CMP Associates Regulation Blog: March 2012

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Sunday, March 25, 2012

Global Financial and Economic Risk, Carry Trades, and Decline of United States New House Sales by 46 percent since 1963 while Population Increased 72 Percent

Global Financial and Economic Risk, Carry Trades, and Decline of United States New House Sales by 46 percent since 1963 while Population Increased 72 Percent

Carlos M. Pelaez

Executive Summary

I United States New House Sales

II United States House Prices

III World Financial Turbulence

IIIA Financial Risks

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

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

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

Appendix I The Great Inflation

Executive Summary

ESI Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/update/01/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider global economic and financial risks, which are analyzed in the comments of this blog.

Economic risks include the following:

1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. Lu Hui, writing on “China lowers GDP target to achieve quality economic growth, on Mar 12, 2012, published in Beijing by Xinhuanet (http://news.xinhuanet.com/english/china/2012-03/12/c_131461668.htm), informs that Premier Jiabao wrote in a government work report that the GDP growth target will be lowered to 7.5 percent to enhance the quality and level of development of China over the long term. There is also ongoing political development in China during a decennial political reorganization

2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. (i) The US economy grew at 1.6 percent in 2011 (http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening.html). (ii) The labor market continues fractured with 30.5 million unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or.html ). There are over 10 million fewer full-time jobs and hiring has collapsed (section I in this blog comment and earlier at http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html). (iii) There is a difficult climb from the record deficit of 9.9 percent in 2009 and cumulative deficit of $5.082 trillion in four consecutive years of deficits exceeding one trillion dollars from 2009 to 2012 (http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html). There is no subsequent jump of debt in US peacetime history as the one from 40.5 percent of GDP in 2008 to 62.8 percent of GDP in 2011 and projected by the Congressional Budget Office (CBO 2012JanBEO) at 67.7 percent in 2012. The CBO (2012JanBEO) must use current law without any changes in the baseline scenario but also calculates another alternative scenario with different assumptions. In the alternative scenario, the debt/GDP ratio rises to 94.2 percent by 2022. The US is facing an unsustainable debt/GDP path. Feldstein (2012Mar19) finds that the most troubling uncertainty in the US is the programmed tax increases projected by the CBO (2012JanBEO) under current law with federal government revenue increasing from $2.4 trillion in fiscal year 2012 to $2.9 trillion in fiscal year 2013. The increase of $512 billion of federal revenue would be about 2.9 percent of GDP, raising the share of federal revenue in GDP from 15.8 percent in fiscal year 2012 to 18.7 percent of GDP in fiscal year 2013. In the analysis of Feldstein (2012Mar19), increasing revenue would originate in higher personal tax rates, payroll tax contributions and taxes on dividends, capital gains and corporate income tax. The share of federal revenue in GDP would increase to 19.8 percent in 2014, remaining above 20 percent during the rest of the decade. Feldstein (2012Mar19) finds that such a shock of sustained tax increases would risk another recession in 2013, requiring preventive legislation to smooth tax increases

3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. Japan’s GDP fell 0.6 percent in IVQ2011 relative to a year earlier. The euro zone’s GDP fell 0.3 percent in IVQ2011; Germany’s GDP fell 0.2 percent in IVQ2011; and the UK’s GDP fell 0.2 percent in IVQ2011. There is still high unemployment in advanced economies

4. World Inflation Waves. Inflation continues in repetitive waves globally (see Section I Inflation Waves at http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html)

A list of financial uncertainties includes:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk. Adjustment programs consist of immediate adoption of economic reforms that would increase future growth permitting fiscal consolidation that would reduce risk spreads on sovereign debt. Fiscal consolidation is challenging in an environment of weak economic growth as analyzed by Blanchard (2011WEOSep). Adjustment of countries such as Italy requires depreciation of the currency to parity, as proposed by Caballero and Giavazzi (2012Jan15), but it is not workable within the common currency and zero interest rates in the US. Bailouts of euro area member countries with temporary liquidity challenges cannot be permanently provided by the fiscally-stronger members at risk of impairing their own sovereign debt credibility

2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation. After deep global recession, regulation, trade and devaluation wars were to be expected (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 181): “There are significant grounds for concern on the basis of this experience. International economic cooperation and the international financial framework can collapse during extreme events. It is unlikely that there will be a repetition of the disaster of the Great Depression. However, a milder contraction can trigger regulatory, trade and exchange wars”

3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes. For example, the DJIA has increased 35.0 percent from the trough of the sovereign debt crisis in Europe on Jul 2, 2010 to Mar 23, 2012, and the S&P 500 has gained 36.6 percent. It is challenging in theory and practice to assess when variables have peaked but sustained valuations to very high levels could be followed by contractions of valuations

4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1

6. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy. The Federal Open Market Committee (FOMC) advised on its Mar 13, 2012 statement that: “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 expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014” (http://www.federalreserve.gov/newsevents/press/monetary/20120313a.htm). At its meeting on Jan 25, the FOMC began to provide to the public the specific forecasts of interest rates and other economic variables by FOMC members (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). These forecasts are analyzed in Section IV Global Inflation. Thomas J. Sargent and William L. Silber, writing on “The challenges of the Fed’s bid for transparency,” on Mar 20, published in the Financial Times (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

), analyze the costs and benefits of transparency by the Fed. In the analysis of Sargent and Silber (2012Mar20), benefits of transparency by the Fed will exceed costs if the Fed is successful in conveying to the public what policies would be implemented and how forcibly in the presence of unforeseen economic events. History has been unkind to policy commitments. The risk in this case is if the Fed would postpone adjustment because of political pressures as has occurred in the past or because of errors of evaluation and forecasting of economic and financial conditions. Both political pressures and errors abounded in the unhappy stagflation of the 1970s also known as the US Great Inflation (see http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I The Great Inflation). The challenge of the Fed, in the view of Sargent and Silber 2012Mar20) is to convey to the public the need to deviate from the commitment to interest rates of zero to ¼ percent because conditions have changed instead of unwarranted inaction or policy changes. Errors have abounded such as a critical cause of the global recession pointed by Sargent and Silber (2012Mar20): “While no president is known to have explicitly pressurized Mr. Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fuelling the credit boom and housing bubble that led to the financial crisis in 2008.” Sargent and Silber (2012Mar20) also find need of commitment of fiscal authorities to consolidation needed to attain sustainable path of debt. More technical analysis is provided in Appendix A: Rules and Discretion.

5. Carry Trades. A simple example illustrates the carry trade while Appendix B: Carry Trade Profit Function provides some elementary algebra and concepts. Consider a strategy of investing USD 100 at 10 percent for 30 days in a foreign country with currency CUR by borrowing USD 100 at 0.5 percent for 30 days. At the initiation of the trade, the USD 100 are converted into CUR 100 at the rate of CUR 1/USD and invested at 10 percent per year, which for a month of 30 days and a year of 360 days is equivalent to 0.833 percent [(30/360)10]. At the end of the 30 days, assume that the rate still CUR 1/USD such that the return amount from the carry trade is USD 0.833. There is still interest on a loan to be paid to USD 0.042 [(0.005)(30/360)USD100]. The investor receives the net amount of USD 0.833 minus USD 0.042 or US 0.791. The rate of return on the investment of the USD 100 is 0.791 percent, which is equivalent to the annual rate of return of 9.49 percent {(0.791)(360/30)}. This is incomparably better than earning 0.5 percent. There are alternatives of hedging by buying forward the exchange for conversion back into USD.

Research by the Federal Reserve Bank of St. Louis finds that the dollar declined on average by 6.56 percent in the events of quantitative easing, ranging from depreciation of 10.8 percent relative to the Japanese yen to 3.6 percent relative to the pound sterling (http://research.stlouisfed.org/wp/2010/2010-018.pdf). A critical assumption of Rudiger Dornbusch (1976) in his celebrated analysis of overshooting (Rogoff 2002MF http://www.imf.org/external/np/speeches/2001/kr/112901.pdf) is “that exchange rates and asset markets adjust fast relative to goods markets” (Rudiger Dornbusch 1976, 1162). The market response of a monetary expansion is “to induce an immediate depreciation in the exchange rate and accounts therefore for fluctuations in the exchange rate and the terms of trade. During the adjustment process, rising prices may be accompanied by an appreciating exchange rate so that the trend behavior of exchange rates stands potentially in strong contrast with the cyclical behavior of exchange rates and prices” (Dornbusch 1976, 1162). The volatility of the exchange rate “is needed to temporarily equilibrate the system in response to monetary shocks, because underlying national prices adjust so slowly” (Rogoff 2002MF http://www.imf.org/external/np/speeches/2001/kr/112901.pdf 3). The exchange rate “is identified as a critical channel for the transmission of monetary policy to aggregate demand for domestic output” (Dornbusch 1976, 1162).

It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in the text after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion. Table ES-1, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 03/23/12,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values show positive change in valuation in column “∆% Trough to 03/23/12” after surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23. Asia and financial entities are experiencing their own risk environments. The highest valuations are by US equities indexes: DJIA 35.0 percent and S&P 500 36.6 percent, driven by stronger earnings and economy in the US than in other advanced economies. The DJIA reached in intraday trading 13,331.77 on Mar 16, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, all assets in the column “∆% Trough to 03/23/12” had double digit gains relative to the trough around Jul 2, 2010 but now only two valuation show increase of less than 10 percent: China’s Shanghai Composite is 1.4 percent below the trough; and STOXX 50 of Europe is 8.4 percent above the trough. DJ UBS Commodities is 16.2 percent above the trough; Dow Global is 17.5 percent above the trough; and DAX is 23.4 percent above the trough. Japan’s Nikkei Average is 13.5 percent above the trough on Aug 31, 2010 and 12.1 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 10,011.47 on Fri Mar 23, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 2.4 percent lower than 10,254.43 on Mar 11 on the date of the Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 11.3 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 03/23/12” in Table ES-1 shows declines of all valuations of risk financial assets in the week of Mar 23, 2012 because of the new issues of world economic and financial risks. There are still high uncertainties on European sovereign risks, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ES-1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 03/23/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Mar 23, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 03/23/12” but also relative to the peak in column “∆% Peak to 03/23/12.” There are now only three equity indexes above the peak in Table ES-1: DJIA 16.7 percent, S&P 500 14.8 percent and Dax 10.5 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 9.9 percent, Nikkei Average by 12.1 percent, Shanghai Composite by 25.8 percent, STOXX 50 by 8.2 percent and Dow Global by 4.1 percent. DJ UBS Commodities Index is now 0.7 percent below the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010.

Table ES-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 03/23 /12	∆% Week 03/23/ 12	∆% Trough to 03/23 12
DJIA	4/26/ 10	7/2/10	-13.6	16.7	-1.1	35.0
S&P 500	4/23/ 10	7/20/ 10	-16.0	14.8	-0.5	36.6
NYSE Finance	4/15/ 10	7/2/10	-20.3	-9.9	-0.7	13.1
Dow Global	4/15/ 10	7/2/10	-18.4	-4.1	-1.6	17.5
Asia Pacific	4/15/ 10	7/2/10	-12.5	-1.2	-1.2	12.9
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-12.1	-1.2	13.5
China Shang.	4/15/ 10	7/02 /10	-24.7	-25.8	-2.3	-1.4
STOXX 50	4/15/10	7/2/10	-15.3	-8.2	-2.4	8.4
DAX	4/26/ 10	5/25/ 10	-10.5	10.5	-2.3	23.4
Dollar Euro	11/25 2009	6/7 2010	21.2	12.3	-0.7	-11.3
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-0.7	-1.5	16.2
10-Year T Note	4/5/ 10	4/6/10	3.986	2.234

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

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

ESII Collapse of House Sales. Percentage changes and average rates of growth of new house sales for selected periods are shown in Table ES-2. The percentage change of new house sales from 1963 to 2011 is minus 45.7 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. 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 2004. 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). The relations of housing and interest rate policies to the financial crisis and global recession are provided in Appendix C: Origins of the Financial Crisis. Sales of new houses sold in 2011 fell 54.4 percent relative to the same period in 1995.

Table ES-2, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses

	∆%	Average Yearly % Rate
1963-2011	-45.7	NA
1991-2001	78.4	5.9
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2011	-54.4	NA
2000-2011	-65.3	NA
2005-2011	-76.3	NA

NA: Not Applicable

Source: http://www.census.gov/construction/nrs/

The depressed level of residential construction and new house sales in the US is evident in Table ES-3 providing new house sales not seasonally adjusted in Jan-Feb of various years. Sales of new houses in Jan-Feb 2012 are substantially lower than in any year between 1995 and 2010. There is only an increase of 9.3 percent between Jan-Feb 2011 and Jan-Feb 2012 that will likely disappear as the year proceeds. Sales of new houses in 2012 are lower by 7.8 percent in relation to 2010 and 11.3 percent below the level in 2009. The housing boom peaked in 2005 and 2006 when increases in fed funds rates 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-Feb 2012 relative to the same period in 2005 fell 76.6 percent and 73.4 percent relative to the same period in 2006. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Feb 2012 fell 50.0 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 (Hoobs and Snoops 2012, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table ES-3 reveals catastrophic data: sales of new houses in Jan-Feb 2012 of 43 thousand units are lower by 39.9 percent relative to 77 thousand units houses sold in Jan-Feb 1963, the first year when data become available, while population increased 72.2 percent.

Table ES-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan-Feb 2012	47
Jan-Feb 2011	43
∆%	9.3
Jan-Feb 2010	51
∆% Jan-Feb 2012/ Jan-Feb 2010	-7.8
Jan-Feb 2009	53
∆% Jan-Feb 2012/ Jan-Feb 2009	-11.3
Jan-Feb 2008	92
∆% Jan-Feb 2012/ Jan-Feb 2008	-49.0
Jan-Feb 2007	134
∆% Jan-Feb 2012/ Jan-Feb 2007	-64.9
Jan-Feb 2006	177
∆% Jan-Feb 2012/Jan-Feb 2006	-73.4
Jan-Feb 2005	201
∆% Jan 2012/Jan 2005	-76.6
Jan-Feb 2004	191
∆% Jan-Feb 2012/Jan-Feb 2004	-75.4
Jan-Feb 2003	158
∆% Jan-Feb 2012/ Jan-Feb 2003	-70.3
Jan-Feb 2002	150
∆% Jan-Feb 2012/ Jan-Feb 2001	-68.7
Jan-Feb 2001	157
∆% Jan 2012/ Jan 2001	-70.1
Jan-Dec 2000	145
∆% Jan-Feb 2012/ Jan-Feb 2000	-67.6
Jan-Feb 1995	94
∆% Jan-Feb 2012/ Jan-Feb 1995	-50.0
Jan-Feb 1963	77
∆% Jan-Feb 2012/ Jan 1963	-39.0

Source: http://www.census.gov/construction/nrs/

ESIII Housing Starts. Housing starts and permits in Jan-Feb not-seasonally adjusted are provided in Table ES-4. Housing starts increased 25.0 percent in Jan-Feb 2012 relative to Jan-Feb 2011 and in the same period new permits increased 34.3 percent. Construction of new houses in the US remains at very depressed levels. Housing starts fell 68.3 percent in Jan-Feb 2012 relative to Jan-Feb 2006 and fell 67.6 percent relative to Jan-Feb 2005. Housing permits fell 67.6 in Jan-Feb 2006 to Jan-Feb 2012 and fell 65.4 percent in Jan-Feb 2012 from Jan-Feb 2005.

Table ES-4, US, Housing Starts and New Permits, Thousands of Units, NSA, and %

	Housing Starts	New Permits
Jan-Feb 2012	94.6	98.6
Jan-Feb 2011	75.7	73.4
∆% Jan 2012/Jan 2011	25.0	34.3
Jan-Feb 2006	298.2	304.2
∆%/Jan-Feb 2012	-68.3	-67.6
Jan-Feb 2005	292.0	285.3
∆%/ Jan-Feb 2012	-67.6	-65.4

Source: http://www.census.gov/construction/nrc/pdf/newresconst.pdf

http://www.census.gov/construction/nrc/pdf/newresconst_200702.pdf

http://www.census.gov/construction/nrc/pdf/newresconst_200602.pdf

Appendix A: Rules and Discretion. The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983, 592, equation 1) is:

U_t = Uⁿ_t – α(π_t – π^e) α > 0 (1)

Where U_t is the rate of unemployment at current time t, Uⁿ_t is the natural rate of unemployment, π_t is the current rate of inflation and π^e is the expected rate of inflation by economic agents based on current information. Equation (1) expresses unemployment net of the natural rate of unemployment as a decreasing function of the gap between actual and expected rates of inflation. The system is completed by a social objective function, W, depending on inflation, π, and unemployment, U:

W = W(π_t, U_t) (2)

The policymaker maximizes the preferences of the public, (2), subject to the constraint of the tradeoff of inflation and unemployment, (1). The total differential of W set equal to zero provides an indifference map in the Cartesian plane with ordered pairs (π_t, U_t- Uⁿ) such that the consistent equilibrium is found at the tangency of an indifference curve and the Phillips curve in (1). The indifference curves are concave to the origin. The consistent policy is not optimal. Policymakers without discretionary powers following a rule of price stability would attain equilibrium with unemployment not higher than with the consistent policy. The optimal outcome is obtained by the rule of price stability, or zero inflation, and no more unemployment than under the consistent policy with nonzero inflation and the same unemployment. Taylor (1998LB) attributes the sustained boom of the US economy after the stagflation of the 1970s to following a monetary policy rule instead of discretion (see Taylor 1993, 1999).

Appendix B: Carry Trade Profit Function. Some analytical aspects of the carry trade are instructive (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 101-5, Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4), Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-4). Consider the following symbols: R_t is the exchange rate of a country receiving carry trade denoted in units of domestic currency per dollars at time t of initiation of the carry trade; R_t₊_τ is the exchange of the country receiving carry trade denoted in units of domestic currency per dollars at time t+τ when the carry trade is unwound; i_f is the domestic interest rate of the high-yielding country where investment will be made; i_usd is the interest rate on short-term dollar debt assumed to be 0.5 percent per year; i_f >i_usd, which expresses the fact that the interest rate on the foreign country is much higher than that in short-term USD (US dollars); S_t is the dollar value of the investment principal; and π is the dollar profit from the carry trade. The investment of the principal S_t in the local currency debt of the foreign country provides a profit of:

π = (1 + i_f)(R_tS_t)(1/R_t₊_τ) – (1 + i_usd)S_t (3)

The profit from the carry trade, π, is nonnegative when:

(1 + i_f)/(1 + i_usd) ≥ R_t₊_τ/R_t (4)

In words, the difference in interest rate differentials, left-hand side of inequality (4), must exceed the percentage devaluation of the currency of the host country of the carry trade, right hand side of inequality (4). The carry trade must earn enough in the host-country interest rate to compensate for depreciation of the host-country at the time of return to USD. A simple example explains the vulnerability of the carry trade in fixed-income. Let i_f be 0.10 (10 percent), i_usd 0.005 (0.5 percent), S_t USD100 and R_t CUR 1.00/USD. Adopt the fixed-income rule of months of 30 days and years of 360 days. Consider a strategy of investing USD 100 at 10 percent for 30 days with borrowing of USD 100 at 0.5 percent for 30 days. At time t, the USD 100 are converted into CUR 100 and invested at [(30/360)10] equal to 0.833 percent for thirty days. At the end of the 30 days, assume that the rate R_t₊₃₀ is still CUR 1/USD such that the return amount from the carry trade is USD 0.833. There is still a loan to be paid [(0.005)(30/360)USD100] equal to USD 0.042. The investor receives the net amount of USD 0.833 minus USD 0.042 or US 0.791. The rate of return on the investment of the USD 100 is 0.791 percent, which is equivalent to the annual rate of return of 9.49 percent {(0.791)(360/30)}. This is incomparably better than earning 0.5 percent. There are alternatives of hedging by buying forward the exchange for conversion back into USD.

Profits in carry trades have greater risks but equally greater returns when the short position in zero interest rates, or borrowing, and on the dollar, are matched with truly agile financial risk assets such as commodities and equities. A simplified analysis could consider the portfolio balance equations A_ij = f(r, x) where A_ij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, r_i, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of A_ij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals and measures by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. In fact, the central bank cannot influence investors and arbitrageurs to allocate funds to assets of desired categories such as asset-backed securities that would lower the costs of borrowing for mortgages and consumer loans. Floods of cheap money may simply induce carry trades in arbitrage of opportunities in fast moving assets such as currencies, commodities and equities instead of much lower returns in fixed income securities (see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html).

Appendix C: Origins the Financial Crisis. Weakness in the housing sector is being considered as an important factor of the financial crisis, global recession and slow growth recession. Chairman Bernanke (2011Oct4JEC, 2-3) states:

“Other sectors of the economy are also contributing to the slower-than-expected rate of expansion. The housing sector has been a significant driver of recovery from most recessions in the United States since World War II. This time, however, a number of factors--including the overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and the large number of “underwater” mortgages (on which homeowners owe more than their homes are worth)--have left the rate of new home construction at only about one-third of its average level in recent decades.”

The answer to these arguments 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.”

I United States New House Sales. Data and other information continue to provide depressed conditions in the US housing market. Table I-1 shows sales of new houses in the US at seasonally-adjusted annual equivalent rate (SAAR). House prices fell in eight of thirteen months from Jan 2011 to Feb 2012. Revisions show decline of house sales of 5.4 percent in Jan and provisional data decline of house sales of 1.6 percent in Feb. The annual equivalent rate in the first two months of 2012 is minus 34.9 percent. There was significant strength in Sep-Dec with annual equivalent rate of 55.1 percent. The annual equivalent rate in May-Aug was minus 22.5 percent and minus 13.1 percent in Jan-Apr.

Table I-1, US, Sales of New Houses at Seasonally-Adjusted (SA) Annual Equivalent Rate, Thousands and %

	SA Annual Rate Thousands	∆%
Feb 2012	313	-1.6
Jan	318	-5.4
AE ∆% Jan-Feb		-34.9
Dec 2011	336	4.3
Nov	322	3.5
Oct	311	3.0
Sep	302	4.1
AE ∆% Sep-Dec		55.1
Aug	290	-1.7
Jul	295	-2.6
Jun	303	-1.6
May	308	-2.5
AE ∆% May-Aug		-22.5
Apr	316	3.6
Mar	305	8.5
Feb	281	-9.4
Jan	310	-6.3
AE ∆% Jan-Apr		-13.1
Dec 2010	331	4.3

AE: Annual Equivalent

Source: http://www.census.gov/construction/nrs/

There is additional information of the report of new house sales in Table I-2. The stock of unsold houses stabilized in Apr-Aug at average 6.6 monthly equivalent sales at current sales rates and then dropped to 6.4 in Sep, 6.1 in Oct, 5.8 in Nov and 5.5 in Dec, increasing slightly to 5.7 in Jan and 5.8 in Feb. Median and average house prices oscillate. In Feb 2012, median prices of new houses sold not seasonally adjusted (NSA) increased 8.3 percent and average prices rose 2.2 percent. There are only five months with price increases in both median and average house prices: Feb with 8.3 percent in median prices and 2.2 percent in average prices, Dec with 2.0 percent in median prices and 4.9 percent in average prices, Oct with 3.6 percent in median prices and 1.1 percent in average prices and Apr with 1.9 percent in median prices and 3.1 percent in average prices. Median prices of new houses sold in the US fell in eight of the 13 months from Jan 2011 to Feb 2012 and average prices fell in nine months

Table I-2, US, New House Stocks and Median and Average New Homes Sales Price

	Unsold* Stocks in Equiv. Months of Sales SA %	Median New House Sales Price USD NSA	Month ∆%	Average New House Sales Price USD NSA	Month ∆%
Feb 2012	5.8	233,700	8.3	267,700	2.2
Jan 2012	5.7	215,700	–1.3	261,900	-0.1
Dec 2011	5.5	218,500	2.0	262,200	4.9
Nov	5.8	214,300	-4.7	250,000	-3.2
Oct	6.1	224,800	3.6	258,300	1.1
Sep	6.4	217,000	-1.2	255,400	-1.5
Aug	6.7	219,600	-4.5	259,300	-4.1
Jul	6.8	229,900	-4.3	270,300	-1.0
Jun	6.6	240,200	8.2	273,100	3.9
May	6.5	222,000	-1.2	262,700	-2.3
Apr	6.6	224,700	1.9	268,900	3.1
Mar	7.0	220,500	0.2	260,800	-0.8
Feb	7.8	220,100	-8.3	262,800	-4.7
Jan	7.2	240,100	-0.5	275,700	-5.5
Dec 2010	6.9	241,200	9.8	291,700	3.5

*Percent of new houses for sale relative to houses sold

Source: http://www.census.gov/construction/nrs/

The depressed level of residential construction and new house sales in the US is evident in Table I-3 providing new house sales not seasonally adjusted in Jan-Feb of various years. Sales of new houses in Jan-Feb 2012 are substantially lower than in any year between 1995 and 2010. There is only an increase of 9.3 percent between Jan-Feb 2011 and Jan-Feb 2012 that will likely disappear as the year proceeds. Sales of new houses in 2012 are lower by 7.8 percent in relation to 2010 and 11.3 percent below the level in 2009. The housing boom peaked in 2005 and 2006 when increases in fed funds rates 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-Feb 2012 relative to the same period in 2005 fell 76.6 percent and 73.4 percent relative to the same period in 2006. Similar percentage declines are also observed for 2012 relative to years from 2000 to 2004. Sales of new houses in Jan-Feb 2012 fell 50.0 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 (Hoobs and Snoops 2012, 16). Detailed historical census reports are available from the US Census Bureau at (http://www.census.gov/population/www/censusdata/hiscendata.html). The US population reached 308.7 million in 2010 (http://2010.census.gov/2010census/data/). The US population increased by 129.4 million from 1960 to 2010 or 72.2 percent. The final row of Table I-3 reveals catastrophic data: sales of new houses in Jan-Feb 2012 of 43 thousand units are lower by 39.9 percent relative to 77 thousand units houses sold in Jan-Feb 1963, the first year when data become available, while population increased 72.2 percent.

Table I-3, US, Sales of New Houses Not Seasonally Adjusted, Thousands and %

	Not Seasonally Adjusted Thousands
Jan-Feb 2012	47
Jan-Feb 2011	43
∆%	9.3
Jan-Feb 2010	51
∆% Jan-Feb 2012/ Jan-Feb 2010	-7.8
Jan-Feb 2009	53
∆% Jan-Feb 2012/ Jan-Feb 2009	-11.3
Jan-Feb 2008	92
∆% Jan-Feb 2012/ Jan-Feb 2008	-49.0
Jan-Feb 2007	134
∆% Jan-Feb 2012/ Jan-Feb 2007	-64.9
Jan-Feb 2006	177
∆% Jan-Feb 2012/Jan-Feb 2006	-73.4
Jan-Feb 2005	201
∆% Jan 2012/Jan 2005	-76.6
Jan-Feb 2004	191
∆% Jan-Feb 2012/Jan-Feb 2004	-75.4
Jan-Feb 2003	158
∆% Jan-Feb 2012/ Jan-Feb 2003	-70.3
Jan-Feb 2002	150
∆% Jan-Feb 2012/ Jan-Feb 2001	-68.7
Jan-Feb 2001	157
∆% Jan 2012/ Jan 2001	-70.1
Jan-Dec 2000	145
∆% Jan-Feb 2012/ Jan-Feb 2000	-67.6
Jan-Feb 1995	94
∆% Jan-Feb 2012/ Jan-Feb 1995	-50.0
Jan-Feb 1963	77
∆% Jan-Feb 2012/ Jan 1963	-39.0

Source: http://www.census.gov/construction/nrs/

Table I-4 provides the entire available annual series of new house sales from 1963 to 2011. The level of 304 thousand new houses sold in 2011 is the lowest since 560,000 in 1963 in the 48 years of available data. In that period, 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. In fact, there is no year from 1963 to 2010 in Table I-4 with sales of new houses below 400 thousand with the exception of the immediately preceding years of 2009 and 2010.

Table I-4, US, New Houses Sold, NSA Thousands

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	304

Source: http://www.census.gov/construction/nrs/

Chart I-1 of the US Bureau of the Census shows the sharp decline of sales of new houses in the US. Sales rose temporarily until about mid 2010 but then declined to a lower plateau.

Chart I-1, US, New One-Family Houses Sold in the US, SAAR (Seasonally-Adjusted Annual Rate)

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr051.html

Percentage changes and average rates of growth of new house sales for selected periods are shown in Table I-5. The percentage change of new house sales from 1963 to 2011 is minus 45.7 percent. Between 1991 and 2001, sales of new houses rose 78.4 percent at the average yearly rate of 5.9 percent. 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 2004. 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 2011 fell 54.4 percent relative to the same period in 1995.

Table I-5, US, Percentage Change and Average Yearly Rate of Growth of Sales of New One-Family Houses

	∆%	Average Yearly % Rate
1963-2011	-45.7	NA
1991-2001	78.4	5.9
1995-2005	92.4	6.8
2000-2005	46.3	7.9
1995-2011	-54.4	NA
2000-2011	-65.3	NA
2005-2011	-76.3	NA

NA: Not Applicable

Source: http://www.census.gov/construction/nrs/

The available historical data of median and average prices of new houses sold in the US between 1963 and 2010 is provided in Table I-6. On a yearly basis, median and average prices reached a peak in 2007 and then fell substantially.

Table I-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	$226,700	$267,500

Source: http://www.census.gov/construction/nrs/

Percentage changes of median and average prices of new houses sold in selected years are shown in Table I-7. Prices rose sharply between 2000 and 2005. In fact, prices in 2011 are higher than in 2000. Between 2006 and 2011, median prices of new houses sold fell 8.0 percent and average prices fell 12.6 percent. Between 2010 and 2011, median prices increased 2.2 percent and average prices fell 2.0 percent.

Table I-7, US, Percentage Change of New Houses Median and Average Prices, NSA, ∆%

	Median New Home Sales Prices ∆%	Average New Home Sales Prices ∆%
∆% 2000 to 2003	15.4	18.9
∆% 2000 to 2005	42.5	43.5
∆% 2000 to 2011	34.1	29.2
∆% 2005 to 2011	-5.9	-9.9
∆% 2000 to 2006	45.9	47.8
∆% 2006 to 2011	-8.0	-12.6
∆% 2009 to 2011	4.6	-1.3
∆% 2010 to 2011	2.2	-2.0

Source: http://www.census.gov/construction/nrs/

Seasonally-adjusted annual rates (SAAR) of housing starts and permits are shown in Table I-8. Housing starts decreased 1.1 percent in Feb after increasing 3.7 percent in Jan, falling 3.0 percent in Nov and jumping 11.8 percent in Nov. The increase of 15 percent in Sep was revised to 10.4 percent. Housing permits, indicating future activity, increased 5.1 percent in Feb after increasing 1.6 percent in Dec. Monthly rates in starts and permits fluctuate significantly as shown in Table I-8.

Table I-8, US, Housing Starts and Permits SSAR Month ∆%

	Housing Starts SAAR	Month ∆%	Housing Permits SAAR	Month ∆%
Feb 2012	698	-1.1	717	5.1
Jan	706	3.7	682	1.6
Dec 2011	681	-3.0	671	-1.3
Nov	702	11.8	680	5.6
Oct	628	-2.8	644	9.3
Sep	646	10.4	589	-5.8
Aug	585	-4.9	625	4.0
Jul	615	0.0	601	-2.6
Jun	615	11.2	617	1.3
May	553	0.7	609	8.2
Apr	549	-7.4	563	-1.9
Mar	593	14.5	574	7.5
Feb	518	-18.6	534	-6.0
Jan	636	20.9	568	-9.8
Dec 2010	526	-4.5	630	-9.8
Nov	551	2.3	564	1.6
Oct	539	-9.7	555	-1.2
Sep	597	-1.5	562	-2.3

SAAR: Seasonally Adjusted Annual Rate

Source: US Census Bureau

http://www.census.gov/construction/nrc/pdf/newresconst.pdf

Housing starts and permits in Jan-Feb not-seasonally adjusted are provided in Table I-9. Housing starts increased 25.0 percent in Jan-Feb 2012 relative to Jan-Feb 2011 and in the same period new permits increased 34.3 percent. Construction of new houses in the US remains at very depressed levels. Housing starts fell 68.3 percent in Jan-Feb 2012 relative to Jan-Feb 2006 and fell 67.6 percent relative to Jan-Feb 2005. Housing permits fell 67.6 in Jan-Feb 2006 to Jan-Feb 2012 and fell 65.4 percent in Jan-Feb 2012 from Jan-Feb 2005.

Table I-9, US, Housing Starts and New Permits, Thousands of Units, NSA, and %

	Housing Starts	New Permits
Jan-Feb 2012	94.6	98.6
Jan-Feb 2011	75.7	73.4
∆% Jan 2012/Jan 2011	25.0	34.3
Jan-Feb 2006	298.2	304.2
∆%/Jan-Feb 2012	-68.3	-67.6
Jan-Feb 2005	292.0	285.3
∆%/ Jan-Feb 2012	-67.6	-65.4

Source: http://www.census.gov/construction/nrc/pdf/newresconst.pdf

http://www.census.gov/construction/nrc/pdf/newresconst_200702.pdf

http://www.census.gov/construction/nrc/pdf/newresconst_200602.pdf

Chart I-2 of the US Census Bureau shows the sharp increase in construction of new houses from 2000 to 2006. Housing construction fell sharply through the recession, recovering from the trough around IIQ2009. The right-hand side of Chart I-2 shows a mild downward trend or stagnation from mid 2010 to the present in single-family houses with a recent mild upward trend in recent months in the category of two or more units.

Chart I-2, US, New Housing Units Started in the US, SAAR (Seasonally Adjusted Annual Rate)

Source: US Census Bureau

http://www.census.gov/briefrm/esbr/www/esbr020.html

A longer perspective on residential construction in the US is provided by Table I-10 with annual data from 1960 to 2011. Housing starts fell 70.5 percent from 2005 to 2011, 61.2 percent from 2000 to 2011 and 51.3 percent relative to 1960. Housing permits fell 71.7 percent from 2005 to 2011, 61.6 percent from 2000 to 2011 and 38.8 percent from 1960 to 2011. Housing starts rose 31.8 from 2000 to 2005 while housing permits grew 35.4 percent. From 1990 to 2000 housing starts increased 31.5 percent while permits increased 43.3 percent.

Table I-10, US, Annual New Privately Owned Housing Units Authorized by Building Permits in Permit-Issuing Places and New Privately Owned Housing Units Started, Thousands

	Starts	Permits
2011	609.2	610.7
∆% 2011/2010	3.8	1.0
∆% 2011/2005	-70.5	-71.7
∆% 2011/2000	-61.2	-61.6
∆% 2011/1960	-51.3	-38.8
2010	586.9	604.6
∆% 2010/2005	-71.6	-71.9
∆% 2010/2000	-62.6	-62.0
∆% 2010/1960	-53.1	-39.4
2009	554,0	583.0
2008	905.5	905.4
2007	1,355,0	1,398.4
2006	1,800.9	1,838.9
2005	2,068.3	2,155.3
∆% 2005/2000	31.8	35.4
2004	1,955.8	2,070.1
2003	1,847.7	1,889,2
2002	1,704.9	1,747.2
2001	1,602.7	1,1637.7
2000	1,568.7	1,592.3
∆% 2000/1990	31.5	43.3
1990	1,192,7	1,110.8
1980	1,292.7	1,190.6
1970	1,433.6	1,351.5
1960	1,252.2	997.6

Source: http://www.census.gov/construction/nrc/

II 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://www.fhfa.gov/webfiles/22558/2q2011HPI.pdf). Table II-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 and by close or higher than 70 percent for New England, Middle Atlantic and South Atlantic but only by 33.2 percent for East South Central. Prices fell relative to 2011 from all years since 2005. From IVQ2000 to IVQ2011, prices rose for the US and the four regions in Table II-1.

Table II-1, US, FHFA House Price Index Purchases Only NSA ∆%

	United States	New England	Middle Atlantic	South Atlantic	East South Central
4Q2000 to 4Q2003	24.6	40.7	35.9	25.8	11.1
4Q2000 to 4Q2005	50.3	65.2	67.9	62.4	25.5
4Q2000 to 4Q2006	55.0	62.3	72.6	70.6	33.2
4Q2005 t0 4Q2011	-16.3	-13.6	-7.3	-22.0	-1.6
4Q2006 to 4Q2011	-18.9	-12.1	-9.8	-25.8	-7.3
4Q2007 to 4Q2011	-16.9	-10.4	-10.2	-23.3	-9.1
4Q2009 to 4Q2011	-6.4	-3.6	-4.9	-8.3	-5.2
4Q2010 to 4Q2011	-2.4	-2.0	-3.4	-2.7	-0.7
4Q2000 to 4Q2011	25.8	42.7	55.6	26.6	23.5

Source: http://www.fhfa.gov/webfiles/23396/4Q2011hpi.pdf

Data of the FHFA HPI for the remaining US regions are provided in Table II-2. Behavior is not very different than in Table II-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 to 2011, there was still appreciation relative to 2000.

Table II-2, US, FHFA House Price Index Purchases Only NSA ∆%

	West South Central	West North Central	East North Central	Mountain	Pacific
4Q2000 to 4Q2003	11.2	18.4	14.8	18.9	44.2
4Q2000 to 4Q2005	23.8	31.2	24.0	57.6	106.9
4Q2000 to 4Q2006	31.7	34.1	23.9	68.8	107.8
4Q2005 t0 4Q2011	8.2	-6.9	-16.4	-26.2	-37.8
4Q2006 to 4Q2011	1.7	-8.9	-16.4	-31.1	-38.1
4Q2007 to 4Q2011	-1.7	-8.5	-13.5	-28.8	-31.5
4Q2009 to 4Q2011	-1.2	-4.7	-5.5	-10.9	-10.3
4Q2010 to 4Q2011	1.2	-1.2	-2.7	-3.5	-4.8
4Q2000 to 4Q2011	33.9	22.1	3.6	16.3	28.6

Source: http://www.fhfa.gov/webfiles/23396/4Q2011hpi.pdf

Chart II-1 of the Federal Housing Finance Agency shows the Housing Price Index four-quarter price change from IVQ2001 to IVQ2011. House prices appreciated sharply from 1998 to 2005 and then fell rapidly. Recovery began already after IVQ2008 but there was another decline after IIIQ2010. The rate of decline improved in the second half of 2011.

Chart II-1, US, Federal Housing Finance Agency House Price Index Four Quarter Price Change

Source: Federal Housing Finance Agency

http://www.fhfa.gov/default.aspx?Page=14

Monthly and 12month percentage changes of the FHFA House Price Index are provided in Table II-3. Percentage monthly increases of the FHFA index were positive from Apr to Jul while 12 months percentage changes improved steadily from more or equal to minus 6 percent in Mar to May to minus 4.3 percent in Jun. The FHFA house price index fell 0.9 percent in Oct and fell 3.5 percent in the 12 months ending in Oct. There was significant recovery in Nov with increase in the house price index of 0.7 percent and reduction of the 12-month rate of decline to 2.2 percent. The house price index rose 0.1 percent in Dec and the 12-month percentage change fell to minus 1.6 percent. There was further improvement with almost no change in Jan 2012 and decline of the 12-month percentage change to minus 0.7 percent.

Table II-3, US, FHFA House Price Index Purchases Only SA. Month and NSA 12-Month ∆%

	Month ∆% SA	12 Month ∆% NSA
Jan 2012	-0.04	-0.7
Dec 2011	0.1	-1.6
Nov	0.7	-2.2
Oct	-0.9	-3.5
Sep	0.3	-2.7
Aug	-0.3	-4.0
Jul	0.2	-3.8
Jun	0.6	-4.3
May	0.2	-6.0
Apr	0.3	-6.1
Mar	-0.3	-6.0
Feb	-1.5	-5.4
Jan	-0.9	-4.6
Dec 2010		-3.8
Dec 2009		-1.9
Dec 2008		-9.6
Dec 2007		-3.0
Dec 2006		2.5
Dec 2005		9.9
Dec 2004		10.1
Dec 2003		7.9
Dec 2002		7.8
Dec 2001		6.8
Dec 2000		7.1
Dec 1999		6.1
Dec 1998		5.9
Dec 1997		3.4
Dec 1996		2.8
Dec 1995		2.7
Dec 1994		2.6
Dec 1993		3.1
Dec 1992		2.4

Source: http://www.fhfa.gov/Default.aspx?Page=87

Weakness in the housing sector is being considered as an important factor of the financial crisis, global recession and slow growth recession. Chairman Bernanke (2011Oct4JEC, 2-3) states:

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

III World Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment; and (3) the outcome of the sovereign debt crisis in Europe. This section provides current data and analysis. Subsection IIIA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. There are various appendixes at the end of this section for convenience of reference of material related to the euro area debt crisis. 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. 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. Subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort considers the policies of the European Central Bank. Appendix IIIE Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IIIF Appendix on Sovereign Bond Valuation provides more technical analysis.

IIIA Financial Risks. The past half year has been characterized by financial turbulence, attaining unusual magnitude in recent months. Table III-1, updated with every comment in this blog, provides beginning values on Fr Mar 16 and daily values throughout the week ending on Fri Mar of several financial assets. Section VI Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Mar 16 and the percentage change in that prior week below the label of the financial risk asset. For example, the US dollar (USD) depreciated 0.7 percent to USD 1.3270/EUR in the week ending on Mar 23. 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. The most 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).

The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.3175/EUR in the first row, first column in the block for currencies in Table III-1 for Fri Mar 16, depreciating to USD 1.3244/EUR on Mon Mar 19, or by 0.5 percent. The dollar depreciated because more dollars, $1.3244, were required on Mar 19 to buy one euro than $1.3175 on Mar 16. 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 in Table III-1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3244/EUR on Mar 19; 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 Mar 16, to the last business day of the current week, in this case Fri Mar 23, such as depreciation by 0.7 percent to USD 1.3270/EUR by Mar 23; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD depreciated (denoted by negative sign) by 0.7 percent from the rate of USD 1.3175/EUR on Fri Mar 16 to the rate of USD 1.3270/EUR on Fri Mar 23 {[(1.3270/1.3175) – 1]100 = 0.7%} and depreciated (denoted by negative sign) by 0.6 percent from the rate of USD 1.3189 on Thus Mar 22 to USD 1.3279/EUR on Fri Mar 23 {[(1.3270/1.3189) -1]100 = 0.6%}. Other factors constant, appreciation of the dollar relative to the euro is caused by increasing risk aversion, with rising uncertainty on European sovereign risks increasing dollar-denominated assets with sales of risk financial investments. Funds move away from higher yielding risk financial assets to the safety of dollar investments. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets, depreciating the dollar.

Table III-I, Weekly Financial Risk Assets Mar 19 to Mar 23, 2012

Fri Mar 16, 2012

M 19

Tue 20

W 21

Thu 22

Fr 23

USD/EUR

1.3175

-0.4%

1.3244

-0.5%

1.3220

-0.3%

0.2%

1.3216

-0.3%

0.0%

1.3189

-0.1%

0.2%

1.3270

-0.7%

-0.6%

JPY/ USD

83.43

-1.2%

83.3485

0.1%

83.7298

-0.3%

-0.4%

83.3200

0.1%

0.5%

82.55

1.1%

0.9%

82.35

1.3%

0.2%

CHF/ USD

0.9157

0.4%

0.9107

0.5%

0.9122

0.4%

-0.2%

0.9122

0.4%

0.0%

0.9141

0.2%

-0.2%

0.9081

0.8%

0.7%

CHF/ EUR

1.2064

0.0%

1.2062

0.0%

1.2059

0.0%

1.2057

0.1%

0.0%

1.2056

0.1%

0.0%

1.2050

0.1%

0.0%

USD/ AUD

1.0591

0.9442

0.1%

1.0613

0.9422

0.2%

1.0481

0.9541

-1.0%

-1.3%

1.0458

0.9562

-1.3%

-0.2%

1.0392

0.9622

-1.9%

-0.6%

1.0463

0.9557

-1.2%

0.7%

10 Year T Note

2.294

2.37

2.36

2.29

2.28

2.234

2 Year T Note

0.36

0.38

0.40

0.37

0.36

0.35

German Bond

2Y 0.33 10Y 2.05

2Y 0.34 10Y 2.06

2Y 0.33 10Y 2.04

2Y 0.29 10Y 1.98

2Y 0.26 10Y 1.91

2Y 0.23 10Y 1.87

DJIA

13232.62

2.4%

13239.13

0.0%

13170.19

-0.5%

13124.62

-0.8%

-0.3%

13046.14

-1.4%

-0.6%

13080.73

-1.1%

0.3%

DJ Global

2033.09

2.7%

2038.36

0.3%

2023.92

-0.5%

-0.7%

2012.73

-1.0%

-0.6%

1999.77

-1.6%

-0.6%

2001.48

-1.6%

0.1%

DJ Asia Pacific

1307.74

0.6%

1307.55

0.0%

1298.71

-0.7%

1290.47

-1.3%

-0.6%

1296.30

-0.9%

0.5%

1291.97

-1.2%

-0.3%

Nikkei

10129.83

2.0%

10141.99

0.1%

10141.99

0.1%

10086.49

-0.4%

-0.5%

10127.08

0.0%

0.4%

10011.47

-1.2%

-1.1%

Shanghai

2404.74

-1.4%

2410.18

0.2%

2376.84

-1.2%

-1.4%

2378.19

-1.1%

0.1%

2375.77

-1.2%

-0.1%

2349.54

-2.3%

-1.1%

DAX

7157.82

4.0%

7154.22

-0.1%

7054.94

-1.4%

7071.32

-1.2%

0.2%

6981.26

-2.5%

-1.3%

6995.62

-2.3%

0.2%

DJ UBS

Comm.

146.23

0.6%

146.48

0.2%

144.33

-1.3%

-1.5%

144.36

-1.3%

0.0%

142.94

-1.0%

144.06

0.8%

WTI $ B

107.26

-0.3%

107.92

0.6%

106.24

-0.9%

-1.6%

106.90

-0.3%

0.6%

105.47

-1.7%

-1.3%

106.87

-0.4%

1.3%

Brent $/B

126.15

0.1%

125.38

-0.6%

123.20

-2.3%

-1.7%

124.00

-1.7%

0.7%

123.11

-2.4%

-0.7%

125.13

-0.8%

1.6%

Gold $/OZ

1651.1

-3.6%

1663.8

0.8%

1649.8

-0.1%

-0.8%

1649.6

-0.1%

0.0%

1643.2

-0.5%

-0.4%

1662.4

0.7%

1.2%

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

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

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

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

A key development in the bailout of Greece is the approval by the Executive Board of the International Monetary Fund (IMF) on Mar 15, 2012, of a new four-year financing in the value of €28 billion to be disbursed in equal quarterly disbursements (http://www.imf.org/external/np/tr/2012/tr031512.htm). The sovereign debt crisis of Europe has moderated significantly with the elimination of immediate default of Greece. New risk factors have developed:

1. There are ongoing political developments in China (see Brian Spegele, “Beijing tightens grip after purge,” published in the Wall Street Journal on Mar 21 (http://professional.wsj.com/article/SB10001424052702303812904577293394008888000.html?mod=WSJPRO_hps_MIDDLEFifthNews and the comprehensive analysis by David Pilling, “The threat to the post-Mao consensus,” Mar 21, published in the Financial Times (http://www.ft.com/intl/cms/s/0/3397c308-71c4-11e1-b853-00144feab49a.html#axzz1pmr0JVOH)) during a decennial reorganization of power and the movement toward a new model of growth at a lower rate of 7.5 percent per year on the basis of consumption instead of high rates of savings (http://news.xinhuanet.com/english/china/2012-03/12/c_131461668.htm)

2. The adjustment of fiscal affairs of Spain in a weakening economy accompanied by new increases in yields of sovereign bonds of Spain and Italy (see Victor Mallet, “Spain economy: gathering gloom,” Mar 22, published in the Financial Times (http://www.ft.com/intl/cms/s/0/d18c93c0-740f-11e1-bcec-00144feab49a.html#axzz1pexRlsiQ))

3. Weak flash estimates of China’s manufacturing by HSBC (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9312

) and of euro zone composite output by Markit (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9310)

The JPY reversed recent depreciation, appreciating 1.3 percent during the week of Mar 23. The Policy Board of the Bank of Japan decided three important measures of enhancing monetary easing at the meeting held on Feb 14, 2012 (Bank of Japan 2012EME, 2012PSG and 2012APP). First, the Bank of Japan (2012Feb14EME, 2012Feb14PSG) adopted a “price stability goal” for the “medium term” of 2 percent of the “year-on-year rate of change of the CPI” with the immediate goal of inflation of 1 percent. Japan’s CPI inflation in the 12 months ending in Dec was minus 0.2 percent. Second, the Bank of Japan (2012Feb14EME, 1-2) will conduct “virtually zero interest rate policy” by maintaining “the uncollateralized overnight call rate at around 0 to 0.1 percent.” Third, the Bank of Japan (20012Feb13EME, 2014Feb14APP) is increasing the size of its quantitative easing:

“The Bank increases the total size of the Asset Purchase Program by about 10 trillion yen, from about 55 trillion yen to about 65 trillion yen. The increase in the Program is earmarked for the purchase of Japanese government bonds. By fully implementing the Program including the additional expansion decided today, by the end of 2012, the amount outstanding of the Program will be increased by about 22 trillion yen from the current level of around 43 trillion yen.”

IIIB Appendix on Safe Haven Currencies analyzes the burden on the Japanese economy of yen appreciation. Policy rates close to zero by major central banks in the world together with quantitative easing tend to depreciate currencies. Monetary policy is an indirect form of currency intervention.

The Swiss franc appreciated 0.8 percent to USD 0.9081/USD relative to the dollar and was virtually flat relative to the euro, appreciating 0.1 percent to CHF 1.2050/EUR. The Australian dollar depreciated to USD 1.0463/AUD by Mar 23. The AUD is considered a carry trade commodity currency.

Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing aversion is captured by decrease of the yield of the ten-year Treasury note from 2.326 percent on Oct 28 to 1.964 percent on Fri Nov 25, 2.065 on Dec 9 and collapse to 1.847 percent by Fr Dec 16. The yield of the ten-year Treasury rose from 1.81 percent on Mon Dec 19 to 2.027 percent on Fri Dec 23, falling to 1.871 percent on Fri Dec 30 and increasing to 1.957 percent on Jan 6 but falling again to 1.869 on Jan 13. More relaxed risk aversion is shown in the increase of the yield of the ten-year Treasury to 2.026 percent on Fri Jan 20 but renewed aversion with decline to 1.893 percent on Jan 27 and 1.923 on Feb 3 but increase to 1.974 on Fri Feb 10 and 2.0 percent on Fri Feb 17. As shown in Table III-1, the ten-year Treasury yield fell marginally to 1.977 on Fri Feb 24 and remained at 1.977 percent on Mar 2, increasing to 2.031 percent on Mar 9 and jumping to 2.294 percent by Mar 16 but falling to 2.234 on Mar 23 during new factors of risk aversion. The ten-year Treasury yield is still at a level well below consumer price inflation of 2.9 percent in the 12 months ending in Feb (see section IB United States Inflation at http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with stable low yield of 0.226 percent on Dec 16 but rising to 0.28 percent on Dec 23 and then falling to 0.239 percent on Fri Dec 30, increasing to 0.256 on Fri Jan 6 but falling to 0.225 on Jan 13. The yield of the two-year Treasury rose to 0.242 percent on Fri Jan 20 in an environment of more relaxed risk aversion but fell to 0.215 on Fri Jan 27 in another shock of aversion, standing at 0.234 on Feb 3, 0.274 on Feb 10 and rising to 0.292 on Fri Feb 17. As shown in Table III-1, the two-year Treasury yield rose to 0.307 percent on Fri Feb 24, falling to 0.274 percent on Mar 2 but increasing to 0.316 percent on Mar 9 and 0.36 percent on Mar 16, falling marginally to 0.35 percent on Mar 23. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities. The latest statement of the Federal Open Market Committee (FOMC) on March 13, 2012 does not have sufficient changes suggesting that it contributed to the rise in Treasury yields. The statement continues to consider inflation low, unemployment high and growth at a moderate pace. Because of the “slack” in the economy, the FOMC maintained the zero interest rate policy until 2014 (http://www.federalreserve.gov/newsevents/press/monetary/20120313a.htm):

“In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

A similar risk aversion phenomenon occurred in Germany. Eurostat confirmed euro zone CPI inflation is at 2.7 percent for the 12 months ending in Feb 2012 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-14032012-BP/EN/2-14032012-BP-EN.PDF) but the yield of the two-year German government bond fell from 0.32 percent on Dec 9 to 0.22 percent on Dec 16, virtually equal to the yield of the two-year Treasury note of the US and settled at 0.23 percent on Fri Dec 23, collapsing to 0.14 percent on Fri Dec 30 and rising to 0.17 percent on Jan 6 and 0.15 percent on Jan 13. The yield of the two-year government bond of Germany increased to 0.21 percent in an environment of marginally more relaxed risk aversion on Jan 20 but fell to 0.19 percent on Jan 27 and 0.20 percent on Feb 3, increasing to 0.24 on Feb 10 and 0.24 percent on Fri Feb 17. As shown in Table III-1, the yield of the two-year German government bond fell from 0.33 percent on Mar 16 to 0.23 percent on Mar 23 because of the new factors of risk aversion. The yield of the ten-year German government bond has also collapsed from 2.15 percent on Dec 9 to 1.85 percent on Dec 16, rising to 1.96 percent on Dec 23, falling to 1.83 percent on Dec 30, which was virtually equal to the yield of 1.871 percent of the US ten-year Treasury note. The ten-year government bond of Germany traded at 1.85 percent on Jan 6 and at 1.77 percent on Jan 13, increasing to 1.93 percent on Jan 20 but falling to 1.86 percent on Jan 27 and rising to 1.93 percent on Feb 10. As shown in Table III-1, the yield of the ten-year government bond of Germany settled at 1.92 percent on Fri Feb 17 and remained almost unchanged at 1.88 percent on Fri Feb 24, falling to 1.80 on Fri Mar 2, remaining almost unchanged at 1.79 percent on Fri Mar 9, rising to 2.05 percent on Mar 16 but falling during risk aversion to 1.87 percent on Mar 23. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence has also affected the market for German sovereign bonds.

Equity indexes in Table III-1 fell during the week of Mar 23 because of the new factors of risk aversion. Germany’s Dax fell 2.3 percent. DJIA lost 1.1 percent in the week of Mar 23 and Dow Global declined 2.6 percent. Japan’s Nikkei Average interrupted recent increased 1.2 percent in the week of Feb 17 and an additional 2.8 percent in the week of Feb 24 because of measures of enhancing monetary easing by the Bank of Japan and expectations of further intervention to weaken the JPY. The Nikkei Average gained 1.3 percent in the week of Mar 2, another 1.6 percent in the week of Mar 9 and 2.0 percent in the week of Mar 16. The surge of the Nikkei Average was interrupted with a drop of 1.2 percent in the week of Mar 23. Dow Asia Pacific decreased 1.2 percent in the week of Mar 16. Shanghai’s composited dropped 2.3 percent.

Commodities were mixed during the week of Mar 23. The DJ UBS Commodities Index gained 0.8 percent. WTI lost 0.4 percent and Brent declined 0.8 percent. Gold increased 0.7 percent.

Risk aversion during the week of Mar 2, 2012, was dominated by the long-term refinancing operations (LTRO) of the European Central Bank. LTROs and related principles are analyzed in subsection IIID Appendix on European Central Bank Large Scale Lender of Last Resort. First, as analyzed by David Enrich, writing on “ECB allots €529.5 billion in long-term refinancing operations,” published on Feb 29, 2012 by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203986604577252803223310964.html?mod=WSJ_hp_LEFTWhatsNewsCollection), the ECB provided a second round of three-year loans at 1.0 percent to about 800 banks. The earlier round provided €489 billion to more than 500 banks. Second, the ECB sets the fixed-rate for main refinancing operations at 1.00 percent and the overnight deposit facility at 0.25 percent (http://www.ecb.int/home/html/index.en.html) for negative spread of 75 basis points. That is, if a bank borrows at 1.0 percent for three years through the LTRO and deposits overnight at the ECB, it incurs negative spread of 75 basis points. An alternative allocation could be to lend for a positive spread to other banks. Richard Milne, writing on “Banks deposit record cash with ECB,” on Mar 2, 2012, published in the Financial Times (http://www.ft.com/intl/cms/s/0/9798fd36-644a-11e1-b30e-00144feabdc0.html#axzz1nxeicB6H), provides important information and analysis that banks deposited a record €776.9 billion at the ECB on Fri Mar 2 at interest receipt of 0.25 percent, just two days after receiving €529.5 billion of LTRO loans at interest cost of 1.0 percent. The main issue here is whether there is ongoing perceptions of high risks in counterparties in financial transactions that froze credit markets in 2008 (see Pelaez and Pelaez, Regulation of Banks and Finance (2009a), 57-60, 217-27, Financial Regulation after the Global Recession (2009b), 155-67).

Table III-1A provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,149,485 million on Mar 16, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,779,931 million in the statement of Mar 16.

Table III-1A, Consolidated Financial Statement of the Eurosystem, Million EUR

	Dec 31, 2010	Dec 28, 2011	Mar 16, 2012
1 Gold and other Receivables	367,402	419,822	423,449
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	246,561
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	71,354
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,018
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,149,485
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	55,269
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	630,446
8 General Government Debt Denominated in Euro	34,954	33,928	31,176
9 Other Assets	278,719	336,574	360,536
TOTAL ASSETS	2,004, 432	2,733,235	2,986,294
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,779,931
Capital and Reserves	78,143	81,481	83,000

Source: European Central Bank

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

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

http://www.ecb.int/press/pr/wfs/2012/html/fs120320.en.html

IIIB Appendix on Safe Haven Currencies. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation but also remained relatively unchanged. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.

1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent. The pain of Japan from dollar devaluation continues as illustrated by Table VI-6 in Section VII Valuation of Risk Financial Assets: The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 78.08/USD on Dec 23, 2011, for cumulative appreciation of 29.1 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Dec 23, 2011 (JPY 78.08) was 6.0 percent.

2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.

There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. The JPY was virtually unchanged in the week of Dec 16 with depreciation of 0.1 percent but depreciated by 0.5 percent in the week of Dec 23, appreciating by 1.5 percent in the week of Dec 30. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:

· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.

· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”

Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc remained unchanged relative to the USD in the week of Dec 23 and appreciated 0.2 percent in the week of Dec 30 relative to the USD and 0.5 percent relative to the euro, as shown in Table II-1. Risk aversion is evident in the depreciation of the Australian dollar by cumulative 2.5 percent in the week of Fr Dec 16 after no change in the week of Dec 9. In the week of Dec 23, the Australian dollar appreciated 1.9 percent, appreciating another 0.5 percent in the week of Dec 30 as shown in Table II-1. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).

IIIC Appendix on Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.

1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.

i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with adjustment of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.

ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.

2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.

i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.

ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in Mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Matthew Dalton and Matina Stevis, writing on Dec 20, 2011, on “Euro Zone Agrees to New IMF Loans,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204791104577107974167166272.html?mod=WSJPRO_hps_MIDDLESecondNews), inform that at a meeting on Dec 20, finance ministers of the euro-zone developed plans to contribute €150 billion in bilateral loans to the IMF as provided in the agreement of Dec 9. Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).

3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.

IIID Appendix on European Central Bank Large Scale Lender of Last Resort. European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”

An important statement of Draghi (2011Dec15) focuses on the role of central banking: “You all know that the statutes of the ECB inherited this important principle and that central bank independence and the credible pursuit of price stability go hand in hand.”

Draghi (2011Dec19) explains measures to ensure “access to funding markets” by euro zone banks:

§ “We have decided on three-year refinancing operations to support the supply of credit to the euro area economy. These measures address the risk that persistent financial markets tensions could affect the capacity of euro area banks to obtain refinancing over longer horizons.

§ Earlier, in October, the Governing Council had already decided to have two more refinancing operations with a maturity of around one year.

§ Also, it was announced then that in all refinancing operations until at least the first half of 2012 all liquidity demand by banks would be fully allotted at fixed rate.

§ Funding via the covered bonds market was also facilitated by the ECB deciding in October to introduce a new Covered Bond Purchase Programme of €40 billion.

§ Funding in US dollar is facilitated by lowering the pricing on the temporary US dollar liquidity swap arrangements.”

Lionel Barber and Ralph Atkins interviewed Mario Draghi on Dec 14 with the transcript published in the Financial Times on Dec 18 (http://www.ft.com/intl/cms/s/0/25d553ec-2972-11e1-a066-00144feabdc0.html#axzz1gzoHXOj6) as “FT interview transcript: Mario Draghi.” A critical question in the interview is if the new measures are a European version of quantitative easing. Draghi analyzes the difference between the measures of the European Central Bank (ECB) and quantitative easing such as in Japan, US and UK:

1. The measures are termed “non-standard” instead of “unconventional.” While quantitative easing attempts to lower the yield of targeted maturities, the three-year facility operates through the “bank channel.” Quantitative easing would not be feasible because the ECB is statutorily prohibited of funding central governments. The ECB would comply with its mandate of medium-term price stability.

2. There is a critical difference in the two programs. Quantitative easing has been used as a form of financial repression known as “directed lending.” For example, the purchase of mortgage-backed securities more recently or the suspension of the auctions of 30-year bonds in response to the contraction early in the 2000s has the clear objective of directing spending to housing. The ECB gives the banks entire discretion on how to use the funding within their risk/return decisions, which could include purchase of government bonds.

The question on the similarity of the ECB three-year lending facility and quantitative easing is quite valid. Tracy Alloway, writing on Oct 10, 2011, on “Investors worry over cheap ECB money side effects,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d2f87d16-f339-11e0-8383-00144feab49a.html#axzz1hAqMH1vn), analyzes the use of earlier long-term refinancing operations (LTRO) of the ECB. LTROs by the ECB in Jun, Sep and Dec 2009 lent €614 billion at 1 percent. Alloway quotes estimates of Deutsche Bank that banks used €442billion to acquire assets with higher yields. Carry trades developed from LTRO funds at 1 percent into liquid investments at a higher yield to earn highly profitable spreads. Alloway quotes estimates of Morgan Stanley that European debt of GIIPS (Greece, Ireland, Italy, Portugal and Spain) in European bank balance sheets is €700 billion. Tracy Alloway, writing on Dec 21, 2011, on “Demand for ECB loans rises to €489bn,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/d6ddd0ae-2bbd-11e1-98bc-00144feabdc0.html#axzz1hAqMH1vn), informs that European banks borrowed the largest value of €489 billion in all LTROs of the ECB. Tom Fairless and David Cottle, writing on Dec 21, 2011, on “ECB sees record refinancing demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204464404577111983838592746.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the first of three operations of the ECB lent €489.19 billion, or $639.96 billion, to 523 banks. Three such LTROs could add to $1.9 trillion, which is not far from the value of quantitative easing in the US of $2.5 trillion. Fairless and Cottle find that there could be renewed hopes that banks could use the LTROs to support euro zone bond markets. It is possible that there could be official moral suasion by governments on banks to increase their holdings of government bonds or at least not to sell existing holdings. Banks are not free to choose assets in evaluation of risk and returns. Floods of cheap money at 1 percent per year induce carry trades to high-risk assets and not necessarily financing of growth with borrowing and lending decisions constrained by shocks of confidence.

The LTROs of the ECB are not very different from the liquidity facilities of the Fed during the financial crisis. Kohn (2009Sep10) finds that the trillions of dollars in facilities provided by the Fed (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-64, Regulation of Banks and Finance (2009b), 224-7) could fall under normal principles of “lender of last resort” of central banks:

“The liquidity measures we took during the financial crisis, although unprecedented in their details, were generally consistent with Bagehot's principles and aimed at short-circuiting these feedback loops. The Federal Reserve lends only against collateral that meets specific quality requirements, and it applies haircuts where appropriate. Beyond the collateral, in many cases we also have recourse to the borrowing institution for repayment. In the case of the TALF, we are backstopped by the Treasury. In addition, the terms and conditions of most of our facilities are designed to be unattractive under normal market conditions, thus preserving borrowers' incentives to obtain funds in the market when markets are operating normally. Apart from a very small number of exceptions involving systemically important institutions, such features have limited the extent to which the Federal Reserve has taken on credit risk, and the overall credit risk involved in our lending during the crisis has been small.

In Ricardo's view, if the collateral had really been good, private institutions would have lent against it. However, as has been recognized since Bagehot, private lenders, acting to protect themselves, typically severely curtail lending during a financial crisis, irrespective of the quality of the available collateral.The central bank--because it is not liquidity constrained and has the infrastructure in place to make loans against a variety of collateral--is well positioned to make those loans in the interest of financial stability, and can make them without taking on significant credit risk, as long as its lending is secured by sound collateral. A key function of the central bank is to lend in such circumstances to contain the crisis and mitigate its effects on the economy.”

The Bagehot (1873) principle is that central banks should provide a safety net, lending to temporarily illiquid but solvent banks and not to insolvent banks (see Cline 2001, 2002; Pelaez and Pelaez, International Financial Architecture (2005), 175-8). Kohn (2009Apr18) characterizes “quantitative easing” as “large scale purchases of assets:”

“Another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large-scale purchases of agency mortgage-backed securities (MBS), agency debt, and longer-term Treasury debt. We initially announced our intention to undertake large-scale asset purchases last November, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. These purchases are intended to reduce intermediate- and longer-term interest rates on mortgages and other credit to households and businesses; those rates influence decisions about investments in long-lived assets like houses, consumer durable goods, and business capital. In ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. However, the extremely large volume of purchases now underway does appear to have substantially lowered yields. The decline in yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage between the yields on longer-term assets and current and expected short-term interest rates. These preferences are likely to be especially strong in current circumstances, so that long-term asset prices rise and yields fall as the Federal Reserve acquires a significant portion of the outstanding stock of securities held by the public.”

Non-standard ECB policy and unconventional Fed policy have a common link in the scale of implementation or policy doses. Direct lending by the central bank to banks is the function “large scale lender of last resort.” If there is moral suasion by governments to coerce banks into increasing their holdings of government bonds, the correct term would be financial repression.

An important additional measure discussed by Draghi (2011Nov19) is relaxation on the collateral pledged by banks in LTROs:

“Some banks’ access to refinancing operations may be restricted by lack of eligible collateral. To overcome this, a temporary expansion of the list of collateral has been decided. Furthermore, the ECB intends to enhance the use of bank loans as collateral in Eurosystem operations. These measures should support bank lending, by increasing the amount of assets on euro area banks’ balance sheets that can be used to obtain central bank refinancing.”

There are collateral concerns about European banks. David Enrich and Sara Schaefer Muñoz, writing on Dec 28, on “European bank worry: collateral,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203899504577126430202451796.html?mod=WSJPRO_hpp_LEFTTopStories), analyze the strain on bank funding from a squeeze in the availability of high-quality collateral as guarantee in funding. High-quality collateral includes government bonds and investment-grade non-government debt. There could be difficulties in funding for a bank without sufficient available high-quality collateral to offer in guarantee of loans. It is difficult to assess from bank balance sheets the availability of sufficient collateral to support bank funding requirements. There has been erosion in the quality of collateral as a result of the debt crisis and further erosion could occur. Perceptions of counterparty risk among financial institutions worsened the credit/dollar crisis of 2007 to 2009. The banking theory of Diamond and Rajan (2000, 2001a, 2001b) and the model of Diamond Dybvig (1983, 1986) provide the analysis of bank functions that explains the credit crisis of 2007 to 2008 (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 155-7, 48-52, Regulation of Banks and Finance (2009b), 52-66, 217-24). In fact, Rajan (2005, 339-41) anticipated the role of low interest rates in causing a hunt for yields in multiple financial markets from hedge funds to emerging markets and that low interest rates foster illiquidity. Rajan (2005, 341) argued:

“The point, therefore, is that common factors such as low interest rates—potentially caused by accommodative monetary policy—can engender excessive tolerance for risk on both sides of financial transactions.”

A critical function of banks consists of providing transformation services that convert illiquid risky loans and investment that the bank monitors into immediate liquidity such as unmonitored demand deposits. Credit in financial markets consists of the transformation of asset-backed securities (SRP) constructed with monitoring by financial institutions into unmonitored immediate liquidity by sale and repurchase agreements (SRP). In the financial crisis financial institutions distrusted the quality of their own balance sheets and those of their counterparties in SRPs. The financing counterparty distrusted that the financed counterparty would not repurchase the assets pledged in the SRP that could collapse in value below the financing provided. A critical problem was the unwillingness of banks to lend to each other in unsecured short-term loans. Emse Bartha, writing on Dec 28, on “Deposits at ECB hit high,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204720204577125913779446088.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that banks deposited €453.034 billion, or $589.72 billion, at the ECB on Dec 28, which is a record high in two consecutive days. The deposit facility is typically used by banks when they do prefer not to extend unsecured loans to other banks. In addition, banks borrowed €6.225 billion from the overnight facility on Dec 28, when in normal times only a few hundred million euro are borrowed. The collateral issues and the possible increase in counterparty risk occurred a week after large-scale lender of last resort by the ECB in the value of €489 billion in the prior week. The ECB may need to extend its lender of last resort operations.

The financial reform of the United States around the proposal of a national bank by Alexander Hamilton (1780) to develop the money economy with specialization away from the barter economy is credited with creating the financial system that brought prosperity over a long period (see Pelaez 2008). Continuing growth and prosperity together with sound financial management earned the US dollar the role as reserve currency and the AAA rating of its Treasury securities. McKinnon (2011Dec18) analyzes the resolution of the European debt crisis by comparison with the reform of Alexander Hamilton. Northern states of the US had financed the revolutionary war with the issue of paper notes that were at risk of default by 1890. Alexander Hamilton proposed the purchase of the states’ paper notes by the Federal government without haircuts. McKinnon (2011Dec18) describes the conflicts before passing the assumption bill in 1790 for federal absorption of the debts of states. Other elements in the Hamilton reform consisted of creation of a market for US Treasury bonds by their use as paid-in capital in the First Bank of the United States. McKinnon (2011Dec18) finds growth of intermediation in the US by the branching of the First Bank of the United States throughout several states, accepting deposits to provide commercial short-term credit. The reform consolidated the union of states, fiscal credibility for the union and financial intermediation required for growth. The reform also introduced low tariffs and an excise tax on whisky to service the interest on the federal debt. Trade relations among members of the euro zone are highly important to economic activity. There are two lessons drawn by McKinnon (2011Dec18) from the experience of Hamilton for the euro zone currently. (1) The reform of Hamilton included new taxes for the assumption of debts of states with concrete provisions for their credibility. (2) Commercial lending was consolidated with a trusted bank both for accepting private deposits and for commercial lending, creating the structure of financial intermediation required for growth.

IIIE Appendix Euro Zone Survival Risk. Markets have been dominated by rating actions of Standard & Poor’s Ratings Services (S&PRS) (2012Jan13) on 16 members of the European Monetary Union (EMU) or eurozone. The actions by S&PRS (2012Jan13) are of several types:

1. Downgrades by two notches of long-term credit ratings of Cyprus (from BBB/Watch/NegA-3+ to BB+/Neg/B), Italy (from A/Watch Neg/A-1 to BBB+/Neg/A-2), Portugal (from BBB-/Watch Neg/A-3 to BB/Neg/B) and Spain (from AA-/Watch Neg/A-1+ to A/Neg/A-1).

2. Downgrades by one notch of long-term credit ratings of Austria (from AAA/Watch Neg/A-1+ to AA+/Neg/A-1+), France (from AAA/Watch Neg/A-1+ to AA+/Neg A-1+), Malta (from A/Watch, Neg/A-1 to A-/Neg/A-2), Slovakia (from A+/Watch Neg/A-1 to A/Stable/A-1) and Slovenia (AA-/Watch Neg/A-1+ to A+/Neg/A-1).

3. Affirmation of long-term ratings of Belgium (AA/Neg/A-1+), Estonia (AA-/Neg/A-1+), Finland (AAA/Neg/A-1+), Germany (AAA/Stable/A-1+), Ireland (BBB+/Neg/A-2), Luxembourg (AAA/Neg/A-1+) and the Netherlands (AAA/Neg/A-1+) with removal from CreditWatch.

4. Negative outlook on the long-term credit ratings of Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain, meaning that S&PRS (2012Jan13) finds that the ratings of these sovereigns have a chance of at least 1-to-3 of downgrades in 2012 or 2013.

S&PRS (2012Jan13) finds that measures by European policymakers may not be sufficient to contain sovereign risks in the eurozone. The sources of stress according to S&PRS (2012Jan13) are:

1. Worsening credit environment

2. Increases in risk premiums for many eurozone borrowers

3. Simultaneous attempts at reducing debts by both eurozone governments and households

4. More limited perspectives of economic growth

5. Deepening and protracted division among Europe’s policymakers in agreeing to approaches to resolve the European debt crisis

There is now only one major country in the eurozone with AAA rating of its long-term debt by S&PRS (2012Jan13): Germany. IIIE Appendix Euro Zone Survival Risk analyzes the hurdle of financial bailouts of euro area members by the strength of the credit of Germany alone. The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is abouy $3531.6 billion. There is some simple “unpleasant bond arithmetic.” 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 about $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. Debt as percent of Germany’s GDP would exceed 224 percent if including debt of France and 165 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. Charles Forelle, writing on Jan 14, 2012, on “Downgrade hurts euro rescue fund,” published by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204409004577159210191567778.html), analyzes the impact of the downgrades on the European Financial Stability Facility (EFSF). The EFSF is a special purpose vehicle that has not capital but can raise funds to be used in bailouts by issuing AAA-rated debt. S&P may cut the rating of the EFSF to the new lowest rating of the six countries with AAA rating, which are now down to four with the downgrades of France and Austria. The other rating agencies Moody’s and Fitch have not taken similar action. On Jan, S&PRS (2012Jan16) did cut the long-term credit rating of the EFSF to AA+ and affirmed the short-term credit rating at A-+. The decision is derived from the reduction in credit rating of the countries guaranteeing the EFSF. In the view of S&PRS (2012Jan16), there are not sufficient credit enhancements after the reduction in the creditworthiness of the countries guaranteeing the EFSF. The decision could be reversed if credit enhancements were provided.

The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.

Bond auctions are also critical in episodes of risk aversion. David Oakley, writing on Jan 3, 2012, on “Sovereign issues draw euro to crunch point,” published by the Financial Times (http://www.ft.com/intl/cms/s/0/63b9d7ca-2bfa-11e1-98bc-00144feabdc0.html#axzz1iLNRyEbs), estimates total euro area sovereign issues in 2012 at €794 billion, much higher than the long-term average of €670 billion. Oakley finds that the sovereign issues are: Italy €220 billion, France €197 billion, Germany €178 billion and Spain €81 billion. Bond auctions will test the resilience of the euro. Victor Mallet and Robin Wigglesworth, writing on Jan 12, 2012, on “Spain and Italy raise €22bn in debt sales,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/e22c4e28-3d05-11e1-ae07-00144feabdc0.html#axzz1j4euflAi), analyze debt auctions during the week. Spain placed €10 billion of new bonds with maturities in 2015 and 2016, which was twice the maximum planned for the auction. Italy placed €8.5 billion of one-year bills at average yield of 2.735 percent, which was less than one-half of the yield of 5.95 percent a month before. Italy also placed €3.5 billion of 136-day bills at 1.64 percent. There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20.

A combination of strong economic data in China analyzed in subsection VC and the realization of the widely expected downgrade could explain the strength of the European sovereign debt market. Emese Bartha, Art Patnaude and Nick Cawley, writing on January 17, 2012, on “European T-bills see solid demand,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204555904577166363369792848.html?mod=WSJPRO_hpp_LEFTTopStories), analyze successful auctions treasury bills by Spain and Greece. A day after the downgrade, the EFSF found strong demand on Jan 17 for its six-month debt auction at the yield of 0.2664 percent, which is about the same as sovereign bills of France with the same maturity.

There may be some hope in the sovereign debt market. The yield of Italy’s 10-year bond dropped from around 7.20 percent on Jan 9 to about 6.70 percent on Jan 13 and then to around 6.30 percent on Jan 20. The yield of Spain’s 10-year bond fell from about 6.60 percent on Jan 9 to around 5.20 percent on Jan 13 and then to 5.50 percent on Jan 20. Paul Dobson, Emma Charlton and Lucy Meakin, writing on Jan 20, 2012, on “Bonds show return of crisis once ECB loans expire,” published in Bloomberg (http://www.bloomberg.com/news/2012-01-20/bonds-show-return-of-crisis-once-ecb-loans-expire-euro-credit.html), analyze sovereign debt and analysis of market participants. Large-scale lending of last resort by the European Central Bank, considered in VD Appendix on European Central Bank Large Scale Lender of Last Resort, provided ample liquidity in the euro zone for banks to borrow at 1 percent and lend at higher rates, including to government. Dobson, Charlton and Meakin trace the faster decline of yields of short-term sovereign debt relative to decline of yields of long-term sovereign debt. The significant fall of the spread of short relative to long yields could signal concern about the resolution of the sovereign debt while expanding lender of last resort operations have moderated relative short-term sovereign yields. Normal conditions would be attained if there is definitive resolution of long-term sovereign debt that would require fiscal consolidation in an environment of economic growth.

Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.

Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).

Improving equity markets and strength of the euro appear related to developments in sovereign debt negotiations and markets. Alkman Granitsas and Costas Paris, writing on Jan 29, 2012, on “Greek debt deal, new loan agreement to finish next week,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204573704577189021923288392.html?mod=WSJPRO_hpp_LEFTTopStories), inform that Greece and its private creditors were near finishing a deal of writing off €100 billion, about $132 billion, of Greece’s debt depending on the conversations between Greece, the euro area and the IMF on the new bailout. An agreement had been reached in Oct 2011 for a new package of fresh money in the amount of €130 billion to fill needs through 2015 but was contingent on haircuts reducing Greece’s debt from 160 percent of GDP to 120 percent of GDP. The new bailout would be required to prevent default by Greece of €14.4 billion maturing on Mar 20, 2012. There has been increasing improvement of sovereign bond yields. Italy’s ten-year bond yield fell from over 6.30 percent on Jan 20, 2012 to slightly above 5.90 percent on Jan 27. Spain’s ten-year bond yield fell from slightly above 5.50 percent on Jan 20 to just below 5 percent on Jan 27.

An important difference, according to Beim (2011Oct9), between large-scale buying of bonds by the central bank between the Federal Reserve of the US and the European Central Bank (ECB) is that the Fed and most banks do not buy local and state government obligations with lower creditworthiness. The European Monetary Union (EMU) that created the euro and the ECB did not include common fiscal policy and affairs. Thus, EMU cannot issue its own treasury obligations. The line “Reserve bank credit” in the Fed balance sheet for Jan 25, 2012, is $2902 billion of which $2570 billion consisting of $1565 billion US Treasury notes and bonds, $68 billion inflation-indexed bonds and notes, $101 billion Federal agency debt securities and $836 billion mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The Fed has been careful in avoiding credit risk in its portfolio of securities. The 11 exceptional liquidity facilities of several trillion dollars created during the financial crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62) have not resulted in any losses. The Fed has used unconventional monetary policy without credit risk as in classical central banking.

Beim (2011Oct9, 6) argues:

“In short, the ECB system holds more than €1 trillion of debt of the banks and governments of the 17 member states. The state-by-state composition of this debt is not disclosed, but the events of the past year suggest that a disproportionate fraction of these assets are likely obligations of stressed countries. If a significant fraction of the €1 trillion were to be restructured at 40-60% discounts, the ECB would have a massive problem: who would bail out the ECB?

This is surely why the ECB has been so shrill in its antagonism to the slightest mention of default and restructuring. They need to maintain the illusion of risk-free sovereign debt because confidence in the euro itself is built upon it.”

Table III-2 provides an update of the consolidated financial statement of the Eurosystem. The balance sheet has swollen with the LTROs. Line 5 “Lending to Euro Area Credit Institutions Related to Monetary Policy” increased from €546,747 million on Dec 31, 2010, to €870,130 million on Dec 28, 2011 and €1,149,485 million on Mar 16, 2012. The sum of line 5 and line 7 (“Securities of Euro Area Residents Denominated in Euro”) has increased to €1,779,931 million in the statement of Mar 16.

This sum is roughly what concerns Beim (2012Oct9) because of the probable exposure relative to capital to institutions and sovereigns with higher default risk. To be sure, there is no precise knowledge of the composition of the ECB portfolio of loans and securities with weights and analysis of the risks of components. Javier E. David, writing on Jan 16, 2012, on “The risks in ECB’s crisis moves,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204542404577158753459542024.html?mod=WSJ_hp_LEFTWhatsNewsCollection), informs that the estimated debt of weakest euro zone sovereigns held by the ECB is €211 billion, with Greek debt in highest immediate default risk being only 17 percent of the total. Another unknown is whether there is high risk collateral in the €489 billion three-year loans to credit institutions at 1 percent interest rates. The potential risk is the need for recapitalization of the ECB that could find similar political hurdles as the bailout fund EFSF. There is a recurring issue of whether the ECB should accept a haircut on its portfolio of Greek bonds of €40 billion acquired at discounts from face value. An article on “Haircut for the ECB? Not so fast,” published by the Wall Street Journal on Jan 28, 2012 (http://blogs.wsj.com/davos/2012/01/28/haircut-for-the-ecb-not-so-fast/), informs of the remarks by Mark Carney, Governor of the Bank of Canada and President of the Financial Stability Board (FSB) (http://www.financialstabilityboard.org/about/overview.htm), expressing what appears to be correct doctrine that there could conceivably be haircuts for official debt but that such a decision should be taken by governments and not by central banks.

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

	Dec 31, 2010	Dec 28, 2011	Mar 16, 2012
1 Gold and other Receivables	367,402	419,822	423,449
2 Claims on Non Euro Area Residents Denominated in Foreign Currency	223,995	236,826	246,561
3 Claims on Euro Area Residents Denominated in Foreign Currency	26,941	95,355	71,354
4 Claims on Non-Euro Area Residents Denominated in Euro	22,592	25,982	18,018
5 Lending to Euro Area Credit Institutions Related to Monetary Policy Operations Denominated in Euro	546,747	879,130	1,149,485
6 Other Claims on Euro Area Credit Institutions Denominated in Euro	45,654	94,989	55,269
7 Securities of Euro Area Residents Denominated in Euro	457,427	610,629	630,446
8 General Government Debt Denominated in Euro	34,954	33,928	31,176
9 Other Assets	278,719	336,574	360,536
TOTAL ASSETS	2,004, 432	2,733,235	2,986,294
Memo Items
Sum of 5 and 7	1,004,174	1,489,759	1,779,931
Capital and Reserves	78,143	81,481	83,000

Source: European Central Bank

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

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

http://www.ecb.int/press/pr/wfs/2012/html/fs120320.en.html

Professors Ricardo Caballero and Francesco Giavazzi (2012Jan15) find that the resolution of the European sovereign crisis with survival of the euro area would require success in the restructuring of Italy. That success would be assured with growth of the Italian economy. A critical problem is that the common currency prevents Italy from devaluation to parity or the exchange rate that would permit export growth to promote internal economic activity that generates fiscal revenues for primary fiscal surplus that ensure creditworthiness. Fiscal consolidation and restructuring are important but of long-term gestation. Immediate growth of the Italian economy would consolidate the resolution of the sovereign debt crisis. Caballero and Giavazzi (2012Jan15) argue that 55 percent of the exports of Italy are to countries outside the euro area such that devaluation of 15 percent would be effective in increasing export revenue. Newly available data in Table III-3 providing Italy’s trade with regions and countries supports the argument of Caballero and Giavazzi (2012Jan15). Italy’s exports to the European Monetary Union (EMU) are only 42.6 percent of the total. Exports to the non-European Union area are growing at 4.8 percent in Jan 2012 relative to Jan 2011 while those to EMU are growing at 2.9 percent.

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

	Exports % Share	∆% Jan 2012/ Jan 2011	Imports % Share	Imports ∆% Jan 2012/ Jan 2011
EU	56.0	3.9	53.3	-5.4
EMU 17	42.6	2.9	43.2	-5.2
France	11.6	4.2	8.3	-3.7
Germany	13.1	7.6	15.6	-4.9
Spain	5.3	-3.6	4.5	-6.2
UK	4.7	9.1	2.7	-12.5
Non EU	44.0	4.8	46.7	0.2
Europe non EU	13.3	21.9	11.1	-2.8
USA	6.1	-19.1	3.3	15.2
China	2.7	-11.8	7.3	-15.8
OPEC	4.7	15.4	8.6	13.6
Total	100.0	4.3	100.0	-2.6

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

Source: http://www.istat.it/it/archivio/57081

Table III-4 provides Italy’s trade balance by regions and countries. Italy has a trade deficit of €44 million with the 17 countries of the euro zone (EMU 17). Depreciation to parity could permit greater competitiveness in improving the trade surpluses of €98 million with Europe non European Union and of €256 million with the US. There is significant rigidity in the trade deficits of €1732 million with China and €2581 million with oil exporting countries (OPEC).

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

Regions and Countries	Trade Balance Jan 2012 Millions of Euro	Trade Balance Cumulative Jan 2012 Millions of Euro
EU	756	756
EMU 17	-44	-44
France	831	831
Germany	-399	-399
Spain	326	326
UK	636	636
Non EU	-5,106	-5,106
Europe non EU	98	98
USA	256	256
China	-1,732	-1,732
OPEC	-2,581	-2,581
Total	-4,350	-4,350

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

Source: http://www.istat.it/it/archivio/57081

Growth rates of Italy’s trade and major products are provided in Table III-5 for the period Jan 2012 relative to Jan 2011. Growth rates are high for the total and all segments with the exception of decline of durable goods imports of 4.5 percent and decline of exports of 0.2 percent. Capital goods exports decreased 0.3 percent relative to a year earlier but imports of capital goods fell 6.6 percent and exports of intermediate products rose 4.2 percent.

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

	Exports Share %	Exports ∆% Jan 2012/ Jan 2011	Imports Share %	Imports ∆% Jan 2012/ Jan 2011
Consumer Goods	28.9	5.6	25.0	0.8
Durable	5.9	-0.2	3.0	-4.5
Non Durable	23.0	6.9	22.0	1.6
Capital Goods	32.2	-0.3	20.8	-6.6
Inter- mediate Goods	34.3	4.2	34.5	-11.9
Energy	4.7	23.2	19.7	11.8
Total ex Energy	95.3	3.2	80.3	-6.6
Total	100.0	4.3	100.0	-2.6

Source: http://www.istat.it/it/archivio/57081

Table III-6 provides Italy’s trade balance by product categories in Jan 2012. Italy’s trade balance excluding energy is a surplus of €1781 million in Jan 2012 but the energy trade balance is a deficit of €6132 million. Italy has significant competitiveness in contrast with some other countries with debt difficulties.

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

	Jan 2012	Cumulative Jan 2012
Consumer Goods	161	161
Durable	471	471
Nondurable	-310	-310
Capital Goods	1,997	1,997
Intermediate Goods	-376	-376
Energy	-6,132	-6,132
Total ex Energy	1,781	1,781
Total	-4,350	-4,350

Source: http://www.istat.it/it/archivio/57081

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 following Subsection IIID 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 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 (see Table III-1). 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 of 120 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 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 2010.

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

	GDP 2010 USD Billions	Primary Net Lending Borrowing % GDP 2010	General Government Net Debt % GDP 2010
World	62,911.2
Euro Zone	12,167.8	-3.6	65.9
Portugal	229.2	-6.3	88.7
Ireland	206.9	-28.9	78.0
Greece	305.4	-4.9	142.8
Spain	1,409.9	-7.8	48.8
Major Advanced Economies G7	31,716.9	-6.5	76.5
United States	14,526.6	-8.4	68.3
UK	2,250.2	-7.7	67.7
Germany	3,286.5	-1.2	57.6
France	2,562.7	-4.9	76.5
Japan	5,458.8	-8.1	117.2
Canada	1,577.0	-4.9	32.2
Italy	2,055.1	-0.3	99.4
China	5,878.3	-2.3	33.8*
Cyprus	23.2	-5.3	61.6

*Gross Debt

Source: http://www.imf.org/external/pubs/ft/weo/2011/01/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” in Table III-8 is generated by applying the percentage in Table III-7 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. 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 $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt 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 percent if including debt of France and 165 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.

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

	Net Debt USD Billions	Debt as % of Germany Plus France GDP	Debt as % of Germany GDP
A Euro Area	8,018.6
B Germany	1,893.0		$7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1%
C France	1,960.5
B+C	3,853.5	GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3%
D Italy	2,042.8
E Spain	688.0
F Portugal	203.3
G Greece	436.1
H Ireland	161.4
Subtotal D+E+F+G+H	3,531.6

Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/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 Jan. German exports to other European Union members are 59.3 percent of total exports in Jan 2012 and 59.2 percent in Jan-Dec 2011. Exports to the euro area are 39.8 percent in Jan and 39.7 percent in Jan-Dec. Exports to third countries are 40.7 percent of the total in Jan and 40.8 percent in Jan-Dec. There is similar distribution for imports. Economic performance in Germany is closely related to its 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 its high share in 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 ∆%

	Jan 2012 € Billions	12-Month ∆%	Jan–Dec 2011 € Billions	Jan-Dec 2011/ Jan-Dec 2010 ∆%
Total Exports	85.9	9.3	1,060.1	11.4
A. EU Members	50.9 % 59.3	5.4	627.3 % 59.2	9.9
Euro Area	34.2 % 39.8	4.6	420.9 % 39.7	8.6
Non-euro Area	16.7 % 19.4	7.1	206.4 % 19.5	12.6
B. Third Countries	35.0 % 40.7	15.4	432.8 % 40.8	13.6
Total Imports	72.8	6.3	902.0	13.2
C. EU Members	44.9 % 61.7	7.4	572.6 % 63.5	13.8
Euro Area	31.4 % 43.1	7.1	401.5 % 44.5	12.9
Non-euro Area	13.5 % 18.5	8.2	171.1 % 18.9	16.1
D. Third Countries	28.0 % 38.5	4.5	329.4 % 36.5	12.0

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

Source:

Statistisches Bundesamt Deutschland

http://www.destatis.de/jetspeed/portal/cms/Sites/destatis/Internet/EN/press/pr/2012/03/PE12__084__51,templateId=renderPrint.psml

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

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

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

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

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

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

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

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

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

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

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

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

M_tV(i_t, ·) = P_tY_t (5)

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

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

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

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

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

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

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

IV Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table IV-1, updated with every blog comment, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. Data in Table IV-1 for the euro zone and its members are updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table IV-1. Data for other countries in Table IV-1 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section V World Economic Slowdown following with individual country and regional data tables.

Table IV-1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates

	GDP	CPI	PPI	UNE
US	1.6	2.9	3.3	8.3
Japan	-0.6	0.1	0.6	4.6
China	8.9	3.2	0.0
UK	0.7	3.4* RPI 3.7	4.1* output 3.0** input 7.3*	8.4
Euro Zone	0.7	2.7	3.7	10.7
Germany	2.0	2.5	3.4	5.8
France	0.2	2.5	4.2	10.0
Nether-lands	-0.7	2.9	4.5	5.0
Finland	1.2	3.0	3.4	7.5
Belgium	0.9	3.3	3.5	7.4
Portugal	-2.7	3.6	4.7	14.8
Ireland	NA	1.3	4.5	14.8
Italy	-0.5	3.4	NA	9.2
Greece	-7.0	1.7	7.7	NA
Spain	0.3	1.9	3.6	23.3

Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier

*Office for National Statistics http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2012/index.html **Core

PPI http://www.ons.gov.uk/ons/rel/ppi2/producer-price-index/february-2012/index.html

Table IV-1 shows the simultaneous occurrence of low growth, inflation and unemployment in advanced economies. The US grew at 1.6 percent in IVQ2011 relative to IVQ2010 (Table 8, p 11 in http://www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_2nd.pdf). Japan’s GDP fell 0.6 percent in IVQ2011 relative to IVQ2010 and contracted 1.7 percent in IIQ2011 relative to IIQ2010 because of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 but grew at the seasonally-adjusted annual rate (SAAR) of 7.1 percent in IIIQ2011 to decline at the SAAR of 0.7 percent in IVQ 2011 (see Section VB at http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html); the UK grew at 0.7 percent in IVQ2011 relative to IVQ2010 and GDP fell 0.2 percent in IVQ2011 relative to IIIQ2011 (http://www.ons.gov.uk/ons/rel/naa2/second-estimate-of-gdp/q4-2011/index.html); and the Euro Zone grew at 0.7 percent in IVQ2011 relative to IVQ2010 but declined 0.3 percent in IVQ2011 relative to IIIQ2011 (see Section VD at http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html and http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-06032012-AP/EN/2-06032012-AP-EN.PDF). These are stagnating or “growth recession” rates, which are positive growth rates instead of contractions but insufficient to recover employment. The rates of unemployment are quite high: 8.3 percent in the US but 18.9 percent for unemployment/underemployment (see Table I-4 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or.html), 4.6 percent for Japan, 8.4 percent for the UK with high rates of unemployment for young people (see the labor statistics of the UK in Subsection VH at http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html) and 10.7 percent in the Euro Zone (section VD http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html). Twelve-month rates of inflation have been quite high, even when some are moderating at the margin: 2.9 percent in the US, 0.1 percent for Japan, 3.2 percent for China, 2.7 percent for the Euro Zone and 3.4 percent for the UK (http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2012/index.html). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration (see http://cmpassocregulationblog.blogspot.com/2011/06/risk-aversion-and-stagflation.html). The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are six key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings (see Section III in this post and the earlier post http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html) (2) the tradeoff of growth and inflation in China now with political developments; (3) slow growth by repression of savings with de facto interest rate controls (see section II in http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or.html and http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html), weak hiring with the loss of 10 million full-time jobs (see section II in http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html and http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html) and continuing job stress of 24 to 31 million people in the US and stagnant wages in a fractured job market (see Section I Thirty Million Unemployed or Underemployed http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or.html); (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see IV Budget/Debt Quagmire in http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html http://cmpassocregulationblog.blogspot.com/2011/03/global-financial-risks-and-fed.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies; (5) the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 that had repercussions throughout the world economy because of Japan’s share of about 9 percent in world output, role as entry point for business in Asia, key supplier of advanced components and other inputs as well as major role in finance and multiple economic activities (http://professional.wsj.com/article/SB10001424052748704461304576216950927404360.html?mod=WSJ_business_AsiaNewsBucket&mg=reno-wsj); and (6) geopolitical events in the Middle East.

In the effort to increase transparency, the Federal Open Market Committee (FOMC) provides both economic projections of its participants and views on future paths of the policy rate that in the US is the federal funds rate or interest on interbank lending of reserves deposited at Federal Reserve Banks. These projections and views are discussed initially followed with appropriate analysis.

The statement of the FOMC at the conclusion of its meeting on Jan 25, 2012, revealed the following policy intentions (http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm):

“Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. ”

There are several important issues in this statement.

1. Mandate. The FOMC 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”

2. Extending Average Maturity of Holdings of Securities. The statement of Jan 25, 2012, invokes the mandate that inflation is subdued but employment below maximum such that further accommodation is required. Accommodation consists of low interest rates. The new “Operation Twist” (http://cmpassocregulationblog.blogspot.com/2011_09_01_archive.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html) or restructuring the portfolio of securities of the Fed by selling short-dated securities and buying long-term securities has the objective of reducing long-term interest rates. Lower interest rates would stimulate consumption and investment, or aggregate demand, increasing the rate of economic growth and thus reducing stress in job markets.

3. Target of Fed Funds Rate. The FOMC continues to maintain the target of fed funds rate at 0 to ¼ percent.

4. Advance Guidance. The FOMC increases transparency by advising on the expectation of the future path of fed funds rate. This guidance is the view that conditions such as “low rates of resource utilization and a subdued outlook for inflation over the medium run are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

5. Monitoring and Policy Focus. The FOMC reconsiders its policy continuously in accordance with available information: “The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.”

These policy statements are carefully crafted to express the intentions of the FOMC. The main objective of the statements is to communicate as clearly and firmly as possible the intentions of the FOMC to fulfill its dual mandate. During periods of low inflation and high unemployment and underemployment such as currently the FOMC may be more biased toward measures that stimulate the economy to reduce underutilization of workers and other productive resources. The FOMC also is vigilant about inflation and ready to change policy in the effort to attain its dual mandate.

The FOMC also released the economic projections of governors of the Board of Governors of the Federal Reserve and Federal Reserve Banks presidents shown in Table IV-2. The Fed releases the data with careful explanations (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). Columns “∆% GDP,” “∆% PCE Inflation” and “∆% Core PCE Inflation” are changes “from the fourth quarter of the previous year to the fourth quarter of the year indicated.” The GDP report for IVQ2011 is analyzed in the current post of this blog in section I. The Bureau of Economic Analysis (BEA) provides the GDP report with the second estimate for IVQ2011 to be released on Feb 29 and the third estimate on Mar 29 (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm). PCE inflation is the index of personal consumption expenditures (PCE) of the report of the Bureau of Economic Analysis (BEA) on “Personal Income and Outlays” (http://www.bea.gov/national/index.htm#personal), which is analyzed in this blog as soon as available. The next report will be released at 8:30 AM on Jan 30, 2012. PCE core inflation consists of PCE inflation excluding food and energy. Column “UNEMP %” is the rate of unemployment measured as the average civilian unemployment rate in the fourth quarter of the year. The Bureau of Labor Statistics (BLS) provides the Employment Situation Report with the civilian unemployment rate in the first Friday of every month, which is analyzed in this blog. The report for February will be released on Feb 3, 2012 (http://www.bls.gov/cps/). “Longer term projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy” (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf).

It is instructive to focus on 2012, as 2013, 2014 and longer term are too far away, and there is not much information on what will happen in 2013 and beyond. The central tendency should provide reasonable approximation of the view of the majority of members of the FOMC but the second block of numbers provides the range of projections by FOMC participants. The first row for each year shows the projection introduced after the meeting of Jan 25 and the second row “Nov PR” the projection of the Nov meeting. There are three major changes in the view.

1. Growth “GDP ∆.” The FOMC has reduced the forecast of GDP growth in 2012 from 3.3 to 3.7 percent in Jun to 2.5 to 2.9 percent in Nov and now to 2.2 to 2.7 percent at the Jan 25 meeting.

2. Rate of Unemployment “UNEM%.” The FOMC increased the rate of unemployment from 7.8 to 8.2 percent in Jun to 8.5 to 8.7 percent in Nov but has reduced it to 8.2 to 8.5 percent at the Jan 25 meeting.

3. Inflation “∆% PCE Inflation.” The FOMC changed the forecast of personal consumption expenditures (PCE) inflation from 1.5 to 2.0 percent in Jun to virtually the same of 1.4 to 2.0 percent in Nov but has reduced it to 1.4 to 1.8 percent at the Jan 25 meeting.

4. Core Inflation “∆% Core PCE Inflation.” Core inflation is PCE inflation excluding food and energy. There is again not much of a difference of the projection for 2012 in Jun of 1.4 to 2.0 percent and the Nov projection of 1.5 to 2.0 percent, which has been reduced slightly to 1.5 to 1.8 percent at the Jan 25 meeting.

Table IV-2, US, Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents in FOMC, January 2012 and November 2011

	∆% GDP	UNEM %	∆% PCE Inflation	∆% Core PCE Inflation
Central Tendency
2012 Nov PR	2.2 to 2.7 2.5 to 2.9	8.2 to 8.5 8.5 to 8.7	1.4 to 1.8 1.4 to 2.0	1.5 to 1.8 1.5 to 2.0
2013 Nov PR	2.8 to 3.2 3.0 to 3.5	7.4 to 8.1 7.8 to 8.2	1.4 to 2.0 1.5 to 2.0	1.5 to 2.0 1.4 to 1.9
2014 Nov PR	3.3 to 4.0 3.0 to 3.9	6.7 to 7.6 6.8 to 7.7	1.6 to 2.0 1.5 to 2.0	1.6 to 2.0 1.5 to 2.0
Longer Run	2.3 to 2.6 2.4 to 2.7	5.2 to 6.0 5.2 to 6.0	2.0 1.7 to 2.0
Range
2012 Nov PR	2.1 to 3.0 2.3 to 3.5	7.8 to 8.6 8.1 to 8.9	1.3 to 2.5 1.4 to 2.8	1.3 to 2.0 1.3 to 2.1
2013 Nov PR	2.4 to 3.8 2.7 to 4.0	7.0 to 8.2 7.5 to 8.4	1.4 to 2.3 1.4 to 2.5	1.4 to 2.0 1.4 to 2.1
2014 Nov PR	2.8 to 4.3 2.7 to 4.5	6.3 to 7.7 6.5 to 8.0	1.5 to 2.1 1.5 to 2.4	1.4 to 2.0 1.4 to 2.2
Longer Run	2.2 to 3.0 2.2 to 3.0	5.0 to 6.0 5.0 to 6.0	2.0 1.5 to 2.0

Notes: UEM: unemployment; PR: Projection

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Another important decision at the FOMC meeting on Jan 25, 2012, is formal specification of the goal of inflation of 2 percent per year but without specific goal for unemployment (http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm):

“Following careful deliberations at its recent meetings, the Federal Open Market Committee (FOMC) has reached broad agreement on the following principles regarding its longer-run goals and monetary policy strategy. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent, roughly unchanged from last January but substantially higher than the corresponding interval several years earlier.

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. ”

The probable intention of this specific inflation goal is to “anchor” inflationary expectations. Massive doses of monetary policy of promoting growth to reduce unemployment could conflict with inflation control. Economic agents could incorporate inflationary expectations in their decisions. As a result, the rate of unemployment could remain the same but with much higher rate of inflation (see Kydland and Prescott 1977 and Barro and Gordon 1983; http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). Strong commitment to maintaining inflation at 2 percent could control expectations of inflation.

The FOMC continues its efforts of increasing transparency that can improve the credibility of its firmness in implementing its dual mandate. Table IV-3 provides the views by participants of the FOMC of the levels at which they expect the fed funds rate in 2012, 2013, 2014 and the in the longer term. The table is inferred from a chart provided by the FOMC with the number of participants expecting the target of fed funds rate (http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf). There are 14 participants expecting the rate to remain at 0 to ¼ percent in 2012 and only three to be higher. Not much change is expected in 2013 either with 11 participants anticipating the rate at the current target of 0 to ¼ percent and only six expecting higher rates. The rate would still remain at 0 to ¼ percent in 2014 for six participants with five expecting the rate to be in the range of 0.5 to 1 percent and two participants expecting rates from 1 to 1.5 percent but only 4 with rates exceeding 2.5 percent. This table is consistent with the guidance statement of the FOMC that rates will remain at low levels until late in 2014.

Table IV-3, US, Views of Target Federal Funds Rate at Year-End of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

Additional information is provided in Table IV-4 with the number of participants expecting increasing interest rates in the years from 2012 to 2016. It is evident from Table IV-4 that the prevailing view in the FOMC is for interest rates to continue at low levels in future years. This view is consistent with the economic projections of low economic growth, relatively high unemployment and subdued inflation provided in Table IV-2.

Table IV-4, US, Views of Appropriate Year of Increasing Target Federal Funds Rate of Federal Reserve Board Members and Federal Reserve Bank Presidents Participating in FOMC, January 25, 2012

Appropriate Year of Increasing Target Fed Funds Rate	Number of Participants
2012	3
2013	3
2014	5
2015	4
2016	2

Source: http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20120125.pdf

The producer price index of Germany increased 0.4 percent in Feb relative to Jan and increased 3.2 percent in the 12 months ending in Feb, as shown in Table IV-5. The producer price index of Germany has similar five waves of inflation as in many other countries (http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html). In the first wave from Jan to Apr, the annual equivalent rate of producer price inflation was 10.3 percent, propelled by carry trades from zero interest rates to exposures in commodity futures in a mood of risk appetite. In the second wave in May and Jun, the annual equivalent rate of producer price inflation was only 0.6 percent because of the collapse of the carry trade in fear of risk from risks of European sovereign debt. In the third wave from Jul to Sep, annual-equivalent producer price inflation in Germany 2.8 percent with fluctuations in commodity prices resulting from perception of the sovereign risk crisis in Europe. In the fourth wave from Oct to Dec, annual equivalent inflation was minus 0.4 percent as financial markets were shocks with strong risk aversion. In the fifth wave from Dec to Feb, annual equivalent inflation was at 1.2 percent. At the margin, annual equivalent inflation in Jan-Feb is at 6.2 percent. Annual data in the bottom of Table IV-5 show that the producer price index fell 5.2 percent in the 12 months ending in Dec 2009 as a result of the fall of commodity prices originating in risk aversion after the panic of 2008.

Table IV-5, Germany, Producer Price Index ∆%

	12 Months ∆% NSA	Month ∆% Calendar and SA
Feb 2012	3.2	0.4
Jan	3.4	0.6
Dec 2011	4.0	-0.4
AE ∆% Dec-Feb		2.4
Nov	5.2	0.1
Oct	5.3	0.2
AE ∆% Oct-Dec		-0.4
Sep	5.5	0.3
Aug	5.5	-0.3
Jul	5.8	0.7
AE ∆% Jul-Sep		2.8
Jun	5.6	0.1
May	6.1	0.0
AE ∆% May-Jun		0.6
Apr	6.4	1.0
Mar	6.2	0.4
Feb	6.4	0.7
Jan	5.7	1.2
AE ∆% Jan-Apr		10.3
Dec 2010	5.3	0.7
Nov	4.4	0.2
Oct	4.3	0.4
Sep	3.9	0.3
Aug	3.2	0.0
Jul	3.7	0.5
Jun	1.7	0.6
May	0.9	0.3
Apr	0.6	0.8
Mar	-1.5	0.7
Feb	-2.9	0.0
Jan	-3.4	0.8
Dec 2009	-5.2	0.2
Dec 2008	4.0	-0.8
Dec 2007	1.9	-0.1
Dec 2006	4.2	0.1
Dec 2005	4.8	0.3
Dec 2004	2.9	0.1
Dec 2003	1.8	0.0
Dec 2002	0.5	0.1
Dec 2001	0.1

Source: https://www.destatis.de/DE/PresseService/Presse/Pressemitteilungen/2012/03/PD12_099_61241.html

Consumer price inflation in the UK is shown in Table IV-6. The CPI index increased 0.6 percent in Feb in 2012, falling 0.5 percent in Jan after increasing 0.4 percent in Dec following increases in all months from Aug to Dec. The same four waves are present in UK CPI inflation (http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html). In the first wave in Jan-Apr, annual equivalent inflation was at a high 6.5 percent. In the second wave in May-Jul, annual equivalent inflation fell to only 0.4 percent. In the third wave in Aug-Dec, annual equivalent inflation returned at 4.6 percent. In the fourth wave in Dec to Feb, annual equivalent inflation was 2.0 percent.

Table IV-6, UK, Consumer Price Index All Items, Month and 12 Months ∆%

	Month ∆%	12 Months ∆%
Feb 2012	0.6	3.4
Jan	-0.5	3.6
Dec 2011	0.4	4.2
AE ∆% Dec-Feb	2.0
Nov	0.2	4.8
Oct	0.1	5.0
Sep	0.6	5.2
Aug	0.6	4.5
AE ∆% Aug-Dec	4.6
Jul	0.0	4.4
Jun	-0.1	4.2
May	0.2	4.5
May-Jul	0.4
Apr	1.0	4.5
Mar	0.3	4.0
Feb	0.7	4.4
Jan	0.1	4.0
AE ∆% Jan-Apr	6.5
Dec 2010	1.0	3.7
Nov	0.4	3.3
Oct	0.3	3.2
Sep	0.0	3.1
Aug	0.5	3.1
Jul	-0.2	3.1
Jun	0.1	3.2
May	0.2	3.4
Apr	0.6	3.7
Mar	0.6	3.4
Feb	0.4	3.0
Jan	-0.2	3.5

Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2012/index.html

Inflation has been unusually high in the UK since 2006, as shown in Table IV-7. There were no rates of inflation close to 2.0 percent in the period from 1997 to 2004. Inflation has exceeded 2 percent since 2005, reaching 3.6 percent in 2008, 3.3 percent in 2010 and 4.5 percent in 2011.

Table IV-7, UK, Consumer Price Index, Annual ∆%

1997	1.8
1998	1.6
1999	1.3
2000	0.8
2001	1.2
2002	1.3
2003	1.4
2004	1.3
2005	2.1
2006	2.3
2007	2.3
2008	3.6
2009	2.2
2010	3.3
2011	4.5

Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2012/index.html

Table IV-8 provides the analysis of inflation in Feb by the UK Office for National Statistics. The drivers of monthly inflation of 0.6 percent were 0.19 percentage points of clothing and footwear, 0.14 percentage points of food and nonalcoholic beverages, 0.10 percentage points of transport and 0.09 percentage points of furniture and household goods. Contributions of percentage points to the 12-month rate of consumer price inflation of 3.6 percent are provided by the final two columns in Table IV-8. Housing and household services rose 7.4 percent in 12 months, contributing 0.87 percentage points. Transport rose 3.7 percent in 12 months, contributing 0.59 percentage points. Food & nonalcoholic beverages rose 3.7 percent in 12 months, contributing 0.43 percentage points. There is only negative change of 0.9 percent in recreation and culture but with negligible impact on the index of 0.13 percentage points.

Table IV-8, UK, Consumer Price Index Month ∆% and Percentage Point Contribution by Components

Feb 2012	Month ∆%	Percentage Point Contribution	12 Months ∆%	Percentage Point Contribution
CPI All Items	0.6		3.4
Food & Non-Alcoholic Beverages	1.2	0.14	3.7	0.43
Alcohol & Tobacco	0.8	0.03	8.3	0.34
Clothing & Footwear	2.9	0.19	2.2	0.14
Housing & Household Services	-0.3	-0.05	6.8	0.87
Furniture & Household Goods	1.5	0.09	4.6	0.28
Health	0.1	0.0	3.5	0.09
Transport	0.6	0.10	3.7	0.59
Communication	0.6	-0.01	4.1	0.11
Recreation & Culture	-0.2	-0.02	-0.9	-0.13
Education	0.0	0.00	5.1	0.09
Restaurants & Hotels	0.4	0.04	2.9	0.35
Miscellaneous Goods & Services	0.6	0.06	2.9	0.28
Rounding Errors		0.0		-0.04

Source: http://www.ons.gov.uk/ons/rel/cpi/consumer-price-indices/february-2012/index.html

V World Economic Slowdown. The International Monetary Fund (IMF) has revised its World Economic Outlook (WEO) to an environment of lower growth (IMF 2012WEOJan24):

“The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere. Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated. Global output is projected to expand by 3¼ percent in 2012—a downward revision of about ¾ percentage point relative to the September 2011 World Economic Outlook (WEO).”

The IMF (2012WEOJan24) projects growth of world output of 3.8 percent in 2011 and 3.3 percent in 2012 after 5.2 percent in 2010. Advanced economies would grow at only 1.6 percent in 2011, 1.2 percent in 2012 and 3.9 percent in 2013 after growing at 3.2 percent in 2010. Emerging and developing economies would drive the world economy, growing at 6.2 percent in 2011, 5.4 percent in 2012 and 5.9 percent in 2012 after growing at 7.3 percent in 2010. The IMF is forecasting deceleration of the world economy.

World economic slowing would be the consequence of the mild recession in the euro area in 2012 caused by “the rise in sovereign yields, the effects of bank deleveraging on the real economy and the impact of additional fiscal consolidation” (IMF 2012WEOJan24). After growing at 1.9 percent in 2010 and 1.6 percent in 2010, the economy of the euro area would contract by 0.5 percent in 2012 and grow at 0.8 percent in 2013. The United States would grow at 1.8 percent in both 2011 and 2012 and at 2.2 percent in 2013. The IMF (2012WEO Jan24) projects slow growth in 2012 of Germany at 0.3 percent and of France at 0.2 percent while Italy contracts 2.2 percent and Spain contracts 1.7 percent. While Germany would grow at 1.5 percent in 2013 and France at 1.0 percent, Italy would contract 0.6 percent and Spain 0.3 percent.

The IMF (2012WEOJan24) also projects a downside scenario, in which the critical risk “is intensification of the adverse feedback loops between sovereign and bank funding pressures in the euro area, resulting in much larger and more protracted bank deleveraging and sizable contractions in credit and output.” In this scenario, there is contraction of private investment by an extra 1.75 percentage points in relation to the projections of the WEO with euro area output contracting 4 percent relative to the base WEO projection. The environment could be complicated by failure in medium-term fiscal consolidation in the United States and Japan.

There is significant deceleration in world trade volume in the projections of the IMF (2012WEOJan24). Growth of the volume of world trade in goods and services decelerates from 12.7 percent in 2010 to 6.9 percent in 2011, 3.8 percent in 2012 and 5.4 percent in 2013. Under these projections there would be significant pressure in economies in stress such as Japan and Italy that require trade for growth. Even the stronger German economy is dependent on foreign trade. There is sharp deceleration of growth of exports of advanced economies from 12.2 percent in 2010 to 2.4 percent in 2012. Growth of exports of emerging and developing economies falls from 13.8 percent in 2010 to 6.1 percent in 2012. Another cause of concern in that oil prices in the projections fall only 4.9 percent in 2012, remaining at relatively high levels.

The JP Morgan Global Manufacturing & Services PMI^™, produced by JP Morgan and Markit in association with ISM and IPFSM, rose to 55.5 in Feb from 54.5 in Jan, indicating expansion at a faster rate (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9282). This index is highly correlated with global GDP, indicating continued growth of the global economy for nearly two years and a half. The US economy drove growth in the global economy from Dec to Jan. New orders are expanding at a faster rate, increasing from 54.0 in Jan to 54.7 in Feb, suggesting further increase in business ahead. The HSBC Brazil Composite Output Index of the HSBC Brazil Services PMI^™, compiled by Markit, rose from 53.8 in Jan to 55.0 in Feb (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9279). Andre Loes, Chief Economist of HSBC in Brazil, finds that the increase of the services HSBC PMI for Brazil from 55.0 in Jan to 57.1 in Feb, which is the highest level since Jul 2007, indicate that the economy may be expanding at a faster rate than anticipated (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9279).

VA United States. Table USA provides the data table for the US.

Table USA, US Economic Indicators

Consumer Price Index	Feb 12 months NSA ∆%: 2.9; ex food and energy ∆%: 2.2 Jan month ∆%: 0.4; ex food and energy ∆%: 0.1 Blog 03/18/12
Producer Price Index	Feb 12 months NSA ∆%: 3.3; ex food and energy ∆% 3.0 Feb month SA ∆% = 0.4; ex food and energy ∆%: 0.2 Blog 03/18/12
PCE Inflation	Jan 12 months NSA ∆%: headline 2.4; ex food and energy ∆% 1.9 Blog 03/04/12
Employment Situation	Household Survey: Jan Unemployment Rate SA 8.3% Blog calculation People in Job Stress Jan: 30.5 million NSA Establishment Survey: Feb Nonfarm Jobs +227,000; Private +233,000 jobs created Jan 12 months Average Hourly Earnings Inflation Adjusted ∆%: minus 1.1% Blog 03/11/12
Nonfarm Hiring	Nonfarm Hiring fell from 69.4 million in 2004 to 50.1 million in 2011 or by 19.3 million Private-Sector Hiring Jan 2012 3.668 million lower by 1.157 million than 4.825 million in Feb 2006 Blog 03/18/12
GDP Growth	BEA Revised National Income Accounts back to 2003 IQ2011 SAAR ∆%: 0.4 IIQ2011 SAAR ∆%: 1.3 IIIQ2011 SAAR ∆%: 1.8 IVQ2011 ∆%: 3.0 Cumulative 2011 ∆%: 1.6 2011/2010 ∆%: 1.7 Blog 03/04/12
Personal Income and Consumption	Jan month ∆% SA Real Disposable Personal Income (RDPI) minus 0.1 Jan month SA ∆% Real Personal Consumption Expenditures (RPCE): 0.0 12 months NSA ∆%: RDPI: 0.6; RPCE ∆%: 1.2 Blog 03/04/2012
Quarterly Services Report	IVQ11/IIIQ11 SA ∆%: Information 0.6 Professional 1.7 Administrative -1.1 Hospitals 3.5 Blog 03/11/12
Employment Cost Index	IVQ2011 SA ∆%: 0.4 Dec 12 months ∆%: 2.0 Blog 02/05/12
Industrial Production	Feb month SA ∆%: 0.0 Feb 12 months SA ∆%: 4.0 Manufacturing Feb SA ∆% 0.3 Feb 12 months SA ∆% 5.1, NSA 5.2 Capacity Utilization: 78.7 Blog 03/18/12
Productivity and Costs	Nonfarm Business Productivity IVQ2011∆% SAAE 0.9; IVQ2011/IVQ2010 ∆% 0.3; Unit Labor Costs IVQ2011 ∆% 2.8; IVQ2011/IVQ2010 ∆%: 3.1 Blog 03/11/2012
New York Fed Manufacturing Index	General Business Conditions From Feb 19.53 to Mar 20.21 New Orders: From Feb 9.73 to Mar 6.84 Blog 03/18/12
Philadelphia Fed Business Outlook Index	General Index from Feb 10.2 to Mar 12.5 New Orders from Feb 11.7 to Mar 3.3 Blog 03/18/12
Manufacturing Shipments and Orders	Jan New Orders SA ∆%: -1.0; ex transport ∆%: -0.3 Jan NSA 12-month ∆%: 8.1; ex transport ∆% 7.2 Blog 03/11/12
Durable Goods	Jan New Orders SA ∆%: minus 4.0; ex transport ∆%: minus 3.2 Jan 12-month NSA New Orders ∆%: 8.8; ex transport ∆% : 6.6 Blog 03/04/12
Sales of New Motor Vehicles	Feb 2012 2,062,683; Feb 2011 1,813,182. Feb SAAR 15.10 million, Dec SAAR 13.56, Feb 2011 SAAR 13.29 million Blog 03/04/12
Sales of Merchant Wholesalers	Jan 2012/Jan 2010 ∆%: Total 11.3; Durable Goods: 14.1; Nondurable Goods 9.1 Blog 03/11/12
Sales and Inventories of Manufacturers, Retailers and Merchant Wholesalers	Jan 12/Jan 11 NSA ∆%: Sales Total Business 8.6; Manufacturers 8.4 Retailers 5.8; Merchant Wholesalers 11.3 Blog 03/18/12
Sales for Retail and Food Services	Feb 2012/Feb 2011 ∆%: Retail and Food Services 8.2; Retail ∆% 8.0 Blog 03/18/12
Value of Construction Put in Place	Jan SAAR month SA ∆%: minus 0.1 Jan 12-month NSA: 8.0 Blog 03/04/12
Case-Shiller Home Prices	Dec 2011/Dec 2010 ∆% NSA: 10 Cities minus 3.9; 20 Cities: minus 4.0 ∆% Dec SA: 10 Cities minus 0.5 ; 20 Cities: minus 0.5 Blog 03/04/12
FHFA House Price Index Purchases Only	Feb SA ∆% 0.0; 12 month ∆%: minus 0.7 Blog 3/25/12
New House Sales	Feb 2012 month SAAR ∆%: minus 1.6 Feb 2012/Jan 2011 NSA ∆%: 9.3 Blog 03/25/12
Housing Starts and Permits	Feb Starts month SA ∆%: minus1.6; Permits ∆%: +5.1 Jan-Feb 2012/Jan-Feb 2011 NSA ∆% Starts 25.0; Permits ∆% 34.3 Blog 3/25/12
Trade Balance	Balance Jan SA -$52,565 million versus Dec -$50,421 million Exports Jan SA ∆%: 1.4 Imports Dec SA ∆%: 2.1 Goods Exports Jan 2012/2011 NSA ∆%: 7.6 Goods Imports Jan 2011/2011 NSA ∆%: 8.4 Blog 03/11/12
Export and Import Prices	Feb 12 months NSA ∆%: Imports 4.5; Exports 1.5 Blog 03/18/12
Consumer Credit	Jan ∆% annual rate: 8.6 Blog 03/11/12
Net Foreign Purchases of Long-term Treasury Securities	Nov Net Foreign Purchases of Long-term Treasury Securities: $101.0 billion Jan versus Dec $19.1 billion Major Holders of Treasury Securities: China $1159 billion; Japan $1079 billion Blog 03/18/12
Treasury Budget	Fiscal Year 2012/2011 ∆%: Receipts 2.8; Outlays -2.4; Individual Income Taxes 0.6 Deficit Fiscal Year 2011 $1,296 billion Deficit Fiscal Year 2012 Oct-Feb $580,830 million Blog 03/18/12 CBO Forecast 2012FY Deficit $1.079 trillion Blog 03/18/2012
Flow of Funds	IVQ2011 ∆ since 2007 Assets -$7315B Real estate -$5183B Financial -$2507 Net Worth -$6743 Blog 03/11/12
Current Account Balance of Payments	IVQ2011 -$124B %GDP 3.2 Blog 03/18/12

Links to blog comments in Table USA: 03/18/12 http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

02/05/12 http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or_05.html

02/19/12 http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states_19.html

VB. Japan. The Markit/JMMA Purchasing Managers’ Index^™ (PMI^™) was mostly unchanged from 51.1 in Jan to 51.2 in Feb but still suggesting only marginal growth in private sector economic activity (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9261). New export business grew for the first time in eleven months with improvement in demand both internal and from abroad. Alex Hamilton, economist at Markit and author of the report finds continuing growth in manufacturing and services (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9261). Table JPY provides the country table for Japan.

Table JPY, Japan, Economic Indicators

Historical GDP and CPI	1981-2010 Real GDP Growth and CPI Inflation 1981-2010 Blog 07/31/11
Corporate Goods Prices	Feb ∆% 0.2 12 months ∆% 0.6 Blog 03/18/12
Consumer Price Index	Jan NSA ∆% 0.2 Jan 12 months NSA ∆% 0.1 Blog 03/04/12
Real GDP Growth	IVQ2011 ∆%: -0.2 on IIIQ2011; IVQ2011 SAAR minus 0.7% ∆% from quarter a year earlier: -0.6 % Blog 3/11/12
Employment Report	Jan Unemployed 2.91 million Change in unemployed since last year: minus 190 thousand Unemployment rate: 4.6% Blog 03/04/12
All Industry Indices	Jan month SA ∆% minus 1.0 12-month NSA ∆% -0.1 Blog 03/25/12
Industrial Production	Jan SA month ∆%: 1.9 12 months NSA ∆% minus 1.3 Blog 03/18/12
Machine Orders	Total Jan ∆% 21.6 Private ∆%: 4.6 Jan ∆% Excluding Volatile Orders 3.4 Blog 03/18/12
Tertiary Index	Jan month SA ∆% minus 1.7 Jan 12 months NSA ∆% 0.1 Blog 03/18/12
Wholesale and Retail Sales	Jan 12 months: Total ∆%: minus 2.1 Wholesale ∆%: minus 3.6 Retail ∆%: +1.9 Blog 03/04/12
Family Income and Expenditure Survey	Jan 12 months ∆% total nominal consumption minus 2.1, real minus 2.3 Blog 03/04/12
Trade Balance	Exports Feb 12 months ∆%: minus 2.7 Imports Feb 12 months ∆% +9.2 Blog 03/25/12

Links to blog comments in Table JPY: 03/18/12 http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

07/31/11: http://cmpassocregulationblog.blogspot.com/2011/07/growth-recession-debt-financial-risk.html

The indices of all industry activity of Japan, which is an approximation of GDP or economic activity, fell to levels close to the worst point of the recession, showing the brutal impact of the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. Table VB-1 with the latest revisions shows the quarterly index which permits comparison with the movement of real GDP. The first row provides weights of the various components of the index: AG (agriculture) 1.4 percent (not shown), CON (construction) 5.7 percent, IND (industrial production) 18.3 percent, TERT (services) 63.2 percent, and GOVT (government) 11.4 percent. GDP fell revised 0.2 percent in IVQ2011 (http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html), industry 0.4 percent and the tertiary sector increased 0.8 percent. The all industry index increased revised 0.1 percent in IVQ2011. Industry contributed minus 0.08 percentage points to growth of the all industry index and the tertiary index contributed 0.54 percentage points. Construction fell 1.3 percent in IVQ2011, with deduction of 0.06 percentage points and government fell 0.3 percent, deducting 0.04 percentage points. Japan had already experienced a very weak quarter in IVQ2010 with decline of the all industry index of 0.2 percent and decline of GDP of revised 0.2 percent when it was unexpectedly hit by the Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011. The worst impact of the natural disaster was on construction with drop of 7.2 percent in IIQ2011 relative to IQ2011 but recovery at 3.8 percent in IIIQ2011. Industrial production fell 4.0 percent from IQ2011 into IIQ2011 but grew 4.3 percent in IIIQ2011. Many accounts had already been closed when the earthquake occurred, but there is visible decline of the index of all industry by 1.9 percent in IQ2011 caused by decline of industrial production by 2.0 percent and services by 1.4 percent with GDP falling 1.8 percent.

Table VB-1, Japan, Indices of All Industry Activity Percentage Change from Prior Quarter SA ∆%

	CON	IND	TERT	GOVT	ALL IND	REAL GDP
Weight %	5.7	18.3	63.2	11.4	100.0
2011
IVQ	-1.3	-0.4	0.8	-0.3	0.1	-0.2
Cont to IVQ % Change	-0.06	-0.08	0.54	-0.04
IIIQ	3.8	4.3	1.2	-0.4	2.0	1.7
IIQ	-7.2	-4.0	0.0	0.7	-0.4	-0.3
IQ	2.7	-2.0	-1.4	0.2	-1.9	-1.8
2010
IV Q	-1.8	-0.1	0.3	-0.3	-0.2	-0.2

AG: indices of agriculture, forestry and fisheries has weight of 1.4% and is not included in official report or in this table; CON: indices of construction industry activity; IND: indices of industrial production; TERT: indices of tertiary industry activity; GOVT: indices of government services, etc.; ALL IND: indices of all industry activity

Source: http://www.meti.go.jp/english/statistics/tyo/zenkatu/index.html

http://www.cao.go.jp/index-e.html

There are more details in Table VB-2. The all industry activity index decreased 1.0 percent in Jan 2012 relative to Dec 2011 with decline of the tertiary or services sector by 1.7 percent and increase of industry of 1.9 percent while construction increased 4.5 percent and government increased 0.9 percent. Industry added 0.34 percentage points to growth in Jan and the tertiary sector deducted 1.12 percentage points with addition of 0.20 percentage points by construction and 0.11 percentage points by government. Weakness in Sep and Aug had interrupted the sharp recovery from Apr to Jul with renewed strength in Oct but weakness again in Nov followed by strong rebound in Dec and January. The highest risk to Japan is if weakening world growth would affect Japanese exports.

Table VB-2, Japan, Indices of All Industry Activity Percentage Change from Prior Month SA ∆%

	CON	IND	TERT	GOVT	ALL IND
Jan 2012	4.5	1.9	-1.7	0.9	-1.0
Cont to Jan % Change	0.20	0.34	-1.12	0.11
Dec 2011	-2.4	3.8	1.8	-0.6	1.6
Nov	1.9	-2.7	-0.6	0.4	-1.0
Oct	-3.8	2.2	0.8	0.3	0.9
Sep	2.3	-3.3	-0.4	-1.0	-0.8
Aug	1.8	0.6	0.1	0.0	-0.3
Jul	0.8	0.4	-0.2	-0.6	0.4
Jun	-0.3	3.8	1.9	0.3	2.2
May	3.7	6.2	0.9	1.0	2.0
Apr	-5.7	1.6	2.7	-0.1	1.7
Mar	-8.6	-15.5	-5.9	-0.1	-6.4
Feb	6.3	1.8	0.8	0.2	0.9
Jan	2.3	0.0	-0.1	0.0	-0.5
Dec 2010	-0.5	2.4	-0.2	0.3	0.1
Nov	-1.4	1.6	0.6	-0.4	0.3
Oct	0.1	-1.4	0.2	-0.1	0.0
Sep	-1.9	-0.8	-0.4	-0.1	-0.4
Aug	1.6	-0.1	0.1	0.1	-0.5
Jul	0.8	0.3	0.7	0.1	1.1
Jun	-2.1	-1.5	0.1	-0.1	0.2
May	6.3	-0.1	-0.3	0.0	0.0
Apr	-3.1	0.6	1.6	-0.2	0.9

Source: http://www.meti.go.jp/english/statistics/tyo/zenkatu/index.html

Percentage changes from a year earlier in calendar years and relative to the same quarter a year earlier are provided in Table VB-3. The first row shows that services contribute 63.2 percent of the total index and industry contributes 18.3 percent for joint contribution of 81.5 percent. The fall of industrial production in 2009 was by a catastrophic 21.9 percent. Japan emerged from the crisis with industrial growth of 16.4 percent in 2010. Quarterly data show that industry is the most dynamic sector of the Japanese economy. The all-industry index fell 0.8 percent in 2011, almost equal to the revised decline of 0.7 percent in GDP (http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html). Industry fell 3.5 percent, deducting 0.64 percentage points, while the tertiary sector was flat. The Tōhoku or Great East Earthquake and Tsunami of Mar 11, 201, declining world trade and revaluation of the yen in fear of world financial risks interrupted the recovery of the Japanese economy from the global recession.

Table VB-3, Japan, Indices of All Industry Activity Percentage Change from Earlier Calendar Year and Same Quarter Year Earlier NSA ∆%

	CON	IND	TERT	GOVT	ALL IND	REAL GDP
Weight %	5.7	18.3	63.2	11.4	100.0
Calendar Year
2011	-2.1	-3.5	0.0	0.2	-0.8	-0.7
Cont to 2011 % Change	-0.10	-0.64	0.00	0.02
2010	-7.0	16.4	1.3	-0.7	3.1	4.4
2009	-5.6	-21.9	-5.2	0.1	-7.7	-5.5
2008	-7.6	-3.4	-1.0	-1.4	-1.9	-1.0
2011
IVQ	-2.6	-2.8	0.4	0.5	-0.4	-0.6
Cont to IVQ % Change	-0.13	-0.51	0.26	0.05
IIIQ	-2.9	-2.1	0.1	0.2	-0.4	-0.4
IIQ	-4.8	-6.8	-0.5	0.5	-1.7	-1.7
IQ	1.6	-2.5	-0.1	-0.4	-0.5	-0.3
2010
IV Q	-0.6	5.9	1.6	-0.8	2.1	3.1
III Q	-3.2	14.0	1.8	-0.6	3.2	5.5
IIQ	-11.3	21.3	1.4	-0.7	3.5	4.4
IQ	-12.4	28.0	0.8	-0.5	3.9	4.8

Source: http://www.meti.go.jp/english/statistics/tyo/zenkatu/index.html

http://www.cao.go.jp/index-e.html

Percentage changes of a month relative to the same month a year earlier for the indices of all industry activity of Japan are shown in Table VB-4. The all industry activity index fell 0.1 percent in Jan 2012 relative to Jan 2011. Industry fell 1.3 in Jan 2012 relative to a year earlier, subtracting 0.22 percentage points from growth of the all industry activity index. The tertiary sector increased 0.1 percent, adding 0.07 percentage points. Construction reduced the index by 0.01 percentage points while government increased it by 0.05 percentage points.

Table VB-4, Japan, Indices of All Industry Activity Percentage Change from Same Month Year Earlier NSA ∆%

	CON	IND	TERT	GOVT	ALL IND
Jan 2012	-0.1	-1.3	0.1	0.1	-0.1
Cont to Jan % Change	-0.01	-0.22	0.0.7	0.05
Dec 2011	-2.8	-4.3	1.0	0.6	-0.2
Nov	-1.0	-4.2	-0.5	0.7	-1.1
Oct	-3.9	0.1	0.7	-0.1	0.2
Sep	-0.1	-3.3	0.0	0.5	-0.7
Aug	-4.2	0.4	0.6	-0.3	0.2
Jul	-4.5	-3.0	-0.2	1.2	-0.8
Jun	-4.5	-1.7	0.9	1.1	0.2
May	-6.0	-5.5	-0.2	0.1	-1.3
Apr	-3.8	-13.6	-2.3	0.4	-4.0
Mar	-1.1	-13.1	-3.1	-0.3	-4.5
Feb	4.4	2.9	2.0	-0.3	2.0
Jan	1.3	4.6	1.1	-0.5	1.4
Dec 2010	-0.5	5.9	1.8	-0.7	2.1
Nov	-0.5	7.0	2.5	-1.9	2.7
Oct	-1.1	5.0	0.5	0.3	1.3
Sep	-2.8	12.1	1.3	-0.6	2.7
Aug	-1.7	15.5	2.3	-1.1	3.8
Jul	-5.3	14.6	1.6	-0.1	3.3
Jun	-8.3	16.6	1.0	-0.7	3.0
May	-8.1	20.7	1.2	-0.9	3.4
Apr	-17.0	27.0	1.9	-0.4	-

Source: http://www.meti.go.jp/english/statistics/tyo/zenkatu/index.html

The structure of exports and imports of Japan is in Table VB-5. Japan imports all types of raw materials and fuels at rapidly increasing prices caused by the carry trade from zero interest rates to commodities. Mineral fuels account for 38.8 percent of Japan’s imports and increased 23.4 percent in the 12 months ending in Feb. Weakness of world demand depresses prices of industrial goods. Manufactured products contribute 12.6 percent of Japan’s exports with decline of 6.4 percent in the 12 months ending in Feb. Machinery contributes 21.6 percent of Japan’s exports with decline of 1.4 percent in the 12 months ending in Feb. Electrical machinery contributes 17.0 percent of Japan’s exports with decline of 3.4 percent in the 12 months ending in Feb. The best outcome is transport equipment with share of 24.7 percent in total exports and increase of 5.4 percent in the 12 months ending in Feb. The breakdown of transport equipment in Table VB-5 shows increase of the major categories of motor vehicles of 7.4 percent: cars increase 6.2 percent with strong growth of 17.3 in the minor category of buses and trucks but decline of 1.2 percent for parts of motor vehicles, fall of 4.9 percent for motorcycles and increase of 4.7 percent for ships. The result of rising commodity prices and stable or declining prices of industrial products is pressure on Japan’s terms of trade

Table VB-5, Japan, Structure and Growth of Exports and Imports % and ∆% Millions Yens

Feb 2012	Value JPY Millions	% of Total	12 Months∆%	Contribution Degree %
Exports	5,440,866	100.0	-2.7	-2.7
Foodstuffs	27,737	0.5	-14.9	-0.1
Raw Materials	89,238	1.6	-2.4	-0.0
Mineral Fuels	61,760	1.1	-37.9	-0.7
Chemicals	520,482	9.6	-14.8	-1.6
Manufactured Goods	687,562	12.6	-6.4	-0.8
Machinery	1,177,758	21.6	-1.4	-0.3
Electrical Machinery	926,671	17.0	-3.4	-0.6
Transport Equipment	1,344,970	24.7	5.4	1.2
Motor Vehicles	871,622	16.0	7.4	1.1
Cars	747,858	13.7	6.2	0.8
Buses & Trucks	115,833	2.1	17.3	0.3
Parts of Motor Vehicles	261,343	4.8	-1.2	-0.1
Motorcycles	31,302	0.6	2.9	0.0
Ships	132,145	2.4	4.7	0.1
Other	604,689	11.1	2.4	0.2
Imports	5,407,945	100.0	9.2	9.2
Foodstuffs	417,293	7.7	4.9	0.4
Raw Materials	363,923	6.7	-1.8	-0.1
Mineral Fuels	2,097,968	38.8	23.4	8.0
Chemicals	427,189	7.9	-1.3	-0.1
Manufactured Goods	390,456	7.2	-4.3	-0.4
Machinery	377,056	7.0	6.3	0.4
Electrical Machinery	629,507	11.6	7.3	0.9
Transport Equipment	159,548	3.0	23.8	0.6
Other	545,006	10.1	-4.8	-0.6

Source: http://www.customs.go.jp/toukei/latest/index_e.htm

Table VB-6 provides Japan’s exports, imports and trade balance in five-year intervals from 1950 to 1975 and then yearly from 1979 to 2011. Exports grew at the average yearly rate of 3.7 percent while imports grew at 3.1 percent per year in the years from 1979 to 2010. The global recession had a brutal impact on Japan’s trade. Exports fell 35.5 percent from 2007 to 2009 while imports fell 29.6 percent. Japan had the first trade deficit in 2011 since 1980. The monthly trade deficit in Jan 2012 is the highest in history.

Table VB-6, Japan, Exports and Imports Calendar Year 1979-2010 Billion Yens

Years	Exports	Imports	Balance
1950	298	348	-50
1955	723	889	-166
1960	1,459	1,616	-157
1965	3,042	2,940	102
1970	6,954	6,797	157
1975	16,545	17,170	-625
1979	22,531	24,245	-1,714
1980	29,382	31,995	-2,613
1981	33,468	31,464	2,004
1982	34,432	32,656	1,776
1983	34,909	30,014	4,895
1984	40,325	32,321	8,004
1985	41,955	31,084	10,871
1986	35,289	21,550	13,739
1987	33,315	21,736	11,579
1988	33,939	24,006	9,933
1989	37,822	28,978	8,844
1990	41,456	33,855	7,601
1991	42,359	31,900	10,459
1992	43,012	29,527	13,485
1993	40,202	26,826	13,376
1994	40,497	28,104	12,393
1995	41,530	31,548	9,982
1996	44,731	37,993	6,738
1997	50,937	40,956	9,981
1998	50,645	36,653	13,992
1999	47,547	35,268	12,279
2000	51,654	40,938	10,716
2001	48,979	42,415	6,564
2002	52,108	42,227	9,881
2003	54,548	44,362	10,186
2004	61,169	49,216	11,953
2005	65,656	56,949	8,707
2006	75,246	67,344	7,902
2007	83,931	73,135	10,796
2008	81,018	78,954	2,424
2009	54,170	51,499	2,671
2010	67,399	60,764	6,635
2011	65,555	68,048	-2,493

Source: http://www.customs.go.jp/toukei/suii/html/time_e.htm

The geographical breakdown of exports by imports of Japan with selected regions and countries is provided in Table VB-7 for Jan 2012. The share of Asia in Japan’s trade is more than one half, 53.5 percent of exports and 41.3 percent of imports. Within Asia, exports to China are 18.4 percent of total exports and imports from China 16.9 percent of total imports. The second largest export market for Japan in Feb 2012 is the US with share of 17.5 percent of total exports and share of imports from the US of 8.8 percent in total imports.

Table VB-7, Japan, Value and 12-Month Percentage Changes of Exports and Imports by Regions and Countries, ∆% and Millions of Yens

Feb 2012	Exports Millions Yens	12 months ∆%	Imports Millions Yens	12 months ∆%
Total	5,440,866	-2.7	5,407,945	9.2
Asia	2,910,120	-6.6	2,232,957	5.8
China	1,001,450	-13.9	916,614	-0.5
USA	953,396	11.9	476,269	4.3
Canada	88,202	22.7	63,454	-23.7
Brazil	39,854	-3.9	86,450	25.2
Mexico	64,429	-3.1	21,977	-17.3
Western Europe	614,124	-12.3	542,499	4.9
Germany	140,368	-9.6	149,079	12.6
France	52,593	-14.2	74,175	14.3
UK	106,082	6.0	41,614	2.1
Middle East	208,942	11.8	1,186,702	14.1
Australia	134,542	19.6	341,782	15.8

Source: http://www.customs.go.jp/toukei/latest/index_e.htm

The geographical distribution of Japan’s trade balance is provided in Table VB-8. The combined trade surpluses with the US, UK, Mexico and Western Europe of JPY 655,114 million are largely erased by the trade deficits of importing raw materials and fuels from Australia and the Middle East, adding to JPY 1,185,000 million. China typically contributes a sizeable trade deficit of Japan but not in Feb 2012 with surplus of JPY 84,836 million.

Table VB-8, Japan, Trade Balance, Millions of Yen

Jan 2012	Millions of Yen
Total	32,921
Asia	677,163
China	84,836
USA	477,127
Canada	24,748
Brazil	-46,596
Mexico	42,254
Western Europe	71,625
Germany	-8,711
France	-21,582
UK	64,468
Middle East	-977,760
Australia	-207,240

Source: http://www.customs.go.jp/toukei/latest/index_e.htm

VC. China. The HSBC Composite Output Index for China, compiled by Markit, registered an increase from 49.7 in Jan to 51.8 in Feb, suggesting improving private-sector business activity (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9262). Growth of services compensated weakness of manufacturing. Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC, finds that increases in new orders drove the increase in services but that the combination with manufacturing deceleration because of weak external orders can result in growth of only 8 percent in IQ2012 GDP until further easing permeates throughout the economy (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9262). The HSBC Flash China Manufacturing PMI^TM, compiled by Markit, fell from 49.6 in Feb to a four-month low at 48.1 in Mar, suggesting contraction at a higher pace (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9312). Hongbin Qu, Chief Economist, China and Co-head of Asian Economic Research at HSBC, finds growth restrained by sluggish new orders, which requires policy easing (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9312). Table CNY provides the country table for China.

Table CNY, China, Economic Indicators

Price Indexes for Industry	Feb 12 months ∆%: 0.0 Feb month ∆%: 0.1 Blog 03/18/12
Consumer Price Index	Feb month ∆%: -0.1 Feb 12 month ∆%: 3.2 Blog 03/11/12
Value Added of Industry	Feb month ∆%: 0.98 Jan-Feb 2012/Jan-Feb 2011 ∆%: 11.4 Blog 3/18/12
GDP Growth Rate	Year IVQ2011 ∆%: 8.9 Quarter IIQ2011 ∆%: 2.0 Blog 1/22/12
Investment in Fixed Assets	Total Jan-Feb 2012 ∆%: 21.5 Jan-Dec ∆% real estate development: 27.8 Blog 03/18/12
Retail Sales	Jan month ∆%: 1.6 Dec 12 month ∆%: 18.1 Jan-Feb ∆%: 14.7 Blog 3/18/12
Trade Balance	Feb balance minus $31.48 billion Exports ∆% 18.4 Imports ∆% 39.6 Cumulative Feb: $4.2 billion Blog 03/18/12

Links to blog comments in Table CNY:

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

01/22/12 http://cmpassocregulationblog.blogspot.com/2012/01/world-inflation-waves-united-states.html

VC Euro Area. The Markit Eurozone PMI^® Composite Output Index declined to 49.3 in Feb from 50.4 in Jan, which is the first reading above the contraction zone at 50.0 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9242). The index suggests decline of business activity during four month, expansion in Jan and then contraction in Feb. Chris Williamson, Chief Economist at Markit, finds that economic activity could have contracted 0.1 percent in IQ2012 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9242). The Markit Eurozone Flash PMI^® Composite Output Index, combining manufacturing and services with high association with euro zone GDP, declined to 48.7 in Mar from 49.3 in Feb, for the lowest reading in three months, the second consecutive decline and the sixth decrease in seven months (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9310). Chris Williamson, Chief Economist at Markit, finds decline of output in the euro zone in IVQ2011 and IQ2012 but loss of output of only about 0.1 to 0.2 percent in IQ2012 with signs of improvement in an increase in business confidence (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9310). Table EUR provides the country economic indicators for the euro area.

Table EUR, Euro Area Economic Indicators

GDP	IVQ2011 ∆% minus 0.3; IVQ2011/IVQ2010 ∆% 0.7 Blog 03/11/12
Unemployment	Jan 2012: 10.7% unemployment rate Jan 2012: 16.925 million unemployed Blog 03/04/12
HICP	Feb month ∆%: 0.5 12 months Feb ∆%: 2.7 Blog 03/18/12
Producer Prices	Euro Zone industrial producer prices Jan ∆%: 0.7 Jan 12 months ∆%: 3.7 Blog 3/04/12
Industrial Production	Jan month ∆%: 0.2 Jan 12 months ∆%: -1.2 Blog 3/18/12
Industrial New Orders	Dec month ∆%: 1.9 Oct 12 months ∆%: minus 1.7 Blog 02/26/12
Construction Output	Jan month ∆%: minus 0.8 Jan 12-month ∆%: minus 1.4 Blog 03/25/12
Retail Sales	Jan month ∆%: 0.3 Jan 12 months ∆%: 0.0 Blog 03/11/12
Confidence and Economic Sentiment Indicator	Sentiment 93.9 Feb 2012 down from 107 in Dec 2010 Confidence minus 20.1 Jan 2012 down from minus 11 in Dec 2010 Blog 03/04/12
Trade	Jan-Dec 2011/2010 Exports ∆%: 12.7 Imports ∆%: 12.3 Jan 2012 12-month Exports ∆% 10.9 Imports ∆% 3.6 Blog 3/18/12
HICP, Rate of Unemployment and GDP	Historical from 1999 to 2011 Blog 3/18/12

Links to blog comments in Table EUR:

03/18/12 http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

02/26/12 http://cmpassocregulationblog.blogspot.com/2012/02/decline-of-united-states-new-house_26.html

Construction is weak throughout most advanced economies. Growth of euro zone construction output in Table VD-1 has fluctuated with alternation of negative change. Nov is the only strong month with monthly percentage increase of 1.9 percent and 1.2 percent in 12 months. Percentage changes were negative in four of the six months from Aug to Jan. In Jan, construction fell 0.8 percent and declined 1.4 percent in 12 months.

Table VD-1, Euro Zone, Construction Output ∆%

	Month ∆%	12-Month ∆%
Jan 2012	-0.8	-1.4
Dec 2011	-1.9	9.8
Nov	1.9	1.2
Oct	-0.9	-2.0
Sep	-1.7	0.9
Aug	1.0	2.6

Source: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-19032012-AP/EN/4-19032012-AP-EN.PDF

VE Germany. The Markit Flash Germany Composite PMI^® Output Index fell from 53.2 in Feb to 51.4 in Mar, for a three-month low, suggesting only marginal expansion of output (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9307). Tim Moore, Senior Economist at Markit, finds that activity in the private sector is indicating expansion of GPD in Germany of 0.2 percent in IQ2012 (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9307). Table DE provides the country data table for Germany.

Table DE, Germany, Economic Indicators

GDP	IVQ2011 -0.2 ∆%; IV/Q2011/IVQ2010 ∆% 1.5 2011/2010: 3.0% GDP ∆% 1992-2011 Blog 02/26/12
Consumer Price Index	Feb month SA ∆%: +0.7 Feb 12-month ∆%: 2.3 Blog 03/11/12
Producer Price Index	Feb month ∆%: 0.4 12-month NSA ∆%: 3.2 Blog 03/25/12
Industrial Production	Mfg Jan month SA ∆%: 1.5 12 months NSA: 6.5 Blog 03/11/12
Machine Orders	Jan month ∆%: -2.7 Jan 12 months ∆%: -2.1 Blog 03/11/12
Retail Sales	Jan Month ∆% minus 1.6 12-Month ∆% 1.6 Blog 03/04/12
Employment Report	Unemployment Rate Feb 7.4% of Labor Force Blog 03/4/12
Trade Balance	Exports Jan 12 months NSA ∆%: 9.3 Imports Dec 12 months NSA ∆%: 6.3 Exports Jan month SA ∆%: 2.3; Imports Jan month SA 2.4 Blog 03/11/12

Links to blog comments in Table DE:

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

02/26/12 http://cmpassocregulationblog.blogspot.com/2012/02/decline-of-united-states-new-house_26.html

VF France. The Markit France Services Activity Index of the Markit France Services PMI^® fell from 52.3 in Jan to 50.0 in Feb such that the Markit France Composite Output Index fell from 51.2 in Jan to 50.2 in Feb (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9277). Higher activity in manufacturing was mostly compensated by flat activity in services. Jack Kennedy, Senior Economist at Markit and author of the Flash France PMI^®, finds encouragement in increasing orders for services even with stagnating output (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9277). Table FR provides the country data table for France. The Markit Flash France Composite PMI^® Output Index fell from 50.2 in Feb to 49.0 in Mar (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9306). Jack Kennedy, Senior Economist at Markit and author of the Flash France PMI^® finds that the data suggest slight decline in IQ2012 GDP (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9306). Table FR provides the country data table for France.

Table FR, France, Economic Indicators

CPI	Feb month ∆% 0.4 12 months ∆%: 2.3 03/18/12
PPI	Jan month ∆%: 0.6 Jan 12 months ∆%: 4.2 Blog 03/04/12
GDP Growth	IVQ2011/IIIQ2011 ∆%: 0.2 IVQ2011/IVQ2010 ∆%: 1.4 Blog 02/19/12
Industrial Production	Jan/Dec SA ∆%: Industrial Production 0.3; Manufacturing 0.2 Dec YOY NSA ∆%: Industrial Production -0.6; Manufacturing 0.6 Blog 03/11/12
Industrial New Orders	Mfg Dec ∆% +0.7 YOY ∆% minus 0.4 Blog 03/25/12
Consumer Spending	Jan Manufactured Goods ∆%: minus 0.8 Jan 12-Month Manufactured Goods ∆%: minus 2.4 Blog 03/04/12
Employment	IVQ2011 Unemployed 2.678 million Unemployment Rate: 9.4% Employment Rate: 63.8% Blog 03/04/12
Trade Balance	Jan Exports ∆%: month 1.5, 12 months 7.3 Jan Imports ∆%: month 1.9, 12 months 3.4 Blog 03/11/12
Confidence Indicators	Historical averages 100 Mar: France 95 Mfg Business Climate 96 Retail Trade 94 Services 93 Building 98 Household 82 Blog 03/25/12

Links to blog comments in Table FR:

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

02/19/12 http://cmpassocregulationblog.blogspot.com/2012/02/world-inflation-waves-united-states_19.html

France’s industrial new orders are provided in Table VF-1. Manufacturing new orders excluding heavy transport orders increased 0.7 percent in Jan 2012, increasing 0.4 percent on the quarter but falling 0.4 percent in the quarter relative to the same quarter a year earlier. Nondomestic manufacturing new orders fell 0.6 percent in Jan but after increasing 2.8 percent in Dec. Manufacturing non-domestic rose 1.9 percent in the quarter and 1.8 percent relative to the same quarter a year earlier. Motor vehicles new orders increased 0.9 percent in Jan after jumping 8.6 percent in Dec but were 9.4 percent below a year earlier.

Table VF-1, France, Industrial New Orders, ∆%

2011	Weight	Jan/ Dec	Dec/ Nov	Quarter on Quarter	Year on Year*
Mfg ex Heavy Transport	931	0.7	-0.2	0.4	-0.4
Mfg Non-Domestic	477	-0.6	2.8	1.9	1.8
Electric and Electronic	212	-2.4	-1.2	-0.5	-5.3
Motor Vehicles	240	0.9	8.6	3.7	-9.4
Other Mfg	479	1.5	-2.5	-0.2	4.6

Notes: Mfg: Manufacturing; * Last three months/same three months last year

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=91&date=20120320

The business climate survey of the Institut National de la Statistique et des Études Économiques (INSEE) of France finds improving conditions in Mar. Table VF-2 shows the INSEE business climate indicator. The headline synthetic index increased to 96 in Mar from 94 in Dec, 92 in Jan and 93 in Feb. The final row shows general production expectations falling to -27 in Feb, well below the average of -8 since 1976, but improving to -15 in Mar. The indicator of demand and export order levels fell to -33 in Feb, well below the average of -12 since 1976 but improved to -15 in Mar.

Table VF-2, France, Business Climate Indicator of Manufacturing of INSEE, General Balance of Opinion, SA

Mfg 2011-2012	Average since 1976	Nov	Dec	Jan	Feb	Mar
Synthetic Index	100	96	94	92	93	96
Recent Changes in Output	5	4	-5	-6	-7	-10
Finished- Goods Inventory Level	13	18	15	16	14	9
Demand and Total Order Levels	-17	-17	-26	-28	-26	-23
Demand and Export Order Levels	-12	-25	-20	-26	-33	-15
Personal Production Expectations	5	-5	-1	-5	-1	6
General Production Expectations	-8	-35	-36	-36	-27	-15

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=11&date=20120323

Chart VF-1 of the Institut National de la Statistique et des Études Économiques (INSEE) provides the history of the business climate synthetic index of INSEE since 1992. The index fell during the contractions of 1991, 2001 and 2008. After rapid recovery beginning in 2009 the synthetic index shows declining trend in 2011 with upward reversal in 2012.

Chart VF-1, France, INSEE Business Climate Synthetic Index

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=11&date=20120323

Chart VF-2 of the Institut National de la Statistique et des Études Économiques (INSEE) shows strong drops of the turning point indicator in the recessions of 1991, 2001 and 2008. There have been other drops of this index. The turning point indicator has fallen to levels in the direction of past contractions and after rebounding in Oct and Nov is showing declining trend in Jan with slight reversal in Feb followed by significant improvement in Mar.

Chart VF-2, INSEE Business Climate Turning Point Indicator

Source: Institut National de la Statistique et des Études

http://www.insee.fr/en/themes/info-rapide.asp?id=11&date=20120323

Chart VF-3 of the Institut National de la Statistique et des Études Économiques (INSEE) of France shows the indexes of general production expectations, personal production expectations and recent changes in output. All three indexes fell during the past three contractions after 1991, 2001 and 2008. The indexes are showing downward trend in 2011 that continued in Nov, Dec and Jan with slight reversal in Feb and significant improvement in Mar.

Chart VF-3, Climate General Production, Personal Production and Recent Changes in Output of INSEE

Source: Institut National de la Statistique et des Études Économiques

http://www.insee.fr/en/themes/info-rapide.asp?id=11&date=20120323

The Business Climate Indicator for France of the business tendency surveys of Institut National de la Statistique et des Études Économiques (INSEE) in Table VF-3 deteriorates slightly in Dec to 92 and to 91 in Jan and also 91 in Feb but improves to 95 in Mar. Retail trade fell to 89 in Jan but improved to 94 in Mar. Services fell from 100 in Jan to 98 in Mar.

Table VF-3, France, Confidence Indicators

2011-2012	Average	Nov	Dec	Jan	Feb	Mar
France	100	93	92	91	91	95
Business Climate Mfg	100 since 1976	96	94	92	93	96
Household Confidence	100 between Jan 1987 and Dec 2010	81	80	81	82	NA
Wholesale trade Business Climate	100 since 1979	96	NA	94	NA	100
Retail Trade	100	93	93	89	90	94
Services	100	92	91	91	91	93
Building	100	99	99	100	99	98

Source: Institut National de la Statistique et des Études Économiques http://www.insee.fr/en/themes/info-rapide.asp?id=105&date=20120323

VG Italy. The Markit/ADACI Purchasing Managers’ Index^® (PMI^®) rose from 46.8 in Jan to 47.8 in Feb, which is the highest level in five months for the seventh consecutive month of deterioration in manufacturing (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9224). Phil Smith, economist at Markit and author of the Italian Manufacturing PMI^® find slower rates of decline of new export orders and employment (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9224). The Markit/ADACI Business Activity Index experienced the fastest contraction since Oct, declining to 44.1 in Feb from 44.8 in Jan for the ninth consecutive monthly decline (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=9266). Phil Smith, economist at Markit and author of the Italy Services PMI^®, finds that low expectations on the future reflect impediments to growth such as cost pressures and unavailability of credit. Table IT provides the country data table for Italy.

Table IT, Italy, Economic Indicators

Consumer Price Index	Feb month ∆%: 0.4 Feb 12 months ∆%: 3.3 Blog 03/18/12
Producer Price Index	Jan month ∆%: 0.7 Jan 12-month ∆%: 3.4 Blog 03/11/12
GDP Growth	IVQ2011/IVQ2010 SA ∆%: minus 0.4 IVQ2011/IIIQ2011 NSA ∆%: minus 0.7 Blog 3/18/12
Labor Report	Jan 2012 Participation rate 62.7% Employment ratio 57.0% Unemployment rate 9.2% Blog 03/04/12
Industrial Production	Jan month ∆%: -2.5 12 months ∆%: minus 5.0 Blog 03/11/12
Retail Sales	Jan month ∆%: 0.7 Jan 12-month ∆%: minus 0.8 Blog 03/25/12
Business Confidence	Mfg Feb 91.5, Oct 93.8 Construction Feb 82.5, Oct 80.7 Blog 03/04/12
Consumer Confidence	Consumer Confidence Jan 91.6, Dec 96.1 Economy Jan 75.3, Dec 77.1 Blog 01/29/12
Trade Balance	Balance Jan SA -€199 million versus Dec €466 Exports Jan month SA ∆%: -2.5; Imports Jan month SA ∆%: -0.5 Exports 12 months NSA ∆%: +4/3 Imports 12 months NSA ∆%: -2/6 Blog 3/18/12

Links to blog comments in Table IT:

03/18/12 http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

03/04/12 http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening_04.html

01/29/12 http://cmpassocregulationblog.blogspot.com/2012/01/mediocre-economic-growth-financial.html

An important part of the analysis of Blanchard (2011WEOSep) is the much more difficult adjustment of economies with need of fiscal consolidation in the presence of weak economic growth. Demand has significantly weakened throughout the advanced economies. There are many sound fundamentals in Italy such as high income and competitive companies. The restraints consist of low economic growth with high debt/GDP ratio. Table VG-1 provides growth of retail sales for Italy. Retail sales increased 0.7 percent in Jan relative to Dec, fell 0.8 percent in Jan 2012 relative to Jan 2011 and declined 1.3 percent in Jan-Dec 2011 relative to Jan-Dec 2010.

Table VG-1, Italy, Retail Sales ∆%

	Jan 2012/ Dec 2011 SA	Nov 11-Jan 12/ Aug-Oct 11 SA	Jan 2012/ Jan 2011 NSA	Jan-Dec 2011/ Jan-Dec 2010
Total	0.7	-0.8	-0.8	-1.3
Food	1.2	-0.7	0.1	0.0
Non-food	0.7	-0.8	-0.8	-1.8

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/57710

Chart VG-1 provides 12-month percentage changes of retail sales in Italy. There are only positive changes in Dec 2010 and Apr 2011. Retail sales fell relative to a year earlier in most months of 2011 with improvement in Jan 2012.

Chart VG-2, Italy, Percentage Changes of Retail Sales in 12 Months

Source: Istituto Nazionale di Statistica

http://www.istat.it/en/

A longer perspective of retail sales in Italy is provided by monthly and 12-month percentages in 2011 and Jan 2012 and yearly rates from 2008 to 2011 in Table VG-2. Retail sales did not decline very sharply during the global recession but rose only 0.2 percent in 2010 and fell 1.3 percent in 2011. There is an evident declining trend in 2011 but only two monthly increases of 0.5 percent in Oct and 0.3 percent in Apr and negative 12-month percentage changes in every month of 2011 with the exception of 2.2 percent in Apr and zero percent in Feb. Retail sales grew 0.7 percent in Jan 2012, reducing sharply the 12-month percentage change from minus 3.7 percent in Dec 2011 to only minus 0.8 percent in Jan 2012.

Table VG-2, Italy, Retail Sales Month and 12-Month ∆%

	12-Month ∆% NSA	Month ∆% SA
Jan 2012	-0.8	0.7
Dec 2011	-3.7	-0.8
Nov	-1.8	-0.7
Oct	-1.4	0.5
Sep	-1.6	-0.4
Aug	-0.3	-0.4
July	-2.3	-0.1
Jun	-1.1	-0.2
May	-0.4	-0.4
Apr	2.2	0.3
Mar	-2.1	-0.2
Feb	0.0	0.1
Jan	-1.1	-1.0
Dec 2010	0.6	0.6
2011	-1.3
2010	0.2
2009	-1.7
2008	-0.3

Source: Istituto Nazionale di Statistica

http://www.istat.it/it/archivio/57710

VH United Kingdom. The Markit/CIPS UK Services PMI^® from from 56.0 in Dec to 53.8 in Feb because of inability to drive sales by discounting (http://www.supplymanagement.com/resources/pmi-reports/uk-services-activity-grows-but-rate-slows/). Chris Williamson, Chief Economist at Markit, finds that IQ2012 activity is the best since the spring of 2010, indicating that the UK economy will avoid another recession (http://www.supplymanagement.com/resources/pmi-reports/uk-services-activity-grows-but-rate-slows/). Table UK provides the country data table for the UK.

Table UK, UK Economic Indicators


CPI	Feb month ∆%: 0.6 Feb 12-month ∆%: 3.6 Blog 03/25/12
Output/Input Prices	Output Prices: Feb 12 months NSA ∆%: 4.1; excluding food, petroleum ∆%: 3.0 Input Prices: Jan 12 months NSA ∆%: 7.3 Excluding ∆%: 5.4 Blog 03/11/12
GDP Growth	IVQ2011 prior quarter ∆% minus 0.2; year earlier same quarter ∆%: 0.7 Blog 02/26/12
Industrial Production	Jan 2011/Dec 2010 NSA ∆%: Production Industries minus 3.8; Manufacturing 0.3 Blog 03/11/12
Retail Sales	Feb month SA ∆%: -0.8 Feb 12-month ∆%: +0.7 Blog 03/25/12
Labor Market	Nov-Jan Unemployment Rate: 8.4%; Claimant Count 5%; Earnings Growth 1.4% Blog 3/18/12
Trade Balance	Balance Jan minus ₤1762 million Exports Jan ∆%: 0.2 Nov-Jan ∆%: 4.7 Imports Jan ∆%: 1.5 Nov/Jan ∆%: 4.7 Blog 3/18/12

Links to blog comments in Table UK:

03/18/12 http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk_18.html

03/11/12 http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or_11.html

02/26/12 http://cmpassocregulationblog.blogspot.com/2012/02/decline-of-united-states-new-house_26.html

The volume of retail sales in the UK decreased 0.8 percent in Feb 2012 and rose 0.7 percent in the 12 months ending in Jan, as shown in Table VH-1. There has been significant volatility in monthly retail sales in the UK.

Table VH-1, UK, Volume of Retail Sales ∆%

	Month SA ∆%	12-Month NSA ∆%
Feb 2012	-0.8	0.7
Jan	0.3	1.2
Dec 2011	0.7	5.4
Nov	-0.2	0.4
Oct	0.7	0.7
Sep	0.7	0.4
Aug	-0.5	-1.2
Jul	0.1	-0.6
Jun	0.5	-0.5
May	-1.6	-0.7
Apr	1.1	3.5
Mar	0.0	-1.0
Feb	-0.5	0.1
Jan	1.5	3.7

Dec 2010	-1.5	-1.1

Source: http://www.ons.gov.uk/ons/rel/rsi/retail-sales/february-2012/index.html

Retail sales in the UK struggle with relatively high inflation. Table VH-2 provides 12-month percentage changes of the implied deflator of UK retail sales. The implied deflator of all retail sales rose 2.4 percent in the 12 months ending in Feb while that of sales excluding auto fuel rose 1.9 percent. The implied deflator of auto fuel sales rose to 17.0 in Sep, which is the highest 12 month increase in 2011, but then declined to 14.8 percent in Oct, 12.6 percent in Nov, 9.1 percent in Dec and 5.3 percent in both Jan and Feb. The percentage change of the implied deflator of sales of food stores at 3.9 percent in Feb is also higher than for total retail sales. Increases in fuel prices at the retail level have occurred throughout most years since 2005 as shown in Table VH-2. UK inflation is particularly sensitive to increases in commodity prices.

Table VH-2, UK, Implied Deflator of Retail Sales, 12-Month Percentage Changes, ∆%

	All Retail	Ex Auto Fuel	Food Stores	Non- Food	Auto Fuel
Jan 2012	2.4	1.9	3.9	0.2	5.3
Jan	2.2	1.8	3.5	0.6	5.3
Dec 2011	2.5	1.8	4.2	0.3	9.1
Nov	3.6	2.5	4.6	1.2	12.6
Oct	4.5	3.2	5.0	1.8	14.8
Sep	4.9	3.4	6.0	1.2	17.0
Aug	5.2	3.8	5.9	2.1	16.3
Jul	4.9	3.7	5.9	1.9	14.5
Jun	4.4	3.1	6.0	0.8	14.5
May	4.4	3.2	5.5	1.5	13.2
Apr	4.1	3.1	4.7	1.7	12.3
Mar	4.1	2.7	4.2	1.5	15.0
Feb	4.7	3.4	5.4	1.6	15.1
Jan	3.8	2.6	5.3	0.8	14.5
Dec 2010	3.1	2.4	5.1	0.6	12.4
Dec 2009	3.4	2.0	2.1	1.4	17.0
Dec 2008	-0.5	0.2	6.9	-4.4	-9.7
Dec 2007	1.7	0.4	3.9	-2.0	15.4
Dec 2006	1.0	0.8	3.3	-1.1	1.1
Dec 2005	-0.4	-1.0	1.3	-2.6	6.6

Source: http://www.ons.gov.uk/ons/rel/rsi/retail-sales/february-2012/index.html

UK monthly retail volume of sales is quite volatile, as shown in Table VH-3. Growth of total volume of sales fell 0.8 percent in Feb 2012 after increasing in Jan with 0.3 percent and in Dec with 0.7 percent. There were increases in all major categories in Jan and Dec with exception of decline of 1.7 percent of auto fuel in Jan. All categories weakened with declines in Feb.

Table VH-3, UK, Growth of Retail Sales Volume by Component Groups Month SA ∆%

	All Retail	Ex Auto Fuel	Food Stores	Non- Food	Auto Fuel
Feb 2012	-0.8	-0.8	-0.1	-1.5	-1.0
Jan	0.3	0.6	-0.5	1.3	-2.1
Dec 2011	0.7	0.6	0.7	0.7	1.1
Nov	-0.2	-0.6	-0.7	-0.8	2.9
Oct	0.7	0.6	0.7	0.7	1.2
Sep	0.7	0.8	0.0	1.6	0.0
Aug	-0.5	-0.5	0.0	-0.9	-0.9
Jul	0.1	0.1	0.9	-0.3	0.8
Jun	0.5	0.6	0.4	0.4	-1.1
May	-1.6	-1.8	-3.8	-0.6	0.6
Apr	1.1	1.2	2.6	0.0	0.1
Mar	0.0	0.1	1.0	-0.5	-0.6
Feb	-0.5	-0.7	-0.6	-1.0	1.2
Jan	1.5	0.9	0.4	1.4	7.5
Dec 2010	-1.5	-1.0	-1.9	-1.1	-6.2

Source: http://www.ons.gov.uk/ons/rel/rsi/retail-sales/february-2012/index.html

Percentage growth in 12 months of retail sales volume by component groups in the UK is provided in Table VH-4. Total retail sales grew 1.0 percent in the 12 months ending in Feb with increase of also 1.0 percent in sales excluding auto fuel. There has been significant improvement since Aug.

Table VH-4, UK, Growth of Retail Sales Volume by Component Groups 12-Month ∆%

	All Retail	Ex Auto Fuel	Food Stores	Non- Food	Auto Fuel
Feb 2012	1.0	1.0	1.0	0.0	1.1
Jan	1.4	1.1	0.5	0.4	3.3
Dec 2011	2.6	1.4	1.4	0.5	13.4
Nov	0.4	-0.2	-1.2	-1.2	5.2
Oct	0.7	0.5	0.5	-0.6	2.3
Sep	0.5	0.1	-0.2	-0.9	3.6
Aug	-1.1	-1.5	-0.5	-3.5	2.1
Jul	-0.7	-1.0	-1.0	-2.5	2.3
Jun	-0.4	-0.8	-4.0	-0.4	3.0
May	-0.5	-0.8	-3.2	-0.5	2.3
Apr	2.1	1.9	1.7	0.7	3.8
Mar	0.4	0.0	-0.9	-0.3	4.0
Feb	0.5	0.0	-2.1	0.2	4.8
Jan	3.8	3.4	-2.4	7.3	7.4
Dec 2010	-1.9	-1.2	-3.8	0.0	-8.4
Dec 2009	1.3	2.0	2.5	0.9	-4.1
Dec 2008	1.3	2.6	-1.1	4.3	-9.0

Source: http://www.ons.gov.uk/ons/rel/rsi/retail-sales/february-2012/index.html

Table VH-5 provides the analysis of the UK Office for National Statistics of contributions to the 12 months percentage changes of value and volume of retail sales in the UK. (1) The volume of retail sales increased 1.0 percent in the 12 months ending in Feb. Sales of predominantly food stores with weight of 41.7 increased 1.0 percent in the 12 months ending in Feb, contributing 0.4 percentage points. Mostly nonfood stores with weight of 43.2 percent were flat without contribution. Positive contributions to 12-month percentage changes of volume were made by non-store retailing with weight of 4.9 percent, growth of 9.2 percent and positive contribution of 0.5 percentage points and automotive fuel with weight of 10.2 percent, growth of 1.1 percent and positive contribution of 0.1 percentage points. The value of retail sales increased 3.2 percent in the 12 months ending in Feb. There were positive contributions to all general categories of retails sales except household goods stores and other: 2.1 percentage points for predominantly food stores, 0.5 percentage points for non-store retailing and 0.6 percentage points for automotive fuel.

Table VH-5, UK, Value of Retail Sales 12-month ∆% and Percentage Points Contributions by Sectors

Nov 2011	Weight % of All Retailing	Volume SA 12- Month ∆%	PP Cont. % points	Value SA 12- Month ∆%	PP Cont. % points
All Retailing	100.0	1.0		3.2
Mostly Food Stores	41.7	1.0	0.4	5.0	2.1
Mostly Nonfood Stores
Total	43.2	0.0	0.0	0.1	0.0
Non- specialized	7.8	2.9	0.2	2.0	0.2
Textile, Clothing & Footwear	12.2	-0.4	0.0	1.8	0.2
Household Goods Stores	9.7	-0.1	0.0	-1.3	-0.2
Other	13.5	-1.3	-0.2	-1.8	-0.2
Non-store Retailing	4.9	9.2	0.5	8.6	0.5
Automotive Fuel	10.2	1.1	0.1	6.2	0.6

Cont.: Contribution

Sources: http://www.ons.gov.uk/ons/rel/rsi/retail-sales/february-2012/index.html

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

Table VI-1 shows the phenomenal impulse to valuations of risk financial assets originating in the initial shock of near zero interest rates in 2003-2004 with the fed funds rate at 1 percent, in fear of deflation that never materialized, and quantitative easing in the form of suspension of the auction of 30-year Treasury bonds to lower mortgage rates. World financial markets were dominated by monetary and housing policies in the US. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of unconventional monetary policy encouraging carry trades from low US interest rates to long leveraged positions in commodities, exchange rates and other risk financial assets. The charts of risk financial assets show sharp increase in valuations leading to the financial crisis and then profound drops that are captured in Table VI-1 by percentage changes of peaks and troughs. The first round of quantitative easing and near zero interest rates depreciated the dollar relative to the euro by 39.3 percent between 2003 and 2008, with revaluation of the dollar by 25.1 percent from 2008 to 2010 in the flight to dollar-denominated assets in fear of world financial risks and then devaluation of the dollar of 11.3 percent by Fri Mar 23, 2012. Dollar devaluation is a major vehicle of monetary policy in reducing the output gap that is implemented in the probably erroneous belief that devaluation will not accelerate inflation, misallocating resources toward less productive economic activities and disrupting financial markets. The last row of Table VI-1 shows CPI inflation in the US rising from 1.9 percent in 2003 to 4.1 percent in 2007 even as monetary policy increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006.

Table VI-1, Volatility of Assets

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
∆%	444.2	-70.8	85.3
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	6/26/03	7/14/08	6/07/10	03/23/2012
Rate	1.1423	1.5914	1.192	1.3270
CNY/USD	01/03 2000	07/21 2005	7/15 2008	03/23/ 2012
Rate	8.2798	8.2765	6.8211	6.3008
New House	1963	1977	2005	2009
Sales 1000s	560	819	1283	375
New House	2000	2007	2009	2010
Median Price $1000	169	247	217	203
	2003	2005	2007	2010
CPI	1.9	3.4	4.1	1.5

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

http://www.census.gov/const/www/newressalesindex_excel.html

http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Table VI-2 extracts four rows of Table VI-I with the Dollar/Euro (USD/EUR) exchange rate and Chinese Yuan/Dollar (CNY/USD) exchange rate that reveal pursuit of exchange rate policies resulting from monetary policy in the US and capital control/exchange rate policy in China. The ultimate intentions are the same: promoting internal economic activity at the expense of the rest of the world. The easy money policy of the US was deliberately or not but effectively to devalue the dollar from USD 1.1423/EUR on Jun 26, 2003 to USD 1.5914/EUR on Jul 14, 2008, or by 39.3 percent. The flight into dollar assets after the global recession caused revaluation to USD 1.192/EUR on Jun 7, 2010, or by 25.1 percent. After the temporary interruption of the sovereign risk issues in Europe from Apr to Jul, 2010, shown in Table VI-4 below, the dollar has devalued again to USD 1.3270/EUR or by 11.3 percent {[(1.3270/1.192)-1]100}. 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. China fixed the CNY to the dollar for a long period at a highly undervalued level of around CNY 8.2765/USD subsequently revaluing to CNY 6.8211/USD until Jun 7, 2010, or by 17.6 percent and after fixing it again to the dollar, revalued to CNY 6.3105/USD on Fri Mar 9, 2012, or by an additional 7.3 percent, for cumulative revaluation of 23.6 percent. The Dow Jones Newswires informs on Oct 15 that the premier of China Wen Jiabao announced that the Chinese yuan will not be further appreciated to prevent adverse effects on exports (http://professional.wsj.com/article/SB10001424052970203914304576632790881396896.html?mod=WSJ_hp_LEFTWhatsNewsCollection). The policy appeared to be implemented because the rate of CNY 6.3838/USD on Oct 21, 2011, amounts to a small depreciation of 0.1 percent relative to the rate of CNY 6.379/USD a week earlier on Oct 14, 2011. Table VI-2 now includes three last rows with the CNY/USD weekly rate. The final row of Table VI-2 shows the percentage change from the prior week with positive signs for appreciation and negative signs for depreciation. In the week of Nov 11 there was no change but the CNY depreciated by 0.2 percent in the week of Nov 18 and by a further 0.4 percent in the week of Nov 25, for cumulative depreciation of 0.6 percent in the two weeks. In the week of Dec 2, revaluation returned with appreciation of 0.3 percent. In the week of Dec 9, there was minute depreciation of 0.1 percent. Revaluation continued with 0.3 percent in the week of Dec 16 and 0.2 percent in the week of Dec 23. Revaluation accelerated in the week of Dec 30 with appreciation of 0.7 percent. A new pause occurred in the week of Jan 6, 2012, with depreciation of 0.2 percent. China fixed the rate at CNY 6.3068/USD on Jan 13, 2012, which is virtually unchanged from the prior week. China devalued the yuan relative to the dollar by 0.4 percent with the rate of CNY 6.334/USD on Jan 20. Financial markets were closed in China during the week of Jan 27. China then resumed revaluation with 0.5 percent in the week of Feb 3, 2012. In the week of Feb 10 China revalued by an additional 0.1 percent. There was marginal devaluation of 0.1 percent in the week of Feb 17. The rate remained virtually unchanged at CNY 6.2986 in the week of Feb 24. There was virtually no change to the rate of 6.2992 on Mar 2. The rate of CNY 6.3105/USD fixed on Mar 9 is equivalent to depreciation of the CNY by 0.2 percent relative to the USD. The rate of CNY 6.3226/USD on Mar 16, 2012 is equivalent to depreciation of the CNY by 0.2 percent relative to the USD. In two weeks, the CNY depreciated by 0.4 percent. In the week of Mar 23, China resumed revaluation of 0.3 percent to CNY 6.3008/USD. The rate of CNY 6.3008/USD on Mar 23, 2012 is equivalent to revaluation of 7.6 percent from CNY 6.8211 on Jul 15, 2008 {[(6.3008/6.8211) – 1]100} and cumulative 23.9 percent from CNY 8.2765 on Jul 21, 2005 {[(6.3008/8.2765) -1]100}. Meanwhile, the Senate of the US is proceeding with a bill on China’s trade that could create a confrontation but may not be approved by the entire Congress.

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

USD/EUR	12/26/03	7/14/08	6/07/10	03/23 /2012
Rate	1.1423	1.5914	1.192	1.3270
CNY/USD	01/03 2000	07/21 2005	7/15 2008	03/23/ 2012
Rate	8.2798	8.2765	6.8211	6.3008
Weekly Rates	003/02/2012	03/09/ 2012	03/016/ 2012	03/23/ 2012
CNY/USD	6.2992	6.3105	6.3226	6.3008
∆% from Earlier Week*	0.0	-0.2	-0.2	0.3

*Negative sign is depreciation, positive sign is appreciation

Source: Table VI-1 and same table in earlier blog posts.

Dollar devaluation did not eliminate the US current account deficit, which is projected by the International Monetary Fund (IMF) with the new database of Sep 2011 at 3.1 percent of GDP in 2011 and at 2.2 percent of GDP in 2015, as shown in Table VI-3. Revaluation of the CNY has not reduced the current account surplus of China, which is projected by the IMF to increase from 5.2 percent of GDP in 2011 to 7.0 percent of GDP in 2015.

Table VI-3, Fiscal Deficit, Current Account Deficit and Government Debt as % of GDP and 2011 Dollar GDP

	GDP $B 2011	FD %GDP 2011	CAD %GDP 2011	Debt %GDP 2011	FD%GDP 2015	CAD%GDP 2015	Debt %GDP 2015
US	15065	-7.9	-3.1	72.6	-3.1	-2.2	86.7
Japan	5855	-8.9	2.5	130.5	-8.4	2.4	160.0
UK	2481	-5.7	-2.7	72.9	0.4	-0.9	75.2
Euro	13355	-1.5	0.1	68.6	1.5	0.5	69.3
Ger	3629	0.4	5.0	56.9	2.1	4.7	55.3
France	2808	-3.4	-2.7	80.9	-2.5	0.6	83.9
Italy	2246	0.5	-3.5	100.4	4.5	-2.0	96.7
Can	1759	-3.7	-3.3	34.9	0.3	-2.6	35.1
China	6988	-1.6	5.2	22.2	0.1	7.0	12.9
Brazil	2518	3.2	-2.3	38.6	2.9	-3.2	34.1

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

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

Source: http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/index.aspx

The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/fmu/eng/2012/01/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/update/01/fmindex.htm). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider global economic and financial risks, which are analyzed in the comments of this blog.

Economic risks include the following:

2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. (i) The US economy grew at 1.6 percent in 2011 (http://cmpassocregulationblog.blogspot.com/2012/03/mediocre-economic-growth-flattening.html). (ii) The labor market continues fractured with 30.5 million unemployed or underemployed (http://cmpassocregulationblog.blogspot.com/2012/03/thirty-million-unemployed-or.html ). There are over 10 million fewer full-time jobs and hiring has collapsed (section I in this blog comment and earlier at http://cmpassocregulationblog.blogspot.com/2012/02/hiring-collapse-ten-million-fewer-full.html). (iii) There is a difficult climb from the record deficit of 9.9 percent in 2009 and cumulative deficit of $5,082 in four consecutive years of deficits exceeding one trillion dollars from 2009 to 2012 (http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html). There is no subsequent jump of debt in US peacetime history as the one from 40.5 percent of GDP in 2008 to 62.8 percent of GDP in 2011 and projected by the Congressional Budget Office (CBO 2012JanBEO) at 67.7 percent in 2012. The CBO (2012JanBEO) must use current law without any changes in the baseline scenario but also calculates another alternative scenario with different assumptions. In the alternative scenario, the debt/GDP ratio rises to 94.2 percent by 2022. The US is facing an unsustainable debt/GDP path. Feldstein (2012Mar19) finds that the most troubling uncertainty in the US is the programmed tax increases projected by the CBO (2012JanBEO) under current law with federal government revenue increasing from $2.4 trillion in fiscal year 2012 to $2.9 trillion in fiscal year 2013. The increase of $512 billion of federal revenue would be about 2.9 percent of GDP, raising the share of federal revenue in GDP from 15.8 percent in fiscal year 2012 to 18.7 percent of GDP in fiscal year 2013. In the analysis of Feldstein (2012Mar19), increasing revenue would originate in higher personal tax rates, payroll tax contributions and taxes on dividends, capital gains and corporate income tax. The share of federal revenue in GDP would increase to 19.8 percent in 2014, remaining above 20 percent during the rest of the decade. Feldstein (2012Mar19) finds that such a shock of sustained tax increases would risk another recession in 2013, requiring preventive legislation to smooth tax increases

A list of financial uncertainties includes:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk. Adjustment programs consist of immediate adoption of economic reforms that would increase future growth permitting fiscal consolidation that would reduce risk spreads on sovereign debt. Fiscal consolidation is challenging in an environment of weak economic growth as analyzed by Blanchard (2011WEOSep). Adjustment of countries such as Italy requires depreciation of the currency to parity, as proposed by Caballero and Giavazzi (2012Jan15), but it is not workable within the common currency and zero interest rates in the US. Bailouts of euro area member countries with temporary liquidity challenges cannot be permanently provided by the stronger members at the risk of impairing their own sovereign debt credibility

3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes. For example, the DJIA has increased 35.0 percent since the trough of the sovereign debt crisis in Europe on Jul 2, 2010, and the S&P 500 has gained 36.6 percent. It is challenging in theory and practice to assess when variables have peaked but sustained valuations to very high levels could be followed by contractions of valuations

The analysis by Kydland and Prescott (1977, 447-80, equation 5) uses the “expectation augmented” Phillips curve with the natural rate of unemployment of Friedman (1968) and Phelps (1968), which in the notation of Barro and Gordon (1983, 592, equation 1) is:

U_t = Uⁿ_t – α(π_t – π^e) α > 0 (1)

W = W(π_t, U_t) (2)

5. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path. Some analytical aspects of the carry trade are instructive (Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 101-5, Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4), Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-4). Consider the following symbols: R_t is the exchange rate of a country receiving carry trade denoted in units of domestic currency per dollars at time t of initiation of the carry trade; R_t₊_τ is the exchange of the country receiving carry trade denoted in units of domestic currency per dollars at time t+τ when the carry trade is unwound; i_f is the domestic interest rate of the high-yielding country where investment will be made; i_usd is the interest rate on short-term dollar debt assumed to be 0.5 percent per year; i_f >i_usd, which expresses the fact that the interest rate on the foreign country is much higher than that in short-term USD (US dollars); S_t is the dollar value of the investment principal; and π is the dollar profit from the carry trade. The investment of the principal S_t in the local currency debt of the foreign country provides a profit of:

π = (1 + i_f)(R_tS_t)(1/R_t₊_τ) – (1 + i_usd)S_t (3)

The profit from the carry trade, π, is nonnegative when:

(1 + i_f)/(1 + i_usd) ≥ R_t₊_τ/R_t (4)

In a world of exchange wars, depreciation of the host-country currency can move even faster such that the profits from the carry trade may become major losses. Depreciation is the percentage change in instants against which the interest rate of a day is in the example [(10)(1/360)] or 0.03 percent. Exchange rates move much faster in the real world as in the overshooting model of Dornbusch (1976). Profits in carry trades have greater risks but equally greater returns when the short position in zero interest rates, or borrowing, and on the dollar, are matched with truly agile financial risk assets such as commodities and equities. A simplified analysis could consider the portfolio balance equations A_ij = f(r, x) where A_ij is the demand for i = 1,2,∙∙∙n assets from j = 1,2, ∙∙∙m sectors, r the 1xn vector of rates of return, r_i, of n assets and x a vector of other relevant variables. Tobin (1969) and Brunner and Meltzer (1973) assume imperfect substitution among capital assets such that the own first derivatives of A_ij are positive, demand for an asset increases if its rate of return (interest plus capital gains) is higher, and cross first derivatives are negative, demand for an asset decreases if the rate of return of alternative assets increases. Theoretical purity would require the estimation of the complete model with all rates of return. In practice, it may be impossible to observe all rates of return such as in the critique of Roll (1976). Policy proposals and measures by the Fed have been focused on the likely impact of withdrawals of stocks of securities in specific segments, that is, of effects of one or several specific rates of return among the n possible rates. In fact, the central bank cannot influence investors and arbitrageurs to allocate funds to assets of desired categories such as asset-backed securities that would lower the costs of borrowing for mortgages and consumer loans. Floods of cheap money may simply induce carry trades in arbitrage of opportunities in fast moving assets such as currencies, commodities and equities instead of much lower returns in fixed income securities (see http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/07/causes-of-2007-creditdollar-crisis.html http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html).

It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 above after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion. Table VI-4, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 03/23/12,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values show positive change in valuation in column “∆% Trough to 03/23/12” after surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23. Asia and financial entities are experiencing their own risk environments. The highest valuations are by US equities indexes: DJIA 35.0 percent and S&P 500 36.6 percent, driven by stronger earnings and economy in the US than in other advanced economies. The DJIA reached in intraday trading 13,331.77 on Mar 16, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, all assets in the column “∆% Trough to 03/23/12” had double digit gains relative to the trough around Jul 2, 2010 but now only two valuation show increase of less than 10 percent: China’s Shanghai Composite is 1.4 percent below the trough; and STOXX 50 of Europe is 8.4 percent above the trough. DJ UBS Commodities is 16.2 percent above the trough; Dow Global is 17.5 percent above the trough; and DAX is 23.4 percent above the trough. Japan’s Nikkei Average is 13.5 percent above the trough on Aug 31, 2010 and 12.1 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 10,011.47 on Fri Mar 23, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 2.4 percent lower than 10,254.43 on Mar 11 on the date of the Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 11.3 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 03/23/12” in Table VI-4 shows declines of all valuations of risk financial assets in the week of Mar 23, 2012 because of the new issues of world economic and financial risks. There are still high uncertainties on European sovereign risks, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table VI-4 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 03/23/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Mar 23, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 03/23/12” but also relative to the peak in column “∆% Peak to 03/23/12.” There are now only three equity indexes above the peak in Table VI-4: DJIA 16.7 percent, S&P 500 14.8 percent and Dax 10.5 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 9.9 percent, Nikkei Average by 12.1 percent, Shanghai Composite by 25.8 percent, STOXX 50 by 8.2 percent and Dow Global by 4.1 percent. DJ UBS Commodities Index is now 0.7 percent below the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010.

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

	Peak	Trough	∆% to Trough	∆% Peak to 03/23 /12	∆% Week 03/23/ 12	∆% Trough to 03/23 12
DJIA	4/26/ 10	7/2/10	-13.6	16.7	-1.1	35.0
S&P 500	4/23/ 10	7/20/ 10	-16.0	14.8	-0.5	36.6
NYSE Finance	4/15/ 10	7/2/10	-20.3	-9.9	-0.7	13.1
Dow Global	4/15/ 10	7/2/10	-18.4	-4.1	-1.6	17.5
Asia Pacific	4/15/ 10	7/2/10	-12.5	-1.2	-1.2	12.9
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-12.1	-1.2	13.5
China Shang.	4/15/ 10	7/02 /10	-24.7	-25.8	-2.3	-1.4
STOXX 50	4/15/10	7/2/10	-15.3	-8.2	-2.4	8.4
DAX	4/26/ 10	5/25/ 10	-10.5	10.5	-2.3	23.4
Dollar Euro	11/25 2009	6/7 2010	21.2	12.3	-0.7	-11.3
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-0.7	-1.5	16.2
10-Year T Note	4/5/ 10	4/6/10	3.986	2.234

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

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

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. Table VI-5 shows a gain by Apr 29, 2011 in the DJIA of 14.3 percent and of the S&P 500 of 12.5 percent since Apr 26, 2010, around the time when sovereign risk issues in Europe began to be acknowledged in financial risk asset valuations. The last row of Table VI-5 for Mar 23, 2012, shows that the S&P 500 is now 15.3 percent above the Apr 26, 2010 level and the DJIA is 16.7 percent above the level on Apr 26, 2010. Multiple rounds of risk aversion eroded the earlier gains, showing that risk aversion can destroy market value even with zero interest rates. Relaxed risk aversion has contributed to recovery of valuations. Much the same as zero interest rates and quantitative easing have not had any effects in recovering economic activity while distorting financial markets and resource allocation.

Table VI-5, Percentage Changes of DJIA and S&P 500 in Selected Dates

2010	∆% DJIA from prior date	∆% DJIA from Apr 26	∆% S&P 500 from prior date	∆% S&P 500 from Apr 26
Apr 26
May 6	-6.1	-6.1	-6.9	-6.9
May 26	-5.2	-10.9	-5.4	-11.9
Jun 8	-1.2	-11.3	2.1	-12.4
Jul 2	-2.6	-13.6	-3.8	-15.7
Aug 9	10.5	-4.3	10.3	-7.0
Aug 31	-6.4	-10.6	-6.9	-13.4
Nov 5	14.2	2.1	16.8	1.0
Nov 30	-3.8	-3.8	-3.7	-2.6
Dec 17	4.4	2.5	5.3	2.6
Dec 23	0.7	3.3	1.0	3.7
Dec 31	0.03	3.3	0.07	3.8
Jan 7	0.8	4.2	1.1	4.9
Jan 14	0.9	5.2	1.7	6.7
Jan 21	0.7	5.9	-0.8	5.9
Jan 28	-0.4	5.5	-0.5	5.3
Feb 4	2.3	7.9	2.7	8.1
Feb 11	1.5	9.5	1.4	9.7
Feb 18	0.9	10.6	1.0	10.8
Feb 25	-2.1	8.3	-1.7	8.9
Mar 4	0.3	8.6	0.1	9.0
Mar 11	-1.0	7.5	-1.3	7.6
Mar 18	-1.5	5.8	-1.9	5.5
Mar 25	3.1	9.1	2.7	8.4
Apr 1	1.3	10.5	1.4	9.9
Apr 8	0.03	10.5	-0.3	9.6
Apr 15	-0.3	10.1	-0.6	8.9
Apr 22	1.3	11.6	1.3	10.3
Apr 29	2.4	14.3	1.9	12.5
May 6	-1.3	12.8	-1.7	10.6
May 13	-0.3	12.4	-0.2	10.4
May 20	-0.7	11.7	-0.3	10.0
May 27	-0.6	11.0	-0.2	9.8
Jun 3	-2.3	8.4	-2.3	7.3
Jun 10	-1.6	6.7	-2.2	4.9
Jun 17	0.4	7.1	0.04	4.9
Jun 24	-0.6	6.5	-0.2	4.6
Jul 1	5.4	12.3	5.6	10.5
Jul 8	0.6	12.9	0.3	10.9
Jul 15	-1.4	11.4	-2.1	8.6
Jul 22	1.6	13.2	2.2	10.9
Jul 29	-4.2	8.4	-3.9	6.6
Aug 05	-5.8	2.1	-7.2	-1.0
Aug 12	-1.5	0.6	-1.7	-2.7
Aug 19	-4.0	-3.5	-4.7	-7.3
Aug 26	4.3	0.7	4.7	-2.9
Sep 02	-0.4	0.3	-0.2	-3.1
Sep 09	-2.2	-1.9	-1.7	-4.8
Sep 16	4.7	2.7	5.4	0.3
Sep 23	-6.4	-3.9	-6.5	-6.2
Sep 30	1.3	-2.6	-0.4	-6.7
Oct 7	1.7	-0.9	2.1	-4.7
Oct 14	4.9	3.9	5.9	1.0
Oct 21	1.4	5.4	1.1	2.2
Oct 28	3.6	9.2	3.8	6.0
Nov 04	-2.0	6.9	-2.5	3.4
Nov 11	1.4	8.5	0.8	4.3
Nov 18	-2.9	5.3	-3.8	0.3
Nov 25	-4.8	0.2	-4.7	-4.4
Dec 02	7.0	7.3	7.4	2.7
Dec 09	1.4	8.7	0.9	3.6
Dec 16	-2.6	5.9	-2.8	0.6
Dec 23	3.6	9.7	3.7	4.4
Dec 30	-0.6	9.0	-0.6	3.8
Jan 6 2012	1.2	10.3	1.6	5.4
Jan 13	0.5	10.9	0.9	6.4
Jan 20	2.4	13.5	2.0	8.5
Jan 27	-0.5	13.0	0.1	8.6
Feb 3	1.6	14.8	2.2	11.0
Feb 10	-0.5	14.2	-0.2	10.8
Feb 17	1.2	15.6	1.4	12.3
Feb 24	0.3	15.9	0.3	12.7
Mar 2	0.0	15.8	0.3	13.0
Mar 9	-0.4	15.3	0.1	13.1
Mar 16	2.4	18.1	2.4	15.9
Mar 23	-1.1	16.7	-0.5	15.3

Source: http://professional.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3014

Table VI-6, updated with every blog comment, shows that exchange rate valuations affect a large variety of countries, in fact, almost the entire world, in magnitudes that cause major problems for domestic monetary policy and trade flows. Dollar devaluation is expected to continue because of zero fed funds rate, expectations of rising inflation, large budget deficit of the federal government (http://professional.wsj.com/article/SB10001424052748703907004576279321350926848.html?mod=WSJ_hp_LEFTWhatsNewsCollection) and now zero interest rates indefinitely but with interruptions caused by risk aversion events. Such an event actually occurred in the week of Sep 23 reversing the devaluation of the dollar in the form of sharp appreciation of the dollar relative to other currencies from all over the world including the offshore Chinese yuan market. Column “Peak” in Table VI-6 shows exchange rates during the crisis year of 2008. There was a flight to safety in dollar-denominated government assets as a result of the arguments in favor of TARP (Cochrane and Zingales 2009). This is evident in various exchange rates that depreciated sharply against the dollar such as the South African rand (ZAR) at the peak of depreciation of ZAR 11.578/USD on Oct 22, 2008, subsequently appreciating to the trough of ZAR 7.238/USD by Aug 15, 2010 but now depreciating by 6.1 percent to ZAR 7.6815/USD on Mar 23, 2012, which is still 33.7 percent stronger than on Oct 22, 2008. An example from Asia is the Singapore Dollar (SGD) highly depreciated at the peak of SGD 1.553/USD on Mar 3, 2009 but subsequently appreciating by 13.2 percent to the trough of SGD 1.348/USD on Aug 9, 2010 but is now only 6.4 percent stronger at SGD 1.2614/USD on Mar 23 relative to the trough of depreciation but still stronger by 18.8 percent relative to the peak of depreciation on Mar 3, 2009. Another example is the Brazilian real (BRL) that depreciated at the peak to BRL 2.43/USD on Dec 5, 2008 but appreciated 28.5 percent to the trough at BRL 1.737/USD on Apr 30, 2010, showing depreciation of 4.2 percent relative to the trough to BRL 1.8099/USD on Mar 12, 2012 but still stronger by 25.5 percent relative to the peak on Dec 5, 2008. At one point in 2011 the Brazilian real traded at BRL 1.55/USD and in the week of Sep 23 surpassed BRL 1.90/USD in intraday trading for depreciation of more than 20 percent. The Banco Central do Brasil, Brazil’s central bank, lowered its policy rate SELIC for the fourth consecutive meeting of its monetary policy committee, COPOM (http://www.bcb.gov.br/textonoticia.asp?codigo=3440&IDPAI=NEWS):

“Copom reduces the Selic rate to 9.75 percent

07/03/2012 7:00:00 PM

Brasília - Continuing the process of adjustment of monetary conditions, the Copom decided to reduce the Selic rate to 9.75 percent, without bias, with five votes for the monetary policy action and two votes in favor of reducing the Selic rate by 50 basis points.”

Jeffrey T. Lewis, writing on “Brazil steps up battle to curb real’s rise,” on Mar 1, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203986604577255793224099580.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes new measures by Brazil to prevent further appreciation of its currency, including the extension of the tax on foreign capital for three years terms, subsequently broadened to five years, and intervention in the foreign exchange market by the central bank. Unconventional monetary policy of zero interest rates and quantitative easing creates trends such as the depreciation of the dollar followed by Table VI-6 but with abrupt reversals during risk aversion. The main effects of unconventional monetary policy are on valuations of risk financial assets and not necessarily on consumption and investment or aggregate demand.

Table VI-6, Exchange Rates

	Peak	Trough	∆% P/T	Mar 23, 2012	∆T Mar 23, 2012	∆P Mar 23, 2012
EUR USD	7/15 2008	6/7 2010		03/23 2012
Rate	1.59	1.192		1.3270
∆%			-33.4		10.2	-19.8
JPY USD	8/18 2008	9/15 2010		03/23 2012
Rate	110.19	83.07		82.35
∆%			24.6		0.9	25.3
CHF USD	11/21 2008	12/8 2009		03/23 2012
Rate	1.225	1.025		0.9081
∆%			16.3		11.4	25.9
USD GBP	7/15 2008	1/2/ 2009		03/23 2012
Rate	2.006	1.388		1.5869
∆%			-44.5		12.5	-26.4
USD AUD	7/15 2008	10/27 2008		03/23 2012
Rate	1.0215	1.6639		1.0468
∆%			-62.9		42.6	6.5
ZAR USD	10/22 2008	8/15 2010		03/23 2012
Rate	11.578	7.238		7.6815
∆%			37.5		-6.1	33.7
SGD USD	3/3 2009	8/9 2010		03/23 2012
Rate	1.553	1.348		1.2614
∆%			13.2		6.4	18.8
HKD USD	8/15 2008	12/14 2009		03/23 2012
Rate	7.813	7.752		7.7678
∆%			0.8		-0.2	0.6
BRL USD	12/5 2008	4/30 2010		03/23 2012
Rate	2.43	1.737		1.8099
∆%			28.5		-4.2	25.5
CZK USD	2/13 2009	8/6 2010		03/23 2012
Rate	22.19	18.693		18.537
∆%			15.7		0.8	16.5
SEK USD	3/4 2009	8/9 2010		03/23 2012
Rate	9.313	7.108		6.7338
∆%			23.7		5.3	27.7
CNY USD	7/20 2005	7/15 2008		03/23 2012
Rate	8.2765	6.8211		6.3008
∆%			17.6		7.6	23.9

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; CNY: Chinese yuan; 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://professional.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm

Chart VI-1 of the Board of Governors of the Federal Reserve System provides indexes of the dollar from 2010 to 2012. The dollar depreciates during episodes of risk appetite but appreciate during risk aversion as funds seek dollar-denominated assets in avoiding financial risk.

Chart VI-1, Broad, Major Currency, and Other Important Trading Partners Indexes for the US Dollar

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/DataDownload/Chart.aspx?rel=H10&series=122e3bcb627e8e53f1bf72a1a09cfb81&lastObs=260&from=&to=&filetype=csv&label=include&layout=seriescolumn&pp=Download&names=%7bH10/H10/JRXWTFB_N.B,H10/H10/JRXWTFN_N.B,H10/H10/JRXWTFO_N.B%7d

Chart VI-2 of the Board of Governors of the Federal Reserve System provides the exchange rate of the US relative to the euro, or USD/EUR. During maintenance of the policy of zero fed funds rates the dollar appreciates during periods of significant risk aversion such as the flight into US government obligations in late 2008 and early 2009 and during the various fears generated by the European sovereign debt crisis.

Chart VI-2, US Dollars per Euro, 2009-2012

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/DataDownload/Chart.aspx?rel=H10&series=e85cfb140ce469e13bec458013262fa1&lastObs=780&from=&to=&filetype=csv&label=include&layout=seriescolumn&pp=Download&names=%7bH10/H10/RXI$US_N.B.EU%7d

Table VI-7, updated with every blog comment, provides in the second column the yield at the close of market of the 10-year Treasury note on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the 10-year note current at the time of the second round of quantitative easing after Nov 3, 2010 and the final column “∆% 11/04/10” calculates the percentage change of the price on the date relative to that of 101.2573 at the close of market on Nov 4, 2010, one day after the decision on quantitative easing by the Fed on Nov 3, 2010. Prices with new coupons such as 2.0 percent in recent auctions (http://www.treasurydirect.gov/RI/OFAuctions?form=extended&cusip=912828RR3) are not comparable to prices in Table VI-7. The highest yield in the decade was 5.510 percent on May 1, 2001 that would result in a loss of principal of 22.9 percent relative to the price on Nov 4. Monetary policy has created a “duration trap” of bond prices. Duration is the percentage change in bond price resulting from a percentage change in yield or what economists call the yield elasticity of bond price. Duration is higher the lower the bond coupon and yield, all other things constant. This means that the price loss in a yield rise from low coupons and yields is much higher than with high coupons and yields. Intuitively, the higher coupon payments offset part of the price loss. Prices/yields of Treasury securities were affected by the combination of Fed purchases for its program of quantitative easing and also by the flight to dollar-denominated assets because of geopolitical risks in the Middle East, subsequently by the tragic Great East Japan Earthquake and Tsunami and now again by the sovereign risk doubts in Europe and the growth recession in the US and the world. The yield of 2.234 percent at the close of market on Fri Mar 23, 2012 would be equivalent to price of 103.4867 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price gain of 2.2 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing, as shown in the first to the last row of Table VI-7. The price loss between Mar 9, 2012 and Mar 16, 2012 is 2.3 percent but much higher when using common leverage of 10:1. If inflation accelerates, yields of Treasury securities may rise sharply. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed, the tragic Tōhoku or Great East Earthquake and Tsunami of Mar 11, 2011 affecting Japan, recurring fears on European sovereign credit issues and worldwide risk aversion in the week of Sep 30 caused by “let’s twist again” monetary policy. The realization of a growth standstill recession is also influencing yields. Important causes of the earlier rise in yields shown in Table VI-7 are expectations of rising inflation and US government debt estimated to be around 70 percent of GDP in 2012 (http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html http://cmpassocregulationblog.blogspot.com/2011/08/united-states-gdp-growth-standstill.html http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html), rising from 40.5 percent of GDP in 2008, 54.1 percent in 2009 (Table IV-1 at http://cmpassocregulationblog.blogspot.com/2012/02/thirty-one-million-unemployed-or.html and Table 2 in http://cmpassocregulationblog.blogspot.com/2011/04/budget-quagmire-fed-commodities_10.html) and 67.7 percent in 2011. On Mar 21, 2012, the line “Reserve Bank credit” in the Fed balance sheet stood at $2876 billion, or $2.9 trillion, with portfolio of long-term securities of $2586 billion, or $2.6 trillion, consisting of $1567 billion Treasury nominal notes and bonds, $69 billion of notes and bonds inflation-indexed, $99 billion Federal agency debt securities and $851 billion mortgage-backed securities; reserve balances deposited with Federal Reserve Banks reached $1543 billion or $1.5 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There is no simple exit of this trap created by the highest monetary policy accommodation in US history together with the highest deficits and debt in percent of GDP since World War II. Risk aversion from various sources, discussed in section III World Financial Turbulence, has been affecting financial markets for several months. The risk is that in a reversal of risk aversion that has been typical in this cyclical expansion of the economy yields of Treasury securities may back up sharply.

Table VI-7, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note

Date	Yield	Price	∆% 11/04/10
05/01/01	5.510	78.0582	-22.9
06/10/03	3.112	95.8452	-5.3
06/12/07	5.297	79.4747	-21.5
12/19/08	2.213	104.4981	3.2
12/31/08	2.240	103.4295	2.1
03/19/09	2.605	100.1748	-1.1
06/09/09	3.862	89.8257	-11.3
10/07/09	3.182	95.2643	-5.9
11/27/09	3.197	95.1403	-6.0
12/31/09	3.835	90.0347	-11.1
02/09/10	3.646	91.5239	-9.6
03/04/10	3.605	91.8384	-9.3
04/05/10	3.986	88.8726	-12.2
08/31/10	2.473	101.3338	0.08
10/07/10	2.385	102.1224	0.8
10/28/10	2.658	99.7119	-1.5
11/04/10	2.481	101.2573	-
11/15/10	2.964	97.0867	-4.1
11/26/10	2.869	97.8932	-3.3
12/03/10	3.007	96.7241	-4.5
12/10/10	3.324	94.0982	-7.1
12/15/10	3.517	92.5427	-8.6
12/17/10	3.338	93.9842	-7.2
12/23/10	3.397	93.5051	-7.7
12/31/10	3.228	94.3923	-6.7
01/07/11	3.322	94.1146	-7.1
01/14/11	3.323	94.1064	-7.1
01/21/11	3.414	93.4687	-7.7
01/28/11	3.323	94.1064	-7.1
02/04/11	3.640	91.750	-9.4
02/11/11	3.643	91.5319	-9.6
02/18/11	3.582	92.0157	-9.1
02/25/11	3.414	93.3676	-7.8
03/04/11	3.494	92.7235	-8.4
03/11/11	3.401	93.4727	-7.7
03/18/11	3.273	94.5115	-6.7
03/25/11	3.435	93.1935	-7.9
04/01/11	3.445	93.1129	-8.0
04/08/11	3.576	92.0635	-9.1
04/15/11	3.411	93.3874	-7.8
04/22/11	3.402	93.4646	-7.7
04/29/11	3.290	94.3759	-6.8
05/06/11	3.147	95.5542	-5.6
05/13/11	3.173	95.3387	-5.8
05/20/11	3.146	95.5625	-5.6
05/27/11	3.068	96.2089	-4.9
06/03/11	2.990	96.8672	-4.3
06/10/11	2.973	97.0106	-4.2
06/17/11	2.937	97.3134	-3.9
06/24/11	2.872	97.8662	-3.3
07/01/11	3.186	95.2281	-5.9
07/08/11	3.022	96.5957	-4.6
07/15/11	2.905	97.5851	-3.6
07/22/11	2.964	97.0847	-4.1
07/29/11	2.795	98.5258	-2.7
08/05/11	2.566	100.5175	-0.7
08/12/11	2.249	103.3504	2.1
08/19/11	2.066	105.270	3.7
08/26/11	2.202	103.7781	2.5
09/02/11	1.992	105.7137	4.4
09/09/11	1.918	106.4055	5.1
09/16/11	2.053	101.5434	0.3
09/23/11	1.826	107.2727	5.9
09/30/11	1.912	106.4602	5.1
10/07/11	2.078	104.9161	3.6
10/14/11	2.251	103.3323	2.0
10/21/11	2.220	103.6141	2.3
10/28/11	2.326	102.6540	1.4
11/04/11	2.066	105.0270	3.7
11/11/11	2.057	105.1103	3.8
11/18/11	2.003	105.6113	4.3
11/25/11	1.964	105.9749	4.7
12/02/11	2.042	105.2492	3.9
12/09/11	2.065	105.0363	3.7
12/16/11	1.847	107.0741	5.7
12/23/11	2.027	105.3883	4.1
12/30/11	1.871	106.8476	5.5
01/06/12	1.957	106.0403	4.7
01/13/12	1.869	106.8664	5.5
01/20/12	2.026	105.3976	4.1
01/27/12	1.893	106.6404	5.3
02/03/12	1.923	106.3586	5.0
02/10/12	1.974	105.8815	4.6
02/17/12	2.000	105.6392	4.3
02/24/12	1.977	105.8535	4.5
03/02/12	1.977	105.8535	4.5
03/09/12	2.031	105.3512	4.0
03/16/12	2.294	102.9428	1.7
03/23/12	2.234	103.4867	2.2

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates and the coupon of 2.625% on 11/04/10

Source:

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

VII Economic Indicators. Crude oil input in refineries decreased 0.9 percent to 14,506 thousand barrels per day on average in the four weeks ending on Mar 16, 2012 from 14,637 thousand barrels per day in the four weeks ending on Mar 9, 2012, as shown in Table VII-1. The rate of capacity utilization in refineries continues at a relatively high level of 83.1 percent on Mar 16, 2012, which is higher than 82.6 percent on Mar 11, 2011 and slightly lower than 83.9 percent on Mar 9, 2012. Imports of crude oil decreased 2.4 percent from 8,890 thousand barrels per day on average in the four weeks ending on Mar 9 to 8,673 thousand barrels per day in the week of Mar 16. The Energy Information Administration (EIA) informs that “US crude oil imports averaged 8.2 million barrels per day last week, down by 492 thousand barrels per day from the previous week [Mar 16]” (http://www.eia.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf). Slight decrease in utilization in refineries with sharply declining imports at the margin in the prior week resulted in decrease of commercial crude oil stocks by 1.2 million barrels from 347.5 million barrels on Mar 9 to 346.3 million barrels on Mar 16. Motor gasoline production decreased 0.6 percent to 8,756 thousand barrels per day in the week of Mar 16 from 8,809 thousand barrels per day on average in the week of Mar 9. Gasoline stocks decreased 1.2 million barrels and stocks of fuel oil increased 1.8 million barrels. Supply of gasoline fell from 9,065 thousand barrels per day on Mar 18, 2011, to 8,355 thousand barrels per day on Mar 16, 2012, or by 7.8 percent, while fuel oil supply fell 7.1 percent. Part of the fall in consumption of gasoline is due to higher prices and part to the growth recession. Table VII-1 also shows increase in the WTI price of crude oil by 6.2 percent from Mar 18, 2011 to Mar 16, 2012. Gasoline prices rose 8.6 percent from Mar 21, 2011 to Mar 19, 2012. Increases in prices of crude oil and gasoline relative to a year earlier are moderating because year earlier prices are already reflecting the commodity price surge and commodity prices have been declining recently during worldwide risk aversion. Gasoline prices are increasing to the highest levels at this time of the year.

Table VII-1, US, Energy Information Administration Weekly Petroleum Status Report

Four Weeks Ending Thousand Barrels/Day	3/16/12	3/9/12	3/11/11
Crude Oil Refineries Input	14,506 Week ∆%: -0.9	14,637	14,068
Refinery Capacity Utilization %	83.1	83.9	82.6
Motor Gasoline Production	8,756 Week ∆%: -0.6	8,809	9,005
Distillate Fuel Oil Production	4,225 Week ∆%: -0.3	4,237	4,153
Crude Oil Imports	8,673 Week ∆%: -2.4	8,890	8,461
Motor Gasoline Supplied	8,355 ∆% 2012/2011= -7.8%	8,417	9,065
Distillate Fuel Oil Supplied	3,567 ∆% 2012/2011 = -8.4%	3,594	3,896
	3/16/12	3/9/12	3/11/11
Crude Oil Stocks Million B	346.3 ∆= -1.2 MB	347.5	352.8
Motor Gasoline Million B	226.9 ∆= -1.2 MB	228.1	219.7
Distillate Fuel Oil Million B	136.6 ∆= 1.8 MB	134.8	152.6
WTI Crude Oil Price $/B	107.3 ∆% 2012/2011 6.2	107.40	101.06
	3/19/12	3/12/12	3/21/11
Regular Motor Gasoline $/G	3.867 ∆% 2012/2011 +8.6	3.829	3.562

B: barrels; G: gallon

Source: http://www.eia.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/pdf/highlights.pdf

Chart VII-1 of the US Energy Information Administration shows commercial stocks of crude oil of the US. There have been fluctuations around an upward trend since 2005. Crude oil stocks trended downwardly during a few weeks but with fluctuations.

Chart VII-1, US, Weekly Crude Oil Ending Stocks

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCESTUS1&f=W

Chart VII-2 of the US Energy Information Administration provides closer view of distillate oil stocks since Jun 2010. Distillate fuel oil stocks rose in a clear trend in 2011 but began to drop on a downward trend after May 2011. There is less need to stock oil after May with declining prices if it is anticipated that prices in future months may be lower. Distillate fuel oil stocks have been in a clear downward trend for some weeks with slight reversal in the past week.

Chart VII-2, US, Distillate Fuel Oil Stocks

Source: US Energy Information Administration

http://www.eia.gov/petroleum/

Chart VII-3 of the US Energy Information Administration shows the price of WTI crude oil since the 1980s. Chart VII-3 captures commodity price shocks during the past decade. The costly mirage of deflation was caused by the decline in oil prices during the recession of 2001. The upward trend after 2003 was promoted by the carry trade from near zero interest rates. The jump above $140/barrel during the global recession in 2008 can only be explained by the carry trade promoted by monetary policy of zero fed funds rate. After moderation of risk aversion, the carry trade returned with resulting sharp upward trend of crude prices.

Chart IIC-13, US, Crude Oil Futures Contract

Source: US Energy Information Administration

http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D

There is significant difference between initial claims for unemployment insurance adjusted and not adjusted for seasonality provided in Table VII-2. Seasonally adjusted claims fell 5,000 from 353,000 on Mar 10 to 348,000 on Mar 17. Claims not adjusted for seasonality fell 24,441 from 340,077 on Mar 10 to 315,636 on Mar 17. Strong seasonality is preventing clear analysis of labor markets.

Table VII-2, US, Initial Claims for Unemployment Insurance

	SA	NSA	4-week MA SA
Mar 17, 12	348,000	315,636	355,000
Mar 10, 12	353,000	340,077	356,250
Change	-5,000	-24,441	-1,250
Mar 3, 12	365,000	368,433	355,750
Prior Year	394,000	354,457	391,000

Note: SA: seasonally adjusted; NSA: not seasonally adjusted; MA: moving average

Source: http://www.dol.gov/opa/media/press/eta/ui/current.htm

Table VII-3 provides seasonally and not seasonally adjusted claims in the comparable week for the years from 2001 to 2012. Seasonally adjusted claims typically are lower than claims not adjusted for seasonality. Claims not seasonally adjusted have declined from 601,192 on Mar 14, 2009 to 354,457 on Mar 19, 2011, and now to 315,636 on Mar 17, 2012. There is strong indication of significant decline in the level of layoffs in the US. Hiring has not recovered (see Hiring Collapse at http://cmpassocregulationblog.blogspot.com/2012/03/global-financial-and-economic-risk.html).

Table VII-3, US, Unemployment Insurance Weekly Claims

	Not Seasonally Adjusted Claims	Seasonally Adjusted Claims
Mar 17, 2001	351,497	393,000
Mar 16, 2002	352,045	392,000
Mar 15, 2003	389,909	430,000
Mar 13, 2004	312,067	338,000
Mar 19, 2005	290,719	329,000
Mar 18, 2006	269,237	303,000
Mar 17, 2007	277,187	307,000
Mar 15, 2008	335,909	365,000
Mar 14, 2009	601,192	640,000
Mar 20, 2010	413,067	460,000
Mar 19, 2011	354,457	394,000
Mar 17, 2012	315,636	348,000

Source: http://www.workforcesecurity.doleta.gov/unemploy/claims.asp

VIII Interest Rates. It is quite difficult to measure inflationary expectations because they tend to break abruptly from past inflation. There could still be an influence of past and current inflation in the calculation of future inflation by economic agents. Table VIII-1 provides inflation of the CPI. In the quarter Dec 2011 to Feb 2012, CPI inflation for all items seasonally adjusted was 2.4 percent in annual equivalent, that is, compounding inflation in Dec-Feb and assuming it would be repeated for a full year. In the 12 months ending in Feb, CPI inflation of all items not seasonally adjusted was 2.9 percent. Inflation in Feb 2012 not seasonally adjusted was 0.4 percent relative to Jan 2011 (http://www.bls.gov/cpi/). The second row provides the same measurements for the CPI of all items excluding food and energy: 2.2 percent in 12 months and 1.6 percent in annual equivalent. Bloomberg provides the yield curve of US Treasury securities (http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/). The lowest yield is 0.07 percent for three months, 0.14 percent for six months, 0.17 percent for 12 months, 0.35 percent for two years, 0.54 percent for three years, 1.08 percent for five years, 1.64 percent for seven years, 2.23 percent for ten years and 3.31 percent for 30 years. The Irving Fisher definition of real interest rates is approximately the difference between nominal interest rates, which are those estimated by Bloomberg, and the rate of inflation expected in the term of the security, which could behave as in Table VIII-1. Real interest rates in the US have been negative during substantial periods in the past decade while monetary policy pursues a policy of attaining its “dual mandate” of (http://www.federalreserve.gov/aboutthefed/mission.htm):

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

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

Table VIII-1, US, Consumer Price Index Percentage Changes 12 months NSA and Annual Equivalent ∆%

	∆% 12 Months Feb 2012/Feb 2011 NSA	∆% Annual Equivalent Dec 2011-Feb 2012 SA
CPI All Items	2.9	2.4
CPI ex Food and Energy	2.2	1.6

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

IX Conclusion. The US economy is in growth standstill at an annual equivalent rate in the four quarters of 2011 of 1.6 percent primarily driven by drawing on savings. Real disposable income stagnates in 12 months and declines at the margin. There are around 30 million people in the US unemployed or underemployed. Real wages are falling. There is no exit from unemployment, underemployment and falling real wages because of the collapse of hiring. The euro is fighting for survival. Inflation has occurred in three waves in 2011 with higher inflation induced by carry trades from zero interest rates to commodity futures when there is subdued risk aversion. Inflation declined in the middle of the year because of unwinding carry trades as a result of financial risk aversion originating in the sovereign debt crisis of Europe. Unconventional monetary policy of zero interest rates and large-scale purchases of assets using the central bank’s balance sheet is designed to increase aggregate demand by stimulating consumption and investment. In practice, there is no control of how cheap money will be used. An alternative allocation of cheap money is through the carry trade from zero interest rates and short dollar positions to exposures in risk financial assets such as equities, commodities and so on. After a decade of unconventional monetary policy it may be prudent to return to normalcy so as to avoid adverse side effects of financial turbulence and inflation waves. Normal monetary policy would also encourage financial intermediation required for financing sound long-term projects that can stimulate economic growth and full utilization of resources. (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)

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Appendix I. The Great Inflation

Inflation and unemployment in the period 1966 to 1985 is analyzed by Cochrane (2011Jan, 23) by means of a Phillips circuit joining points of inflation and unemployment. Chart I1 for Brazil in Pelaez (1986, 94-5) was reprinted in The Economist in the issue of Jan 17-23, 1987 as updated by the author. Cochrane (2011Jan, 23) argues that the Phillips circuit shows the weakness in Phillips curve correlation. The explanation is by a shift in aggregate supply, rise in inflation expectations or loss of anchoring. The case of Brazil in Chart I1 cannot be explained without taking into account the increase in the fed funds rate that reached 22.36 percent on Jul 22, 1981 (http://www.federalreserve.gov/releases/h15/data.htm) in the Volcker Fed that precipitated the stress on a foreign debt bloated by financing balance of payments deficits with bank loans in the 1970s; the loans were used in projects, many of state-owned enterprises with low present value in long gestation. The combination of the insolvency of the country because of debt higher than its ability of repayment and the huge government deficit with declining revenue as the economy contracted caused adverse expectations on inflation and the economy. This interpretation is consistent with the case of the 24 emerging market economies analyzed by Reinhart and Rogoff (2010GTD, 4), concluding that “higher debt levels are associated with significantly higher levels of inflation in emerging markets. Median inflation more than doubles (from less than seven percent to 16 percent) as debt rises from the low (0 to 30 percent) range to above 90 percent. Fiscal dominance is a plausible interpretation of this pattern.”

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

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

Chart I1, Brazil, Phillips Circuit 1963-1987

©Carlos Manuel Pelaez, O cruzado e o austral. São Paulo: Editora Atlas, 1986, pages 94-5. Reprinted in: Brazil. Tomorrow’s Italy, The Economist, 17-23 January 1987, page 25.

DeLong (1997, 247-8) shows that the 1970s were the only peacetime period of inflation in the US without parallel in the prior century. The price level in the US drifted upward since 1896 with jumps resulting from the two world wars: “on this scale, the inflation of the 1970s was as large an increase in the price level relative to drift as either of this century’s major wars” (DeLong, 1997, 248). Monetary policy focused on accommodating higher inflation, with emphasis solely on the mandate of promoting employment, has been blamed as deliberate or because of model error or imperfect measurement for creating the Great Inflation (http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html). As DeLong (1997) shows, the Great Inflation began in the mid 1960s, well before the oil shocks of the 1970s (see also the comment to DeLong 1997 by Taylor 1997, 276-7). TableI1 provides the change in GDP, CPI and the rate of unemployment from 1960 to 1990. There are three waves of inflation (1) in the second half of the 1960s; (2) from 1973 to 1975; and (3) from 1978 to 1981. In one of his multiple important contributions to understanding the Great Inflation, Meltzer (2005) distinguishes between one-time price jumps, such as by oil shocks, and a “maintained” inflation rate. Meltzer (2005) uses a dummy variable to extract the one-time oil price changes, resulting in a maintained inflation rate that was never higher than 8 to 10 percent in the 1970s. There is revealing analysis of the Great Inflation and its reversal by Meltzer (2005, 2010a, 2010b).

Table I1, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1960-1982

	∆% GDP	∆% CPI	UNE
1960	2.5	1.4	6.6
1961	2.3	0.7	6.0
1962	6.1	1.3	5.5
1963	4.4	1.6	5.5
1964	5.8	1.0	5.0
1965	6.4	1.9	4.0
1966	6.5	3.5	3.8
1967	2.5	3.0	3.8
1968	4.8	4.7	3.4
1969	3.1	6.2	3.5
1970	0.2	5.6	6.1
1971	3.4	3.3	6.0
1972	5.3	3.4	5.2
1973	5.8	8.7	4.9
1974	-0.6	12.3	7.2
1975	-0.2	6.9	8.2
1976	5.4	4.9	7.8
1977	4.6	6.7	6.4
1978	5.6	9.0	6.0
1979	3.1	13.3	6.0
1980	-0.3	12.5	7.2
1981	2.5	8.9	8.5
1982	-1.9	3.8	10.8
1983	4.5	3.8	8.3
1984	7.2	3.9	7.3
1985	4.1	3.8	7.0
1986	3.5	1.1	6.6
1987	3.2	4.4	5.7
1988	4.1	4.4	5,3
1989	3.6	4.6	5.4
1990	1.9	6.1	6.3

Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment; CPI and UNE are at year end instead of average to obtain a complete series

Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2009&LastYear=2010&3Place=N&Update=Update&JavaBox=no

http://www.bls.gov/web/empsit/cpseea01.htm

http://data.bls.gov/pdq/SurveyOutputServlet

There is a false impression of the existence of a monetary policy “science,” measurements and forecasting with which to steer the economy into “prosperity without inflation.” Market participants are remembering the Great Bond Crash of 1994 shown in Table I2 when monetary policy pursued nonexistent inflation, causing trillions of dollars of losses in fixed income worldwide while increasing the fed funds rate from 3 percent in Jan 1994 to 6 percent in Dec. The exercise in Table I2 shows a drop of the price of the 30-year bond by 18.1 percent and of the 10-year bond by 14.1 percent. CPI inflation remained almost the same and there is no valid counterfactual that inflation would have been higher without monetary policy tightening because of the long lag in effect of monetary policy on inflation (see Culbertson 1960, 1961, Friedman 1961, Batini and Nelson 2002, Romer and Romer 2004). The pursuit of nonexistent deflation during the past ten years has resulted in the largest monetary policy accommodation in history that created the 2007 financial market crash and global recession and is currently preventing smoother recovery while creating another financial crash in the future. The issue is not whether there should be a central bank and monetary policy but rather whether policy accommodation in doses from zero interest rates to trillions of dollars in the fed balance sheet endangers economic stability.

Table I2, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994

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

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

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

1.75 to 2.0

2.5 to 2.75

3.75 to 4.5

Longer Run