Financial Turbulence, Quantitative Easing, the G20 and Global Devaluation War
Carlos M. Pelaez
©Carlos M. Pelaez, 2010
This comment relates renewed factors and evidence of financial turbulence to quantitative easing splitting the G20 in coordinating global imbalances and the turmoil of the global devaluation war. The contents are as follows:
I Factors of Financial Turbulence
II Indicators of Financial Turbulence
III G20 Seoul Meeting
IV Quantitative Easing and the Global Devaluation War
V Economic Indicators
VI Interest Rates
VII Conclusion
I Factors of Financial Turbulence. There are three factors of global financial instability or turbulence originating in regional economic and financial sources. First, the potential slowdown of growth of China can affect Asian and world economic growth. China is a major trading partner in Asian and world trade such that lower growth of the Chinese economy and trade could affect most countries in Asia and the rest of the world. Equity markets reacted positively to the release of industrial production of China with growth of 13.1 percent in October relative to a year earlier and retail sales growing by 18.6 percent in October relative to a year earlier (http://www.ft.com/cms/s/0/005c52da-ed48-11df-8cc9-00144feab49a.html#axzz14xU98wBj). The concern is with the official inflation target of year-end inflation of 3 percent as measured by the consumer price index (CPI) and ceiling of new bank lending of 7.5 trillion yuan, which is about $1.1 trillion (http://professional.wsj.com/article/SB10001424052748703848204575607710490344620.html?mod=wsjproe_hps_LEFTWhatsNews). The targets were set by the government in an attempt to steer away from the stimulus injected to soften the impact of the global recession on the Chinese economy. The data on industry and sales were released simultaneously with CPI inflation of 4.4 percent in October relative to a year earlier, much higher than 3.6 percent in Sep, well above the target of 3 percent and the highest CPI inflation in 25 months. The People’s Bank of China or the country’s central bank increased reserve requirements of banks by 0.5 percentage points on Nov 10 after increasing interest rates a month earlier for the first time in three years. Tightening monetary policy could slow growth of the economy while accelerating inflation could have adverse effects on growth in the future. The data on industrial growth and retail sales influenced rallies in world financial markets on Thursday and the inflation data influenced the selloff on Friday when it was soberly evaluated jointly with weakness in sovereign risks in Europe.
Second, the cohesiveness and stability of the economy and financial markets of the euro zone is continuously affected by financial and economic weakness in highly-indebted countries. Table 1 provides growth quarterly and relative to a year earlier of third-quarter 2010 (3Q10) GDP and industry in Sep and relative to a year earlier. GDP growth of the euro zone in the third quarter was 1.9 percent relative to a year earlier and growth of industry in Sep was 5.2 percent relative to a year earlier. There is sharp contrast with excellent growth in the export-driven economy of Germany of 3.9 percent in GDP in the third quarter relative to a year earlier and industry of 8.3 percent in Sep relative to a year earlier. The concern is with the highly-indebted economies of Portugal, Ireland, Italy, Greece and Spain, with third quarter GDP growth below that of the euro zone and in some cases negative growth. Debt restricts GDP growth and external financing but growth is required to increase government revenue to reduce the deficit and prevent increases in debt. While Ireland, Greece and Portugal account for about 5 percent of the economy of the euro zone, Italy and Spain are the third and fourth largest economies in the euro zone (http://professional.wsj.com/article/SB10001424052748704865704575610763484082240.html?mod=wsjproe_hps_LEFTWhatsNews). Various measures have been taken by the European Union to contain the difficulties with sovereign risk in some member countries. The European Commission provides a lending facility of €60 billion to bridge countries from temporary insufficient foreign financing. The European Financial Stability Facility (EFSF) is a special-purpose vehicle created under Luxembourg law with authorization of borrowing €440 in bond markets with guarantees by euro zone governments (Ibid, http://www.efsf.europa.eu/attachment/efsf_framework_agreement_en.pdf). The International Monetary Fund (IMF) is providing additional funding and protracted expertise in resolution of sovereign crises that typically acts as a catalyst in bringing private-sector funding and refinancing (see Pelaez and Pelaez, International Financial Architecture (2005)). Sovereign debt difficulties in Europe surfaced in Apr and have receded but returned in various occasions. Ireland has been restructuring its banking system with government support, taking the costs upfront with a deficit of 32 percent of GDP, while programming austerity in government budgets. A proposal would reduce the 2011 budget by €6 billion, which would be equivalent in the US to immediate elimination of the entire Defense Department (http://professional.wsj.com/article/SB10001424052748704506404575592360334457040.html?mod=wsjproe_hps_LEFTWhatsNews). The selloff of debt of highly-indebted countries was reversed by a statement of European Union finance ministers on Nov 12, clarifying that any changes to the EFSF would not affect bonds issued before mid 2013 (http://professional.wsj.com/article/SB10001424052748703305404575610263842709930.html?mod=WSJ_hpp_MIDDLETopStories). There was concern in markets that bondholders would be forced into absorbing a substantial part of the costs of restructuring debt. European finance ministers of the euro zone are monitoring the situation to determine if there is need to bail out Ireland’s debt before markets open on Monday, according to the Financial Times (http://www.ft.com/cms/s/0/cdef84ce-ef41-11df-8bbb-00144feab49a.html#axzz15HIytXOg).
Table 1, Europe, Growth of GDP and Industry
| GDP 3Q10 | GDP 3Q09 to 3Q10 | Industry Aug 10 to Sep 10 | Industry Sep 09 to Sep 10 | |
| Euro Zone | 0.4 | 1.9 | -0.9 | 5.2 |
| EA 27 | 0.4 | 2.1 | -0.5 | 5.8 |
| Germany | 0.7 | 3.9 | -0.8 | 8.3 |
| France | 0.4 | 1.8 | 0.0 | 4.2 |
| Portugal | 0.4 | 1.5 | -4.7 | -2.4 |
| Ireland | -1.2* | -1.8** | 7.9 | 10.9 |
| Italy | 0.2 | 1.0 | -2.1 | 4.1 |
| Greece | -1.1 | -4.5 | -5.4 | -7.6 |
| Spain | 0.0 | 0.2 | -1.5 | -1.4 |
| UK | 0.8 | 2.8 | 0.3 | 5.0 |
| Japan | 0.4* | 2.4** | -1.9 | -- |
| USA | 0.5 | 3.1 | -0.2 | 5.4 |
*2Q09 to 3Q10 **2Q09 to 2Q10
Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-12112010-BP/EN/2-12112010-BP-EN.PDF http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-12112010-AP/EN/4-12112010-AP-EN.PDF http://www.federalreserve.gov/releases/g17/Current/default.htm http://www.boj.or.jp/en/type/release/teiki/gp/data/gp1011.pdf
Third, the US faces six tough policy challenges. (1) Jobs. The main challenge of policy is providing employment opportunities to 26.6 million people in job stress: 14.8 million unemployed (of whom 6.2 million unemployed for 27 weeks or longer or 41.8 percent of total unemployed), 9.2 million “employed part-time for economic reasons” (because their hours were reduced or could not find a full-time job) and 2.6 million “marginally attached to the labor force” (who are not part of the labor force but are willing and available for work and had looked for employment in the past 12 months) (http://www.bls.gov/news.release/pdf/empsit.pdf). (2) Growth. Professor Michael Boskin of Stanford, former Chairman of the CEA, provides analysis of growth in cyclical expansions in an article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html ). The critical historical perspective is that average quarterly rates of growth in the expansions after a severe recession were incomparably higher than during the current expansion: 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, 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter in 1983 and only 3 percent in the first four quarters and 2.9 percent forecast in the first 12 quarters after the trough in the third quarter of 2009. GDP grew at the seasonally annualized (SA) quarter-on-quarter yearly-equivalent rate of 1.7 percent in 2Q2010 and 2.0 percent in 3Q2010. (3) Sectors in Recession Condition. Housing construction and real estate indicators are only at a fraction of what they were in 2005: housing starts in Jan-Sep 2010 are lower by 71.8 percent than in Jan-Sep 2005 and sales of new houses in the same period are lower by 74.2 percent. Labor markets have not improved as desired. Consumer confidence remains restricted. (4) Rising Interest Rates. The monetary policy of zero interest rates and the experiment with quantitative easing created a duration trap of long-term debt securities such that expectations of rapidly rising rates in an improving economy could slow future growth. (5) Increasing Taxes. Fiscal policy of increasing expenditures to 24.7 percent of GDP while revenue declined to 14.8 percent of GDP in 2009 created record deficits and debt/GDP ratios since World War II (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml). The expectation of future tax increases has added to the uncertainty, frustrating growth of investment and consumption. (6) Disruption of Business Models. Profound legislative restructurings and regulation disrupted business models with resulting frustration of investment decisions and hiring. The minutes of the Federal Open Market Committee (FOMC) contain the following statement: “A number of participants reported that business contacts again indicated that uncertainty about future taxes, regulation and health care costs made them reluctant to expand their workforces. Instead, business had continued to meet growth in demand for their products largely through productivity gains and by increasing existing employees’ hours” (http://www.federalreserve.gov/monetarypolicy/files).
II Indicators of Financial Turbulence. The three factors discussed in (I) interact to create fluctuations in financial variables. The last column of Table 2 shows sharp upward trend of financial risk assets since the trough that occurred for many classes around Jul 2. This trend accelerated after Aug 27 when Chairman Bernanke outlined the tools that could be used to provide additional stimulus, including quantitative easing and that the Federal Open Market Committee (FOMC) “will certainly use its tools as needed to maintain price stability—avoiding excessive inflation or further disinflation—and to promote the continuation of the economic recovery” (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm). Subsequent statements by members of the FOMC, in favor and against further quantitative easing, created the anticipation of increasing purchases of long-term securities after the election of Nov 2, which actually occurred on Nov 3 with the decision by the FOMC on the intention of purchasing “a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). The correctly anticipated additional round of quantitative easing partly caused devaluation of the dollar by 14.8 percent and high double-digit increases in risk financial assets such as equities, commodities and prices of debt securities. Financial turbulence returned in the week of Nov 8 to 12 with declines in risk financial assets shown in the first-to-last column of Table 2 with heading “∆ % week 11/12”, showing the percentage change of variables in Nov 8 to 12. The Shanghai Composite Index fell 5.16 percent on Nov 12 as a result of the increase of 12-month inflation to 4.4 percent in Oct (http://www.ft.com/cms/s/0/123cc2ce-ee2d-11df-8b90-00144feab49a,dwp_uuid=9c33700c-4c86-11da-89df-0000779e2340.html#axzz15CyhHar5). The Dow Global index fell by 2.6 percent in the week with the Dow Jones Industrial Average (DJIA) and S&P 500 indexes declining by the same 2.2 percent. Commodities fluctuated but retreated during the week with decline of the Dow Jones UBS Commodities Index by 3.5 percent. The week of Nov 8 to 12 proved that the factors of financial turbulence are still not resolved such as to bring sustained calm in markets of financial risk assets.
Table 2, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% to 11/12 | ∆% Week 11/12 | ∆% T to 11/12 | |
| DJIA | 4/26/10 | 7/2/10 | -13.6 | -0.1 | -2.2 | 15.5 |
| S&P 500 | 4/23/10 | 7/20/10 | -16.0 | -1.5 | -2.2 | 17.3 |
| NYSE Finance | 4/15/10 | 7/2/10 | -20.3 | -10.2 | -3.7 | 12.8 |
| Dow Global | 4/15/10 | 7/2/10 | -18.4 | -2.6 | -2.6 | 19.4 |
| Asia Pacific | 4/15/10 | 7/2/10 | -12.5 | 3.4 | -1.9 | 18.1 |
| Japan Nikkei Average | 4/05/10 | 8/31/10 | -22.5 | -14.6 | 1.0 | 10.2 |
| China Shanghai | 4/15/10 | 7/2/10 | -24.7 | -5.7 | -4.6 | 25.3 |
| STOXX Europe 50 | 4/15/10 | 7/2/10 | -15.3 | -4.8 | -0.9 | 12.5 |
| DAX | 4/26/10 | 5/25/10 | -10.5 | 6.4 | -0.3 | 18.8 |
| Dollar EUR | 11/25 2009 | 6/7 2010 | 21.2 | 9.5 | 2.4 | -14.8 |
| DJ UBS Comm. | 1/6/10 | 7/2/10 | -14.5 | 1.9 | -3.5 | 19.2 |
| 10-Year Treasury | 4/5 2010 | 10/29 2010 | 3.986 | 2.785 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html
III G20 Seoul Meeting. At the Pittsburgh 2009 Summit, the leaders of the G20 agreed to “the G20 Framework for Strong, Sustainable and Balanced Growth” (http://www.pittsburghsummit.gov/mediacenter/129639.htm). The Framework consists of “a shared responsibility” that includes, among others, two issues of current relevance: (1) “promote more balanced current accounts and support open trade and investment to advance global prosperity and growth sustainability, while actively rejecting protectionist measures” and (2) “undertake monetary policies consistent with price stability in the context of market oriented exchange rates that reflect underlying economic fundamentals” (Ibid). The Framework established a Mutual Assessment Program (MAP) consisting of: (1) agreement by “G20 members of shared policy objectives”; (2) setting by G20 members of “their medium policy frameworks,” working “together to assess the collective implications” of national policy frameworks; and (3) that “G20 leaders will consider, based on the results of the mutual assessment, and agree any actions to meet our common objectives” (Ibid; http://www.imf.org/external/np/exr/facts/g20map.htm). The finance ministers of the G20 were entrusted with the development of MAP in evaluating “the collective implications of national policies for the world economy” (Ibid). The IMF was entrusted with assisting finance ministers to: (1) “develop a forward looking assessment of G20 economic developments” to analyze how economic conditions and policies promote “strong, sustainable and balanced growth”; (2) assess how fiscal and monetary policies affect the world economy, financial variables and “current account imbalances”; and (3) provide the G20 and International Monetary and Financial Committee (IFMC) of the IMF regular reports (Ibid).
The main underlying issue of concern in the G20 Seoul Summit is shown in Table 3. The current account deficit of the US is measured as “the combined balances on trade in goods and services, income and net unilateral current transfers” (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm). For purposes of analysis, “a country’s current account balance over a period is the change in the value of its net claims on the rest of the world—the change in net foreign assets. The current account balance is said to be in surplus if positive, so that the economy as a whole is lending, and in deficit if negative, so that the economy is borrowing” (Obstfeld and Rogoff 1996, 5). Current account balances as percent of GDP are provided in Table 3 for five economies. The IMF projects the current account deficit of the US to be 3.3 percent in 2015, which is substantially below 4.7 percent in 2008, while the current account surplus of China in 2015 will be 7.8 percent, which is not substantially different from 9.6 percent in 2008. A major concern is if the US will be able to finance growing fiscal deficits and increasing government debt together with a substantial current account deficit. Ability to finance means at current market interest rates or yields of Treasuries. The risk is the development of a premium over yield required by investors to increase positions in US debt. There was earlier similar concern that led to the creation of the “doctrine of shared responsibility” by the finance ministers and heads of central banks of the G7 in the Washington meeting of 2006 (http://www.g8.utoronto.ca/finance/fm060421.htm http://www.g8.utoronto.ca/finance/fm060421.htm#annex).
Table 3, Current Account Balance as Percent of GDP
| 2008 | 2010 | 2015 | |
| Germany | 6.7 | 6.1 | 3.9 |
| Japan | 3.2 | 3.1 | 1.9 |
| China | 9.6 | 4.7 | 7.8 |
| USA | -4.7 | -3.2 | -3.3 |
| Brazil | -1.7 | -2.6 | -3.3 |
Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx
The difference in this new round of “shared responsibility” is that the US government debt is growing from 47.6 percent of GDP in 2008 to 84.7 percent in 2015, as shown in Table 4. The evaluation by the IMF Staff is that “limited progress is being made towards external rebalancing, with current accounts expected to widen again towards pre-crisis levels” (http://www.imf.org/external/np/g20/pdf/111210.pdf).
Table 4, Net Government Debt as Percent of GDP
| 2008 | 2010 | 2015 | |
| Germany | 49.7 | 58.7 | 61.7 |
| Japan | 94.9 | 120.7 | 153.4 |
| China | 16.8 | 19.1 | 13.9 |
| USA | 47.6 | 65.8 | 84.7 |
| Brazil | 37.9 | 36.7 | 30.8 |
Note: China is gross debt.
Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx
The G20 pushed forward decisions on global imbalances. There will be further work on MAP to be considered in the meeting in France in Nov 2011: “we call on our Framework Working Group, with technical support from the IMF and other international organizations, to develop these indicative guidelines, with progress to be discussed by our Finance Ministers and Central Bank Governors in the first half of 2011” (http://www.g20.utoronto.ca/2010/g20seoul.pdf). That is, the problems remained undefined in search of “indicative guidelines” and the measurement continues. Economic policy lags identified by Friedman (1953) can be applied to the doctrine of shared responsibility (Pelaez and Pelaez, The Global Recession Risk (2007), 214): (1) the lag between the need for policy and the recognition of the need with technical work alerting about the imbalances since the late 1990s but recognition by policymakers only after 2005-2006; (2) the lag between the recognition of the need and the agreement by the G7 and currently by the G20, which is exemplified by the earlier effort and the current delay of considering indicative guidelines in late 2011; (3) the lag between agreeing coordination and taking action, which never occurred in the earlier effort and may have similar destiny in the current one; and (4) the lag between actual implementation of measures and their effects, which is subject to demarches by individual countries and free-rider problems as analyzed by Olson (1965), meaning that one country does not adjust in the hope that other will do its share in adjustment (the work of Olson is an important part of the theory of the state analyzed in Pelaez and Pelaez, Globalization and the State, Vol. II (2009a), 110-56). Much less is to be expected of a tighter group that probably emerges from these meetings: the G2, China and the US, with both members attempting for the other to take actions.
IV Quantitative Easing and the Global Devaluation War. An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart 2004, 88). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans.
The channel of transmission of large increases in base money, or currency held by the public and reserves deposited by banks at the Fed, depends on the assumption that money and other financial assets are not perfect substitutes. The framework of Tobin (1969) analyzes the determination of market-clearing rates of returns and volumes in the capital accounts of economic units, sectors and the economy as a whole. The model specifies the determinants of the demand and supply of these assets and how prices of assets and rates of return clear markets. Money is one of the assets and the commercial banking system one of many sectors. National wealth is the sum of private total wealth plus net government debt, obtained by summing the columns of assets in a balance sheet of the economy. Tobin’s q variable is the ratio of the market value of capital to the reproduction cost of capital. The concept of capital extends to houses, plants, equipment, durable goods and others (Tobin 1969, 29). Money, M, in Tobin’s complete model of money, physical capital, securities and banks is “high-powered money,” consisting of currency held by the public and reserves of commercial banks at the Fed. Tobin derives the sensitivity of q to M as ∂q/∂M > 0, that is, an increase in base money, M, causes an increase in q, which is the price of the market value of capital relative to its reproduction cost. Current production and asset accumulation increase (see also Pelaez and Suzigan 1978, 120-3). According to Tobin (1969, 25-6): “the essential characteristic is that the interest on money is exogenously fixed by law or convention, while the rate of return on securities is endogenous, market determined. If the roles of the two assets in this respect were reversed, so also would be the economic impacts of changing their supplies. The way for the central bank to achieve an expansionary monetary impact would be to buy money with securities!” The effect of an increase in the supply of an asset with non-fixed rate is a change in its own rate of return. When the rate of return is determined exogenously, as in the case of outside money, the adjustment is by changes in the rates of return of other assets or equivalently their prices. Large scale purchases of securities, or quantitative easing, inject high-powered money or bank reserves in exchange for withdrawal of the supply of duration-rich bonds, reducing their rates of return or increasing their prices. The intended effect is to lower the reproduction cost of capital, or long-term borrowing costs, such that Tobin’s q or its expectation increases, augmenting the demand for physical assets such as plant, equipment, houses, durables goods and the like.
Brunner and Meltzer (1973, 51) point to a deficiency of earlier research: “when inflation occurs, asset owners shift from money to bonds and real capital; these assets are perfect substitutes, so bond prices adjust costlessly and instantaneously to changes in the rate of inflation.” The key change in assumptions is that “the movements of interest rates and asset prices can diverge, and asset owners can choose to hold money or bonds or real capital” (Ibid, 52). In this model “the market value of wealth consists of money, bonds and capital at current prices” (Ibid, 53).
An optimizing model from microeconomic foundations is developed by Andrés et al. (2004) with the assumption of imperfect substitution between different classes of securities. The estimates of this model using quarterly data for the US from 1980 to 1999 “confirm that some of the observed deviations of long-term rates from the expectations theory of the term structure can be traced to movements in the relative stocks of financial assets, just as claimed by Tobin (1969)” (Andrés et al, 688). The traditional channel of transmission of monetary policy is by influencing long-term interest rates with changes in the expected path of short-term rates. The “unconventional” or “quantitative easing” channel of monetary policy is processed by increases in base money that alter relative prices of financial securities, thus reducing long-term yields and increasing aggregate demand.
Dwelling into the simplest possible equation, the demand for a financial asset, Ai, with the subscript i denoting 1 to m financial assets, can be expressed in terms of its own rate of return, ri, a vector r of m-1 rates of alternative financial assets, and a vector x of other relevant variables, or Ai = f(ri, r, x). Large increases in base money alter relative rates of return of multiple assets, triggering rebalancing of asset portfolios. These large increases in base money are accompanied by fed funds rates of 0 to ¼ percent, which is effectively a near zero short-term interest rate. The problem with quantitative easing is that the zero interest rate creates arbitrage opportunity to fund portfolios at low interest rates in the US and take long positions in high risk financial assets such as commodities, emerging market stocks, currencies and anything that is traded in relatively liquid markets. Consider the short-term rate of 4.75 percent in Australia. The traditional carry trade (Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4) consisted of borrowing in the low-yielding currency, the US dollar, selling the US dollar against the Australian dollar, and investing the proceeds at 4.75 percent. An investor with risk aversion would buy the US dollar forward to hedge depreciation of the Australian dollar. The high risk of this strategy is found in the critical assumption in the overshooting model of Dornbusch (1976) that foreign exchange rates move more rapidly than prices of goods and services. If the carry trade were fixed for 30 days, the investor would only obtain (30/360)4.75 or 0.396 percent, which is a huge gain relative to the cost of 0.5 percent per year of borrowing in the US for a month of 0.66 percent (using the annualized money market yield as proxy) or (30/360)0.66 equal to 0.055 percent in 30 days. Assuming no change in the US dollar/Australian exchange rate, the gain would be: (360/30)(0.396-0.055) equal to earning 0.34 percent in a month or 4.092 percent per year. Table 6 below shows that exchange rates have changed sharply such that the risk of principal loss is quite high. Investors discovered far more rewarding arbitrage by the carry trade to commodities, emerging market stocks and debt securities, junk bonds and currencies. Investment in physical capital for production has been inhibited by legislative restructurings and regulation together with uncertainty about future taxes and interest rates.
Economic agents interpreted the monetary stimulus and housing subsidies to be permanent, creating the expectation that the Fed had issued an illusory put option or floor on wealth. The result of the first round of near-zero interest rates and housing subsidies was to distort the calculation of risks and returns by households, business and government. The belief in a floor on wealth induced high leverage, excessive risk, minimum liquidity because of its high opportunity cost or foregone yield and unsound credit decisions that caused the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4).
The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 5. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-7, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2008 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.
| DJIA | 10/08/02- 10/01/07 | 10/01/07- 3/4/09 | 3/4/09- 4/6/10 | |
| ∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
| ∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
| ∆% | 442.2 | -70.8 | 85.3 | |
| Nikkei Average | 5/01/03- 2/23/07 | 2/23/07- 3/06/09 | 3/06/09- 4/01/10 | |
| ∆% | 131.3 | -60.6 | 56.8 | |
| STOXX Europe 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
| ∆% | 93.5 | -57.9 | -64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
| ∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
| ∆% | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 7/14/08 | 6/07/10 | 8/13/10 | |
| Rate | 1.59 | 1.192 | 1.323 | |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000s | 169 | 247 | 217 | 203 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):
“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the US deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market”
Fed policy is seeking, deliberately or as a side effect, what Irving Fisher proposed “that great depressions are curable and preventable through reflation and stabilization” (Fisher 1933, 350). The Fed has created not only high volatility of assets but also what many countries are regarding as a competitive devaluation similar to those criticized by Nurkse (1944). There is increasing unrest within the G20 and worldwide about the appreciation of exchange rates of most countries while the dollar devalues, as shown in Table 6.
Table 6, Exchange Rates
| Peak | Trough | ∆% P/T | Nov 12 2010 | ∆% T Nov 12 | ∆% P Nov 12 | |
| EUR USD | 7/15 2008 | 6/07 2010 | 11/5 2010 | |||
| Rate | 1.59 | 1.192 | 1.369 | |||
| ∆% | -33.4 | 15.0 | -13.3 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 11/5 2010 | |||
| Rate | 110.9 | 83.07 | 82.51 | |||
| ∆% | 24.6 | 0.7 | 25.1 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 11/5 2010 | |||
| Rate | 1.225 | 1.025 | 0.977 | |||
| ∆% | 16.3 | 4.7 | 20.2 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 11/5 2010 | |||
| Rate | 2.006 | 1.388 | 1.611 | |||
| ∆% | -44.5 | 13.8 | -24.5 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 11/5 2010 | |||
| Rate | 0.979 | 0.601 | 0.984 | |||
| ∆% | -62.9 | 42.3 | 6.1 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 11/5 2010 | |||
| Rate | 11.578 | 7.238 | 6.964 | |||
| ∆% | 37.5 | 3.8 | 42.2 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 11/5 2010 | |||
| Rate | 1.553 | 1.348 | 1.297 | |||
| ∆% | 13.2 | 3.8 | 16.5 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 10/29 2010 | |||
| Rate | 7.813 | 7.752 | 7.751 | |||
| ∆% | 0.8 | 0.01 | 0.8 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 10/29 2010 | |||
| Rate | 2.43 | 1.737 | 1.719 | |||
| ∆% | 28.5 | 1.0 | 29.3 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 11/5 2010 | |||
| Rate | 22.19 | 18.693 | 17.961 | |||
| ∆% | 15.7 | 3.9 | 19.1 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 11/5 2010 | |||
| Rate | 9.313 | 7.108 | 6.862 | |||
| ∆% | 23.7 | 3.5 | 26.3 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
V Economic Indicators. The Bureau of Economic Analysis (BEA) estimates that the deficit of trade of goods and services of the US fell slightly to $44.0 billion in Sep from $46.5 billion in Aug. The goods and services deficit increased $8.8 billion from Sep 2009 to Sep 2010, with exporting increasing by $19.9 billion, or 14.8 percent, and imports increasing by $28.8 billion, or 17.0 percent (http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm). Initial jobless claims in the US fell by 24,000 to 435,000 in the week ending on Nov 6 relative to the revised 459,000 in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm). The National Association of Realtors survey finds that median house prices rose in 77 out of 155 metropolitan statistical areas in the third quarter of 2010 relative to the third quarter of 2009 while falling in 76 metropolitan statistical areas (http://www.realtor.org/press_room/news_releases/2010/11/metro_hold).
VI Interest Rates. Although quantitative easing is designed to decrease long-term interest rates, the yield of the 10-year Treasury rose to 2.79 percent on Nov 12, higher than 2.54 percent a week earlier and 2.50 percent a month before. There may be a combination of fear of rising yields in the future together with the market folklore of “buy on the rumor, sell on the news.” The 10-year government bond of Germany traded at 2.53 percent for a negative spread of 25 basis points relative to the comparable Treasury. The 10-year government bond of Greece traded at 11.49 percent and the 10-year government bond of Portugal at 6.84 percent (http://markets.ft.com/markets/bonds.asp?ftauth=1289753245068). The US government bond with coupon of 2.63 and maturity in 11/20 traded at a price of 98.61 or equivalent yield of 2.79 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-121110). The same bond would settle at yield of 2.50 percent on Nov 15 for price of 101.0551. That is, the yield of 2.50 percent a month ago results in a principal loss of 2.4 percent relative to the yield of 2.79 on Nov 12. If the yield were to back up to 3.986 traded on Apr 5, 2010, the price for settlement on Nov 15 would be 88.8318 for a loss of principal relative to the yield of 2.79 percent on Nov 12 of 9.9 percent. If the yield were to back up to 5.297 percent traded on Jun 12, 2007, as shown in Table 5, the price would be 79.4364, for a principal loss relative to 2.79 percent of 19.4 percent. Quantitative easing creates a duration trap of monetary policy with heavy bond market losses in increasing yields on high-duration securities from artificially low yield levels.
VII Conclusion. Financial turbulence returned during the week because of combined uncertainties of doubts about continuing growth in China, renewed difficulties of sovereign risks in Europe and the incomplete recovery and policy challenges in the US. The G20 moved forward for one year consideration of global imbalances. Quantitative easing is devaluing the dollar with sharp criticism and reactions of G20 leaders complaining of global exchange war. The risks and benefits of quantitative easing should be evaluated more carefully (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
References
Andrés, Javier, J. David López-Salido and Edward Nelson. 2004. Tobin’s imperfect asset substitution in optimizing equilibrium. Journal of Money, Credit and Banking 36 (4, Aug): 665-90.
Bernanke, Ben S. and Vincent Reinhart. 2004. Conducting monetary policy at very low short-term interest rates. American Economic Review 94 (2, May): 85-90.
Brunner, Karl and Allan H. Meltzer. 1973. Mr. Hicks and the “monetarists.” Economica 40 (157, Feb): 44-59.
Dornbusch, Rudiger. 1976. Expectations and exchange rate dynamics. Journal of Political Economy 84 (6, Dec): 1161-76.
Fisher, Irving. 1933. The debt-deflation theory of great depressions. Econometrica 1 (4, Oct): 337-57.
Friedman, Milton. 1953. The effects of a full-employment policy on external stability: a formal analysis. In Essays on positive economics. Chicago: University of Chicago Press.
Obstfeld, Maurice and Kenneth S. Rogoff. 1996. Foundations of international macroeconomics. Cambridge, MA: MIT Press.
Olson, Mancur. 1965. The logic of collective action. Cambridge, MA: Harvard University Press.
Nurkse, Ragnar. 1944. International currency experience: lessons of the interwar experience. Geneva: League of Nations.
Pelaez, Carlos M. and Carlos A. Pelaez. 2005. International Financial Architecture. Basingstoke: Palgrave Macmillan. http://us.macmillan.com/QuickSearchResults.aspx?search=pelaez%2C+carlos&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.x=26&ctl00%24ctl00%24cphContent%24ucAdvSearch%24imgGo.y=14 http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2007. The Global Recession Risk. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008a. Globalization and the State: Vol. I. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2008b. Globalization and the State: Vol. II. Basingstoke: Palgrave Macmillan.
Pelaez, Carlos M. and Carlos A. Pelaez. 2008c. Government Intervention in Globalization. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009a. Financial Regulation after the Global Recession. Basingstoke: Palgrave Macmillan. http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos M. and Carlos A. Pelaez. 2009b. Regulation of Banks and Finance. Basingstoke: Palgrave Macmillan.http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10
Pelaez, Carlos Manuel and Wilson Suzigan. 1978. Economia Monetária. São Paulo, Atlas.
Tobin, James. 1969. A general equilibrium approach to monetary theory. Journal of Money Credit and Banking 1(1, Feb): 15-29.
©Carlos M. Pelaez, 2010
