CMP Associates Regulation Blog: Interest Rate Policy Uncertainty, IMF View of World Economy and Finance, Collapse of United States Dynamism of Income Growth and Employment Creation, United States International Trade, Household Income at 1996 Levels, 46 Million in Poverty and 33 Million without Health Insurance, World Cyclical Slow Growth and Global Recession Risk: Part I

Interest Rate Policy Uncertainty, IMF View of World Economy and Finance, Collapse of United States Dynamism of Income Growth and Employment Creation, United States International Trade, Household Income at 1996 Levels, 46 Million in Poverty and 33 Million without Health Insurance, World Cyclical Slow Growth and Global Recession Risk

Carlos M. Pelaez

I IMF View of World Economy and Finance

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

IIA United States International Trade

IIB Household Income at 1996 Levels, 46 Million in Poverty and 33 Million without Health Insurance

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

IV Global Inflation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

Executive Summary

Contents of Executive Summary

ESI Financial “Irrational Exuberance,” Increasing Interest Rate and Exchange Rate Risk, Duration Dumping, Competitive Devaluations, Steepening Yield Curve and Global Financial and Economic Risk

ESII IMF View of World Economy and Finance

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

ESIV United States International Trade

ESV Household Income at 1996 Levels, 46 Million in Poverty and 33 Million without Health Insurance

ESI “Financial “Irrational Exuberance,” Increasing Interest Rate and Exchange Rate Risk, Duration Dumping, Competitive Devaluations, Steepening Yield Curve and Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task for both theory and measurement. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task for both theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/ns/cs.aspx?id=29), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/gfsr/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/ns/cs.aspx?id=262). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

China’s Economic Growth. China lowered the growth target to approximately 7.0 percent in 2015, as analyzed by Xiang Bo, writing on “China lowers 2015 economic growth target to around 7 percent,” published on Xinhuanet on Mar 5, 2015 (http://news.xinhuanet.com/english/2015-03/05/c_134039341.htm). China had lowered its growth target to 7.5 percent per year. Lu Hui, writing on “China lowers GDP target to achieve quality economic growth, on Mar 12, 2012, published in Beijing by Xinhuanet (http://news.xinhuanet.com/english/china/2012-03/12/c_131461668.htm), informs that Premier Jiabao wrote in a government work report that the GDP growth target will be lowered to 7.5 percent to enhance the quality and level of development of China over the long term. The Third Plenary Session of the 18^th Central Committee of the Communist Party of China adopted unanimously on Nov 15, 2013, a new round of reforms with 300 measures (Xinhuanet, “China details reform decision-making process,” Nov 19, 2013 http://news.xinhuanet.com/english/china/2013-11/19/c_125722517.htm). Growth rates of GDP of China in a quarter relative to the same quarter a year earlier have been declining from 2011 to 2015. China’s GDP grew 1.4 percent in IQ2012, annualizing to 5.7 percent, and 8.1 percent relative to a year earlier. The GDP of China grew at 2.1 percent in IIQ2012, which annualizes to 8.7 percent and 7.6 percent relative to a year earlier. China grew at 2.0 percent in IIIQ2012, which annualizes at 8.2 percent and 7.4 percent relative to a year earlier. In IVQ2012, China grew at 1.9 percent, which annualizes at 7.8 percent, and 7.9 percent in IVQ2012 relative to IVQ2011. In IQ2013, China grew at 1.7 percent, which annualizes at 7.0 percent and 7.8 percent relative to a year earlier. In IIQ2013, China grew at 1.8 percent, which annualizes at 7.4 percent and 7.5 percent relative to a year earlier. China grew at 2.3 percent in IIIQ2013, which annualizes at 9.5 percent and 7.9 percent relative to a year earlier. China grew at 1.8 percent in IVQ2013, which annualized to 7.4 percent and 7.6 percent relative to a year earlier. China’s GDP grew 1.6 percent in IQ2014, which annualizes to 6.6 percent, and 7.4 percent relative to a year earlier. China’s GDP grew 1.9 percent in IIQ2014, which annualizes at 7.8 percent, and 7.5 percent relative to a year earlier. China’s GDP grew 1.9 percent in IIIQ2014, which is equivalent to 7.8 percent in a year, and 7.3 percent relative to a year earlier. The GDP of China grew 1.5 percent in IVQ2014, which annualizes at 6.1 percent, and 7.3 percent relative to a year earlier. The GDP of China grew at 1.4 percent in IQ2015, which annualizes at 5.7 percent, and 7.0 percent relative to a year earlier. The GDP of China grew 1.7 percent in IIQ2015, which annualizes at 7.0 percent, and increased 7.0 percent relative to a year earlier. There is decennial change in leadership in China (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). (http://cmpassocregulationblog.blogspot.com/2015/07/valuation-of-risk-financial-assets.html and earlier (http://cmpassocregulationblog.blogspot.com/2015/04/imf-view-of-economy-and-finance-united.html and earlier http://cmpassocregulationblog.blogspot.com/2015/01/competitive-currency-conflicts-world.html and earlier http://cmpassocregulationblog.blogspot.com/2014/10/financial-oscillations-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html and earlier http://cmpassocregulationblog.blogspot.com/2014/04/imf-view-world-inflation-waves-squeeze.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/capital-flows-exchange-rates-and.html). There is also ongoing political development in China during a decennial political reorganization with new leadership (http://www.xinhuanet.com/english/special/18cpcnc/index.htm). Xinhuanet informs that Premier Wen Jiabao considers the need for macroeconomic stimulus, arguing that “we should continue to implement proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Premier Wen elaborates that “the country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations” (http://news.xinhuanet.com/english/china/2012-05/20/c_131599662.htm). Bob Davis, writing on “At China’s NPC, Proposed Changes,” on Mar 5, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304732804579420743344553328?KEYWORDS=%22china%22&mg=reno64-wsj), analyzes the wide ranging policy changes in the annual work report by Prime Minister Li Keqiang to China’s NPC (National People’s Congress of the People’s Republic of China http://www.npc.gov.cn/englishnpc/news/). There are about sixty different fiscal and regulatory measures.
United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 25.6 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically low hiring and declining/stagnating real wages. Actual GDP is about two trillion dollars lower than trend GDP.
Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.
World Inflation Waves. Inflation continues in repetitive waves globally (http://cmpassocregulationblog.blogspot.com/2015/09/interest-rate-increase-on-hold-because.html and earlier http://cmpassocregulationblog.blogspot.com/2015/08/global-decline-of-values-of-financial.html and earlier http://cmpassocregulationblog.blogspot.com/2015/07/fluctuating-risk-financial-assets.html and earlier http://cmpassocregulationblog.blogspot.com/2015/06/fluctuating-financial-asset-valuations.html and earlier http://cmpassocregulationblog.blogspot.com/2015/05/interest-rate-policy-and-dollar.html and earlier http://cmpassocregulationblog.blogspot.com/2015/04/global-portfolio-reallocations-squeeze.html and earlier http://cmpassocregulationblog.blogspot.com/2015/03/dollar-revaluation-and-financial-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2015/03/irrational-exuberance-mediocre-cyclical.html and earlier (http://cmpassocregulationblog.blogspot.com/2015/03/irrational-exuberance-mediocre-cyclical.html and earlier http://cmpassocregulationblog.blogspot.com/2015/01/competitive-currency-conflicts-world.html and earlier http://cmpassocregulationblog.blogspot.com/2014/12/patience-on-interest-rate-increases.html and earlier http://cmpassocregulationblog.blogspot.com/2014/11/squeeze-of-economic-activity-by-carry.html and earlier http://cmpassocregulationblog.blogspot.com/2014/09/world-inflation-waves-squeeze-of.html and earlier http://cmpassocregulationblog.blogspot.com/2014/08/monetary-policy-world-inflation-waves.html). There is growing concern on capital outflows and currency depreciation of emerging markets.

A list of financial uncertainties includes:

Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.
Competitive Devaluations. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies with alternating episodes of revaluation.
Valuation and Volatility of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with oscillating volumes. The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

“But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility…the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.”

Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.
Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20)
Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion mixed with reallocations of portfolios of risk financial assets

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

The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). Central bank commitment to maintain the fed funds rate at 1.00 percent induced adjustable-rate mortgages (ARMS) linked to the fed funds rate. Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment. The exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at interest rates close to zero, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV). The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper with the objective of purchasing default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever-increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity by the penalty in the form of low interest rates and unsound credit decisions. The put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VIII-1. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession.
On Dec 16, 2008, the policy determining committee of the Fed decided (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm): “The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.” Policymakers emphasize frequently that there are tools to exit unconventional monetary policy at the right time. At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states that: “The Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.” Perception of withdrawal of $2671 billion, or $2.7 trillion, of bank reserves (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1), would cause Himalayan increase in interest rates that would provoke another recession. There is no painless gradual or sudden exit from zero interest rates because reversal of exposures created on the commitment of zero interest rates forever.

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

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

Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and r^e the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+r^e). Thus, g = [(r/r^e) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dr^e>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Friedman 1957). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.

Dan Strumpf and Pedro Nicolaci da Costa, writing on “Fed’s Yellen: Stock Valuations ‘Generally are Quite High,’” on May 6, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-cites-progress-on-bank-regulation-1430918155?tesla=y ), quote Chair Yellen at open conversation with Christine Lagarde, Managing Director of the IMF, finding “equity-market valuations” as “quite high” with “potential dangers” in bond valuations. The DJIA fell 0.5 percent on May 6, 2015, after the comments and then increased 0.5 percent on May 7, 2015 and 1.5 percent on May 8, 2015.

Fri May 1

Mon 4

Tue 5

Wed 6

Thu 7

Fri 8

DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

There are two approaches in theory considered by Bordo (2012Nov20) and Bordo and Lane (2013). The first approach is in the classical works of Milton Friedman and Anna Jacobson Schwartz (1963a, 1987) and Karl Brunner and Allan H. Meltzer (1973). There is a similar approach in Tobin (1969). Friedman and Schwartz (1963a, 66) trace the effects of expansionary monetary policy into increasing initially financial asset prices: “It seems plausible that both nonbank and bank holders of redundant balances will turn first to securities comparable to those they have sold, say, fixed-interest coupon, low-risk obligations. But as they seek to purchase these they will tend to bid up the prices of those issues. Hence they, and also other holders not involved in the initial central bank open-market transactions, will look farther afield: the banks, to their loans; the nonbank holders, to other categories of securities-higher risk fixed-coupon obligations, equities, real property, and so forth.”

The second approach is by the Austrian School arguing that increases in asset prices can become bubbles if monetary policy allows their financing with bank credit. Professor Michael D. Bordo provides clear thought and empirical evidence on the role of “expansionary monetary policy” in inflating asset prices (Bordo2012Nov20, Bordo and Lane 2013). Bordo and Lane (2013) provide revealing narrative of historical episodes of expansionary monetary policy. Bordo and Lane (2013) conclude that policies of depressing interest rates below the target rate or growth of money above the target influences higher asset prices, using a panel of 18 OECD countries from 1920 to 2011. Bordo (2012Nov20) concludes: “that expansionary money is a significant trigger” and “central banks should follow stable monetary policies…based on well understood and credible monetary rules.” Taylor (2007, 2009) explains the housing boom and financial crisis in terms of expansionary monetary policy.

Another hurdle of exit from zero interest rates is “competitive easing” that Professor Raghuram Rajan, governor of the Reserve Bank of India, characterizes as disguised “competitive devaluation” (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). The fed has been considering increasing interest rates. The European Central Bank (ECB) announced, on Mar 5, 2015, the beginning on Mar 9, 2015 of its quantitative easing program denominated as Public Sector Purchase Program (PSPP), consisting of “combined monthly purchases of EUR 60 bn [billion] in public and private sector securities” (http://www.ecb.europa.eu/mopo/liq/html/pspp.en.html). Expectation of increasing interest rates in the US together with euro rates close to zero or negative cause revaluation of the dollar (or devaluation of the euro and of most currencies worldwide). US corporations suffer currency translation losses of their foreign transactions and investments (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) while the US becomes less competitive in world trade (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), Government Intervention in Globalization (2008c)). The DJIA fell 1.5 percent on Mar 6, 2015 and the dollar revalued 2.2 percent from Mar 5 to Mar 6, 2015. The euro has devalued 40.0 percent relative to the dollar from the high on Jul 15, 2008 to Oct 9, 2015.

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Chair Yellen explained the removal of the word “patience” from the advanced guidance at the press conference following the FOMC meeting on Mar 18, 2015 (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150318.pdf):

“In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient. Moreover, even after the initial increase in the target funds rate, our policy is likely to remain highly accommodative to support continued progress toward our objectives of maximum employment and 2 percent inflation.”

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

“For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term. After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain.”

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The Managing Director of the International Monetary Fund (IMF), Christine Lagarde, warned on Jun 4, 2015, that: (http://blog-imfdirect.imf.org/2015/06/04/u-s-economy-returning-to-growth-but-pockets-of-vulnerability/):

“The Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed. Nevertheless, regardless of the timing, higher US policy rates could still result in significant market volatility with financial stability consequences that go well beyond US borders. I weighing these risks, we think there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident. Even after the first rate increase, a gradual rise in the federal fund rates will likely be appropriate.”

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

“Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy. But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step. I currently anticipate that the appropriate pace of normalization will be gradual, and that monetary policy will need to be highly supportive of economic activity for quite some time. The projections of most of my FOMC colleagues indicate that they have similar expectations for the likely path of the federal funds rate. But, again, both the course of the economy and inflation are uncertain. If progress toward our employment and inflation goals is more rapid than expected, it may be appropriate to remove monetary policy accommodation more quickly. However, if progress toward our goals is slower than anticipated, then the Committee may move more slowly in normalizing policy.”

There is essentially the same view in the Testimony of Chair Yellen in delivering the Semiannual Monetary Policy Report to the Congress on Jul 15, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20150715a.htm).

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

“The outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets. Developments since our July meeting, including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads, have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Given the significant economic and financial interconnections between the United States and the rest of the world, the situation abroad bears close watching.”

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

10188.13

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. Chair Yellen, in a lecture on “Inflation dynamics and monetary policy,” on Sep 24, 2015 (http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm), states that (emphasis added):

“The economic outlook, of course, is highly uncertain”
“Considerable uncertainties also surround the outlook for economic activity”
“Given the highly uncertain nature of the outlook…”

Is there a “science” or even “art” of central banking under this extreme uncertainty in which policy does not generate higher volatility of money, income, prices and values of financial assets?

Chart VIII-1, Fed Funds Rate and Yields of Ten-year Treasury Constant Maturity and Baa Seasoned Corporate Bond, Jan 2, 2001 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

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

	Fed Funds Overnight Rate	10-Year Treasury Constant Maturity	Seasoned Baa Corporate Bond
1/2/2001	6.67	4.92	7.91
10/1/2002	1.85	3.72	7.46
7/3/2003	0.96	3.67	6.39
6/22/2004	1.00	4.72	6.77
6/28/2006	5.06	5.25	6.94
9/17/2008	2.80	3.41	7.25
10/26/2008	0.09	2.16	8.00
10/31/2008	0.22	4.01	9.54
4/6/2009	0.14	2.95	8.63
4/5/2010	0.20	4.01	6.44
2/4/2011	0.17	3.68	6.25
7/25/2012	0.15	1.43	4.73
5/1/13	0.14	1.66	4.48
9/5/13	0.089	2.98	5.53
11/21/2013	0.09	2.79	5.44
11/26/13	0.09	2.74	5.34 (11/26/13)
12/5/13	0.09	2.88	5.47
12/11/13	0.09	2.89	5.42
12/18/13	0.09	2.94	5.36
12/26/13	0.08	3.00	5.37
1/1/2014	0.08	3.00	5.34
1/8/2014	0.07	2.97	5.28
1/15/2014	0.07	2.86	5.18
1/22/2014	0.07	2.79	5.11
1/30/2014	0.07	2.72	5.08
2/6/2014	0.07	2.73	5.13
2/13/2014	0.06	2.73	5.12
2/20/14	0.07	2.76	5.15
2/27/14	0.07	2.65	5.01
3/6/14	0.08	2.74	5.11
3/13/14	0.08	2.66	5.05
3/20/14	0.08	2.79	5.13
3/27/14	0.08	2.69	4.95
4/3/14	0.08	2.80	5.04
4/10/14	0.08	2.65	4.89
4/17/14	0.09	2.73	4.89
4/24/14	0.10	2.70	4.84
5/1/14	0.09	2.63	4.77
5/8/14	0.08	2.61	4.79
5/15/14	0.09	2.50	4.72
5/22/14	0.09	2.56	4.81
5/29/14	0.09	2.45	4.69
6/05/14	0.09	2.59	4.83
6/12/14	0.09	2.58	4.79
6/19/14	0.10	2.64	4.83
6/26/14	0.10	2.53	4.71
7/2/14	0.10	2.64	4.84
7/10/14	0.09	2.55	4.75
7/17/14	0.09	2.47	4.69
7/24/14	0.09	2.52	4.72
7/31/14	0.08	2.58	4.75
8/7/14	0.09	2.43	4.71
8/14/14	0.09	2.40	4.69
8/21/14	0.09	2.41	4.69
8/28/14	0.09	2.34	4.57
9/04/14	0.09	2.45	4.70
9/11/14	0.09	2.54	4.79
9/18/14	0.09	2.63	4.91
9/25/14	0.09	2.52	4.79
10/02/14	0.09	2.44	4.76
10/09/14	0.08	2.34	4.68
10/16/14	0.09	2.17	4.64
10/23/14	0.09	2.29	4.71
11/13/14	0.09	2.35	4.82
11/20/14	0.10	2.34	4.86
11/26/14	0.10	2.24	4.73
12/04/14	0.12	2.25	4.78
12/11/14	0.12	2.19	4.72
12/18/14	0.13	2.22	4.78
12/23/14	0.13	2.26	4.79
12/30/14	0.06	2.20	4.69
1/8/15	0.12	2.03	4.57
1/15/15	0.12	1.77	4.42
1/22/15	0.12	1.90	4.49
1/29/15	0.11	1.77	4.35
2/05/15	0.12	1.83	4.43
2/12/15	0.12	1.99	4.53
2/19/15	0.12	2.11	4.64
2/26/15	0.11	2.03	4.47
3/5/215	0.11	2.11	4.58
3/12/15	0.11	2.10	4.56
3/19/15	0.12	1.98	4.48
3/26/15	0.11	2.01	4.56
4/03/15	0.12	1.92	4.47
4/9/15	0.12	1.97	4.50
4/16/15	0.13	1.90	4.45
4/23/15	0.13	1.96	4.50
5/1/15	0.08	2.05	4.65
5/7/15	0.13	2.18	4.82
5/14/15	0.13	2.23	4.97
5/21/15	0.12	2.19	4.94
5/28/15	0.12	2.13	4.88
6/04/15	0.13	2.31	5.03
6/11/15	0.13	2.39	5.10
6/18/15	0.14	2.35	5.17
6/25/15	0.13	2.40	5.20
7/1/15	0.13	2.43	5.26
7/9/15	0.13	2.32	5.20
7/16/15	0.14	2.36	5.24
7/23/15	0.13	2.28	5.13
7/30/15	0.14	2.28	5.16
8/06/15	0.14	2.23	5.15
8/20/15	0.15	2.09	5.13
8/27/15	0.14	2.18	5.33
9/03/15	0.14	2.18	5.35
9/10/15	0.14	2.23	5.35
9/17/15	0.14	2.21	5.39
9/25/15	0.14	2.13	5.29
10/01/15	0.13	2.05	5.36
10/08/15	0.13	2.12	5.40

Source: Board of Governors of the Federal Reserve System

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

Chart VIII-2 of the Board of Governors of the Federal Reserve System provides the rate of US dollars (USD) per euro (EUR), USD/EUR. The rate appreciated from USD 1.2670/EUR from Oct 2, 2014 to USD 1.1276/EUR on Oct 2, 2015 or 11.0 percent. The euro has devalued 40.0 percent relative to the dollar from the high on Jul 15, 2008 to Oct 9, 2015. US corporations with foreign transactions and net worth experience losses in their balance sheets in converting revenues from depreciated currencies to the dollar. Corporate profits with IVA and CCA fell at $123.0 billion in IQ2015 with decrease of domestic industries at $93.9 billion, mostly because of decline of nonfinancial business at $70.5 billion, and decrease of profits from operations in the rest of the world at $29.0 billion. Receipts from the rest of the world fell at $40.0 billion. Total corporate profits with IVA and CCA were $2012.5 billion in IQ2015 of which $1618.9 billion from domestic industries, or 80.4 percent of the total, and $393.6 billion, or 19.6 percent, from the rest of the world. Nonfinancial corporate profits of $1285.5 billion account for 62.5 percent of the total. There is partial recovery in IIQ2015 with growth of domestic industry corporate profits at $59.0 billion and increase of profits from the rest of the world at $11.4 billion. There is increase in corporate profits from devaluing the dollar with unconventional monetary policy of zero interest rates and decrease of corporate profits in revaluing the dollar with attempts at “normalization” or increases in interest rates. Conflicts arise while other central banks differ in their adjustment process.

Chart VIII-2, Exchange Rate of US Dollars (USD) per Euro (EUR), Oct 2, 2014 to Oct 2, 2015

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VIII-3 of the Board of Governors of the Federal Reserve System provides the yield of the 10-year Treasury constant maturity note from 2.22 percent on Jul 8, 2015 to 2.12 percent on Oct 8, 2015. There is turbulence in financial markets originating in a combination of intentions of normalizing or increasing US policy fed funds rate, quantitative easing in Europe and Japan and increasing perception of financial/economic risks.

Chart VIII-3, Yield of Ten-year Constant Maturity Treasury, Jul 8, 2015 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

The Communiqué of the Istanbul meeting of G20 Finance Ministers and Central Bank Governors on February 10, 2015, sanctions the need of unconventional monetary policy with warning on collateral effects (http://www.g20.utoronto.ca/2015/150210-finance.html):

“We agree that consistent with central banks' mandates, current economic conditions require accommodative monetary policies in some economies. In this regard, we welcome that central banks take appropriate monetary policy action. The recent policy decision by the ECB aims at fulfilling its price stability mandate, and will further support the recovery in the euro area. We also note that some advanced economies with stronger growth prospects are moving closer to conditions that would allow for policy normalization. In an environment of diverging monetary policy settings and rising financial market volatility, policy settings should be carefully calibrated and clearly communicated to minimize negative spillovers.”

In the Semiannual Monetary Policy Report to Congress on Feb 24, 2015, Chair Yellen analyzes the timing of interest rate increases (http://www.federalreserve.gov/newsevents/testimony/yellen20150224a.htm):

“The FOMC's assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting. Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.”

What is truly important is the fixing of the overnight fed funds at 0 to ¼ percent for which there is no end in sight as evident in the FOMC statement for Sep 17, 2015 (http://www.federalreserve.gov/newsevents/press/monetary/20150917a.htm): To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, 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 and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term“(emphasis added).The FOMC added “readings” of “international developments” after Jan 28, 2015.

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 the press conference following the meeting on Dec 17, 2014, Chair Yellen answered a question by Jon Hilseranth of the Wall Street Journal explaining “patience” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20141217.pdf):

“So I did say that this statement that the committee can be patient should be interpreted as meaning that it is unlikely to begin the normalization process, for at least the next couple of meetings. Now that doesn't point to any preset or predetermined time at which normalization is -- will begin. There are a range of views on the committee, and it will be dependent on how incoming data bears on the progress, the economy is making. First of all, I want to emphasize that no meeting is completely off the table in the sense that if we do see faster progress toward our objectives than we currently expect, then it is possible that the process of normalization would occur sooner than we now anticipated. And of course the converse is also true. So at this point, we think it unlikely that it will be appropriate, that we will see conditions for at least the next couple of meetings that will make it appropriate for us to decide to begin normalization. A number of committee participants have indicated that in their view, conditions could be appropriate by the middle of next year. But there is no preset time.”

The Swiss National Bank (SNB) announced on Jan 15, 2015, the termination of its peg of the exchange rate of the Swiss franc to the euro (http://www.snb.ch/en/mmr/speeches/id/ref_20150115_tjn/source/ref_20150115_tjn.en.pdf):

“The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it.”

The SNB also lowered interest rates to nominal negative percentages (http://www.snb.ch/en/mmr/speeches/id/ref_20150115_tjn/source/ref_20150115_tjn.en.pdf):

“At the same time as discontinuing the minimum exchange rate, the SNB will be lowering the interest rate for balances held on sight deposit accounts to –0.75% from 22 January. The exemption thresholds remain unchanged. Further lowering the interest rate makes Swiss-franc investments considerably less attractive and will mitigate the effects of the decision to discontinue the minimum exchange rate. The target range for the three-month Libor is being lowered by 0.5 percentage points to between –1.25% and –0.25%.”

The Swiss franc rate relative to the euro (CHF/EUR) appreciated 18.7 percent on Jan 15, 2015. The Swiss franc rate relative to the dollar (CHF/USD) appreciated 17.7 percent. Central banks are taking measures in anticipation of the quantitative easing by the European Central Bank.

On Jan 22, 2015, the European Central Bank (ECB) decided to implement an “expanded asset purchase program” with combined asset purchases of €60 billion per month “until at least Sep 2016 (http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html). The objective of the program is that (http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html):

“Asset purchases provide monetary stimulus to the economy in a context where key ECB interest rates are at their lower bound. They further ease monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.”

The President of the ECB, Mario Draghi, explains the coordination of asset purchases with NCBs (National Central Banks) of the euro area and risk sharing (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“In March 2015 the Eurosystem will start to purchase euro-denominated investment-grade securities issued by euro area governments and agencies and European institutions in the secondary market. The purchases of securities issued by euro area governments and agencies will be based on the Eurosystem NCBs’ shares in the ECB’s capital key. Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme. As regards the additional asset purchases, the Governing Council retains control over all the design features of the programme and the ECB will coordinate the purchases, thereby safeguarding the singleness of the Eurosystem’s monetary policy. The Eurosystem will make use of decentralised implementation to mobilise its resources. With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.”

The President of the ECB, Mario Draghi, rejected the possibility of seigniorage in the new asset purchase program, or central bank financing of fiscal expansion (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“As I just said, it would be a big mistake if countries were to consider that the presence of this programme might be an incentive to fiscal expansion. They would undermine the confidence, so it’s not directed to monetary financing at all. Actually, it’s been designed as to avoid any monetary financing.”

The President of the ECB, Mario Draghi, does not find effects of monetary policy in inflating asset prices (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

“On the first question, we monitor closely any potential instance of risk to financial stability. So we're very alert to that risk. So far we don't see bubbles. There may be some local episodes of certain specific markets where prices are going up fast. But to have a bubble, besides having that, one should also identify, detect an increase, dramatic increase in leverage or in bank credit, and we don't see that now. However, we, as I said, we are alert. If bubbles are of a local nature, they should be addressed by local instruments, namely macro-prudential instruments rather than by monetary policy.”

The DAX index of German equities increased 1.3 percent on Jan 22, 2015 and 2.1 percent on Jan 23, 2015. The euro depreciated from EUR 1.1611/USD (EUR 0.8613/USD) on Wed Jan 21, 2015, to EUR 1.1206/USD (EUR 0.8924/USD) on Fri Jan 23, 2015, or 3.6 percent. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. Risk aversion erodes devaluation of the dollar.

Fri May 1

Mon 4

Tue 5

Wed 6

Thu 7

Fri 8

DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

10188.13

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

· “The economic outlook, of course, is highly uncertain”

· “Considerable uncertainties also surround the outlook for economic activity”

· “Given the highly uncertain nature of the outlook…”

Chart S provides the yield of the two-year Treasury constant maturity from Mar 17, 2014, two days before the guidance of Chair Yellen on Mar 19, 2014, to Oct 8, 2015. Chart SA provides the yields of the seven-, ten- and thirty-year Treasury constant maturity in the same dates. Yields increased right after the guidance of Chair Yellen. The two-year yield remain at a higher level than before while the ten-year yield fell and increased again. There could be more immediate impact on two-year yields of an increase in the fed funds rates but the effects would spread throughout the term structure of interest rates (Cox, Ingersoll and Ross 1981, 1985, Ingersoll 1987). Yields converged toward slightly lower earier levels in the week of Apr 24, 2014 with reallocation of portfolios of risk financial assets away from equities and into bonds and commodities. There is ongoing reshuffling of portfolios to hedge against geopolitical events and world/regional economic performance.

Chart S, US, Yield of Two-Year Treasury Constant Maturity, Mar 17, 2014 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

Chart SA, US, Yield of Seven-Year, Ten-Year and Thirty-Year Treasury Constant Maturity, Mar 17, 2014 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table VIII-1 provides inflation of the CPI. In the three months from Jun 2015 to Aug 2015, CPI inflation for all items seasonally adjusted was 1.2 percent in annual equivalent, obtained by calculating accumulated inflation from Jun 2015 to Aug 2015 and compounding for a full year. In the 12 months ending in Aug 2015, CPI inflation of all items not seasonally adjusted was 0.2 percent. Inflation in Aug 2015 seasonally adjusted was minus 0.1 percent relative to Jul 2015, or minus 1.2 percent annual equivalent (http://www.bls.gov/cpi/). The second row provides the same measurements for the CPI of all items excluding food and energy: 1.8 percent in 12 months, 1.6 percent in annual equivalent Jun 2015-Aug 2015 and 0.1 percent in Aug 2015 or 1.2 percent in annual equivalent. The Wall Street Journal provides the yield curve of US Treasury securities (http://professional.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3000). The shortest term is 0.005 percent for one month, 0.013 percent for three months, 0.081 percent for six months, 0.257 percent for one year, 0.641 percent for two years, 0.854 percent for three years, 1.403 percent for five years, 1.778 percent for seven years, 2.089 percent for ten years and 2.920 percent for 30 years. The Irving Fisher (1930) definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by the Wall Street Journal, and the rate of inflation expected in the term of the security, which could behave as in Table VIII-1. Inflation in Aug 2015 is low in 12 months because of the unwinding of carry trades from zero interest rates to commodity futures prices but could ignite again with subdued risk aversion. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

Negative real rates of interest distort calculations of risk and returns from capital budgeting by firms, through lending by financial intermediaries to decisions on savings, housing and purchases of households. Inflation on near zero interest rates misallocates resources away from their most productive uses and creates uncertainty of the future path of adjustment to higher interest rates that inhibit sound decisions.

Table VIII-1, US, Consumer Price Index Percentage Change 12 Months NSA and Annual Equivalent

	∆% 12 Months Aug 2015/Aug 2014 NSA	∆% Annual Equivalent Jun 2015 to Aug 2015 SA	∆% Aug 2015/Jul 2015 SA
CPI All Items	0.2	1.2	-0.1
CPI ex Food and Energy	1.8	1.6	0.1

Source: Bureau of Labor Statistics

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

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

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

Analysis of these methods is in Pelaez and Pelaez (International Financial Architecture (2005), 101-162) and Pelaez and Pelaez, Globalization and the State, Vol. (I) (2008a), 78-100). Frederick R. Macaulay (1938) introduced the concept of duration in contrast with maturity for analyzing bonds. Duration is the sensitivity of bond prices to changes in yields. In economic jargon, duration is the yield elasticity of bond price to changes in yield, or the percentage change in price after a percentage change in yield, typically expressed as the change in price resulting from change of 100 basis points in yield. The mathematical formula is the negative of the yield elasticity of the bond price or –[dB/d(1+y)]((1+y)/B), where d is the derivative operator of calculus, B the bond price, y the yield and the elasticity does not have dimension (Hallerbach 2001). The duration trap of unconventional monetary policy is that duration is higher the lower the coupon and higher the lower the yield, other things being constant. Coupons and yields are historically low because of unconventional monetary policy. Duration dumping during a rate increase may trigger the same crossfire selling of high duration positions that magnified the credit crisis. Traders reduced positions because capital losses in one segment, such as mortgage-backed securities, triggered haircuts and margin increases that reduced capital available for positioning in all segments, causing fire sales in multiple segments (Brunnermeier and Pedersen 2009; see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 217-24). Financial markets are currently experiencing fear of duration and riskier asset classes resulting from the debate within and outside the Fed on tapering quantitative easing. Table VIII-2 provides the yield curve of Treasury securities on Oct 9, 2015, Dec 31, 2013, May 1, 2013, Oct 9, 2014 and Oct 10, 2006. There is oscillating steepening of the yield curve for longer maturities, which are also the ones with highest duration. The 10-year yield increased from 1.45 percent on Jul 26, 2012 to 3.04 percent on Dec 31, 2013 and 2.12 percent on Oct 9, 2015, as measured by the United States Treasury. Assume that a bond with maturity in 10 years were issued on Dec 31, 2013, at par or price of 100 with coupon of 1.45 percent. The price of that bond would be 86.3778 with instantaneous increase of the yield to 3.04 percent for loss of 13.6 percent and far more with leverage. Assume that the yield of a bond with exactly ten years to maturity and coupon of 2.12 percent would jump instantaneously from yield of 2.12 percent on Oct 9, 2015 to 4.75 percent as occurred on Oct 10, 2006 when the economy was closer to full employment. The price of the hypothetical bond issued with coupon of 2.12 percent would drop from 100 to 79.2561 after an instantaneous increase of the yield to 4.75 percent. The price loss would be 20.7 percent. Losses absorb capital available for positioning, triggering crossfire sales in multiple asset classes (Brunnermeier and Pedersen 2009). What is the path of adjustment of zero interest rates on fed funds and artificially low bond yields? There is no painless exit from unconventional monetary policy. Chris Dieterich, writing on “Bond investors turn to cash,” on Jul 25, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323971204578625900935618178.html), uses data of the Investment Company Institute (http://www.ici.org/) in showing withdrawals of $43 billion in taxable mutual funds in Jun, which is the largest in history, with flows into cash investments such as $8.5 billion in the week of Jul 17 into money-market funds.

Table VIII-2, United States, Treasury Yields

	10/9/15	12/31/13	5/01/13	10/09/14	10/10/06
1 M	0.01	0.01	0.03	0.02	4.81
3 M	0.01	0.07	0.06	0.01	5.00
6 M	0.07	0.10	0.08	0.05	5.10
1 Y	0.28	0.13	0.11	0.10	5.00
2 Y	0.65	0.38	0.20	0.46	4.82
3 Y	0.96	0.78	0.30	0.91	4.75
5 Y	1.41	1.75	0.65	1.58	4.71
7 Y	1.80	2.45	1.07	2.02	4.71
10 Y	2.12	3.04	1.66	2.34	4.75
20 Y	2.55	3.72	2.44	2.81	4.96
30 Y	2.94	3.96	2.83	3.07	4.88

M: Months; Y: Years

Source: United States Treasury

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

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.”

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart VI-1B for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart VI-1B cannot be explained without taking into account the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s. The loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

The reading of the Phillips circuits of the 1970s by Cochrane (2011Jan, 25) is doubtful about the output gap and inflation expectations:

“So, inflation is caused by ‘tightness’ and deflation by ‘slack’ in the economy. This is not just a cause and forecasting variable, it is the cause, because given ‘slack’ we apparently do not have to worry about inflation from other sources, notwithstanding the weak correlation of [Phillips circuits]. These statements [by the Fed] do mention ‘stable inflation expectations. How does the Fed know expectations are ‘stable’ and would not come unglued once people look at deficit numbers? As I read Fed statements, almost all confidence in ‘stable’ or ‘anchored’ expectations comes from the fact that we have experienced a long period of low inflation (adaptive expectations). All these analyses ignore the stagflation experience in the 1970s, in which inflation was high even with ‘slack’ markets and little ‘demand, and ‘expectations’ moved quickly. They ignore the experience of hyperinflations and currency collapses, which happen in economies well below potential.”

Yellen (2014Aug22) states that “Historically, slack has accounted for only a small portion of the fluctuations in inflation. Indeed, unusual aspects of the current recovery may have shifted the lead-lag relationship between a tightening labor market and rising inflation pressures in either direction.”

Chart VI-1B provides the tortuous Phillips Circuit of Brazil from 1963 to 1987. There were no reliable consumer price index and unemployment data in Brazil for that period. Chart VI-1B used the more reliable indicator of inflation, the wholesale price index, and idle capacity of manufacturing as a proxy of unemployment in large urban centers.

ChVI1-B, Brazil, Phillips Circuit, 1963-1987

Source:

©Carlos Manuel Pelaez, O Cruzado e o Austral: Análise das Reformas Monetárias do Brasil e da Argentina. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

The minutes of the meeting of the Federal Open Market Committee (FOMC) on Sep 16-17, 2014, reveal concern with global economic conditions (http://www.federalreserve.gov/monetarypolicy/fomcminutes20140917.htm):

“Most viewed the risks to the outlook for economic activity and the labor market as broadly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they expected if foreign economic growth came in weaker than anticipated, structural productivity continued to increase only slowly, or the recovery in residential construction continued to lag.”

There is similar concern in the minutes of the meeting of the FOMC on Dec 16-17, 2014 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20141217.htm):

“In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.”

Interest rate risk is increasing in the US with amplifying fluctuations. Chart VI-13 of the Board of Governors provides the conventional mortgage rate for a fixed-rate 30-year mortgage. The rate stood at 5.87 percent on Jan 8, 2004, increasing to 6.79 percent on Jul 6, 2006. The rate bottomed at 3.35 percent on May 2, 2013. Fear of duration risk in longer maturities such as mortgage-backed securities caused continuing increases in the conventional mortgage rate that rose to 4.51 percent on Jul 11, 2013, 4.58 percent on Aug 22, 2013 and 3.76 percent on Oct 8, 2015, which is the last data point in Chart VI-13. The current decline of yields is encouraging a surge in mortgage applications that could be reversed in a new increase. Shayndi Raice and Nick Timiraos, writing on “Banks cut as mortgage boom ends,” on Jan 9, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303754404579310940019239208), analyze the drop in mortgage applications to a 13-year low, as measured by the Mortgage Bankers Association. Nick Timiraos, writing on “Demand for home loans plunges,” on Apr 24, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304788404579522051733228402?mg=reno64-wsj), analyzes data in Inside Mortgage Finance that mortgage lending of $235 billion in IQ2014 is 58 percent lower than a year earlier and 23 percent below IVQ2013. Mortgage lending collapsed to the lowest level in 14 years. In testimony before the Committee on the Budget of the US Senate on May 8, 2004, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm): “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.”

Chart VI-13, US, Conventional Mortgage Rate, Jan 8, 2004 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table VI-7G when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table VI-7G shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. 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). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table VI-7G, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

1994	FF	30Y	30P	10Y	10P	MOR	CPI
Jan	3.00	6.29	100	5.75	100	7.06	2.52
Feb	3.25	6.49	97.37	5.97	98.36	7.15	2.51
Mar	3.50	6.91	92.19	6.48	94.69	7.68	2.51
Apr	3.75	7.27	88.10	6.97	91.32	8.32	2.36
May	4.25	7.41	86.59	7.18	88.93	8.60	2.29
Jun	4.25	7.40	86.69	7.10	90.45	8.40	2.49
Jul	4.25	7.58	84.81	7.30	89.14	8.61	2.77
Aug	4.75	7.49	85.74	7.24	89.53	8.51	2.69
Sep	4.75	7.71	83.49	7.46	88.10	8.64	2.96
Oct	4.75	7.94	81.23	7.74	86.33	8.93	2.61
Nov	5.50	8.08	79.90	7.96	84.96	9.17	2.67
Dec	6.00	7.87	81.91	7.81	85.89	9.20	2.67

Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months

Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.t

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

Table VI-2 provides the Euro/Dollar (EUR/USD) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table VI-4 below, the dollar has revalued to USD 1.1359 EUR on Oct 9, 2015 or by 4.7 percent {[(1.1359/1.192)-1]100 = -4.7%}. Yellen (2011AS, 6) admits that Fed monetary policy results in dollar devaluation with the objective of increasing net exports, which was the policy that Joan Robinson (1947) labeled as “beggar-my-neighbor” remedies for unemployment. Risk aversion erodes devaluation of the dollar. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD subsequently revaluing to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent. After fixing again the CNY to the dollar, China revalued to CNY 6.3447/USD on Fri Oct 9, 2015, or by an additional 7.0 percent, for cumulative revaluation of 23.3 percent. The final row of Table VI-2 shows: revaluation of 0.1 percent in the week of Sep 18, 2015; devaluation of 0.2 percent in the week of Sep 25, 2015; revaluation of 0.3 percent in the week of Oct 2, 2015; and revaluation of 0.2 percent in the week of Oct 9. There could be reversal of revaluation to devalue the Yuan.

Table VI-2, Dollar/Euro (USD/EUR) Exchange Rate and Chinese Yuan/Dollar (CNY/USD) Exchange Rate

USD/EUR	12/26/03	7/14/08	6/07/10	10/09/15
Rate	1.1423	1.5914	1.192	1.1359
CNY/USD	01/03 2000	07/21 2005	7/15 2008	10/09/ 2015
Rate	8.2765	8.2765	6.8211	6.3447
Weekly Rates	9/18/2015	9/25/2015	10/02/2015	10/09/ 2015
CNY/USD	6.3639	6.3754	6.3552	6.3447
∆% from Earlier Week*	0.1	-0.2	0.3	0.2

*Negative sign is depreciation; positive sign is appreciation

Source: http://professional.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

Professor Edward P Lazear (2013Jan7), writing on “Chinese ‘currency manipulation’ is not the problem,” on Jan 7, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323320404578213203581231448.html), provides clear thought on the role of the yuan in trade between China and the United States and trade between China and Europe. There is conventional wisdom that Chinese exchange rate policy causes the loss of manufacturing jobs in the United States, which is shown by Lazear (2013Jan7) to be erroneous. The fact is that manipulation of the CNY/USD rate by China has only minor effects on US employment. Lazear (2013Jan7) shows that the movement of monthly exports of China to its major trading partners, United States and Europe, since 1995 cannot be explained by the fixing of the CNY/USD rate by China. The period is quite useful because it includes rapid growth before 2007, contraction until 2009 and weak subsequent expansion. Chart VI-1 of the Board of Governors of the Federal Reserve System provides the CNY/USD exchange rate from Jan 3, 1995 to Oct 2, 2015 together with US recession dates in shaded areas. China fixed the CNY/USD rate for a long period as shown in the horizontal segment from 1995 to 2005. There was systematic revaluation of 17.6 percent from CNY 8.2765 on Jul 21, 2005 to CNY 6.8211 on Jul 15, 2008. China fixed the CNY/USD rate until Jun 7, 2010, to avoid adverse effects on its economy from the global recession, which is shown as a horizontal segment from 2009 until mid 2010. China then continued the policy of appreciation of the CNY relative to the USD with oscillations until the beginning of 2012 when the rate began to move sideways followed by a final upward slope of devaluation that is measured in Table VI-2A but virtually disappeared in the rate of CNY 6.3589/USD on Aug 17, 2012 and was nearly unchanged at CNY 6.3558/USD on Aug 24, 2012. China then appreciated 0.2 percent in the week of Dec 21, 2012, to CNY 6.2352/USD for cumulative 1.9 percent revaluation from Oct 28, 2011 and left the rate virtually unchanged at CNY 6.2316/USD on Jan 11, 2013, appreciating to CNY 6.3559/USD on Oct 2, 2015, which is the last data point in Chart VI-1. Revaluation of the CNY relative to the USD by 23.3 percent by Oct 9, 2015 has not reduced the trade surplus of China but reversal of the policy of revaluation could result in international confrontation. The interruption with upward slope in the final segment on the right of Chart VI-I is measured as virtually stability in Table VI-2A followed with decrease or revaluation and subsequent increase or devaluation. The final segment shows decline or revaluation with another upward move or devaluation. Linglin Wei, writing on “China intervenes to lower yuan,” on Feb 26, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304071004579406810684766716?KEYWORDS=china+yuan&mg=reno64-wsj), finds from informed sources that the central bank of China conducted the ongoing devaluation of the yuan with the objective of driving out arbitrageurs to widen the band of fluctuation. There is concern if the policy of revaluation is changing to devaluation.

Chart VI-1, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 3, 1995-Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1A provides the daily CNY/USD rate from Jan 5, 1981 to Oct 2, 2015. The exchange rate was CNY 1.5418/USD on Jan 5, 1981. There is sharp cumulative depreciation of 107.8 percent to CNY 3.2031 by Jul 2, 1986, continuing to CNY 5.8145/USD on Dec 29, 1993 for cumulative 277.1 percent since Jan 5, 1981. China then devalued sharply to CNY 8.7117/USD on Jan 7, 1994 for 49.8 percent relative to Dec 29, 1993 and cumulative 465.0 percent relative to Jan 5, 1981. China then fixed the rate at CNY 8.2765/USD until Jul 21, 2005 and revalued as analyzed in Chart VI-1. The final data point in Chart VI-1A is CNY 6.3559/USD on Oct 2, 2015. To be sure, China fixed the exchange rate after substantial prior devaluation. It is unlikely that the devaluation could have been effective after many years of fixing the exchange rate with high inflation and multiple changes in the world economy. The argument of Lazear (2013Jan7) is still valid in view of the lack of association between monthly exports of China to the US and Europe since 1995 and the exchange rate of China.

Chart VI-1A, Chinese Yuan (CNY) per US Dollar (USD), Business Days, Jan 5, 1981-Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-1B provides finer details with the rate of Chinese Yuan (CNY) to the US Dollar (USD) from Oct 28, 2011 to Sep 4, 2015. There have been alternations of revaluation and devaluation. The initial data point is CNY 6.5370 on Oct 28, 2011. There is an episode of devaluation from CNY 6.2790 on Apr 30, 2012 to CNY 6.3879 on Jul 25, 2012, or devaluation of 1.4 percent. Another devaluation is from CNY 6.0402/USD on Jan 21, 2014 to CNY 6.3559/USD on Oct 2, 2015, or devaluation of 5.2 percent.

The United States Treasury estimates US government debt held by private investors at $10,238 billion in Jun 2015. China’s holding of US Treasury securities represent 12.1 percent of US government marketable interest-bearing debt held by private investors (http://www.fms.treas.gov/bulletin/index.html). Min Zeng, writing on “China plays a big role as US Treasury yields fall,” on Jul 16, 2004, published in the Wall Street Journal (http://online.wsj.com/articles/china-plays-a-big-role-as-u-s-treasury-yields-fall-1405545034?tesla=y&mg=reno64-wsj), finds that acceleration in purchases of US Treasury securities by China has been an important factor in the decline of Treasury yields in 2014. Japan decreased its holdings from $1219.0 billion in Jul 2014 to $1197.5 billion in Jul 2015 or 1.8 percent. The combined holdings of China and Japan in Jul 2015 add to $2438.3 billion, which is equivalent to 23.8 percent of US government marketable interest-bearing securities held by investors of $10,238 billion in Jun 2015 (http://www.fms.treas.gov/bulletin/index.html). Total foreign holdings of Treasury securities rose from $6002.6 billion in Jul 2014 to $6076.6 billion in Jul 2015, or 1.2 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):

“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.”

Chart VI-1B, Chinese Yuan (CNY) per US Dollar (US), Business Days, Oct 28, 2011-Oct 2, 2015

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

There are major ongoing and unresolved realignments of exchange rates in the international financial system as countries and regions seek parities that can optimize their productive structures. Seeking exchange rate parity or exchange rate optimizing internal economic activities is complex in a world of unconventional monetary policy of zero interest rates and even negative nominal interest rates of government obligations such as negative yields for the two-year government bond of Germany. Regulation, trade and devaluation conflicts should have been expected from a global recession (Pelaez and Pelaez (2007), The Global Recession Risk, Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008a)): “There are significant grounds for concern on the basis of this experience. International economic cooperation and the international financial framework can collapse during extreme events. It is unlikely that there will be a repetition of the disaster of the Great Depression. However, a milder contraction can trigger regulatory, trade and exchange wars” (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 181). Chart VI-2 of the Board of Governors of the Federal Reserve System provides the key exchange rate of US dollars (USD) per euro (EUR) from Jan 4, 1999 to Oct 2, 2015. US recession dates are in shaded areas. The rate on Jan 4, 1999 was USD 1.1812/EUR, declining to USD 0.8279/EUR on Oct 25, 2000, or appreciation of the USD by 29.9 percent. The rate depreciated 21.9 percent to USD 1.0098/EUR on Jul 22, 2002. There was sharp devaluation of the USD of 34.9 percent to USD 1.3625/EUR on Dec 27, 2004 largely because of the 1 percent interest rate between Jun 2003 and Jun 2004 together with a form of quantitative easing by suspension of auctions of the 30-year Treasury, which was equivalent to withdrawing supply from markets. Another depreciation of 17.5 percent took the rate to USD 1.6010/EUR on Apr 22, 2008, already inside the shaded area of the global recession. The flight to the USD and obligations of the US Treasury appreciated the dollar by 22.3 percent to USD 1.2446/EUR on Oct 27, 2008. In the return of the carry trade after stress tests showed sound US bank balance sheets, the rate depreciated 21.2 percent to USD 1.5085/EUR on Nov 25, 2009. The sovereign debt crisis of Europe in the spring of 2010 caused sharp appreciation of 20.7 percent to USD 1.1959/EUR on Jun 6, 2010. Renewed risk appetite depreciated the rate 24.4 percent to USD 1.4875/EUR on May 3, 2011. The rate appreciated 5.7 percent to USD 1.1276/EUR on Oct 2, 2015, which is the last point in Chart VI-2. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-2, US Dollars (USD) per Euro (EUR), Jan 4, 1999 to Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3 provides three indexes of the US Dollars (USD) from Jan 4, 1995 to Oct 2, 2015.

Chart VI-3A provides the overnight fed funds rate and yields of the three-month constant maturity Treasury bill, the ten-year constant maturity Treasury note and Moody’s Baa bond from Jan 4, 1995 to Oct 8, 2015. The first phase from 1995 to 2001 shows sharp trend of appreciation of the USD while interest rates remained at relatively high levels. The dollar revalued partly because of the emerging market crises that provoked inflows of financial investment into the US and partly because of a deliberate strong dollar policy. DeLong and Eichengreen (2001, 4-5) argue:

“That context was an economic and political strategy that emphasized private investment as the engine for U.S. economic growth. Both components of this term, "private" and "investment," had implications for the administration’s international economic strategy. From the point of view of investment, it was important that international events not pressure on the Federal Reserve to raise interest rates, since this would have curtailed capital formation and vitiated the effects of the administration’s signature achievement: deficit reduction. A strong dollar -- or rather a dollar that was not expected to weaken -- was a key component of a policy which aimed at keeping the Fed comfortable with low interest rates. In addition, it was important to create a demand for the goods and services generated by this additional productive capacity. To the extent that this demand resided abroad, administration officials saw it as important that the process of increasing international integration, of both trade and finance, move forward for the interest of economic development in emerging markets and therefore in support of U.S. economic growth.”

The process of integration consisted of restructuring “international financial architecture” (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Debtors and Creditors (2005)). Policy concerns subsequently shifted to the external imbalances, or current account deficits, and internal imbalances, or government deficits (Pelaez and Pelaez, The Global Recession Risk: Dollar Devaluation and the World Economy (2007)). Fed policy consisted of lowering the policy rate or fed funds rate, which is close to the marginal cost of funding of banks, toward zero during the past decade. Near zero interest rates induce carry trades of selling dollar debt (borrowing), shorting the USD and investing in risk financial assets. Without risk aversion, near zero interest rates cause devaluation of the dollar. Chart VI-3 shows the weakening USD between the recession of 2001 and the contraction after IVQ2007. There was a flight to dollar assets and especially obligations of the US government after Sep 2008. Cochrane and Zingales (2009) show that flight was coincident with proposals of TARP (Troubled Asset Relief Program) to withdraw “toxic assets” in US banks (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a) and Regulation of Banks and Finance (2009b)). There are shocks to globalization in the form of regulation, trade and devaluation wars and breakdown of international cooperation (Pelaez and Pelaez, Globalization and the State: Vol. I (2008a), Globalization and the State: Vol. II (2008b) and Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c)). As evident in Chart VI-3A, there is no exit from near zero interest rates without a financial crisis and economic contraction, verified by the increase of interest rates from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. The Federal Open Market Committee (FOMC) lowered the target of the fed funds rate from 7.03 percent on Jul 3, 2000, to 1.00 percent on Jun 22, 2004, in pursuit of non-existing deflation (Pelaez and Pelaez, International Financial Architecture (2005), 18-28, The Global Recession Risk (2007), 83-85). The FOMC implemented increments of 25 basis points of the fed funds target from Jun 2004 to Jun 2006, raising the fed funds rate to 5.25 percent on Jul 3, 2006, as shown in Chart VI-3A. The gradual exit from the first round of unconventional monetary policy from 1.00 percent in Jun 2004 (http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm) to 5.25 percent in Jun 2006 (http://www.federalreserve.gov/newsevents/press/monetary/20060629a.htm) caused the financial crisis and global recession. There are conflicts on exchange rate movements among central banks. There is concern of declining inflation in the euro area and appreciation of the euro. 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). At the press conference following the meeting of the ECB on Jul 3, 2014, Mario Draghi stated (http://www.ecb.europa.eu/press/pressconf/2014/html/is140703.en.html): “In fact, as I said, interest rates will stay low for an extended period of time, and the Governing Council is unanimous in its commitment to use also nonstandard, unconventional measures to cope with the risk of a too-prolonged period of time of low inflation.”

The President of the ECB Mario Draghi analyzed unemployment in the euro area and the policy response policy in a speech at the Jackson Hole meeting of central bankers on Aug 22, 2014 (http://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html):

“We have already seen exchange rate movements that should support both aggregate demand and inflation, which we expect to be sustained by the diverging expected paths of policy in the US and the euro area (Figure 7). We will launch our first Targeted Long-Term Refinancing Operation in September, which has so far garnered significant interest from banks. And our preparation for outright purchases in asset-backed security (ABS) markets is fast moving forward and we expect that it should contribute to further credit easing. Indeed, such outright purchases would meaningfully contribute to diversifying the channels for us to generate liquidity.”

On Sep 4, 2014, the European Central Bank lowered policy rates (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140904.en.html):

“4 September 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 0.05%, starting from the operation to be settled on 10 September 2014.
The interest rate on the marginal lending facility will be decreased by 10 basis points to 0.30%, with effect from 10 September 2014.
The interest rate on the deposit facility will be decreased by 10 basis points to -0.20%, with effect from 10 September 2014.”

The President of the European Central Bank announced on Sep 4, 2014, the decision to expand the balance sheet by purchases of asset-backed securities (ABS) in a new ABS Purchase Program (ABSPP) and covered bonds (http://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html):

“Based on our regular economic and monetary analyses, the Governing Council decided today to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.05% and the rate on the marginal lending facility by 10 basis points to 0.30%. The rate on the deposit facility was lowered by 10 basis points to -0.20%. In addition, the Governing Council decided to start purchasing non-financial private sector assets. The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme (CBPP3). Interventions under these programmes will start in October 2014. The detailed modalities of these programmes will be announced after the Governing Council meeting of 2 October 2014. The newly decided measures, together with the targeted longer-term refinancing operations which will be conducted in two weeks, will have a sizeable impact on our balance sheet.”

At the Thirtieth Meeting of the International Monetary and Financial Committee of the IMF (IMFC), the President of the European Central Bank (ECB), Mario Draghi stated (http://www.ecb.europa.eu/press/key/date/2014/html/sp141010.en.html):

“Our monetary policy continues to aim at firmly anchoring medium to long-term inflation expectations, in line with our objective of maintaining inflation rates below, but close to, 2% over the medium term. In this context, we have taken both conventional and unconventional measures that will contribute to a return of inflation rates to levels closer to our aim. Our unconventional measures, more specifically our TLTROs (Targeted Longer-Term Refinancing Operations) and our new purchase programmes for ABSs and covered bonds, will further enhance the functioning of our monetary policy transmission mechanism and facilitate credit provision to the real economy. Should it become necessary to further address risks of too prolonged a period of low inflation, the ECB’s Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate.”

In a speech on “Monetary Policy in the Euro Area,” on Nov 21, 2014, the President of the European Central Bank, Mario Draghi, advised of the determination to bring inflation back to normal levels by aggressive holding of securities in the balance sheet (http://www.ecb.europa.eu/press/key/date/2014/html/sp141121.en.html):

“In short, there is a combination of policies that will work to bring growth and inflation back on a sound path, and we all have to meet our responsibilities in achieving that. For our part, we will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us.

If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.”

In the Introductory Statement to the press conference on Dec 4, 2014, the President of the European Central Bank Mario Draghi advised that (http://www.ecb.europa.eu/press/pressconf/2014/html/is141204.en.html):

“In this context, early next year the Governing Council will reassess the monetary stimulus achieved, the expansion of the balance sheet and the outlook for price developments. We will also evaluate the broader impact of recent oil price developments on medium-term inflation trends in the euro area. Should it become necessary to further address risks of too prolonged a period of low inflation, the Governing Council remains unanimous in its commitment to using additional unconventional instruments within its mandate. This would imply altering early next year the size, pace and composition of our measures.”

“The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate of

CHF 1.20 per euro with immediate effect and to cease foreign currency purchases associated with enforcing it.”

The SNB also lowered interest rates to nominal negative percentages (http://www.snb.ch/en/mmr/speeches/id/ref_20150115_tjn/source/ref_20150115_tjn.en.pdf):

The President of the ECB, Mario Draghi, does not find effects of monetary policy in inflating asset prices (http://www.ecb.europa.eu/press/pressconf/2015/html/is150122.en.html):

Fri May 1

Mon 4

Tue 5

Wed 6

Thu 7

Fri 8

DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

10188.13

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

· “The economic outlook, of course, is highly uncertain”

· “Considerable uncertainties also surround the outlook for economic activity”

· “Given the highly uncertain nature of the outlook…”

Chart VI-3, US Dollar Currency Indexes, Jan 4, 1995-Oct 2, 2015

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-3A, US, Overnight Fed Funds Rate, Yield of Three-Month Treasury Constant Maturity, Yield of Ten-Year Treasury Constant Maturity and Yield of Moody’s Baa Bond, Jan 4, 1995 to Oct 8, 2015

Source: Board of Governors of the Federal Reserve System

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

Carry trades induced by zero interest rates increase capital flows into emerging markets that appreciate exchange rates. Portfolio reallocations away from emerging markets depreciate their exchange rates in reversals of capital flows. Chart VI-4A provides the exchange rate of the Mexican peso (MXN) per US dollar from Nov 8, 1993 to Oct 2, 2015. The first data point in Chart VI-4A is MXN 3.1520 on Nov 8, 1993. The rate devalued to 11.9760 on Nov 14, 1995 during emerging market crises in the 1990s and the increase of interest rates in the US in 1994 that stressed world financial markets (Pelaez and Pelaez, International Financial Architecture 2005, The Global Recession Risk 2007, 147-77). The MXN depreciated sharply to MXN 15.4060/USD on Mar 2, 2009, during the global recession. The rate moved to MXN 11.5050/USD on May 2, 2011, during the sovereign debt crisis in the euro area. The rate depreciated to 11.9760 on May 9, 2013. The final data point is MXN 16.8115/USD on Oct 2, 2015.

Chart VI-4A, Mexican Peso (MXN) per US Dollar (USD), Nov 8, 1993 to Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

There are collateral effects worldwide from unconventional monetary policy. 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. Professor Willem Buiter (2014Feb4), a distinguished economist currently Global Chief Economist at Citigroup (http://www.willembuiter.com/resume.pdf), writing on “The Fed’s bad manners risk offending foreigners,” on Feb 4, 2014, published in the Financial Times (http://www.ft.com/intl/cms/s/0/fbb09572-8d8d-11e3-9dbb-00144feab7de.html#axzz2suwrwkFs), concurs with Raghuram Rajan. Buiter (2014Feb4) argues that international policy cooperation in monetary policy is both in the interest of the world and the United States. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows. In a speech at the Brookings Institution on Apr 10, 2014, Raghuram G. Rajan (2014Apr10, 1, 10) argues:

“As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.”

Chart VI-4B provides the rate of the Indian rupee (INR) per US dollar (USD) from Jan 2, 1973 to Oct 2, 2015. The first data point is INR 8.0200 on Jan 2, 1973. The rate depreciated sharply to INR 51.9600 on Mar 3, 2009, during the global recession. The rate appreciated to INR 44.0300/USD on Jul 28, 2011 in the midst of the sovereign debt event in the euro area. The rate overshot to INR 68.8000 on Aug 28, 2013. The final data point is INR 65.3500/USD on Oct 2, 2015.

Chart VI-4B, Indian Rupee (INR) per US Dollar (USD), Jan 2, 1973 to Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-5 provides the exchange rate of JPY (Japan yen) per USD (US dollars). The first data point on the extreme left is JPY 357.7300/USD for Jan 4, 1971. The JPY has appreciated over the long term relative to the USD with fluctuations along an evident long-term appreciation. Before the global recession, the JPY stood at JPY 124.0900/USD on Jun 22, 2007. The use of the JPY as safe haven is evident by sharp appreciation during the global recession to JPY 110.48/USD on Aug 15, 2008, and to JPY 87.8000/USD on Jan 21, 2009. The final data point in Chart VI-5 is JPY 119.4200/USD on Oct 2, 2015 for appreciation of 3.8 percent relative to JPY 124.0900/USD on Jun 22, 2007 before the global recession and expansion characterized by recurring bouts of risk aversion. Takashi Nakamichi and Eleanor Warnock, writing on “Japan lashes out over dollar, euro,” on Dec 29, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323530404578207440474874604.html?mod=WSJ_markets_liveupdate&mg=reno64-wsj), analyze the “war of words” launched by Japan’s new Prime Minister Shinzo Abe and his finance minister Taro Aso, arguing of deliberate devaluations of the USD and EUR relative to the JPY, which are hurting Japan’s economic activity. Gerard Baker and Jacob M. Shlesinger, writing on “Bank of Japan’s Kuroda signals impatience with Abe government,” on May 23, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303480304579579311491068756?KEYWORDS=bank+of+japan+kuroda&mg=reno64-wsj), analyze concerns of the Governor of the Bank of Japan Haruhiko Kuroda that the JPY has strengthened relative to the USD, partly eroding earlier depreciation. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-5, Japanese Yen JPY per US Dollars USD, Monthly, Jan 4, 1971-Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html

Zero interest rates in the United States forever tend to depreciate the dollar against every other currency if there is no risk aversion preventing portfolio rebalancing toward risk financial assets, which include the capital markets and exchange rates of emerging-market economies. The objective of unconventional monetary policy as argued by Yellen 2011AS) is to devalue the dollar to increase net exports that increase US economic growth. Increasing net exports and internal economic activity in the US is equivalent to decreasing net exports and internal economic activity in other countries.

Continental territory, rich endowment of natural resources, investment in human capital, teaching and research universities, motivated labor force and entrepreneurial initiative provide Brazil with comparative advantages in multiple economic opportunities. Exchange rate parity is critical in achieving Brazil’s potential but is difficult in a world of zero interest rates. Chart IV-6 of the Board of Governors of the Federal Reserve System provides the rate of Brazilian real (BRL) per US dollar (USD) from BRL 1.2074/USD on Jan 4, 1999 to BRL 3.9712/USD on Oct 2, 2015. The rate reached BRL 3.9450/USD on Oct 10, 2002 appreciating 60.5 percent to BRL 1.5580/USD on Aug 1, 2008. The rate depreciated 68.1 percent to BRL 2.6187/USD on Dec 5, 2008 during worldwide flight from risk. The rate appreciated again by 41.3 percent to BRL 1.5375/USD on Jul 26, 2011. The final data point in Chart VI-6 is BRL 3.9712/USD on Oct 2, 2015 for depreciation of 158.3 percent. The data in Table VI-6 is obtained from closing dates in New York published by the Wall Street Journal (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata).

Chart VI-6, Brazilian Real (BRL) per US Dollar (USD) Jan 4, 1999 to Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

Chart VI-7 of the Board of Governors of the Federal Reserve System provides the history of the BRL beginning with the first data point of BRL 0.8440/USD on Jan 2, 1995. The rate jumped to BRL 2.0700/USD on Jan 29, 1999 after changes in exchange rate policy and then to BRL 2.2000/USD on Mar 3, 1999. The rate depreciated 26.7 percent to BRL 2.7880/USD on Sep 21, 2001 relative to Mar 3, 1999.

Chart VI-7, Brazilian Real (BRL) per US Dollar (USD), Jan 2, 1995 to Oct 2, 2015

Note: US Recessions in Shaded Areas

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/H10/default.htm

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

(1 + i_r) = (1 + i_n)/(1 + π^e) (1)

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

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

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

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

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

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

Focus is shifting from tapering quantitative easing by the Federal Open Market Committee (FOMC). There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. Markets overreacted to the so-called “paring” of outright purchases to $15 billion of securities per month for the balance sheet of the Fed.

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):

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

Yellen (2014Aug22) provides comprehensive review of the theory and measurement of labor markets. Monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

“Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”

Yellen (2014Aug22) finds that the unemployment rate is not sufficient in determining slack:

“One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

Yellen (2014Aug22) restates that the FOMC determines monetary policy on newly available information and interpretation of labor markets and inflation and does not follow a preset path:

“But if progress in the labor market continues to be more rapid than anticipated by the Committee or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter. Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate. As I have noted many times, monetary policy is not on a preset path. The Committee will be closely monitoring incoming information on the labor market and inflation in determining the appropriate stance of monetary policy.”

There is similar concern in the minutes of the meeting of the FOMC on Dec 16-17, 2014 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20141217.htm):

Chair Yellen analyzes the view of inflation (http://www.federalreserve.gov/newsevents/speech/yellen20140416a.htm):

“Inflation, as measured by the price index for personal consumption expenditures, has slowed from an annual rate of about 2-1/2 percent in early 2012 to less than 1 percent in February of this year. This rate is well below the Committee's 2 percent longer-run objective. Many advanced economies are observing a similar softness in inflation.

To some extent, the low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters. Longer-run inflation expectations have remained remarkably steady, however. We anticipate that, as the effects of transitory factors subside and as labor market gains continue, inflation will gradually move back toward 2 percent.”

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

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.”

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

The argument that anemic population growth causes “secular stagnation” in the US (Hansen 1938, 1939, 1941) is as misplaced currently as in the late 1930s (for early dissent see Simons 1942). There is currently population growth in the ages of 16 to 24 years but not enough job creation and discouragement of job searches for all ages (http://cmpassocregulationblog.blogspot.com/2015/09/interest-rate-policy-dependent-on-what_13.html and earlier http://cmpassocregulationblog.blogspot.com/2015/08/exchange-rate-and-financial-asset.html). This is merely another case of theory without reality with dubious policy proposals. The current reality is cyclical slow growth.

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 http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html). 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.

A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2015/01/peaking-valuations-of-risk-financial.html and earlier http://cmpassocregulationblog.blogspot.com/2014/01/theory-and-reality-of-secular.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 17,084.49 on Fri Oct 9, 2015, which is higher by 2.6 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 20.3 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial assets 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):

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).

In a speech at the IMF on Jul 2, 2014, Chair Yellen analyzed the link between monetary policy and financial risks (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm):

“Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment--the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

Yellen (2014Jul14) warned again at the Committee on Banking, Housing and Urban Affairs on Jul 15, 2014:

“The Committee recognizes that low interest rates may provide incentives for some investors to “reach for yield,” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance. More broadly, the financial sector has continued to become more resilient, as banks have continued to boost their capital and liquidity positions, and growth in wholesale short-term funding in financial markets has been modest” (emphasis added).

Greenspan (1996) made similar warnings:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy” (emphasis added).

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”?

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.

Professor Raguram G Rajan, governor of the Reserve Bank of India, which is India’s central bank, warned about risks in high valuations of asset prices in an interview with Christopher Jeffery of Central Banking Journal on Aug 6, 2014 (http://www.centralbanking.com/central-banking-journal/interview/2358995/raghuram-rajan-on-the-dangers-of-asset-prices-policy-spillovers-and-finance-in-india). Professor Rajan demystifies in the interview “competitive easing” by major central banks as equivalent to competitive devaluation. Rajan (2005) anticipated the risks of the world financial crisis. Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor (1993, 1998LB, 1999, 1998LB, 1999, 2007JH, 2008Nov, 2009, 2012JMCB, 2014Jan3) finds that a monetary policy rule would function best in promoting an environment of low inflation and strong economic growth with stability of financial markets. There is strong case for using rules instead of discretionary authorities in monetary policy (http://cmpassocregulationblog.blogspot.com/search?q=rules+versus+authorities http://cmpassocregulationblog.blogspot.com/2014/07/financial-irrational-exuberance.html http://cmpassocregulationblog.blogspot.com/2014/07/world-inflation-waves-united-states.html).

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.

Fri May 1

Mon 4

Tue 5

Wed 6

Thu 7

Fri 8

DJIA

18024.06

-0.3%

1.0%

18070.40

0.3%

17928.20

-0.5%

-0.8%

17841.98

-1.0%

-0.5%

17924.06

-0.6%

0.5%

18191.11

0.9%

1.5%

Fri 27 Feb

Mon 3/2

Tue 3/3

Wed 3/4

Thu 3/5

Fri 3/6

USD/ EUR

1.1197

1.6%

0.0%

1.1185

0.1%

1.1176

0.2%

0.1%

1.1081

1.0%

0.9%

1.1030

1.5%

0.5%

1.0843

3.2%

1.7%

Exchange rate volatility is increasing in response of “impatience” in financial markets with monetary policy guidance and measures:

Fri Mar 6

Mon 9

Tue 10

Wed 11

Thu 12

Fri 13

USD/ EUR

1.0843

3.2%

1.7%

1.0853

-0.1%

1.0700

1.3%

1.4%

1.0548

2.7%

1.4%

1.0637

1.9%

-0.8%

1.0497

3.2%

1.3%

Fri Mar 13

Mon 16

Tue 17

Wed 18

Thu 19

Fri 20

USD/ EUR

1.0497

3.2%

1.3%

1.0570

-0.7%

1.0598

-1.0%

-0.3%

1.0864

-3.5%

-2.5%

1.0661

-1.6%

1.9%

1.0821

-3.1%

-1.5%

Fri Apr 24

Mon 27

Tue 28

Wed 29

Thu 30

May Fri 1

USD/ EUR

1.0874

-0.6%

-0.4%

1.0891

-0.2%

1.0983

-1.0%

-0.8%

1.1130

-2.4%

-1.3%

1.1223

-3.2%

-0.8%

1.1199

-3.0%

0.2%

In a speech at Brown University on May 22, 2015, Chair Yellen stated (http://www.federalreserve.gov/newsevents/speech/yellen20150522a.htm):

The US dollar appreciated 3.8 percent relative to the euro in the week of May 22, 2015:

Fri May 15

Mon 18

Tue 19

Wed 20

Thu 21

Fri 22

USD/ EUR

1.1449

-2.2%

-0.3%

1.1317

1.2%

1.1150

2.6%

1.5%

1.1096

3.1%

0.5%

1.1113

2.9%

-0.2%

1.1015

3.8%

0.9%

The President of the European Central Bank (ECB), Mario Draghi, warned on Jun 3, 2015 that (http://www.ecb.europa.eu/press/pressconf/2015/html/is150603.en.html):

The Chair of the Board of Governors of the Federal Reserve System, Janet L. Yellen, stated on Jul 10, 2015 that (http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm):

At the press conference after the meeting of the FOMC on Sep 17, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20150917.pdf 4):

Some equity markets fell on Fri Sep 18, 2015:

Fri Sep 11

Mon 14

Tue 15

Wed 16

Thu 17

Fri 18

DJIA

16433.09

2.1%

0.6%

16370.96

-0.4%

16599.85

1.0%

1.4%

16739.95

1.9%

0.8%

16674.74

1.5%

-0.4%

16384.58

-0.3%

-1.7%

Nikkei 225

18264.22

2.7%

-0.2%

17965.70

-1.6%

18026.48

-1.3%

0.3%

18171.60

-0.5%

0.8%

18432.27

0.9%

1.4%

18070.21

-1.1%

-2.0%

DAX

10123.56

0.9%

-0.9%

10131.74

0.1%

10188.13

0.6%

10227.21

1.0%

0.4%

10229.58

1.0%

0.0%

9916.16

-2.0%

-3.1%

· “The economic outlook, of course, is highly uncertain”

· “Considerable uncertainties also surround the outlook for economic activity”

· “Given the highly uncertain nature of the outlook…”

The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. The DJIA has increased 76.4 percent since the trough of the sovereign debt crisis in Europe on Jul 16, 2010 to Oct 9, 2015; S&P 500 has gained 97.0 percent and DAX 78.1 percent. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 10/9/15” had double digit gains relative to the trough around Jul 2, 2010 followed by negative performance but now some valuations of equity indexes show varying behavior. China’s Shanghai Composite is 33.6 percent above the trough. Japan’s Nikkei Average is 109.0 percent above the trough. DJ Asia Pacific TSM is 21.2 percent above the trough. Dow Global is 41.8 percent above the trough. STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 35.1 percent above the trough. NYSE Financial Index is 49.3 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 78.1 percent above the trough. Japan’s Nikkei Average is 109.0 percent above the trough on Aug 31, 2010 and 61.8 percent above the peak on Apr 5, 2010. The Nikkei Average closed at 18,438.67 on Fri Oct 9, 2015 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 79.8 percent higher than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar appreciated 4.7 percent relative to the euro. The dollar devalued before the new bout of sovereign risk issues in Europe. The column “∆% week to 10/9/15” in Table VI-4 shows

increase of 4.3 percent in the week for China’s Shanghai Composite. The Nikkei increased 4.0 percent. DJ Asia Pacific increased 5.1 percent. NYSE Financial increased 3.3 percent in the week. Dow Global increased 5.9 percent in the week of Oct 9, 2015. The DJIA increased 3.7 percent and S&P 500 increased 3.3 percent. DAX of Germany increased 5.7 percent. STOXX 50 increased 4.2 percent. The USD depreciated 1.3 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 10/9/15” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Oct 9, 2015. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 10/9/15” but also relative to the peak in column “∆% Peak to 10/9/15.” There are now several equity indexes above the peak in Table VI-4: DJIA 52.5 percent, S&P 500 65.5 percent, DAX 59.5 percent, Dow Global 15.7 percent, NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) 19.0 percent, Nikkei Average 61.8 percent, STOXX 50 14.4 percent. Shanghai Composite is 0.6 percent above the peak and DJ Asia Pacific TSM is 6.1 percent above the peak. The Shanghai Composite increased 61.2 percent from March 12, 2014, to Oct 9, 2015. The US dollar strengthened 24.9 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318). The Federal Open Market Committee (FOMC) is following “financial and international developments” as part of the process of framing interest rate policy (http://www.federalreserve.gov/newsevents/press/monetary/20150128a.htm). Inyoung Hwang, writing on “Fed optimism spurs record bets against stock volatility,” on Aug 21, 2014, published in Bloomberg.com (http://www.bloomberg.com/news/2014-08-21/fed-optimism-spurs-record-bets-against-stock-voalitlity.html), informs that the S&P 500 is trading at 16.6 times estimated earnings, which is higher than the five-year average of 14.3 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) for 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, real gross private domestic investment in the US was $951.6 billion of chained 2009 dollars, growing to $1,248.4 billion in IVQ1988 or 31.2 percent. Real gross private domestic investment in the US increased 10.0 percent from $2605.2 billion in IVQ2007 to $2,864.8 billion in IIQ2015. As shown in Table IAI-2, real private fixed investment increased 5.8 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,735.5 billion in IIQ2015. Private fixed investment fell relative to IVQ2007 in all quarters preceding IIQ2014. Growth of real private investment in Table IA1-2 is mediocre for all but four quarters from IIQ2011 to IQ2012. The investment decision of United States corporations is fractured in the current economic cycle in preference of cash.

There are three aspects. First, there is increase in undistributed corporate profits. Corporate profits with IVA and CCA increased $90.5 billion in IIIQ2014 and decreased 25.5 billion in IVQ2014. Corporate profits with IVA and CCA decreased $123.0 billion in IQ2015 and increased $70.4 billion in IIQ2015. Profits after tax with IVA and CCA increased at $99.6 billion in IIIQ2014. Profits after tax with IVA and CCA fell at $19.5 billion in IVQ2014 and decreased at $128.5 billion in IQ2015. Profits after tax with IVA and CCA increased at $39.2 billion in IIQ2015. Net dividends fell at $3.5 billion in IIIQ2014 and decreased at $3.9 billion in IVQ2014. Net dividends increased at $18.6 billion in IQ2015 and increased at $1.1 billion in IIQ2015. Undistributed profits with IVA and CCA increased at $103.1 billion in IIIQ2014. Undistributed corporate profits fell at $38.1 billion in IVQ2014 and decreased at $134.7 billion in IQ2015. Undistributed profits with IVA and CCA increased at $38.1 billion in IIQ2015. Undistributed corporate profits swelled 243.4 percent from $107.7 billion in IQ2007 to $369.8 billion in IIQ2015 and changed signs from minus $55.9 billion in current dollars in IVQ2007. 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. Second, sharp and continuing strengthening of the dollar is affecting balance sheets of US corporations with foreign operations (http://www.fasb.org/jsp/FASB/Pronouncement_C/SummaryPage&cid=900000010318) and the overall US economy. Corporate profits with IVA and CCA fell at $123.0 billion in IQ2015 with decrease of domestic industries at $93.9 billion, mostly because of decline of nonfinancial business at $70.5 billion, and decrease of profits from operations in the rest of the world at $29.0 billion. Receipts from the rest of the world fell at $40.0 billion. Total corporate profits with IVA and CCA were $2012.5 billion in IQ2015 of which $1618.9 billion from domestic industries, or 80.4 percent of the total, and $393.6 billion, or 19.6 percent, from the rest of the world. Nonfinancial corporate profits of $1285.5 billion account for 62.5 percent of the total. There is partial recovery in IIQ2015 with growth of domestic industry corporate profits at $59.0 billion and increase of profits from the rest of the world at $11.4 billion. Third, there is reduction in the use of corporate cash for investment. Vipal Monga, David Benoit and Theo Francis, writing on “Companies send more cash back to shareholders,” published on May 26, 2015 in the Wall Street Journal (http://www.wsj.com/articles/companies-send-more-cash-back-to-shareholders-1432693805?tesla=y), use data of a study by Capital IQ conducted for the Wall Street Journal. This study shows that companies in the S&P 500 reduced investment in plant and equipment to median 29 percent of operating cash flow in 2013 from 33 percent in 2003 while increasing dividends and buybacks to median 36 percent in 2013 from 18 percent in 2003.

The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

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

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation.

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

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

	Peak	Trough	∆% to Trough	∆% Peak to 10/09/ /15	∆% Week 10/09/15	∆% Trough to 10/09/ 15
DJIA	4/26/ 10	7/2/10	-13.6	52.5	3.7	76.4
S&P 500	4/23/ 10	7/20/ 10	-16.0	65.5	3.3	97.0
NYSE Finance	4/15/ 10	7/2/10	-20.3	19.0	3.3	49.3
Dow Global	4/15/ 10	7/2/10	-18.4	15.7	5.9	41.8
Asia Pacific	4/15/ 10	7/2/10	-12.5	6.1	5.1	21.2
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	61.8	4.0	109.0
China Shang.	4/15/ 10	7/02 /10	-24.7	0.6	4.3	33.6
STOXX 50	4/15/10	7/2/10	-15.3	14.4	4.2	35.1
DAX	4/26/ 10	5/25/ 10	-10.5	59.5	5.7	78.1
Dollar Euro	11/25 2009	6/7 2010	21.2	24.9	-1.3	4.7
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	NA	NA	NA
10-Year T Note	4/5/ 10	4/6/10	3.986	2.784	2.096

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

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

ESII IMF View of World Economy and Finance. The International Financial Institutions (IFI) consist of the International Monetary Fund, World Bank Group, Bank for International Settlements (BIS) and the multilateral development banks, which are the European Investment Bank, Inter-American Development Bank and the Asian Development Bank (Pelaez and Pelaez, International Financial Architecture (2005), The Global Recession Risk (2007), 8-19, 218-29, Globalization and the State, Vol. II (2008b), 114-48, Government Intervention in Globalization (2008c), 145-54). There are four types of contributions of the IFIs:

1. Safety Net. The IFIs contribute to crisis prevention and crisis resolution.

i. Crisis Prevention. An important form of contributing to crisis prevention is by surveillance of the world economy and finance by regions and individual countries. The IMF and World Bank conduct periodic regional and country evaluations and recommendations in consultations with member countries and also jointly with other international organizations. The IMF and the World Bank have been providing the Financial Sector Assessment Program (FSAP) by monitoring financial risks in member countries that can serve to mitigate them before they can become financial crises.

ii. Crisis Resolution. The IMF jointly with other IFIs provides assistance to countries in resolution of those crises that do occur. Currently, the IMF is cooperating with the government of Greece, European Union and European Central Bank in resolving the debt difficulties of Greece as it has done in the past in numerous other circumstances. Programs with other countries involved in the European debt crisis may also be developed.

2. Surveillance. The IMF conducts surveillance of the world economy, finance and public finance with continuous research and analysis. Important documents of this effort are the World Economic Outlook (http://www.imf.org/external/ns/cs.aspx?id=29), Global Financial Stability Report (http://www.imf.org/external/pubs/ft/gfsr/index.htm) and Fiscal Monitor (http://www.imf.org/external/ns/cs.aspx?id=262).

3. Infrastructure and Development. The IFIs also engage in infrastructure and development, in particular the World Bank Group and the multilateral development banks.

4. Soft Law. Significant activity by IFIs has consisted of developing standards and codes under multiple forums. It is easier and faster to negotiate international agreements under soft law that are not binding but can be very effective (on soft law see Pelaez and Pelaez, Globalization and the State, Vol. II (2008c), 114-25). These norms and standards can solidify world economic and financial arrangements.

The objective of this section is to analyze current projections of the IMF database for the most important indicators.

Table I-1 is constructed with the database of the IMF (http://www.imf.org/external/ns/cs.aspx?id=29) to show GDP in dollars in 2014 and the growth rate of real GDP of the world and selected regional countries from 2014 to 2017. The data illustrate the concept often repeated of “two-speed recovery” of the world economy from the recession of 2007 to 2009. The IMF has changed its forecast of the world economy to 3.4 percent in 2014 and 3.1 percent in 2015 but accelerating to 3.6 percent in 2016 and 3.8 percent in 2017. Slow-speed recovery occurs in the “major advanced economies” of the G7 that account for $35,542 billion of world output of $77,269 billion, or 46.0 percent, but are projected to grow at much lower rates than world output, 2.0 percent on average from 2014 to 2017 in contrast with 3.5 percent for the world as a whole. While the world would grow 14.6 percent in the four years from 2014 to 2017, the G7 as a whole would grow 8.1 percent. The difference in dollars of 2014 is high: growing by 14.6 percent would add around $11.3 trillion of output to the world economy, or roughly, two times the output of the economy of Japan of $4,602 billion but growing by 8.1 percent would add $6.3 trillion of output to the world, or about the output of Japan in 2014. The “two speed” concept is in reference to the growth of the 150 countries labeled as emerging and developing economies (EMDE) with joint output in 2014 of $30,296 billion, or 39.2 percent of world output. The EMDEs would grow cumulatively 19.5 percent or at the average yearly rate of 4.5 percent, contributing $5.9 trillion from 2014 to 2017 or the equivalent of somewhat less than the GDP of $10,357 billion of China in 2014. The final four countries in Table I-1 often referred as BRIC (Brazil, Russia, India, China), are large, rapidly growing emerging economies. Their combined output in 2014 adds to $16,616 billion, or 21.5 percent of world output, which is equivalent to 46.8 percent of the combined output of the major advanced economies of the G7.

Table I-1, IMF World Economic Outlook Database Projections of Real GDP Growth

	GDP USD 2014	Real GDP ∆% 2014	Real GDP ∆% 2015	Real GDP ∆% 2016	Real GDP ∆% 2017
World	77,269	3.4	3.1	3.6	3.8
G7	35,542	1.7	1.9	2.2	2.1
Canada	1,785	2.4	1.0	1.7	2.4
France	2,834	0.2	1.2	1.5	1.6
DE	3,874	1.6	1.5	1.6	1.5
Italy	2,148	-0.4	0.8	1.3	1.2
Japan	4,602	-0.1	0.6	1.0	0.4
UK	2,950	3.0	2.5	2.2	2.2
US	17,348	2.4	2.6	2.8	2.8
Euro Area	13,457	0.9	1.5	1.6	1.7
DE	3,874	1.6	1.5	1.6	1.5
France	2,834	0.2	1.2	1.5	1.6
Italy	2,148	-0.4	0.8	1.3	1.2
POT	230	0.9	1.6	1.5	1.4
Ireland	251	5.2	4.9	3.8	3.2
Greece	238	0.8	-2.3	-1.3	2.7
Spain	1,407	1.4	3.1	2.5	2.2
EMDE	30,296	4.6	4.0	4.5	5.1
Brazil	2,347	0.1	-3.0	-1.0	2.3
Russia	1,861	0.6	-3.8	-0.6	1.0
India	2,051	7.3	7.3	7.5	7.5
China	10,357	7.3	6.8	6.3	6.0

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries); POT: Portugal

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

Continuing high rates of unemployment in advanced economies constitute another characteristic of the database of the WEO (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx ). Table I-2 is constructed with the WEO database to provide rates of unemployment from 2013 to 2017 for major countries and regions. In fact, unemployment rates for 2014 in Table I-2 are high for all countries: unusually high for countries with high rates most of the time and unusually high for countries with low rates most of the time. The rates of unemployment are particularly high in 2014 for the countries with sovereign debt difficulties in Europe: 13.9 percent for Portugal (POT), 11.3 percent for Ireland, 26.5 percent for Greece, 24.5 percent for Spain and 12.7 percent for Italy, which is lower but still high. The G7 rate of unemployment is 6.4 percent. Unemployment rates are not likely to decrease substantially if slow growth persists in advanced economies.

Table I-2, IMF World Economic Outlook Database Projections of Unemployment Rate as Percent of Labor Force

	% Labor Force 2013	% Labor Force 2014	% Labor Force 2015	% Labor Force 2016	% Labor Force 2017
World	NA	NA	NA	NA	NA
G7	7.1	6.4	5.9	5.6	5.6
Canada	7.1	6.9	6.8	6.8	6.6
France	10.3	10.3	10.2	9.9	9.7
DE	5.2	5.0	4.7	4.7	4.7
Italy	12.2	12.7	12.2	11.9	11.6
Japan	4.0	3.6	3.5	3.5	3.6
UK	7.6	6.2	5.6	5.5	5.4
US	7.4	6.2	5.3	4.9	4.8
Euro Area	12.0	11.6	11.0	10.5	10.1
DE	5.2	5.0	4.7	4.7	4.7
France	10.3	10.3	10.2	9.9	9.7
Italy	12.2	12.7	12.2	11.9	11.6
POT	16.2	13.9	12.3	11.3	10.9
Ireland	13.0	11.3	9.6	8.5	7.7
Greece	27.5	26.5	26.8	27.1	25.7
Spain	26.1	24.5	21.8	19.9	18.7
EMDE	NA	NA	NA	NA	NA
Brazil	5.4	4.8	6.6	8.6	8.9
Russia	5.5	5.2	6.0	6.5	6.0
India	NA	NA	NA	NA	NA
China	4.1	4.1	4.1	4.1	4.1

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries)

Source: IMF World Economic Outlook

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

The database of the WEO (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx) is used to construct the debt/GDP ratios of regions and countries in Table I-3. The concept used is general government debt, which consists of central government debt, such as Treasury debt in the US, and all state and municipal debt. Net debt is provided for all countries except for the only available gross debt for China, Russia and India. The net debt/GDP ratio of the G7 decreases from 83.4 in 2013 to 82.7 in 2017. G7 debt is pulled by the high debt of Japan that grows from 122.9 percent of GDP in 2013 to 129.2 percent of GDP in 2017. US general government debt decreases from 80.8 percent of GDP in 2013 to 80.3 percent of GDP in 2017. Debt/GDP ratios of countries with sovereign debt difficulties in Europe are particularly worrisome. General government net debts of Italy, Greece and Portugal exceed 100 percent of GDP or are expected to exceed 100 percent of GDP by 2017. The only country with relatively lower debt/GDP ratio is Spain with 58.8 in 2013 but growing to 66.5 in 2017. Ireland’s debt/GDP ratio decreases from 89.8 in 2013 to 76.4 in 2017. Fiscal adjustment, voluntary or forced by defaults, may squeeze further economic growth and employment in many countries as analyzed by Blanchard (2012WEOApr). Defaults could feed through exposures of banks and investors to financial institutions and economies in countries with sounder fiscal affairs.

Table I-3, IMF World Economic Outlook Database Projections, General Government Net Debt as Percent of GDP

	% Debt/ GDP 2013	% Debt/ GDP 2014	% Debt/ GDP 2015	% Debt/ GDP 2016	% Debt/ GDP 2017
World	NA	NA	NA	NA	NA
G7	83.4	83.4	82.9	83.3	82.7
Canada	37.1	36.4	37.8	38.0	37.2
France	84.6	87.9	89.4	90.3	90.3
DE	53.1	51.4	48.4	46.4	44.6
Italy	109.6	112.6	113.5	112.8	111.2
Japan	122.9	126.1	126.0	128.1	129.2
UK	78.7	80.9	80.3	79.5	78.2
US	80.8	80.1	79.9	80.7	80.3
Euro Area	69.0	70.0	70.1	69.7	68.9
DE	53.1	51.4	48.4	46.4	44.6
France	84.6	87.9	89.4	90.3	90.3
Italy	109.6	112.6	113.5	112.8	111.2
POT	119.1	120.3	120.6	118.0	117.3
Ireland	89.8	88.2	82.4	78.7	76.4
Greece	172.1	175.0	194.1	202.8	199.1
Spain	58.8	62.6	64.8	66.0	66.5
EMDE*	39.4	41.4	44.4	46.2	47.3
Brazil	31.5	34.1	38.0	42.1	43.5
Russia*	14.0	17.8	20.4	21.0	21.9
India*	65.8	66.1	65.3	63.9	62.8
China*	39.4	41.1	43.2	46.0	48.3

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries); *General Government Gross Debt as percent of GDP

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

The primary balance consists of revenues less expenditures but excluding interest revenues and interest payments. It measures the capacity of a country to generate sufficient current revenue to meet current expenditures. There are various countries with primary surpluses in 2014: Germany 1.7 percent, Italy 1.4 percent and Portugal 0.5 percent. There are also various countries with expected primary surpluses by 2017: Greece 1.3 percent, Italy 2.6 percent and so on. Most countries in Table I-4 face significant fiscal adjustment in the future without “fiscal space.” Investors in government securities may require higher yields when the share of individual government debts hit saturation shares in portfolios. 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 (1)

Equation (1) 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}. Expectations by investors of future primary balances of indebted governments may be less optimistic than those in Table I-4 because of government revenues constrained by low growth and government expenditures rigid because of entitlements. Political realities may also jeopardize structural reforms and fiscal austerity.

Table I-4, IMF World Economic Outlook Database Projections of General Government Primary Net Lending/Borrowing as Percent of GDP

	% GDP 2013	% GDP 2014	% GDP 2015	% GDP 2016	% GDP 2017
World	NA	NA	NA	NA	NA
G7	-2.7	-2.1	-1.8	-1.3	-0.8
Canada	-2.3	-1.3	-1.3	-1.0	-0.8
France	-1.9	-1.9	-1.8	-1.6	-1.0
DE	1.8	1.7	1.7	1.2	1.2
Italy	1.7	1.4	1.3	2.0	2.6
Japan	-7.8	-6.7	-5.4	-4.0	-3.5
UK	-4.4	-3.8	-2.6	-1.1	0.3
US	-2.7	-2.0	-1.8	-1.5	-1.1
Euro Area	-0.4	-0.1	0.1	0.3	0.7
DE	1.8	1.7	1.7	1.2	1.2
France	-1.9	-1.9	-1.8	-1.6	-1.0
Italy	1.7	1.4	1.3	2.0	2.6
POT	0.1	0.5	1.7	1.8	1.9
Ireland	-1.8	-0.6	0.8	1.2	2.1
Greece	1.0	0.0	-0.5	0.0	1.3
Spain	-4.0	-2.9	-1.8	-0.7	-0.1
EMDE	-0.2	-0.9	-2.5	-2.3	-1.7
Brazil	1.8	-0.6	-0.4	-0.9	0.8
Russia	-0.9	-0.7	-5.0	-3.0	-1.1
India	-3.1	-2.5	-2.8	-2.4	-2.3
China	-0.6	-0.6	-1.4	-1.7	-1.5

*General Government Net Lending/Borrowing

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries)

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

The database of the World Economic Outlook of the IMF (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx) is used to obtain government net lending/borrowing as percent of GDP in Table I-5. Interest on government debt is added to the primary balance to obtain overall government fiscal balance in Table I-4. For highly indebted countries there is an even tougher challenge of fiscal consolidation. Adverse expectations on the success of fiscal consolidation may drive up yields on government securities that could create hurdles to adjustment, growth and employment.

Table I-5, IMF World Economic Outlook Database Projections of General Government Net Lending/Borrowing as Percent of GDP

	% GDP 2013	% GDP 2014	% GDP 2015	% GDP 2016	% GDP 2017
World	NA	NA	NA	NA	NA
G7	-4.5	-4.0	-3.5	-3.1	-2.6
Canada	-2.7	-1.6	-1.7	-1.3	-1.0
France	-4.1	-4.0	-3.8	-3.4	-2.8
DE	0.1	0.3	0.5	0.3	0.4
Italy	-2.9	-3.0	-2.7	-2.0	-1.2
Japan	-8.5	-7.3	-5.9	-4.6	-4.1
UK	-5.7	-5.7	-4.2	-2.8	-1.6
US	-4.7	-4.1	-3.9	-3.6	-3.3
Euro Area	-2.9	-2.4	-2.0	-1.7	-1.2
DE	0.1	0.3	0.5	0.3	0.4
France	-4.1	-4.0	-3.8	-3.4	-2.8
Italy	-2.9	-3.0	-2.7	-2.0	-1.2
POT	-4.8	-4.5	-3.1	-2.7	-2.5
Ireland	-5.6	-4.0	-2.0	-1.3	-0.4
Greece	-2.9	-3.9	-4.2	-3.6	-2.4
Spain	-6.8	-5.8	-4.4	-3.2	-2.5
EMDE	-1.8	-2.6	-4.3	-4.0	-3.5
Brazil	-3.1	-6.2	-7.7	-7.2	-5.4
Russia	-1.3	-1.2	-5.7	-3.9	-2.2
India	-7.4	-7.0	-7.2	-7.0	-6.7
China	-1.1	-1.2	-1.9	-2.3	-2.1

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries)

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

There were some hopes that the sharp contraction of output during the global recession would eliminate current account imbalances. Table I-6 constructed with the database of the WEO (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx) shows that external imbalances have been maintained in the form of current account deficits and surpluses. China’s current account surplus is 2.1 percent of GDP for 2014 and is projected to stabilize at 2.0 percent of GDP in 2017. At the same time, the current account deficit of the US is 2.2 percent of GDP in 2014 and is projected at 3.2 percent of GDP in 2017. The current account surplus of Germany is 7.4 percent for 2014 and remains at a high 7.5 percent of GDP in 2017. Japan’s current account surplus is 0.5 percent of GDP in 2014 and increases to 3.0 percent of GDP in 2017.

Table I-6, IMF World Economic Outlook Databank Projections, Current Account of Balance of Payments as Percent of GDP

	% CA/ GDP 2013	% CA/ GDP 2014	% CA/ GDP 2015	% CA/ GDP 2016	% CA/ GDP 2017
World	NA	NA	NA	NA	NA
G7	-0.8	-0.8	-0.6	-0.8	-1.0
Canada	-3.0	-2.1	-2.9	-2.3	-2.7
France	-0.8	-0.9	-0.2	-0.4	-0.4
DE	6.4	7.4	8.5	8.0	7.5
Italy	0.9	1.9	2.0	2.3	1.7
Japan	0.8	0.5	3.0	3.0	3.0
UK	-4.5	-5.9	-4.7	-4.3	-3.5
US	-2.3	-2.2	-2.6	-3.0	-3.2
Euro Area	1.8	2.0	3.2	3.0	2.8
DE	6.4	7.4	8.5	8.0	7.5
France	-0.8	-0.9	-0.2	-0.4	-0.4
Italy	0.9	1.9	2.0	2.3	1.7
POT	1.4	0.6	0.7	1.6	1.2
Ireland	3.1	3.6	3.2	3.0	2.7
Greece	0.6	0.9	0.7	1.5	1.2
Spain	1.4	0.8	0.9	1.1	1.1
EMDE	0.6	0.5	-0.1	-0.2	-0.3
Brazil	-3.8	-4.4	-4.0	-3.8	-3.8
Russia	1.6	3.2	5.0	5.4	5.7
India	-1.7	-1.3	-1.4	-1.6	-2.0
China	1.6	2.1	3.1	2.8	2.0

Notes; DE: Germany; EMDE: Emerging and Developing Economies (150 countries)

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

The G7 meeting in Washington on Apr 21 2006 of finance ministers and heads of central bank governors of the G7 established the “doctrine of shared responsibility” (G7 2006Apr):

“We, Ministers and Governors, reviewed a strategy for addressing global imbalances. We recognized that global imbalances are the product of a wide array of macroeconomic and microeconomic forces throughout the world economy that affect public and private sector saving and investment decisions. We reaffirmed our view that the adjustment of global imbalances:

Is shared responsibility and requires participation by all regions in this global process;
Will importantly entail the medium-term evolution of private saving and investment across countries as well as counterpart shifts in global capital flows; and
Is best accomplished in a way that maximizes sustained growth, which requires strengthening policies and removing distortions to the adjustment process.

In this light, we reaffirmed our commitment to take vigorous action to address imbalances. We agreed that progress has been, and is being, made. The policies listed below not only would be helpful in addressing imbalances, but are more generally important to foster economic growth.

In the United States, further action is needed to boost national saving by continuing fiscal consolidation, addressing entitlement spending, and raising private saving.
In Europe, further action is needed to implement structural reforms for labor market, product, and services market flexibility, and to encourage domestic demand led growth.
In Japan, further action is needed to ensure the recovery with fiscal soundness and long-term growth through structural reforms.

Others will play a critical role as part of the multilateral adjustment process.

In emerging Asia, particularly China, greater flexibility in exchange rates is critical to allow necessary appreciations, as is strengthening domestic demand, lessening reliance on export-led growth strategies, and actions to strengthen financial sectors.

In oil-producing countries, accelerated investment in capacity, increased economic diversification, enhanced exchange rate flexibility in some cases.

Other current account surplus countries should encourage domestic consumption and investment, increase micro-economic flexibility and improve investment climates.

We recognized the important contribution that the IMF can make to multilateral surveillance.”

The concern at that time was that fiscal and current account global imbalances could result in disorderly correction with sharp devaluation of the dollar after an increase in premiums on yields of US Treasury debt (see Pelaez and Pelaez, The Global Recession Risk (2007)). The IMF was entrusted with monitoring and coordinating action to resolve global imbalances. The G7 was eventually broadened to the formal G20 in the effort to coordinate policies of countries with external surpluses and deficits.

The database of the WEO (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx) is used to contract Table I-7 with fiscal and current account imbalances projected for 2015 and 2017. The WEO finds the need to rebalance external and domestic demand (IMF 2011WEOSep xvii):

“Progress on this front has become even more important to sustain global growth. Some emerging market economies are contributing more domestic demand than is desirable (for example, several economies in Latin America); others are not contributing enough (for example, key economies in emerging Asia). The first set needs to restrain strong domestic demand by considerably reducing structural fiscal deficits and, in some cases, by further removing monetary accommodation. The second set of economies needs significant currency appreciation alongside structural reforms to reduce high surpluses of savings over investment. Such policies would help improve their resilience to shocks originating in the advanced economies as well as their medium-term growth potential.”

The IMF (2012WEOApr, XVII) explains decreasing importance of the issue of global imbalances as follows:

“The latest developments suggest that global current account imbalances are no longer expected to widen again, following their sharp reduction during the Great Recession. This is largely because the excessive consumption growth that characterized economies that ran large external deficits prior to the crisis has been wrung out and has not been offset by stronger consumption in .surplus economies. Accordingly, the global economy has experienced a loss of demand and growth in all regions relative to the boom years just before the crisis. Rebalancing activity in key surplus economies toward higher consumption, supported by more market-determined exchange rates, would help strengthen their prospects as well as those of the rest of the world.”

The IMF (http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/c4.pdf) analyzes global imbalances as:

Global current account imbalances have narrowed by more than a third from

their peak in 2006. Key imbalances—the large deficit of the United States and

the large surpluses of China and Japan—have more than halved.

The narrowing in imbalances has largely been driven by demand contraction

(“expenditure reduction”) in deficit economies.

Exchange rate adjustment has facilitated rebalancing in China and the United

States, but in general the contribution of exchange rate changes (“expenditure

switching”) to current account adjustment has been relatively modest.

The narrowing of imbalances is expected to be durable, as domestic demand in

deficit economies is projected to remain well below pre-crisis trends.

Since flow imbalances have narrowed but not reversed, net creditor and debtor

positions have widened further. Weak growth has also contributed to still high

ratios of net external liabilities to GDP in some debtor economies.

Risks of a disruptive adjustment in global current account balances have

decreased, but global demand rebalancing remains a policy priority. Stronger

external demand will be instrumental for reviving growth in debtor countries and

reducing their net external liabilities.”

Table I-7, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2015 Dollar GDP

	GDP $B 2015	FD %GDP 2015	CAD %GDP 2015	Debt %GDP 2015	FD%GDP 2017	CAD%GDP 2017	Debt %GDP 2017
US	17968	-1.8	-2.6	79.9	-1.1	-3.2	80.3
Japan	4116	-5.4	3.0	126.0	-3.5	3.0	129.2
UK	2865	-4.3	-4.7	80.3	-1.6	-3.5	78.1
Euro	11568	0.1	3.2	70.1	0.7	2.8	68.8
Ger	3371	1.7	8.5	48.4	1.2	7.5	44.6
France	2423	-1.8	-0.2	89.4	-1.0	-0.4	90.3
Italy	1819	1.3	2.0	113.5	2.6	1.7	111.2
Can	1573	-1.3	-2.9	37.8	-0.8	-2.7	37.2
China	11385	-1.4	3.1	43.2	-1.5	2.0	48.3
Brazil	1800	-0.4	-4.0	38.0	0.8	-3.8	43.5

Note: GER = Germany; Can = Canada; FD = fiscal deficit; CAD = current account deficit

FD is primary except total for China; Debt is net except gross for China

Source: IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

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 I-8 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx) for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2015.

Table I-8, World and Selected Regional and Country GDP and Fiscal Situation

	GDP 2015 USD Billions	Primary Net Lending Borrowing % GDP 2015	General Government Net Debt % GDP 2015
World	73,509
Euro Zone	11,568	0.1	70.1
Portugal	198	1.7	120.6
Ireland	227	0.8	82.4
Greece	193	-0.5	194.1
Spain	1,221	-1.8	64.8
Major Advanced Economies G7	34,135	-1.8	82.9
United States	17,968	-1.8	79.9
UK	2,865	-2.6	80.3
Germany	3,371	1.7	48.4
France	2,423	-1.8	89.4
Japan	4,116	-5.9	126.0
Canada	1,573	-1.4	37.8
Italy	1,819	1.3	113.5
China	11,385	-1.4	43.2**

*Net Lending/borrowing**Gross Debt

Source: IMF World Economic Outlook

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

The data in Table I-8 are used for some very simple calculations in Table I-9. The column “Net Debt USD Billions 2015” in Table I-9 is generated by applying the percentage in Table I-8 column “General Government Net Debt % GDP 2015” to the column “GDP 2015 USD Billions.” The total debt of France and Germany in 2015 is $3797.8 billion, as shown in row “B+C” in column “Net Debt USD Billions 2015.” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3656.2 billion, adding rows D+E+F+G+H in column “Net Debt USD billions 2015.” 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 $7454.0 billion, which would be equivalent to 128.7 percent of their combined GDP in 2015. 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 221.1 percent if including debt of France and 156.9 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 I-9, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %

	Net Debt USD Billions 2015	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,109.2
B Germany	1,631.6		$7454.0 as % of $3371 =221.1% $5287.8 as % of $3371 =156.9%
C France	2,166.2
B+C	3,797.8	GDP $5,794 Total Debt $7,454.0 Debt/GDP: 128.7%
D Italy	2,064.6
E Spain	791.2
F Portugal	238.8
G Greece	374.6
H Ireland	187.0
Subtotal D+E+F+G+H	3,656.2

Source: calculation with IMF data IMF World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

World trade projections of the IMF are in Table I-10. There is increasing growth of the volume of world trade of goods and services from 3.3 percent in 2013 to 4.1 percent in 2016 and 4.7 percent on average from 2016 to 2019. World trade would be slower for advanced economies while emerging and developing economies (EMDE) experience faster growth. World economic slowdown would be more challenging with lower growth of world trade.

Table I-10, IMF, Projections of World Trade, USD Billions, USD/Barrel and Annual ∆%

	2014	2015	2016	Average ∆% 2017-2019
World Trade Volume (Goods and Services)	3.3	3.2	4.1	4.7
Exports Goods & Services	3.2	3.4	3.9	4.6
Imports Goods & Services	3.5	3.0	4.3	4.8
Average Oil Price USD/Barrel	96.25	51.62	50.36	Average ∆% 2007-2016 82.03
Average Annual ∆% Export Unit Value of Manufactures	-0.6	-4.1	-0.7	Average ∆% 2007-2016 0.8
Exports of Goods & Services	2014	2015	2016	Average ∆% 2007-2016
EMDE	2.9	3.9	4.8	4.6
G7	3.4	3.1	3.4	2.9
Imports Goods & Services
EMDE	3.6	1.3	4.4	6.0
G7	3.4	4.0	4.2	2.4
Terms of Trade of Goods & Services
EMDE	-0.5	-4.7	-1.0	0.1
G7	0.4	1.6	0.1	0.0
Terms of Trade of Goods
EMDE	-0.6	-4.3	-0.6	0.2
G7	0.2	1.4	0.0	-0.1

Notes: Commodity Price Index includes Fuel and Non-fuel Prices; Commodity Industrial Inputs Price includes agricultural raw materials and metal prices; Oil price is average of WTI, Brent and Dubai

Source: International Monetary Fund World Economic Outlook databank

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

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

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

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

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

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

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

Table IB-1 provides the data required for broader comparison of long-term and cyclical performance of the United States economy. Revisions and enhancements of United States GDP and personal income accounts by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) provide important information on long-term growth and cyclical behavior. First, Long-term performance. Using annual data, US GDP grew at the average rate of 3.2 percent per year from 1929 to 2014 and at 3.2 percent per year from 1947 to 2014. Real disposable income grew at the average yearly rate of 3.2 percent from 1929 to 2014 and at 3.7 percent from 1947 to 1999. Real disposable income per capita grew at the average yearly rate of 2.0 percent from 1929 to 2014 and at 2.3 percent from 1947 to 1999. US economic growth was much faster during expansions, compensating contractions in maintaining trend growth for whole cycles. Using annual data, US real disposable income grew at the average yearly rate of 3.5 percent from 1980 to 1989 and real disposable income per capita at 2.6 percent. The US economy has lost its dynamism in the current cycle: real disposable income grew at the yearly average rate of 1.4 percent from 2006 to 2014 and real disposable income per capita at 0.6 percent. Real disposable income grew at the average rate of 1.3 percent from 2007 to 2014 and real disposable income per capita at 0.5 percent. Table IB-1 illustrates the contradiction of long-term growth with the proposition of secular stagnation (Hansen 1938, 1938, 1941 with early critique by Simons (1942). Secular stagnation would occur over long periods. Table IB-1 also provides the corresponding rates of population growth that is only marginally lower at 0.7 to 0.9 percent recently from 1.1 percent over the long-term. GDP growth fell abruptly from 2.6 percent on average from 2000 to 2006 to 1.1 percent from 2006 to 2014 and 1.0 percent from 2007 to 2014 and real disposable income growth fell from 2.9 percent on average from 2000 to 2006 to 1.4 percent from 2006 to 2014. The decline of growth of real per capita disposable income is even sharper from average 2.0 percent from 2000 to 2006 to 0.6 percent from 2006 to 2014 and 0.5 percent from 2007 to 2014 while population growth was 0.8 percent on average. Lazear and Spletzer (2012JHJul122) provide theory and measurements showing that cyclic factors explain currently depressed labor markets. This is also the case of the overall economy. Second, first four quarters of expansion. Growth in the first four quarters of expansion is critical in recovering loss of output and employment occurring during the contraction. In the first four quarters of expansion from IQ1983 to IVQ1983: GDP increased 7.8 percent, real disposable personal income 5.3 percent and real disposable income per capita 4.4 percent. In the first four quarters of expansion from IIIQ2009 to IIQ2010: GDP increased 2.7 percent, real disposable personal income 0.2 percent and real disposable income per capita decreased 0.7 percent. Third, first 24 quarters of expansion. In the expansion from IQ1983 to IVQ1988: GDP grew 32.6 percent at the annual equivalent rate of 4.8 percent; real disposable income grew 27.5 percent at the annual equivalent rate of 4.1 percent; and real disposable income per capita grew 20.9 percent at the annual equivalent rate of 3.2 percent. In the expansion from IIIQ2009 to IIQ2015: GDP grew 13.8 percent at the annual equivalent rate of 2.2 percent; real disposable income grew 11.4 percent at the annual equivalent rate of 1.8 percent; and real disposable personal income per capita grew 6.7 percent at the annual equivalent rate of 1.1 percent. Fourth, entire quarterly cycle. In the entire cycle combining contraction and expansion from IQ1980 to IVQ1988: GDP grew 32.4 percent at the annual equivalent rate of 3.1 percent; real disposable personal income grew 34.9 percent at the annual equivalent rate of 3.3 percent; and real disposable personal income per capita 24.0 percent at the annual equivalent rate of 2.4 percent. In the entire cycle combining contraction and expansion from IVQ2007 to IIQ2015: GDP grew 9.0 percent at the annual equivalent rate of 1.2 percent; real disposable personal income 12.0 percent at the annual equivalent rate of 1.5 percent; and real disposable personal income per capita 5.6 percent at the annual equivalent rate of 0.7 percent. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction of 4.2 percent from IVQ2007 to IIQ2009 and the financial crisis. The proposition of secular stagnation should explain a long-term process of decay and not the actual abrupt collapse of the economy and labor markets currently.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population Long-term and in 1983-88 and 2007-2014, %

Long-term Average ∆% per Year	GDP	Population
1929-2014	3.2	1.1
1947-2014	3.2	1.2
1947-1999	3.6	1.3
1980-1989	3.5	0.9
2000-2014	1.7	0.9
2000-2006	2.6	0.9
2006-2014	1.1	0.8
2007-2014	1.0	0.8
Long-term Average ∆% per Year	Real Disposable Income	Real Disposable Income per Capita	Population
1929-2014	3.2	2.0	1.1
1947-1999	3.7	2.3	1.3
2000-2014	2.1	1.2	0.9
2000-2006	2.9	2.0	0.9
2006-2014	1.4	0.6	0.8
2007-2014	1.3	0.5	0.7
Whole Cycles Average ∆% per Year
1980-1989	3.5	2.6	0.9
2006-2014	1.4	0.6	0.8
2007-2014	1.3	0.5	0.7
Comparison of Cycles	# Quarters	∆%	∆% Annual Equivalent
GDP
I83 to IV83 I83 to IQ87 I83 to II87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88	4 17 18 19 20 21 22 23 24	7.8 23.1 24.5 25.6 27.7 28.4 30.1 30.9 32.6	7.8 5.0 5.0 4.9 5.0 4.9 4.9 4.8 4.8
RDPI
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88	4 17 19 20 21 22 23 24	5.3 19.5 20.5 22.1 23.8 25.1 26.3 27.5	5.3 4.3 4.0 4.1 4.2 4.2 4.1 4.1
RDPI Per Capita
I83 to IV83 I83 to I87 I83 to III87 I83 to IV87 I83 to I88 I83 to II88 I83 to III88 I83 to IV88	4 17 19 20 21 22 23 24	4.4 15.1 15.5 16.7 18.2 19.2 20.0 20.9	4.4 3.4 3.1 3.1 3.2 3.2 3.2 3.2
Whole Cycle IQ1980 to IVQ1988
GDP	37	32.4	3.1
RDPI	37	34.9	3.3
RDPI per Capita	37	24.0	2.4
Population	37	8.8	0.9
GDP
III09 to II10 III09 to II15	4 24	2.7 13.8	2.7 2.2
RDPI
III09 to II10 III09 to II15	4 24	0.2 11.4	0.2 1.8
RDPI per Capita
III09 to II10 III09 to II15	4 24	-0.7 6.7	-0.7 1.1
Population
III09 to II10 III09 to I15	4 24	0.8 4.7	0.8 0.8
IVQ2007 to IIQ2015	30
GDP	30	9.0	1.2
RDPI	30	12.0	1.5
RDPI per Capita	30	5.6	0.7
Population	30	6.1	0.8

RDPI: Real Disposable Personal Income

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

ESIV United States International Trade. Table IIA-1 provides the trade balance of the US and monthly growth of exports and imports seasonally adjusted with the latest release and revisions (http://www.census.gov/foreign-trade/). Because of heavy dependence on imported oil, fluctuations in the US trade account originate largely in fluctuations of commodity futures prices caused by carry trades from zero interest rates into commodity futures exposures in a process similar to world inflation waves (http://cmpassocregulationblog.blogspot.com/2015/09/interest-rate-increase-on-hold-because.html). The Census Bureau revised data for 2015, 2014, 2013 and 2012. Exports decreased 2.0 percent in Aug 2015 while imports increased 1.2 percent. The trade deficit increased from $41,807 million in Jul 2015 to $48,330 million in Aug 2015. The trade deficit increased to $39,462 million in Jan 2014 and deficit of $42,835 million in Feb 2014. The trade deficit increased to $43,121 million in Mar 2014 and $44,271 million in Apr 2014. The deficit improved to $42,070 million in May 2014 and $41,411 million in Jul 2014. The trade deficit moved to $41,275 million in Aug 2014, deteriorating to $43,186 million in Sep 2014 and $42,753 million in Oct 2014. The trade deficit improved to $40,021 million in Nov 2014, deteriorating to $45,549 million in Dec 2014 and improving to $43,588 million in Jan 2015 and $38,537 million in Feb 2015. The trade deficit deteriorated to $52,163 million in Mar 2015. The trade deficit improved to $42,258 million in Apr 2015 and $42,535 million in May 2015. The trade deficit deteriorated to $45,205 million in Jun 2015 and improved to $41,807 million in Jul 2015, deteriorating to $48,330 million in Aug 2015.

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

	Trade Balance	Exports	Month ∆%	Imports	Month ∆%
Aug 2015	-48,330	185,094	-2.0	233,424	1.2
Jul	-41,807	188,807	0.6	230,615	-1.0
Jun	-45,205	187,690	-0.1	232,896	1.1
May	-42,535	187,863	-0.7	230,398	-0.4
Apr	-42,258	189,142	1.3	231,399	-3.2
Mar	-52,163	186,765	0.5	238,928	6.5
Feb	-38,537	185,889	-1.7	224,427	-3.5
Jan	-43,588	189,025	-3.1	232,613	-3.3
Dec 2014	-45,549	194,975	-0.6	240,524	1.8
Nov	-40,021	196,201	-0.8	236,222	-1.8
Oct	-42,753	197,759	1.4	240,513	1.0
Sep	-43,186	195,053	-1.1	238,239	-0.1
Aug	-41,275	197,303	0.2	238,578	0.1
Jul	-41,411	196,907	0.7	238,317	0.2
Jun	-42,371	195,579	-0.9	237,950	-0.6
May	-42,070	197,269	1.2	239,340	0.0
Apr	-44,271	195,024	0.1	239,295	0.6
Mar	-43,121	194,759	2.8	237,881	2.4
Feb	-42,835	189,495	-1.8	232,330	0.0
Jan	-39,462	192,879	0.1	232,341	0.8
Jan-Dec 2014	-508,324	2,343,205	2.9	2,851,529	3.4

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

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

Chart IIA-2 of the US Census Bureau provides the US trade account in goods and services SA from Jan 1992 to Aug 2015. There is long-term trend of deterioration of the US trade deficit shown vividly by Chart IIA-2. The global recession from IVQ2007 to IIQ2009 reversed the trend of deterioration. Deterioration resumed together with incomplete recovery and was influenced significantly by the carry trade from zero interest rates to commodity futures exposures (these arguments are elaborated in Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4 http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html). Earlier research focused on the long-term external imbalance of the US in the form of trade and current account deficits (Pelaez and Pelaez, The Global Recession Risk (2007), Globalization and the State Vol. II (2008b) 183-94, Government Intervention in Globalization (2008c), 167-71). US external imbalances have not been fully resolved and tend to widen together with improving world economic activity and commodity price shocks.

Chart IIA-2, US, Balance of Trade SA, Monthly, Millions of Dollars, Jan 1992-Aug 2015

Source: US Census Bureau

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

Chart IIA-3 of the US Census Bureau provides US exports SA from Jan 1992 to Aug 2015. There was sharp acceleration from 2003 to 2007 during worldwide economic boom and increasing inflation. Exports fell sharply during the financial crisis and global recession from IVQ2007 to IIQ2009. Growth picked up again together with world trade and inflation but stalled in the final segment with less rapid global growth and inflation.

Chart IIA-3, US, Exports SA, Monthly, Millions of Dollars Jan 1992-Aug 2015

Source: US Census Bureau

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

Chart IIA-4 of the US Census Bureau provides US imports SA from Jan 1992 to Aug 2015. Growth was stronger between 2003 and 2007 with worldwide economic boom and inflation. There was sharp drop during the financial crisis and global recession. There is stalling import levels in the final segment resulting from weaker world economic growth and diminishing inflation because of risk aversion and portfolio reallocations from commodity exposures to equities.

Chart IIA-4, US, Imports SA, Monthly, Millions of Dollars Jan 1992-Aug 2015

Source: US Census Bureau

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

There is deterioration of the US trade balance in goods in Table IIA-3 from deficit of $60,824 million in Aug 2014 to deficit of $67,907 million in Aug 2015. The nonpetroleum deficit increased by $13,875 million while the petroleum deficit shrank by $6,711 million. Total exports of goods decreased 9.9 percent in Aug 2015 relative to a year earlier while total imports decreased 3.3 percent. Nonpetroleum exports decreased 6.6 percent from Aug 2014 to Aug 2015 while nonpetroleum imports increased 3.4 percent. Petroleum imports fell 44.7 percent.

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

	Aug 2015	Aug 2014	∆%
Total Balance	-67,907	-60,824
Petroleum	-6,942	-13,653
Non Petroleum	-59,658	-45,783
Total Exports	124,458	138,155	-9.9
Petroleum	8,132	13,613	-40.3
Non Petroleum	115,707	123,820	-6.6
Total Imports	192,366	198,979	-3.3
Petroleum	15,073	27,266	-44.7
Non Petroleum	175,365	169,603	3.4

Details may not add because of rounding and seasonal adjustment

Source: US Census Bureau

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

US exports and imports of goods not seasonally adjusted in Jan-Aug 2015 and Jan-Aug 2014 are in Table IIA-4. The rate of growth of exports was minus 6.0 percent and minus 3.7 percent for imports. The US has partial hedge of commodity price increases in exports of agricultural commodities that decreased 9.8 percent and of mineral fuels that decreased 31.1 percent both because prices of raw materials and commodities increase and fall recurrently as a result of shocks of risk aversion and portfolio reallocations. The US exports an insignificant but growing amount of crude oil, decreasing 30.4 percent in cumulative Jan-Aug 2015 relative to a year earlier. US exports and imports consist mostly of manufactured products, with less rapidly increasing prices. US manufactured exports decreased 5.6 percent while manufactured imports decreased 3.7 percent. Significant part of the US trade imbalance originates in imports of mineral fuels decreasing 43.4 percent and petroleum decreasing 43.9 percent with wide oscillations in oil prices. The limited hedge in exports of agricultural commodities and mineral fuels compared with substantial imports of mineral fuels and crude oil results in waves of deterioration of the terms of trade of the US, or export prices relative to import prices, originating in commodity price increases caused by carry trades from zero interest rates. These waves are similar to those in worldwide inflation.

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

	Jan-Aug 2015 $ Millions	Jan-Aug 2014 $ Millions	∆%
Exports	1,008,747	1,073,264	-6.0
Manufactured	749,397	793,907	-5.6
Agricultural Commodities	87,059	96,502	-9.8
Mineral Fuels	73,529	106,679	-31.1
Petroleum	61,104	87,745	-30.4
Imports	1,492,650	1,549,285	-3.7
Manufactured	1,289,050	1,259,898	2.3
Agricultural Commodities	77,169	75,163	2.7
Mineral Fuels	138,529	244,761	-43.4
Petroleum	128,697	229,503	-43.9

Source: US Census Bureau

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

The current account of the US balance of payments is provided in Table IIA2-1 for IIQ2014 and IIQ2015. The Bureau of Economic Analysis analyzes as follows (http://www.bea.gov/newsreleases/international/transactions/2015/pdf/trans215.pdf):

“The U.S. current-account deficit—a net measure of transactions between the United States and the rest of the world in goods, services, primary income (investment income and compensation), and secondary income (current transfers)— decreased to $109.7 billion (preliminary) in the second quarter of 2015 from $118.3 billion (revised) in the first quarter. The deficit decreased to 2.5 percent of current dollar gross domestic product (GDP) from 2.7 percent in the first quarter. The decrease in the current-account deficit was largely accounted for by decreases in the deficits on goods and secondary income. Increases in the surpluses on primary income and services also contributed to the decrease in the current-account deficit.”

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 $99.3 billion in IIQ2014 to $117.3 billion in IIQ2015. The current account deficit seasonally adjusted at annual rate increased from 2.1 percent of GDP in IIQ2014 to 2.7 percent of GDP in IQ2015, decreasing to 2.5 percent of GDP in IIQ2015. 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

	IIQ2014	IIQ2015	Difference
Goods Balance	-190,998	-189,195	-1,803
X Goods	414,005	390,400	-5.7 ∆%
M Goods	-605,003	-579,595	-4.2 ∆%
Services Balance	51,963	49,886	-2,077
X Services	175,117	175,981	0.5 ∆%
M Services	-123,154	-126,095	2.4 ∆%
Balance Goods and Services	-139,035	-139,309	274
Exports of Goods and Services and Income Receipts	838,590	803,037
Imports of Goods and Services and Income Payments	-937,920	-920,295
Current Account Balance	-99,330	-117,258	17,928
% GDP	IIQ2014	IIQ2015	IQ2015
	2.1	2.5	2.7

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):

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.

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.

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 IIA2-3 provides data on the US fiscal and balance of payments imbalances incorporating all revisions and methods. 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 estimate of the deficit for 2013 is $680 billion or 4.1 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 $5.094 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, slightly less than the combined deficits from 2009 to 2012 of $5094 billion. Federal debt in 2012 was 70.4 percent of GDP (CBO 2015Jan26) and 72.3 percent of GDP in 2013 (http://www.cbo.gov/). 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.”

The most recent CBO long-term budget on Jun 16, 2015, projects US federal debt at 103 percent of GDP in 2040 (CBO (The 2015 long-term budget outlook. Washington, DC, Congressional Budget Office, Jun 16).

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

	2007	2008	2009	2010	2011	2012	2013	2014
Goods & Services	-705	-709	-384	-495	-549	-538	-478	-508
Primary Income	101	146	124	178	221	212	225	238
Secondary Income	-114	-128	-124	-125	-133	-125	-123	-119
Current Account	-719	-691	-384	-442	-460	-450	-377	-390
NGDP	14478	14719	14419	14964	15518	16155	16663	17348
Current Account % GDP	-5.0	-4.7	-2.7	-3.0	-3.0	-2.8	-2.3	-2.2
NIIP	-1279	-3995	-2628	-2512	-4455	-4518	-5328	-7020
US Owned Assets Abroad	20705	19423	19426	21768	22209	22562	24159	24595
Foreign Owned Assets in US	21984	23418	22054	24280	26664	27080	29487	31615
NIIP % GDP	-8.8	-27.1	-18.2	-16.8	-28.7	-28.3	-32.1	-39.7
Exports Goods, Services and Income	2569	2751	2286	2631	2988	3098	3202	3307
NIIP % Exports Goods, Services and Income	-50	-145	-115	-95	-149	-146	-166	-212
DIA MV	5858	3707	4945	5486	5215	5968	7117	7124
DIUS MV	4134	3091	3619	4099	4199	4661	5781	6229
Fiscal Balance	-161	-459	-1413	-1294	-1300	-1087	-680	-483
Fiscal Balance % GDP	-1.1	-3.1	-9.8	-8.7	-8.5	-6.8	-4.1	-2.8
Federal Debt	5035	5803	7545	9019	10128	11281	11983	12779
Federal Debt % GDP	35.1	39.3	52.3	61.0	65.8	70.1	72.0	74.1
Federal Outlays	2729	2983	3518	3457	3603	3537	3455	3504
∆%	2.8	9.3	17.9	-1.7	4.2	-1.8	-2.3	1.4
% GDP	19.1	20.2	24.4	23.4	23.4	22.1	20.8	20.3
Federal Revenue	2568	2524	2105	2163	2304	2450	2775	3021
∆%	6.7	-1.7	-16.6	2.7	6.5	6.3	13.3	8.9
% GDP	17.9	17.1	14.6	14.6	15.0	15.3	16.7	17.5

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 VI-3C provides quarterly estimates NSA of the external imbalance of the United States. The current account deficit seasonally adjusted increases from 2.1 percent of GDP in IIQ2014 to 2.2 percent in IIIQ2014. The current account deficit increases to 2.3 percent of GDP in IVQ2014 and increases to 2.7 percent of GDP in IQ2015. The deficit decreases to 2.5 percent of GDP in IIQ2015. The net international investment position increases from $5.5 trillion in IIQ2014 to $6.2 trillion in IIIQ2014, increasing to $7.0 trillion in IVQ2014. The net international investment position decreases to 6.8 trillion in IQ2015 and decreases to $6.7 trillion in IIQ2015.

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

	IIQ2014	IIIQ2014	IVQ2014	IQ2015	IIQ2015
Goods & Services	-139	-143	-126	-109	-139
Primary Income	59	63	59	50	51
Secondary Income	-20	-35	-34	-34	-29
Current Account	-99	-115	-102	-93	-117
Current Account % GDP	-2.1	-2.2	-2.3	-2.7	-2.5
NIIP	-5519	-6205	-7020	-6801	-6688
US Owned Assets Abroad	24987	24597	24595	25317	24538
Foreign Owned Assets in US	-30506	-30802	-31615	-32118	-31226
DIA MV	7481	7232	7124	7251	7298
DIA MV Equity	6413	6156	6052	6178	6202
DIUS MV	5935	6023	6229	6392	6434
DIUS MV Equity	4603	4639	4839	4977	4978

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

ESV Household Income at 1996 Levels, 46 Million in Poverty and 33 Million without Health Insurance. The objective of this section is to analyze newly released data by the US Census Bureau on income, poverty and health insurance (DeNavas-Walt, Proctor and Smith 2013), DeNavas and Proctor (2014), DeNavas and Proctor (2015) and Smith and Medalia 2014) and Smith and Medalia (2015). This report depicts 2014 household income of the US in constant 2014 dollars regressing to the level of 1996. The number of people in poverty in the US in 2014 is 46.657 million, equivalent to 14.8 percent of the population, which is almost the same as 15.0 percent in 1982 and higher than any percentage since 17.3 percent in 1965 with exception of isolated years in the range of 15.1 to 15.2 percent. The number of people without health insurance in 2014 is 32.968 million, which is equivalent to 10.4 percent of the population. Although the economy recovered throughout 2011, 2012, 2013 and 2014, income deteriorated while poverty and lack of health insurance remained at stress levels. Increasing poverty and lack of health insurance challenge the social and health safety net because of a sudden jump of needs for social and health services on capacity that provide those needs that is fixed in the short run while growth of the economy requires absorbing labor input and maintaining health of the stock of human capital. Part of the explanation of the dramatically poor socio-economic indicators of the US could be explained by the sharp economic contraction from IV2007 to IIQ2009 but part originates in the worst recovery in a cyclical expansion during the postwar period (http://cmpassocregulationblog.blogspot.com/2015/09/monetary-policy-designed-on-measurable.html).

The report of the US Bureau of the Census on Income, poverty and health insurance coverage in the United States: 2014 provides highly valuable socio-economic information and analysis (DeNavas-Walt and Proctor 2015). Table IIB-1 provides years of high percentage of people below poverty in the US. Data for 2006 to 2009 are included to provide a framework of reference for the current deterioration. The series has two high points of 15.1 percent of the population in poverty in 2010 and 1993 exceeded only by 15.2 percent in 1983. The prior high numbers of poverty are in 1960 to 1965 with 17.3 percent in 1965 and higher numbers going to 22.4 percent in 1959. The number of people in poverty in the US in 2014 was 46.657 million, which has increased by 10.197 million from 36.460 million in 2006. The fractured job market with 25.6 million unemployed or underemployed because they cannot find full-time jobs (http://cmpassocregulationblog.blogspot.com/2015/10/labor-market-uncertainty-and-interest.html) and recovery without hiring (http://cmpassocregulationblog.blogspot.com/2015/09/interest-rate-policy-dependent-on-what_13.html) prevents exit from poverty. Inflation-adjusted average weekly wages stagnated (http://cmpassocregulationblog.blogspot.com/2015/10/labor-market-uncertainty-and-interest.html).

Table IIB-1, US, Historical High Percentage of People below Poverty, Thousands and Percent

	Total Population	Number Below Poverty	Percent Below Poverty
2014	315,804	46,657	14.8
2013	313,096	46,269	14.8
2012	310,648	46,496	15.0
2011	308,456	46,247	15.0
2010	306,130	46,343	15.1
2009	303,820	43,569	14.3
1993	259,278	39,265	15.1
1983	231,700	35,303	15.2
1982	229,412	34,398	15.0
1965	191,413	33,185	17.3
1964	189,710	36,055	19.0
1963	187,258	36,436	19.5
1962	184,276	38,625	21.0
1961	181,277	39,628	21.9
1960	179,503	39,851	22.2
1959	176,557	39,490	22.4
Memo
2009	303,820	43,569	14.3
2008	301,041	39,829	13.2
2007	298,699	37,276	12.5
2006	296,450	36,460	12.3

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas-Walt and Proctor (2014), DeNavas-Walt and Proctor (2015).

Millions in poverty in the calendar year in which the recession ended and in the first calendar year after the recession are provided in Table IIB-2. There have been increases in the number of people in poverty in the first calendar years after the recessions since 1980. The brief recession of Jan to Jul 1980 experienced the highest increase in the first calendar year of 1.0 percent and 2.550 million more in poverty. In the three recessions before 1980 shown in Table IIB-2, the number of people in poverty fell in the first calendar year after the end of the recession.

Table IIB-2, US, Millions in Poverty in the Calendar Year in which Recession Ended and in the First Calendar Year after Recession, Millions and ∆%

	Millions	%	Millions	%	Change Millions	% Points
Dec 2007 to Jun 2009
2009	43.569	14.3
2010			46.343	15.1	2.774	0.8
Mar 2001 to Nov 2001
2001	32.907	11.7
2002			34.570	12.1	1.663	0.4
Jul 1990 to Mar 1991
1991	35.708	14.2
1992			38.014	14.8	2.306	0.6
Jul 1981 to Nov 1982
1982	34.398	15.0
1983			35.303	15.2	0.905	0.2
Jan 1980 to July 1980
1980	29.272	13.0
1981			31.822	14.0	2.550	1.0
Nov 1973 to Mar 1975
1975	25.877	12.3
1976			24.975	11.8	-0.902	-0.5
Dec 1960 to Nov 1970
1970	25.420	12.6
1971			25.559	12.5	-0.139	-0.1
Apr 1960 to Feb 1961
1961	39.628	21.9
1962			38.625	21.0	-1.003	-0.9

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014), DeNavas-Walt and Proctor (2015).

Another dramatic fact revealed by DeNavas-Walt, Proctor and Smith (2013) is the increase in the number people without health insurance shown in Table IIB-3 at 49.951 million for 2010. Approximately 16.3 percent of the US population did not have health insurance in 2010. There was marginal improvement with 47.951 million without health insurance in 2012, corresponding to 15.4 percent of the population.

Table IIB-3, US, People without Health Insurance in the Final Year of Recession and in the First Calendar Year after Recession Ended, Millions and Percent

	Millions Without Health Insurance	Percent of Population
Recession Dec 2007 to Jun 2009
2009	49.985	16.4
2010	49.951	16.3
Change/2009	0.919	-0.1 % Points
2012	47.951	15.7
Change/2009	-2.034	-0.7 % Points
Recession Mar 2001 to Nov 2001
2001	38.023	13.5
2002	39.776	13.9
Change	1.753	0.4
Recession Jul 1990 to Mar 1991
1991	35.445	14.1
1992	38.641	15.0
Change	3.196	0.9

Source: DeNavas-Walt, Proctor and Smith (2013).

The population of the US increased by 19.344 million from 296.824 million in 2006 to 316.168 million in 2014, as shown in Table IIB-4. The number uncovered by health insurance decreased by 12.246 million between 2006 and 2014. Private health insurance coverage increased by 4.658 million from 2006 to 2014 while government health insurance coverage increased by 35.127 million.

Table IIB-4, US, Population, Private and Government Health Insurance and Uncovered by Health Insurance, Thousands and Percent, 2006-2011

	Population	Private Health Insurance	Govern- ment Health Insurance	Uncovered
2014	316,168	208,600	115,470	32,968
2013	313,401	201,038	108,287	41,795
2012	311,116	198,812	101,493	47,951
2011	308,827	197,323	99,497	48,614
2010	306,553	196,147	95,525	49,951
2009	304,280	196,245	93,245	48,985
2008	301,483	202,626	87,586	44,780
2007	299,106	203,903	83,147	44,088
2006	296,824	203,942	80,343	45,214

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014), DeNavas-Walt and Proctor (2015), Smith and Medalia (2014), Smith and Medalia 2015.

Median household income in the US fell 6.5 percent from $57,357 in 2007 to $53,657 in 2014, as shown in Table IIB-5. Median income fell 4.2 percent in 2012 relative to 2009 even after four years of recovery of the economy.

Table IIB-5, US, Median Household Income, 2014 CPI Adjusted Dollars and Number of Households

	2014	2013	2012	2010	2009	2007
NH	124,587	123,931	122,459	119,927	117,538	116,783
MINC	53,657	54,462	52,605	53,507	54,925	57,357
∆% 2014/2007			-6.5
∆% 2014/2013			-1.5
∆% 2014/2012			2.0
∆% 2014/2011			1.8
∆% 2014/2010			0.3

Notes: NH: Total Number of Households, Thousands; MINC: Median Income, Dollars

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014, DeNavas-Walt and Proctor (2015).

Numbers of households in the US, median income in constant CPI-adjusted 2014 dollars and mean income in 2014 dollars are in Table IIB-6. There is a dramatic fact in Table IIB-6: inflation-adjusted median household income in the US is higher in all years from 1996 to 2014 than the $53,657 of 2014 with exception of 2010 to 2012. The contraction and low rate of growth in the expansion have resulted in the destruction of the progress in household income accomplished in 18 years of technological advance and use of humans, machines and natural resources in economic activity. The median measures the center of the middle class of the US that is no better off after 19 years of efforts. There is sharp contrast with the 1980s. Rapid economic growth after the contraction from Jul 1981 to Nov 1982 (http://www.nber.org/cycles.html) resulted in an increase of household median income from $47,229 in 1983 to $53,306 in 1989, or by 12.9 percent. Another fact of Table IA-6 is that household income in 2014 of $53,567 is virtually the same as $53,306 in 1989. The typical household in the US is no better off than in 1989, which is separated from the present by 25 years of efforts.

Table IIB-6, Median and Mean Household Income in 2014 Consumer Price Adjusted Dollars

Year	# Households	Median Income 2014 Dollars	Mean Income 2014 Dollars
2014	124,587	53,657	75,738
2013	123,931	54,462	78,426
2012	122,459	52,605	73,493
2011	121,084	52,690	73,346
2010	119,927	53,507	73,178
2009	117,538	54,925	75,007
2008	117,181	55,313	75,238
2007	116,783	57,357	77,198
2006	116,011	55,598	78,167
2005	114,384	56,160	76,790
2004	113,343	55,565	75,784
2003	112,000	55,759	76,031
2002	111,278	55,807	76,129
2001	109,297	56,466	77,834
2000	108,209	57,724	78,544
1999	106,434	57,843	77,799
1998	103,874	56,445	75,272
1997	102,528	54,443	73,109
1996	101,018	53,345	70,827
1995	99,627	52,604	69,372
1994	98,990	51,006	68,189
1993	97,107	50,421	66,862
1992	96,426	50,667	64,235
1991	95,669	51,086	64,307
1990	94,312	52,623	65,734
1989	93,347	53,306	67,347
1988	92,830	52,372	65,438
1987	91,124	51,973	64,634
1986	89,479	51,329	63,414
1985	88,458	49,574	61,009
1984	86,789	48,664	59,625
1983	85,407	47,229	57,441
1982	83,918	47,530	57,281
1981	83,527	47,658	56,935
1980	82,368	48,462	57,637

Source: DeNavas-Walt, Proctor and Smith (2013), DeNavas and Proctor (2014), DeNavas-Walt and Proctor (2015).

The percentage change in median household income and the change in number of workers with earnings in the first calendar years after recessions are provided in Table IIB-7. The first calendar year after the end of recession in 2010 is by far the worst of any such year in recessions since 1970. Household median income fell 2.6 percent from 2009 to 2010 and the number of workers with earnings fell by 1.334 million. The first calendar year 2010 after the end of recession in 2009 is the only in the recessions back to 1970 in which there was decline of the number of workers with earnings and the one with lowest increase in full-time year-round workers.

Table IIB-7, Percentage Change in Median Household Income and Change in Number of Workers with Earnings in First Calendar Years after Recessions, ∆% and Thousands

	Median Household Income ∆%	Change in Number of Workers with Earnings Thousands	Change in Full-time Year-round Workers Thousands
Recession Dec 2007 to June 2009
2010	-2.6	-1,334	192
Recession Mar 2001 to Nov 2001
2002	-1.2	470	286
Recession Jul 1990 to Mar 1991
1992	-0.8	1,692	1,468
Recession Jul 1981 to Nov 1982
1983	-0.7	1,696	2,887
Recession Jan 1980 to Jul 1980
1981	-1.7	995	362
Recession Nov 1973 to Mar 1975
1976	1.7	2,821	1,538
Recession Dec 1960 to Nov 1970
1971	-1.0	1,277	1,213

Source:

DeNavas-Walt, Proctor and Smith (2013).

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