The Financial

State of the Union

Cosmos Club

Washington, DC

September 20, 2012

Important Notice

Proprietary and Confidential

This presentation and any information and discussions concerning its contents, are the proprietary information of the Center for Financial Stability (CFS). Disclosure of this information is accompanied by an obligation

that the recipient receive and hold this information in confidence, and not use or disclose it except for the purposes of conducting business with CFS or except with the prior written permission of CFS.

Copyright © 2012 CFS as an unpublished work. All rights reserved.

Lawrence Goodman President – Center for Financial Stability

2

Contents

I. Global Macro Themes

II. Deficits and Debt

III. It's the Principal that Matters!

IV. “Nontraditional” Monetary Operations

V. Implications for Reserve Currency Status

VI. Concluding Thoughts / New Policy Strategies

3

World Trade: Extreme Policy Response Limits

Duration of Recession…Distortions Remain

Source: IMF Direction of Trade Statistics and Center for Financial Stability .

0

200

400

600

800

1,000

1,200

1,400

1,600

Jan-70 Jan-74 Jan-78 Jan-82 Jan-86 Jan-90 Jan-94 Jan-98 Jan-02 Jan-06 Jan-10

US$

Bill

ion

, R

eal

Ju

ne

'12

Oil ShockTrade: - 26% in 15 months

Fed Policy ShiftTrade: - 31%in 47 months

Tech BubbleTrade = - 24%in 16 months

US RecessionTrade: - 24% in 27 months

Financial CrisisTrade: - 42% in7 months

4

Spectrum of Fundamental Drivers: Why Advanced Economies look more like Emerging Markets.

Advanced

Economies

Middle Income

Emerging Markets

Fragile

States

More strictly

ECONOMIC analysis

More strictly

POLITICAL analysis

Economics Politics

5

Weak, Fragile and Volatile Economic Recovery

Source: Bureau of Economic Analysis and Center for Financial Stability . -10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

q/q

sa

ar

Average since '50

Latest Recession

Q3 '07

Q2 '12

Deeper and longer recession: Q3 2008 - Q2 2009

Weaker, fragile and volatile recovery: Q3 2009 - present

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10

Great Recession

Great Depression

1982 Recession

Strong and Swift US Fiscal Response: ’08 - ’11

6

Cumulative Deficits in Deep Downturns, % of GDP

Source: Office of Management and Budget, Historical Financial Statistics and Center for Financial Stability.

0%

20%

40%

60%

80%

100%

120%

140%

1929 1939 1949 1959 1969 1979 1989 1999 2009 2019

Safe Threshold

105% in 2012

THEFUTURE!!!

7

Fiscal Stimulus and Capacity to Expand

Source: US Treasury, Bureau of Economic Analysis and Center for Financial Stability.

8

It’s the Principal Matters!!!

Despite legitimate concerns regarding the budget deficit,

large refinancings of debt represent an equally severe – yet

lesser known challenge. The experience of emerging markets

and some advanced economies suggests that…it is the

repayment of principal that often triggers a crisis rather than

simply the size of the debt or deficit.

From: “Treasury Maturities: The Other Fiscal Problem,” March 10, 2011

(http://www.centerforfinancialstability.org/research/USFiscal031011.pdf)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1973 1978 1983 1988 1993 1998 2003 2008

Mat

uri

ng

De

bt,

% o

f G

DP

Average (1973 - 2007) Fiscal Surplusesreduced

refuning needs

Low and Stable Refunding Demands on Treasury Market

Surge in Treasury Debt Rollovers

9

USG Debt Maturities Spike in Coming Year

Note: Interest bearing public debt held by private investors.

Source: US Treasury and Center for Financial Stability.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

<1y 1-5 5-10 >10

% o

f To

tal

Mat

uri

tie

s1946

2012

Post WWII

Today

10

More Dangerous Treasury Debt Profile

Note: Interest bearing public debt held by private investors.

Source: US Treasury and Center for Financial Stability.

Although

US public

debt-to-

GDP was

higher after

the post-

WWII

period, the

profile of

maturing

obligations

was much

safer!

11

Limits to the Fed’s Quantitative Easing (QE)

With thanks to William Barnett, Director of Advances in Monetary and Financial Measurement and Jeff van den Noort, Chief

Technology Officer at the Center for Financial Stability.

Source: Federal Reserve, other official bank rates, and the Center for Financial Stability.

50

100

150

200

250

300

350

400

450

500

Jan

-00

Au

g-0

0

Mar

-01

Oct

-01

May

-02

Dec

-02

Jul-

03

Feb

-04

Sep

-04

Ap

r-0

5

No

v-0

5

Jun

-06

Jan

-07

Au

g-0

7

Mar

-08

Oct

-08

May

-09

Dec

-09

Jul-

10

Feb

-11

Sep

-11

Ap

r-1

2

Ind

ex

Jan

uar

y 2

00

0 =

10

0

Base Money

CFS DM4-

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

20

09

Q1

20

09

Q2

20

09

Q3

20

09

Q4

20

10

Q1

20

10

Q2

20

10

Q3

20

10

Q4

20

11

Q1

20

11

Q2

20

11

Q3

20

11

Q4

20

12

Q1

12

Federal Reserve Funding of Fiscal Deficit Net Purchases of Treasury Securities by the Fed, %

Source: Federal Reserve, Flow of Funds Accounts and the Center for Financial Stability.

Fed purchases

of Treasury

bonds distort

market

relationships.

0

10

20

30

40

50

60

70

Jan

-20

Jan

-25

Jan

-30

Jan

-35

Jan

-40

Jan

-45

Jan

-50

Jan

-55

Jan

-60

Jan

-65

Jan

-70

Jan

-75

Jan

-80

Jan

-85

Jan

-90

Jan

-95

Jan

-00

Jan

-05

Jan

-10

Pri

ce-t

o-E

arn

ings

or

Pri

ce t

o Y

ield

Vau

lati

on

UST Bond Valuation

S&P Price Earnings Ratio

Average PE = 17

13

Policy Distortions: Risks for Markets and Fed

Source: Robert Shiller (Yale University), Bloomberg LP, and Center for Financial Stability.

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

55%

57%

59%

61%

63%

65%

67%

69%

71%

73%

75%

Q1 1999 Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 Q1 2011

% o

f To

tal

Ho

ldin

gs,

Oth

er

Cu

rre

nci

es

% o

f To

tal

Ho

ldin

gs,

USD

USD - left axis

Other Currencies - right axis

Constant drop in USD holdings Surge in Holdings of "Other" Currencies

14

Reserve Currencies: Shifting “Stores of Value”

Note: Composition of World Central Bank Reserves. “Other” is largely AUD, CAD, NOK, SEK and NZD.

Source: Datastream, International Monetary Fund (COFER) and Center for Financial Stability.

15

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