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Dollar Devaluation, Cyclically Stagnating Real Disposable Income per Capita in the Lost Economic Cycle of the Global Recession with Economic Growth Underperforming Below Trend Worldwide, Financial Repression, United States Housing, Destruction of Household Nonfinancial Wealth with Cyclically Stagnating Total Real Wealth Growing below Historical Trend, World Cyclical Slow Growth and Global Recession Risk
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017
I Stagnating Real Disposable Income and Consumption Expenditures
IB1 Stagnating Real Disposable Income and Consumption Expenditures
IB2 Financial Repression
IIB United States Housing Collapse
IIA1 Sales of New Houses
IIA2 United States House Prices
IIC Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth
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
I United States Housing Collapse. Data and other information continue to provide depressed conditions in the US housing market in a longer perspective, with recent improvement at the margin. Table IIB-1 shows sales of new houses in the US at seasonally adjusted annual equivalent rate (SAAR). House sales fell in 31 of 83 months from Jan 2011 to Nov 2017 with monthly declines of 5 in 2011, 4 in 2012, 4 in 2013, 6 in 2014, 3 in 2015, 5 in 2016 and 4 in 2017. In Jan-Apr 2012, house sales increased at the annual equivalent rate of 11.8 percent and at 22.3 percent in May-Sep 2012. There was significant strength in Sep-Dec 2011 with annual equivalent rate of 48.4 percent. Sales of new houses fell 7.0 percent in Oct 2012 with increase of 9.5 percent in Nov 2012. Sales of new houses rebounded 10.8 percent in Jan 2013 with annual equivalent rate of 51.5 percent from Oct 2012 to Jan 2013 because of the increase of 10.8 percent in Jan 2013. New house sales increased at annual equivalent 9.9 percent in Feb-Mar 2013. New house sales weakened, decreasing at 2.3 percent in annual equivalent from Apr to Dec 2013 with significant volatility illustrated by decline of 18.8 percent in Jul 2013 and increase of 11.3 percent in Oct 2013. New house sales fell 1.1 percent in Dec 2013. New house sales increased 1.4 percent in Jan 2014 and fell 5.4 percent in Feb 2014, decreasing 3.1 percent in Mar 2014. New house sales decreased 2.2 percent in Apr 2014 and increased 12.7 percent in May 2014. New house sales fell 8.0 percent in Jun 2014 and decreased 3.4 percent in Jul 2014. New house sales jumped 11.7 percent in Aug 2014 and increased 3.8 percent in Sep 2014. New House sales increased 1.7 percent in Oct 2014 and fell 5.9 percent in Nov 2014. House sales fell at the annual equivalent rate of 2.6 percent in Sep-Nov 2014. New house sales increased 10.3 percent in Dec 2014 and increased 6.3 percent in Jan 2015. Sales of new houses increased 5.0 percent in Feb
2015 and fell 12.4 percent in Mar 2015. House sales increased 4.0 percent in Apr 2015. The annual equivalent rate in Dec 2014-Apr 2015 was 31.7 percent. New house sales increased 0.8 percent in May 2015 and fell 5.6 percent in Jun 2015, increasing 4.6 percent in Jul 2015. New house sales fell at annual equivalent 1.9 percent in May-Jul 2015. New house sales increased 3.0 percent in Aug 2015 and fell 10.1 percent in Sep 2015. New house sales decreased at annual equivalent 37.0 percent in Aug-Sep 2015. New house sales increased 4.6 percent in Oct 2015 and increased 5.4 percent in Nov 2015, increasing 5.5 percent in Dec 2015. New house sales increased at the annual equivalent rate of 83.0 percent in Oct-Dec 2015. New house sales decreased 3.0 percent in Jan 2016 at the annual equivalent rate of minus 30.6 percent. New house sales increased 1.0 percent in Feb 2016 and increased 1.5 percent in Mar 2016. New house sales jumped at 6.2 percent in Apr 2016. New house sales increased at the annual equivalent rate of 40.5 percent in Feb-Apr 2016. New house sales decreased 1.1 percent in May 2016 and decreased 0.2 percent in Jun 2016. New house sales jumped 12.2 percent in Aug 2016. New house sales increased at the annual equivalent rate of 50.4 percent in May-Jul 2016. New house sales fell 9.6 percent in Aug 2016 and increased 0.5 percent in Sep 2016, increasing 1.2 percent in Oct 2016. New house sales fell at the annual equivalent rate of minus 28.5 percent in Aug-Oct 2016. New house sales increased at 0.3 percent in Nov 2016 and fell at 5.4 percent in Dec 2016. New house sales fell at 27.0 percent annual equivalent in Nov-Dec 2016. New house sales increased at 9.3 percent in Jan 2017 and increased at 2.7 percent in Feb 2017. New house sales increased at 100.1 percent in Jan-Feb 2017. New house sales increased at 3.7 percent in Mar 2017 and fell at 7.5 percent in Apr 2017. New house sales decreased at annual equivalent 22.1 percent in Mar-Apr 2017. New house sales increased at 2.7 percent in May 2017 and increased at 2.1 percent in Jun 2017. New house sales increased at annual equivalent 32.9 percent in May-Jun 2017. New house sales decreased at 8.9 percent in Jul 2017 and decreased at 0.9 percent in Aug 2017, increasing at 13.6 percent in Sep 2017. New house sales decreased at 1.7 percent in Oct 2017. New house sales increased at 17.5 percent in Nov 2017. New house sales increased at 50.2 percent in Jul-Nov 2017. There are wide monthly oscillations. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), analyze how builders have provided financial assistance to home buyers, including those short of cash and with weaker credit background, explaining the rise in new home sales and the highest gap between prices of new and existing houses. The 30-year conventional mortgage rate increased from 3.40 on Apr 25, 2013 to 4.58 percent on Aug 22, 2013 (http://www.federalreserve.gov/releases/h15/data.htm), which could also be a factor in recent weakness with improvement after the rate fell to 4.26 in Nov 2013. The conventional mortgage rate rose to 4.48 percent on Dec 26, 2013 and fell to 4.32 percent on Jan 30, 2014. The conventional mortgage rate increased to 4.37 percent on Feb 26, 2014 and 4.40 percent on Mar 27, 2014. The conventional mortgage rate fell to 4.14 percent on Apr 22, 2014, stabilizing at 4.14 on Jun 26, 2014. The conventional mortgage rate stood at 3.93 percent on Aug 20, 2015 and at 3.91 percent on Sep 17, 2015. The conventional mortgage rate was at 3.79 percent on Oct 22, 2015. The conventional mortgage rate was 3.97 percent on Nov 20, 2015. The conventional mortgage rate was 3.97 percent on Dec 18, 2015, and 3.92 percent on Jan 14, 2016. The conventional mortgage rate was 3.65 percent on Feb 19, 2016. The commercial mortgage rate was 3.73 percent on Mar 17, 2016 and 3.59 percent on Apr 21, 2016. The conventional mortgage rate was 3.58 on May 19, 2016. The conventional mortgage rate was 3.54 percent on Jun 19, 2016 and 3.45 percent on Jul 21, 2016. The conventional mortgage rate was 3.43 percent on Aug 18, 2016 and 3.48 percent on Sep 22, 2016. The conventional mortgage rate was 3.94 on Nov 17, 2016 and 4.30 percent on Dec 22. The conventional mortgage rate was 4.19 percent on Jan 26, 2017 and 4.15 percent on Feb 17, 2017. The conventional mortgage rate was 4.1 percent on Mar 16, 2017. The conventional mortgage rate was 3.97 percent on Apr 20, 2017. The conventional mortgage rate was 4.05 percent on May 18, 2017. The conventional mortgage rate was 3.90 percent on Jun 22, 2017. The conventional mortgage rate was 3.96 percent on Jul 20, 2017. The conventional mortgage rate was 3.90 percent on Aug 18, 2017. The conventional mortgage rate was 3.83 percent on Sep 21, 2017. The conventional mortgage rate was 3.88 percent on Oct 20, 2017. The conventional mortgage rate was 3.92 percent on Nov 22, 2017 and 3.94 on Dec 21, 2017. The conventional mortgage rate measured in a survey by Freddie Mac (http://www.freddiemac.com/pmms/ http://www.freddiemac.com/pmms/abtpmms.htm) is the “interest rate a lender would charge to lend mortgage money to a qualified borrower.”
Table IIB-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %
| SA Annual Rate | ∆% | |
| Nov 2017 | 733 | 17.5 |
| Oct | 624 | -1.7 |
| Sep | 635 | 13.6 |
| Aug | 559 | -0.9 |
| Jul | 564 | -8.9 |
| AE ∆% Jul-Nov | 50.2 | |
| Jun | 619 | 2.1 |
| May | 606 | 2.7 |
| AE ∆% May -Jun | 32.9 | |
| Apr | 590 | -7.5 |
| Mar | 638 | 3.7 |
| AE ∆% Mar-Apr | -22.1 | |
| Feb | 615 | 2.7 |
| Jan | 599 | 9.3 |
| AE ∆% Jan-Feb | 100.1 | |
| Dec 2016 | 548 | -5.4 |
| Nov | 579 | 0.3 |
| AE ∆% Nov-Dec | -27.0 | |
| Oct | 577 | 1.2 |
| Sep | 570 | 0.5 |
| Aug | 567 | -9.6 |
| AE ∆% Aug-Oct | -28.5 | |
| Jul | 627 | 12.2 |
| Jun | 559 | -0.2 |
| May | 560 | -1.1 |
| AE ∆% May-Jul | 50.4 | |
| Apr | 566 | 6.2 |
| Mar | 533 | 1.5 |
| Feb | 525 | 1.0 |
| AE ∆% Feb-Apr | 40.5 | |
| Jan | 520 | -3.0 |
| AE ∆% Jan | -30.6 | |
| Dec 2015 | 536 | 5.5 |
| Nov | 508 | 5.4 |
| Oct | 482 | 4.6 |
| AE ∆% Oct-Dec | 83.0 | |
| Sep | 461 | -10.1 |
| Aug | 513 | 3.0 |
| AE ∆% Aug-Sep | -37.0 | |
| Jul | 498 | 4.6 |
| Jun | 476 | -5.6 |
| May | 504 | 0.8 |
| AE ∆% May-Jul | -1.9 | |
| Apr | 500 | 4.0 |
| Mar | 481 | -12.4 |
| Feb | 549 | 5.0 |
| Jan | 523 | 6.3 |
| Dec 2014 | 492 | 10.3 |
| AE ∆% Dec-Apr | 31.7 | |
| Nov | 446 | -5.9 |
| Oct | 474 | 1.7 |
| Sep | 466 | 3.8 |
| AE ∆% Sep-Nov | -2.6 | |
| Aug | 449 | 11.7 |
| Jul | 402 | -3.4 |
| Jun | 416 | -8.0 |
| May | 452 | 12.7 |
| Apr | 401 | -2.2 |
| Mar | 410 | -3.1 |
| Feb | 423 | -5.4 |
| Jan | 447 | 1.4 |
| AE ∆% Jan-Aug | 2.6 | |
| Dec 2013 | 441 | -1.1 |
| Nov | 446 | 0.5 |
| Oct | 444 | 11.3 |
| Sep | 399 | 5.0 |
| Aug | 380 | 1.1 |
| Jul | 376 | -18.8 |
| Jun | 463 | 7.7 |
| May | 430 | -4.7 |
| Apr | 451 | 0.4 |
| AE ∆% Apr-Dec | -2.3 | |
| Mar | 449 | 2.3 |
| Feb | 439 | -0.7 |
| AE ∆% Feb-Mar | 9.9 | |
| Jan | 442 | 10.8 |
| Dec 2012 | 399 | 1.8 |
| Nov | 392 | 9.5 |
| Oct | 358 | -7.0 |
| AE ∆% Oct-Jan | 51.5 | |
| Sep | 385 | 2.7 |
| Aug | 375 | 1.6 |
| Jul | 369 | 2.5 |
| Jun | 360 | -2.7 |
| May | 370 | 4.5 |
| AE ∆% May-Sep | 22.3 | |
| Apr | 354 | 0.0 |
| Mar | 354 | -3.3 |
| Feb | 366 | 9.3 |
| Jan | 335 | -1.8 |
| AE ∆% Jan-Apr | 11.8 | |
| Dec 2011 | 341 | 4.0 |
| Nov | 328 | 3.8 |
| Oct | 316 | 3.9 |
| Sep | 304 | 1.7 |
| AE ∆% Sep-Dec | 48.4 | |
| Aug | 299 | 1.0 |
| Jul | 296 | -1.7 |
| Jun | 301 | -1.3 |
| May | 305 | -1.6 |
| AE ∆% May-Aug | -10.3 | |
| Apr | 310 | 3.3 |
| Mar | 300 | 11.1 |
| Feb | 270 | -12.1 |
| Jan | 307 | -5.8 |
| AE ∆% Jan-Apr | -14.2 | |
| Dec 2010 | 326 | 13.6 |
AE: Annual Equivalent
Source: US Census Bureau
http://www.census.gov/construction/nrs/
There is additional information of the report of new house sales in Table IIB-2. The stock of unsold houses fell from rates of 6 to 8 percent of sales in 2011 to 4 to 5 percent in 2013 and 4.6 percent in Nov 2017. Robbie Whelan and Conor Dougherty, writing on “Builders fuel home sale rise,” on Feb 26, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324338604578327982067761860.html), find that inventories of houses have declined as investors acquire distressed houses of higher quality. Median and average house prices oscillate. In Nov 2017, median prices of new houses sold not seasonally adjusted (NSA) decreased 0.3 percent after decreasing 2.7 percent in
Oct 2017. Average prices decreased 4.5 percent in Nov 2017 and increased 4.4 percent in Oct 2017. Between Dec 2010 and Nov 2017, median prices increased 32.1 percent, with increases of 6.0 percent in Feb 2016, 4.9 percent in Nov 2015, 2.2 percent in Sep 2015, 13.6 percent in Oct 2014, 4.0 percent in Aug 2014, 4.0 percent in May 2014 and 5.2 percent in Mar 2014. Average prices increased 29.3 percent between Dec 2010 and Nov 2017, with increases of 5.1 percent in Mar 2016, 4.0 percent in Sep 2015, 4.4 percent in Jul 2015 and 18.3 percent in Oct 2014. Between Dec 2010 and Dec 2012, median prices increased 7.1 percent and average prices increased 2.6 percent. Price increases concentrated in 2012 with increase of median prices of 18.2 percent from Dec 2011 to Dec 2012 and of average prices of 13.8 percent. Median prices increased 16.7 percent from Dec 2012 to Dec 2014, with increase of 13.6 percent in Oct 2014, while average prices increased 24.7 percent, with increase of 18.3 percent in Oct 2014. Median prices decreased 1.5 percent from Dec 2014 to Dec 2015 while average prices fell 5.5 percent. Median prices increased 10.1 percent from Dec 2015 to Dec 2016 while average prices increased 8.5 percent. Median prices decreased 1.2 percent from Nov 2016 to Nov 2017 while average prices increased 3.8 percent. Robbie Whelan, writing on “New homes hit record as builders cap supply,” on May 24, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323475304578500973445311276.html?mod=WSJ_economy_LeftTopHighlights), finds that homebuilders are continuing to restrict the number of new homes for sale. Restriction of available new homes for sale increases prices paid by buyers.
Table IIB-2, US, New House Stocks and Median and Average New Homes Sales Price
| Unsold* | Median | Month | Average New House Sales Price USD | Month | |
| Nov 2017 | 4.6 | 318,700 | -0.3 | 377,100 | -4.5 |
| Oct | 5.4 | 319,600 | -2.7 | 394,700 | 4.4 |
| Sep | 5.3 | 328,500 | 4.6 | 377,900 | 2.4 |
| Aug | 6.0 | 314,200 | -2.7 | 369,200 | -0.9 |
| Jul | 5.9 | 322,900 | 2.4 | 372,400 | 0.5 |
| Jun | 5.3 | 315,200 | -2.6 | 370,600 | -2.1 |
| May | 5.4 | 323,600 | 4.0 | 378,400 | 3.4 |
| Apr | 5.4 | 311,100 | -3.3 | 365,800 | -4.8 |
| Mar | 5.0 | 321,700 | 8.0 | 384,400 | 3.8 |
| Feb | 5.1 | 298,000 | -5.5 | 370,500 | 3.6 |
| Jan | 5.2 | 315,200 | -3.6 | 357,700 | -6.5 |
| Dec 2016 | 5.6 | 327,000 | 3.8 | 382,500 | 5.3 |
| Nov | 5.1 | 315,000 | 4.0 | 363,400 | 3.2 |
| Oct | 5.2 | 302,800 | -3.8 | 352,200 | -3.8 |
| Sep | 5.1 | 314,800 | 5.3 | 366,100 | 3.1 |
| Aug | 5.1 | 298,900 | 0.5 | 355,100 | 0.6 |
| Jul | 4.5 | 297,400 | -4.4 | 353,000 | -1.3 |
| Jun | 5.2 | 311,200 | 5.4 | 357,800 | 2.3 |
| May | 5.2 | 295,200 | -7.3 | 349,700 | -5.3 |
| Apr | 5.1 | 318,300 | 5.0 | 369,300 | 2.9 |
| Mar | 5.5 | 303,200 | -0.9 | 359,000 | 5.1 |
| Feb | 5.5 | 305,800 | 6.0 | 341,700 | -5.4 |
| Jan | 5.5 | 288,400 | -2.9 | 361,200 | 2.5 |
| Dec 2015 | 5.2 | 297,100 | -5.0 | 352,500 | -5.5 |
| Nov | 5.4 | 312,600 | 4.9 | 373,200 | 1.2 |
| Oct | 5.6 | 298,000 | -0.5 | 368,900 | 3.3 |
| Sep | 5.8 | 299,500 | 2.2 | 357,200 | 4.0 |
| Aug | 5.1 | 293,000 | 0.2 | 343,300 | 0.6 |
| Jul | 5.2 | 292,300 | 2.5 | 341,200 | 4.4 |
| Jun | 5.4 | 285,100 | -0.8 | 326,900 | -2.8 |
| May | 5.0 | 287,500 | -2.4 | 336,200 | -1.2 |
| Apr | 4.9 | 294,500 | 2.8 | 340,400 | -2.5 |
| Mar | 5.1 | 286,600 | 0.0 | 349,300 | 0.9 |
| Feb | 4.5 | 286,600 | -1.8 | 346,300 | -0.6 |
| Jan | 4.7 | 292,000 | -3.2 | 348,300 | -6.7 |
| Dec 2014 | 5.1 | 301,500 | 1.1 | 373,200 | 7.0 |
| Nov | 5.7 | 298,300 | 0.4 | 348,900 | -7.6 |
| Oct | 5.3 | 297,000 | 13.6 | 377,500 | 18.3 |
| Sep | 5.3 | 261,500 | -10.4 | 319,100 | -10.4 |
| Aug | 5.5 | 291,700 | 4.0 | 356,200 | 3.2 |
| Jul | 6.1 | 280,400 | -2.3 | 345,200 | 2.1 |
| Jun | 5.7 | 287,000 | 0.5 | 338,100 | 4.5 |
| May | 5.1 | 285,600 | 4.0 | 323,500 | -0.5 |
| Apr | 5.7 | 274,500 | -2.8 | 325,100 | -1.9 |
| Mar | 5.6 | 282,300 | 5.2 | 331,500 | 1.7 |
| Feb | 5.3 | 268,400 | -0.5 | 325,900 | -3.4 |
| Jan | 5.1 | 269,800 | -2.1 | 337,300 | 5.0 |
| Dec 2013 | 5.1 | 275,500 | -0.6 | 321,200 | -4.3 |
| Nov | 5.0 | 277,100 | 4.8 | 335,600 | 0.0 |
| Oct | 4.9 | 264,300 | -2.0 | 335,700 | 4.4 |
| Sep | 5.5 | 269,800 | 5.7 | 321,400 | 3.4 |
| Aug | 5.5 | 255,300 | -2.6 | 310,800 | -5.8 |
| Jul | 5.4 | 262,200 | 0.9 | 329,900 | 7.8 |
| Jun | 4.1 | 259,800 | -1.5 | 306,100 | -2.5 |
| May | 4.5 | 263,700 | -5.6 | 314,000 | -6.8 |
| Apr | 4.3 | 279,300 | 8.5 | 337,000 | 12.3 |
| Mar | 4.1 | 257,500 | -2.9 | 300,200 | -3.9 |
| Feb | 4.2 | 265,100 | 5.4 | 312,500 | 1.8 |
| Jan | 4.0 | 251,500 | -2.6 | 306,900 | 2.6 |
| Dec 2012 | 4.5 | 258,300 | 5.4 | 299,200 | 2.9 |
| Nov | 4.6 | 245,000 | -0.9 | 290,700 | 1.9 |
| Oct | 4.9 | 247,200 | -2.9 | 285,400 | -4.1 |
| Sep | 4.5 | 254,600 | 0.6 | 297,700 | -2.6 |
| Aug | 4.6 | 253,200 | 6.7 | 305,500 | 8.2 |
| Jul | 4.6 | 237,400 | 2.1 | 282,300 | 3.9 |
| Jun | 4.8 | 232,600 | -2.8 | 271,800 | -3.2 |
| May | 4.7 | 239,200 | 1.2 | 280,900 | -2.4 |
| Apr | 4.9 | 236,400 | -1.4 | 287,900 | 1.5 |
| Mar | 4.9 | 239,800 | 0.0 | 283,600 | 3.5 |
| Feb | 4.8 | 239,900 | 8.2 | 274,000 | 3.1 |
| Jan | 5.3 | 221,700 | 1.4 | 265,700 | 1.1 |
| Dec 2011 | 5.3 | 218,600 | 2.0 | 262,900 | 5.2 |
| Nov | 5.7 | 214,300 | -4.7 | 250,000 | -3.2 |
| Oct | 6.0 | 224,800 | 3.6 | 258,300 | 1.1 |
| Sep | 6.3 | 217,000 | -1.2 | 255,400 | -1.5 |
| Aug | 6.5 | 219,600 | -4.5 | 259,300 | -4.1 |
| Jul | 6.7 | 229,900 | -4.3 | 270,300 | -1.0 |
| Jun | 6.6 | 240,200 | 8.2 | 273,100 | 4.0 |
| May | 6.6 | 222,000 | -1.2 | 262,700 | -2.3 |
| Apr | 6.7 | 224,700 | 1.9 | 268,900 | 3.1 |
| Mar | 7.2 | 220,500 | 0.2 | 260,800 | -0.8 |
| Feb | 8.1 | 220,100 | -8.3 | 262,800 | -4.7 |
| Jan | 7.3 | 240,100 | -0.5 | 275,700 | -5.5 |
| Dec 2010 | 7.0 | 241,200 | 9.8 | 291,700 | 3.5 |
*Percent of new houses for sale relative to houses sold
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The depressed level of residential construction and new house sales in the US is evident in Table IIB-3 providing new house sales not seasonally adjusted in Jan-Nov of various years. New house sales increased 9.0 percent from Jan-Nov 2016 to Jan-Nov 2017. Sales of new houses are higher in Jan-Nov 2017 relative to Jan-Nov 2015 with increase of 22.9 percent. Sales of new houses are higher in Jan-Nov 2017 relative to Jan-Nov 2014 with increase of 40.8 percent. Sales of new houses in Jan-Nov 2017 are substantially lower than in many years between 1971 and 2017 except for the years from 2008 to 2017. There are only six other increases of 43.0 percent relative to Jan-Nov 2013, 66.9 percent relative to Jan-Nov 2012, 102.5 percent relative to Jan-Nov 2011, 90.3 percent relative to Jan-Nov 2010 and 62.6 percent relative to Jan-Nov 2009. New house sales in Jan-Nov 2017 are 24.0 percent higher than in Jan-Nov 2008. Sales of new houses in Jan-Nov 2017 are lower by 22.3 percent relative to Jan-Nov 2007, 42.0 percent relative to 2006, 52.4 percent relative to 2005 and 49.2 percent relative to 2004. The housing boom peaked in 2005 and 2006 when increases in fed funds rates to 5.25 percent in Jun 2006 from 1.0 percent in Jun 2004 affected subprime mortgages that were programmed for refinancing in two or three years on the expectation that price increases forever would raise home equity. Higher home equity would permit refinancing under feasible mortgages incorporating full payment of principal and interest (Gorton 2009EFM; see other references in http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html). Sales of new houses in Jan 2017 relative to the same period in 2003 fell 43.8 percent and 36.9 percent relative to the same period in 2002. Similar percentage declines are also for 2017 relative to years from 2000 to 2004. Sales of new houses in Jan-Nov 2017 fell 8.2 per cent relative to the same period in 1995. The population of the US was 179.3 million in 1960 and 281.4 million in 2000 (Hobbs and Stoops 2002, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The estimate of the US population is 418.8 million in 2015. The US population increased by 133.6 percent from 1960 to 2015. The final row of Table IIB-3 reveals catastrophic data: sales of new houses in Jan-Nov 2017 of 569 thousand units are lower by 7.2 percent relative to 613 thousand units of houses sold in Jan-Nov 1971, which is the ninth year when data become available in 1963. The civilian noninstitutional population increased from 122.416 million in 1963 to 253.538 million in 2016, or 107.1 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”
Table IIB-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %
| Jan-Nov 2017 | 569 |
| Jan-Nov 2016 | 522 |
| Jan-Nov 2017/Jan-Nov 2016 | 9.0 |
| Jan-Nov 2015 | 463 |
| ∆% Jan-Nov 2017/Jan-Nov 2015 | 22.9 |
| Jan-Nov 2014 | 404 |
| ∆% Jan-Nov 2017/Jan-Nov 2014 | 40.8 |
| Jan-Nov 2013 | 398 |
| ∆% Jan-Nov 2017/Jan-Nov 2013 | 43.0 |
| Jan-Nov 2012 | 341 |
| ∆% Jan-Nov 2017/Jan-Nov 2012 | 66.9 |
| Jan-Nov 2011 | 281 |
| ∆% Jan-Nov 2017/Jan-Nov 2011 | 102.5 |
| Jan-Nov 2010 | 299 |
| ∆% Jan-Nov 2017/ | 90.3 |
| Jan-Nov 2009 | 350 |
| ∆% Jan-Nov 2017/ | 62.6 |
| Jan-Nov 2008 | 459 |
| ∆% Jan-Nov 2017/ | 24.0 |
| Jan-Nov 2007 | 732 |
| ∆% Jan-Nov 2017/ | -22.3 |
| Jan-Nov 2006 | 981 |
| ∆% Jan-Nov 2017/Jan-Nov 2006 | -42.0 |
| Jan-Nov 2005 | 1196 |
| ∆% Jan-Nov 2017/Jan-Nov 2005 | -52.4 |
| Jan-Nov 2004 | 1,120 |
| ∆% Jan-Nov 2017/Jan-Nov 2004 | -49.2 |
| Jan-Nov 2003 | 1013 |
| ∆% Jan-Nov 2017/ | -43.8 |
| Jan-Nov 2002 | 902 |
| ∆% Jan-Nov 2017/ | -36.9 |
| Jan-Nov 2001 | 843 |
| ∆% Jan-Nov 2017/ | -32.5 |
| Jan-Nov 2000 | 812 |
| ∆% Jan-Nov 2017/ | -29.9 |
| Jan-Nov 1995 | 620 |
| ∆% Jan-Nov 2017/ | -8.2 |
| Jan-Nov 1971 | 613 |
| ∆% Jan-Nov 2017/ | -7.2 |
*Computed using unrounded data
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The revised level of 306 thousand new houses sold in 2011 is the lowest since 560 thousand in 1963 in the 53 years of available data while the level of 368 thousand in 2012 is only higher than 323 thousand in 2010. The level of sales of new houses of 437 thousand in 2014 is the lowest from 1963 to 2009 with exception of 412 thousand in 1982 and 436 thousand in 1981. The population of the US increased 129.4 million from 179.3 million in 1960 to 308.7 million in 2010, or 72.2 percent. The estimate of the US population is 418.8 million in 2015. The US population increased 133.6 percent from 1960 to 2015. The civilian noninstitutional population increased from 122.416 million in 1963 to 253.538 million in 2016, or 107.1 percent (http://www.bls.gov/data/). The Bureau of Labor Statistics (BLS) defines the civilian noninstitutional population (http://www.bls.gov/lau/rdscnp16.htm#cnp): “The civilian noninstitutional population consists of persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.”
The civilian noninstitutional population is the universe of the labor force. In fact, there is no year from 1963 to 2013 in Table IIA-4 with sales of new houses below 400 thousand except for the immediately preceding years of 2009, 2010, 2011 and 2012.
Table IIB-4, US, New Houses Sold, NSA Thousands
| Period | Sold during Period |
| 1963 | 560 |
| 1964 | 565 |
| 1965 | 575 |
| 1966 | 461 |
| 1967 | 487 |
| 1968 | 490 |
| 1969 | 448 |
| 1970 | 485 |
| 1971 | 656 |
| 1972 | 718 |
| 1973 | 634 |
| 1974 | 519 |
| 1975 | 549 |
| 1976 | 646 |
| 1977 | 819 |
| 1978 | 817 |
| 1979 | 709 |
| 1980 | 545 |
| 1981 | 436 |
| 1982 | 412 |
| 1983 | 623 |
| 1984 | 639 |
| 1985 | 688 |
| 1986 | 750 |
| 1987 | 671 |
| 1988 | 676 |
| 1989 | 650 |
| 1990 | 534 |
| 1991 | 509 |
| 1992 | 610 |
| 1993 | 666 |
| 1994 | 670 |
| 1995 | 667 |
| 1996 | 757 |
| 1997 | 804 |
| 1998 | 886 |
| 1999 | 880 |
| 2000 | 877 |
| 2001 | 908 |
| 2002 | 973 |
| 2003 | 1,086 |
| 2004 | 1,203 |
| 2005 | 1,283 |
| 2006 | 1,051 |
| 2007 | 776 |
| 2008 | 485 |
| 2009 | 375 |
| 2010 | 323 |
| 2011 | 306 |
| 2012 | 368 |
| 2013 | 429 |
| 2014 | 437 |
| 2015 | 501 |
| 2016 | 561 |
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIB-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally Adjusted Annual Rate)
Source: US Census Bureau
https://www.census.gov/construction/nrs/img/c25_curr.gif
Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 6.0 percent, as shown in Table IB-5. Between 1995 and 2005 sales of new houses increased 92.4 percent at the yearly rate of 6.8 percent. There are similar rates in all years from 2000 to 2005. The boom in housing construction and sales began in the 1980s and 1990s. The collapse of real estate culminated several decades of housing subsidies and policies to lower mortgage rates and borrowing terms (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 42-8). Sales of new houses sold in 2016 fell 16.0 percent relative to the same period in 1995 and 56.4 percent relative to 2005.
Table IIB-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses
| ∆% | Average Yearly % Rate | |
| 1963-2016 | 0.0 | NA |
| 1991-2001 | 78.4 | 6.0 |
| 1995-2005 | 92.4 | 6.8 |
| 2000-2005 | 46.3 | 7.9 |
| 1995-2016 | -16.0 | NA |
| 2000-2016 | -36.1 | NA |
| 2005-2016 | -56.4 | NA |
NA: Not Applicable
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIB-2, US, New Single-family Houses Sold, NSA, 1963-2017
Source: US Census Bureau
http://www.census.gov/construction/nrs/
The available historical annual data of median and average prices of new houses sold in the US between 1963 and 2016 is in Table IIB-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially. There is recovery in 2012-2016.
Table IIB-6, US, Median and Average Prices of New Houses Sold, Annual Data
| Period | Median | Average |
| 1963 | $18,000 | $19,300 |
| 1964 | $18,900 | $20,500 |
| 1965 | $20,000 | $21,500 |
| 1966 | $21,400 | $23,300 |
| 1967 | $22,700 | $24,600 |
| 1968 | $24,700 | $26,600 |
| 1969 | $25,600 | $27,900 |
| 1970 | $23,400 | $26,600 |
| 1971 | $25,200 | $28,300 |
| 1972 | $27,600 | $30,500 |
| 1973 | $32,500 | $35,500 |
| 1974 | $35,900 | $38,900 |
| 1975 | $39,300 | $42,600 |
| 1976 | $44,200 | $48,000 |
| 1977 | $48,800 | $54,200 |
| 1978 | $55,700 | $62,500 |
| 1979 | $62,900 | $71,800 |
| 1980 | $64,600 | $76,400 |
| 1981 | $68,900 | $83,000 |
| 1982 | $69,300 | $83,900 |
| 1983 | $75,300 | $89,800 |
| 1984 | $79,900 | $97,600 |
| 1985 | $84,300 | $100,800 |
| 1986 | $92,000 | $111,900 |
| 1987 | $104,500 | $127,200 |
| 1988 | $112,500 | $138,300 |
| 1989 | $120,000 | $148,800 |
| 1990 | $122,900 | $149,800 |
| 1991 | $120,000 | $147,200 |
| 1992 | $121,500 | $144,100 |
| 1993 | $126,500 | $147,700 |
| 1994 | $130,000 | $154,500 |
| 1995 | $133,900 | $158,700 |
| 1996 | $140,000 | $166,400 |
| 1997 | $146,000 | $176,200 |
| 1998 | $152,500 | $181,900 |
| 1999 | $161,000 | $195,600 |
| 2000 | $169,000 | $207,000 |
| 2001 | $175,200 | $213,200 |
| 2002 | $187,600 | $228,700 |
| 2003 | $195,000 | $246,300 |
| 2004 | $221,000 | $274,500 |
| 2005 | $240,900 | $297,000 |
| 2006 | $246,500 | $305,900 |
| 2007 | $247,900 | $313,600 |
| 2008 | $232,100 | $292,600 |
| 2009 | $216,700 | $270,900 |
| 2010 | $221,800 | $272,900 |
| 2011 | $227,200 | $267,900 |
| 2012 | $245,200 | $292,200 |
| 2013 | $268,900 | $324,500 |
| 2014 | $288,500 | $347,700 |
| 2015 | $294,200 | $352,700 |
| 2016 | $307,800 | $360,900 |
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Prices rose sharply between 2000 and 2005 as shown in Table IIB-7. In fact, prices in 2016 are higher than in 2000. Between 2006 and 2016, median prices of new houses sold increased 24.9 percent and average prices increased 18.0 percent. Between 2015 and 2016, median prices increased 4.6 percent and average prices increased 2.3 percent.
Table IIB-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%
| Median New | Average New Home Sales Prices ∆% | |
| ∆% 2000 to 2003 | 15.4 | 19.0 |
| ∆% 2000 to 2005 | 42.5 | 43.5 |
| ∆% 2000 to 2016 | 82.1 | 74.3 |
| ∆% 2005 to 2016 | 27.8 | 21.5 |
| ∆% 2000 to 2006 | 45.9 | 47.8 |
| ∆% 2006 to 2016 | 24.9 | 18.0 |
| ∆% 2009 to 2016 | 42.0 | 33.2 |
| ∆% 2010 to 2016 | 38.8 | 32.2 |
| ∆% 2011 to 2016 | 35.5 | 34.7 |
| ∆% 2012 to 2016 | 25.5 | 23.5 |
| ∆% 2013 to 2016 | 14.5 | 11.2 |
| ∆% 2014 to 2016 | 6.7 | 3.8 |
| ∆% 2015 to 2016 | 4.6 | 2.3 |
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIB-3 of the US Census Bureau provides the entire series of new single-family sales median prices from Jan 1963 to Oct 2017. There is long-term sharp upward trend with few declines until the current collapse. Median prices increased sharply during the Great Inflation of the 1960s and 1970s and paused during the savings and loans crisis of the late 1980s and the recession of 1991. Housing subsidies throughout the 1990s caused sharp upward trend of median new house prices that accelerated after the fed funds rate of 1 percent from 2003 to 2004. There was sharp reduction of prices after 2006 with recovery recently above earlier prices.
Chart IIB-3, US, Median Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1963-2017
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIB-4 of the US Census Bureau provides average prices of new houses sold from the mid-1970s to Oct 2017. There is similar behavior as with median prices of new houses sold in Chart IIB-3. The only stress occurred in price pauses during the savings and loans crisis of the late 1980s and the collapse after 2006 with recent recovery.
Chart IIB-4, US, Average Sales Price of New Single-family Houses Sold, US Dollars, NSA, 1975-2017
Source: US Census Bureau
http://www.census.gov/construction/nrs/
Chart IIB-5 of the Board of Governors of the Federal Reserve System provides the rate for the 30-year conventional mortgage, the yield of the 30-year Treasury bond and the rate of the overnight federal funds rate, monthly, from 1954 to 2016. All rates decline throughout the period from the Great Inflation of the 1970s through the following Great Moderation and until currently. In Apr 1971, the fed funds rate was 4.15 percent and the conventional mortgage rate 7.31 percent. In November 2012, the fed funds rate was 0.16 percent, the yield of the 30-year Treasury 2.80 percent and the conventional mortgage rate 3.35. The final segment shows an increase in the yield of the 30-year Treasury to 3.61 percent in July 2013 with the fed funds rate at 0.09 percent and the conventional mortgage at 4.37 percent. The final data point shows marginal decrease of the conventional mortgage rate to 3.60 percent in May 2016 with the yield of the 30-year Treasury bond at 2.63 percent and overnight rate on fed funds at 0.37 percent. The recent increase in interest rates if sustained could affect the US real estate market. 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 IIB-5, US, Thirty-year Conventional Mortgage, Thirty-year Treasury Bond and Overnight Federal Funds Rate, Monthly, 1954-2016
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/H15/default.htm
Chart IIB-5A of the Board of Governors of the Federal Reserve System provides the yield of the 30-year Treasury bond and the rate of the overnight federal funds rate, monthly, from 2001 to 2017. The Board of Governors of the Federal Reserve System discontinued the conventional mortgage rate in its data bank. The final data point is 1.16 percent for the fed funds rate in Nov 2017 and 2.80 percent for the thirty-year Treasury bond. The conventional mortgage rate stood at 3.92 percent in Nov 2017.
Chart IIB-5A, US, Thirty-year Treasury Bond and Overnight Federal Funds Rate, Monthly, 2001-2017
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/H15/default.htm
Table IIB-8, US, Fed Funds Rate, Thirty Year Treasury Bond and Conventional Mortgage Rate, Monthly, Percent per Year, Dec 2012 to Jul 2017
| Fed Funds Rate | Yield of Thirty Year Constant Maturity | Conventional Mortgage Rate | |
| 2012-12 | 0.16 | 2.88 | 3.35 |
| 2013-01 | 0.14 | 3.08 | 3.41 |
| 2013-02 | 0.15 | 3.17 | 3.53 |
| 2013-03 | 0.14 | 3.16 | 3.57 |
| 2013-04 | 0.15 | 2.93 | 3.45 |
| 2013-05 | 0.11 | 3.11 | 3.54 |
| 2013-06 | 0.09 | 3.40 | 4.07 |
| 2013-07 | 0.09 | 3.61 | 4.37 |
| 2013-08 | 0.08 | 3.76 | 4.46 |
| 2013-09 | 0.08 | 3.79 | 4.49 |
| 2013-10 | 0.09 | 3.68 | 4.19 |
| 2013-11 | 0.08 | 3.80 | 4.26 |
| 2013-12 | 0.09 | 3.89 | 4.46 |
| 2014-01 | 0.07 | 3.77 | 4.43 |
| 2014-02 | 0.07 | 3.66 | 4.30 |
| 2014-03 | 0.08 | 3.62 | 4.34 |
| 2014-04 | 0.09 | 3.52 | 4.34 |
| 2014-05 | 0.09 | 3.39 | 4.19 |
| 2014-06 | 0.10 | 3.42 | 4.16 |
| 2014-07 | 0.09 | 3.33 | 4.13 |
| 2014-08 | 0.09 | 3.2 | 4.12 |
| 2014-09 | 0.09 | 3.26 | 4.16 |
| 2014-10 | 0.09 | 3.04 | 4.04 |
| 2014-11 | 0.09 | 3.04 | 4.00 |
| 2014-12 | 0.12 | 2.83 | 3.86 |
| 2015-01 | 0.11 | 2.46 | 3.67 |
| 2015-02 | 0.11 | 2.57 | 3.71 |
| 2015-03 | 0.11 | 2.63 | 3.77 |
| 2015-04 | 0.12 | 2.59 | 3.67 |
| 2015-05 | 0.12 | 2.96 | 3.84 |
| 2015-06 | 0.13 | 3.11 | 3.98 |
| 2015-07 | 0.13 | 3.07 | 4.05 |
| 2015-08 | 0.14 | 2.86 | 3.91 |
| 2015-09 | 0.14 | 2.95 | 3.89 |
| 2015-10 | 0.12 | 2.89 | 3.80 |
| 2015-11 | 0.12 | 3.03 | 3.94 |
| 2015-12 | 0.24 | 2.97 | 3.96 |
| 2016-01 | 0.34 | 2.86 | 3.87 |
| 2016-02 | 0.38 | 2.62 | 3.66 |
| 2016-03 | 0.36 | 2.68 | 3.69 |
| 2016-04 | 0.37 | 2.62 | 3.61 |
| 2016-05 | 0.37 | 2.63 | 3.60 |
| 2016-06 | 0.38 | 2.45 | 3.57 |
| 2016-07 | 0.39 | 2.23 | 3.44 |
| 2016-08 | 0.40 | 2.26 | 3.44 |
| 2016-09 | 0.40 | 2.35 | 3.46 |
| 2016-10 | 0.40 | 2.50 | 3.47 |
| 2016-11 | 0.41 | 2.86 | 3.77 |
| 2016-12 | 0.54 | 3.11 | 4.20 |
| 2017-01 | 0.65 | 3.02 | 4.15 |
| 2017-02 | 0.66 | 3.03 | 4.17 |
| 2017-03 | 0.79 | 3.08 | 4.20 |
| 2017-04 | 0.90 | 2.94 | 4.05 |
| 2017-05 | 0.91 | 2.96 | 4.01 |
| 2017-06 | 1.04 | 2.80 | 3.90 |
| 2017-07 | 1.15 | 2.88 | 3.97 |
| 2017-08 | 1.16 | 2.80 | 3.88 |
| 2017-09 | 1.15 | 2.78 | 3.81 |
| 2017-10 | 1.15 | 2.88 | 3.90 |
| 2017-11 | 1.6 | 2.80 | 3.92 |
Source: Board of Governors of the Federal Reserve System
http://www.federalreserve.gov/releases/H15/default.htm
http://www.freddiemac.com/pmms/pmms30.htm
IIB2 United States House Prices. The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae and Freddie Mac-acquired mortgages” (http://fhfa.gov/webfiles/24216/q22012hpi.pdf 1). The Federal Housing Finance Agency (FHFA), which regulates Fannie Mae and Freddie Mac, provides the FHFA House Price Index (HPI) that “is calculated using home sales price information from Fannie Mae and Freddie Mac-acquired mortgages” (http://fhfa.gov/webfiles/24216/q22012hpi.pdf 1). Table IIA2-1 provides the FHFA HPI for purchases only, which shows behavior similar to that of the Case-Shiller index but with lower magnitudes. House prices catapulted from 2000 to 2003, 2005 and 2006. From IVQ2000 to IVQ2006, the index for the US as a whole rose 55.0 percent, with 62.1 percent for New England, 72.0 percent for Middle Atlantic, 71.2 percent for South Atlantic but only by 33.1 percent for East South Central. Prices fell relative to 2014 for the US and all regions from 2006 with exception of increase of 2.6 percent for East South Central. Prices for the US increased 4.9 percent in IVQ2014 relative to IVQ2013 and 12.9 percent from IVQ2012 to IVQ2014. From IVQ2000 to IVQ2014, prices rose for the US and the four regions in Table IIA2-1.
Table IIA2-1, US, FHFA House Price Index Purchases Only NSA ∆%
| United States | New England | Middle Atlantic | South Atlantic | East South Central | |
| IVQ2000 | 24.0 | 40.6 | 35.8 | 25.9 | 11.0 |
| IVQ2000 | 50.5 | 65.0 | 67.6 | 62.9 | 25.4 |
| IVQ2000 to | 55.0 | 62.1 | 72.0 | 71.2 | 33.1 |
| IVQ2005 to | -1.5 | -8.7 | -2.3 | -7.4 | 8.9 |
| IVQ2006 | -4.4 | -7.1 | -4.8 | -11.9 | 2.6 |
| IVQ2007 to | -1.9 | -5.1 | -5.0 | -8.6 | 0.7 |
| IVQ2011 to | 18.9 | 7.3 | 6.9 | 19.9 | 11.8 |
| IVQ2012 to | 12.9 | 6.8 | 5.7 | 13.8 | 8.6 |
| IVQ2013 to IVQ2014 | 4.9 | 2.5 | 2.2 | 5.1 | 4.2 |
| IVQ2000 to | 48.3 144.27 | 50.6 138.40 | 63.7 127.30 | 50.9 140.28 | 36.6 146.07 |
Source: Federal Housing Finance Agency
http://www.fhfa.gov/KeyTopics/Pages/House-Price-Index.aspx
Data of the FHFA HPI for the remaining US regions are in Table IIA2-2. Behavior is not very different from that in Table IIA2-1 with the exception of East North Central. House prices in the Pacific region doubled between 2000 and 2006. Although prices of houses declined sharply from 2005 and 2006 to 2014 with exception of West South Central and West North Central, there was still appreciation relative to 2000.
Table IIA2-2, US, FHFA House Price Index Purchases Only NSA ∆%
| West South Central | West North Central | East North Central | Mountain | Pacific | |
| IVQ2000 | 11.1 | 18.3 | 14.7 | 18.9 | 44.6 |
| IVQ2000 | 23.9 | 31.0 | 23.8 | 58.0 | 107.7 |
| IVQ2000 to IVQ2006 | 31.6 | 33.7 | 23.7 | 68.6 | 108.7 |
| IVQ2005 to | 26.6 | 4.7 | -5.4 | -2.6 | -14.7 |
| IVQ2006 | 19.1 | 2.6 | -5.4 | -8.7 | -15.1 |
| IVQ2007 to | 15.2 | 3.2 | -2.1 | -5.6 | -6.0 |
| IVQ2011 to | 18.1 | 13.5 | 14.2 | 32.9 | 37.6 |
| IVQ2012 to | 12.1 | 8.9 | 11.1 | 17.9 | 24.4 |
| IVQ2013 to IVQ2014 | 5.9 | 4.0 | 4.6 | 5.5 | 7.3 |
| IVQ2000 to IVQ2014 | 56.8 145.53 | 37.1 158.59 | 17.1 155.13 | 53.9 172.46 | 77.1 132.21 |
Source: Federal Housing Finance Agency
http://www.fhfa.gov/KeyTopics/Pages/House-Price-Index.aspx
Monthly and 12-month percentage changes of the FHFA House Price Index are in Table IIA2-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul 2011 with exception of declines in May and Aug 2011 while 12-month percentage changes improved steadily from around minus 6.0 percent in Mar to May 2011 to minus 4.5 percent in Jun 2011. The FHFA house price index fell 0.6 percent in Oct 2011 and fell 3.2 percent in the 12 months ending in Oct 2011. There was significant recovery in Nov 2011 with increase in the house price index of 0.5 percent and reduction of the 12-month rate of decline to 2.3 percent. The house price index rose 0.3 percent in Dec 2011 and the 12-month percentage change improved to minus 1.3 percent. There was further improvement with revised change of minus 0.3 percent in Jan 2012 and decline of the 12-month percentage change to minus 1.3 percent. The index improved to positive change of 0.2 percent in Feb 2012 and change of 0.0 percent in the 12 months ending in Feb 2012. There was strong improvement in Mar 2012 with gain in prices of 0.9 percent and 2.0 percent in 12 months. The house price index of FHFA increased 0.7 percent in Apr 2012 and 2.4 percent in 12 months and improvement continued with increase of 0.6 percent in May 2012 and 3.3 percent in the 12 months ending in May 2012. Improvement consolidated with increase of 0.4 percent in Jun 2012 and 3.4 percent in 12 months. In Jul 2012, the house price index increased 0.2 percent and 3.3 percent in 12 months. Strong increase of 0.5 percent in Aug 2012 pulled the 12-month change to 4.1 percent. There was another increase of 0.6 percent in Oct 2012 and 5.1 percent in 12 months followed by increase of 0.5 percent in Nov 2012 and 5.0 percent in 12 months. The FHFA house price index increased 0.8 percent in Jan 2013 and 6.4 percent in 12 months. Improvement continued with increase of 0.5 percent in Apr 2013 and 7.1 percent in 12 months. In May 2013, the house price indexed increased 0.8 percent and 7.3 percent in 12 months. The FHFA house price index increased 0.6 percent in Jun 2013 and 7.5 percent in 12 months. In Jul 2013, the FHFA house price index increased 0.6 percent and 7.9 percent in 12 months. Improvement continued with increase of 0.3 percent in Aug 2013 and 7.7 percent in 12 months. In Sep 2013, the house price index increased 0.5 percent and 7.7 percent in 12 months. The house price index increased 0.4 percent in Oct 2013 and 7.4 percent in 12 months. In Nov 2013, the house price index increased 0.1 percent and increased 7.0 percent in 12 months. The house price index rose 0.5 percent in Dec 2013 and 7.1 percent in 12 months. Improvement continued with increase of 0.5 percent in Jan 2014 and 6.8 percent in 12 months. In Feb 2014, the house price index increased 0.4 percent and 6.7 percent in 12 months. The house price index increased 0.3 percent in Mar 2014 and 6.0 percent in 12 months. In Apr 2014, the house price index increased 0.2 percent and increased 5.6 percent in 12 months. The house price index increased 0.3 percent in May 2014 and 5.0 percent in 12 months. In Jun 2014, the house price index increased 0.5 percent and 4.8 percent in 12 months. The house price index increased 0.4 percent in Jul 2014 and 4.6 percent in 12 months. In Sep 2014, the house price index increased 0.2 percent and increased 4.4 percent in 12 months. The house price index increased 0.5 percent in Oct 2014 and 4.5 percent in 12 months. In Nov 2014, the house price index increased 0.4 percent and 4.8 percent in 12 months. The house price index increased 0.9 percent in Dec 2014 and increased 5.3 percent in 12 months. In Mar 2015, the house price index increased 0.3 percent and increased 5.3 percent in 12 months. In Apr 2015, the house price index increased 0.4 percent and 5.4 percent in 12 months. The house price index increased 0.6 percent in May 2015 and 5.7 percent in 12 months. House prices increased 0.4 percent in Jun 2015 and 5.6 percent in 12 months. The house price index increased 0.4 percent in Jul 2015 and increased 5.6 percent in 12 months. House prices increased 0.2 percent in Aug 2015 and increased 5.4 percent in 12 months. In Sep 2015, the house price index increased 0.7 percent and increased 5.9 percent in 12 months. The house price index increased 0.5 percent in Oct 2015 and increased 5.8 percent in 12 months. House prices increased 0.6 percent in Nov 2015 and increased 6.0 percent in 12 months. The house price index increased 0.5 percent in Dec 2015 and increased 5.7 percent in 12 months. House prices increased 0.6 percent in Jan 2016 and increased 6.2 percent in 12 months. The house price index increased 0.3 percent in Feb 2016 and increased 5.7 percent in 12 months. House prices increased 0.7 percent in Mar 2016 and increased 6.1 percent in 12 months. The house price index increased 0.4 percent in Apr 2016 and increased 6.1 percent in 12 months. House prices increased 0.4 percent in May 2016 and increased 6.1 percent in 12 months. The house price index increased 0.5 percent in Jun 2016 and increased 5.9 percent in 12 months. House prices increased 0.5 percent in Jul 2016 and increased 6.1 percent in 12 months. The house price index increased 0.6 percent in Aug 2016 and increased 6.4 percent in 12 months. House prices increased 0.7 percent in Sep 2016 and increased 6.5 percent in 12 months. The house price index increased 0.5 percent in Oct 2016 and increased 6.4 percent in 12 months. House prices increased 0.6 percent in Nov 2016 and increased 6.5 percent in 12 months. The house price index increased 0.5 percent in Dec 2016 and increased 6.5 percent in 12 months. House prices increased 0.2 percent in Jan 2017 and increased 6.1 percent in 12 months. In Feb 2017, the house price index increased 0.8 percent and increased 6.7 percent in 12 months. House prices increased 0.7 percent in Mar 2017 and increased 6.8 percent in 12 months. In Apr 2017, the house price index increased 0.7 percent and increased 7.1 percent in 12 months. House prices increased 0.4 percent in May 2017 and increased 7.0 percent in 12 months. The house price index increased 0.2 percent in Jun 2017 and increased 6.7 percent in 12 months. House prices increased 0.4 percent in Jul 2017 and increased 6.6 percent in 12 months. The house price index increased 0.8 percent in Oct 2017 and increased 6.8 percent in 12 months. House prices increased 0.5 percent in Sep 2017 and increased 6.6 percent in 12 months. The house price index increased 0.5 percent in Oct 2017 and increased 6.6 percent in 12 months.
Table IIA2-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%
| Month ∆% SA | 12 Month ∆% NSA | |||
| 10/1/2017 | 0.5 | 6.6 | ||
| 9/1/2017 | 0.5 | 6.6 | ||
| 8/1/2017 | 0.8 | 6.8 | ||
| 7/1/2017 | 0.4 | 6.6 | ||
| 6/1/2017 | 0.2 | 6.7 | ||
| 5/1/2017 | 0.4 | 7.0 | ||
| 4/1/2017 | 0.7 | 7.1 | ||
| 3/1/2017 | 0.7 | 6.8 | ||
| 2/1/2017 | 0.8 | 6.7 | ||
| 1/1/2017 | 0.2 | 6.1 | ||
| 12/1/2016 | 0.5 | 6.5 | ||
| 11/1/2016 | 0.6 | 6.5 | ||
| 10/1/2016 | 0.5 | 6.4 | ||
| 9/1/2016 | 0.7 | 6.5 | ||
| 8/1/2016 | 0.6 | 6.4 | ||
| 7/1/2016 | 0.5 | 6.1 | ||
| 6/1/2016 | 0.5 | 5.9 | ||
| 5/1/2016 | 0.4 | 5.9 | ||
| 4/1/2016 | 0.4 | 6.1 | ||
| 3/1/2016 | 0.7 | 6.1 | ||
| 2/1/2016 | 0.3 | 5.7 | ||
| 1/1/2016 | 0.6 | 6.2 | ||
| 12/1/2015 | 0.5 | 5.7 | ||
| 11/1/2015 | 0.6 | 6.0 | ||
| 10/1/2015 | 0.5 | 5.8 | ||
| 9/1/2015 | 0.7 | 5.9 | ||
| 8/1/2015 | 0.2 | 5.4 | ||
| 7/1/2015 | 0.4 | 5.6 | ||
| 6/1/2015 | 0.4 | 5.6 | ||
| 5/1/2015 | 0.6 | 5.7 | ||
| 4/1/2015 | 0.4 | 5.4 | ||
| 3/1/2015 | 0.3 | 5.3 | ||
| 2/1/2015 | 0.8 | 5.2 | ||
| 1/1/2015 | 0.1 | 4.8 | ||
| 12/1/2014 | 0.9 | 5.3 | ||
| 11/1/2014 | 0.4 | 4.8 | ||
| 10/1/2014 | 0.5 | 4.5 | ||
| 9/1/2014 | 0.2 | 4.4 | ||
| 8/1/2014 | 0.5 | 4.7 | ||
| 7/1/2014 | 0.4 | 4.6 | ||
| 6/1/2014 | 0.5 | 4.8 | ||
| 5/1/2014 | 0.3 | 5.0 | ||
| 4/1/2014 | 0.2 | 5.6 | ||
| 3/1/2014 | 0.3 | 6.0 | ||
| 2/1/2014 | 0.4 | 6.7 | ||
| 1/1/2014 | 0.5 | 6.8 | ||
| 12/1/2013 | 0.5 | 7.1 | ||
| 11/1/2013 | 0.1 | 7.0 | ||
| 10/1/2013 | 0.4 | 7.4 | ||
| 9/1/2013 | 0.5 | 7.7 | ||
| 8/1/2013 | 0.3 | 7.7 | ||
| 7/1/2013 | 0.6 | 7.9 | ||
| 6/1/2013 | 0.6 | 7.5 | ||
| 5/1/2013 | 0.8 | 7.3 | ||
| 4/1/2013 | 0.5 | 7.1 | ||
| 3/1/2013 | 1.1 | 7.2 | ||
| 2/1/2013 | 0.6 | 6.9 | ||
| 1/1/2013 | 0.8 | 6.4 | ||
| 12/1/2012 | 0.5 | 5.3 | ||
| 11/1/2012 | 0.5 | 5.0 | ||
| 10/1/2012 | 0.6 | 5.1 | ||
| 9/1/2012 | 0.4 | 3.9 | ||
| 8/1/2012 | 0.5 | 4.1 | ||
| 7/1/2012 | 0.2 | 3.3 | ||
| 6/1/2012 | 0.4 | 3.4 | ||
| 5/1/2012 | 0.6 | 3.3 | ||
| 4/1/2012 | 0.7 | 2.4 | ||
| 3/1/2012 | 0.9 | 2.0 | ||
| 2/1/2012 | 0.2 | 0.0 | ||
| 1/1/2012 | -0.3 | -1.3 | ||
| 12/1/2011 | 0.3 | -1.3 | ||
| 11/1/2011 | 0.5 | -2.3 | ||
| 10/1/2011 | -0.6 | -3.2 | ||
| 9/1/2011 | 0.6 | -2.4 | ||
| 8/1/2011 | -0.3 | -3.8 | ||
| 7/1/2011 | 0.2 | -3.6 | ||
| 6/1/2011 | 0.4 | -4.5 | ||
| 5/1/2011 | -0.2 | -5.9 | ||
| 4/1/2011 | 0.3 | -5.7 | ||
| 3/1/2011 | -1.0 | -5.9 | ||
| 2/1/2011 | -1.1 | -5.1 | ||
| 1/1/2011 | -0.4 | -4.5 | ||
| 12/1/2010 | -0.7 | -3.9 | ||
| 12/1/2009 | -1.0 | -2.0 | ||
| 12/1/2008 | -0.3 | -10.4 | ||
| 12/1/2007 | -0.5 | -3.3 | ||
| 12/1/2006 | 0.1 | 2.4 | ||
| 12/1/2005 | 0.6 | 9.8 | ||
| 12/1/2004 | 0.9 | 10.2 | ||
| 12/1/2003 | 0.9 | 8.0 | ||
| 12/1/2002 | 0.7 | 7.8 | ||
| 12/1/2001 | 0.6 | 6.7 | ||
| 12/1/2000 | 0.6 | 7.1 | ||
| 12/1/1999 | 0.5 | 6.1 | ||
| 12/1/1998 | 0.5 | 5.9 | ||
| 12/1/1997 | 0.3 | 3.4 | ||
| 12/1/1996 | 0.3 | 2.8 | ||
| 12/1/1995 | 0.4 | 3.0 | ||
| 12/1/1994 | 0.0 | 2.5 | ||
| 12/1/1993 | 0.5 | 3.1 | ||
| 12/1/1992 | -0.1 | 2.4 |
Source: Federal Housing Finance Agency
Source: Federal Housing Finance Agency
The bottom part of Table IIA2-3 provides 12-month percentage changes of the FHFA house price index since 1992 when data become available for 1991. Table IIA2-4 provides percentage changes and average rates of percent change per year for various periods. Between 1992 and 2016, the FHFA house price index increased 130.5 percent at the yearly average rate of 3.5 percent. In the period 1992-2000, the FHFA house price index increased 39.3 percent at the average yearly rate of 4.2 percent. The average yearly rate of price increase accelerated to 7.5 percent in the period 2000-2003, 8.5 percent in 2000-2005 and 7.5 percent in 2000-2006. At the margin, the average rate jumped to 10.0 percent in 2003-2005 and 7.4 percent in 2003-2006. House prices measured by the FHFA house price index increased 7.5 percent at the average yearly rate of 0.7 percent between 2006 and 2016 and 10.1 percent between 2005 and 2016 at the average yearly rate of 0.9 percent.
Table IIA2-4, US, FHFA House Price Index, Percentage Change and Average Rate of Percentage Change per Year, Selected Dates 1992-2016
| Dec | ∆% | Average ∆% per Year |
| 1992-2016 | 130.5 | 3.5 |
| 1992-2000 | 39.3 | 4.2 |
| 2000-2003 | 24.2 | 7.5 |
| 2000-2005 | 50.3 | 8.5 |
| 2003-2005 | 21.0 | 10.0 |
| 2005-2016 | 10.1 | 0.9 |
| 2000-2006 | 53.9 | 7.5 |
| 2003-2006 | 23.9 | 7.4 |
| 2006-2016 | 7.5 | 0.7 |
Source: Federal Housing Finance Agency
The explanation of the sharp contraction of household wealth can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:
“On the maturity date T, the firm must either pay the promised payment of B to the debtholders or else the current equity will be valueless. Clearly, if at time T, V(T) > B, the firm should pay the bondholders because the value of equity will be V(T) – B > 0 whereas if they do not, the value of equity would be zero. If V(T) ≤ B, then the firm will not make the payment and default the firm to the bondholders because otherwise the equity holders would have to pay in additional money and the (formal) value of equity prior to such payments would be (V(T)- B) < 0.”
Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:
“The house market [in 2006] is probably operating with low historical levels of individual equity. There is an application of structural models [Duffie and Singleton 2003] to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown.”
There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Ingersoll 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.
The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (1)
Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.
Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).
The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.
In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection skills of the relationship banker convert an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.
Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by the financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.
The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):
“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”
Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US, the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:
“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”
Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.
In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):
“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”
The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. The Federal Home Loan Bank (FHLB) system was established by Congress in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly-owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.
According to Pinto (2008) in testimony to Congress:
“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
Table IIA-1 shows the euphoria of prices during the housing boom and the subsequent decline. House prices rose 96.0 percent in the 10-city composite of the Case-Shiller home price index, 81.2 percent in the 20-city composite and 65.9 percent in the US national home price index between Oct 2000 and Oct 2005. Prices rose around 100 percent from Oct 2000 to Oct 2006, increasing 101.1 percent for the 10-city composite, 86.7 percent for the 20-city composite and 70.9 percent in the US national index. House prices rose 38.9 percent between Oct 2003 and Oct 2005 for the 10-city composite, 34.9 percent for the 20-city composite and 29.5 percent for the US national propelled by low fed funds rates of 1.0 percent between Dec 2003 and Jun 2004. Fed funds rates increased by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) from Jun 2004 until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Oct 2003 and Oct 2006, the 10-city index gained 42.5 percent; the 20-city index increased 39.0 percent; and the US national 33.4 percent. House prices have fallen from Oct 2006 to Oct 2017 by 3.1 percent for the 10-city composite and 0.8 percent for the 20-city composite, increasing 6.3 percent for the US national. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Oct 2017, house prices increased 6.0 percent in the 10-city composite, increasing 6.4 percent in the 20-city composite and 5.6 percent in the US national. Table IIA-1 also shows that house prices increased 94.8 percent between Oct 2000 and Oct 2017 for the 10-city composite, increasing 85.2 percent for the 20-city composite and 81.6 percent for the US national. House prices are close to the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 3.6 percent from the peak in Jun 2006 to Oct 2017 and the 20-city composite fell 1.3 percent from the peak in Jul 2006 to Oct 2017. The US national increased 6.0 percent in Oct 2017 from the peak of the 10-city composite in Jun 2006 and increased 6.0 percent from the peak of the 20-city composite in Jul 2016. The final part of Table II-2 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2016 for the 10-city composite was 3.8 percent and 3.5 percent for the US national. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. The average rate for the US national was 3.4 percent from Dec 1987 to Dec 2016 and 3.6 percent from Dec 1987 to Dec 2000. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2016 was 3.8 percent while the rate of the 20-city composite was 3.5 percent and 3.4 percent for the US national.
Table IIA-1, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%
| 10-City Composite | 20-City Composite | US National | |
| ∆% Oct 2000 to Oct 2003 | 41.1 | 34.3 | 28.1 |
| ∆% Oct 2000 to Oct 2005 | 96.0 | 81.2 | 65.9 |
| ∆% Oct 2003 to Oct 2005 | 38.9 | 34.9 | 29.5 |
| ∆% Oct 2000 to Oct 2006 | 101.1 | 86.7 | 70.9 |
| ∆% Oct 2003 to Oct 2006 | 42.5 | 39.0 | 33.4 |
| ∆% Oct 2005 to Oct 2017 | -0.6 | 2.2 | 9.4 |
| ∆% Oct 2006 to Oct 2017 | -3.1 | -0.8 | 6.3 |
| ∆% Oct 2009 to Oct 2017 | 37.2 | 39.1 | 31.6 |
| ∆% Oct 2010 to Oct 2017 | 37.0 | 40.3 | 36.7 |
| ∆% Oct 2011 to Oct 2017 | 41.8 | 45.5 | 41.4 |
| ∆% Oct 2012 to Oct 2017 | 37.2 | 39.6 | 35.9 |
| ∆% Oct 2013 to Oct 2017 | 20.7 | 22.9 | 22.6 |
| ∆% Oct 2014 to Oct 2017 | 15.7 | 17.7 | 17.2 |
| ∆% Oct 2015 to Oct 2017 | 10.4 | 11.7 | 11.7 |
| ∆% Oct 2016 to Oct 2017 | 6.0 | 6.4 | 5.6 |
| ∆% Oct 2000 to Oct 2017 | 94.8 | 85.2 | 81.6 |
| ∆% Peak Jun 2006 Oct 2017 | -3.8 | 6.0 | |
| ∆% Peak Oct 2006 to Oct 2017 | -1.3 | 6.0 | |
| Average ∆% Dec 1987-Dec 2016 | 3.8 | NA | 3.5 |
| Average ∆% Dec 1987-Dec 2000 | 3.8 | NA | 3.6 |
| Average ∆% Dec 1992-Dec 2000 | 5.0 | NA | 4.5 |
| Average ∆% Dec 2000-Dec 2016 | 3.8 | 3.5 | 3.4 |
Source: http://us.spindices.com/index-family/real-estate/sp-corelogic-case-shiller
Price increases measured by the Case-Shiller house price indices show in data for Oct 2017 that “home prices continued their rise across the country over the last 12 months” (https://www.spice-indices.com/idpfiles/spice-assets/resources/public/documents/638549_cshomeprice-release-1226.pdf?force_download=true). Monthly house prices increased sharply from Feb 2013 to Jan 2014 for both the 10- and 20-city composites, as shown in Table IIA-2. In Jan 2013, the seasonally adjusted 10-city composite increased 0.8 percent and the 20-city increased 0.8 percent while the 10-city not seasonally adjusted changed 0.0 percent and the 20-city changed 0.0 percent. House prices increased at high monthly percentage rates from Feb to Nov 2013. Except for Mar through Apr 2012, house prices seasonally adjusted declined in most months for both the 10-city and 20-city Case-Shiller composites from Dec 2010 to Jan 2012, as shown in Table IIA-2. The most important seasonal factor in house prices is school changes for wealthier homeowners with more expensive houses. Without seasonal adjustment, house prices fell from Dec 2010 throughout Mar 2011 and then increased in every month from Apr to Aug 2011 but fell in every month from Sep 2011 to Feb 2012. The not seasonally adjusted index registers decline in Mar 2012 of 0.1 percent for the 10-city composite and is flat for the 20-city composite. Not seasonally adjusted house prices increased 1.4 percent in Apr 2012 and at high monthly percentage rates until Sep 2012. House prices not seasonally adjusted stalled from Oct 2012 to Jan 2013 and surged from Feb to Sep 2013, decelerating in Oct 2013-Feb 2014. House prices grew at fast rates in Mar 2014. The 10-city NSA index increased 0.2 percent in Oct 2017 and the 20-city increased 0.2 percent. The 10-city SA increased 0.7 percent in Oct 2017 and the 20-city composite SA increased 0.7 percent. Declining house prices cause multiple adverse effects of which two are quite evident. (1) There is a disincentive to buy houses in continuing price declines. (2) More mortgages could be losing fair market value relative to mortgage debt. Another possibility is a wealth effect that consumers restrain purchases because of the decline of their net worth in houses.
Table IIA-2, US, Monthly Percentage Change of S&P Corelogic Case-Shiller Home Price Indices, Seasonally Adjusted and Not Seasonally Adjusted, ∆%
| 10-City Composite SA | 10-City Composite NSA | 20-City Composite SA | 20-City Composite NSA | |
| October 2017 | 0.7 | 0.2 | 0.7 | 0.2 |
| September 2017 | 0.9 | 0.5 | 1.0 | 0.4 |
| August 2017 | 0.4 | 0.4 | 0.2 | 0.4 |
| July 2017 | 0.4 | 0.8 | 0.4 | 0.7 |
| June 2017 | 0.1 | 0.6 | 0.2 | 0.7 |
| May 2017 | 0.1 | 0.8 | 0.2 | 0.9 |
| April 2017 | -0.3 | 0.8 | -0.3 | 1.0 |
| March 2017 | 0.8 | 0.9 | 1.0 | 1.0 |
| February 2017 | 0.5 | 0.3 | 0.6 | 0.4 |
| January 2017 | 0.8 | 0.3 | 0.8 | 0.2 |
| December 2016 | 0.7 | 0.2 | 0.8 | 0.2 |
| November 2016 | 0.8 | 0.2 | 0.7 | 0.2 |
| October 2016 | 0.4 | -0.1 | 0.5 | 0.0 |
| September 2016 | 0.4 | 0.0 | 0.6 | 0.1 |
| August 2016 | 0.3 | 0.3 | 0.2 | 0.3 |
| July 2016 | 0.2 | 0.5 | 0.2 | 0.6 |
| June 2016 | 0.1 | 0.8 | 0.2 | 0.8 |
| May 2016 | 0.0 | 0.8 | 0.1 | 0.9 |
| April 2016 | 0.0 | 1.0 | -0.1 | 1.1 |
| March 2016 | 0.8 | 0.9 | 0.9 | 0.9 |
| February 2016 | 0.4 | 0.2 | 0.5 | 0.2 |
| January 2016 | 0.5 | -0.1 | 0.5 | 0.0 |
| December 2015 | 0.4 | -0.1 | 0.5 | 0.0 |
| November 2015 | 0.6 | 0.0 | 0.7 | 0.0 |
| October 2015 | 0.5 | -0.1 | 0.6 | 0.0 |
| September 2015 | 0.5 | 0.1 | 0.6 | 0.1 |
| August 2015 | 0.2 | 0.2 | 0.2 | 0.3 |
| July 2015 | 0.2 | 0.6 | 0.2 | 0.7 |
| June 2015 | 0.2 | 0.9 | 0.2 | 1.0 |
| May 2015 | 0.2 | 1.0 | 0.3 | 1.1 |
| April 2015 | 0.1 | 1.1 | 0.0 | 1.1 |
| March 2015 | 0.6 | 0.8 | 0.8 | 0.9 |
| February 2015 | 0.8 | 0.5 | 0.8 | 0.5 |
| January 2015 | 0.5 | -0.1 | 0.5 | -0.1 |
| December 2014 | 0.6 | 0.0 | 0.6 | 0.0 |
| November 2014 | 0.4 | -0.3 | 0.5 | -0.2 |
| October 2014 | 0.5 | -0.1 | 0.5 | -0.1 |
| September 2014 | 0.3 | -0.1 | 0.4 | -0.1 |
| August 2014 | 0.1 | 0.2 | 0.1 | 0.2 |
| July 2014 | 0.0 | 0.6 | 0.0 | 0.6 |
| June 2014 | 0.2 | 1.0 | 0.1 | 1.0 |
| May 2014 | 0.1 | 1.1 | 0.2 | 1.1 |
| April 2014 | 0.2 | 1.1 | 0.1 | 1.2 |
| March 2014 | 0.6 | 0.8 | 0.7 | 0.9 |
| February 2014 | 0.5 | 0.0 | 0.5 | 0.0 |
| January 2014 | 0.6 | -0.1 | 0.6 | -0.1 |
| December 2013 | 0.6 | -0.1 | 0.6 | -0.1 |
| November 2013 | 0.8 | 0.0 | 0.7 | -0.1 |
| October 2013 | 0.9 | 0.2 | 0.9 | 0.2 |
| September 2013 | 1.1 | 0.7 | 1.1 | 0.7 |
| August 2013 | 1.2 | 1.3 | 1.2 | 1.3 |
| July 2013 | 1.2 | 1.9 | 1.1 | 1.8 |
| June 2013 | 1.2 | 2.2 | 1.1 | 2.2 |
| May 2013 | 1.4 | 2.5 | 1.4 | 2.5 |
| April 2013 | 1.9 | 2.6 | 1.7 | 2.6 |
| March 2013 | 1.1 | 1.3 | 1.1 | 1.3 |
| February 2013 | 0.9 | 0.3 | 0.9 | 0.2 |
| January 2013 | 0.8 | 0.0 | 0.8 | 0.0 |
| December 2012 | 0.9 | 0.2 | 0.9 | 0.2 |
| November 2012 | 0.6 | -0.3 | 0.7 | -0.2 |
| October 2012 | 0.6 | -0.2 | 0.7 | -0.1 |
| September 2012 | 0.6 | 0.3 | 0.6 | 0.3 |
| August 2012 | 0.6 | 0.8 | 0.7 | 0.9 |
| July 2012 | 0.6 | 1.5 | 0.7 | 1.6 |
| June 2012 | 1.0 | 2.1 | 1.1 | 2.3 |
| May 2012 | 1.0 | 2.2 | 1.1 | 2.4 |
| April 2012 | 0.8 | 1.4 | 0.8 | 1.4 |
| March 2012 | -0.2 | -0.1 | -0.2 | 0.0 |
| February 2012 | -0.2 | -0.9 | 0.0 | -0.8 |
| January 2012 | -0.3 | -1.1 | -0.2 | -1.0 |
| December 2011 | -0.5 | -1.2 | -0.4 | -1.1 |
| November 2011 | -0.6 | -1.4 | -0.5 | -1.3 |
| October 2011 | -0.5 | -1.3 | -0.6 | -1.4 |
| September 2011 | -0.3 | -0.6 | -0.5 | -0.7 |
| August 2011 | -0.2 | 0.1 | -0.2 | 0.1 |
| July 2011 | 0.0 | 0.9 | 0.0 | 1.0 |
| June 2011 | -0.1 | 1.0 | -0.1 | 1.2 |
| May 2011 | -0.2 | 1.0 | -0.2 | 1.0 |
| April 2011 | 0.1 | 0.6 | 0.1 | 0.6 |
| March 2011 | -0.9 | -1.0 | -1.1 | -1.0 |
| February 2011 | -0.4 | -1.3 | -0.3 | -1.2 |
| January 2011 | -0.3 | -1.1 | -0.3 | -1.1 |
| December 2010 | -0.2 | -0.9 | -0.2 | -1.0 |
Source: http://us.spindices.com/index-family/real-estate/sp-corelogic-case-shiller
Table IIA-4, Difference of Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars from 2007 to 2008 and 2009
| 2007 | 2008 | Change to 2008 | 2009 | Change to 2009 | |
| A | 80,886.6 | 70,545.8 | -10,340.8 | 72,195.1 | -8,691.5 |
| Non | 28,062.7 | 24,397.6 | -3,665.1 | 23,496.2 | -4,566.5 |
| RE | 23,253.2 | 19,463.4 | -3,789.8 | 18,539.8 | -4,713.4 |
| FIN | 52,823.9 | 46,148.2 | -6,675.7 | 48,698.9 | -4,125.0 |
| LIAB | 14,436.7 | 14,337.5 | -99.2 | 14,138.9 | -297.8 |
| NW | 66,450.0 | 56,208.3 | -10,241.7 | 58,056.3 | -8,933.7 |
A: Assets; Non FIN: Nonfinancial Assets; RE: Real Estate; FIN: Financial Assets; LIAB: Liabilities; NW: Net Worth
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
IIA Destruction of Household Nonfinancial Wealth with Stagnating Total Real Wealth. The valuable report on Financial Accounts of the United States formerly Flow of Funds Accounts of the United States provided by the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/releases/z1/Current/ http://www.federalreserve.gov/apps/fof/) is rich in important information and analysis. Table IIA-1, updated in this blog for every new quarterly release, shows the balance sheet of US households combined with nonprofit organizations in 2007, 2015, 2016 and IIIQ2017. Assets stood at $100.9 trillion in 2015 for gain of $20.0 trillion relative to $80.9 trillion in 2007 or increase by 24.7 percent, using unrounded data for percentage calculations. Assets increased to $106.7 trillion in 2016 by $25.8 trillion relative to 2007 or 31.9 percent. Assets increased to $112.4 trillion in IIIQ2017 by $31.5 trillion relative to 2007 or 38.9 percent. Liabilities increased $138.9 billion or 1.0 percent from 2007 to 2015. Liabilities increased from $14.4 trillion in 2007 to $15.0 trillion in 2016, by $596.2 billion or increase of 4.1 percent. Liabilities increased from $14.4 trillion in 2007 to $15.4 trillion in IIIQ2017, by $984.1 billion or increase of 6.8 percent. Net worth increased from $66,450.0 billion in 2007 to $96,939.2 billion in IIIQ2017 by $30,489.2 billion or 45.9 percent. The US consumer price index for all items increased from 210.036 in Dec 2007 to 246.819 in Sep 2017 (http://www.bls.gov/cpi/data.htm) or 17.5 percent. Net worth adjusted by CPI inflation increased 24.1 percent from 2007 to IIIQ2017. Nonfinancial assets increased $5,443.0 billion from $28,062.7 billion in 2007 to $33,505.7 billion in IIIQ2017 or 19.4 percent. There was increase from 2007 to IIIQ2017 of $4,175.1 billion in real estate assets or by 18.0 percent. Real estate assets adjusted for CPI inflation increased 0.4 percent between 2007 and IIIQ2017. The National Association of Realtors estimated that the gains in net worth in homes by Americans were about $4 trillion between 2000 and 2005 (quoted in Pelaez and Pelaez, The Global Recession Risk (2007), 224-5).
Table IIA-1, US, Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars Outstanding End of Period, NSA
| 2007 | 2015 | 2016 | IIIQ2017 | |
| Assets | 80,886.6 | 100,862.9 | 106,727.3 | 112,360.0 |
| Nonfinancial | 28,062.7 | 30,289.2 | 31,990.0 | 33,505.7 |
| Real Estate | 23,253.2 | 24,585.4 | 26,120.3 | 27,428.3 |
| Durable Goods | 4,476.0 | 5,236.5 | 5,388.1 | 5,581.4 |
| Financial | 52,823.9 | 70,573.7 | 74,737.3 | 78,854.3 |
| Deposits | 5,968.2 | 8,385.2 | 9,078.6 | 9,215.5 |
| Debt Secs. | 3,892.9 | 4,448.4 | 4,332.6 | 3,931.5 |
| Mutual Fund Shares | 4,343.2 | 6,759.6 | 7,255.2 | 8,319.8 |
| Equities Corporate | 10,075.3 | 13,840.2 | 15,374.1 | 17,282.7 |
| Equity Noncorporate | 9,055.9 | 10,498.3 | 11,138.0 | 11,484.6 |
| Pension | 15,305.0 | 20,910.8 | 21,834.3 | 22,870.3 |
| Liabilities | 14,436.7 | 14,575.6 | 15,034.9 | 15,420.8 |
| Home Mortgages | 10,638.0 | 9,586.0 | 9,796.1 | 10,012.2 |
| Consumer Credit | 2,609.5 | 3,417.2 | 3,645.2 | 3,768.7 |
| Net Worth | 66,450.0 | 86,287.3 | 91,692.5 | 96,939.2 |
Notes: Deposits: Total Time and Savings Deposits FL15303005; Net Worth = Assets – Liabilities
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
The explanation of the sharp contraction of household wealth can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:
“On the maturity date T, the firm must either pay the promised payment of B to the debtholders or else the current equity will be valueless. Clearly, if at time T, V(T) > B, the firm should pay the bondholders because the value of equity will be V(T) – B > 0 whereas if they do not, the value of equity would be zero. If V(T) ≤ B, then the firm will not make the payment and default the firm to the bondholders because otherwise the equity holders would have to pay in additional money and the (formal) value of equity prior to such payments would be (V(T)- B) < 0.”
Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:
“The house market [in 2006] is probably operating with low historical levels of individual equity. There is an application of structural models [Duffie and Singleton 2003] to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown.”
There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Ingersoll 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.
The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (1)
Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.
Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).
The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.
In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection skills of the relationship banker convert an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.
Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by the financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.
The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):
“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”
Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US, the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:
“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”
Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.
In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):
“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”
The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. The Federal Home Loan Bank (FHLB) system was established by Congress in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly-owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.
According to Pinto (2008) in testimony to Congress:
“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”
In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in the US. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:
“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”
In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.
Table IIA-1 shows the euphoria of prices during the housing boom and the subsequent decline. House prices rose 96.0 percent in the 10-city composite of the Case-Shiller home price index, 81.2 percent in the 20-city composite and 65.9 percent in the US national home price index between Oct 2000 and Oct 2005. Prices rose around 100 percent from Oct 2000 to Oct 2006, increasing 101.1 percent for the 10-city composite, 86.7 percent for the 20-city composite and 70.9 percent in the US national index. House prices rose 38.9 percent between Oct 2003 and Oct 2005 for the 10-city composite, 34.9 percent for the 20-city composite and 29.5 percent for the US national propelled by low fed funds rates of 1.0 percent between Dec 2003 and Jun 2004. Fed funds rates increased by 0.25 basis points at every meeting of the Federal Open Market Committee (FOMC) from Jun 2004 until Jun 2006, reaching 5.25 percent. Simultaneously, the suspension of auctions of the 30-year Treasury bond caused decline of yields of mortgage-backed securities with intended decrease in mortgage rates. Similarly, between Oct 2003 and Oct 2006, the 10-city index gained 42.5 percent; the 20-city index increased 39.0 percent; and the US national 33.4 percent. House prices have fallen from Oct 2006 to Oct 2017 by 3.1 percent for the 10-city composite and 0.8 percent for the 20-city composite, increasing 6.3 percent for the US national. Measuring house prices is quite difficult because of the lack of homogeneity that is typical of standardized commodities. In the 12 months ending in Oct 2017, house prices increased 6.0 percent in the 10-city composite, increasing 6.4 percent in the 20-city composite and 5.6 percent in the US national. Table IIA-1 also shows that house prices increased 94.8 percent between Oct 2000 and Oct 2017 for the 10-city composite, increasing 85.2 percent for the 20-city composite and 81.6 percent for the US national. House prices are close to the lowest level since peaks during the boom before the financial crisis and global recession. The 10-city composite fell 3.6 percent from the peak in Jun 2006 to Oct 2017 and the 20-city composite fell 1.3 percent from the peak in Jul 2006 to Oct 2017. The US national increased 6.0 percent in Oct 2017 from the peak of the 10-city composite in Jun 2006 and increased 6.0 percent from the peak of the 20-city composite in Jul 2016. The final part of Table II-2 provides average annual percentage rates of growth of the house price indexes of Standard & Poor’s Case-Shiller. The average annual growth rate between Dec 1987 and Dec 2016 for the 10-city composite was 3.8 percent and 3.5 percent for the US national. Data for the 20-city composite are available only beginning in Jan 2000. House prices accelerated in the 1990s with the average rate of the 10-city composite of 5.0 percent between Dec 1992 and Dec 2000 while the average rate for the period Dec 1987 to Dec 2000 was 3.8 percent. The average rate for the US national was 3.4 percent from Dec 1987 to Dec 2016 and 3.6 percent from Dec 1987 to Dec 2000. Although the global recession affecting the US between IVQ2007 (Dec) and IIQ2009 (Jun) caused decline of house prices of slightly above 30 percent, the average annual growth rate of the 10-city composite between Dec 2000 and Dec 2016 was 3.8 percent while the rate of the 20-city composite was 3.5 percent and 3.4 percent for the US national.
Table IIA-1, US, Percentage Changes of Standard & Poor’s Case-Shiller Home Price Indices, Not Seasonally Adjusted, ∆%
| 10-City Composite | 20-City Composite | US National | |
| ∆% Oct 2000 to Oct 2003 | 41.1 | 34.3 | 28.1 |
| ∆% Oct 2000 to Oct 2005 | 96.0 | 81.2 | 65.9 |
| ∆% Oct 2003 to Oct 2005 | 38.9 | 34.9 | 29.5 |
| ∆% Oct 2000 to Oct 2006 | 101.1 | 86.7 | 70.9 |
| ∆% Oct 2003 to Oct 2006 | 42.5 | 39.0 | 33.4 |
| ∆% Oct 2005 to Oct 2017 | -0.6 | 2.2 | 9.4 |
| ∆% Oct 2006 to Oct 2017 | -3.1 | -0.8 | 6.3 |
| ∆% Oct 2009 to Oct 2017 | 37.2 | 39.1 | 31.6 |
| ∆% Oct 2010 to Oct 2017 | 37.0 | 40.3 | 36.7 |
| ∆% Oct 2011 to Oct 2017 | 41.8 | 45.5 | 41.4 |
| ∆% Oct 2012 to Oct 2017 | 37.2 | 39.6 | 35.9 |
| ∆% Oct 2013 to Oct 2017 | 20.7 | 22.9 | 22.6 |
| ∆% Oct 2014 to Oct 2017 | 15.7 | 17.7 | 17.2 |
| ∆% Oct 2015 to Oct 2017 | 10.4 | 11.7 | 11.7 |
| ∆% Oct 2016 to Oct 2017 | 6.0 | 6.4 | 5.6 |
| ∆% Oct 2000 to Oct 2017 | 94.8 | 85.2 | 81.6 |
| ∆% Peak Jun 2006 Oct 2017 | -3.8 | 6.0 | |
| ∆% Peak Oct 2006 to Oct 2017 | -1.3 | 6.0 | |
| Average ∆% Dec 1987-Dec 2016 | 3.8 | NA | 3.5 |
| Average ∆% Dec 1987-Dec 2000 | 3.8 | NA | 3.6 |
| Average ∆% Dec 1992-Dec 2000 | 5.0 | NA | 4.5 |
| Average ∆% Dec 2000-Dec 2016 | 3.8 | 3.5 | 3.4 |
Source: http://us.spindices.com/index-family/real-estate/sp-corelogic-case-shiller
Price increases measured by the Case-Shiller house price indices show in data for Oct 2017 that “home prices continued their rise across the country over the last 12 months” (https://www.spice-indices.com/idpfiles/spice-assets/resources/public/documents/638549_cshomeprice-release-1226.pdf?force_download=true). Monthly house prices increased sharply from Feb 2013 to Jan 2014 for both the 10- and 20-city composites, as shown in Table IIA-2. In Jan 2013, the seasonally adjusted 10-city composite increased 0.8 percent and the 20-city increased 0.8 percent while the 10-city not seasonally adjusted changed 0.0 percent and the 20-city changed 0.0 percent. House prices increased at high monthly percentage rates from Feb to Nov 2013. Except for Mar through Apr 2012, house prices seasonally adjusted declined in most months for both the 10-city and 20-city Case-Shiller composites from Dec 2010 to Jan 2012, as shown in Table IIA-2. The most important seasonal factor in house prices is school changes for wealthier homeowners with more expensive houses. Without seasonal adjustment, house prices fell from Dec 2010 throughout Mar 2011 and then increased in every month from Apr to Aug 2011 but fell in every month from Sep 2011 to Feb 2012. The not seasonally adjusted index registers decline in Mar 2012 of 0.1 percent for the 10-city composite and is flat for the 20-city composite. Not seasonally adjusted house prices increased 1.4 percent in Apr 2012 and at high monthly percentage rates until Sep 2012. House prices not seasonally adjusted stalled from Oct 2012 to Jan 2013 and surged from Feb to Sep 2013, decelerating in Oct 2013-Feb 2014. House prices grew at fast rates in Mar 2014. The 10-city NSA index increased 0.2 percent in Oct 2017 and the 20-city increased 0.2 percent. The 10-city SA increased 0.7 percent in Oct 2017 and the 20-city composite SA increased 0.7 percent. Declining house prices cause multiple adverse effects of which two are quite evident. (1) There is a disincentive to buy houses in continuing price declines. (2) More mortgages could be losing fair market value relative to mortgage debt. Another possibility is a wealth effect that consumers restrain purchases because of the decline of their net worth in houses.
Table IIA-2, US, Monthly Percentage Change of S&P Corelogic Case-Shiller Home Price Indices, Seasonally Adjusted and Not Seasonally Adjusted, ∆%
| 10-City Composite SA | 10-City Composite NSA | 20-City Composite SA | 20-City Composite NSA | |
| October 2017 | 0.7 | 0.2 | 0.7 | 0.2 |
| September 2017 | 0.9 | 0.5 | 1.0 | 0.4 |
| August 2017 | 0.4 | 0.4 | 0.2 | 0.4 |
| July 2017 | 0.4 | 0.8 | 0.4 | 0.7 |
| June 2017 | 0.1 | 0.6 | 0.2 | 0.7 |
| May 2017 | 0.1 | 0.8 | 0.2 | 0.9 |
| April 2017 | -0.3 | 0.8 | -0.3 | 1.0 |
| March 2017 | 0.8 | 0.9 | 1.0 | 1.0 |
| February 2017 | 0.5 | 0.3 | 0.6 | 0.4 |
| January 2017 | 0.8 | 0.3 | 0.8 | 0.2 |
| December 2016 | 0.7 | 0.2 | 0.8 | 0.2 |
| November 2016 | 0.8 | 0.2 | 0.7 | 0.2 |
| October 2016 | 0.4 | -0.1 | 0.5 | 0.0 |
| September 2016 | 0.4 | 0.0 | 0.6 | 0.1 |
| August 2016 | 0.3 | 0.3 | 0.2 | 0.3 |
| July 2016 | 0.2 | 0.5 | 0.2 | 0.6 |
| June 2016 | 0.1 | 0.8 | 0.2 | 0.8 |
| May 2016 | 0.0 | 0.8 | 0.1 | 0.9 |
| April 2016 | 0.0 | 1.0 | -0.1 | 1.1 |
| March 2016 | 0.8 | 0.9 | 0.9 | 0.9 |
| February 2016 | 0.4 | 0.2 | 0.5 | 0.2 |
| January 2016 | 0.5 | -0.1 | 0.5 | 0.0 |
| December 2015 | 0.4 | -0.1 | 0.5 | 0.0 |
| November 2015 | 0.6 | 0.0 | 0.7 | 0.0 |
| October 2015 | 0.5 | -0.1 | 0.6 | 0.0 |
| September 2015 | 0.5 | 0.1 | 0.6 | 0.1 |
| August 2015 | 0.2 | 0.2 | 0.2 | 0.3 |
| July 2015 | 0.2 | 0.6 | 0.2 | 0.7 |
| June 2015 | 0.2 | 0.9 | 0.2 | 1.0 |
| May 2015 | 0.2 | 1.0 | 0.3 | 1.1 |
| April 2015 | 0.1 | 1.1 | 0.0 | 1.1 |
| March 2015 | 0.6 | 0.8 | 0.8 | 0.9 |
| February 2015 | 0.8 | 0.5 | 0.8 | 0.5 |
| January 2015 | 0.5 | -0.1 | 0.5 | -0.1 |
| December 2014 | 0.6 | 0.0 | 0.6 | 0.0 |
| November 2014 | 0.4 | -0.3 | 0.5 | -0.2 |
| October 2014 | 0.5 | -0.1 | 0.5 | -0.1 |
| September 2014 | 0.3 | -0.1 | 0.4 | -0.1 |
| August 2014 | 0.1 | 0.2 | 0.1 | 0.2 |
| July 2014 | 0.0 | 0.6 | 0.0 | 0.6 |
| June 2014 | 0.2 | 1.0 | 0.1 | 1.0 |
| May 2014 | 0.1 | 1.1 | 0.2 | 1.1 |
| April 2014 | 0.2 | 1.1 | 0.1 | 1.2 |
| March 2014 | 0.6 | 0.8 | 0.7 | 0.9 |
| February 2014 | 0.5 | 0.0 | 0.5 | 0.0 |
| January 2014 | 0.6 | -0.1 | 0.6 | -0.1 |
| December 2013 | 0.6 | -0.1 | 0.6 | -0.1 |
| November 2013 | 0.8 | 0.0 | 0.7 | -0.1 |
| October 2013 | 0.9 | 0.2 | 0.9 | 0.2 |
| September 2013 | 1.1 | 0.7 | 1.1 | 0.7 |
| August 2013 | 1.2 | 1.3 | 1.2 | 1.3 |
| July 2013 | 1.2 | 1.9 | 1.1 | 1.8 |
| June 2013 | 1.2 | 2.2 | 1.1 | 2.2 |
| May 2013 | 1.4 | 2.5 | 1.4 | 2.5 |
| April 2013 | 1.9 | 2.6 | 1.7 | 2.6 |
| March 2013 | 1.1 | 1.3 | 1.1 | 1.3 |
| February 2013 | 0.9 | 0.3 | 0.9 | 0.2 |
| January 2013 | 0.8 | 0.0 | 0.8 | 0.0 |
| December 2012 | 0.9 | 0.2 | 0.9 | 0.2 |
| November 2012 | 0.6 | -0.3 | 0.7 | -0.2 |
| October 2012 | 0.6 | -0.2 | 0.7 | -0.1 |
| September 2012 | 0.6 | 0.3 | 0.6 | 0.3 |
| August 2012 | 0.6 | 0.8 | 0.7 | 0.9 |
| July 2012 | 0.6 | 1.5 | 0.7 | 1.6 |
| June 2012 | 1.0 | 2.1 | 1.1 | 2.3 |
| May 2012 | 1.0 | 2.2 | 1.1 | 2.4 |
| April 2012 | 0.8 | 1.4 | 0.8 | 1.4 |
| March 2012 | -0.2 | -0.1 | -0.2 | 0.0 |
| February 2012 | -0.2 | -0.9 | 0.0 | -0.8 |
| January 2012 | -0.3 | -1.1 | -0.2 | -1.0 |
| December 2011 | -0.5 | -1.2 | -0.4 | -1.1 |
| November 2011 | -0.6 | -1.4 | -0.5 | -1.3 |
| October 2011 | -0.5 | -1.3 | -0.6 | -1.4 |
| September 2011 | -0.3 | -0.6 | -0.5 | -0.7 |
| August 2011 | -0.2 | 0.1 | -0.2 | 0.1 |
| July 2011 | 0.0 | 0.9 | 0.0 | 1.0 |
| June 2011 | -0.1 | 1.0 | -0.1 | 1.2 |
| May 2011 | -0.2 | 1.0 | -0.2 | 1.0 |
| April 2011 | 0.1 | 0.6 | 0.1 | 0.6 |
| March 2011 | -0.9 | -1.0 | -1.1 | -1.0 |
| February 2011 | -0.4 | -1.3 | -0.3 | -1.2 |
| January 2011 | -0.3 | -1.1 | -0.3 | -1.1 |
| December 2010 | -0.2 | -0.9 | -0.2 | -1.0 |
Source: http://us.spindices.com/index-family/real-estate/sp-corelogic-case-shiller
Table IIA-4 summarizes the brutal drops in assets and net worth of US households and nonprofit organizations from 2007 to 2008 and 2009. Total assets fell $10.3 trillion or 12.8 percent from 2007 to 2008 and $8.7 trillion or 10.7 percent to 2009. Net worth fell $10.2 trillion from 2007 to 2008 or 15.4 percent and $8.9 trillion to 2009 or 12.6 percent. Subsidies to housing prolonged over decades together with interest rates at 1.0 percent from Jun 2003 to Jun 2004 inflated valuations of real estate and risk financial assets such as equities. The increase of fed funds rates by 25 basis points until 5.25 percent in Jun 2006 reversed carry trades through exotic vehicles such as subprime adjustable rate mortgages (ARM) and world financial markets. 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 to purchase 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).
Table IIA-4, Difference of Balance Sheet of Households and Nonprofit Organizations, Billions of Dollars from 2007 to 2008 and 2009
| 2007 | 2008 | Change to 2008 | 2009 | Change to 2009 | |
| A | 80,886.6 | 70,545.8 | -10,340.8 | 72,195.1 | -8,691.5 |
| Non | 28,062.7 | 24,397.6 | -3,665.1 | 23,496.2 | -4,566.5 |
| RE | 23,253.2 | 19,463.4 | -3,789.8 | 18,539.8 | -4,713.4 |
| FIN | 52,823.9 | 46,148.2 | -6,675.7 | 48,698.9 | -4,125.0 |
| LIAB | 14,436.7 | 14,337.5 | -99.2 | 14,138.9 | -297.8 |
| NW | 66,450.0 | 56,208.3 | -10,241.7 | 58,056.3 | -8,933.7 |
A: Assets; Non FIN: Nonfinancial Assets; RE: Real Estate; FIN: Financial Assets; LIAB: Liabilities; NW: Net Worth
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
The apparent improvement in Table IIA-4A is mostly because of increases in valuations of risk financial assets by the carry trade from zero interest rates to leveraged exposures in risk financial assets such as stocks, high-yield bonds, emerging markets, commodities and so on. Zero interest rates also act to increase net worth by reducing debt or liabilities. The net worth of households has become an instrument of unconventional monetary policy by zero interest rates in the theory that increases in net worth increase consumption that accounts for 68.9 percent of GDP in IIIQ2017 (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html), generating demand to increase aggregate economic activity and employment. There are neglected and counterproductive risks in unconventional monetary policy. Between 2007 and IIIQ2017, real estate increased in value by $4175.1 billion and financial assets increased $26,030.4 billion for net gain of real estate and financial assets of $30,205.5 billion, explaining most of the increase in net worth of $30,489.2 billion obtained by deducting the increase in liabilities of $984.1 billion from the increase of assets of $31,473.4 billion (with minor rounding error). Net worth increased from $66,450.0 billion in 2007 to $96,939.2 billion in IIIQ2017 by $30,489.2 billion or 45.9 percent. The US consumer price index for all items increased from 210.036 in Dec 2007 to 246.819 in Sep 2016 (http://www.bls.gov/cpi/data.htm) or 17.5 percent. Net worth adjusted by CPI inflation increased 24.1 percent from 2007 to IIIQ2017. Real estate assets adjusted for CPI inflation increased 0.4 percent from 2007 to IIIQ2017. There are multiple complaints that unconventional monetary policy concentrates income on wealthier individuals because of their holdings of financial assets while the middle class has gained less because of fewer holdings of financial assets and higher share of real estate in family wealth. There is nothing new in these arguments. Interest rate ceilings on deposits and loans have been commonly used. The Banking Act of 1933 imposed prohibition of payment of interest on demand deposits and ceilings on interest rates on time deposits. These measures were justified by arguments that the banking panic of the 1930s was caused by competitive rates on bank deposits that led banks to engage in high-risk loans (Friedman, 1970, 18; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 74-5). The objective of policy was to prevent unsound loans in banks. Savings and loan institutions complained of unfair competition from commercial banks that led to continuing controls with the objective of directing savings toward residential construction. Friedman (1970, 15) argues that controls were passive during periods when rates implied on demand deposit were zero or lower and when Regulation Q ceilings on time deposits were above market rates on time deposits. The Great Inflation or stagflation of the 1960s and 1970s changed the relevance of Regulation Q. Friedman (1970, 26-7) predicted the future:
“The banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.”
In short, Depression regulation exported the US financial system to London and offshore centers. What is vividly relevant currently from this experience is the argument by Friedman (1970, 27) that the controls affected the most people with lower incomes and wealth who were forced into accepting controlled-rates on their savings that were lower than those that would be obtained under freer markets. As Friedman (1970, 27) argues:
“These are the people who have the fewest alternative ways to invest their limited assets and are least sophisticated about the alternatives.” Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 33 quarters from IIIQ2009 to IIIQ2017. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIIQ2017 (https://www.bea.gov/newsreleases/national/gdp/2017/pdf/gdp3q17_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by dividing GDP of $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[($14,745.9/$14,355.6) -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987, 4.9 percent from IQ1983 to IIQ1988, 4.8 percent from IQ1983 to IIIQ1988, 4.8 percent from IQ1983 to IVQ1988, 4.8 percent from IQ1983 to IQ1989, 4.7 percent from IQ1983 to IIQ1989, 4.7 percent from IQ1983 to IIIQ1989, 4.5 percent from IQ1983 to IVQ1989. 4.5 percent from IQ1983 to IQ1990, 4.4 percent from IQ1983 to IIQ1990, 4.3 percent from IQ1983 to IIIQ1990, 4.0 percent from IQ1983 to IVQ1990, 3.8 percent from IQ1983 to IQ1991 and at 7.8 percent from IQ1983 to IVQ1983 (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html). The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIIQ2017 would have accumulated to 33.4 percent. GDP in IIIQ2017 would be $19,999.1 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2835.2 billion than actual $17,163.9 billion. There are about two trillion dollars of GDP less than at trend, explaining the 21.4 million unemployed or underemployed equivalent to actual unemployment/underemployment of 12.6 percent of the effective labor force (https://cmpassocregulationblog.blogspot.com/2017/12/twenty-one-million-unemployed-or.html and earlier https://cmpassocregulationblog.blogspot.com/2017/11/unchanged-fomc-policy-rate-gradual.html). US GDP in IIIQ2017 is 14.2 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $17,163.9 billion in IIIQ2017 or 14.5 percent at the average annual equivalent rate of 1.4 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.1 percent per year from Nov 1919 to Nov 2017. Growth at 3.1 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 146.5098 in Nov 2017. The actual index NSA in Nov 2017 is 104.6305, which is 28.6 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Nov 2017. Using trend growth of 2.0 percent per year, the index would increase to 131.7256 in Nov 2017. The output of manufacturing at 104.6305 in Nov 2017 is 20.6 percent below trend under this alternative calculation.
Table IIA-4A, US, Difference of Balance Sheet of Households and Nonprofit Organizations Billions of Dollars from 2007 to 2015, 2016 and IIQ2017
| Value 2007 | Change to 2015 | Change to 2016 | Change to IIIQ2017 | |
| Assets | 80,886.6 | 19,976.3 | 25,840.7 | 31,473.4 |
| Nonfinancial | 28,062.7 | 2,226.5 | 3,927.3 | 5,443.0 |
| Real Estate | 23,253.2 | 1,332.2 | 2,867.1 | 4,175.1 |
| Financial | 52,823.9 | 17,749.8 | 21,913.4 | 26,030.4 |
| Liabilities | 14,436.7 | 138.9 | 598.2 | 984.1 |
| Net Worth | 66,450.0 | 19,837.3 | 25,242.5 | 30,489.2 |
Net Worth = Assets – Liabilities
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and from IVQ1979) to IQ1991 and from IVQ2007 to IIIQ2017 is in Table IIA-5. The data reveal the following facts for the cycles in the 1980s:
- IVQ1979 to IQ1991. Net worth increased 151.1 percent from IVQ1979 to IQ1991, the all items CPI index increased 76.0 percent from 76.7 in Dec 1979 to 135.0 in Mar 1991 and real net worth increased 42.7 percent.
- IQ1980 to IVQ1985. Net worth increased 65.7 percent, the all items CPI index increased 36.5 percent from 80.1 in Mar 1980 to 109.3 in Dec 1985 and real net worth increased 21.5 percent.
- IVQ1979 to IVQ1985. Net worth increased 69.2 percent, the all items CPI index increased 42.5 percent from 76.7 in Dec 1979 to 109.3 in Dec 1985 and real net worth increased 18.7 percent.
- IQ1980 to IQ1989. Net worth increased 118.8 percent, the all items CPI index increased 52.7 percent from 80.1 in Mar 1980 to 122.3 in Mar 1989 and real net worth increased 43.3 percent.
- IQ1980 to IIQ1989. Net worth increased 123.2 percent, the all items CPI index increased 54.9 percent from 80.1 in Mar 1980 to 124.1 in Jun 1989 and real net worth increased 44.1 percent.
- IQ1980 to IIIQ1989. Net worth increased 129.2 percent, the all items CPI index increased 56.1 percent from 80.1 in Mar 1980 to 125.0 in Sep 1989 and real net worth increased 46.9 percent.
- IQ1980 to IVQ1989. Net worth increased 133.2 percent, the all items CPI index increased 57.4 from 80.1 in Mar 1980 to 126.1 in Dec 1989 and real net worth increased 48.1 percent.
- IQ1980 to IQ1990. Net worth increased 134.4 percent, the all items CPI index increased 60.7 percent from 80.1 in Mar 1980 to 128.7 in Mar 1990 and real net worth increased 45.9 percent.
- IQ1980 to IIQ1990. Net worth increased 136.9 percent, the all items CPI index increased 62.2 percent from 80.1 in Mar 1980 to 129.9 in Jun 1990 and real net worth increased 46.1 percent
- IQ1980 to IIIQ1990. Net worth increased 134.3 percent, the all items CPI index increased 65.7 percent from 80.1 in Mar 1980 to 132.7 in Jun 1990 and real net worth increased 41.4 percent.
- IQ1980 to IVQ1990. Net worth increased 139.2 percent, the all items CPI index increased 67.0 percent from 80.1 in Mar 1980 to 133.8 in Dec 1990 and real net worth increased 43.2 percent. The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). This new cyclical contraction explains the contraction of net worth in IIIQ1990
- IQ1980 to IQ1991. Net worth increased 146.0 percent, the all items CPI index increased 68.5 percent from 80.1 in Mar 1980 to 135.0 in Mar 1991 and real net worth increased 46.0 percent.
There is disastrous performance in the current economic cycle:
- IVQ2007 to IIIQ2017. Net worth increased 45.9 percent, the all items CPI increased 17.5 percent from 210.036 in Dec 2007 to 246.819 in Sep 2017 and real or inflation adjusted net worth increased 24.1 percent. Real estate assets adjusted for inflation increased 0.4 percent. Growth of real net worth at the long-term average of 3.1 percent per year from IVQ1945 to IIIQ2017 would have accumulated to 34.7 percent in the entire cycle from IVQ2007 to IIIQ2017, much higher than actual 24.1 percent.
The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. Long-term economic performance in the United States consisted of trend growth of GDP at 3 percent per year and of per capita GDP at 2 percent per year as measured for 1870 to 2010 by Robert E Lucas (2011May). The economy returned to trend growth after adverse events such as wars and recessions. The key characteristic of adversities such as recessions was much higher rates of growth in expansion periods that permitted the economy to recover output, income and employment losses that occurred during the contractions. Over the business cycle, the economy compensated the losses of contractions with higher growth in expansions to maintain trend growth of GDP of 3 percent and of GDP per capita of 2 percent. The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. US economic growth has been at only 2.2 percent on average in the cyclical expansion in the 33 quarters from IIIQ2009 to IIIQ2017. Boskin (2010Sep) measures that the US economy grew at 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975; and at 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter of 1983 (Professor Michael J. Boskin, Summer of Discontent, Wall Street Journal, Sep 2, 2010 http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html). There are new calculations using the revision of US GDP and personal income data since 1929 by the Bureau of Economic Analysis (BEA) (http://bea.gov/iTable/index_nipa.cfm) and the third estimate of GDP for IIIQ2017 (https://www.bea.gov/newsreleases/national/gdp/2017/pdf/gdp3q17_3rd.pdf). The average of 7.7 percent in the first four quarters of major cyclical expansions is in contrast with the rate of growth in the first four quarters of the expansion from IIIQ2009 to IIQ2010 of only 2.7 percent obtained by dividing GDP of $14,745.9 billion in IIQ2010 by GDP of $14,355.6 billion in IIQ2009 {[($14,745.9/$14,355.6) -1]100 = 2.7%], or accumulating the quarter on quarter growth rates (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html). The expansion from IQ1983 to IVQ1985 was at the average annual growth rate of 5.9 percent, 5.4 percent from IQ1983 to IIIQ1986, 5.2 percent from IQ1983 to IVQ1986, 5.0 percent from IQ1983 to IQ1987, 5.0 percent from IQ1983 to IIQ1987, 4.9 percent from IQ1983 to IIIQ1987, 5.0 percent from IQ1983 to IVQ1987, 4.9 percent from IQ1983 to IIQ1988, 4.8 percent from IQ1983 to IIIQ1988, 4.8 percent from IQ1983 to IVQ1988, 4.8 percent from IQ1983 to IQ1989, 4.7 percent from IQ1983 to IIQ1989, 4.7 percent from IQ1983 to IIIQ1989, 4.5 percent from IQ1983 to IVQ1989. 4.5 percent from IQ1983 to IQ1990, 4.4 percent from IQ1983 to IIQ1990, 4.3 percent from IQ1983 to IIIQ1990, 4.0 percent from IQ1983 to IVQ1990, 3.8 percent from IQ1983 to IQ1991 and at 7.8 percent from IQ1983 to IVQ1983 (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html). The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). The US maintained growth at 3.0 percent on average over entire cycles with expansions at higher rates compensating for contractions. Growth at trend in the entire cycle from IVQ2007 to IIIQ2017 would have accumulated to 33.4 percent. GDP in IIIQ2017 would be $19,999.1 billion (in constant dollars of 2009) if the US had grown at trend, which is higher by $2835.2 billion than actual $17,163.9 billion. There are about two trillion dollars of GDP less than at trend, explaining the 21.4 million unemployed or underemployed equivalent to actual unemployment/underemployment of 12.6 percent of the effective labor force (https://cmpassocregulationblog.blogspot.com/2017/12/twenty-one-million-unemployed-or.html and earlier https://cmpassocregulationblog.blogspot.com/2017/11/unchanged-fomc-policy-rate-gradual.html). US GDP in IIIQ2017 is 14.2 percent lower than at trend. US GDP grew from $14,991.8 billion in IVQ2007 in constant dollars to $17,163.9 billion in IIIQ2017 or 14.5 percent at the average annual equivalent rate of 1.4 percent. Professor John H. Cochrane (2014Jul2) estimates US GDP at more than 10 percent below trend. Cochrane (2016May02) measures GDP growth in the US at average 3.5 percent per year from 1950 to 2000 and only at 1.76 percent per year from 2000 to 2015 with only at 2.0 percent annual equivalent in the current expansion. Cochrane (2016May02) proposes drastic changes in regulation and legal obstacles to private economic activity. The US missed the opportunity to grow at higher rates during the expansion and it is difficult to catch up because growth rates in the final periods of expansions tend to decline. The US missed the opportunity for recovery of output and employment always afforded in the first four quarters of expansion from recessions. Zero interest rates and quantitative easing were not required or present in successful cyclical expansions and in secular economic growth at 3.0 percent per year and 2.0 percent per capita as measured by Lucas (2011May). There is cyclical uncommonly slow growth in the US instead of allegations of secular stagnation. There is similar behavior in manufacturing. There is classic research on analyzing deviations of output from trend (see for example Schumpeter 1939, Hicks 1950, Lucas 1975, Sargent and Sims 1977). The long-term trend is growth of manufacturing at average 3.1 percent per year from Nov 1919 to Nov 2017. Growth at 3.1 percent per year would raise the NSA index of manufacturing output from 108.2393 in Dec 2007 to 146.5098 in Nov 2017. The actual index NSA in Nov 2017 is 104.6305, which is 28.6 percent below trend. Manufacturing output grew at average 2.0 percent between Dec 1986 and Nov 2017. Using trend growth of 2.0 percent per year, the index would increase to 131.7256 in Nov 2017. The output of manufacturing at 104.6305 in Nov 2017 is 20.6 percent below trend under this alternative calculation.
Table IIA-5, Net Worth of Households and Nonprofit Organizations in Billions of Dollars, IVQ1979 to IQ1991 and IVQ2007 to IIIQ2017
| Period IQ1980 to IQ1991 | |
| Net Worth of Households and Nonprofit Organizations USD Millions | |
| IVQ1979 IQ1980 | 8,994.9 9,181.1 |
| IVQ1985 IIIQ1986 IVQ1986 IQ1987 IIQ1987 IIIQ1987 IVQ1987 IQ1988 IIQ1988 IIIQ1988 IVQ1988 IQ1989 IIQ1989 IIIQ1989 IVQ1989 IQ1990 IIQ1990 | 15,216.1 16,227.8 16,779.1 17,439.4 17,727.0 18,143.0 17,991.8 18,466.7 18,868.5 19,160.2 19,644.4 20,084.8 20,491.3 21,042.4 21,407.4 21,521.8 21,753.0 |
| III1990 | 21,514.0 |
| IV1990 | 21,963.6 |
| I1991 | 22,589.6 |
| ∆ USD Billions IVQ1985 IVQ1979 to IQ1991 IQ1980-IVQ1985 IQ1980-IIIQ1986 IQ1980-IVQ1986 IQ1980-IQ1987 IQ1980-IIQ1987 IQ1980-IIIQ1987 IQ1980-IVQ1987 IQ1980-IQ1988 IQ1980-IIQ1988 IQ1980-IIIQ1988 IQ1980-IVQ1988 IQ1980-IQ1989 IQ1980-IIQ1989 IQ1980-IIIQ1989 IQ1980-IVQ1989 IQ1980-IQ1990 IQ1980-IIQ1990 | +6,221.2 ∆%69.2 R∆18.7 +13,594.7 ∆%151.1 R∆%42.7 +6,035.0∆%65.7 R∆%21.5 +7,046.7 ∆%76.8 R∆%28.5 +7,598.0 ∆%82.8 R∆%32.5 +8,258.3 ∆%89.9 R∆%35.7 +8,545.9 ∆%93.1 R∆%36.3 +8,961.9 ∆%97.6 R∆%37.6 +8810.7 ∆%96.0 R∆%36.0 +9285.6 ∆%101.1 R∆%38.3 +9687.4 ∆%105.5 R∆%39.5 +9979.1 ∆%108.7 R∆%39.5 +10463.3 ∆%114.0 R∆%42.2 +10903.7 ∆%118.8 R∆%43.3 +11,310.2 ∆%123.2 R∆% 44.1 +11,861.3 ∆%129.2 R∆% 46.9 +12,226.3 ∆%133.2 R∆%48.1 +12,340.7 ∆%134.4 R∆%45.9 +12,571.9 ∆%136.9 R∆%46.1 |
| IQ1980-IIIQ1990 | +12,332.9 ∆%134.3 R∆%41.4 |
| IQ1980-IVQ1990 | +12,782.5 ∆%139.2 R∆%43.2 |
| IQ1980-IQ1991 | +13,408.5 ∆%146.0 R∆%46.0 |
| Period IVQ2007 to IIIQ2017 | |
| Net Worth of Households and Nonprofit Organizations USD Millions | |
| IVQ2007 | 66,450.0 |
| IIIQ2017 | 96,939.2 |
| ∆ USD Billions | +30,489.2 ∆%45.9 R∆%24.1 |
Net Worth = Assets – Liabilities. R∆% real percentage change or adjusted for CPI percentage change.
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
Chart IIA-1 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ2007 to IIIQ2017. There is remarkable stop and go behavior in this series with two sharp declines and two standstills in the 33 quarters of expansion of the economy beginning in IIIQ2009. The increase in net worth of households and nonprofit organizations is the result of increases in valuations of risk financial assets and compressed liabilities resulting from zero interest rates. Wealth of households and nonprofits organization increased 24.1 percent from IVQ2007 to IIIQ2017 when adjusting for consumer price inflation.
Chart IIA-1, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ2007 to IIIQ2017
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
Chart IIA-2 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1979 to IVQ1990. There are changes in the rates of growth of wealth suggested by the changing slopes but there is smooth upward trend. There was significant financial turmoil during the 1980s. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5657.7 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.65 percent of GDP in a year. The Bureau of Economic Analysis estimates US GDP in 2016 at $18,624.5 billion, such that the bailout would be equivalent to cost to taxpayers of about $493.5 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery. Money center banks were under extraordinary pressure from the default of sovereign debt by various emerging nations that represented a large share of their net worth (see Pelaez 1986). Net worth of households and nonprofit organizations increased 151.1 percent from IVQ1979 to IQ1991 and 42.7 percent when adjusting for consumer price inflation. Net worth of households and nonprofit organizations increased 146.0 percent from IQ1980 to IQ1991 and 46.0 percent when adjusting for consumer price inflation. The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). This new cyclical contraction explains the contraction of net worth in the final segment in Chart IIA-2.
Chart IIA-2, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1979 to IQ1991
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
Chart IIA-3 of the Board of Governors of the Federal Reserve System provides US wealth of households and nonprofit organizations from IVQ1945 at $803.1 billion to IIIQ2017 at $96,939.2 billion or increase of 11,971 percent. The consumer price index not seasonally adjusted was 18.2 in Dec 1945 jumping to 246.819 in IIIQ2017 or increase of 1,256.1 percent. There was a gigantic increase of US net worth of households and nonprofit organizations over 71.75 years with inflation-adjusted increase from $44.126 in dollars of 1945 to $392.754 in IIIQ2017 or 790.1 percent. In a simple formula: {[($96,939.2/$803.1)/(246.819/18.2)-1]100 = 790.07%}. Wealth of households and nonprofit organizations increased from $803.1 billion at year-end 1945 to $96,939.2 billion at the end of IIIQ2017 or 11,971 percent. The consumer price index increased from 18.2 in Dec 1945 to 246.819 in Sep 2017 or 1,256.1 percent. Net wealth of households and nonprofit organizations in dollars of 1945 increased from $44.126 in 1945 to $392.754 in IIIQ2017 or 790.07 percent at the average yearly rate of 3.1 percent. US real GDP grew at the average rate of 2.9 percent from 1945 to 2016 (http://www.bea.gov/iTable/index_nipa.cfm). The combination of collapse of values of real estate and financial assets during the global recession of IVQ2007 to IIQ2009 caused sharp contraction of net worth of US households and nonprofit organizations. Recovery has been in stop-and-go fashion during the worst cyclical expansion in the 70 years when US GDP grew at 2.2 percent on average in the thirty-three quarters between IIIQ2009 and IIIQ2017 (https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states_23.html and earlier https://cmpassocregulationblog.blogspot.com/2017/12/mediocre-cyclical-united-states.html). US GDP was $228.2 billion in 1945 and net worth of households and nonprofit organizations $803.1 billion for ratio of wealth to GDP of 3.52. The ratio of net worth of households and nonprofits of $66,450.0 billion in 2007 to GDP of $14,477.6 billion was 4.59. The ratio of net worth of households and nonprofits of $91,692.5 billion in 2016 to GDP of $18,624.5 billion was 4.92. The final data point in Chart IIA-3 is net worth of household and nonprofit institutions at $96,939.2 billion in IIIQ2017 for increase of 11,971 percent relative to $803.1 billion in IVQ1945. CPI adjusted net worth of household and nonprofit institutions increased from $44.126 in IVQ1945 to $392.754 in IIIQ2017 or 790.07 percent at the annual equivalent rate of 3.1 percent.
Chart IIA-3, Net Worth of Households and Nonprofit Organizations in Millions of Dollars, IVQ1945 to IIIQ2017
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
Table IIA-6 provides percentage changes of nonfinancial domestic sector debt. Households increased debt by 10.5 percent in 2006 but reduced debt from 2010 to 2011. Households have increased debt moderately since 2012. Financial repression by zero fed funds rates or negative interest rates intends to increase debt and reduce savings. Business had not been as exuberant in acquiring debt and has been increasing debt benefitting from historically low costs while increasing cash holdings to around $2 trillion by swelling undistributed profits because of the uncertainty of capital budgeting. The key to growth and hiring consists in creating the incentives for business to invest and hire. States and local government were forced into increasing debt by the decline in revenues but began to contract in IQ2011, decreasing again from IQ2011 to IVQ2011, increasing at 2.1 percent in IIQ2012 and decreasing at 0.2 percent in IIIQ2012 and 2.6 percent in IVQ2012. State and local government increased debt at 1.9 percent in IQ2013 and decreased at 1.1 percent in IIQ2013. State and local government decreased debt at 3.0 percent in IIIQ2013 and at 2.8 percent in IVQ2013. State and local government reduced debt at 1.7 percent in IQ2014 and decreased at 0.4 percent in IIQ2014. State and local government reduced debt at 2.7 percent in IIIQ2014 and increased at 0.7 percent in IVQ2014. State and local government increased debt at 1.6 percent in IQ2015 and increased at 0.3 percent in IIIQ2015. State and local government decreased debt at 1.0 percent in IVQ2015. State and local government increased debt at 0.7 percent in IQ2016 and increased at 2.2 percent in IIQ2016. State and local government increased debt at 0.7 percent in IIIQ2016. State and local government reduced debt at 0.1 percent in IIIQ2017. Opposite behavior is for the federal government that has been rapidly accumulating debt but without success in the self-assigned goal of promoting economic growth. Financial repression constitutes seigniorage of government debt (http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-financial.html http://cmpassocregulationblog.blogspot.com/2011/05/global-inflation-seigniorage-monetary.html).
Table IIA-6, US, Percentage Change of Nonfinancial Domestic Sector Debt
| Total | Households | Business | Federal | State & | |
| IIIQ2017 | 6.2 | 3.7 | 5.4 | 10.3 | -0.1 |
| IIQ2017 | 3.8 | 3.8 | 5.1 | 3.6 | -1.0 |
| IQ2017 | 1.7 | 3.6 | 6.0 | -2.6 | -3.4 |
| IVQ2016 | 3.1 | 3.8 | 2.3 | 3.6 | 0.4 |
| IIIQ2016 | 5.0 | 3.5 | 6.1 | 6.3 | 0.7 |
| IIQ2016 | 4.6 | 4.4 | 4.0 | 5.7 | 2.2 |
| IQ2016 | 5.5 | 2.5 | 9.2 | 6.2 | 0.7 |
| IVQ2015 | 8.0 | 4.1 | 5.9 | 15.6 | -1.0 |
| IIIQ2015 | 2.1 | 1.3 | 5.3 | 0.6 | 0.3 |
| IIQ2015 | 4.6 | 3.8 | 8.2 | 3.4 | 0.2 |
| IQ2015 | 2.8 | 2.2 | 7.5 | -0.3 | 1.6 |
| IVQ2014 | 3.5 | 2.3 | 6.4 | 3.1 | 0.7 |
| 2016 | 4.6 | 3.6 | 5.5 | 5.6 | 1.0 |
| 2015 | 4.5 | 2.9 | 6.9 | 5.0 | 0.3 |
| 2014 | 4.3 | 3.0 | 6.1 | 5.4 | -1.3 |
| 2013 | 3.8 | 1.8 | 4.7 | 6.7 | -1.8 |
| 2012 | 5.0 | 2.0 | 4.5 | 10.1 | -0.2 |
| 2011 | 3.5 | -0.4 | 2.7 | 10.8 | -1.4 |
| 2010 | 4.4 | -0.4 | -0.7 | 18.5 | 2.5 |
| 2009 | 3.6 | 0.4 | -4.0 | 20.4 | 4.5 |
| 2008 | 5.8 | 0.0 | 5.7 | 21.4 | 1.3 |
| 2007 | 8.1 | 7.1 | 12.5 | 4.7 | 6.2 |
| 2006 | 8.4 | 10.5 | 9.8 | 3.9 | 4.4 |
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
Table IIA-7 provides wealth of US households and nonprofit organizations since 2005 in billions of current dollars at the end of period, NSA. Wealth fell from $66,450 billion in 2007 to $58,056 billion in 2009 or 12.6 percent and to $62,972 billion in 2011 or 5.2 percent. Wealth increased 45.9 percent from 2007 to IIIQ2017, increasing 24.1 percent after adjustment for inflation, primarily because of bloating financial assets while nonfinancial assets declined/stagnated in real terms.
Table IIA-7, US, Net Worth of Households and Nonprofit Organizations, Billions of Dollars, Amounts Outstanding at End of Period, NSA
| Quarter | Net Worth |
| IIIQ2017 | 96,939 |
| IIQ2017 | 95,197 |
| IQ2017 | 93,921 |
| IVQ2016 | 92,692 |
| IIIQ2016 | 89,730 |
| IIQ2016 | 87,524 |
| IQ2016 | 86,809 |
| IVQ2015 | 86,287 |
| IIIQ2015 | 84,397 |
| IIQ2015 | 85,626 |
| IQ2015 | 85,066 |
| IVQ2014 | 83,280 |
| IIIQ2014 | 81,399 |
| IIQ2014 | 81,080 |
| IQ2014 | 79,639 |
| IVQ2013 | 78,332 |
| IIIQ2013 | 75,636 |
| IIQ2013 | 73,246 |
| IQ2013 | 71,694 |
| IVQ2012 | 68,700 |
| 2016 | 91,692 |
| 2015 | 86,287 |
| 2014 | 83,280 |
| 2013 | 78,332 |
| 2012 | 68,700 |
| 2011 | 62,972 |
| 2010 | 61,938 |
| 2009 | 58,056 |
| 2008 | 56,208 |
| 2007 | 66,450 |
| 2006 | 66,435 |
| 2005 | 61,936 |
Source: Board of Governors of the Federal Reserve System. 2017. Flow of funds, balance sheets and integrated macroeconomic accounts: third quarter 2017. Washington, DC, Federal Reserve System, Dec 7. https://www.federalreserve.gov/releases/z1/current/default.htm
III World Financial Turbulence. Financial markets are being shocked by multiple factors including:
(1) World economic slowdown
(2) Slowing growth in China with political development and slowing growth in Japan and world trade
(3) Slow growth propelled by savings/investment reduction in the US with high unemployment/underemployment, falling wages, hiring collapse, contraction of real private fixed investment and loss of ten million full-time jobs. Wealth of households increased over the business cycle by total 24.1 percent adjusted for inflation from IVQ2007 to IIIQ2017, while growing at 3.1 percent per year adjusted for inflation from IVQ1945 to IIIQ2017 with unsustainable fiscal deficit/debt threatening prosperity that can cause risk premium on Treasury debt with Himalayan interest rate hikes. Growth of inflation-adjusted wealth at historical trend would have been 34.7 percent between 2007 and IIIQ2017, which is much higher than actual 24.1 percent
(4) Outcome of the sovereign debt crisis in Europe with complex financial, economic and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times).
This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk financial assets during the week. There are various appendixes for convenience of reference of material related to the debt crisis of the euro area. Some of this material is updated in Subsection IIIA when new data are available and then maintained in the appendixes for future reference until updated again in Subsection IIIA. Subsection IIIB Appendix on Safe Haven Currencies discusses arguments and measures of currency intervention and is available in the Appendixes section at the end of the blog comment. Subsection IIIC Appendix on Fiscal Compact provides analysis of the restructuring of the fiscal affairs of the European Union in the agreement of European leaders reached on Dec 9, 2011 and is available in the Appendixes section at the end of the blog comment. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank and is available in the Appendixes section at the end of the blog comment. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union and is available following Subsection IIIA. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis and is available following Subsection IIIA. Subsection IIIG Appendix on Deficit Financing of Growth and the Debt Crisis provides analysis of proposals to finance growth with budget deficits together with experience of the economic history of Brazil and is available in the Appendixes section at the end of the blog comment.
IIIA Financial Risks. Financial turbulence, attaining unusual magnitude in recent months, characterized the expansion from the global recession since IIIQ2009. Table III-1, updated with every comment in this blog, provides beginning values on Dec 22, 2017 and daily values throughout the week ending on Dec 29, 2017, of various financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at the close of business. The first column provides the value on Fri Dec 22 and the percentage change in that prior week below the label of the financial risk asset. For example, the first column “Fri Dec 22, 2017,” first row “USD/EUR 1.1862 -1.0% 0.1%,” provides the information that the US dollar (USD) depreciated 1.0 percent to USD 1.1862/EUR in the week ending on Fri Dec 22 relative to the exchange rate on Fri Dec 15 and appreciated 0.1 percent relative to Thu Dec 21. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing waves of inflation. An important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9 (European Council 2911Dec9), which is analyzed in IIIC Appendix on Fiscal Compact. European leaders reached a new agreement on Jan 30 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/127631.pdf) and another agreement on Jun 29, 2012 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/131388.pdf). There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). The most important source of financial turbulence is shifting toward fluctuating interest rates. The dollar/euro rate is quoted as number of US dollars USD per euro EUR, USD 1.1862/EUR in the first row, first column in the block for currencies in Table III-1 for Dec 22, depreciating to USD 1.1876/EUR on Mon Dec 25, 2017, or by 0.1 percent. The dollar depreciated because more dollars, $1.1876, were required on Mon Dec 25 to buy one euro than $1.1862 on Fri Dec 22. Table III-1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention used throughout this blog is required to maintain consistency in characterizing movements of the exchange rate such as in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the market closing exchange rate at New York time, such as USD 1.1862/EUR on Dec 22. The second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Dec 22, to the last business day of the current week, in this case Dec 29, such as depreciation of 1.2 percent to USD 1.2003/EUR by Dec 29. The third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 1.2 percent from the rate of USD 1.1862/EUR on Fri Dec 22 to the rate of USD 1.2003 on Dec 29 {[(1.2003/1.1862) - 1]100 = 1.2%}. The dollar depreciated (denoted by negative sign) by 0.5 percent from the rate of USD 1.1943 on Thu Dec 28 to USD 1.2003/EUR on Fri Dec 29 {[(1.2003/1.1943) -1]100 = 0.5%}. Other factors constant, increasing risk aversion causes appreciation of the dollar relative to the euro, with rising uncertainty on European and global sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk assets to the safety of dollar-denominated assets.
Table III-I, Weekly Financial Risk Assets Dec 18 to Dec 22, 2017
| Fri 22 | Mon 25 | Tue 26 | Wed 27 | Thu 28 | Fri 29 |
| USD/EUR 1.1862 -1.0% 0.1% | 1.1876 -0.1% -0.1% | 1.1859 0.0% 0.1% | 1.1889 -0.2% -0.3% | 1.1943 -0.7% -0.5% | 1.2003 -1.2% -0.5% |
| JPY/ USD 113.29 -0.6% 0.0% | 113.24 0.0% 0.0% | 113.23 0.1% 0.0% | 113.35 -0.1% -0.1% | 112.87 0.4% 0.4% | 112.70 0.5% 0.2% |
| CHF/ USD 0.9887 0.2% 0.0% | 0.9898 -0.1% -0.1% | 0.9893 -0.1% 0.1% | 0.9864 0.2% 0.3% | 0.9785 1.0% 0.8% | 0.9744 1.4% 0.4% |
| CHF/ EUR 1.1727 -0.8% 0.1% | 1.1754 -0.2% -0.2% | 1.1732 0.0% 0.2% | 1.1727 0.0% 0.0% | 1.1686 0.3% 0.3% | 1.1695 0.3% -0.1% |
| USD/ AUD 0.7695 1.2995 0.7% -0.1% | 0.7716 1.2960 0.3% 0.3% | 0.7728 1.2940 0.4% 0.2% | 0.7770 1.2870 1.0% 0.5% | 0.7797 1.2825 1.3% 0.3% | 0.7809 1.2806 1.5% 0.1% |
| 10Y Note 2.487 | 2.487 | 2.463 | 2.411 | 2.433 | 2.411 |
| 2Y Note 1.899 | 1.899 | 1.903 | 1.887 | 1.899 | 1.891 |
| German Bond 2Y -0.64 10Y 0.42 | 2Y -0.64 10Y 0.42 | 2Y -0.65 10Y 0.42 | 2Y -0.65 10Y 0.38 | 2Y -0.61 10Y 0.43 | 2Y -0.62 10Y 0.43 |
| DJIA 24754.06 0.4% -0.1% | 24754.06 0.0% 0.0% | 24746.21 0.0% 0.0% | 24774.30 0.1% 0.1% | 24837.51 0.3% 0.3% | 24719.22 -0.1% -0.5% |
| Dow Global 3077.11 1.2% 0.0% | 3077.11 0.0% 0.0% | 3077.15 0.0% 0.0% | 3083.89 0.2% 0.2% | 3087.78 0.3% 0.1% | 3086.45 0.3% 0.0% |
| DJ Asia Pacific NA | NA | NA | NA | NA | NA |
| Nikkei 22902.76 1.5% 0.2% | 22939.18 0.2% 0.2% | 22892.69 0.0% -0.2% | 22911.21 0.0% 0.1% | 22783.98 -0.5% -0.6% | 22764.94 -0.6% -0.1% |
| Shanghai 3297.06 0.9% -0.1% | 3280.46 -0.5% -0.5% | 3306.12 0.3% 0.8% | 3275.78 -0.6% -0.9% | 3296.38 0.0% 0.6% | 3307.17 0.3% 0.3% |
| DAX 13072.79 -0.2% -0.3% | 13072.79 0.0% 0.0% | 13072.79 0.0% 0.0% | 13070.02 0.0% 0.0% | 12979.94 -0.7% -0.7% | 12917.64 -1.2% -0.5% |
| DJ UBS Comm. NA | NA | NA | NA | NA | NA |
| WTI $/B 58.47 2.0% 0.2% | 58.47 0.0% 0.0% | 59.97 2.6% 2.6% | 59.64 2.0% -0.6% | 59.84 2.3% 0.3% | 60.42 3.3% 1.0% |
| Brent $/B 65.25 3.2% 0.5% | 65.25 0.0% 0.0% | 67.02 2.7% 2.7% | 66.44 1.8% -0.9% | 66.72 2.3% 0.4% | 66.87 2.5% 0.2% |
| 44Gold 1275.4 1.7% 0.6% | 1275.4 0.0% 0.0% | 1284.1 0.7% 0.7% | 1287.0 0.9% 0.2% | 1294.1 1.5% 0.6% | 1306.3 2.4% 0.9% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
http://www.bloomberg.com/markets/
There is initial discussion of current and recent risk-determining events followed below by analysis of risk-measuring yields of the US and Germany and the USD/EUR rate.
1 First, risk determining events. Jon Hilsenrath, writing on “New view into Fed’s response to crisis,” on Feb 21, 2014, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303775504579396803024281322?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes 1865 pages of transcripts of eight formal and six emergency policy meetings at the Fed in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm). If there were an infallible science of central banking, models and forecasts would provide accurate information to policymakers on the future course of the economy in advance. Such forewarning is essential to central bank science because of the long lag between the actual impulse of monetary policy and the actual full effects on income and prices many months and even years ahead (Romer and Romer 2004, Friedman 1961, 1953, Culbertson 1960, 1961, Batini and Nelson 2002). The transcripts of the Fed meetings in 2008 (http://www.federalreserve.gov/monetarypolicy/fomchistorical2008.htm) analyzed by Jon Hilsenrath demonstrate that Fed policymakers frequently did not understand the current state of the US economy in 2008 and much less the direction of income and prices. The conclusion of Friedman (1953) is that monetary impulses increase financial and economic instability because of lags in anticipating needs of policy, taking policy decisions and effects of decisions. This is a fortiori true when untested unconventional monetary policy in gargantuan doses shocks the economy and financial markets.
In 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.”
In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):
“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level (emphasis added).”
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.”
Prior risk determining events are in an appendix below following Table III-1A. 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 now currently at 1¼ to 1½ 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 $25 billion of securities per month for the balance sheet of the Fed. What is truly important is the fixing of the overnight fed funds at 1¼ to 1½ percent with gradual consideration of further rate increases with all measures depending on “incoming data” (https://www.federalreserve.gov/newsevents/pressreleases/monetary20171213a.htm): “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to 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 will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data” (emphasis added). The FOMC is initiating the “normalization” or reduction of the balance sheet of securities held outright for monetary policy.
There is concern at the Federal Open Market Committee (FOMC) with the world economy and financial markets (http://www.federalreserve.gov/newsevents/press/monetary/20160127a.htm): “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook” (emphasis added). This concern should include the effects on dollar revaluation of competitive easing by other central banks such as quantitative and qualitative easing with negative nominal interest rates (https://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf).
At the confirmation hearing on nomination for Chair of the Board of Governors of the Federal Reserve System, Vice Chair Yellen (2013Nov14 http://www.federalreserve.gov/newsevents/testimony/yellen20131114a.htm), states needs and intentions of policy:
“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve's goal of 2 percent and is expected to continue to do so for some time.
For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.”
There is sharp distinction between the two measures of unconventional monetary policy: (1) fixing of the overnight rate of fed funds at 0 to ¼ percent; and (2) outright purchase of Treasury and agency securities and mortgage-backed securities for the balance sheet of the Federal Reserve. 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 $25 billion of securities per month for the balance sheet of the Fed.
Perhaps one of the most critical statements on policy is the answer to a question of Peter Barnes by Chair Janet Yellen at the press conference following the meeting on Jun 18, 2014 (page 19 at http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140618.pdf):
So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly” (emphasis added).
How long is “considerable time”? At the press conference following the meeting on Mar 19, 2014, Chair Yellen answered a question of Jon Hilsenrath of the Wall Street Journal explaining “In particular, the Committee has endorsed the view that it anticipates that will be a considerable period after the asset purchase program ends before it will be appropriate to begin to raise rates. And of course on our present path, well, that's not utterly preset. We would be looking at next, next fall. So, I think that's important guidance” (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf). Many focused on “next fall,” ignoring that the path of increasing rates is not “utterly preset.”
At 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.”
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.”
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.”
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.”
In testimony on the Semiannual Monetary Policy Report to the Congress before the Committee on Financial Services, US House of Representatives, on Feb 11, 2014, Chair Janet Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm):
“Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. That said, purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. In December of last year and again this January, the Committee said that its current expectation--based on its assessment of a broad range of measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments--is that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the 2 percent goal. I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that
Another critical concern in the statement of the FOMC on Sep 18, 2013, is on the effects of tapering expectations on interest rates (http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm):
“Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth” (emphasis added).
Will the FOMC increase purchases of mortgage-backed securities if mortgage rates increase?
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 ¾ and 1 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.
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.”
Professor Raguram G Rajan, former 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 (2016Dec 7, 2016Dec20), in Testimony to the Subcommittee on Monetary Policy and Trade Committee on Financial Services, on Dec 7, 2016, analyzes the adverse effects of unconventional monetary policy:
“My research and that of others over the years shows that these policies were not effective, and may have been counterproductive. Economic growth was consistently below the Fed’s forecasts with the policies, and was much weaker than in earlier U.S. recoveries from deep recessions. Job growth has been insufficient to raise the percentage of the population that is working above pre-recession levels. There is a growing consensus that the extra low interest rates and unconventional monetary policy have reached diminishing or negative returns. Many have argued that these policies widen the income distribution, adversely affect savers, and increase the volatility of the dollar exchange rate. Experienced market participants have expressed concerns about bubbles, imbalances, and distortions caused by the policies. The unconventional policies have also raised public policy concerns about the Fed being transformed into a multipurpose institution, intervening in particular sectors and allocating credit, areas where Congress may have a role, but not a limited-purpose independent agency of government.”
Professor John B. Taylor (2014Jul15, 2014Jun26) building on advanced research (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB, 2015, 2012 Oct 25; 2013Oct28, 2014 Jan01, 2014Jan3, 2014Jun26, 2014Jul15, 2015, 2016Dec7, 2016Dec20 http://www.johnbtaylor.com/) 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/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).
In testimony before the Committee on the Budget of the US Senate on May 8, 2014, Chair Yellen provides analysis of the current economic situation and outlook (http://www.federalreserve.gov/newsevents/testimony/yellen20140507a.htm):
“The economy has continued to recover from the steep recession of 2008 and 2009. Real gross domestic product (GDP) growth stepped up to an average annual rate of about 3-1/4 percent over the second half of last year, a faster pace than in the first half and during the preceding two years. Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity--a sector that has been recovering since 2011--have remained disappointing so far this year and will bear watching.
Conditions in the labor market have continued to improve. The unemployment rate was 6.3 percent in April, about 1-1/4 percentage points below where it was a year ago. Moreover, gains in payroll employment averaged nearly 200,000 jobs per month over the past year. During the economic recovery so far, payroll employment has increased by about 8-1/2 million jobs since its low point, and the unemployment rate has declined about 3-3/4 percentage points since its peak.
While conditions in the labor market have improved appreciably, they are still far from satisfactory. Even with recent declines in the unemployment rate, it continues to be elevated. Moreover, both the share of the labor force that has been unemployed for more than six months and the number of individuals who work part time but would prefer a full-time job are at historically high levels. In addition, most measures of labor compensation have been rising slowly--another signal that a substantial amount of slack remains in the labor market.
Inflation has been quite low even as the economy has continued to expand. Some of the factors contributing to the softness in inflation over the past year, such as the declines seen in non-oil import prices, will probably be transitory. Importantly, measures of longer-run inflation expectations have remained stable. That said, the Federal Open Market Committee (FOMC) recognizes that inflation persistently below 2 percent--the rate that the Committee judges to be most consistent with its dual mandate--could pose risks to economic performance, and we are monitoring inflation developments closely.
Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent. A faster rate of economic growth this year should be supported by reduced restraint from changes in fiscal policy, gains in household net worth from increases in home prices and equity values, a firming in foreign economic growth, and further improvements in household and business confidence as the economy continues to strengthen. Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment.”
In his classic restatement of the Keynesian demand function in terms of “liquidity preference as behavior toward risk,” James Tobin (http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1981/tobin-bio.html) identifies the risks of low interest rates in terms of portfolio allocation (Tobin 1958, 86):
“The assumption that investors expect on balance no change in the rate of interest has been adopted for the theoretical reasons explained in section 2.6 rather than for reasons of realism. Clearly investors do form expectations of changes in interest rates and differ from each other in their expectations. For the purposes of dynamic theory and of analysis of specific market situations, the theories of sections 2 and 3 are complementary rather than competitive. The formal apparatus of section 3 will serve just as well for a non-zero expected capital gain or loss as for a zero expected value of g. Stickiness of interest rate expectations would mean that the expected value of g is a function of the rate of interest r, going down when r goes down and rising when r goes up. In addition to the rotation of the opportunity locus due to a change in r itself, there would be a further rotation in the same direction due to the accompanying change in the expected capital gain or loss. At low interest rates expectation of capital loss may push the opportunity locus into the negative quadrant, so that the optimal position is clearly no consols, all cash. At the other extreme, expectation of capital gain at high interest rates would increase sharply the slope of the opportunity locus and the frequency of no cash, all consols positions, like that of Figure 3.3. The stickier the investor's expectations, the more sensitive his demand for cash will be to changes in the rate of interest (emphasis added).”
Tobin (1969) provides more elegant, complete analysis of portfolio allocation in a general equilibrium model. The major point is equally clear in a portfolio consisting of only cash balances and a perpetuity or consol. Let g be the capital gain, r the rate of interest on the consol and re the expected rate of interest. The rates are expressed as proportions. The price of the consol is the inverse of the interest rate, (1+re). Thus, g = [(r/re) – 1]. The critical analysis of Tobin is that at extremely low interest rates there is only expectation of interest rate increases, that is, dre>0, such that there is expectation of capital losses on the consol, dg<0. Investors move into positions combining only cash and no consols. Valuations of risk financial assets would collapse in reversal of long positions in carry trades with short exposures in a flight to cash. There is no exit from a central bank created liquidity trap without risks of financial crash and another global recession. The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent statement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:
W = Y/r (10
Equation (1) shows that as r goes to zero, r→0, W grows without bound, W→∞. Unconventional monetary policy lowers interest rates to increase the present value of cash flows derived from projects of firms, creating the impression of long-term increase in net worth. An attempt to reverse unconventional monetary policy necessarily causes increases in interest rates, creating the opposite perception of declining net worth. As r→∞, W = Y/r →0. There is no exit from unconventional monetary policy without increasing interest rates with resulting pain of financial crisis and adverse effects on production, investment and employment.
In delivering the biannual report on monetary policy (Board of Governors 2013Jul17), Chairman Bernanke (2013Jul17) advised Congress that:
“Instead, we are providing additional policy accommodation through two distinct yet complementary policy tools. The first tool is expanding the Federal Reserve's portfolio of longer-term Treasury securities and agency mortgage-backed securities (MBS); we are currently purchasing $40 billion per month in agency MBS and $45 billion per month in Treasuries. We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving a substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized. We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low--our second tool--to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination, these two tools can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.
The Committee's decisions regarding the asset purchase program (and the overall stance of monetary policy) depend on our assessment of the economic outlook and of the cumulative progress toward our objectives. Of course, economic forecasts must be revised when new information arrives and are thus necessarily provisional.”
Friedman (1953) argues there are three lags in effects of monetary policy: (1) between the need for action and recognition of the need; (2) the recognition of the need and taking of actions; and (3) taking of action and actual effects. Friedman (1953) finds that the combination of these lags with insufficient knowledge of the current and future behavior of the economy causes discretionary economic policy to increase instability of the economy or standard deviations of real income σy and prices σp. 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/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).
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 program of 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 3ECB 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.
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% 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. Professor Martin Feldstein (2016), at Harvard University, writing on “A Federal Reserve oblivious to its effects on financial markets,” on Jan 13, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/a-federal-reserve-oblivious-to-its-effect-on-financial-markets-1452729166), analyzes how unconventional monetary policy drove values of risk financial assets to high levels. Quantitative easing and zero interest rates distorted calculation of risks with resulting vulnerabilities in financial markets.
Another hurdle of exit from zero interest rates is “competitive easing” that Professor Raghuram Rajan, former 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 32.5 percent relative to the dollar from the high on Jul 15, 2008 to Dec 29, 2017.
| 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% 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% -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% -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% -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% 1.2% | 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):
“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.”
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% -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% -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% 0.1% | 10188.13 0.6% 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?
Lingling Wei, writing on Oct 23, 2015, on China’s central bank moves to spur economic growth,” published in the Wall Street Journal (http://www.wsj.com/articles/chinas-central-bank-cuts-rates-1445601495), analyzes the reduction by the People’s Bank of China (http://www.pbc.gov.cn/ http://www.pbc.gov.cn/english/130437/index.html) of borrowing and lending rates of banks by 50 basis points and reserve requirements of banks by 50 basis points. Paul Vigna, writing on Oct 23, 2015, on “Stocks rally out of correction territory on latest central bank boost,” published in the Wall Street Journal (http://blogs.wsj.com/moneybeat/2015/10/23/stocks-rally-out-of-correction-territory-on-latest-central-bank-boost/), analyzes the rally in financial markets following the statement on Oct 22, 2015, by the President of the European Central Bank (ECB) Mario Draghi of consideration of new quantitative measures in Dec 2015 (https://www.youtube.com/watch?v=0814riKW25k&rel=0) and the reduction of bank lending/deposit rates and reserve requirements of banks by the People’s Bank of China on Oct 23, 2015. The dollar revalued 2.8 percent from Oct 21 to Oct 23, 2015, following the intended easing of the European Central Bank. The DJIA rose 2.8 percent from Oct 21 to Oct 23 and the DAX index of German equities rose 5.4 percent from Oct 21 to Oct 23, 2015.
| Fri Oct 16 | Mon 19 | Tue 20 | Wed 21 | Thu 22 | Fri 23 |
| USD/ EUR 1.1350 0.1% 0.3% | 1.1327 0.2% 0.2% | 1.1348 0.0% -0.2% | 1.1340 0.1% 0.1% | 1.1110 2.1% 2.0% | 1.1018 2.9% 0.8% |
| DJIA 17215.97 0.8% 0.4% | 17230.54 0.1% 0.1% | 17217.11 0.0% -0.1% | 17168.61 -0.3% -0.3% | 17489.16 1.6% 1.9% | 17646.70 2.5% 0.9% |
| Dow Global 2421.58 0.3% 0.6% | 2414.33 -0.3% -0.3% | 2411.03 -0.4% -0.1% | 2411.27 -0.4% 0.0% | 2434.79 0.5% 1.0% | 2458.13 1.5% 1.0% |
| DJ Asia Pacific 1402.31 1.1% 0.3% | 1398.80 -0.3% -0.3% | 1395.06 -0.5% -0.3% | 1402.68 0.0% 0.5% | 1396.03 -0.4% -0.5% | 1415.50 0.9% 1.4% |
| Nikkei 225 18291.80 -0.8% 1.1% | 18131.23 -0.9% -0.9% | 18207.15 -0.5% 0.4% | 18554.28 1.4% 1.9% | 18435.87 0.8% -0.6% | 18825.30 2.9% 2.1% |
| Shanghai 3391.35 6.5% 1.6% | 3386.70 -0.1% -0.1% | 3425.33 1.0% 1.1% | 3320.68 -2.1% -3.1% | 3368.74 -0.7% 1.4% | 3412.43 0.6% 1.3% |
| DAX 10104.43 0.1% 0.4% | 10164.31 0.6% 0.6% | 10147.68 0.4% -0.2% | 10238.10 1.3% 0.9% | 10491.97 3.8% 2.5% | 10794.54 6.8% 2.9% |
Ben Leubsdorf, writing on “Fed’s Yellen: December is “Live Possibility” for First Rate Increase,” on Nov 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/feds-yellen-december-is-live-possibility-for-first-rate-increase-1446654282) quotes Chair Yellen that a rate increase in “December would be a live possibility.” The remark of Chair Yellen was during a hearing on supervision and regulation before the Committee on Financial Services, US House of Representatives (http://www.federalreserve.gov/newsevents/testimony/yellen20151104a.htm) and a day before the release of the employment situation report for Oct 2015 (http://cmpassocregulationblog.blogspot.com/2015/11/live-possibility-of-interest-rates.html). The dollar revalued 2.4 percent during the week. The euro has devalued 32.5 percent relative to the dollar from the high on Jul 15, 2008 to Dec 29, 2017.
| Fri Oct 30 | Mon 2 | Tue 3 | Wed 4 | Thu 5 | Fri 6 |
| USD/ EUR 1.1007 0.1% -0.3% | 1.1016 -0.1% -0.1% | 1.0965 0.4% 0.5% | 1.0867 1.3% 0.9% | 1.0884 1.1% -0.2% | 1.0742 2.4% 1.3% |
The release on Nov 18, 2015 of the minutes of the FOMC (Federal Open Market Committee) meeting held on Oct 28, 2015 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20151028.htm) states:
“Most participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labor market, and inflation, these conditions [for interest rate increase] could well be met by the time of the next meeting. Nonetheless, they emphasized that the actual decision would depend on the implications for the medium-term economic outlook of the data received over the upcoming intermeeting period… It was noted that beginning the normalization process relatively soon would make it more likely that the policy trajectory after liftoff could be shallow.”
Markets could have interpreted a symbolic increase in the fed funds rate at the meeting of the FOMC on Dec 15-16, 2015 (http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm) followed by “shallow” increases, explaining the sharp increase in stock market values and appreciation of the dollar after the release of the minutes on Nov 18, 2015:
| Fri Nov 13 | Mon 16 | Tue 17 | Wed 18 | Thu 19 | Fri 20 |
| USD/ EUR 1.0774 -0.3% 0.4% | 1.0686 0.8% 0.8% | 1.0644 1.2% 0.4% | 1.0660 1.1% -0.2% | 1.0735 0.4% -0.7% | 1.0647 1.2% 0.8% |
| DJIA 17245.24 -3.7% -1.2% | 17483.01 1.4% 1.4% | 17489.50 1.4% 0.0% | 17737.16 2.9% 1.4% | 17732.75 2.8% 0.0% | 17823.81 3.4% 0.5% |
| DAX 10708.40 -2.5% -0.7% | 10713.23 0.0% 0.0% | 10971.04 2.5% 2.4% | 10959.95 2.3% -0.1% | 11085.44 3.5% 1.1% | 11119.83 3.8% 0.3% |
In testimony before The Joint Economic Committee of Congress on Dec 3, 2015 (http://www.federalreserve.gov/newsevents/testimony/yellen20151203a.htm), Chair Yellen reiterated that the FOMC (Federal Open Market Committee) “anticipates that even after employment and inflation are near mandate-consistent levels, economic condition may, for some time, warrant keeping the target federal funds rate below the Committee views as normal in the longer run.” Todd Buell and Katy Burne, writing on “Draghi says ECB could step up stimulus efforts if necessary,” on Dec 4, 2015, published in the Wall Street Journal (http://www.wsj.com/articles/draghi-says-ecb-could-step-up-stimulus-efforts-if-necessary-1449252934), analyze that the President of the European Central Bank (ECB), Mario Draghi, reassured financial markets that the ECB will increase stimulus if required to raise inflation the euro area to targets. The USD depreciated 3.1 percent on Thu Dec 3, 2015 after weaker than expected measures by the European Central Bank. DJIA fell 1.4 percent on Dec 3 and increased 2.1 percent on Dec 4. DAX fell 3.6 percent on Dec 3.
| Fri Nov 27 | Mon 30 | Tue 1 | Wed 2 | Thu 3 | Fri 4 |
| USD/ EUR 1.0594 0.5% 0.2% | 1.0565 0.3% 0.3% | 1.0634 -0.4% -0.7% | 1.0616 -0.2% 0.2% | 1.0941 -3.3% -3.1% | 1.0885 -2.7% 0.5% |
| DJIA 17798.49 -0.1% -0.1% | 17719.92 -0.4% -0.4% | 17888.35 0.5% 1.0% | 17729.68 -0.4% -0.9% | 17477.67 -1.8% -1.4% | 17847.63 0.3% 2.1% |
| DAX 11293.76 1.6% -0.2% | 11382.23 0.8% 0.8% | 11261.24 -0.3% -1.1% | 11190.02 -0.9% -0.6% | 10789.24 -4.5% -3.6% | 10752.10 -4.8% -0.3% |
At the press conference following the meeting of the FOMC on Dec 16, 2015, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20151216.pdf page 8):
“And we recognize that monetary policy operates with lags. We would like to be able to move in a prudent, and as we've emphasized, gradual manner. It's been a long time since the Federal Reserve has raised interest rates, and I think it's prudent to be able to watch what the impact is on financial conditions and spending in the economy and moving in a timely fashion enables us to do this.”
The implication of this statement is that the state of the art is not accurate in analyzing the effects of monetary policy on financial markets and economic activity. The US dollar appreciated and equities fluctuated:
| Fri Dec 11 | Mon 14 | Tue 15 | Wed 16 | Thu 17 | Fri 18 |
| USD/ EUR 1.0991 -1.0% -0.4% | 1.0993 0.0% 0.0% | 1.0932 0.5% 0.6% | 1.0913 0.7% 0.2% | 1.0827 1.5% 0.8% | 1.0868 1.1% -0.4% |
| DJIA 17265.21 -3.3% -1.8% | 17368.50 0.6% 0.6% | 17524.91 1.5% 0.9% | 17749.09 2.8% 1.3% | 17495.84 1.3% -1.4% | 17128.55 -0.8% -2.1% |
| DAX 10340.06 -3.8% -2.4% | 10139.34 -1.9% -1.9% | 10450.38 -1.1% 3.1% | 10469.26 1.2% 0.2% | 10738.12 3.8% 2.6% | 10608.19 2.6% -1.2% |
The Bank of Japan decided on Jan 29, 2016 to determine “a negative interest rate of minus 0.1 percent to current accounts that financial institutions hold at the Bank” and “will cut the interest rate further into negative territory if judged as necessary” (https://www.boj.or.jp/en/announcements/release_2016/k160129b.pdf). The new policy is quantitative and qualitative (QQE) with a negative interest rate “designed to enable the Bank to pursue additional monetary easing in terms of three dimensions, combining a negative interest rate with quantity and quality” (https://www.boj.or.jp/en/announcements/release_2016/k160129b.pdf). The yen devalued sharply relative to the dollar and world equity markets soared after the new policy announced on Jan 29, 2016:
| Fri 22 | Mon 25 | Tue 26 | Wed 27 | Thu 28 | Fri 29 |
| JPY/ USD 118.77 -1.5% -0.9% | 118.30 0.4% 0.4% | 118.42 0.3% -0.1% | 118.68 0.1% -0.2% | 118.82 0.0% -0.1% | 121.13 -2.0% -1.9% |
| DJIA 16093.51 0.7% 1.3% | 15885.22 -1.3% -1.3% | 16167.23 0.5% 1.8% | 15944.46 -0.9% -1.4% | 16069.64 -0.1% 0.8% | 16466.30 2.3% 2.5% |
| Nikkei 16958.53 -1.1% 5.9% | 17110.91 0.9% 0.9% | 16708.90 -1.5% -2.3% | 17163.92 1.2% 2.7% | 17041.45 0.5% -0.7% | 17518.30 3.3% 2.8% |
| Shanghai 2916.56 0.5% 1.3 | 2938.51 0.8% 0.8% | 2749.79 -5.7% -6.4% | 2735.56 -6.2% -0.5% | 2655.66 -8.9% -2.9% | 2737.60 -6.1% 3.1% |
| DAX 9764.88 2.3% 2.0% | 9736.15 -0.3% -0.3% | 9822.75 0.6% 0.9% | 9880.82 1.2% 0.6% | 9639.59 -1.3% -2.4% | 9798.11 0.3% 1.6% |
In testimony on the Semiannual Monetary Policy Report to the Congress on Feb 10-11, 2016, Chair Yellen (http://www.federalreserve.gov/newsevents/testimony/yellen20160210a.htm) states: “U.S. real gross domestic product is estimated to have increased about 1-3/4 percent in 2015. Over the course of the year, subdued foreign growth and the appreciation of the dollar restrained net exports. In the fourth quarter of last year, growth in the gross domestic product is reported to have slowed more sharply, to an annual rate of just 3/4 percent; again, growth was held back by weak net exports as well as by a negative contribution from inventory investment.”
Jon Hilsenrath, writing on “Yellen Says Fed Should Be Prepared to Use Negative Rates if Needed,” on Feb 11, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/yellen-reiterates-concerns-about-risks-to-economy-in-senate-testimony-1455203865), analyzes the statement of Chair Yellen in Congress that the FOMC (Federal Open Market Committee) is considering negative interest rates on bank reserves. The Wall Street Journal provides yields of two and ten-year sovereign bonds with negative interest rates on shorter maturities where central banks pay negative interest rates on excess bank reserves:
| Sovereign Yields 2/12/16 | Japan | Germany | USA |
| 2 Year | -0.168 | -0.498 | 0.694 |
| 10 Year | 0.076 | 0.262 | 1.744 |
On Sep 4, 2014, the European Central Bank lowered policy rates (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140904.en.html):
On Mar 10, 2016, the European Central Bank (ECB) announced (1) reduction of the refinancing rate by 5 basis points to 0.00 percent; decrease the marginal lending rate to 0.25 percent; reduction of the deposit facility rate to 0,40 percent; increase of the monthly purchase of assets to €80 billion; include nonbank corporate bonds in assets eligible for purchases; and new long-term refinancing operations (https://www.ecb.europa.eu/press/pr/date/2016/html/pr160310.en.html). The President of the ECB, Mario Draghi, stated in the press conference (https://www.ecb.europa.eu/press/pressconf/2016/html/is160310.en.html): “How low can we go? Let me say that rates will stay low, very low, for a long period of time, and well past the horizon of our purchases…We don’t anticipate that it will be necessary to reduce rates further. Of course, new facts can change the situation and the outlook.”
The dollar devalued relative to the euro and open stock markets traded lower after the announcement on Mar 10, 2016, but stocks rebounded on Mar 11:
| Fri 4 | Mon 7 | Tue 8 | Wed 9 | Thu10 | Fri 11 |
| USD/ EUR 1.1006 -0.7% -0.4% | 1.1012 -0.1% -0.1% | 1.1013 -0.1% 0.0% | 1.0999 0.1% 0.1% | 1.1182 -1.6% -1.7% | 1.1151 -1.3% 0.3% |
| DJIA 17006.77 2.2% 0.4% | 17073.95 0.4% 0.4% | 16964.10 -0.3% -0.6% | 17000.36 0.0% 0.2% | 16995.13 -0.1% 0.0% | 17213.31 1.2% 1.3% |
| DAX 9824.17 3.3% 0.7% | 9778.93 -0.5% 0.5% | 9692.82 -1.3% -0.9% | 9723.09 -1.0% 0.3% | 9498.15 -3.3% -2.3% | 9831.13 0.1% 3.5% |
At the press conference after the FOMC meeting on Sep 21, 2016, Chair Yellen states (http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20160921.pdf ): “However, the economic outlook is inherently uncertain.” In the address to the Jackson Hole symposium on Aug 26, 2016, Chair Yellen states: “I believe the case for an increase in in federal funds rate has strengthened in recent months…And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course” (http://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm). In a speech at the World Affairs Council of Philadelphia, on Jun 6, 2016 (http://www.federalreserve.gov/newsevents/speech/yellen20160606a.htm), Chair Yellen finds that “there is considerable uncertainty about the economic outlook.” There are fifteen references to this uncertainty in the text of 18 pages double-spaced. In the Semiannual Monetary Policy Report to the Congress on Jun 21, 2016, Chair Yellen states (http://www.federalreserve.gov/newsevents/testimony/yellen20160621a.htm), “Of course, considerable uncertainty about the economic outlook remains.” Frank H. Knight (1963, 233), in Risk, uncertainty and profit, distinguishes between measurable risk and unmeasurable uncertainty. 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?
What is truly important is the fixing of the overnight fed funds at 1¼ to 1½ percent with gradual consideration of further rate increases with all measures depending on “incoming data” (https://www.federalreserve.gov/newsevents/pressreleases/monetary20171213a.htm): “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to 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 will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data” (emphasis added). The FOMC is initiating the “normalization” or reduction of the balance sheet of securities held outright for monetary policy.
The decisions of the FOMC (Federal Open Market Committee) depend on incoming data. There are unexpected swings in valuations of risk financial assets by “carry trades” from interest rates below inflation to exposures in stocks, commodities and their derivatives. Another issue is the unexpected “data surprises” such as the sharp decline in 12 months rates of increase of real disposable income, or what is left after taxes and inflation, and the price indicator of the FOMC, prices of personal consumption expenditures (PCE) excluding food and energy. There is no science or art of monetary policy that can deal with this uncertainty.
| Real Disposable Personal Income | Real Personal Consumption Expenditures | Prices of Personal Consumption Expenditures | PCE Prices Excluding Food and Energy |
| ∆%12M | ∆%12M | ∆%12M | ∆%12M |
| 6/2017 | 6/2017 | 6/2017 | 6/2017 |
| 1.2 | 2.4 | 1.4 | 1.5 |
“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.”
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.”
On Jun 5, 2014, the European Central Bank introduced cuts in interest rates and a negative rate paid on deposits of banks (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605.en.html):
“5 June 2014 - Monetary policy decisions
At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 10 basis points to 0.15%, starting from the operation to be settled on 11 June 2014.
- The interest rate on the marginal lending facility will be decreased by 35 basis points to 0.40%, with effect from 11 June 2014.
- The interest rate on the deposit facility will be decreased by 10 basis points to -0.10%, with effect from 11 June 2014. A separate press release to be published at 3.30 p.m. CET today will provide details on the implementation of the negative deposit facility rate.”
The ECB also introduced new measures of monetary policy on Jun 5, 2014 (http://www.ecb.europa.eu/press/pr/date/2014/html/pr140605_2.en.html):
“5 June 2014 - ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechanism
In pursuing its price stability mandate, the Governing Council of the ECB has today announced measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. In particular, the Governing Council has decided:
- To conduct a series of targeted longer-term refinancing operations (TLTROs) aimed at improving bank lending to the euro area non-financial private sector [1], excluding loans to households for house purchase, over a window of two years.
- To intensify preparatory work related to outright purchases of asset-backed securities (ABS).”
The President of the European Central Bank (ECB) Mario Draghi analyzed the measures at a press conference (http://www.ecb.europa.eu/press/pressconf/2014/html/is140605.en.html).
The President of the European Central Bank (ECB) Mario Draghi reaffirmed the policy stance at the press conference following the meeting on Feb 6, 2014 (http://www.ecb.europa.eu/press/pressconf/2014/html/is140206.en.html): “As I have said several times we are willing to act and we stand ready to act. We confirmed our forward guidance, so interest rates will stay at the present or lower levels for an extended period of time.”
The President of the European Central Bank (ECB) Mario Draghi explained the indefinite period of low policy rates during the press conference following the meeting on Jul 4, 2013 (http://www.ecb.int/press/pressconf/2013/html/is130704.en.html):
“Yes, that is why I said you haven’t listened carefully. The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney [Governor of the Bank of England] said in London is just a coincidence.”
The European Central Bank (ECB) lowered the policy rates on Nov 7, 2013 (http://www.ecb.europa.eu/press/pr/date/2013/html/pr131107.en.html):
“PRESS RELEASE
7 November 2013 - Monetary policy decisions
At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.25%, starting from the operation to be settled on 13 November 2013.
- The interest rate on the marginal lending facility will be decreased by 25 basis points to 0.75%, with effect from 13 November 2013.
- The interest rate on the deposit facility will remain unchanged at 0.00%.
The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.”
Mario Draghi, President of the ECB, explained as follows (http://www.ecb.europa.eu/press/pressconf/2013/html/is131107.en.html):
“Based on our regular economic and monetary analyses, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain unchanged at 0.00%. These decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlying price pressures in the euro area over the medium term, starting from currently low annual inflation rates of below 1%. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.”
The ECB decision together with the employment situation report on Fri Nov 8, 2013, influenced revaluation of the dollar. Market expectations were of relatively easier monetary policy in the euro area.
The statement of the meeting of the Monetary Policy Committee of the Bank of England on Jul 4, 2013, may be leading toward the same forward guidance (http://www.bankofengland.co.uk/publications/Pages/news/2013/007.aspx):
“At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report. The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent
developments in the domestic economy.”
A competing event is the high level of valuations of risk financial assets (http://cmpassocregulationblog.blogspot.com/2017/01/unconventional-monetary-policy-and.html and earlier http://cmpassocregulationblog.blogspot.com/2016/01/unconventional-monetary-policy-and.html and earlier 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 24,719.22 on Dec 29, 2017, which is higher by 74.5 percent than the value of 14,164.53 reached on Oct 9, 2007 and higher by 74.1 percent than the value of 14,198.10 reached on Oct 11, 2007. Values of risk financial assets have been 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 1¼ and 1½ 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, former 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 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB, 2015, 2012 Oct 25; 2013Oct28, 2014 Jan01, 2014Jan3, 2014Jun26, 2014Jul15, 2015, 2016Dec7, 2016Dec20 http://www.johnbtaylor.com/) 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/2017/01/rules-versus-discretionary-authorities.html and earlier http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html).
In remarkable anticipation in 2005, Professor Raghuram G. Rajan (2005) warned of low liquidity and high risks of central bank policy rates approaching the zero bound (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 218-9). Professor Rajan excelled in a distinguished career as an academic economist in finance and was chief economist of the International Monetary Fund (IMF). Shefali Anand and Jon Hilsenrath, writing on Oct 13, 2013, on “India’s central banker lobbies Fed,” published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304330904579133530766149484?KEYWORDS=Rajan), interviewed Raghuram G Rajan, who is the current Governor of the Reserve Bank of India, which is India’s central bank (http://www.rbi.org.in/scripts/AboutusDisplay.aspx). In this interview, Rajan argues that central banks should avoid unintended consequences on emerging market economies of inflows and outflows of capital triggered by monetary policy. Professor Rajan, in an interview with Kartik Goyal of Bloomberg (http://www.bloomberg.com/news/2014-01-30/rajan-warns-of-global-policy-breakdown-as-emerging-markets-slide.html), warns of breakdown of global policy coordination. Portfolio reallocations induced by combination of zero interest rates and risk events stimulate carry trades that generate wide swings in world capital flows.
Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Calomiris and Haber (2014) find that broad voting rights and institutions restricting coalitions of bankers and populists ensure stable banking systems and access to credit. Summerhill (2015) finds compelling evidence that sovereign credibility is insufficient to develop financial intermediation required for economic growth in the presence of inadequate political institutions.
Professor Ronald I. McKinnon (2013Oct27), writing on “Tapering without tears—how to end QE3,” on Oct 27, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702304799404579153693500945608?KEYWORDS=Ronald+I+McKinnon), finds that the major central banks of the world have fallen into a “near-zero-interest-rate trap.” World economic conditions are weak such that exit from the zero interest rate trap could have adverse effects on production, investment and employment. The maintenance of interest rates near zero creates long-term near stagnation. The proposal of Professor McKinnon is credible, coordinated increase of policy interest rates toward 2 percent. Professor John B. Taylor at Stanford University, writing on “Economic failures cause political polarization,” on Oct 28, 2013, published in the Wall Street Journal (http://online.wsj.com/news/articles/SB10001424052702303442004579121010753999086?KEYWORDS=John+B+Taylor), analyzes that excessive risks induced by near zero interest rates in 2003-2004 caused the financial crash. Monetary policy continued in similar paths during and after the global recession with resulting political polarization worldwide.
Second, Risk-Measuring Yields and Exchange Rate. The ten-year government bond of Spain was quoted at 6.868 percent on Aug 17, 2012, declining to 6.447 percent on Aug 17 and 6.403 percent on Aug 24, 2012, and the ten-year government bond of Italy fell from 5.894 percent on Aug 10, 2012 to 5.709 percent on Aug 17 and 5.618 percent on Aug 24, 2012. The yield of the ten-year sovereign bond of Spain traded at 1.541 percent on Dec 29, 2017 compared with 1.334 percent a year earlier, and that of the ten-year sovereign bond of Italy at 1.989 percent compared with 1.795 percent a year earlier (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Diminishing aversion is captured by increase of the yield of the two- and ten-year Treasury notes and the two- and ten-year government bonds of Germany. Table III-1A provides yields of US and German governments bonds and the rate of USD/EUR. Yields of US and German government bonds decline during shocks of risk aversion and the dollar strengthens in the form of fewer dollars required to buy one euro. The yield of the US ten-year Treasury note fell from 2.202 percent on Aug 26, 2011 to 1.459 percent on Jul 20, 2012, reminiscent of experience during the Treasury-Fed accord of the 1940s that placed a ceiling on long-term Treasury debt (Hetzel and Leach 2001), while the yield of the ten-year government bond of Germany fell from 2.16 percent to 1.17 percent. In the week of Dec 29, 2017, the yield of the two-year Treasury decreased to 1.891 percent and that of the ten-year Treasury decreased to 2.411 percent while the yield of the two-year bond of German increased at minus 0.62 percent and the ten-year yield increased at 0.43 percent; and the dollar depreciated at USD 1.2003/EUR. The zero interest rates for the monetary policy rate of the US, or fed funds rate, induce carry trades that ensure devaluation of the dollar if there is no risk aversion but the dollar appreciates in flight to safe haven during episodes of risk aversion. Unconventional monetary policy induces significant global financial instability, excessive risks and low liquidity. The ten-year Treasury yield of 2.411 percent is close to consumer price inflation of 2.2 percent in the 12 months ending in Nov 2017 (https://cmpassocregulationblog.blogspot.com/2017/12/fomc-increases-interest-rates-with.html and earlier https://cmpassocregulationblog.blogspot.com/2017/11/dollar-devaluation-and-decline-of.html and earlier https://cmpassocregulationblog.blogspot.com/2017/10/world-inflation-waves-long-term-and.html and earlier https://www.bls.gov/cpi/ https://cmpassocregulationblog.blogspot.com/2017/09/dollar-devaluation-world-inflation.html and earlier https://cmpassocregulationblog.blogspot.com/2017/08/fluctuating-valuations-of-risk.html and earlier https://cmpassocregulationblog.blogspot.com/2017/07/dollar-devaluation-and-valuation-of.html and earlier https://cmpassocregulationblog.blogspot.com/2017/06/fomc-interest-rate-increase-planned.html and earlier (https://cmpassocregulationblog.blogspot.com/2017/05/dollar-devaluation-world-inflation.html and earlier https://cmpassocregulationblog.blogspot.com/2017/04/world-inflation-waves-united-states.html and earlier https://cmpassocregulationblog.blogspot.com/2017/03/fomc-increases-interest-rates-world.html and earlier https://cmpassocregulationblog.blogspot.com/2017/02/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2017/01/world-inflation-waves-united-states.html and earlier http://cmpassocregulationblog.blogspot.com/2016/12/of-course-economic-outlook-is-highly.html and earlier http://cmpassocregulationblog.blogspot.com/2016/11/interest-rate-increase-could-well.html and earlier http://cmpassocregulationblog.blogspot.com/2016/10/dollar-revaluation-world-inflation.html and earlier http://cmpassocregulationblog.blogspot.com/2016/09/interest-rates-and-volatility-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/08/interest-rate-policy-uncertainty-and.html and earlier http://cmpassocregulationblog.blogspot.com/2016/07/oscillating-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2016/06/fomc-projections-world-inflation-waves.html and earlier http://cmpassocregulationblog.blogspot.com/2016/05/most-fomc-participants-judged-that-if.html and earlier (http://cmpassocregulationblog.blogspot.com/2016/04/contracting-united-states-industrial.html and earlier (http://cmpassocregulationblog.blogspot.com/2016/03/monetary-policy-and-competitive.html and earlier http://cmpassocregulationblog.blogspot.com/2016/02/squeeze-of-economic-activity-by-carry.html and earlier http://cmpassocregulationblog.blogspot.com/2016/01/uncertainty-of-valuations-of-risk.html and earlier http://cmpassocregulationblog.blogspot.com/2015/12/liftoff-of-interest-rates-with-monetary.html and earlier http://cmpassocregulationblog.blogspot.com/2015/11/interest-rate-liftoff-followed-by.html and earlier http://cmpassocregulationblog.blogspot.com/2015/10/interest-rate-policy-quagmire-world.html and earlier 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 the expectation of higher inflation if risk aversion diminishes. The one-year Treasury yield of 1.744 percent (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3002) is lower than the 12-month consumer price inflation of 2.2 percent, which appears to be temporary. Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury. The lower part of Table III-1A provides the same flight to government securities of the US and Germany and the USD during the financial crisis and global recession and the beginning of the European debt crisis in the spring of 2010 with the USD trading at USD 1.192/EUR on Jun 7, 2010.
Table III-1A, Two- and Ten-Year Yields of Government Bonds of the US and Germany and US Dollar/EUR Exchange rate
Note: DE: Germany
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
http://www.bloomberg.com/markets/
http://www.federalreserve.gov/releases/h15
Appendix: Prior Risk Determining Events. Current risk analysis concentrates on deciphering what the Federal Open Market Committee (FOMC) may decide on quantitative easing. The week of May 24 was dominated by the testimony of Chairman Bernanke to the Joint Economic Committee of the US Congress on May 22, 2013 (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm), followed by questions and answers and the release on May 22, 2013 of the minutes of the meeting of the Federal Open Market Committee (FOMC) from Apr 30 to May 1, 2013 (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm). Monetary policy emphasizes communication of policy intentions to avoid that expectations reverse outcomes in reality (Kydland and Prescott 1977). Jon Hilsenrath, writing on “In bid for clarity, Fed delivers opacity,” on May 23, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath), analyzes discrepancies in communication by the Fed. The annotated chart of values of the Dow Jones Industrial Average (DJIA) during trading on May 23, 2013 provided by Hinselrath, links the prepared testimony of Chairman Bernanke at 10:AM, following questions and answers and the release of the minutes of the FOMC at 2PM. Financial markets strengthened between 10 and 10:30AM on May 23, 2013, perhaps because of the statement by Chairman Bernanke in prepared testimony (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm):
“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further. Such outcomes tend to be associated with extended periods of lower, not higher, interest rates, as well as poor returns on other assets. Moreover, renewed economic weakness would pose its own risks to financial stability.”
In that testimony, Chairman Bernanke (http://www.federalreserve.gov/newsevents/testimony/bernanke20130522a.htm) also analyzes current weakness of labor markets:
“Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers' skills and--particularly relevant during this commencement season--by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.”
Hilsenrath (op. cit. http://online.wsj.com/article/SB10001424127887323336104578501552642287218.html?KEYWORDS=articles+by+jon+hilsenrath) analyzes the subsequent decline of the market from 10:30AM to 10:40AM as Chairman Bernanke responded questions with the statement that withdrawal of stimulus would be determined by data but that it could begin in one of the “next few meetings.” The DJIA recovered part of the losses between 10:40AM and 2PM. The minutes of the FOMC released at 2PM on May 23, 2013, contained a phrase that troubled market participants (http://www.federalreserve.gov/monetarypolicy/fomcminutes20130501.htm): “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.” The DJIA closed at 15,387.58 on May 21, 2013 and fell to 15,307.17 at the close on May 22, 2013, with the loss of 0.5 percent occurring after release of the minutes of the FOMC at 2PM when the DJIA stood at around 15,400. The concern about exist of the Fed from stimulus affected markets worldwide as shown in declines of equity indexes in Table III-1 with delays because of differences in trading hours. This behavior shows the trap of unconventional monetary policy with no exit from zero interest rates without risking financial crash and likely adverse repercussions on economic activity.
Financial markets worldwide were affected by the reduction of policy rates of the European Central Bank (ECB) on May 2, 2013. (http://www.ecb.int/press/pr/date/2013/html/pr130502.en.html):
“2 May 2013 - Monetary policy decisions
At today’s meeting, which was held in Bratislava, the Governing Council of the ECB took the following monetary policy decisions:
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.50%, starting from the operation to be settled on 8 May 2013.
- The interest rate on the marginal lending facility will be decreased by 50 basis points to 1.00%, with effect from 8 May 2013.
- The interest rate on the deposit facility will remain unchanged at 0.00%.”
Financial markets in Japan and worldwide were shocked by new bold measures of “quantitative and qualitative monetary easing” by the Bank of Japan (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The objective of policy is to “achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf). The main elements of the new policy are as follows:
- Monetary Base Control. Most central banks in the world pursue interest rates instead of monetary aggregates, injecting bank reserves to lower interest rates to desired levels. The Bank of Japan (BOJ) has shifted back to monetary aggregates, conducting money market operations with the objective of increasing base money, or monetary liabilities of the government, at the annual rate of 60 to 70 trillion yen. The BOJ estimates base money outstanding at “138 trillion yen at end-2012) and plans to increase it to “200 trillion yen at end-2012 and 270 trillion yen at end 2014” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
- Maturity Extension of Purchases of Japanese Government Bonds. Purchases of bonds will be extended even up to bonds with maturity of 40 years with the guideline of extending the average maturity of BOJ bond purchases from three to seven years. The BOJ estimates the current average maturity of Japanese government bonds (JGB) at around seven years. The BOJ plans to purchase about 7.5 trillion yen per month (http://www.boj.or.jp/en/announcements/release_2013/rel130404d.pdf). Takashi Nakamichi, Tatsuo Ito and Phred Dvorak, wiring on “Bank of Japan mounts bid for revival,” on Apr 4, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887323646604578401633067110420.html), find that the limit of maturities of three years on purchases of JGBs was designed to avoid views that the BOJ would finance uncontrolled government deficits.
- Seigniorage. The BOJ is pursuing coordination with the government that will take measures to establish “sustainable fiscal structure with a view to ensuring the credibility of fiscal management” (http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf).
- Diversification of Asset Purchases. The BOJ will engage in transactions of exchange traded funds (ETF) and real estate investment trusts (REITS) and not solely on purchases of JGBs. Purchases of ETFs will be at an annual rate of increase of one trillion yen and purchases of REITS at 30 billion yen.
The European sovereign debt crisis continues to shake financial markets and the world economy. Debt resolution within the international financial architecture requires that a country be capable of borrowing on its own from the private sector. Mechanisms of debt resolution have included participation of the private sector (PSI), or “bail in,” that has been voluntary, almost coercive, agreed and outright coercive (Pelaez and Pelaez, International Financial Architecture: G7, IMF, BIS, Creditors and Debtors (2005), Chapter 4, 187-202). Private sector involvement requires losses by the private sector in bailouts of highly indebted countries. The essence of successful private sector involvement is to recover private-sector credit of the highly indebted country. Mary Watkins, writing on “Bank bailouts reshuffle risk hierarchy,” published on Mar 19, 2013, in the Financial Times (http://www.ft.com/intl/cms/s/0/7666546a-9095-11e2-a456-00144feabdc0.html#axzz2OSpbvCn8) analyzes the impact of the bailout or resolution of Cyprus banks on the hierarchy of risks of bank liabilities. Cyprus banks depend mostly on deposits with less reliance on debt, raising concerns in creditors of fixed-income debt and equity holders in banks in the euro area. Uncertainty remains as to the dimensions and structure of losses in private sector involvement or “bail in” in other rescue programs in the euro area. Alkman Granitsas, writing on “Central bank details losses at Bank of Cyprus,” on Mar 30, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324000704578392502889560768.html), analyzes the impact of the agreement with the €10 billion agreement with IMF and the European Union on the banks of Cyprus. The recapitalization plan provides for immediate conversion of 37.5 percent of all deposits in excess of €100,000 to shares of special class of the bank. An additional 22.5 percent will be frozen without interest until the plan is completed. The overwhelming risk factor is the unsustainable Treasury deficit/debt of the United States (http://cmpassocregulationblog.blogspot.com/2013/02/united-states-unsustainable-fiscal.html). Another rising risk is division within the Federal Open Market Committee (FOMC) on risks and benefits of current policies as expressed in the minutes of the meeting held on Jan 29-30, 2013 (http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130130.pdf 13):
“However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy.
Jon Hilsenrath, writing on “Fed maps exit from stimulus,” on May 11, 2013, published in the Wall Street Journal (http://online.wsj.com/article/SB10001424127887324744104578475273101471896.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the development of strategy for unwinding quantitative easing and how it can create uncertainty in financial markets. Jon Hilsenrath and Victoria McGrane, writing on “Fed slip over how long to keep cash spigot open,” published on Feb 20, 2013 in the Wall street Journal (http://professional.wsj.com/article/SB10001424127887323511804578298121033876536.html), analyze the minutes of the Fed, comments by members of the FOMC and data showing increase in holdings of riskier debt by investors, record issuance of junk bonds, mortgage securities and corporate loans.
Jon Hilsenrath, writing on “Jobs upturn isn’t enough to satisfy Fed,” on Mar 8, 2013, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324582804578348293647760204.html), finds that much stronger labor market conditions are required for the Fed to end quantitative easing. Unconventional monetary policy with zero interest rates and quantitative easing is quite difficult to unwind because of the adverse effects of raising interest rates on valuations of risk financial assets and home prices, including the very own valuation of the securities held outright in the Fed balance sheet. Gradual unwinding of 1 percent fed funds rates from Jun 2003 to Jun 2004 by seventeen consecutive increases of 25 percentage points from Jun 2004 to Jun 2006 to reach 5.25 percent caused default of subprime mortgages and adjustable-rate mortgages linked to the overnight fed funds rate. The zero interest rate has penalized liquidity and increased risks by inducing carry trades from zero interest rates to speculative positions in risk financial assets. There is no exit from zero interest rates without provoking another financial crash.
An important risk event is the reduction of growth prospects in the euro zone discussed by European Central Bank President Mario Draghi in “Introductory statement to the press conference,” on Dec 6, 2012 (http://www.ecb.int/press/pressconf/2012/html/is121206.en.html):
“This assessment is reflected in the December 2012 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.
The Governing Council continues to see downside risks to the economic outlook for the euro area. These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area, geopolitical issues and fiscal policy decisions in the United States possibly dampening sentiment for longer than currently assumed and delaying further the recovery of private investment, employment and consumption.”
Reuters, writing on “Bundesbank cuts German growth forecast,” on Dec 7, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/8e845114-4045-11e2-8f90-00144feabdc0.html#axzz2EMQxzs3u), informs that the central bank of Germany, Deutsche Bundesbank reduced its forecast of growth for the economy of Germany to 0.7 percent in 2012 from an earlier forecast of 1.0 percent in Jun and to 0.4 percent in 2012 from an earlier forecast of 1.6 percent while the forecast for 2014 is at 1.9 percent.
The major risk event during earlier weeks was sharp decline of sovereign yields with the yield on the ten-year bond of Spain falling to 5.309 percent and that of the ten-year bond of Italy falling to 4.473 percent on Fri Nov 30, 2012 and 5.366 percent for the ten-year of Spain and 4.527 percent for the ten-year of Italy on Fri Nov 14, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). Vanessa Mock and Frances Robinson, writing on “EU approves Spanish bank’s restructuring plans,” on Nov 28, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578146520774638316.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the European Union regulators approved restructuring of four Spanish banks (Bankia, NCG Banco, Catalunya Banc and Banco de Valencia), which helped to calm sovereign debt markets. Harriet Torry and James Angelo, writing on “Germany approves Greek aid,” on Nov 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887323751104578150532603095790.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the German parliament approved the plan to provide Greece a tranche of €44 billion in promised financial support, which is subject to sustainability analysis of the bond repurchase program later in Dec 2012. A hurdle for sustainability of repurchasing debt is that Greece’s sovereign bonds have appreciated significantly from around 24 percent for the bond maturing in 21 years and 20 percent for the bond maturing in 31 years in Aug 2012 to around 17 percent for the 21-year maturity and 15 percent for the 31-year maturing in Nov 2012. Declining years are equivalent to increasing prices, making the repurchase more expensive. Debt repurchase is intended to reduce bonds in circulation, turning Greek debt more manageable. Ben McLannahan, writing on “Japan unveils $11bn stimulus package,” on Nov 30, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/adc0569a-3aa5-11e2-baac-00144feabdc0.html#axzz2DibFFquN), informs that the cabinet in Japan approved another stimulus program of $11 billion, which is twice larger than another stimulus plan in late Oct and close to elections in Dec. Henry Sender, writing on “Tokyo faces weak yen and high bond yields,” published on Nov 29, 2012 in the Financial Times (http://www.ft.com/intl/cms/s/0/9a7178d0-393d-11e2-afa8-00144feabdc0.html#axzz2DibFFquN), analyzes concerns of regulators on duration of bond holdings in an environment of likelihood of increasing yields and yen depreciation.
First, Risk-Determining Events. The European Council statement on Nov 23, 2012 asked the President of the European Commission “to continue the work and pursue consultations in the coming weeks to find a consensus among the 27 over the Union’s Multiannual Financial Framework for the period 2014-2020” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf) Discussions will continue in the effort to reach agreement on a budget: “A European budget is important for the cohesion of the Union and for jobs and growth in all our countries” (http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/133723.pdf). There is disagreement between the group of countries requiring financial assistance and those providing bailout funds. Gabrielle Steinhauser and Costas Paris, writing on “Greek bond rally puts buyback in doubt,” on Nov 23, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324352004578136362599130992.html?mg=reno64-wsj) find a new hurdle in rising prices of Greek sovereign debt that may make more difficult buybacks of debt held by investors. European finance ministers continue their efforts to reach an agreement for Greece that meets with approval of the European Central Bank and the IMF. The European Council (2012Oct19 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/133004.pdf ) reached conclusions on strengthening the euro area and providing unified financial supervision:
“The European Council called for work to proceed on the proposals on the Single Supervisory Mechanism as a matter of priority with the objective of agreeing on the legislative framework by 1st January 2013 and agreed on a number of orientations to that end. It also took note of issues relating to the integrated budgetary and economic policy frameworks and democratic legitimacy and accountability which should be further explored. It agreed that the process towards deeper economic and monetary union should build on the EU's institutional and legal framework and be characterised by openness and transparency towards non-euro area Member States and respect for the integrity of the Single Market. It looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based.”
Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. The Bank of Spain released new data on doubtful debtors in Spain’s credit institutions (http://www.bde.es/bde/en/secciones/prensa/Agenda/Datos_de_credit_a6cd708c59cf931.html). In 2006, the value of doubtful credits reached €10,859 million or 0.7 percent of total credit of €1,508,626 million. In Aug 2012, doubtful credit reached €178,579 million or 10.5 percent of total credit of €1,698,714 million.
There are three critical factors influencing world financial markets. (1) Spain could request formal bailout from the European Stability Mechanism (ESM) that may also affect Italy’s international borrowing. David Roman and Jonathan House, writing on “Spain risks backlash with budget plan,” on Sep 27, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443916104578021692765950384.html?mod=WSJ_hp_LEFTWhatsNewsCollection) analyze Spain’s proposal of reducing government expenditures by €13 billion, or around $16.7 billion, increasing taxes in 2013, establishing limits on early retirement and cutting the deficit by €65 billion through 2014. Banco de España, Bank of Spain, contracted consulting company Oliver Wyman to conduct rigorous stress tests of the resilience of its banking system. (Stress tests and their use are analyzed by Pelaez and Pelaez Globalization and the State Vol. I (2008b), 95-100, International Financial Architecture (2005) 112-6, 123-4, 130-3).) The results are available from Banco de España (http://www.bde.es/bde/en/secciones/prensa/infointeres/reestructuracion/ http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). The assumptions of the adverse scenario used by Oliver Wyman are quite tough for the three-year period from 2012 to 2014: “6.5 percent cumulative decline of GDP, unemployment rising to 27.2 percent and further declines of 25 percent of house prices and 60 percent of land prices (http://www.bde.es/f/webbde/SSICOM/20120928/informe_ow280912e.pdf). Fourteen banks were stress tested with capital needs estimates of seven banks totaling €59.3 billion. The three largest banks of Spain, Banco Santander (http://www.santander.com/csgs/Satellite/CFWCSancomQP01/es_ES/Corporativo.html), BBVA (http://www.bbva.com/TLBB/tlbb/jsp/ing/home/index.jsp) and Caixabank (http://www.caixabank.com/index_en.html), with 43 percent of exposure under analysis, have excess capital of €37 billion in the adverse scenario in contradiction with theories that large, international banks are necessarily riskier. Jonathan House, writing on “Spain expects wider deficit on bank aid,” on Sep 30, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444138104578028484168511130.html?mod=WSJPRO_hpp_LEFTTopStories), analyzes the 2013 budget plan of Spain that will increase the deficit of 7.4 percent of GDP in 2012, which is above the target of 6.3 percent under commitment with the European Union. The ratio of debt to GDP will increase to 85.3 percent in 2012 and 90.5 percent in 2013 while the 27 members of the European Union have an average debt/GDP ratio of 83 percent at the end of IIQ2012. (2) Symmetric inflation targets appear to have been abandoned in favor of a self-imposed single jobs mandate of easing monetary policy even after the economy grows again at or close to potential output. Monetary easing by unconventional measures is now apparently open ended in perpetuity as provided in the statement of the meeting of the Federal Open Market Committee (FOMC) on Sep 13, 2012 (http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm):
“To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
In fact, it is evident to the public that this policy will be abandoned if inflation costs rise. There is the concern of the production and employment costs of controlling future inflation.
(2) The European Central Bank (ECB) approved a new program of bond purchases under the name “Outright Monetary Transactions” (OMT). The ECB will purchase sovereign bonds of euro zone member countries that have a program of conditionality under the European Financial Stability Facility (EFSF) that is converting into the European Stability Mechanism (ESM). These programs provide enhancing the solvency of member countries in a transition period of structural reforms and fiscal adjustment. The purchase of bonds by the ECB would maintain debt costs of sovereigns at sufficiently low levels to permit adjustment under the EFSF/ESM programs. Purchases of bonds are not limited quantitatively with discretion by the ECB as to how much is necessary to support countries with adjustment programs. Another feature of the OMT of the ECB is sterilization of bond purchases: funds injected to pay for the bonds would be withdrawn or sterilized by ECB transactions. The statement by the European Central Bank on the program of OTM is as follows (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html):
“6 September 2012 - Technical features of Outright Monetary Transactions
As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:
Conditionality
A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.
The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.
Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.
Coverage
Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access.
Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.
No ex ante quantitative limits are set on the size of Outright Monetary Transactions.
Creditor treatment
The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.
Sterilisation
The liquidity created through Outright Monetary Transactions will be fully sterilised.
Transparency
Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.
Securities Markets Programme
Following today’s decision on Outright Monetary Transactions, the Securities Markets Programme (SMP) is herewith terminated. The liquidity injected through the SMP will continue to be absorbed as in the past, and the existing securities in the SMP portfolio will be held to maturity.”
Jon Hilsenrath, writing on “Fed sets stage for stimulus,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390443864204577623220212805132.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the essay presented by Chairman Bernanke at the Jackson Hole meeting of central bankers, as defending past stimulus with unconventional measures of monetary policy that could be used to reduce extremely high unemployment. Chairman Bernanke (2012JHAug31, 18-9) does support further unconventional monetary policy impulses if required by economic conditions (http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm):
“Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”
Professor John H Cochrane (2012Aug31), at the University of Chicago Booth School of Business, writing on “The Federal Reserve: from central bank to central planner,” on Aug 31, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444812704577609384030304936.html?mod=WSJ_hps_sections_opinion), analyzes that the departure of central banks from open market operations into purchase of assets with risks to taxpayers and direct allocation of credit subject to political influence has caused them to abandon their political independence and accountability. Cochrane (2012Aug31) finds a return to the proposition of Milton Friedman in the 1960s that central banks can cause inflation and macroeconomic instability.
Mario Draghi (2012Aug29), President of the European Central Bank, also reiterated the need of exceptional and unconventional central bank policies (http://www.ecb.int/press/key/date/2012/html/sp120829.en.html):
“Yet it should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole.
The ECB is not a political institution. But it is committed to its responsibilities as an institution of the European Union. As such, we never lose sight of our mission to guarantee a strong and stable currency. The banknotes that we issue bear the European flag and are a powerful symbol of European identity.”
Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. Table III-7 in IIIE Appendix Euro Zone Survival Risk below provides the combined GDP in 2012 of the highly indebted euro zone members estimated in the latest World Economic Outlook of the IMF at $4167 billion or 33.1 percent of total euro zone GDP of $12,586 billion. Using the WEO of the IMF, Table III-8 in IIIE Appendix Euro Zone Survival Risk below provides debt of the highly indebted euro zone members at $3927.8 billion in 2012 that increases to $5809.9 billion when adding Germany’s debt, corresponding to 167.0 percent of Germany’s GDP. There are additional sources of debt in bailing out banks. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html).
Chart III-1A of the Board of Governors of the Federal Reserve System provides the ten-year, two-year and one-month Treasury constant maturity yields together with the overnight fed funds rate, and the yield of the corporate bond with Moody’s rating of Baa. The riskier yield of the Baa corporate bond exceeds the relatively riskless yields of the Treasury securities. The beginning yields in Chart III-1A for Jan 2, 1962, are 2.75 percent for the fed fund rates and 4.06 percent for the ten-year Treasury constant maturity. On July 31, 2001, the yields in Chart III-1A are 3.67 percent for one month, 3.79 percent for two years, 5.07 percent for ten years, 3.82 percent for the fed funds rate and 7.85 percent for the Baa corporate bond. On July 30, 2007, yields inverted with the one-month at 4.95 percent, the two-year at 4.59 percent and the ten-year at 5.82 percent with the yield of the Baa corporate bond at 6.70 percent. Another interesting point is for Oct 31, 2008, with the yield of the Baa jumping to 9.54 percent and the Treasury yields declining: one month 0.12 percent, two years 1.56 percent and ten years 4.01 percent during a flight to the dollar and government securities analyzed by Cochrane and Zingales (2009). Another spike in the series is for Apr 4, 2006 with the yield of the corporate Baa bond at 8.63 and the Treasury yields of 0.12 percent for one month, 0.94 for two years and 2.95 percent for ten years. During the beginning of the flight from risk financial assets to US government securities (see Cochrane and Zingales 2009), the one-month yield was 0.07 percent, the two-year yield 1.64 percent and the ten-year yield 3.41. The combination of zero fed funds rate and quantitative easing caused sharp decline of the yields from 2008 and 2009. Yield declines have also occurred during periods of financial risk aversion, including the current one of stress of financial markets in Europe. The final point of Chart III1-A is for Jul 7, 2016, with the one-month yield at 0.27 percent, the two-year at 0.58 percent, the ten-year at 1.40 percent, the fed funds rate at 0.40 percent and the
Chart III-1A, Yield of Moody’s Baa Corporate Bond and US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 2, 1962-Jul 21, 2016
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
https://www.federalreserve.gov/releases/h15/
Chart III-1B provides the same data as Chart III-1A from Jan 3, 2001 to Oct 6, 2016. The last point of Chart III1-A is for Oct 6, 2016, with the one-month yield at 0.26 percent, the two-year at 0.86 percent, the ten-year at 1.75 percent, the fed funds rate at 0.40 percent and the corporate Baa bond at 4.36 percent.
Chart III-1B, Yield of Moody’s Baa Corporate Bond and US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 1, 2001-Oct 6, 2016
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
https://www.federalreserve.gov/releases/h15/
Chart III-1C provides the yields of the ten-year, two-year, one-month Treasury Constant Maturity, and the overnight Fed funds rate from Jan 2, 1962 to Dec 28, 2017. The final data point is for Dec 28, 2017 with the Fed funds rate at 1.42 percent, the one-month Treasury constant maturity at 1.14 percent, the two-year at 1.91 percent and the ten-year at 2.43 percent.
Chart III-1C, Yield US Ten-Year, Two-Year and One-Month Treasury Constant Maturity Yields and Overnight Fed Funds Rate, Jan 2, 1962-Dec 28, 2017
Note: US Recessions in shaded areas
Source: Board of Governors of the Federal Reserve System
https://www.federalreserve.gov/releases/h15/
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). Recently, the dollar is depreciating. 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). Kate Linebaugh, writing on “Corporate profits set to shrink for fourth consecutive quarter,” on Jul 17, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/corporate-profits-set-to-shrink-for-fourth-consecutive-quarter-1468799278), quotes forecasts of Thomson Reuters of 4.7 decline of adjusted earnings per share in the S&P 500 index in IIQ2016 relative to a year earlier. That would be the fourth consecutive quarterly decline. Theo Francis and Kate Linebaugh, writing on “US corporate profits on pace for third straight decline,” on Apr 28, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-corporate-profits-on-pace-for-third-straight-decline-1461872242), analyze three consecutive quarters of decline of corporate earnings and revenue in companies in S&P 500. They quote Thomson Reuters on expected decline of earnings of 6.1 percent in IQ2016 based on 55 percent of reporting companies. Weakness of economic activity shows in decline of revenues in IQ2016 of 1.4 percent, increasing 1.7 percent excluding energy, and contraction of profits of 0.5 percent. Justin Lahart, writing on “S&P 500 Earnings: far worse than advertised,” on Feb 24, 2016, published in the Wall Street Journal (http://www.wsj.com/articles/s-p-500-earnings-far-worse-than-advertised-1456344483), analyzes S&P 500 earnings in 2015. Under data provided by companies, earnings increased 0.4 percent in 2015 relative to 2014 but under GAAP (Generally Accepted Accounting Principles), earnings fell 12.7 percent, which is the worst decrease since 2008. Theo Francis e Kate Linebaugh, writing on Oct 25, 2015, on “US Companies Warn of Slowing Economy, published in the Wall Street Journal (http://www.wsj.com/articles/u-s-companies-warn-of-slowing-economy-1445818298) analyze the first contraction of earnings and revenue of big US companies. Production, sales and employment are slowing in a large variety of companies with some contracting. Corporate profits also suffer from revaluation of the dollar that constrains translation of foreign profits into dollar balance sheets. Francis and Linebaugh quote Thomson Reuters that analysts expect decline of earnings per share of 2.8 percent in IIIQ2015 relative to IIIQ2014 based on reports by one third of companies in the S&P 500. Sales would decline 4.0% in a third quarter for the first joint decline of earnings per share and revenue in the same quarter since IIIQ2009. Dollar revaluation also constrains corporate results.
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 $1,137.1 billion in IQ1991 or 19.5 percent. The National Bureau of Economic Research (NBER) dates a contraction of the US from IQ1990 (Jul) to IQ1991 (Mar) (http://www.nber.org/cycles.html). The expansion lasted until another contraction beginning in IQ2001 (Mar). US GDP contracted 1.3 percent from the pre-recession peak of $8983.9 billion of chained 2009 dollars in IIIQ1990 to the trough of $8865.6 billion in IQ1991 (http://www.bea.gov/iTable/index_nipa.cfm). Real gross private domestic investment in the US increased 14.3 percent from $2605.2 billion in IVQ2007 to $2,976.5 billion in IIIQ2017. Real private fixed investment increased 12.7 percent from $2,586.3 billion of chained 2009 dollars in IVQ2007 to $2,915.8 billion in IIIQ2017. Private fixed investment fell relative to IVQ2007 in all quarters preceding IQ2014 and increased 0.4 percent in IIIQ2016, increasing 0.3 percent in IIQ2016 and falling 0.1 percent in IQ2016. Private fixed investment increased 0.4 percent in IVQ2016. Private fixed investment increased 2.0 percent in IQ2017 and increased 0.8 percent in IIQ2017. Private fixed investment increased 0.6 percent in IIIQ2017. Growth of real private investment 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 fluctuation in corporate profits. Corporate profits increased at $53.9 billion in IVQ2016. Corporate profits fell at $46.2 billion in IQ2017. Corporate profits increased at $14.4 billion in IIQ2017. Corporate profits increased $90.3 billion in IIIQ2017. Profits after tax with IVA and CCA increased at $71.6 billion in IVQ2016. Profits after tax with IVA and CCA fell at $43.0 billion in IQ2017. After tax profits increased at $1.1 billion in IIQ2017. Profits after tax with IVA and CCA increased at $94.4 billion in IIIQ2017. Net dividends increased at $2.8 billion in IVQ2016. Net dividends increased at $9.0 billion in IQ2017. Net dividends increased at $6.1 billion in IIQ2017. Net dividends increased at $4.4 billion in IIIQ2017. Undistributed corporate profits increased at $68.9 billion in IVQ2016. Undistributed profits fell at $52.0 billion in IQ2017. Undistributed profits decreased at $5.0 billion in IIQ2017. Undistributed profits increased at $90.0 billion in IIIQ2017. Undistributed corporate profits swelled 389.3 percent from $107.7 billion in IQ2007 to $527.0 billion in IIIQ2017 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, with recent depreciation at the margin, 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. The bottom part of Table IA1-9 provides the breakdown of corporate profits with IVA and CCA in domestic industries and the rest of the world. Corporate profits with IVA and CCA increased at $53.9 billion in IVQ2016. Profits from domestic industries increased at $6.7 billion and profits from nonfinancial business decreased at $20.5 billion. Profits from the rest of the world increased at $47.3 billion. Corporate profits with IVA and CCA decreased at $46.2 billion in IQ2017. Profits from domestic industries decreased at $36.9 billion and profits from nonfinancial business increased at $3.8 billion. Profits from the rest of the world decreased at $9.3 billion. Corporate profits with IVA and CCA increased at $14.4 billion in IIQ2017. Profits from domestic industries increased at $25.2 billion and profits from nonfinancial business increased at $59.1 billion. Profits from the rest of the world decreased at $10.8 billion. Corporate profits with IVA and CCA increased at $90.3 billion in IIIQ2017. Profits from domestic industries increased at $58.2 billion and profits from nonfinancial business increased at $10.4 billion. Profits from the rest of the world increased at $32.0 billion. Total corporate profits with IVA and CCA were $2213.7 billion in IIIQ2017 of which $1766.1 billion from domestic industries, or 79.8 percent of the total, and $447.5 billion, or 20.2 percent, from the rest of the world. Nonfinancial corporate profits of $1276.7 billion account for 57.7 percent of the total. 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 Rτ is expected revenue in the time horizon from τ =1 to T; Cτ 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, Rτ, causes decline in valuation. There is mixed performance in equity indexes with several indexes in Table III-1 decreasing in the week ending on Dec 29, 2017, after wide swings caused by reallocations of investment portfolios worldwide. Stagnating revenues, corporate cash hoarding, effects of currency oscillations on corporate earnings and declining investment are causing reevaluation of discounted net earnings with deteriorating views on the world economy and United States fiscal sustainability but investors have been driving indexes higher. There are complex economic, financial and political effects of the withdrawal of the UK from the European Union or BREXIT after the referendum on Jun 23, 2016 (https://next.ft.com/eu-referendum for extensive coverage by the Financial Times). Nuclear conflicts in the Korean Peninsula and global geopolitics are also affecting financial markets. DJIA decreased 0.5 percent on Dec 29, decreasing 0.1 percent in the week. Germany’s DAX decreased 0.5 percent on Dec 29 and decreased 1.2 percent in the week. Dow Global changed 0.0 percent on Dec 29 and increased 0.3 percent in the week. Japan’s Nikkei Average decreased 0.1 percent on Dec 29 and decreased 0.6 percent in the week as the yen continues oscillating but relatively weaker and the stock market gains in expectations of success of fiscal stimulus by a new administration and monetary stimulus by a new board of the Bank of Japan. Shanghai Composite that decreased 1.0 percent on Mar 8 and decreased 1.7 percent in the week of Mar 8, falling below 2000 at 1974.38 on Mar 12, 2014 but closing at 3307.17 on Dec 29, 2017, for increase of 0.3 percent and increasing 0.3 percent in the week. The Shanghai Composite increased 67.5 percent from March 12, 2014 to Dec 29, 2017. There is deceleration with oscillations of the world economy that could affect corporate revenue and equity valuations, causing fluctuations in equity markets with increases during favorable risk appetite. The global hunt for yield induced by central bank policy rates of near zero percent motivates wide portfolio reshufflings among classes of risk financial assets.
Commodities were mixed in the week of Dec 29, 2017. Table III-1 shows that WTI increased 3.3 percent in the week of Dec 29 while Brent increased 2.5 percent in the week with turmoil in oil producing regions but oscillating action by OPEC. Gold increased 0.9 percent on Dec 29 and increased 2.4 percent in the week.
Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the long-term refinancing operations (LTROs). Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €879,130 million on Dec 28, 2011 and €764,286 million on Dec 22, 2017, with decrease of loans from €765,741 million in the prior week of Dec 15, 2017. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has reached €3,432,632 million in the statement of Dec 22, 2017, with increase from €3,421,534 million in the prior week of Dec 15. There is high credit risk in these transactions with capital of only €102,298 million as analyzed by Cochrane (2012Aug31).
Table III-2, Consolidated Financial Statement of the Eurosystem, Million EUR
| Dec 31, 2010 | Dec 28, 2011 | Dec 22, 2017 | |
| 1 Gold and other Receivables | 367,402 | 419,822 | 379,045 |
| 2 Claims on Non-Euro Area Residents Denominated in Foreign Currency | 223,995 | 236,826 | 300,641 |
| 3 Claims on Euro Area Residents Denominated in Foreign Currency | 26,941 | 95,355 | 39,417 |
| 4 Claims on Non-Euro Area Residents Denominated in Euro | 22,592 | 25,982 | 16,463 |
| 5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro | 546,747 | 879,130 | 764,286 12/15/17: 765,741 12/8/17: 766,089 12/1/17 768,934 11/24/17 767,109 11/17/17: 766,772 11/10/17: 766,535 |
| 6 Other Claims on Euro Area Credit Institutions Denominated in Euro | 45,654 | 94,989 | 43,143 |
| 7 Securities of Euro Area Residents Denominated in Euro | 457,427 | 610,629 | 2,668,346 12/15/17: 2,655,793 12/8/17: 2,643,079 12/1/17: 2,627,250 11/24/17: 2,613,966 11/17/17: 2,599,009 |
| 8 General Government Debt Denominated in Euro | 34,954 | 33,928 | 25,056 |
| 9 Other Assets | 278,719 | 336,574 | 250,887 |
| TOTAL ASSETS | 2,004, 432 | 2,733,235 | 4,487,284 |
| Memo Items | |||
| Sum of 5 and 7 | 1,004,174 | 1,489,759 | 3,432,632 12/15/17: 3,421,534 12/8/17: 3,409,168 12/1/17: 3,396,184 11/24/17: 3,381,075 11/17/17: 3,365,781 11/10/17: 3,350,425 11/03/17: 3,334,972 |
| Capital and Reserves | 78,143 | 81,481 | 102,298 |
Source: European Central Bank
http://www.ecb.int/press/pr/wfs/2011/html/fs110105.en.html
http://www.ecb.int/press/pr/wfs/2011/html/fs111228.en.html
https://www.ecb.europa.eu/press/pr/wfs/2017/html/ecb.fst171228.en.html
Table III-3, Italy, Exports and Imports by Regions and Countries, % Share and 12-Month ∆%
| Oct 2017 | Exports | ∆% Jan-Oct 2017/ Jan-Oct 2016 | Imports | ∆% Jan-Oct 2017/ Jan-Oct 2016 |
| EU | 55.9 | 7.1 | 60.8 | 8.0 |
| EMU 19 | 41.1 | 7.0 | 47.9 | 8.5 |
| France | 10.5 | 5.2 | 8.9 | 8.2 |
| Germany | 12.6 | 6.4 | 16.3 | 8.2 |
| Spain | 5.0 | 10.6 | 5.4 | 8.8 |
| UK | 5.4 | 3.4 | 3.1 | -0.4 |
| Non-EU Countries | 44.1 | 8.5 | 39.2 | 11.9 |
| Europe non- EU Countries | 10.4 | 8.7 | 9.6 | 13.0 |
| USA | 8.8 | 9.6 | 3.8 | 8.5 |
| China | 2.6 | 24.2 | 7.4 | 5.2 |
| OPEC | 5.0 | -6.4 | 5.0 | 24.2 |
| Total | 100.0 | 7.7 | 100.0 | 9.6 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/207691
Table III-4 provides Italy’s trade balance by regions and countries. Italy had trade deficit of €789 million with the 19 countries of the euro zone (EMU 19) in Oct 2017 and cumulative deficit of €4,808 million in Jan-Oct 2017. Depreciation to parity could permit greater competitiveness in improving the trade surplus of €5,938 million in Jan-Oct 2017 with Europe non-European Union, the trade surplus of €20,361 million with the US and the trade surplus with non-European Union of €28,348 million in Jan-Oct 2017. There is significant rigidity in the trade deficit in Jan-Oct 2017 of €13,392 million with China. There is a trade deficit of €2,781 million in Jan-Oct 2017 with members of the Organization of Petroleum Exporting Countries (OPEC). Higher exports could drive economic growth in the economy of Italy that would permit less onerous adjustment of the country’s fiscal imbalances, raising the country’s credit rating.
Table III-4, Italy, Trade Balance by Regions and Countries, Millions of Euro
| Regions and Countries | Trade Balance Oct 2017 Millions of Euro | Trade Balance Cumulative Jan-Oct 2017 Millions of Euro |
| EU | 666 | 8,979 |
| EMU 19 | -789 | -4,808 |
| France | 991 | 9,424 |
| Germany | -708 | -6,874 |
| Spain | 176 | 1,630 |
| UK | 1,081 | 9,918 |
| Non-EU | 4,287 | 28,348 |
| Europe non-EU | 966 | 5,938 |
| USA | 2,313 | 20,361 |
| China | -1,111 | -13,392 |
| OPEC | -337 | -2,781 |
| Total | 4,953 | 37,327 |
Notes: EU: European Union; EMU: European Monetary Union (euro zone)
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/207691
Growth rates of Italy’s trade and major products are in Table III-5 for the period Jan-Oct 2017 relative to Jan-Oct 2016. Growth rates of cumulative imports relative to a year earlier are positive for energy with 28.9 percent. Exports of durable goods increased 5.3 percent and exports of capital goods increased 6.2 percent. The rate of growth of exports of 7.7 percent in Jan-Oct 2017/Jan-Oct 2016 relative to that of imports of 9.6 percent may partly reflect weak demand in Italy with GDP declining during seven consecutive quarters from IIIQ2011 through IQ2013 together with softening commodity prices. GDP increased 0.3 percent in IIIQ2013, decreased 0.1 percent in IVQ2013, changed 0.0 percent in IQ2014 and decreased 0.1 percent in IIQ2014. Italy’s GDP increased 0.2 percent in IIIQ2014 and increased 0.1 percent in IVQ2014. Italy’s GDP increased 0.2 percent in IQ2015 and increased 0.4 percent in IIQ2015. Italy’s GDP increased 0.3 percent in IIIQ2015 and increased 0.3 percent in IVQ2015. GDP increased 0.3 percent in IQ2016. The GDP of Italy increased 0.1 percent in IIQ2016 and increased 0.2 percent in IIIQ2016. GDP increased 0.4 percent in IVQ2016 and increased 0.5 percent in IQ2017. The GDP of Italy increased 0.3 percent in IIQ2017, increasing 0.4 percent in IIIQ2017.
Table III-5, Italy, Exports and Imports % Share of Products in Total and ∆%
| Exports | Exports | Imports | Imports | |
| Consumer | 32.2 | 6.9 | 30.1 | 4.8 |
| Durable | 6.0 | 5.3 | 3.6 | 8.2 |
| Non-Durable | 26.3 | 7.2 | 26.4 | 4.3 |
| Capital Goods | 34.2 | 6.2 | 26.8 | 6.9 |
| Inter- | 31.0 | 7.7 | 32.9 | 10.3 |
| Energy | 2.6 | 40.3 | 10.2 | 28.9 |
| Total ex Energy | 97.4 | 10.4 | 89.8 | 7.4 |
| Total | 100.0 | 7.7 | 100.0 | 9.6 |
Note: % Share for 2014 total trade.
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/207691
Table III-6 provides Italy’s trade balance by product categories in Oct and cumulative Jan-Oct 2017. Italy’s trade balance excluding energy, generated surplus of €7,489 million in Oct 2017 and €64,593 million cumulative in Jan-Oct 2017 but the energy trade balance created deficit of €2536 million in Oct 2016 and cumulative deficit of €27,266 million in Jan-Oct 2017. The overall surplus in Oct 2016 was €4953 million with cumulative surplus of €37,327 million in Jan-Oct 2017. Italy has significant competitiveness in various economic activities in contrast with some other countries with debt difficulties.
Table III-6, Italy, Trade Balance by Product Categories, € Millions
| Oct 2017 | Cumulative Jan-Oct 2017 | |
| Consumer Goods | 2,912 | 22,471 |
| Durable | 1,067 | 9,538 |
| Nondurable | 1,845 | 12,933 |
| Capital Goods | 3,817 | 38,213 |
| Intermediate Goods | 760 | 3,909 |
| Energy | -2,536 | -27,266 |
| Total ex Energy | 7,489 | 64,593 |
| Total | 4,953 | 37,327 |
Source: Istituto Nazionale di Statistica
http://www.istat.it/it/archivio/207691
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30, 2011, the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt exceeding 100 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2017/01/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 2017.
Brazil faced in the debt crisis of 1982 a more complex policy mix. Between 1977 and 1983, Brazil’s terms of trade, export prices relative to import prices, deteriorated 47 percent and 36 percent excluding oil (Pelaez 1987, 176-79; Pelaez 1986, 37-66; see Pelaez and Pelaez, The Global Recession Risk (2007), 178-87). Brazil had accumulated unsustainable foreign debt by borrowing to finance balance of payments deficits during the 1970s. Foreign lending virtually stopped. The German mark devalued strongly relative to the dollar such that Brazil’s products lost competitiveness in Germany and in multiple markets in competition with Germany. The resolution of the crisis was devaluation of the Brazilian currency by 30 percent relative to the dollar and subsequent maintenance of parity by monthly devaluation equal to inflation and indexing that resulted in financial stability by parity in external and internal interest rates avoiding capital flight. With a combination of declining imports, domestic import substitution and export growth, Brazil followed rapid growth in the US and grew out of the crisis with surprising GDP growth of 4.5 percent in 1984.
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the Subsection IIIF Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 30, 2011, the yield of the 2-year bond of the government of Greece was quoted around 100 percent. In contrast, the 2-year US Treasury note traded at 0.239 percent and the 10-year at 2.871 percent while the comparable 2-year government bond of Germany traded at 0.14 percent and the 10-year government bond of Germany traded at 1.83 percent. There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt exceeding 100 percent of GDP, which is the third largest in the world after the US and Japan. Appendix IIIE links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy (for the experience of Brazil in the debt crisis of 1982 see Pelaez 1986, 1987).
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table III-7 is constructed with IMF World Economic Outlook database (http://www.imf.org/external/pubs/ft/weo/2017/02/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 2017.
Table III-7, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2017 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 79,281 | ||
| Euro Zone | 12,526 | 0.6 | 71.8 |
| Portugal | 212 | 2.4 | 111.2 |
| Ireland | 326 | 1.5 | 60.9 |
| Greece | 204 | 1.7 | 180.2** |
| Spain | 1,307 | -0.7 | 86.6 |
| Major Advanced Economies G7 | 36,600 | -1.7 | 83.7 |
| United States | 19,362 | -2.2 | 82.5 |
| UK | 2,565 | -1.1 | 80.5 |
| Germany | 3,652 | 1.7 | 45.8 |
| France | 2,575 | -1.4 | 88.5 |
| Japan | 4,884 | -4.0 | 120.9 |
| Canada | 1,640 | -1.5 | 24.6 |
| Italy | 1,921 | 1.5 | 121.2 |
| China | 11,938 | -2.8 | 47.6*** |
*Net Lending/borrowing**Gross Debt
Source: IMF World Economic Outlook
http://www.imf.org/external/pubs/ft/weo/2017/02/weodata/index.aspx
The data in Table III-7 are used for some very simple calculations in Table III-8. The column “Net Debt USD Billions 2017” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2017” to the column “GDP 2017 USD Billions.” The total debt of France and Germany in 2017 is $3951.6 billion, as shown in row “B+C” in column “Net Debt USD Billions 2017.” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $4262.0 billion, adding rows D+E+F+G+H in column “Net Debt USD billions 2017.” There is some simple “unpleasant bond arithmetic” in the two final columns of Table III-8. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $8,213.6 billion, which would be equivalent to 131.9 percent of their combined GDP in 2017. 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 224.9 percent if including debt of France and 162.5 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-8, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions 2017 | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 8,993.7 | ||
| B Germany | 1,672.6 | $8213.6 as % of $3652 =224.9% $5934.7 as % of $3652 =162.5% | |
| C France | 2,278.9 | ||
| B+C | 3,951.6 | GDP $6227 Total Debt $8,213.6 Debt/GDP: 131.9% | |
| D Italy | 2,328.3 | ||
| E Spain | 1,131.9 | ||
| F Portugal | 235.7 | ||
| G Greece | 367.6 | ||
| H Ireland | 198.5 | ||
| Subtotal D+E+F+G+H | 4,262.0 |
Source: calculation with IMF data IMF World Economic Outlook databank
http://www.imf.org/external/pubs/ft/weo/2017/02/weodata/index.aspx
There is extremely important information in Table III-9 for the current sovereign risk crisis in the euro zone. Table III-9 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Oct 2017. German exports to other European Union (EU) members are 59.7 percent of total exports in Oct 2017 and 58.8 percent in cumulative Jan-Oct 2017. Exports to the euro area are 37.4 percent of the total in Oct and 36.8 percent cumulative in Jan-Oct. Exports to third countries are 40.3 percent of the total in Oct and 41.2 percent cumulative in Jan-Oct. There is similar distribution for imports. Exports to non-euro countries are increasing 9.1 percent in the 12 months ending in Oct 2017, increasing 4.8 percent cumulative in Jan-Oct 2017 relative to a year earlier while exports to the euro area are increasing 8.6 percent in the 12 months ending in Oct 2017 and increasing 6.6 percent cumulative in Jan-Oct 2017. Exports to third countries, accounting for 40.3 percent of the total in Oct 2017, are increasing 4.1 percent in the 12 months ending in Oct 2017 and increasing 6.8 percent cumulative in Jan-Oct 2017, accounting for 41.2 percent of the cumulative total in Jan-Oct 2017. Price competitiveness through devaluation could improve export performance and growth. Economic performance in Germany is closely related to Germany’s high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone. Germany could benefit from depreciation of the euro because of high share in its exports to countries not in the euro zone but breakdown of the euro zone raises doubts on the region’s economic growth that could affect German exports to other member states.
Table III-9, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Oct 2017 | Oct 12-Month | Cumulative Jan-Oct 2017 € Billions | Cumulative Jan-Oct 2017/ 2016 ∆% | |
| Total | 108.0 | 6.8 | 1062.2 | 6.3 |
| A. EU | 64.5 % 59.7 | 8.7 | 624.1 % 58.8 | 5.9 |
| Euro Area | 40.4 % 37.4 | 8.6 | 391.2 % 36.8 | 6.6 |
| Non-euro Area | 24.1 % 22.3 | 9.1 | 232.9 % 21.9 | 4.8 |
| B. Third Countries | 43.5 % 40.3 | 4.1 | 438.1 % 41.2 | 6.8 |
| Total Imports | 89.1 | 8.3 | 859.0 | 8.7 |
| C EU Members | 59.6 % 66.9 | 10.1 | 565.4 % 65.8 | 7.9 |
| Euro Area | 39.8 % 44.7 | 9.3 | 380.6 % 44.3 | 7.0 |
| Non-euro Area | 19.8 % 22.2 | 11.9 | 184.9 % 21.5 | 9.8 |
| D Third Countries | 29.4 % 33.0 | 4.8 | 293.6 % 34.2 | 10.2 |
Notes: Total Exports = A+B; Total Imports = C+D
Source: Statistisches Bundesamt Deutschland
https://www.destatis.de/EN/PressServices/Press/pr/2017/12/PE17_444_51.html
IIIF Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unpleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.
First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:
D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)
Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,
{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:
N(t+1) = (1+n)N(t), n>-1 (2)
The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:
B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)
On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.
Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+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 Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
© Carlos M. Pelaez, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017.
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