10.6
Aug	1.0	-13.6
Jul	1.4	-15.2
Jun	-0.3	-17.7
May	-1.1	-17.6
Apr	-0.7	-18.2
Mar	-1.8	-17.3
Feb	-0.3	-16.1
Jan	-2.9	-16.4
Dec 2008	-3.4	-13.9
Nov	-2.4	-11.3
Oct	-0.6	-8.9
Sep	-3.4	-8.5
Aug	-1.2	-5.0
Jul	-1.1	-3.5
Jun	-0.6	-3.1
May	-0.5	-2.4
Apr	-1.1	-1.1
Mar	-0.3	-0.6
Feb	-0.6	0.9
Jan	-0.4	2.2
Dec 2007	0.1	1.9
Nov	0.5	3.3
Oct	-0.4	2.8
Sep	0.5	2.9
Aug	-0.4	2.6
Jul	0.2	3.5
Jun	0.3	3.0
May	-0.1	3.1
Apr	0.7	3.6
Mar	0.8	2.5
Feb	0.4	1.6
Jan	-0.5	1.3
Dec 2006		2.7
Dec 2005		3.5
Dec 2004		3.8
Dec 2003		2.0
Dec 2002		2.4
Dec 2001		-5.7
Dec 2000		0.7
Dec 1999		5.3
Average ∆% Dec 1986-Dec 2013		2.3
Average ∆% Dec 1986-Dec 2012		2.3
Average ∆% Dec 1986-Dec 1999		4.2
Average ∆% Dec 1999-Dec 2006		1.3
Average ∆% Dec 1999-Dec 2013		0.6
∆% Peak 103.0351 in 06/2007 to 96.4739 in 12/2013		-6.4
∆% Peak 103.0351 in 06/2007 to Trough 80.4551 in 4/2009		-21.9
∆% Trough 80.4551 in 04/2009 to 96.4739 in 12/2013		19.9
∆% Trough 80.4551 in 04/2009 to 99.5887 in 5/2014		23.8
∆% Peak 103.0351 on 06/2007 to 99.5887 in 5/2014		-3.3

Source: Board of Governors of the Federal Reserve System

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

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

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

Source: Board of Governors of the Federal Reserve System

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

The modern industrial revolution of Jensen (1993) is captured in Chart I-2 of the Board of Governors of the Federal Reserve System (for the literature on M&A and corporate control see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 143-56, Globalization and the State, Vol. I (2008a), 49-59, Government Intervention in Globalization (2008c), 46-49). The slope of the curve of total industrial production accelerates in the 1990s to a much higher rate of growth than the curve excluding high-technology industries. Growth rates decelerate into the 2000s and output and capacity utilization have not recovered fully from the strong impact of the global recession. Growth in the current cyclical expansion has been more subdued than in the prior comparably deep contractions in the 1970s and 1980s. Chart II-2 shows that the past recessions after World War II are the relevant ones for comparison with the recession after 2007 instead of common comparisons with the Great Depression (http://cmpassocregulationblog.blogspot.com/2014/03/financial-uncertainty-mediocre-cyclical.html). The bottom left-hand part of Chart II-2 shows the strong growth of output of communication equipment, computers and semiconductor that continued from the 1990s into the 2000s. Output of semiconductors has already surpassed the level before the global recession.

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

Source: Board of Governors of the Federal Reserve System

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

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

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

Source: Board of Governors of the Federal Reserve System

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

United States manufacturing output from 1919 to 2014 on a monthly basis is in Chart I-4 of the Board of Governors of the Federal Reserve System. The second industrial revolution of Jensen (1993) is quite evident in the acceleration of the rate of growth of output given by the sharper slope in the 1980s and 1990s. Growth was robust after the shallow recession of 2001 but dropped sharply during the global recession after IVQ2007. Manufacturing output recovered sharply but has not reached earlier levels and is losing momentum at the margin. Current output is well below the extrapolation of a long-term linear trend.

Chart I-4, US, Manufacturing Output, 1919-2014

Source: Board of Governors of the Federal Reserve System

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

Manufacturing jobs increased 10,000 in May 2014 relative to Apr 2014, seasonally adjusted. Manufacturing jobs not seasonally adjusted increased 104,000 from May 2013 to
May 2014 or at the average monthly rate of 8,667. There are effects of the weaker economy and international trade together with the yearly adjustment of labor statistics. Industrial production increased 0.6 percent in May 2014 after decreasing 0.3 percent in Apr 2014 and increasing 0.8 percent in Mar 2014 with all data seasonally adjusted. The Federal Reserve completed its annual revision of industrial production and capacity utilization on Mar 28, 2014 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm). The report of the Board of Governors of the Federal Reserve System states (http://www.federalreserve.gov/releases/g17/Current/default.htm):

Manufacturing increased 0.6 percent in May 2014 after decreasing 0.1 percent in Feb 2014 and increasing 0.8 percent in Mar 2014 seasonally adjusted, increasing 3.6 percent not seasonally adjusted in the 12 months ending in May 2014. Manufacturing grew cumulatively 2.0 percent in the six months ending in May 2014 or at the annual equivalent rate of 4.0 percent. Excluding the increase of 1.4 percent in Feb 2014, manufacturing accumulated growth of 0.6 percent from Dec 2013 to May 2014 or at the annual equivalent rate of 1.2 percent. Table I-2 provides a longer perspective of manufacturing in the US. There has been evident deceleration of manufacturing growth in the US from 2010 and the first three months of 2011 into more recent months as shown by 12 months rates of growth. Growth rates appeared to be increasing again closer to 5 percent in Apr-Jun 2012 but deteriorated. The rates of decline of manufacturing in 2009 are quite high with a drop of 18.2 percent in the 12 months ending in Apr 2009. Manufacturing recovered from this decline and led the recovery from the recession. Rates of growth appeared to be returning to the levels at 3 percent or higher in the annual rates before the recession but the pace of manufacturing fell steadily in the past six months with some strength at the margin. The Board of Governors of the Federal Reserve System conducted the annual revision of industrial production released on Mar 28, 2014 (http://www.federalreserve.gov/releases/g17/revisions/Current/DefaultRev.htm):

Manufacturing fell 21.9 from the peak in Jun 2007 to the trough in Apr 2009 and increased by 19.9 percent from the trough in Apr 2009 to Dec 2013. Manufacturing grew 23.8 percent from the trough in Apr 2009 to May 2014. Manufacturing output in May 2014 is 3.3 percent below the peak in Jun 2007.

Table I-13 provides national income by industry without capital consumption adjustment (WCCA). “Private industries” or economic activities have share of 86.7 percent in IVQ2013. Most of US national income is in the form of services. In May 2014, there were 139.192 million nonfarm jobs NSA in the US, according to estimates of the establishment survey of the Bureau of Labor Statistics (BLS) (http://www.bls.gov/news.release/empsit.nr0.htm Table B-1). Total private jobs of 116.929 million NSA in May 2014 accounted for 84.0 percent of total nonfarm jobs of 139.192 million, of which 12.091 million, or 10.3 percent of total private jobs and 8.7 percent of total nonfarm jobs, were in manufacturing. Private service-producing jobs were 97.885 million NSA in May 2014, or 70.3 percent of total nonfarm jobs and 83.7 percent of total private-sector jobs. Manufacturing has share of 11.0 percent in US national income in IVQ2013, as shown in Table I-13. Most income in the US originates in services. Subsidies and similar measures designed to increase manufacturing jobs will not increase economic growth and employment and may actually reduce growth by diverting resources away from currently employment-creating activities because of the drain of taxation.

Table I-13, US, National Income without Capital Consumption Adjustment by Industry, Seasonally Adjusted Annual Rates, Billions of Dollars, % of Total

	SAAR IV2013	% Total	SAAR IQ2014	% Total
National Income WCCA	14,811.5	100.0	14,927.6	100.0
Domestic Industries	14,527.6	98.1	14,692.8	98.4
Private Industries	12,844.2	86.7	13,003.8	87.1
Agriculture	206.0	1.4
Mining	258.4	1.7
Utilities	208.8	1.4
Construction	650.1	4.4
Manufacturing	1635.5	11.0
Durable Goods	914.2	6.2
Nondurable Goods	721.3	4.9
Wholesale Trade	885.8	6.0
Retail Trade	1000.5	6.8
Transportation & WH	453.5	3.1
Information	519.1	3.5
Finance, Insurance, RE	2531.8	17.1
Professional & Business Services	2033.6	13.7
Education, Health Care	1451.5	9.8
Arts, Entertainment	591.4	4.0
Other Services	418.1	2.8
Government	1683.4	11.4	1689.1	11.3
Rest of the World	284.0	1.9	234.8	1.6

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

Source: US Bureau of Economic Analysis

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

Motor vehicle sales and production in the US have been in long-term structural change. Table VA-1 provides the data on new motor vehicle sales and domestic car production in the US from 1990 to 2010. New motor vehicle sales grew from 14,137 thousand in 1990 to the peak of 17,806 thousand in 2000 or 29.5 percent. In that same period, domestic car production fell from 6,231 thousand in 1990 to 5,542 thousand in 2000 or -11.1 percent. New motor vehicle sales fell from 17,445 thousand in 2005 to 11,772 in 2010 or 32.5 percent while domestic car production fell from 4,321 thousand in 2005 to 2,840 thousand in 2010 or 34.3 percent. In May 2014, light vehicle sales accumulated to 6,742,948, which is higher by 5.0 percent relative to 6,424,707 a year earlier (http://motorintelligence.com/m_frameset.html). The seasonally adjusted annual rate of light vehicle sales in the US reached 16.77 million in May 2014, higher than 16.04 million in Apr 2014 and higher than 15.48 million in May 2013 (http://motorintelligence.com/m_frameset.html).

Table VA-1, US, New Motor Vehicle Sales and Car Production, Thousand Units

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

Source: US Census Bureau

http://www.census.gov/compendia/statab/cats/wholesale_retail_trade/motor_vehicle_sales.html

Chart I-5 of the Board of Governors of the Federal Reserve provides output of motor vehicles and parts in the United States from 1972 to 2014. Output virtually stagnated since the late 1990s.

Chart I-5, US, Motor Vehicles and Parts Output, 1972-2014

Source: Board of Governors of the Federal Reserve System

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

Chart I-6 of the Board of Governors of the Federal Reserve System provides output of computers and electronic products in the United States from 1972 to 2014. Output accelerated sharply in the 1990s and 2000s and has surpassed the level before the global recession beginning in IVQ2007.

Chart I-6, US, Output of Computers and Electronic Products, 1972-2014

Source: Board of Governors of the Federal Reserve System

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

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

Chart I-7, US, Output of Durable Manufacturing, 1972-2014

Source: Board of Governors of the Federal Reserve System

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

Chart I-8 of the Board of Governors of the Federal Reserve System provides output of aerospace and miscellaneous transportation equipment from 1972 to 2014. There is long-term upward trend with oscillations around the trend and cycles of large amplitude.

Chart I-8, US, Output of Aerospace and Miscellaneous Transportation Equipment, 1972-2014

Source: Board of Governors of the Federal Reserve System

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

The Empire State Manufacturing Survey Index in Table VA-1 provides continuing deterioration that started in Jun 2012 well before Hurricane Sandy in Oct 2012. The current general index has been in negative contraction territory from minus 3.86 in Aug 2012 to minus 7.93 in Jan 2013 and 0.27 in May 2013. The current general index improved to 19.28 in Jun 2014. The index of current orders has also been in negative contraction territory from minus 3.24 in Aug 2012 to minus 8.48 in Jan 2013 and minus 4.32 in Jun 2013. The index of current new orders increased to 18.36 in Jun 2014. Number of workers and hours worked have registered negative or declining readings since Sep 2012 with improvement to 10.75 for number of workers in Jun 2014 and 9.68 for average workweek. There is improvement in the general index for the next six months at 39.84 in Jun 2014 and strengthening new orders at 44.52.

Table VA-1, US, New York Federal Reserve Bank Empire State Manufacturing Survey Index SA

Current	General Index	New Orders	Shipments	Number of Workers	Average Workweek
Sep-11	-4.55	-4.13	-5.6	-5.43	-2.17
Oct-11	-6.07	0.64	1.48	3.37	-4.49
Nov-11	4.09	0.66	13.22	-3.66	2.44
Dec-11	10.7	8.03	22.09	2.33	-2.33
Jan-12	11.63	10.42	19.7	12.09	6.59
Feb-12	16.36	5.28	17.16	11.76	7.06
Mar-12	15.97	4.67	13.76	13.58	18.52
Apr-12	5.92	4.21	4.24	19.28	6.02
May-12	15.85	9.29	22.95	20.48	12.05
Jun-12	3.48	4.75	11.39	12.37	3.09
Jul-12	6.64	-2.2	11	18.52	0
Aug-12	-3.86	-3.24	8.41	16.47	3.53
Sep-12	-7.41	-10.41	6.4	4.26	-1.06
Oct-12	-4.91	-8.25	-7.44	-1.08	-4.3
Nov-12	-1.8	5.02	17.01	-14.61	-7.87
Dec-12	-6.35	-1.9	10.04	-9.68	-10.75
Jan-13	-7.93	-8.48	-2.13	-4.3	-5.38
Feb-13	7.25	9.84	9.72	8.08	-4.04
Mar-13	6.45	5.8	5.39	3.23	0
Apr-13	2.46	1.4	0.51	6.82	5.68
May-13	0.27	-0.67	-0.36	5.68	-1.14
Jun-13	7.09	-4.32	-6.3	0	-11.29
Jul-13	8.88	3.99	8.26	3.26	-7.61
Aug-13	8.3	1.88	4	10.84	4.82
Sep-13	6.78	2.62	15.69	7.53	1.08
Oct-13	3.24	6.6	12.98	3.61	3.61
Nov-13	0.83	-3.46	1.46	0	-5.26
Dec-13	2.22	-1.69	4.69	0	-10.84
Jan-14	12.51	10.98	15.52	12.2	1.22
Feb-14	4.48	-0.21	2.13	11.25	3.75
Mar-14	5.61	3.13	3.97	5.88	4.71
Apr-14	1.29	-2.77	3.15	8.16	2.04
May-14	19.01	10.44	17.44	20.88	2.2
Jun-14	19.28	18.36	14.15	10.75	9.68

Future	General Index	New Orders	Shipments	Number of Workers	Average Workweek
Sep-11	22.77	23.38	22.66	0	-6.52
Oct-11	14.41	18.95	23.42	6.74	-2.25
Nov-11	35.91	30.35	32.7	14.63	8.54
Dec-11	46.81	45.01	41.56	24.42	22.09
Jan-12	51.83	45.4	44.3	28.57	17.58
Feb-12	45.6	38.41	41.41	29.41	18.82
Mar-12	42.56	37.16	39.87	32.1	20.99
Apr-12	40.21	36.97	38.62	27.71	10.84
May-12	33.49	30.86	25.03	12.05	8.43
Jun-12	26.78	28.74	23.59	16.49	2.06
Jul-12	22.79	20.36	21.46	6.17	-4.94
Aug-12	20.15	15.26	22.39	3.53	-8.24
Sep-12	27.17	27.74	23.17	8.51	2.13
Oct-12	20.23	22.03	18.34	0	-11.83
Nov-12	18.53	15.49	25.5	-1.12	0
Dec-12	21.18	21.43	23.86	10.75	5.38
Jan-13	22.54	24.4	24.1	7.53	3.23
Feb-13	30.39	28.04	27.94	15.15	11.11
Mar-13	33.2	32.59	39.59	19.35	2.15
Apr-13	30.42	34.02	37	25	7.95
May-13	27.3	28.85	24.72	11.36	1.14
Jun-13	26.85	22.9	22.13	1.61	-9.68
Jul-13	32.59	31.53	33.97	1.09	-1.09
Aug-13	37	31.33	31.71	8.43	-6.02
Sep-13	40.39	37.71	37.66	4.3	-2.15
Oct-13	40.86	36.94	33.74	7.23	2.41
Nov-13	38.32	39.31	37.09	22.37	-3.95
Dec-13	38.96	30.15	33.31	9.64	1.2
Jan-14	37.51	39.1	30.58	20.73	9.76
Feb-14	38.99	45.31	43.33	25	7.5
Mar-14	33.21	36.02	35.17	17.65	9.41
Apr-14	38.23	32.69	38.83	22.45	1.02
May-14	43.96	36.71	33.8	17.58	-3.3
Jun-14	39.84	44.52	45.15	20.43	0

Source: Federal Reserve Bank of New York

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

Chart VA-1 of the Federal Reserve Bank of New York provides indexes of current and expected economic activity. There were multiple contractions in current activity after the global recession shown in shade. Current activity is weakening relative to strong recovery in the initial expansion in 2010 and 2011.

Chart VA-1, US, US, Federal Reserve Bank of New York, Diffusion Index of Current and Expected Activity, Seasonally Adjusted

Source: Federal Reserve Bank of New York

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

The Business Outlook Survey Diffusion Index of the Federal Reserve Bank of Philadelphia in Table VA-2 also shows improvement after prior deterioration followed by current improvement. The general index moved out contraction at 1.7 in May 2013 to 17.8 in Jun 2014 together with 16.8 for new orders. Expectations for the next six months are brighter with the general index at 52.0 in Jun 2014 and the index of new orders at 57.8.

Table VA-2, FRB of Philadelphia Business Outlook Survey Diffusion Index

	Current General Index	Current New Orders	Current Ship-ments	Future General Index	Future New Orders	Future Ship- ments
11-Jan	15.3	19.1	10.9	42.9	35.1	36.8
11-Feb	27	15.8	22.3	41.1	37.4	42.4
11-Mar	34.7	32.4	27.5	54.7	52.8	52.6
11-Apr	13.7	13.2	20.9	30.5	28	34.5
11-May	5.5	7.6	8	24.8	24.1	27.4
11-Jun	-0.6	-1.7	7.6	8.3	10.3	9.7
11-Jul	8.2	5.2	9.4	29.7	33.4	29.3
11-Aug	-17.1	-17.5	-2.4	14.6	28.9	25.9
11-Sep	-11.9	-4.7	-8	23.2	22.8	24.9
11-Oct	7.7	7	10	27.6	29.6	30.5
11-Nov	6.6	4.3	7.9	39.1	37.5	34.8
11-Dec	3.8	5	6	35.5	39	32.2
12-Jan	4.9	8.8	3.8	42.6	42.3	41.6
12-Feb	6.4	5.7	6	28.7	30.1	25.7
12-Mar	6.2	-2.3	-1.4	26.8	33.2	27.9
12-Apr	6.3	-0.3	-3.3	31.8	37.2	31.2
12-May	-2.1	0.6	6.4	22	32.8	28.3
12-Jun	-12	-13.3	-10.9	25.5	36.6	38.1
12-Jul	-10.7	-1.3	-7.2	23.8	28.2	22.6
12-Aug	1.1	1.7	-2.3	23.6	29.6	21.9
12-Sep	-0.9	2.1	-10.7	38.2	47.2	39.5
12-Oct	1	-3.5	-5.6	19.4	22.2	21.9
12-Nov	-6.9	-3.2	-4.4	21.2	25.1	26.1
12-Dec	4.4	3.6	13.9	25.3	29.8	28.9
13-Jan	-5.6	-4.5	-0.2	26.2	30.1	33.3
13-Feb	-11.9	-7.7	-1.4	29.2	35.6	29.3
13-Mar	-1.4	-1.9	1.4	30.1	32.7	30
13-Apr	1	-0.8	4	19.9	27.1	28.2
13-May	-1.7	-6.6	-3.9	35.1	37.9	35
13-Jun	14.4	17.3	8.2	37.2	43	40.4
13-Jul	18	11.3	14.5	45	56	49.1
13-Aug	13.1	8.9	3.9	44.1	44.8	46
13-Sep	20	20.8	21.9	57	57.2	54.4
13-Oct	15.6	23.8	17.3	58.3	63.4	52.6
13-Nov	9.2	14	7.8	48.1	49.3	43.5
13-Dec	6.4	12.9	11.9	44.8	45.7	42
14-Jan	9.4	5.1	12.1	34.4	38.4	33.2
14-Feb	-6.3	-5.2	-9.9	40.2	35.4	36
14-Mar	9	5.7	5.7	35.4	32.2	41.1
14-Apr	16.6	14.8	22.7	26.6	29.7	32.8
14-May	15.4	10.5	14.2	37.4	36.5	38.7
14-Jun	17.8	16.8	15.5	52	57.8	48

Source: Federal Reserve Bank of Philadelphia

http://www.phil.frb.org/index.cfm

Chart VA-2 of the Federal Reserve Bank of Philadelphia is very useful, providing current and future general activity indexes from Jan 1995 to Apr 2014. The shaded areas are the recession cycle dates of the National Bureau of Economic Research (NBER) (http://www.nber.org/cycles.html). The Philadelphia Fed index dropped during the initial period of recession and then led the recovery, as industry overall. There was a second decline of the index into 2011 followed now by what hopefully appeared as renewed strength from late 2011 into Jan 2012. There is decline to negative territory of the current activity index in Nov 2012 and return to positive territory in Dec 2012 with decline of current conditions into contraction in Jan-Feb 2013 and rebound to mild expansion in Mar-Apr 2013. The index of current activity moved into expansion in Jun-Oct 2013 with weakness in Nov-Dec 2013, improving in Jan 2014. There is renewed deterioration in Feb 2014 with rebound in Apr-Jun 2014.

Chart VA-2, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current and Future Activity Indexes

Source: Federal Reserve Bank of Philadelphia

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

The index of current new orders of the Business Outlook Survey of the Federal Reserve Bank of Philadelphia in Chart VA-3 illustrates the weakness of the cyclical expansion. The index weakened in 2006 and 2007 and then fell sharply into contraction during the global recession. There have been twelve readings into contraction from Jan 2012 to May 2013 and generally weak readings with some exceptions. The index of new orders moved into expansion in Jun-Oct 2013 with moderation in Nov-Dec 2013 and into Jan 2014. The index fell into contraction in Feb 2014, recovering in Mar-Apr 2014 but weaker reading in May 2014. There is improvement in Jun 2014.

Chart VA-3, Federal Reserve Bank of Philadelphia Business Outlook Survey, Current New Orders Diffusion Index SA

Source: Federal Reserve Bank of Philadelphia

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

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, increase of wealth of households over the business cycle by total 7.3 percent adjusted for inflation from IVQ2007 to IVQ2013 while growing at 3.1 percent per year adjusted for inflation from IVQ1945 to IVQ2013 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 May 30 and daily values throughout the week ending on Jun 13, 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 Jun 13 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Jun 13, 2014”, first row “USD/EUR 1.3540 0.8% 0.1 %,” provides the information that the US dollar (USD) appreciated 0.8 percent to USD 1.3540/EUR in the week ending on Fri Jun 13 relative to the exchange rate on Fri Jun 6 and appreciated 0.1 percent relative to Thu Jun 12. 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 fluctuating interest rates. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3540/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Jun 13, depreciating to USD 1.3573/EUR on Mon Jun 16, 2014, or by 0.2 percent. The dollar depreciated because more dollars, 1.3573, were required on Mon Jun 16 to buy one euro than $1.3540 on Fri Jun 13. 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 1.3540/EUR on Jun 13. The second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Jun 13, to the last business day of the current week, in this case Fri Jun 20, such as depreciation of 0.4 percent to USD 1.3600/EUR by Jun 20. 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 0.4 percent from the rate of USD 1.3540/EUR on Fri Jun 13 to the rate of USD 1.3600/EUR on Fri Jun 20 {[(1.3600/1.3540) – 1]100 = 0.4%}. The dollar appreciated (denoted by positive sign) by 0.1 percent from the rate of USD 1.3607 on Thu Jun 19 to USD 1.3600/EUR on Fri Jun 20 {[(1.3600/1.3607) -1]100 = -0.1%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European and global 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 Jun 9 to Jun 13, 2014

Fri Jun 13, 2014

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.3540

0.8%

0.1%

1.3573

-0.2%

1.3547

-0.1%

0.2%

1.3596

-0.4%

1.3607

-0.5%

-0.1%

1.3600

-0.4%

0.1%

JPY/ USD

102.05

0.4%

-0.3%

101.83

0.2%

102.16

-0.1%

-0.3%

101.92

0.1%

0.2%

101.94

0.1%

0.0%

102.07

0.0%

-0.1%

CHF/ USD

0.9001

-0.7%

-0.2%

0.8971

0.3%

0.8994

0.1%

-0.3%

0.8958

0.5%

0.4%

0.8941

0.7%

0.2%

0.8951

0.6%

-0.1%

CHF/ EUR

1.2187

0.0%

-0.1%

1.2177

0.1%

1.2184

0.0%

-0.1%

1.2178

0.1%

0.0%

1.2167

0.2%

0.1%

1.2173

0.1%

0.0%

USD/ AUD

0.9402

1.0636

0.7%

0.4%

0.9401

1.0637

0.0%

0.9338

1.0709

-0.7%

0.9409

1.0628

0.1%

0.8%

0.9400

1.0638

0.0%

-0.1%

0.9388

1.0652

-0.1%

10Y Note

2.605

2.599

2.654

2.591

2.627

2.609

2Y Note

0.451

0.465

0.482

0.446

0.454

0.458

German Bond

2Y 0.02 10Y 1.36

2Y 0.02 10Y 1.35

2Y 0.04 10Y 1.40

2Y 0.03 10Y 1.37

2Y 0.03 10Y 1.32

2Y 0.03 10Y 1.34

DJIA

16775.74

-0.9%

0.2%

16781.01

0.0%

16808.49

0.2%

16906.62

0.8%

0.6%

16921.46

0.9%

0.1%

16947.08

1.0%

0.2%

Dow Global

2586.99

-0.5%

0.2%

2584.91

-0.1%

2587.20

0.0%

0.1%

2604.22

0.7%

2622.06

1.4%

0.7%

2616.47

1.1%

-0.2%

DJ Asia Pacific

1487.10

0.6%

-0.2%

1483.67

-0.2%

1482.22

-0.3%

-0.1%

1484.31

-0.2%

0.1%

1501.05

0.9%

1.1%

1494.11

0.5%

-0.5%

Nikkei

15097.84

0.1%

0.8%

14933.29

-1.1%

14975.97

-0.8%

0.3%

15115.80

0.1%

0.9%

15361.16

1.7%

1.6%

15349.42

1.7%

-0.1%

Shanghai

2070.71

2.0%

0.9%

2085.98

0.7%

2066.70

-0.2%

-0.9%

2055.52

-0.7%

-0.5%

2023.73

-2.3%

-1.5%

2026.67

-2.1%

0.1%

DAX

9912.87

-0.7%

-0.3%

9883.98

-0.3%

9920.32

0.1%

0.4%

9930.33

0.2%

0.1%

10004.00

0.9%

0.7%

9987.24

0.8%

-0.2%

DJ UBS Comm.

134.77

0.8%

0.4%

134.71

0.0%

134.66

-0.1%

0.0%

134.87

0.1%

0.2%

136.27

1.1%

1.0%

136.55

1.3%

0.2%

WTI $/B

106.91

4.1%

0.4%

106.90

0.0%

106.36

-0.5%

105.97

-0.9%

-0.4%

106.43

-0.4%

0.4%

107.26

0.3%

0.8%

Brent $/B

113.41

4.4%

0.3%

112.94

-0.4%

113.45

0.0%

0.5%

114.26

0.7%

115.06

1.5%

0.7%

114.81

1.2%

-0.2%

Gold $/OZ

1277.2

2.0%

0.3%

1274.9

-0.2%

1271.7

-0.4%

-0.3%

1272.4

-0.3%

0.1%

1313.7

2.9%

3.2%

1316.2

3.1%

0.2%

Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss

Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce

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

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

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. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.

In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):

“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”

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 Mar 19, 2014, the FOMC decided additional tapering monthly bond purchases. Earlier programs are continued with an additional lower open-ended $35 billion of bond purchases per month, increasing the stock of $4,103,552 million securities held outright and bank reserves deposited at the Fed of $2,637,585 million (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) (http://www.federalreserve.gov/newsevents/press/monetary/20140618a.htm):

“The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 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 as evident in the FOMC statement for Jun 18, 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20140618a.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 remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored” (emphasis added).

Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).

How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”

At a speech on Mar 31, 2014, Chair Yellen analyzed labor market conditions as follows (http://www.federalreserve.gov/newsevents/speech/yellen20140331a.htm):

“And based on the evidence available, it is clear to me that the U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress. The first of those goals is maximum sustainable employment, the highest level of employment that can be sustained while maintaining a stable inflation rate. Most of my colleagues on the Federal Open Market Committee and I estimate that the unemployment rate consistent with maximum sustainable employment is now between 5.2 percent and 5.6 percent, well below the 6.7 percent rate in February.

Let me explain what I mean by that word "slack" and why it is so important.

Slack means that there are significantly more people willing and capable of filling a job than there are jobs for them to fill. During a period of little or no slack, there still may be vacant jobs and people who want to work, but a large share of those willing to work lack the skills or are otherwise not well suited for the jobs that are available. With 6.7 percent unemployment, it might seem that there must be a lot of slack in the U.S. economy, but there are reasons why that may not be true.”

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?

Bernanke (2010WP) and Yellen (2011AS) reveal the emphasis of monetary policy on the impact of the rise of stock market valuations in stimulating consumption by wealth effects on household confidence. What is the success in evaluating deviations of valuations of risk financial assets from “historical norms”? What are the consequences on economic activity and employment of deviations of valuations of risk financial assets from those “historical norms”? What are the policy tools and their effectiveness in returning valuations of risk financial assets to their “historical norms”?

In testimony before the Committee on the Budget of the US Senate on May 8, 2014, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm):

“The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.

Conditions in the labor market have continued to improve. The unemployment rate was 6.3 percent in April, about 1-1/4 percentage points below where it was a year ago. Moreover, gains in payroll employment averaged nearly 200,000 jobs per month over the past year. During the economic recovery so far, payroll employment has increased by about 8-1/2 million jobs since its low point, and the unemployment rate has declined about 3-3/4 percentage points since its peak.

While conditions in the labor market have improved appreciably, they are still far from satisfactory. Even with recent declines in the unemployment rate, it continues to be elevated. Moreover, both the share of the labor force that has been unemployed for more than six months and the number of individuals who work part time but would prefer a full-time job are at historically high levels. In addition, most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.

Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.

Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.”

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 (10

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.

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).

There is concern of declining inflation and appreciation of the euro. In the “Introductory statement to the press conference,” on May 8, 2014, the President of the European Central Bank Mario Draghi states (http://www.ecb.europa.eu/press/pressconf/2014/html/is140508.en.html):

“We will maintain a high degree of monetary accommodation and act swiftly, if required, with further monetary policy easing. We firmly reiterate that we continue to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy, the high degree of unutilised capacity, and subdued money and credit creation. The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation. Further information and analysis concerning the outlook for inflation and the availability of bank loans to the private sector will be available in early June.”

On Jun 5, 2014, the European Central Bank introduced cuts in interest rates and a negative rate paid on deposits of banks (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605.en.html):

“5 June 2014 - 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 10 basis points to 0.15%, starting from the operation to be settled on 11 June 2014.
The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
The interest rate on the deposit facility will be decreased by 10 basis points to -0.10%, with effect from 11 June 2014. A separate press release to be published at 3.30 p.m. CET today will provide details on the implementation of the negative deposit facility rate.”

The ECB also introduced new measures of monetary policy on Jun 5, 2014 (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605_2.en.html):

“5 June 2014 - ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechanism

In pursuing its price stability mandate, the Governing Council of the ECB has today announced measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. In particular, the Governing Council has decided:

To conduct a series of targeted longer-term refinancing operations (TLTROs) aimed at improving bank lending to the euro area non-financial private sector ^[¹^], excluding loans to households for house purchase, over a window of two years.
To intensify preparatory work related to outright purchases of asset-backed securities (ABS).”

The President of the European Central Bank (ECB) Mario Draghi analyzed the measures at a press conference (http://www.ecb.europa.eu/press/pressconf/2014/html/is140605.en.html).

The President of the European Central Bank (ECB) Mario Draghi reaffirmed the policy stance at the press conference following the meeting on Feb 6, 2014 (http://www.ecb.europa.eu/press/pressconf/2014/html/is140206.en.html): “As I have said several times we are willing to act and we stand ready to act. We confirmed our forward guidance, so interest rates will stay at the present or lower levels for an extended period of time.”

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 16,947.08 on Fri Jun 20, 2014, which is higher by 19.6 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 19.4 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial are approaching or exceeding historical highs. Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):

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. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. 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 2.742 percent on Jun 20, 2014, and that of the ten-year sovereign bond of Italy at 2.838 percent (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Jun 20, 2014, the yield of the two-year Treasury increased to 0.458 percent and that of the ten-year Treasury increased to 2.609 percent while the yield of the two-year bond of Germany increased to 0.03 percent and the ten-year yield decreased to 1.34 percent; and the dollar depreciated at USD 1.3600/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 2.605 percent is higher than consumer price inflation of 2.0 percent in the 12 months ending in May 2014 (Section I and earlier http://cmpassocregulationblog.blogspot.com/2014/05/world-inflation-waves-squeeze-of.html and earlier http://cmpassocregulationblog.blogspot.com/2014/04/imf-view-world-inflation-waves-squeeze.html) and the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 0.084 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 2.0 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
06/20/14	0.458	2.609	0.03	1.34	1.3600
06/13/14	0.451	2.605	0.02	1.36	1.3540
06/06/14	0.405	2.598	0.05	1.35	1.3643
05/30/14	0.373	2.473	0.06	1.36	1.3632
05/23/14	0.345	2.532	0.06	1.41	1.3630
05/16/14	0.357	2.520	0.09	1.33	1.3694
05/09/14	0.385	2.624	0.13	1.45	1.3760
05/02/14	0.421	2.583	0.12	1.45	1.3873
04/25/14	0.432	2.668	0.17	1.48	1.3833
04/18/14	0.401	2.724	0.17	1.51	1.3813
04/11/14	0.357	2.628	0.16	1.50	1.3885
04/04/14	0.413	2.724	0.16	1.55	1.3704
03/28/14	0.448	2.721	0.14	1.55	1.3752
03/21/14	0.431	2.743	0.20	1.63	1.3793
03/14/14	0.340	2.654	0.15	1.54	1.3912
03/07/14	0.367	2.792	0.17	1.65	1.3877
02/28/14	0.323	2.655	0.13	1.62	1.3801
02/21/14	0.316	2.730	0.12	1.66	1.3739
02/14/14	0.313	2.743	0.11	1.68	1.3693
02/07/14	0.305	2.681	0.09	1.66	1.3635
1/31/14	0.330	2.645	0.07	1.66	1.3488
1/24/14	0.342	2.720	0.12	1.66	1.3677
1/17/14	0.373	2.818	0.17	1.75	1.3541
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/

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

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 Jun 19, 2014, with the one-month yield at 0.01 percent, the two-year at 0.48 percent, the ten-year at 2.64 percent, the fed funds rate at 0.10 percent and the corporate Baa bond at 4.83 percent. There is an evident increase in the yields of the 10-year Treasury constant maturity and the Moody’s Baa corporate bond with decline in wide swings of portfolio reallocations.

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-Jun 19, 2014

Note: US Recessions in shaded areas

Source: Board of Governors of the Federal Reserve System

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

Tom Lauricella, writing on Mar 31, 2014, on “Stock investors see hints of a stronger quarter,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304157204579473513864900656?mod=WSJ_smq0314_LeadStory&mg=reno64-wsj), finds views of stronger earnings among many money managers with positive factors for equity markets in continuing low interest rates and US economic growth. There is important information in the Quarterly Markets review of the Wall Street Journal (http://online.wsj.com/public/page/quarterly-markets-review-03312014.html) foir IQ2014. Alexandra Scaggs, writing on “Tepid profits, roaring stocks,” on May 16, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323398204578487460105747412.html), analyzes stabilization of earnings growth: 70 percent of 458 reporting companies in the S&P 500 stock index reported earnings above forecasts but sales fell 0.2 percent relative to forecasts of increase of 0.5 percent. Paul Vigna, writing on “Earnings are a margin story but for how long,” on May 17, 2013, published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2013/05/17/earnings-are-a-margin-story-but-for-how-long/), analyzes that corporate profits increase with stagnating sales while companies manage costs tightly. More than 90 percent of S&P components reported moderate increase of earnings of 3.7 percent in IQ2013 relative to IQ2012 with decline of sales of 0.2 percent. Earnings and sales have been in declining trend. In IVQ2009, growth of earnings reached 104 percent and sales jumped 13 percent. Net margins reached 8.92 percent in IQ2013, which is almost the same at 8.95 percent in IIIQ2006. Operating margins are 9.58 percent. There is concern by market participants that reversion of margins to the mean could exert pressure on earnings unless there is more accelerated growth of sales. Vigna (op. cit.) finds sales growth limited by weak economic growth. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. Future company cash flows derive from investment projects. In IQ1980, gross private domestic investment in the US was $951.6 billion of 2009 dollars, growing to $1,174.6 billion in IIIQ1987 or 23.4 percent. Real gross private domestic investment in the US decreased 1.6 percent from $2,605.2 billion of 2009 dollars in IVQ2007 to $2,562.4 billion in IQ2014. Real private fixed investment fell 3.5 percent from $2,586.3 billion of 2009 dollars in IVQ2007 to $2,496.6 billion in IQ2014. Growth of real private investment is mediocre for all but four quarters from IIQ2011 to IQ2012.

(http://cmpassocregulationblog.blogspot.com/2014/06/financial-instability-mediocre-cyclical.html and earlier http://cmpassocregulationblog.blogspot.com/2014/05/financial-volatility-mediocre-cyclical.html). The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Corporate profits with IVA and CCA fell $26.6 billion in IQ2013 after increasing $34.9 billion in IVQ2012 and $13.9 billion in IIIQ2012. Corporate profits with IVA and CCA rebounded with $66.8 billion in IIQ2013 and $39.2 billion in IIIQ2013. Corporate profits with IVA and CCA increased $47.1 billion in IVQ2013. Corporate profits with IVA and CCA fell $213.4 billion in IQ2014. Profits after tax with IVA and CCA fell $1.7 billion in IQ2013 after increasing $40.8 billion in IVQ2012 and $4.5 billion in IIIQ2012. In IIQ2013, profits after tax with IVA and CCA increased $56.9 billion and $39.5 billion in IIIQ2013. In IVQ2013, profits after tax with IVA and CCA increased $33.8 billion. Profits after tax with IVA and CCA fell at $239.5 billion in IQ2014. Anticipation of higher taxes in the “fiscal cliff” episode caused increase of $120.9 billion in net dividends in IVQ2012 followed with adjustment in the form of decrease of net dividends by $103.8 billion in IQ2013, rebounding with $273.5 billion in IIQ2013. Net dividends fell at $179.0 billion in IIIQ2013 and increased at $90.5 billion in IVQ2013. Net dividends fell at $89 billion in IQ2014. There is similar decrease of $80.1 billion in undistributed profits with IVA and CCA in IVQ2012 followed by increase of $102.1 billion in IQ2013 and decline of $216.6 billion in IIQ2013. Undistributed profits with IVA and CCA rose at $218.6 billion in IIIQ2013 and fell at $56.7 billion in IVQ2013. Undistributed profits with IVA and CCA fell at $150.6 billion in IQ2014. Undistributed profits of US corporations swelled 328.5 percent from $107.7 billion IQ2007 to $461.5 billion in IQ2014 and changed signs from minus $55.9 billion in billion in IVQ2007 (Section IA2). In IQ2013, corporate profits with inventory valuation and capital consumption adjustment fell $26.6 billion relative to IVQ2012, from $2047.2 billion to $2020.6 billion at the quarterly rate of minus 1.3 percent. In IIQ2013, corporate profits with IVA and CCA increased $66.8 billion from $2020.6 billion in IQ2013 to $2087.4 billion at the SAAR of 3.3 percent. Corporate profits with IVA and CCA increased $39.2 billion from $2087.4 billion in IIQ2013 to $2126.6 billion in IIIQ2013 at the SAAR of 1.9 percent. Corporate profits with IVA and CCA increased at $47.1 billion in IVQ2013 from $2126.6 billion in IIIQ2013 to $2173.7 billion in IVQ2013 at the SAAR of 2.2 percent. Corporate profits with IVA and CCA fell at $213.4 billion from $2173.7 billion in IVQ2013 to $1960.3 billion in IQ2014 at the SAAR of minus 9.8 percent (http://www.bea.gov/newsreleases/national/gdp/2014/pdf/gdp1q14_2nd.pdf). Uncertainty originating in fiscal, regulatory and monetary policy causes wide swings in expectations and decisions by the private sector with adverse effects on investment, real economic activity and employment. The investment decision of US business is fractured. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

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

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation. There is mixed performance in equity indexes with several indexes in Table III-1 increasing in the week ending on Jun 6, 2014, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. DJIA increased 0.2 percent on Jun 20, increasing 1.0 percent in the week. Germany’s DAX decreased 0.2 percent on Jun 20 and increased 0.8 percent in the week. Dow Global decreased 0.2 percent on Jun 20 and increased 1.1 percent in the week. Japan’s Nikkei Average decreased 0.1 percent on Jun 20 and increased 1.7 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Dow Asia Pacific TSM decreased 0.5 percent on Jun 20 and increased 0.5 percent in the week. Shanghai Composite that decreased 0.2 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 to close at 1980.13 on Fri Nov 30 but closing at 2026.67 on Jun 20 for increase of 0.1 percent and decrease of 2.1 percent in the week of Jun 20. There is deceleration with oscillations of the world economy that could affect corporate revenue and equity valuations, causing fluctuations in equity markets with increases during favorable risk appetite.

Commodities were mixed in the week of Jun 20, 2014. The DJ UBS Commodities Index increased 0.2 percent on Jun 20 and increased 1.3 percent in the week, as shown in Table III-1. WTI increased 0.3 percent in the week of Jun 20 while Brent increased 1.2 percent in the week with turmoil in the Middle East. Gold increased 0.2 percent on Jun 20 and increased 3.1 percent in the week.

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €607,617 million on Jun 13, 2014, with some repayment of loans already occurring. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €1,177,130 million in the statement of Jun 13, 2014, with marginal reduction. There is high credit risk in these transactions with capital of only €93,404 million as analyzed by Cochrane (2012Aug31).

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

	Dec 31, 2010	Dec 28, 2011	Jun 13, 2014
1 Gold and other Receivables	367,402	419,822	326,478
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	247,484
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	23,399
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,836
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	607,617
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	63,814
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	569,966
8 General Government Debt Denominated in Euro	34,954	33,928	27,267
9 Other Assets	278,719	336,574	239,419
TOTAL ASSETS	2,004, 432	2,733,235	2,124,281
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,177,583
Capital and Reserves	78,143	81,481	93,403

Source: European Central Bank

http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html

http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html

http://www.ecb.europa.eu/press/pr/wfs/2014/html/fs140617.en.html

IIIE Appendix Euro Zone Survival Risk. Resolution of the European sovereign debt crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would assure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness.

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. Growth of the Italian economy would ensure that success. A critical problem is that the common euro currency prevents Italy from devaluing the exchange rate to parity or the exchange rate that would permit export growth to promote internal economic activity, which could generate fiscal revenues for primary fiscal surpluses that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU), or euro area, are only 39.8 percent of the total in Apr 2014. Exports to the non-European Union area with share of 46.3 percent in Italy’s total exports are growing at minus 2.0 percent in Jan-Apr 2014 relative to Jan-Apr 2013 while those to EMU are growing at 3.2 percent.

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

Apr 2014	Exports % Share	∆% Jan-Apr 2014/ Jan-Apr 2013	Imports % Share	∆% Jan-Apr 2014/ Jan-Apr 2013
EU	53.7	4.6	55.3	-0.5
EMU 17	39.8	3.2	44.3	-1.3
France	10.8	-0.6	8.4	-1.6
Germany	12.4	4.4	14.7	0.7
Spain	4.4	3.5	4.5	1.1
UK	5.0	7.3	2.7	-0.1
Non EU	46.3	-2.0	44.7	-6.7
Europe non EU	13.0	-9.7	12.1	-8.4
USA	6.9	5.7	3.2	11.7
China	2.5	11.1	6.4	1.9
OPEC	6.0	-6.9	8.1	-36.1
Total	100.0	1.6	100.0	-3.3

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

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/125901

Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade surplus of €535 million with the 17 countries of the euro zone (EMU 17) in Apr 2014 and cumulative surplus of €616 million in Jan-Apr 2014. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €1022 million in Jan-Apr 2014 with Europe non-European Union, the trade surplus of €4460 million with the US and trade surplus with non-European Union of €4826 million in Jan-Apr 2014. There is significant rigidity in the trade deficits in Jan-Apr 2014 of €4489 million with China and €156 million with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.

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

Regions and Countries	Trade Balance Apr 2014 Millions of Euro	Trade Balance Cumulative Jan-Apr 2014 Millions of Euro
EU	1,851	5,556
EMU 17	535	616
France	1,142	4,131
Germany	-204	-1,158
Spain	150	439
UK	828	3,270
Non EU	1,654	4,826
Europe non EU	378	1,400
USA	1,109	4,460
China	-836	-4,489
OPEC	-30	-156
Total	3,505	10,382

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

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/125901

Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Apr 2014 relative to Jan-Apr 2013. Growth rates of cumulative imports relative to a year earlier are negative for energy with minus 20.3 percent. Exports of durable goods grew 3.6 percent and exports of capital goods increased 5.2 percent. The higher rate of growth of exports of 1.6 percent in Jan-Apr 2014/Jan-Apr 2013 relative to that of imports of minus 3.3 percent may reflect weak demand in Italy with GDP declining during nine consecutive quarters from IIIQ2011 through IIIQ2013 together with softening commodity prices. GDP increased marginally 0.1 percent in IVQ2013 and fell 0.1 percent in IQ2014.

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

	Exports Share %	Exports ∆% Jan-Apr 2014/ Jan-Apr 2013	Imports Share %	Imports ∆% Jan-Apr 2014/ Jan-Apr 2013
Consumer Goods	31.0	3.6	27.3	2.1
Durable	6.0	3.6	2.9	7.2
Non-Durable	25.1	3.6	24.4	1.5
Capital Goods	32.3	5.2	20.3	2.1
Inter- mediate Goods	32.3	-1.3	32.5	-0.4
Energy	4.4	-14.9	19.9	-20.3
Total ex Energy	95.6	2.4	80.1	1.0
Total	100.0	1.6	100.0	-3.3

Note: % Share for 2012 total trade.

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/125901

Table III-6 provides Italy’s trade balance by product categories in Apr 2014 and cumulative Jan-Apr 2014. Italy’s trade balance excluding energy, generated surplus of €7030 million in Apr 2014 and €25,236 million cumulative in Jan-Apr 2014 but the energy trade balance created deficit of €3524 million in Apr 2014 and cumulative €14,854 million in Jan-Apr 2014. The overall surplus in Apr 2014 was €3505 million with cumulative surplus of €10,382 million in Jan-Apr 2014. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.

Table III-6, Italy, Trade Balance by Product Categories, € Millions

	Apr 2014	Cumulative Jan-Apr 2014
Consumer Goods	1,602	7,193
Durable	1,049	4,060
Nondurable	554	3,133
Capital Goods	4,456	16,350
Intermediate Goods	971	1,694
Energy	-3,524	-14,854
Total ex Energy	7,030	25,236
Total	3,505	10,382

Source: Istituto Nazionale di Statistica

Source: Istituto Nazionale di Statistica http://www.istat.it/it/archivio/125901

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

The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30, 2011, the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt exceeding 100 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).

Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.

Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:

“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”

If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.

The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/ns/cs.aspx?id=28) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2014.

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

	GDP 2014 USD Billions	Primary Net Lending Borrowing % GDP 2014	General Government Net Debt % GDP 2014
World	76,776
Euro Zone	13,416	-0.1	73.2
Portugal	231	0.3	119.9
Ireland	230	-0.7	103.5
Greece	249	1.5	169.3
Spain	1,415	-2.8	65.7
Major Advanced Economies G7	35,904	-2.7	87.0
United States	17,528	-3.2	82.3
UK	2,828	-3.5	84.4
Germany	3,876	1.6	52.9
France	2,886	-1.7	89.5
Japan	4,846	-6.4	137.1
Canada	1,769	-2.2	39.5
Italy	2,172	2.3	112.4
China	10,028	-2.0*	20.2**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook http://www.imf.org/external/ns/cs.aspx?id=28

The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions 2014” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2014” to the column “GDP 2014 USD Billions.” The total debt of France and Germany in 2014 is $4633.4 billion, as shown in row “B+C” in column “Net Debt USD Billions 2014” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4307.7 billion, adding rows D+E+F+G+H in column “Net Debt USD billions 2014.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table I-9. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8941.1 billion, which would be equivalent to 132.2 percent of their combined GDP in 2014. Under this arrangement, the entire debt of selected members of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 230.7 percent if including debt of France and 164.0 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks. Analysis of fiscal stress is quite difficult without including another global recession in an economic cycle that is already mature by historical experience.

Table III-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions 2014	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	9,820.5
B Germany	2,050.4		$8941.1 as % of $3876 =230.7% $6358.1 as % of $3876 =164.0%
C France	2,583.0
B+C	4,633.4	GDP $6,762.0 Total Debt $8941.1 Debt/GDP: 132.2%
D Italy	2,441.3
E Spain	929.7
F Portugal	277.0
G Greece	421.6
H Ireland	238.1
Subtotal D+E+F+G+H	4,307.7

Source: calculation with IMF data IMF World Economic Outlook databank

http://www.imf.org/external/ns/cs.aspx?id=28

There is extremely important information in Table VE-9 for the current sovereign risk crisis in the euro zone. Table VE-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Apr 2014. German exports to other European Union (EU) members are 58.3 percent of total exports in Apr 2014 and 58.8 percent in cumulative Jan-Apr 2014. Exports to the euro area are 37.4 percent of the total in Apr and 37.6 percent cumulative in Jan-Apr. Exports to third countries are 41.7 percent of the total in Apr and 41.2 percent cumulative in Jan-Apr. There is similar distribution for imports. Exports to non-euro countries are increasing 6.9 percent in the 12 months ending in Apr 2014, increasing 9.7 percent cumulative in Jan-Apr 2014 while exports to the euro area are increasing 2.7 percent in the 12 months ending in Apr 2014 and increasing 2.3 percent cumulative in Jan-Apr 2014. Exports to third countries, accounting for 41.7 percent of the total in Apr 2014, are decreasing 5.7 percent in the 12 months ending in Apr 2014 and decreasing 1.3 percent cumulative in Jan-Apr 2014, accounting for 41.2 percent of the cumulative total in Jan-Apr 2014. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to Germany’s high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of high share in its exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.

Table VE-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%

	Apr 2014 € Billions	Apr 12-Month ∆%	Cumulative Jan-Apr 2014 € Billions	Cumulative Jan-Apr 2014/ Jan-Apr 2013 ∆%
Total Exports	93.8	-0.2	372.9	2.2
A. EU Members	54.7 % 58.3	4.1	219.4 % 58.8	4.9
Euro Area	35.1 % 37.4	2.7	140.1 % 37.6	2.3
Non-euro Area	19.6 % 20.9	6.9	79.3 % 21.3	9.7
B. Third Countries	39.1 % 41.7	-5.7	153.5 % 41.2	-1.3
Total Imports	76.4	0.6	307.7	3.5
C EU Members	50.6 % 66.2	3.3	201.5 % 65.5	5.1
Euro Area	34.8 % 45.6	1.6	139.0 % 45.2	4.1
Non-euro Area	15.8 % 20.7	7.3	62.4 % 20.3	7.3
C Third Countries	25.8 % 33.8	-4.4	106.2 % 34.5	0.6

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

Source: Statistisches Bundesamt Deutschland

https://www.destatis.de/EN/PressServices/Press/pr/2014/06/PE14_199_51.html

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

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