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May 2001

Effect of US Government Policies on the Financial Market Economy

By Wale Idris

Columbus University
Post Office Box 19167
New Orleans, Louisiana 70179-0167

Telephone: (504) 486-2101

Fax: (504) 483-3265

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By Wale Idris
Table of Contents

Preface I-IV

1. The Role of Government in the Financial market 1-7

a. A Retrospect of the US Financial Market Economy 2-3
b. The Onset Of The American Market Hegemony 3-4
i. The New Deal 4-5
ii. NASDAQ 5
iii. Reaganomics 6
iv. The Internet 7

2. The Power of the Federal Reserve System 8-15

a. Board Members 9
b. Scope of Integrity 10-11
i. New York 11
ii. Philadelphia 11
iii. Cleveland 12
iv. Chicago 12
v. St. Louis 12-13
vi. Minneapolis 13
vii. San Francisco 13
viii. Boston (District One) 13-14
c. The Humphrey-Hawkins law 14
d. The Feds Mandate 15-16

3. The Federal Reserve Reform Act 17-18

a. The Greenspan effect 17-18

4. Monetary Regulation 19-27

a. Value of Money 19-22
b. Money Supply Vs Money Stock 23-24
i. M1 24-25
ii. M2 25-26
iii. M3 26-27
5. Monetary Policy 28-39
a. Interpretation of policy 30-31
b. Variable Lags 31-32
c. Conflict of Interests 32-33
d. The Phenomenon of Public Expectation 33-34
e. The Policy Focus 34-35
f. Open Market Operations 35-36
i. Bank Reserves 36
ii. Discount rate 36
iii. Foreign Currency Operations 37
iv. Federal Funds Market 37-38
g. Federal Fund Rates 38
i. Adds and Drains 39

6. United States Department of the Treasury 40-41

a. Duties of the US Treasury Department 41

7. Fiscal Policy 42-50

a. Historical Lessons in the U.S. Tax reforms 42-44
b. The Burden of Higher Taxes on Capital Formation 44-46
c. Tax biases on income 46-47
d. Benefits of Tax reduction 47-48
e. Criticisms of Tax cut 48-50

8. The Federal Budget 51-55

a. Deficits and Surpluses 51
b. Budget Resolution 51-53
c. The Patterns of Federal Government spending 53
d. President George W. Bushs Budget Proposal 54-55

9. Federal Deficit 56-59

a. Public Held Debt 56
b. Gross Federal Debt 56-57
c. Effects of Federal Debt on the Economy 57-58
d. Debt as a share of GDP 59
10. The Risks of Inflation 60-67
a. Analysis of Inflation 61-64
i. The Keynesian theory 62-63
b. The Impact of Inflation 64-65
c. Price stability 66-67

11. Current Economic Indicators 68-81

a. Gross Domestic Product 69-70
b. GDP price deflator 70-71
c. The Consumer Price Index (CPI) 71-72
d. Import and Export Prices (United States) 72-76
e. Employment Cost Index (ECI) 76-78
f. Producer Price Indexes (PPI) 78-79
g. The Economic Cycle Research Institute (ECRI) Future Inflation Gauge 80-81

12. The Yield Curve 82-90

a. The Yield Curve as a Predictor of Recession 83-84
b. A Probability of Recession 84-85
c. Estimating the Probability of Recession 86-90

13. The U.S. Financial Market System 91-108

a. U.S. Securities and Exchange Commission 92-97
i. Regulation Integrity 94-95
ii. International Relations 96
iii. International Regulation 96
iv. The Bottom line 97
b. Amplitude of the US Financial Services 97-98
i. Financial Instruments and Products 99
c. Analysis of the US Financial Market Fundamentals 100-01
i. The Primary Market 100
ii. The Secondary Market 100-01
d. The Financial Markets 101
e. The Money Market 102
i. Types of Money Market Instruments 103-05
ii. Derivatives Markets 105
f. Financial Exchanges 106
g. The Capital Market 106-08

14. The Basic Principles of Intermarket Analysis 108-29

a. Global Effect 109-15
i. Japans Effect on U.S. Market 110-11
ii. Focal Points 111-12
iii. Global Waves 112-13
iv. The Euro Zone 113-15
b. Intermarket Relationship 116-18
c. Commodities versus Bonds 119-22
d. Bonds and Equities factor 123-27
e. The Healthcare Sector 127-28
f. Commodities as Economic indicators 128-29

15. The Oil Factor 130-45

a. Transport Hurt By Rising Oil 132-34
b. The Repercussion of Oil Dependence 135
c. How the World Has Became Utterly Dependent On Oil 135-36
d. The Organization of Petroleum Exporting Countries (OPEC) 137
e. World Crude Oil Reserves 138-39
i. Highlights of Oil Crisis 139
ii. World Crude Oil Supply & Demand Balance 140
f. The Real and Nominal Crises 141-45

16. The Wealth Effect 146-60

a. The Premise of Wealth Creation 150-52
b. Consequences of the Wealth Effect 152-53
c. The logic of Investment Failure 154-55
d. The Lack of Wealth Effect 155
e. Consumer Confidence 156-60

17. Saving the US Economy 161-72

a. The Duties and Responsibilities of the United States 162-63
b. US Foreign Exchange and Trade Controls - 1st Quarter 2001 163-64
c. The US Economy Need Not Recede 165-66
d. The Riddles of the US Financial Crisis 166-67
e. Comparison between Job Cuts and the Executive Pay trends 167-69
f. Executive Pay Rises at Three Times Rate of Inflation 170-72

18. The Culture of Transformation 173-87

a. The Efficiency of Value 173-75
b. The Ideals of Nationalism 175-76
c. Economic Nations 176-77
d. Developing Nations 177-79
e. The Nominal Nations 179-85
f. The Progress of Efficiency 185-86
g. The Publics Private Economy 187

19. Global Finance 188-92

a. Country Risk Assessment 189--90
i. External debt analysis and debt-equity conversion opportunities 189
ii. Capital Flight and Money Laundering 189
iii. Enhancing private sector involvement 189
iv. Customized Global Security instruments 189
b. The Role of Technology Development in Globalization 190-92

20. The Worlds Wealth 193-

a. World Wealth Ranked by Individuals 195
b. The Philosopher Kings of Global Finance 196
c. Citigroups Sandy Weill 196-00
21. Conclusion 201-
Resources I-V

1. The Twelve Federal Reserve Districts (Chart: 0.1) 10
2. Key Cross Currency Rates (Chart: 0.2) 21
3. Nominal US Dollar Exchange Rate indexes (Chart: 0.3) 22
4. M2 Velocity comparisons (Chart: 0.4) 25
5. Top Tax rate and total Federal Reserve Revenue (Chart: 0.5) 44
6. Capital to Labor Ratio and Real wage rates (Chart: 0.6) 45
7. Presidents 10 year budget plan (Chart: 0.7) 55
8. Government Spending (Chart: 0.8) 57
9. Annualized Inflation- Adjusted return (Chart: 0.9) 65
10. GDP trend impact on Economy (Chart: 1.0) 69
11. GDP Deflator trend impact on Economy (Chart: 1.1) 71
12. ECI (Chart: 1.2) 77
13. Yield curve (Chart: 1.3) 82
14. Yield Spread (Chart: 1.4) 83
15. Comparative Indicative Indices (Chart: 1.5) 86
16. Risk Reward Tradeoff (Chart: 1.6) 107
17. The Best/worst total returns (Chart: 1.7) 107
18. The historical price spread/Indexes (Chart: 1.8) 109
19. Intra-day-spread analysis (Chart: 1.9) 109
20. Japans Effect on U.S. Market (Chart: 2.0) 110
21. Commodity Index Value (Chart: 2.1) 118
22. Commodity Index Movers (Chart: 2.2) 119
23. Treasury Commodity comparative analysis Chart: 2.3) 120
24. Bar Chart Treasury yield (Chart: 2.4) 121
25. Regression Analysis (Chart: 2.5) 122
26. Stock Indexes Vs Government Bonds (Chart: 2.6) 124
27. Consumer/Oil Vs Rates (Chart: 2.7) 125
28. REIT/NASDAQ/ reaction to Rates Chart: 2.8) 126
29. Biotech/Pharmaceutical/NASDAQ analysis (Chart: 2.9) 127
30. Gold/Treasury/Cooper/Lumber Analytics (Chart: 3.0) 128
31. Fed Fund Rate/Treasury Yield and Crude Oil (Chart: 3.1) 131
32. Treasury Yield and Crude Oil Comparison (Chart: 3.2) 132
33. Comparative Return analysis Oil Vs Transportation (Chart: 3.3) 134
34. World Crude Oil Supply & Demand Balance (Chart: 3.4) 140
35. Ranked Return Analysis of World Equity Indices (Chart: 3.5) 143
36. Trade Balance with China (Chart: 3.6) 144
37. Wealth Effect in Action (Chart: 3.7A&B) 148-49
38. ABC /Money National Economy status analytics (Chart: 3.8) 150
39. National economy plunge: (Chart: 3.9) 153
40. US Spending on Computers (Chart: 4.0) 158
41. Consumer confidence expectation (Chart: 4.1) 158
42. Expectation Volatility (Chart: 4.2) 159
43. Financial Earning Vs Employment trend Analysis (Chart: 4.3) 170
44. Citigroup Product Segmentation (Chart: 4.4) 200

1. M1 Money Supply (Tab: 0.1) 25
2. M2 Money Supply (Tab: 0.2) 25
3. Debt Measures (Tab: 0.3) 56
4. Debt as a share of GDP {Tab: 0.4} 59
5. FOMC Price Stability {Tab: 0.5} 66
6. Current Economic Indicators {Tab: 0.6} 68
7. CPI Figures {Tab: 0.7} 72
8. Import to the US Tab: 0.8} 73
9. Trade Balance Tab: 0.9} 74
10. Import and Export {Tab: 1.0} 75
11. Wages and Salaries {Tab: 1.1} 76
12. PPI Total Return Performance {Tab: 1.2} 79
13. UECRI US Future Inflation Gauge {Tab: 1.3} 80
14. State Leading Indicators {Tab: 1.4} 88-89
15. Treasuries and Money Market data {Tab: 1.5} 103
16. World Interest Rate Futures {Tab: 1.6} 113
17. Demographic profile of OPEC Members {Tab: 1.7} 138
18. Oil Import to the US {Tab: 1.8} 140
19. Conference Board {Tab: 1.9} 147
20. Foreign Holdings of US Treas. {Tab: 2.0} 151
21. The Logic of Investment Failure {Tab: 2.1} 153
22. Consumer Confidence figures {Tab: 2.2} 154
23. Overpaid Executives {Tab: 2.3} 168
24. Option grant Champs {Tab: 2.4} 169
25. Productivity {Tab: 2.5} 171
26. OECD Countries {Tab: 2.6} 177
27. JP Morgans Emerging Market Bond Indices {Tab: 2.7} 178
28. Emerging Market Equity {Tab: 2.8} 179
29. Least Developed Countries {Tab: 2.9} 184
30. Top Global companies {Tab: 3.0} 193
31. All Time largest Mergers and Acquisition US {Tab: 3.1} 194
32. World Wealth Ranked by Individuals {Tab: 3.2} 195
33. Citigroup, Management featuring Sandy Weill {Tab: 3.3} 197
34. Bloomberg Wall Street Index {Tab: 3.4} 198
35. Philadelphia Bank index {Tab: 3.5} 198
36. Citigroup Corporate Action Calendar {Tab: 3.6} 199

The withering value of investment portfolios is finally taking its toll on consumer confidence as
consumers are being worn-out by high cost of energy, layoffs, and stock market declines. Many
financial analyst including the National Association of Business Economics, the largest group of US
corporate economists, which sharply lowered its forecast for economic growth in 2001 from 3.4
percent to 2 percent, warned of "heightened" recession risks as the majority of the leading security
market indexes are becoming oversold. This current economic situation inspires research interest on
how, and to what extent government decisions can affect the financial market economy in modern
times. By all measures, the US economy is slowing down compared to the preceding years of
exuberance. Just immediately after the gruesome skewed Florida election experience,1 consumer and
business confidence eroded. For the fear of a recession, the Federal Open Market Committee cut
short-term interest rates twice, by 0.50 basis points at each time in January alone. Even, after these
policy actions were implemented, market risk continued to increase; and the U.S. economic
performance continued to deteriorate. It seemed as if the federal governments decision in balancing
the equation of a stable economic recourse tussles between an obvious political alacrity to fuel the
economy with rate and tax cuts. The question of whether or not the reforms undertaken would
boost fundamental economic perpetuity remains open. The impending fiscal reform could also
recreate another bearish market effect.

The financial market economy cycle depend upon different aspect of the governments actions. On
March 20, as the downturn continued, the Federal Reserves administrating techniques inferred a
0.50 basis point cut in interest rate, which defied the conventional investors expectation of a 0.75
basis point cut. This action, as it has already, prompted a reiterated continuum probability of some
near-term economic sloppiness slouching towards a worse case market scenario. This result largely
contradicts the popular belief that the Fed could always provide necessary monetary policy support
to aid recovery, at least in the short term. It seems however, that policy measures, in spite of its
technicality, should also always be symmetrical with public and corporate requisites because the
psychology of the market participants as it seems cannot be disregarded. The fact that the central
bank hurried to cut interest rates, but only triggered a bear phase may have induced a moral hazard
among investors, or undermine the value of such moves. It could also exacerbate an economically

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damaging tendency toward excessive risk-taking on the assumption that the Fed will "bail out"
financial markets, or alternatively feed fears that the central bank is powerless to prevent a recession.

If consumers are downbeat, they postpone home and car purchases and reign in overall spending. In
addition, the value of the goods and services exchanged between its international trade partners has
declined drastically. Between mid-July and early-October, consumers lost $1.5 trillion in value from
their stock portfolios and signs are appearing that consumers are readjusting their spending patterns
to this new regime. Given the strong link between the stock market and the economy that forged the
rapid rise in prices and stock ownership in the late 1990s, the current free-fall in prices, if not soon
reversed, will discourage confidence and a recession will surely ensue.

Bond prices are also influenced by the credit risk of the issuing government, agency, or company.
When stock prices were high, equity capital was cheap and ample, particularly for high-flying
information technology businesses. Bond investors and bank lenders showered the emerging IT
companies with easy cash. For much of the past two years, the Fed has had to raise interest rates on
few occasions to slowdown the economy. Government treasury also benefited enormously when
stock prices were rising. The extra tax revenues generated on rising capital gains, exercised stock
options and the stronger corporate earnings resulting from rising stock values account for an
estimated one-third of the swing in the federal government's $200 billion deficit in fiscal year 1994
to $240 billion surplus in Fiscal Year 2000. When money is being invested in stocks, or in mutual
funds, the value of the investment fluctuates, depending on the price each share commands in the
market every day. When money is being invested in bonds, or bond mutual funds, the value of the
investment is influenced by interest rates. In general, when interest rates rise, the value of investment
decreases and when interest rates fall, the value of investment rises. This fluctuation in the US
interest rates largely affects the financial aspect of global economy.

There is a slower global demand for the US goods now. It, thus, remain within the fact of just how
well established the great strength behind the US economic infrastructure has matured -- consistent
with the global economic development situation. Some of the most notable of these strengths are the
remarkable step-up in structural productivity growth, the long-term credit markets stability, and the
global market access facility. Some political economy critics argued that the situation is changing and

Prolongation of the Bush-Gore election dispute in Florida 4Q-00

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the political accesses to the global economy are deteriorating compared to the past 10 years. The
recent tremendous growth in Europe and developing countries have created a new ball game that is
seemingly becoming more favorable to the longer Europeancolonialists well-established
relationship. For instance, the US China relationship remains on shaky ground, and this tie is
significant. This thesis will the attempt to establish a understanding of the fundamental aspects of
the United States economy, stressing the importance of its structure and experience which has come
to endow its phenomenal strengths. The thesis will also explore the efficiency of policy amendments
on the financial market, with much focus on its cyclical effects on the inter-market relationships. On
the amplitude of intermarket efficiency, the thesis lays much emphasis on the effect of US
government regulation on financial markets and the effect of foreign regulations on global finance.
Since there are certain relationships, how the actions of monetary authorities influence security
prices to the extent that security values can effectively become another lever of monetary policy.
Further analysis will attempt to provide suggestion on how to improve the US economy growth. In
addition, which market areas provide candid feasibilities, and which firms and sectors are prone to
lags, and why. Arguments are based upon historical and expectation analyses and juxtaposing
economists standpoints as established in concurrent political and economic affairs.

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The Role of Government in the Financial Market

The US Financial Market system is the most advanced economic system and its policy is the most
influential key decision factor in the global economic directional movements. This status is due to
the concept of capitalism whereby individuals economic decisions concerning how to use or
accumulate capital, or expend resources is based on privatized strategy rather than formal
government intervention. This concept has created the most prolific society and the largest
consumers of advance industrial products in the whole world. This system has enabled the most
beneficent creation of utilities, of new industries, ideas, products, which still keeps attracting the
most brilliant work forces from around the globe. No other single entity in the world compares in
wealth, size, scope, and complexity to the United States economic system.

To fulfill its constitutional mandates, the U.S. Government under takes a wide variety of programs,
which include creating and regulating the value of money, providing adequate domestic economic
and intellectual growth system. The US government must also manage and boost other national
interest activities such as service, productivity, defense, law and order, education, cultural benefits,
justice etc. The size of Federal budget, of course, affects the US economy and reflects on the
consumption confidence of American people. Federal Government spending was a little less than 19
per cent of the gross domestic product (GDP, which measures the size of the economy) in 1999; the
lowest since 1966 and its budgeted spending for fiscal 1999 was $1.7 trillion.

Government's role in a free-market economy also includes protecting private property, enforcing
contracts, and regulating certain economic activities. Governments generally regulate "natural
monopolies" such as utilities or rail service, and recently, technology sector as in the case of
Microsoft. Regulations are imposed to ensure fair competition and consumer rights.

A Retrospect of the US Financial Market Economy

Those days before Federal Deposit Insurance Corporation (FDIC, a federal agency that insures
deposits in savings accounts of qualifying banks) and other reforms of the 1930's; previously, when
bank failed client money was lost. As the crisis threatened to topple one bank after another, J.P.
Morgan took charge. Peirpont Morgan appointed a team of younger analysts to do research at the
height of the panic of 1907, and they came up with an institution strong enough to take instant

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action in a financial crisis. That institution, the Federal Reserve was established in 1913, just before
J.P. Morgan died in that same year.

The Federal Reserve System then became the central bank for the United States banking system and
the institution that holds the primary responsibility for the making and execution of American
monetary policies. The Federal Reserve System represents an almost unique hybrid or blending of
elements of governmental power with elements of private ownership and control. The private
banking community was also given a major role in the running of the Federal Reserve System that
continues to give banking interests privileged access to the process by which the US government's
monetary policy is made. The Federal Reserve system generates its own revenues to pay its expenses
from fees and interest payments paid to it by the commercial banks it regulates, so Congress lacks
the normal leverage it has over other agencies through carrots and sticks brandished during the
annual appropriations process.

The primary reason why the banking industry supported the creation of the Federal Reserve System
and continues to support it today despite the occasional inconveniences imposed by the Fed's
regulations is the valuable privilege that the membership Fed fund availability for emergency loans of
cash if they someday need it to survive a "run" on their bank. In a bank "run," large numbers of
depositors frightened by rumors that their bank is about to fail suddenly begin crowding into the
bank, demanding to withdraw all their deposits in cash. This exhausts the very limited cash reserves
normally kept on hand in the bank's own vaults within a few hours

The Onset of the American Market Hegemony

During the First World War crisis, stock markets around the world were closing, and in 1914, the
New York stock exchange stopped trading for four and a half months. Europeans began repatriating
their gold to America and, this would replenish the American financial system of its money supply.
The European gold has been in the vaults below the Federal Reserve Bank in downtown Manhattan
ever since. At this time, a share of Bethlehem steel went from 46 to 459, and reached as high as 600.
General motors already one of the country's biggest mobile manufacturers, started the war at 39. Six
months later, it was 81 1/2, and a year later, 500. When America entered the war in 1917, the
economy got even hotter, and a huge new market developed on Wall Street, the liberty bond was
initiated to finance Americas role in the war. Much of Europe was devastated after the war and the

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dollar began replacing the British pound as the international medium of exchange. Wall street was
pouring enormous wealth into an unprecedented construction boom. Success was creating
Manhattans unmistakable skyline including what became known as the American stock exchange.

By 1928, the economy was beginning to slow down. Rural banks were failing, and this was putting
pressure on banks. The Federal Reserve was raising interest rates in order to slow down the economy
because Wall Street was becoming guilty of irrational exuberance. On September 2, the Dow
reached a record high of 381.17. The market would not see such heights again for 25 years. The
crash of 1929 occurred over a six-day period, beginning October 24 to the 29 . The panic worsened
as prices plummeted. Everyone was forced to sell. Wall street was completely undone. In just two
day, the Dow had lost more than 22% of its value, wiping out many investors. Historians and
economists debate whether the crash caused the great depression or was the symptom of a larger
problem in the economy. Nevertheless, it was the worst American economic calamity of the 20th

The New Deal

In Washington, the Hover administration made matters worse when they raised Tariffs to protect
American industry from foreign competition, and other countries did the same. 15 Million people
were unemployed. Half a home loans foreclosed, thousands lost their farms. Hoover lost the next
election in a landslide to Franklin Delano Roosevelt took office in 1933. Roosevelt assured the
people that the only thing they have to fear is fear itself and proposed the new deal that affected Wall
Street business. Now securities had to be registered with the federal government. Basic disclosures to
investors were required. Banks could not take in deposits and underwrite securities, forcing venerable
institutions like the Morgan bank to split into separate entities. For Wall Street, the most
controversial new change was the creation of the SEC, the Securities and Exchange Commission to
oversee the nations investment market.

Despite FDR's best efforts, the new deal did not end the great depression but the World War II. As
the U.S. Industrial machine met the challenges of war, the economy grew by an overwhelming 125
percent between 1940 and 1944. However, Wall Street did not boom during the Second World
War because people were reluctant to invest their money on Wall Street until Charles Merrill
appeared and formed a brokerage company called Charles Merrill company in 1914 and joined with

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Edmond lynch. They did well, especially by underwriting chain stores, which were rapidly
expanding across the country. Bringing the Wall Street concept to everywhere in the U.S.A. Marietta
in Atlanta, Federal Street in Boston, Main Street in Waco, Texas people to invest their money, to
buy and sell securities. Merrill's ideas were an instant success. By the 1950s, Merrill Lynch was the
largest brokerage house on Wall Street and by the 1960s, it was grossing almost four times as it
biggest competitor and became known as the thundering herd.

By the late 1960s, great changes were taking place on Wall Street. In 1967, the great bull market was
stalling out and Wall Street was literally drowning in paper. It was called the back office crunch. The
stock exchange had to close in the middle of the week for a whole day to allow the brokers to catch
up with their paperwork. So backlogged they simply had to give up and go out of business, and more
than Four billion dollars worth of securities could not be accounted for; things would get even worse
for wall street during the 70s. Severe inflation eroded purchasing power and the Dow fell more than
a decade as the Vietnam War tore the country apart. At this low point, the institutional investor, the
biggest players in the financial markets decided to throw their weight around with the consentient of
exchanges like the American stock exchange and regional stock markets were happy to cut a deal to
create the NASDAQ. Instead of having a floor where brokers were physically present to buy and sell,
they had a series of automated machines where investors could post whatever they wanted to do and
type in that they wanted to buy or sell at that stock. NASDAQ greatly grew in volume and
importance, although it's not technically a stock exchange at all because It doesn't have a physical
existence, it has grown to become the one of the most important indexes in the world. Competition
increased, the New York stock exchange with a nudge from the Securities and Exchange
Commission took a radical step to make sure that investors can negotiate the lowest commission rate
to trade rather than the previous fixed commission method.

Computer sped up the whole velocity of all transactions. As Wall Street was transforming itself, the
mood in America was changing as well. Ronald Reagan and Paul Voker, the Chairman of the
Federal Reserve the federal economy needed shock theory and came up with what became popular as
Reaganomics. Reaganomics was the most ambitious reform effort since the New Deal. The four key
parts of Reaganomics were income-tax cuts, new expenditure priorities, monetary restraint, and

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regulatory reform. Ironically, it was the enactment of tax cuts unmatched by spending cuts that
scared the Fed into a tighter monetary policy. The subsequent recession caused serious budgetary
imbalance. They raised interest rates to offset a runaway inflation but instead, borrowing money
became expensive and the country fell into a serious recession. The Dow plunged; unemployment
went above 10 percent since the first time of the great depression. Some economists argued that
Reagan presidency was a high-water mark for the American economy, but others disagreed. A report
cards showed that real GDP declined by one-half of 1 percent in 1980, President Carter's last year,
and rose 3.9 percent in 1988, President Reagan's last year. The CPI rose 13.5 percent in 1980 and
by 4.1 percent in '88. The prime rate dropped from 15 percent in 1980 to 9 percent in 1988. Real
median family income rose from $34,200 in 1980 to $37,000 in 1988. The unemployment rate
declined from 7.0 percent in 1980 to 5.4 percent in 1988. On the other hand, the budget deficit
rose from $74 billion in 1980 to $155 billion in 1988, while the trade deficit rose from $15 billion
to $129 billion during the same period. Contrary to widespread belief, the portion of the population
below the poverty line was 13 percent in both years. One more set of numbers: Real national wealth
rose from $11.9 trillion in 1980 to $14.2 trillion in 1988. Contrary to widespread belief, the portion
of the population below the poverty line was 13 percent in both 1980 and 1988.

The Internet
The 1990s encountered the emergence of the Internet, which revolutionize new methods in
communications. Day trading won and loss in Internet stocks, and the fiscal 1999 recorded an
accelerated economic growth. The Real GDP grew by 4.3 per cent across the four quarters, which
encompasses the fourth quarter of calendar 1998 through the third quarter of calendar 1999. This
was faster and higher than the average throughout the expansionary period. In 1999, productivity
growth picked up even more, to 3.1 per cent over the four quarters of the fiscal year. The Federal
Reserve raised short-term interest rates in the second half of the fiscal year and again in fiscal 2000.
These actions more than reversed earlier easing moves that had been under taken in 1998 to deal
with temporary financial turmoil both here and abroad. In raising rates, the Federal Reserve cited
concerns that continued faster growth in economic demand than in potential supply could foster
inflationary imbalances.

Murray Weidenbaum, chairman of the Center for the Study of American Business at Washington University in St. Louis, served as
chairman of President Reagan's Council of Economic Advisers, 1981-82.

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The Power of the Federal Reserve System
The Federal Reserve bears the power of government to create and set the value of the Dollar. As the
of the United States central bank, the Fed holds the primary responsibility for the making and
execution of American monetary policies and administer funds to domestic banking institutions.
The Federal Reserve System is ran by Board of Governors from 12 separate Federal Reserve District
Banks. The district Federal Reserve Banks act as non-profit "bankers' banks" -- that is, only
commercial banking or depository institutions (and certain agencies of the federal government)
maintain deposits at the Federal Reserve, and only member banking institutions and the US
government are eligible clients. The Federal Reserve System represents an almost unique hybrid or
blending of elements of governmental power with elements of private ownership and control,
generating its revenues from fees and interests it receives from commercial banks that it regulates.

Its Board of Governors consists of seven district members are nominated for their positions by the
President of the United States before they must be confirmed by a majority vote of the Senate before
taking office. Each Reserve Bank is governed by a nine-member board, which includes three banking
representatives and six public affairs representatives. These nominations are divided into three
categories (Classes A, B, &C). Member banks in the district select the three banking, or Class A
directors, and three of the six public directors (Class B seats). The Feds Board of Governors selects
the three remaining (Class C) public directors. According to the law, Class B and C directors must
be chosen with due consideration to the interests of agriculture, commerce, industry, services, labor
and consumers. That Banks Board of Directors, subject to final approval by the Board of
Governors, appoints each Reserve Bank President to a five-year term. This procedure adds to
independence because the Directors of each Reserve Bank are not chosen by politicians but are
selected to provide a cross-section of interests within the region, including those of depository
institutions, nonfinancial businesses, labor, and the public.

The Fed's Board of Governors sets policies regarding reserve requirements and the discount rate all
by itself, but changes in these two policy levers tend to be relatively infrequent (perhaps once or
twice a year on average for the discount rate, and perhaps once every five or six years on average for
the reserve requirement). The Fed's main policy tool of choice for exerting its influence on the
money stock and interest rates on a week-to-week basis is its "open market operations. The
necessary policy decisions about the Fed's on-going open market operations (buying or selling

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varying quantities of U.S. bonds and other treasury securities on the New York financial markets) are
made for the Fed's Board of Governors by a slightly expanded body called the Federal Open Market
Committee (FOMC).

Board Members
The seven Governors are permanent members of the FOMC, and the Chairman of the Federal
Reserve (currently Alan Greenspan) also serves as the Chairman of the FOMC. The Vice Chairman
of the Federal Reserve Board, Dr. Roger W. Ferguson, Jr., however, does not serve as the Vice
Chairman of the FOMC - that position is traditionally reserved for the president of the New York
Fed district bank, who is also a permanent member of the FOMC. The final four slots on the
FOMC are filled by four of the remaining eleven district bank presidents, who serve for one year at a
time on a rotating basis. All 12-district bank presidents participate in every FOMC meeting, but
only the four in the current rotation and the New York president may cast a vote on the policy
decision of the committee.

The Twelve Federal Reserve Districts

Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis,
Kansas City, Dallas, San Francisco.
Chart: 0.1

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Scope of Integrity
Most studies of central bank independence rank the Fed among the most independent in the world.
In order that not all affiliations readily predict the perspectives or actions of Reserve Bank directors,
it is arguable that not all enterprises fit neatly into rate-sensitive or rate-insensitive pigeonholes.
Moreover, there are limits (some self-imposed) on directors influence over Fed policy.
Representation levels remain modest for labor, consumers, and community interests, which now
claim 12.5 percent of all public directorships. For the first-time ever, the number of labor, consumer,
and community representatives holding Class B directorships (five) tops the number holding Class C
seats (four). In past years, the Feds Board of Governors appointed the vast majority of such
representatives. From 1994 to 1996, for example, labor, consumer, and community representatives
with Class C seats outnumbered their counterpart with a Class B seat nine to one. Of the seven new
Class B and C directors, three are current or retired managers of large manufacturing or
development firms; the group of departed directors included only two individuals whose businesses
are similarly sensitive to changes in borrowing rates. The Reserve Bank Directorship (2001-2003
terms) includes the following new members:

New York
Class B: Jerry I. Speyer, President, and CEO, Tishman Speyer Properties replaced Eugene R.
McGrath, Chairman& CEO, Consolidated Edison Co. of New York. One of the worlds largest real
estate developers, Tishman Speyer is the biggest owner of office space in New York City, where its
holdings include Rockefeller Center and the Chrysler Building. The New York Times says Speyer
"achieved success the old-fashioned way: with affluent parents, a top-drawer education and marriage
into a family of real estate magnates." Tishman Speyers most important global investment partner is
Citigroup, the largest financial holding company supervised by the New York Fed. In 2001,
Citigroup chief Sandy Weill also became a board member of the FRBNY, representing member
banks in District 2.

Class B: Doris M. Damm, President & CEO, ACCU Staffing Services replaced Robert D. Burris,
President & CEO, Burris Foods, Inc. With $40 million in annual sales, ACCU places temp workers
with employers in Pennsylvania, New Jersey and Maryland. According to press accounts, ACCU has
faced troubles with workers comp claims and an INS review of undocumented immigrants in its

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employ. In recent years, Damm has repeatedly cited low levels of joblessness as problematic for
ACCU. Unemployment is so low, she told Business News New Jersey, we cant get the people to
fill the orders.

Class C: Robert W. Mahoney, Former Chairman, Diebold Inc. replaced G. Watts Humphrey,
President, GWH Holdings Inc. Originally a manufacturer of bank vaults; Diebold now ranks as the
largest domestic manufacturer of ATMs and cash dispensers. As such, its customers include Fed-
regulated financial firms throughout the Fourth District. Diebolds foreign subsidiaries also make
electronic voting equipment; a recent $106 million contract to provide voting machines to the
Brazilian government was the largest order in the companys 142-year history. Mahoney stepped
down as Diebolds president and CEO in October 1999.

Class C: W. James Farrell, Chairman & CEO, Illinois Tool Works Inc. replaced Lester H.
McKeever, Managing Partner, Washington, Pittman & McKeever Called the most decentralized
company in the world, ITW contains more than 500 manufacturing units, each of which operates
as a semi-autonomous business. The $10 billion company makes a huge variety of products,
including nails, auto parts, welding equipment and small appliances (it also owns a mortgage
company). Over the years, ITW has acquired an anti-Dunlap reputation for aggressively buying up
mature businesses and producing satisfactory returns without cutting the workforce. CEO Farrell sits
on the boards of Allstate Insurance, Quaker Oats, Sears and Northwestern University.

St. Louis
Class C: Walter L. Metcalfe, Jr., Chairman, Bryan Cave LLP. Replaced Susan S. Elliott, Chairman
& CEO, Systems Service Enterprises, Inc. One of the 50 biggest law firms in the world, St. Louis-
based Bryan Cave boasts 600 lawyers (including former U.S. Senator John Danforth) and 1999
revenues of $210 million. The firms clients include Anheuser-Busch, Monsanto, Boeing and
Marriott. Metcalfe has helped facilitate the financing and development of sports facilities and other
major projects in St. Louis. Bryan Caves extensive financial services practice involves its attorneys in
regulatory and legislative matters that fall within the Feds ambit

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Class B: D. Greg Heineman, Chairman, Williams Insurance Company replaced Kathryn L. Ogren,
Owner, Bitterroot Motors. The Williams agencys fortune is relative to South Dakotas first
managed-care company, Dakota Care, which it helped launch and battled in court (over a $13
million wrongful termination suit). Before selling out to former NBA star Isaiah Thomas, Heineman
and his business partner owned the Sioux Falls Skyforce, the Continental Basketball Associations
most successful franchise. Heineman was voted CBA executive of the year in 1995.

San Francisco
Class B: Barbara L. Wilson, Idaho and Regional Vice President, Qwest Communications
International Inc. replaced Krestine Corbin, President & CEO, Sierra Machinery, Inc. A broadband
communications firm, Qwest more than doubled in size with its recent acquisition of US West the
firm Wilson worked for most of her career. Wilson served as a Board of Governors-appointed
director of the San Francisco Feds Salt Lake City branch bank and has been active in Boise business
and civic organizations.

Boston (District One)

Class B: Robert R. Glauber Adjunct Lecturer, John F. Kennedy School of Government, Harvard
2001 University, Cambridge, Massachusetts replaced Orit Gadeish Chairman, Bain & Company,
Boston, Massachusetts. Other members include Class C: William C. Brainard Professor of
Economics, Yale University, New Haven, Connecticut, William 0. Taylor Chairman Emeritus, the
Boston Globe, Boston, Massachusetts, and James J. Norton Former President, Graphic
Communications International Union, Washington, DC.

The above list names only few of the board members, of course, the objective to depict the
conglomeration of respected personalities with earned caliber of potentials and intelligence that
makes up the dynamic reserved board is thus fulfilled. Historically, narrow interests have dominated
most Reserve Bank boards. A 1976 report by the Banking Committee of the U.S. House of
Representatives found that "in many areas, the list of Federal Reserve directors reads like a blue-
ribbon list of 'Who's Who in American Corporations. Additional background on Federal Reserve
Bank Directors Eligibility includes that Class B and Class C directors may not be officers, directors
or employees of any bank. In addition, Class C directors may not be stockholders in any bank and

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must reside in the Bank's district for at least two years before their appointment. Federal Reserve
regulations prohibit Reserve Bank directors from engaging in most partisan political activity.

The Humphrey-Hawkins law

The 1978 Humphrey-Hawkins Act mandated that the Fed set annual targets for money supply and
that the Fed Chairman report to Congress twice, by February 20 and July 20, each year regarding
these targets before both the House and Senate Banking Committees to submit a report to Congress.
One required element of this report is the growth targets for money and debt (a preliminary target
for the year in February and a revision, if needed, in July). This provision is not specific regarding
which monetary and debt aggregates are targeted or how the targets must be achieved, if at all. The
ultimate loophole in the Humphrey-Hawkins Act was that it did not require that the Fed actually
hit its money supply targets. It only required that the Fed publicly explain its reasons for missing the
targets if it did miss.

The FOMC is guided in its policy decisions by the Humphrey-Hawkins law, which also dictates that
the Fed must promote the twin goals of full employment and low inflation. Many Fed officials see
their goal as solely the attainment of price stability - believing that full employment will follow in the
end. Others believe that the two goals must be balanced even over the short term. Federal law
requires the FOMC to hold meetings at least four times each year, though the FOMC almost always
exceeds this number, and will hold eight meetings in both 1996 and 1997. When necessary, the
FOMC can also meet via teleconference between regularly scheduled meetings. Regular meetings
typically begin at 9:00 ET and end in the early afternoon. Twice each year in late January/early
February and again in early July, the FOMC holds a two-day meeting, which will begin the early
afternoon of the first day and end around midday on the second day. The purpose of these two-day
affairs is to establish targets for money and credit growth, which the Fed Chairman must report to
Congress twice each year in February and July (this report is also known as the Humphrey-Hawkins
report - named after the Humphrey-Hawkins Act of 1978).

The Feds Mandate

In gauging the course of policy which will best achieve their goals, members look both to the Federal
Reserve staff for guidance and, more importantly, to their own intuition. In discussing policy,
FOMC members are presented with three studies by the Fed staff - the Beige Book, the Green Book,

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and the Blue Book. The Beige Book is probably the most recognized, as it is released publicly two
weeks before every FOMC meeting. The Green Book presents the Fed staff's view of the economy,
and is slightly more important than the Beige Book. By far the most significant book is the one with
the blue cover. This document lays out three alternative scenarios for interest rates following the
FOMC meeting. The Blue Book discusses the impact, which these scenarios will have on money,
credit, the dollar, and the economy.

A relatively recent development for the FOMC has been the announcement of policy changes.
Before 1994, policy changes were signaled to the market via purchases and sales of government
securities (also known as open market operations). This practice often resulted in
miscommunications between the Fed and the market, and it worked against public awareness and
understanding of Federal Reserve policy. The FOMC's policy objective is carried out via a target for
the federal funds rate - the rate which banks charge each other for overnight loans. The Fed can
control this rate quite closely by its purchases and sales of government securities, which are
implemented by the New York Fed. The only interest rate set directly by the Fed (rather than just
influenced by their actions) is the discount rate - the rate that the Fed charges banks for overnight
loans. As relatively little borrowing is done at the Fed's discount window, the discount rate is not
particularly important. Changes in the rate are mostly symbolic, and it is the funds rate, which has
the greater impact on the economy.

The Federal Reserve Reform Act

The committee report and comprehensive hearings on the Fed helped convince Congress to pass the
Federal Reserve Reform Act of 1977. The Act restated the Fed's obligation "to promote effectively
the goals of maximum employment, stable prices and moderate long-term interest rates. It also
directed the Reserve Banks to include the interests of agriculture, labor and consumers on their
governing boards. During the 1980s, members of Congress tried and failed despite support from
the Board of Governors to expand the number of Class C directorships in order to promote greater
diversity of interest. By 1990, a study by the House Banking Committee staff reported that the Fed
had "simply ignored those parts of the law which require consumer and labor representation on the
Reserve Bank Boards. According to the report, not a single representative of consumer or labor
organizations served on Reserve Bank boards in 1990. At the same time, fully half the Reserve
Banks' supposedly public directors were former officers, directors or employees of banks. These

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findings fueled new congressional calls for more accountability at the central bank. In an appearance
before the House Banking Committee in October 1993, Fed chairman Alan Greenspan attempted
to deflect those calls by claiming that the Board of Governors had "made substantial progress...
increasing the number of labor and consumer interest people on [Reserve Bank boards." Chairman
Greenspan has an admirable way of conveying empirical complex observation of concurrent affairs
through his integral philosophy.

The Greenspan effect

The Greenspan effect has become quite a significant phenomenon in the market economy scenario.
When Alan Greenspan speaks, Wall street listens and the world waits for it s impending impact of
his announcements. Dr. Greenspan took office June 20, 2000, as Chairman of the Board of
Governors of the Federal Reserve System for a fourth four-year term ending June 20, 2004. Dr.
Greenspan also serves as Chairman of the Federal Open Market Committee, the System's principal
monetary policymaking body. There have been several changes in the Feds modus operandi since he
took office. The Fed once operated in secrecy; it now announces its policy decisions. The Fed once
moved almost exclusively in quarter point increments; it now changes the funds by anywhere from a
quarter point to three quarters of a point in one move. The Fed once changed policy immediately
after key releases such as employment; it now tries to change policy only at FOMC meetings. When
Greenspan joined the Fed in August 1987, the Fed targeted reserves, not the funds rate. The stock
market crash of 1987 was the turning point. In its immediate aftermath, the Fed flooded the system
with liquidity without regard to its reserve-borrowing target. As a result of this reluctance to borrow
from the Fed, the relationship between the funds rate and the discount rate broke down. A specified
level of borrowings from the Fed would no longer produce the expected funds rate spread above the
discount rate. The Fed opted to focus on the funds rate as a result, always noting that it would
return to a borrowings target once normal relationships between the funds and discount rates
resumed. The normal relationships never resumed, and the Fed never turned back. Only in the last
few years have Fed officials finally acknowledged that they target the funds rate. The next key change
for the Fed was that the secrecy in which policy changes were carried out was gradually abandoned.
At that time, the Fed had been gradually easing policy. They signaled these changes subtly via open
market operations. Due to a normal seasonal need to add reserves to the banking system, the Fed
conducted a 5-day system repurchase agreement, which was purely technical in nature. The Fed
announced a policy change. Other important changes also evolved. The first was the tendency to

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change policy only at FOMC meetings. Just after that February 4 tightening, the FOMC tightened
between meetings on April 18, 1994 - that was the last inter-meeting policy tightening. Greenspan
maintains that the Fed reserves the right to change policy any time it deems necessary and indeed it
will never give up that flexibility. There are situations such as market crashes, which demand an
immediate Fed response.

Monetary Regulation
The US is a very important nation among the multitudes of well-established economic nations
around the world. With its highly sophisticated monetary system, it provides financial, market
economy and political economic hegemony for the rest of the world, significantly. To some
economists, it is to manipulate the purchasing power of money in reference to the level of debt in
society, to the level of economic activity, to the price level, or to some other economic or political
criterion. In the financial arena, to regulate the value amounts to a power of raw inflationism: to
generate sufficient money in order to enable the people to pay their debts". Some financiers argue
that "to regulate value" amounts to a power to stimulate and support trade: the power to provide
sufficient money (of whatever kind) to grease the gears of finance-capitalism-specifically, by
facilitating credit-expansion which enables the private banks to make more commercial loans. One
fairly popular notion is that the government may use the power "to regulate the value" to create
whatever supply of money is necessary to maintain low, fixed rates of interest in the markets for
business loans. Thus, the power "to regulate the Value" amounts to a power to maintain "economic

The Value of Money

A full gold standard was in effect from 1900 to 1933, providing for free coinage of gold and full
convertibility of currency into gold coin; the volume of money in circulation was closely related to
the gold supply. The 1934 Gold Reserve act stipulated that gold could no longer be used as a
medium of domestic exchange. Fiat money is a legal tender by unique legal qualification such as the
dollar ($). The government supplies whatever amount of money is necessary so that it can loan to
private banks at a nominal rate and the banks can then make commercial loans at another nominal
rate to the public borrowers.

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The horizon of the use of money being limitless in the modern world as extends across international
borders serving as a means of foreign exchanges and a proper measure of wealth and wealth factors.
Therefore, the International monetary system provides the rules and procedures by which different
national currencies are exchanged for each other in world trade. Monetary agreement, attempt by
two (bilateral) or more (multilateral) nations to regulate and coordinate their financial relations by
treaty. The objectives are usually to promote trade by facilitating payment of international debts and
to maintain in each nation a stable exchange rate by making available credits to meet temporary
difficulties with balance of payments. After World War II there was a significant movement toward
multilateral monetary agreements, of which the most important were the International Monetary
Fund and the European Payments Union (1950). Customs unions such as the European
Community (EC) and the European Free Trade Association often require a large degree of monetary
cooperation, and the increasing European integration that has transformed the EC into the
European Union (EU) has led to increasing monetary cooperation through the European Monetary
System. In 1999, 11 EU nations adopted a single currency, the euro.

A nation's exchange rate or currency value depends on many factors. One of the major factors is its
governments ability to maintain its price stability and to consistently control the size of its money
stock and money supply over consecutive fiscal years. Many other nations have found this logic
compelling and have given their central banks the sole mandate of price stability. Among these banks
are the German Bundesbank, and the central banks of Canada and New Zealand. In the U.S.,
Governments act to stabilize their countries' exchange rates by limiting imports, stimulating exports,
or devaluing currencies.

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Chart: 0.2

The exchange rate of currencies is, hence based on the price of a country's money in relation to
another country's money. An exchange rate is thus fixed, when countries use gold or another
agreed-upon standard, and each currency is worth a specific measure of the metal or other standard.
An exchange rate is considered to be floating when supply and demand or speculation sets
exchange rates (conversion units). If a country imports large quantities of goods, the demand will
push up the exchange rate for that country, making the imported goods more expensive to buyers in
that country. As the goods become more expensive demand drops, and that country's money
becomes cheaper in relation to other countries' money. Then the country's goods become cheaper to
buyers abroad, demand rises, and exports from the country increase. World trade now depends on a
managed floating exchange system. The following charts are extracted from the Feds report on
economy indication. These charts observed how strong the Dollar had remained compared to the
currencies of its trading partners.

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Chart: 0.3

Political instability plays a major factor behind financial pressures, and declines in exchange rates of
different countries. Argentina encountered considerable financial distress in year 2000 when low tax
revenues due to continued weak activity along with the increasing political uncertainty greatly
aroused concern about the ability of the country to fund its debt. The fall in U.S. short-term interest
rates in January 2001 thus eased pressure on Argentina's dollar-linked economy. A similar effect was
observed when Turkey's financial markets came under severe strain in late November, 2000 as
international investors withdrew capital as the market worries about the health of Turkey's banks,
the viability of the government's reform program and its crawling peg exchange rate regime, and the
widening current account deficit. In Asia, market concerns over political instability heightened and
took its toll on the Indonesia, Thailand, and the Philippines exchange rates.

To enjoy these benefits of a currency board, a country must be prepared for its implementation.
Most importantly, the country must have ample foreign exchange reserves to cover every

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penny/rupiah/peso of domestic currency at the fixed exchange rate. It is also imperative that the
country's economic system and most critically, its financial system remain very open. If not, foreign
investment will not flow to that country, Forex reserves will fall, and the money supply will contract.
It is also important in a crisis that the central bank reserve remains protected; else, there is no lender
of last resort. In a financial crisis, banks may need to rely on foreign capital, which would not be
possible if the banking system is fully or even partly closed to foreign investment. As long as the
overall capital account balance is in surplus, the monetary base and the money supply will grow. In
most developing countries with open economies, foreign investment will indeed produce a capital
account surplus. The danger for a currency board country is that a crisis of confidence in the
currency can produce a sharp drop of FX reserves and a dramatic contraction in the money supply.

Money Supply Vs Money Stock

Money stock is the total amount of money available in a particular economy at a particular point in
time. This is often associated with the term money supply, which describes as the entire supply
schedule of associated interest rates and the quantities of money that a government must create at
those rates. Since supply determines value, the US government employs certain aggregates to control
the total amount of money circulated in a fiscal year. The changing relationships between money
supply and the economy triggered both other changes significantly. The Fed used to set targets point
for M1 growth. Now, the Fed sets only target ranges for M2 and M3. Meeting these target ranges
are rather complex, the Fed tends to adjust the range rather than it is to change policy to get M2 and
M3 back within the range. If the Fed misses its target, it is more likely to change the target.

Before much of the deregulation of the financial markets in the 1980s, measures of the money
supply were pretty reliable predictors of aggregate spending; moreover, they could be controlled
relatively well by the Fed. From late 1979 to late 1982, the Fed explicitly targeted money on a short-
term basis. However, the predictable relationship between the money supply and aggregate spending
began to fall apart once financial markets were deregulated and new financial instruments were
introduced. Once banks were allowed to pay explicit interest nationwide on checkable deposits, M1
no longer reflected spending so well, because people started to leave money in those deposits over
and above what they needed for transactions. Furthermore, once private financial markets started
introducing instruments that competed with M1 deposits, some people shifted their funds to those
instruments, and that weakened the relationship between M1 and spending.

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In the early 1980s, the Federal Reserve directly targeted M1, and its weekly release was of critical
importance to the financial markets. It measures the domestic money supply that incorporates only
money that is ordinarily used for spending on goods and services. This includes currency, checking
account balances (including NOW accounts and credit union share draft accounts), and travelers'
checks. Today, M1 is barely noticed, and its stock continues to decline. However, M1 remains a key
indicator of past and future Federal Reserve actions.
Tab: 0.1

M2 is the next broadest measure of the money stock. It is used to measure domestic money supply,
which includes M1 plus savings and time deposits, overnight repurchase agreements, and personal
balances in money market accounts. Basically, M2 includes money that can be used for spending
(M1) plus items that can be quickly converted to cash. That is, M1 plus savings accounts and small
denomination time deposits, plus shares in money market mutual funds (other than those restricted
to institutional investors), plus overnight Eurodollars and repurchase agreements. Thus, M2 adds on
to the totals included in M1 the total amount of deposits in short-term savings accounts and small
certificates of deposit.

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Tab: 0.2

M2 is a useful indicator only so long as its velocity (the rate of turnover of a dollar of M2, or
mathematically, nominal GDP divided by M2) is stable over the long term. Unfortunately, the long-
term stability of M2 velocity, which was at the core of monetarism, disappeared beginning in the late
1980s. Banks and thrifts, devastated by lagging assets, pulled back from their traditional lending
business, with market financing sources picking up the slack. The result was a break from the long-
term trend in M2 velocity. The depressing effect of higher short-term market interest rates was most
apparent in the liquid deposit components, including checkable deposits and savings accounts,
whose rates respond very sluggishly to movements in market rates. This behavior in the components
of M2 was influenced by interest rate spreads. Without question, M2 is now the most closely
watched monetary aggregate, by both economists and the Federal Reserve. Nevertheless, the M2
target is the one which the Fed takes most seriously and which the market watches most closely

M3 measures the domestic money supply, which consists of M2 plus large-denomination time
deposits at all depositor institutions (deposits in denominations of $100,000 or more balances in

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institutional money market funds (minimum investments of more than $50,000) and money market
fund balances restricted to institutional investors and Overnight and term repurchase agreements
and Overnight and term eurodollars held by U.S. residents. M3 growth eased somewhat in the
fourth quarter because the slowing of bank credit led depository institutions to reduce their reliance
on managed liabilities. Institutional money funds increased rapidly throughout 2000, despite the
tightening of policy early in the year, in part owing to continued growth in their provision of cash
management services for businesses.
Chart: 0.4

The Fed still establishes annual ranges for M2 and M3, as well as for debt aggregate which consists
of the outstanding credit market debt of the U.S. government, state and local governments,
households and nonprofit organizations, nonfinancial businesses, and farms as required by Congress.

Monetary Policy
The government makes rules and regulation to keep its values vibrant and consistent. The Fed's
FOMC (Federal Open Market Committee) has primary responsibility for conducting monetary
policy, which is its own tool for regulating money stock, and maintaining a consistent economic
growth. Monetary policy has two basic goals. That is to promote "maximum" output and
employment and to promote price stability. These goals are prescribed in a 1977 amendment to the

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Federal Reserve Act. The intent of the policy is reflected the central bank's actions to influence
short-term interest rates and the supply of money and credit, as a means of helping to promote
national economic goals. These tools include open market operations, discount rate policy, and
reserve requirements. The monetary policy is considered easy, "loose, or "expansionary" when the
quantity of money in circulation is being rapidly increased and short-term interest rates are thus
being pushed down. The monetary policy is said to be "tight" or "contractionary" when the quantity
of money available is being reduced (or else allowed to grow only at a slower rate than in the recent
past) and short-term interest rates are thus being pushed to higher levels.

In order to achieve policy objectives, the Fed often implement the following strategies:
Control the rate of increase in the general price level (inflation),
Speed up or slow down the overall rate of economic growth mainly by affecting the interest rates
that constitute such a large share of suppliers' costs for new investment but partly by influencing
consumer demand through the availability of consumer credit and mortgage money,
Manage the level of unemployment
o By stimulating or retarding total demand for goods and services
o By manipulating the amount of money in the hands of consumers and investors,
o Or influencing the exchange rates at which the national currency trades for other
foreign currencies (mainly by pushing domestic interest rates above or below foreign
interest rates; in order to attract or discourage foreign savings from entering or
leaving domestic financial markets).

Although monetary policy cannot expand the economy beyond its potential growth path or reduce
unemployment in the long run, it can stabilize prices in the long run. Because, in the long run, the
level of output and employment in the economy depends on factors other than monetary policy.
These include technology and people's preferences for saving, risk, and work effort. Therefore,
"maximum" employment and output means the levels consistent with these factors in the long run.
However, the economy goes through business cycles in which output and employment are above or
below their long-run levels. Even though monetary policy cannot affect either output or
employment in the long run, it can affect them in the short run. For example, when demand
contracts and there's a recession, the Fed can stimulate the economy temporarily and help push it
back toward its long-run level of output by lowering interest rates. Therefore, in the short run, the

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Fed and many other central banks are concerned with stabilizing the economythat is, smoothing
out the peaks and valleys in output and employment around their long-run growth paths.

In the short run, lower real interest rates in the U.S. also tend to reduce the foreign exchange value
of the dollar, which lowers the prices of the exports and raises the import prices. This leads to higher
aggregate spending on goods and services produced in the U.S. The increase in aggregate demand for
the economy's output through these various channels leads firms to raise production and
employment, which in turn increases business spending on capital goods even further by making
greater demands on existing factory capacity. It also boosts consumption further because of the
income gains that result from the higher level of economic output.

Interpretation of policy
The Fed cannot control inflation or influence output and employment directly; instead, it affects
them indirectly, mainly by raising or lowering short-term interest rates. These variations in expected
inflation can make a big difference in interpreting the stance of monetary policy. Since the whole
point of implementing policy through raising or lowering interest rates is to affect consumer and
firms' demand for goods and services changes with real interest rates. This phenomena affects the
consumer demand for goods and services, thus mainly by altering borrowing costs, the availability of
bank loans, the wealth of households, and foreign exchange rates. For the most part, a decrease in
real interest rates lowers the cost of borrowing and leads to increases in business investment spending
and household purchases of durable goods, such as autos and new homes.

In addition, lower real rates and a healthy economy may increase banks' willingness to lend to
businesses and households. This may increase spending, especially by smaller borrowers who have
few sources of credit other than banks. Lower real rates make common stocks and other such
investments more attractive than bonds and other debt instruments; as a result, common stock prices
tend to rise. Households with stocks in their portfolios find that the value of their holdings has gone
up, and this increase in wealth makes them willing to spend more. Higher stock prices also make it
more attractive for businesses to invest in plant and equipment by issuing stock.

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Variable Lags
The Fed's job of stabilizing output in the short run and promoting price stability in the long run is
made more difficult by two main factors: the long and variable lags in policy, and the uncertain
influences of factors other than monetary policy on the economy. That is, it does take long for a
policy action to affect the economy and inflation because the lags in monetary policy are long and
variable. The Fed's job would be much easier if monetary policy had swift and sure effects.
Policymakers could set policy, see its effects, and then adjust the settings until they eliminated any
discrepancy between economic developments and the goals. Nevertheless, with the long lags and
uncertain effects of monetary policy actions, the Fed must be able to anticipate the effects of its
policy actions into the distant future. The major effects of a change in policy on growth in the
overall production of goods and services usually are felt within three months to two years. In
addition, the effects on inflation tend to involve even longer lags, perhaps one to three years, or
more. The lags are so hard to predict since monetary policy is being aimed at affecting people's
demand, it is dealing with human responses, which are changeable and hard to predict. For example,
the effect of a policy action on the economy will depend on what people think the Fed action means
for inflation in the future. If people believe that a tightening of policy means the Fed is determined
to keep inflation under control, they'll immediately expect low inflation in the future, so they're
likely to ask for smaller wage and price increases, and this will help to achieve that end. But if people
aren't convinced that the Fed is going to contain inflation, they're likely to ask for bigger wage and
price increases, and that means that inflation is likely to rise. In this case, the only way to bring
inflation down is to tighten so much and for so long that there are significant losses in employment
and output.

With all these uncertainties contained, the Fed must determine how and when its policies will affect
the economy. Thus, the Fed looks at a whole range of indicators of the future course of output,
employment, and inflation. Among the indicators are measures of the money supply, real interest
rates, the unemployment rate, nominal and real GDP growth, commodity prices, exchange rates,
various interest rate spreads (including the term structure of interest rates), and inflation expectations
surveys. These economic forecasting models help give structure to understanding the interplay of
these indicators and policy actions. However, these models are far from being accurate, therefore
judgments of policymakers play a significance in the direction of the economy as well. Indeed,

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policymakers often disagree about how important one indicator is rather than another because the
indicators can give contradictory signals.

Conflict of Interests
Since the Fed can determine the economy's average rate of inflation, some commentators and some
members of Congress as well have emphasized the need to define the goals of monetary policy in
terms of price stability, which is achievable. Nonetheless, volatility in output and employment also is
costly to people. In practice, the Fed, like most central banks, cares about both inflation and
measures of the short-run performance of the economy. These interests often clash. One kind of
conflict involves deciding which goal should take precedence at any point in time. For instance,
there is a recession and the Fed works to prevent employment losses from being too severe; this
short-run success could turn into a long-run problem if monetary policy remains expansionary too
long, because that could trigger inflationary pressures. Therefore, it is important for the Fed to find
the balance between its short-run goal of stabilization and its longer-run goal of maintaining low

Another kind of conflict involves the potential for pressure from the political arena. For example, in
the day-to-day course of governing the country and making economic policy, politicians may be
tempted to put the emphasis on short-run results rather than on the longer-run health of the
economy. The Fed is somewhat insulated from such pressure, however, by its independence, which
allows it to achieve a more appropriate balance between short-run and long run objectives. Wages
and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to
push labor and capital markets beyond their long-run capacities. In fact, a monetary policy that
persistently attempts to keep short-term real rates low will lead eventually to higher inflation and
higher nominal interest rates, with no permanent increases in the growth of output or decreases in
unemployment. As noted earlier, in the long run, output and employment cannot be set by
monetary policy. In other words, while there is a trade-off between higher inflation and lower
unemployment in the short run, the trade-off disappears in the long run.

The Phenomenon of Public Expectation

Policy also can affect inflation directly through people's expectations about future inflation. For
example, suppose the Fed eases monetary policy. If consumers and businesspeople expect higher

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inflation in the future, they will ask for bigger increases in wages and prices. That, in itself, will raise
inflation without big changes in employment and output. In this era of intense global competition,
it might seem parochial to focus on U.S. capacity as a determinant of U.S. inflation, rather than on
world capacity. For example, some argue that even if unemployment in the U.S. drops to very low
levels, U.S. workers wouldn't be able to push for higher wages, because they're competing for jobs
with workers abroad, who are willing to accept much lower wages. This reasoning does not hold up
too well, however, for a couple of reasons. First, a large proportion of what is consumed in the U.S.
is not affected very much by foreign trade. One example is health care, which is not traded
internationally and, which amounts to about 14% of GDP. Second, even when goods traded
internationally are considered, the effect on U.S. prices is largely offset by flexible foreign exchange
rates. Despite this fact, the currency market has been benefiting as the dollar continues to strengthen
from low inflation and low interest rates. While the Euro value has fallen back below $0.90 from
$0.95 since the beginning of the current market crisis, the dollar is at a 15-year high on a trade-
weighted basis.

The Policy Focus

The truth is that the Feds responsibility is not to guarantee the favorable stock market speculation
but to keep the national economy vibrant and healthy. When the Federal Reserve submitted its
previous Monetary Policy Report to the Congress, in July of 2000, uncertain signs of a moderation
in the growth of economic activity were emerging following several quarters of extraordinarily rapid
expansion. After having increased the interest rate on federal funds through the spring to bring the
growth of aggregate demand and potential supply into better alignment and thus contain
inflationary pressures, the Federal Reserve stopped tightening as evidence of an easing of economic
growth began to appear. Over the last few months of the year, however, economic restraint emerged
from several directions to slow growth even more. Many businesses encountered tightening credit
conditions, including a widening of risk spreads on corporate debt issuance and bank loans. Foreign
economic activity slowed in the later part of the year, contributing to a weakening of the demand for
U.S. exports, which also was being restrained by an earlier appreciation in the exchange value of the
U.S. dollar.

Government monetary policy-makers are generally much more successful in manipulating short-
term interest rates (rates on loans for periods of less than a year) than they are in manipulating

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medium-term interest rates (1 to 5 years) and long-term interest rates (more than five years). This is
because demand and supply for medium-term and long-term loans tend to be both much more
elastic and much more affected by the public's expectations about future rates of inflation than the
supply and demand for short-term loans are. A very expansionary monetary policy may well lower
short-term interest rates by flooding the banks and financial markets with loanable funds and yet at
the same time may actually raise longer-term interest rates by prompting fears among lenders that
inflation will soon be accelerating.

Open market operations

The Fed affects interest rates mainly through open market operations, discount policy and reserve
requirements, and these methods work through the market for bank reserves, known as the federal
funds market. Thus, the Federal Reserve Open Market Desks daily focus is on the federal funds rate
(the rate which banks charge each other for overnight loans). The Fed achieves its policy goals by
targeting the funds rate, and it is the job of the Open Market Desk (or simply the Desk) to ensure
that the funds rate stays close to its target rate. Achieving that goal is a matter of maintaining the
right amount of reserves in the banking system, so that there is relative stability between the supply
and demand of bank reserves.

The Open market operations directly affect the supply of reserves in the banking system. Thus, the
Fed buys and sells government securities on the open market. The Federal Reserve Bank of New
York conducts the entailed business operations. If the Fed wants the funds rate to fall, it buys
government securities from a bank. The Fed then pays for the securities by increasing that bank's
reserves. As a result, the bank would have more reserves than it is required to hold. Therefore, the
bank can lend these excess reserves to another bank in the federal funds market. Thus, the Fed's
open market purchase increases the supply of reserves to the banking system, and the federal funds
rate falls. When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government
securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in
the banking system, and the funds rate rises. The following factors are determinant in how the fed
uses interest rates to influence the financial market economy:

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Bank Reserves
Banks and other depository institutions are legally required to hold a specific amount of funds in
reserve. These funds, which can be used to meet unexpected outflows, are called reserves, and banks
keep them as cash in their vaults or as deposits with the Fed. Currently, banks must hold between
3% and 10% of the funds they have in interest-bearing and non-interest-bearing checking accounts
as reserves (depending on the dollar amount of such accounts held at each bank). Banks also may
hold additional reserves needed for clearing overnight checks and other payments.

Discount rate
Banks may borrow reserves from the Federal Reserve Banks at their "discount windows, and the
interest rate they must pay on this borrowing is called the discount rate. The total quantity of
discount window borrowing tends to be small, because the Fed discourages such borrowing except to
meet occasional short-term reserve deficiencies. The discount rate plays a role in monetary policy
because, traditionally, changes in the rate may have "announcement effects" that is, they sometimes
signal to markets a significant change in monetary policy. A higher discount rate can be used to
indicate a more restrictive policy, while a lower rate may signal a more expansionary policy. Thus,
discount rate changes are often coordinated with FOMC decisions to change the funds rate.

Foreign currency operations

Purchases and sales of foreign currency by the Fed are directed by the FOMC, acting in cooperation
with the Treasury, which has overall responsibility for these operations. The Fed does not have
targets, or desired levels, for the exchange rate. Instead, the Fed gets involved to counter disorderly
movements in foreign exchange markets, such as speculative movements that may disrupt the
efficient functioning of these markets or of financial markets in general. For instance, during periods
of declines in the dollar, the Fed purchases more dollars (sold foreign currency) to mitigate selling.
However, intervention operations involving dollars, whether initiated by the Fed, the Treasury, or by
a foreign authority, are not allowed to alter the supply of bank reserves or the funds rate. The process
of keeping intervention from affecting reserves and the funds rate is called the "sterilization" of
exchange market operations. As such, these operations are not used as a tool of monetary policy.

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Federal funds market
The federal funds are funds in excess of bank reserve requirements that commercial banks deposit in
Federal Reserve banks. Member banks may lend federal funds to one another on an overnight basis.
Federal reserve uses these funds to pay for its purchase of government securities and the funds are
used to settle transactions in which there is no float. Thus, from day to day, the amount of reserves a
bank must hold changes by the volume of deposits and transactions. When a bank needs additional
reserves on a short-term basis, it may borrow from other banks that might have excess reserves. These
loans take place in a private financial market called the federal funds market.

Almost all banks are members of the Federal Reserve System. The Federal Reserve requires banks to
keep a certain percentage of their assets on deposit with the Federal Reserve Bank, which covers their
geographic area. Banks loan out the majority of the money depositors put in them. However, they
are not allowed to loan out all of it. On a daily basis, the amount of money the bank has on deposit
with the Federal Reserve may fluctuate above and below the amount they actually need to keep on
deposit. When the amount on money on deposit with the Federal Reserve is greater than the amount
the bank needs to keep on deposit, this money is referred to as 'Excess Reserves'. When the bank has
less than is required to be kept on deposit with the Federal Reserve, the bank must borrow money to
put on deposit.

Federal fund Rates

Because banks do not earn any interest on the money they have on deposit with the Federal Reserve,
they gladly loan out their excess reserves to other banks that need to add money to their reserves.
The lending banks charge interest for this service. The lending, which goes on between banks with
their Federal Reserve funds, is known as 'Federal Funds Lending'. The rate of interest they charge is
known as the 'Federal Funds Rate' or Fed Funds Rate. It is possible for the lending bank to loan the
money for longer periods of time than one day. However, almost all the federal funds lending is for
one overnight period. The federal funds rate is the most volatile of all the money market rates. It
adjusts to balance the supply of and demand for reserves. For example, an increase in the amount of
reserves supplied to the federal funds market causes the funds rate to fall, while a decrease in the
supply of reserves raises that rate.

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In pursuit of such implied stability in the funds rate, Banks hold reserves both for meeting reserve
requirements on certain types of deposit accounts, and for clearing purposes. This means that the
banks' need for funds to accommodate typical daily operations. It is the Desk's job to accommodate
a rising demand for reserves by adding reserves to the banking system and to offset declining demand
for reserves by draining reserves.

Adds and Drains

Depending on the expected duration of the increase or decrease in the demand for reserves, the Fed
Desk can add or drain reserves on a permanent or temporary basis. Operations that temporarily add
reserves are known as customer or system repurchase (repo or rp) agreements. A customer repo is
typically an overnight addition of reserves to the banking system carried out for a "customer" of the
Fed - these customers are foreign central banks. The Desk can drain reserves temporarily via
matched sales agreements, also referred to as reverse repos or reverses.

Permanent reserve additions are seen much less frequently than temporary additions, but they are
not altogether rare, occurring about eight times each year. Since demand for reserves increases in
synch with growth in the economy, thus necessitating occasional permanent reserve additions to
keep the funds rate steady. Permanent reserve additions are quite common around holiday periods,
when consumer demand for currency rises sharply, producing a sharp drain of reserves from the
banking system. Permanent reserve additions can take the form of either a bill pass or a coupon pass.
The term pass is synonymous with purchase - also referred to as an outright purchase. The Desk
typically alternates between purchases of bills and coupons, in order to keep the duration of its
portfolio relatively stable.

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United States Department of the Treasury

United States Department of the Treasury was established in 1789. It is the department of a
government in charge of the collection, management, and expenditure of the public revenue.
Therefore advises the president on fiscal policy, acting as fiscal agent for the federal government, and
performing certain law enforcement tasks through the Secret Service. Under the Articles of
Confederation the limited financial administration of the United States was taken care of by a
superintendent of finance, who was replaced in 1784 by a treasury board. One of the first necessities,
after the new government was set up in 1789 under the Constitution of the United States, was
machinery for the collection of taxes, the custody of federal funds, and the keeping of accounts. To
this end, the Dept. of the Treasury was created and its head, the secretary of the treasury, became the
second-ranking cabinet member (after the secretary of state). Alexander Hamilton was the first
secretary. The office of U.S. Treasurer was also created in 1789 to receive and pay out money for the
federal government. Divisions that were added over the years include the U.S. Mint (1792), the U.S.
Secret Service (1860), the Internal Revenue Service (1862), the Office of the Comptroller of the
Currency (1863), the Bureau of Engraving and Printing (1877), the U.S. Customs Service (1927),
the Bureau of the Public Debt (1940), the U.S. Savings Bonds Division (1945, transferred to the
Bureau of the Public Debt in 1994), the Federal Law Enforcement Training Center (1970), the
Bureau of Alcohol, Tobacco and Firearms (1972), the Financial Management Service (formerly the
Bureau of Government Financial Operations, 1974), and the Office of Thrift Supervision (1989).
Until 1829, the department supervised the U.S. Postal Service and until 1849, the General Land
Office before 1903 the department was charged with many duties pertaining to commerce. The
Department of the Treasury has the following duties:
Reports to Congress and the president on the financial state of the government and the
Regulates the interstate and foreign sale of alcohol and firearms; supervises the printing of stamps
for the U.S. Postal Service;
Operates the Secret Service, which protects the president, the vice president, their families, and
other officials;
Curbs counterfeiting; and operates the Customs Service, which regulates and taxes imports.
The Internal Revenue Service, a branch of the Treasury, regulates tax laws and collects Federal

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In December 2000, President to elect George W. Bush appointed Paul O'Neill to head the Treasury
Department to replace Lawrence H. Summers. Paul O'Neill was a veteran of the Nixon and Ford
administrations. Some of O'Neill's upcoming tasks as treasury secretary includes: to keep the growth
rate high, to pass a $1.3 trillion tax cut, to serve as a liaison to Wall Street and other financial
markets. Government treasury benefited enormously when stock prices were rising. The extra tax
revenues generated on rising capital gains, exercised stock options and the stronger corporate
earnings resulting from rising stock values account for an estimated one-third of the swing in the
federal government's $200 billion deficit in fiscal year 1994 to $240 billion surplus in Fiscal Year
2000. State and local governments also benefited from the previously booming equity market as it
buoyed retailing and thus sales tax revenues for state governments, as well as supported the housing
market and thus property tax revenues for local government. While the stock market's current
travails may temporarily lift tax receipts, as households pay taxes on the gains they are realizing on
stocks they are selling today but purchased at much lower prices in the late 1990s, falling stock prices
will quickly weigh on government's good fiscal fortunes.

Fiscal Policy
Fiscal policy is a composition of regulative decisions set to determine governments inclination
towards raising revenue through taxation relative to the expenditures required to function
adequately. The function of fiscal policy is coherent with monetary policies; thereby helps regulate
the level of economic activity, the price level, and the balance of payments. Fiscal policy also
determines the distribution of resources between the public sector and the private sector and
influences the distribution of wealth. Government can mostly manipulate economic outcomes with
this tool. Keynesian economist believe that government can, and should, regulate the overall pace of
activity in the national economy through fiscal policy, principally by deliberately having government
borrow and spend more than it takes in (running a budget deficit) to increase total demand for
goods and services in times of high unemployment and economic slowdown (the deficit being
created either by cutting taxes or by increasing spending or both). Similarly, Keynesian theorists
advocate having government spend less than it takes in (running a budget surplus) to cool down the
national economy when too great an expansion of total demand has pushed production to its
physical limits and threatens to bring on excessive inflation.

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Historical Lessons in the U.S. Tax reform
Since the inception of the income tax, America has had three major episodes of individual income
tax rate reductions notably in the 1920s, 1960s, and 1980s. These changes offer valuable lessons
about the impact of tax policy. All three periods saw individual income tax revenues increased in
general and strong economic growth. Periods of rising tax rates, by contrast, are associated with
weaker economic performance and slower revenue growth. Tax rate increases in the 1930s, starting
with Herbert Hoover's decision to boost the top rate from 25 percent to 63 percent, contributed to
the economy's misery during the depression years. Inflation-induced bracket creep in the 1970s and
early 1980s certainly hindered economic growth in the 1973-1982 period (prior to the 1981 tax rate
reductions and indexing). Finally, tax increases in the 1990s have affected growth and incomes.

The Revenue Acts of 1921, 1924, and 1926 slashed individual income tax rates and reduced the top
rate from 73 percent to 25 percent. Notwithstanding (or perhaps because of) the dramatic reduction
in tax rates, individual income tax revenues increased substantially during the 1920s, rising from
$719 million in 1921 to $1160 million in 1928, an increase of more than 61 percent (in a period of
virtually no inflation). The share of the tax burden paid by the rich (those with incomes of $50,000
and up in those days) rose dramatically, climbing from 44.2 percent in 1921 to 78.4 percent in
1928. Andrew Mellon, the Treasury Secretary who oversaw the tax cuts, wrote, "The history of
taxation shows that taxes which are inherently excessive are not paid.

There is an inverse relationship between revenue collections from the wealthy and high marginal tax
rates. Following the Kennedy tax cuts in the early 1960s, the economy grew by nearly five percent
per year and real tax revenues rose by 29% from 1962 to 1968 (after having remained flat for a
decade). In the seven years following the 1981 Reagan tax cuts, the economy grew by nearly four
percent per year while real federal revenues rose by 26 percent. Over the years, there has not been an
economic output rise as tax rates fell (and fall as tax rates rose). Nevertheless, federal revenue raised
as a percentage of national output has remained flat. As the following chart indicates, the federal
government historically collects about 19 percent of gross domestic product - regardless of how high
the tax rate has been pushed.

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Chart: 0.5

The Burden of Higher Taxes on Capital Formation

Capital is the real engine of the growing the U.S. economy. Capital is any revenue-generating factor.
The burden of higher tax rates can trigger weaker or slower economy as it directly influences the size
of capital accumulation. Primarily, capital and productivity explains this surge in the living standards
of the people in American, whose real wages are higher than that most other nations, because
America has one of the highest ratios of capital per worker in the world. Thus, punitive tax policy
discourages capital accumulation, because productivity and real wages will languish or decline.
According to Nobel laureate Paul Samuelson, when each person works with more capital goods,
marginal product [or productivity] rises. Therefore, the competitive real wage rises as workers
become worth more to capitalists and meet with spirited bidding up of their market wage rates. The
following chart confirms that capital formation is the key ingredient to rising wages. When there is
more capital per worker, wages rise. Whenever the ratio of capital worker stops rising, wages
stagnate. When capital taxes are running high and investment capital grows scarce, the last areas that
will receive funds from the shrinking investment pool will be low-income, inner city neighborhoods.
They will increase GDP by increasing the percentage of adults who are willing to work, the intensity
and skill of work, the amount of personal and business saving, the amount of investment (including
investment in education), risk-taking by entrepreneurs and investors, and the efficiency with which
labor and capital are used. Human capital is also critical to increasing productivity and living
standards. By discouraging improvements in physical and human capital, such tax policies slow the
growth of the economy and of real wages.

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Chart: 0.6

From 1981 to 1988, the highest tax rate fell from 70% to 28%, and rates were generally reduced
across the board. Estimates prepared before the tax reduction suggested that revenue growth would
be impaired. In 1993, by contrast, real revenues were only $921.9 billion, barely changed from the
1989 level. It may not yet be technically feasible to estimate the exact impact of tax policy on
savings, employment, interest rates and production. It is, however, possible to estimate the direction
and general magnitude of such effects using models that appropriately account for the manner in
which tax changes alter incentives to supply labor and capital. Thus, by increasing the incentive and
ability to save, and to invest time and money in education and training, a tax system that taxes
income only once, and does so at a single low rate, will greatly enlarge and improve the economy's
stock of capital and human capital. Tax burdens are distributed based on existing incomes, for
example, even though making it easier to increase income and wealth is a major objective of a new
tax system.

Tax biases on income

The income tax impacts income that is saved and invested much harder than income used for
consumption. The income tax is imposed on income that is saved and again on the income

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produced by the saving. In contrast, the income tax falls on income used for consumption but does
not fall again on the consumption spending and the services and enjoyment it provides. For
example, if one uses after-tax income to buy a bond, the stream of interest payments is also taxed. If
one uses after-tax income to buy a television, there is no additional tax on the purchase of the TV or
the stream of entertainment it provides. In fact, people who save and invest find their income subject
to four layers of federal tax (versus one layer for consumption).

There are several types of tax systems that successfully exclude saving and investment or their returns
from tax, eliminate the bias against saving and investment, and simplify the tax system. These
include two types of unbiased income taxes and various types of sales taxes. The two neutral income-
style taxes are imposed on income as it is earned, with the amount saved and invested excluded (or
the earnings of saving excluded). Saving and investment are outlays that people make to earn
income. There is no real income or profit from saving and investment until the returns exceed the
outlays. Consequently, taxing that part of the payments to labor and capital left over after saving and
investment is the correct amount of income from labor and capital to tax. The potential for faster
growth of jobs and incomes should allay concerns that tax reform might force a choice between
higher short-term budget deficits and tax increases for some taxpayers.

Benefits of Tax reduction

In particular, tax reform affects a family or individual worker or taxpayer. As saving and investment
increase, productivity, and the taxpayer's income will grow faster for a decade or more and be higher
by increasing amounts over time. The taxpayer will enjoy lower interest rates on mortgages and
student loans as the tax burden on saving is reduced. Although reduced taxes on saving may not
instantly lower the tax of a twenty-year-old who has not yet begun to save, it will lower taxes on that
worker as he or she accumulates assets over a working lifetime, and leave that worker many tens of
thousands, or even hundreds of thousands, of dollars better off by age 65, and far more secure in
retirement. Excluding (or deducting) saving and investment from taxable income is called
"expensing". In the case of saving, expensing is parallel to the tax-deferred treatment which allowed
limited amounts of retirement saving today (as with current IRAs, 401(k) plans, 403 (b) plans, SEPs,
and Keogh plans), but with no restrictions on the amount of saving that could be deducted, no
penalty tax on withdrawal at any age, and no forced distribution at any age.

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An extra point on the growth rate would add a cumulative extra half trillion dollars to federal
revenues over seven years. More people working, and working at higher paying jobs, would men a
natural reduction in claims for income support payments. The foreign tax provisions of the internal
revenue code put U.S. businesses and individuals at a considerable competitive disadvantage in
global markets, and generally reduce total world-wide investment by, and income of, U.S. residents.
Other nations have income tax systems that are primarily territorial. They do not impose taxes on
the foreign earnings of their resident businesses or individuals. Consequently, U.S. firms operating in
a foreign country with corporate tax rates that are lower than in the U.S. are at a competitive
disadvantage compared with firms from most European or Asian countries, because only the U.S.
firms would owe a second layer of tax to the country in which its parent company is based. Similarly,
American workers abroad in low tax countries, and the companies that employ them, are at a
disadvantage relative to foreign workers and firms in such locations. Thus, the global tax system of
the United States discourages U.S. firms from engaging in production or other activities abroad, or
pressures U.S. businesses to structure foreign business operations in particular forms purely for tax
reasons. Imposing higher taxes on foreign operations of U.S. businesses does not improve the U.S.
investment climate, and does not add to domestic investment. Under some circumstances, the
opposite problem arises; other U.S. tax provisions sometimes force foreign subsidiaries to invest in
foreign projects at the expense of U.S. projects to avoid additional U.S. taxes.

A lower tax system will undoubtedly encourage domestic saving, but it will probably attract foreign
capital too by making the United States a particularly attractive place in which to invest. A capital
importing country may raise more revenue from a simple territorial tax system than from a system
based on the residence of the investor.

Criticisms of Tax cut

On March 1, the House Ways and Means Committee passed the Economic Growth and Tax Relief
Act of 2001, which reduces income tax rates roughly in line with the Bush administration's tax cut
proposal. Many advocates of the tax cut, including members of the Bush administration, have
argued that it will help to spur the economy out of its current period of sluggish growth and avoid a
possible recession. Some economists disagree of this argument. Even Treasury Secretary Paul O'Neill
stated in his confirmation hearings that: "I'm not going to make a huge case that this is the
investment we need to make sure we don't go into a recession.

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Some economists argue that the proposed tax cut is back-loaded, and does not provide much
stimulus in short run. Alan Auerbach, a leading tax economist at the University of California,
Berkeley, recently noted, such back-loading is inconsistent with spurring the economy in the short
run: The tax cuts would do little to boost families' spending power immediately and therefore do
little to spur the economy in the months ahead. Political opponents advocate that the Bush tax cut is
not designed to stimulate the economy in the short run, and not only that it is back-loaded but also
that it is heavily tilted toward high-income earners. They maintained that when fully in effect, the
Bush tax cut would deliver nearly 40 percent of its benefits (including its estate tax reductions) to the
top one percent of the population. This substantially exceeds the share of federal taxes this group
pays. (The top one percent pays 24 percent of all federal taxes.) Moreover, the share of the tax cuts
the top one percent of the population would receive when the Bush proposal is fully in effect is
greater than the share the bottom 80 percent of the population would receive.

Some other economists, including Paul Krugman, a well-known economist at Princeton, recently
wrote, "almost all economists now agree with the position that monetary policy, not fiscal policy, is
the tool of choice for fighting recessions." Thus, that tax cuts are not effective tools for managing the
economy. Whatever the design of the tax cut, a large majority of economists believes tax cuts are
simply not an effective tool for managing the macro-economy. In many cases, such tax cuts take
effect after the economy has already started to recover. By then, as William McDonough, the
President of the Federal Reserve Bank of New York, was recently quoted as saying, the economy is
expected to be "quite strong" even in the absence of a tax cut.

Most economists believe that monetary policy is more effective than fiscal policy in managing short-
term problems in the economy. Alan Greenspan noted in testimony on January 25, "Lately there has
been much discussion of cutting taxes to confront the evident pronounced weakening in recent
economic performance. Such tax initiatives, however, historically have proved difficult to implement
in the time frame in which recessions have developed and ended."

The effects will depend also on the budgetary context in which the tax cuts are to occur. One final
point must not be overlooked, and that is the fact that a Tax cut is a loss to government revenues.
Thus, unless large tax cuts are offset by large spending cuts, the deficit will rise faster than CBO
projects. An increase in the deficit is a dollar-for-dollar reduction in net national saving. As a result,

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any extra private saving that might be generated by lower tax rates is more than offset by higher
government borrowing. In the words, because of the effect of government borrowing on investment,
there is no tax incentive that promotes growth as effectively as deficit reduction under this current

The Federal Budget

Federal Budgets are meant to reflect a comprehensive plan of what the government will spend for its
various programs during the next fiscal year and how it expects to raise the money to pay for them
(tax receipts, charges for services, sale of assets, borrowing, new emissions of currency, etc.).
However, the same term denotes both the advance estimate and plan of what the government will be
taking in and spending even though the planned and actual numbers are never exact. The US budget
is based on estimates of the expenditures to be made by the government's main subdivisions (wages
and salaries of government employees; consultants' fees; purchases of equipment, supplies, real
estate, etc. This also includes money transferred to beneficiaries of various programs, and so on)
during the specified period, along with estimates of the revenues to be realized from the various
sources of income that will be available for paying for these expenditures.

Deficits and Surpluses

There is a Budget deficit incurred when the total government spending is more than government
income during the specified period. This also represents the amount of money that the government
has to raise by borrowing or currency emission in order to make up for the shortfall in tax revenues.
On the other hand, a Budget surplus results when government revenues are more than government
spending during a specified period.

Budget Resolution
The annual budget process begins in late January or early February with the presentation of the
President's budget for the coming fiscal year. The President's proposals serve as an outline for
Congress, particularly when the same party controls the White House and Congress. The legislative
process of budget begins once the President has submitted his budget to Congress. Within six weeks
of the date that the President presents his budget, each Congressional committee must report to the
House and Senate Budget Committees regarding budget estimates for programs overseen by their
committee. The Budget Committees then approve a budget resolution based on these estimates.

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After full House and Senate approval of these resolutions, any differences between the House and
Senate versions are worked out in conference committee and then each house approves a final
resolution. One of the most common misperceptions about the budget process is that the annual
budgeting actually covers all federal spending. Though the President's proposed budget will include
projections for all federal government outlays, less than half of all spending is actually controlled by
the annual budget legislation. Roughly, permanent law mandates 67% of federal outlays. Unless
these laws are changed, no legislative review of spending programs funded by permanent law is
required in the appropriations process.

Permanent laws are changed frequently, with the 1990 and 1993 budget deals being the most recent
examples. These recent efforts to reduce the deficit have incorporated both changes in discretionary
spending and changes in permanent laws affecting taxes and spending. Such deficit reduction efforts
are usually packaged into the Omnibus Budget Reconciliation Act (OBRA). In the absence of these
comprehensive deficit reduction efforts, the annual budget review will only deal with discretionary
spending which makes up roughly 33% of the budget. These discretionary programs are not
bundled into one budget package. The real job of budgeting begins after the budget resolution is
adopted. The appropriations process is when actual budget authority for discretionary programs is
legislated. The annual budget for discretionary spending is actually comprised of 13 separate
appropriations bills. As all tax and spending bills must originate in the House, the House
Appropriations subcommittees will see the first action in the appropriations process. Once a House
Appropriations subcommittee approves its bill, the legislation proceeds to the full Committee and
then to the House floor. Upon approval by the full Senate, differences between the House and
Senate versions of the bill are reconciled in conference committee and then a final version of the bill
is sent back to the House and Senate floors. Presidential approval of each of the 13 appropriations
bills completes the process.

Emergency spending
Supplemental appropriations bills may be approved at any time to provide additional funding for
government programs. Tight caps on discretionary spending set by the 1990 and 1993 budget acts
require a pay-as-you-go approach to such funding, thus limiting the number of supplemental
appropriations. "Emergency" spending circumvents the pay-as-you-go mandate, however, allowing
for a variety of supplemental appropriations. Past "emergencies" have covered everything from the

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Gulf War to extended unemployment insurance to natural disaster relief. After decades of deficits,
the federal budget recently yielded surpluses, and projections suggest that the surplus will rise
significantly over the next decade.

The Patterns of Federal Government spending

The arrival of budget surpluses in 1998 has led to an explosion in Federal Government spending.
For the past three years, spending has exceeded the statutory limits that Congress and President
Clinton wrote into law in 1997 by $199 billion. During this period, appropriated spending has
grown by an average of six percent. If growth continued at a six percent pace going forward, an
additional $1.4 trillion of the surplus would be consumed over 10 years approximately the amount
of the President's tax cut. This means redeploying resources away from programs that have expired.
It will also mean exercising restraint both in the Administration and in Congress. Just as budget
deficits dominated policy discussions in the 1980s and early 1990s, choice regarding how to spend
the surplus accumulated in the exuberance era was the centerfold in the Gore Vs Bush presidential
election campaign. The biggest uncertainty relating to budgetary costs concerns retirement saving
and Medicare expansion. Bush has advocated diverting some Social Security contributions into
private retirement accounts, while Gore proposed voluntary, progressive, government run
Retirement Savings Plus accounts modeled on Individual Retirement Accounts.

President George W. Bushs Budget Proposal

President Bush aimed to limit federal tax revenues to no more than one-third of the income people
earn. An economic gloom was starting to thwart the market as Bush became the US 43rd President
and, the tax cut argument took on a more ideological cast, capturing different visions of individuals
and corporate investors in the most dramatically. The budget submitted by the President for
statistical activities covered by this report is estimated at $3,944.4 million. Bushs moves should give
individuals and companies greater amounts of liquid assets to expend and thus increase demand.
Lower interest rates means less cost prices for everything from adjustable mortgages to automobile
loans, while lower taxes will give the active public more cash. The most recent Congressional Budget
Office (CBO) baseline forecast projected cumulative surpluses is between $4.5 trillion and $5.8
trillion between 2001 and 2010. The CBO provided the following chart illustrating an overview of
the president's 10-year budget plan.

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Chart: 0.7

Some supporters of a large tax cut and the Bush Administration argue that a large tax cut is needed
to prevent an explosion of federal spending. A $1.6 trillion tax cut is needed, this argument goes, or
else further spending explosions will occur. The baseline that CBO employs assumes the
maintenance of discretionary spending at its level for the preceding fiscal year, adjusted only for
inflation. Since the U.S. population increases each year but the CBO baseline contains no
adjustment for population growth, the CBO baseline essentially assumes a decline each year in the
purchasing power of discretionary programs on a per-person basis. All of the income tax rate
reductions proposed under the Bush plan would be phased in gradually between tax years 2002 and
2006. The proposed new ten percent rate would actually be a 14 percent rate in 2002, and would
decline by a single percentage. The President's plan may perhaps help accelerate this trend to record
rates by retiring an historic $2 trillion in debt over the next 10 years.

Federal Deficit
The two most commonly used measures of federal debt are: Debt held by the public and Gross
Federal Debt. Debt held by the public reflects the governments borrowing from the private sector
(i.e., from banks, pension plans, private bond-holders, foreign investors, and others). Debt held by

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the public includes debt held by the Federal Reserve Banks. In 1998, debt held by the public
amounted to $3,719.9 billion. The Federal Reserve Banks held $458.1 billion of that total. Changes
in debt held by the public have important economic implications. These changes can affect national
saving, private-sector investment, interest rates, and economic growth.

Tab: 0.3

Gross Federal debt

Gross Federal debt includes debt held by the public plus debt that various parts of the government
hold. In other words, it includes debt that one part of government owes to another part. For
example, Social Security surpluses are currently used to help finance other parts of the government;
in exchange, the Social Security trust fund is given an IOU from the rest of the government. Such
IOUs, held as Treasury bonds, increase the gross Federal debt but do not affect the debt the
government owes to outside entities (i.e., the debt held by the public). The majority of debt that one
part of the federal government owes to another part is debt the Social Security and Medicare trust
funds hold in the form of Treasury bonds that reflect the recent surpluses in these programs.
Federal Government spending

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Chart: 0.8

Effects of Federal Debt on the Economy

Debt held by the public approximates the Federal governments competition with other sectors in
the credit markets. This affects interest rates and private capital accumulation. Increased government
borrowing from entities outside government (i.e., increases in debt held by the public) discourages
private investment in part through higher interest rates. Since the increase in government borrowing
results in more competition for the capital available in private credit markets, the amount that
lenders can charge to lend funds i.e., interest rates can rise. When debt held by the public rises, the
government must compete with private borrowers to a greater degree for the capital (or saving) from
which one can borrow. Thus, some of the money that otherwise would be available for private
investment is used instead to purchase the increased volume of bonds the Treasury is issuing. Debt
held by the public is the debt that hurts the economy by crowding out private savings, whereas
debts owed one part of the government to another do not hurt the economy nor do they crowd out
private savings. There also is one other important difference between debt held by the public and
debt held by the trust funds. Interest payments on debt held by the public are a government

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In addition, interest payments on debt held by the trust funds are not expenditure but a transfer of
funds from one part of the government to another. (The actual expenditure occurs when Social
Security and Medicare pay benefits, not when an intra-government fund transfer is made.) Reducing
or eliminating debt held by the public thus cuts government costs; under the Administrations
proposal, for example, federal expenditures for interest payments on the debt held by the public
would drop from 14 percent of the budget in 1998 to just two percent by 2014. Increases or
decreases in the debt held by the trust funds have no similar effect they do not raise or lower
government expenditures. The costs of the programs are the costs of providing Social Security and
Medicare benefits; providing more Treasury bonds to the trust funds does not raise those costs.
Rather, the issuance of additional debt to the trust funds could help narrow the gap that already
exists While gross Federal debt would increase in dollar terms under the an aggressive tax cut
proposal. It would decline as a percentage of GDP between 1998 and 2004.
Debt as a share of GDP
{Tab: 0.4)
Debt held by Debt held by Govt. Gross Federal
the public accounts (trust funds) debt

1960 45.7% 10.4% 56.1%

1970 28.1% 9.7% 37.8%
1980 26.1% 7.3% 33.4%
1990 42.4% 14.0% 56.4%
1993 50.2% 17.0% 67.2%
1998 44.3% 20.9% 65.2%
2004 30.4% 32.2% 62.7%

Source: Office of Management and Budget, FY 2000 Budget, Historical Tables FY 2000 Budget,
Table S-14 and calculations.
First, and more important, gross Federal debt does not affect economic performance; debt held by
the public does. Second, the dollar increase in gross Federal debt is misleading; relative to GDP,
gross Federal debt declines between 1998 and 2004. If the nation can largely or eliminate the
publicly held debt over the next two decades, America will enter the baby boom retirement period
free of substantial annual costs for interest payments on the publicly held debt. Elimination of the

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debt held by the public would produce large interest savings that could create room in the budget for
anticipated increases in Social Security benefit costs during the next few decades. Debt held by the
public would fall by more and gross Federal debt would rise by less under such a baseline. Since the
gross Federal debt is the sum of debt held by the public and debt held by the trust funds, thus, the
two different policies that generate increases of equivalent size in the gross Federal debt can have very
different economic effects. If one policy raises the gross debt because it swells debt held by the public
while the other policy raises the gross debt because it increases debt held by the trust funds.

Predictors of Inflation
When government fails to recognize inflation previously before it strikes, dealing with it effectively
can be highly difficult. Therefore, the US government makes sure that they have inflation in check at
all times. Inflationism is relative to the concurrent regulative instance of fair value compared to the
recurring rate of sufficient consumers income and spending and the combined incentives to meet
essential debt obligations. If the publics basic needs were readily identifiable as separated from
certain individual desires, inflation would be less complicated to sight and combat. The various and
complex needs of a society makes the concept of inflation quite difficult to analyze across cultures.
However, all instances of inflation reflect drastic increments in the cost of fundamental needs,
without a proportionate rate of growth in the general earning levels. Fundamental needs in the US
are those essential and primary requisite such as Health care, Nutrition, Housing, Energy and
Utility, Transportation, Clothing, Production, Services, and Debts. These needs are considered
fundamental, essentially because they are required for human sustenance and societal operations.
Therefore, any lacking thereof will eventually hamper growth unfavorably on the overview.

In well established economies, such as the U.SA, a persistent attempts to immediately expand the
economy beyond its long-run growth horizon would press capacity constraints resulting from higher
unemployment, or lower profit and output with unfavorable effects on economic growth and can
eventually lead to inflation. High inflation tends to vary and makes people uncertain about where
the economy will be in the future, and that uncertainty alone can hinder growth in a couple of ways.
It can add an inflation risk premium to long-term interest rates, or complicates the planning and
contracting by businesses and households that are so essential to capital formation. However,
inflation performance in developing countries has improved substantially. In the U.S., government

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generally thinks of inflation as an inordinate rise in the unrestricted levels of prices. Therefore,
government usually employ certain broad-based price index methodologies, such as the implicit
deflator for Gross Domestic Product, the Consumer Price Index, Producer Price Index, Employment
Cost Index etc., as measures of the rate of inflation. The success of these combined methodologies
reflects in large part a thorough conceptual analysis adopted from great economists across the
modern times.

Analysis of Inflation
The first and the oldest method of analysis held a view that the level of prices is determined by the
quantity of money in circulation. The theory is based on the perspective that the ratio of the money
stock that people hold to transactions they perform is supposed to be fixed by such factors as the
frequency of wage payments, the structure of the economy, and saving and shopping habits. Thus,
so long as these remain constant, the price level will be directly proportional to the supply of money
and inversely proportional to the physical volume of production. This theory became contradicted
by those challenges that are imperative to befall a society, such as rate of employment and
unemployment due to population growth, wars, political and other factors that supports or
contradicts production, supply and demand. In order to have stable prices would require increasing
the money supply regularly at a rate equal to that, at which the economy is estimated to be
expanding. Moreover, they concluded that while money supply may not have served as a reliable
instrument for controlling short-term movements in the economy, it could still be very effective in
controlling longer-term movements of the price level. To their contradiction, highly developed
economies money supply varies largely with the demand for it rendering the monetary authorities
rather powerless disabling them somewhat to really vary the supply through purely monetary

The Keynesian theory

Maynard Keynes theory was based on income determination. His assumption was that consumers
tend to spend a fixed proportion of any increases they receive in their incomes. Thus, at any given
level of national income there is a gap of predictable size between income and consumption
expenditure. Therefore, in order to establish and maintain that level of national income it would
only be necessary to fix the expenditures on all non-consumption goods and services at such a level as
to fill the gap. Thus, Keynes invented most of the basic ideas of what is today the macroeconomists'

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conventional system of national income accounting when he formulated his famous aggregate
demand identity (Y = C + I + G + (X - M)). This means that, a single country's aggregate demand
for national product (Y) is always equal to the total demands of its households for Consumer goods
and services (C), plus the total demands of its firms for Investment goods (I), plus the total demands
of its various Government agencies for goods and services (G), plus the net demands of foreign
consumers, firms and governments for the country's goods and services (exports minus imports).

The view that inflation arises entirely from attempts to buy more goods and services than can be
supplied was contradicted by the fact that there was continuous inflation in conditions that do not
suggest the existence of an inflationary gap after World War II. There was much more than can be
produced at the full employment level of activity. If, for instance, government expenditure is
higher than the difference between production and consumption at the level corresponding to full
employment, there is an inflationary gap. The market process closes this gap by bidding up of
prices to the point at which the difference between income and consumption, in money terms, is big
enough to accommodate the government expenditure. (In an economy open to foreign trade, the
gap may be fully closed or in part by the creation of an import surplus). Apart from government
outlays, the main constituent of this non-consumption expenditure is private investment. Keynesian
theory supposed investment to be fairly sensitive to the rate of interest and that there is a bottom,
below which long-term interest rates will not fall, no matter how low the velocity of circulation.
Many economists believe that the approach has led to better control over short-term changes in
employment and real income.

The third analysis assumed that prices of goods are determined by their costs, whereas supplies of
money are responsive to demand. Under such circumstances, increasing costs would generate
inflationary pressures, which might continue through the operation of the price-wage spiral. The
supposition is that wage earners and profit receivers (neglecting for the moment other groups in the
economy) aspire to incomes that add up to more than the total value of their production at full
employment. The wage earners, if dissatisfied, demand wage increments. Later, employers increase
prices to reflect their higher costs, and, while this restores profits, it also reduces wage earners' real
incomes, sowing the seeds of a further round of wage demands. If the supply of money were fixed,
this process would lead to increasing monetary hoard. It would essentially, because it would be
difficult to finance increases in wages and purchases of goods the prices that had just been raised. In

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practice, money supply responds to demand, partly because monetary authorities do not wish to see
the dislocation of capital markets that would follow if monetary stringency produced very large rises
in rates of interest.

The fourth basic approach emphasizes the structural maladjustment of money wages in the
economy. Thus, the obvious relative changes in the supply of, and demand for - labor in different
industries or occupations have to be accomplished through the absolute raising of all wages except
those of the group of workers whose market position is weakest. The rate of wage-inflation as a
whole is then seen as proportional to the rate of structural change in the economy. This is more
apparent in developing countries, some of which must monitor the gap between their imports and
exports. If import exceeds export over a sizable period, consequently, there is a continuous
downward pressure on the international value of the country's currency.

Inflation may also result from social and political pressures to provide employment for the overflow
into the towns of a rapidly growing rural population. In the case where there is a shortage of savings,
this may lead to excessive creation of new credit in one-way or another and thus to a straightforward
demand-pull inflation. The chronic inflationary tendencies in some Latin American countries have
been attributed to mechanisms of these kinds.

The Impacts of Inflation

In large part, interest rates reflect an assumed level of inflation plus a premium for various kinds of
risk that lenders take. Unlike cash dividends from stocks, interest payments from bonds (usually
distributed semiannually) typically remain fixed over the entire life of the bond. A $100 interest
payment received three years from now, however, is not likely to have as much purchasing power as
a $100 payment received tomorrow. Therefore, investors generally require a higher yield from
longer-term securities. Typically, bond prices rise during periods in which expectations of inflation
lower. Conversely, when investors expect inflation to rise, bonds become less attractive to investors
and prices generally decline. The returns from fixed-income investments tend to weaken during
periods of high inflation (e.g., 1979 and 1980, when inflation was at a double-digit annual rate).
The returns from U.S. Treasury bills are less volatile, in both directions. This is because, with
investors due to receive their return of principal sooner than they will from long-term bonds, erosion
of purchasing power, or inflation, is less of an issue.

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Chart: 0.9

With some nations' economies growing faster than others and with varying political situations, there
have been wide differences in returns from various financial markets. Although the economies of
various nations are increasingly being linked, significant differences among them remain. Differences
in the performance of various stock markets can be significant from one country to the next and
from year to year. In recent years, the overall return from international stocks has substantially
trailed that of the U.S.-based S&P 500. In part, this is due to the Japanese market, where the 10-
year annual total return from stocks, through 1996, was just 3.3% (measured in dollars), compared
to 15.1% from the U.S., according to returns calculated by Goldman, Sachs, & Co. During that
same 10-year period, a number of international markets, such as Mexico and Malaysia, provided
dollar-denominated returns that surpassed those of the S&P 500. However, U.S. investors should be
aware that investing in international stocks might often carry more price volatility (risk) than U.S.

Price "stability"
Price "stability" is basically low inflationthat is, inflation that's so low that people don't worry
about it when they make decisions about what to buy, whether to borrow or invest, and so on.
Persistent attempts to expand the economy beyond its long-run growth path will press capacity
constraints and lead to higher and higher inflation, without producing lower unemployment or
higher output in the end. Thus, not only are there no long-term gains from persistently pursuing

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expansionary policies, but there is also a price higher inflation. High inflation can hinder
economic growth. For instance, when inflation is high, it also tends to vary a lot, and that makes
people uncertain about what inflation will be in the future. That uncertainty can hinder economic
growth in a couple of waysit can add an inflation risk premium to long-term interest rates, and it
complicates the planning and contracting by businesses and households that are so essential to
capital formation. High inflation also hinders economic growth in other ways. For instance, because
many aspects of the tax system are not indexed to inflation, high inflation distorts economic
decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of
economic activities. In addition, it leads people to spend time and resources hedging against inflation
instead of pursuing activities that are more productive.

Tab: 0.5

Rising concern about slower growth and worker layoffs contributed to a sharp deterioration of
consumer confidence. In response to the accumulating weakness, the Federal Open Market
Committee (FOMC) lowered the intended interest rate on federal funds significantly. Nevertheless,
medium and long-term interest rates have much more influence on the rate of growth of the
economy and on levels of unemployment than short-term interest rates do. Because, major new
investment spending like research and development for new products or the construction of whole

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new factories are long-term projects that require long-term financing, and they are much less likely
to be undertaken if long-term interest costs are high than if they are low.

Current Economic Indicators

Economic analyses are often accomplished by measuring benefits and costs in units of stable
purchasing power. Such estimates may reflect expected future changes in relative prices, however,
where there is a reasonable basis for estimating such changes. Thus, Nominal and real values are
usually not combined in the same analysis. Logical consistency requires both analyses be conducted
either in constant dollars or in terms of nominal values. This may require converting some nominal
values to real values, or vice versa. The U.S. government employ certain broad-based price indexes,
such as the implicit deflator for Gross Domestic Product, the Consumer Price Index, Import and
Export, Producer Price Index, Employment Cost Index etc., as measures of the rate of inflation. In
gauging the overall economy, other broad based indexes
Tab: 0.6

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Gross Domestic Product
This is the total value of all goods and services produced domestically each year by a country. It
equals gross national product minus income from abroad. Gross Domestic Product is a measure of
the total production and consumption of goods and services in the U.S. The BEA constructs two
complementary measures of GDP, one based on income, and one based on expenditures. GDP is
measured on the product side by adding up the labor, capital, and tax costs of producing the output.
On the consumption side, GDP is measured by adding up expenditures by households, businesses,
government, and net foreign purchases. Theoretically, these two measures should be equal. However,
due to problems collecting data, there is often a discrepancy between the two measures. Analysts
usually look for total real GDP growth, change in consumer demand, business investment growth
and change in inventories, Trade balance, and the GDP deflator.
Chart: 1.0

GDP growth was a weak 1.0% in the fourth quarter. The 1.0% annualized pace was the slowest
since 1995, with weakness in exports, consumer, and business spending. Trade continues to act as a
drag on the economy. Exports fell by 6.4% following robust growth in the previous two quarters, a
warning sign that exports may not support the economy in the near term. Imports also fell by 1.2%.
The 2.1% decline in imported goods followed six quarters of double-digit growth, an indication that

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weak demand for autos is consistent for both domestic and import models. The economy may weak,
but it is still growing.

GDP price deflator

The GDP price deflator is used to convert output measured at current prices into constant-dollar
GDP. This data is used to define business cycle peaks and troughs. Total GDP growth of between
2.0% and 2.5% is generally considered optimal when the economy is at full employment
(unemployment between 5.5% and 6.0%). Higher growth than this leads to accelerating inflation,
while lower growth indicates a weak economy. GDP deflators has the advantage of not being a fixed
basket of goods and services, so that changes in consumption patterns or the introduction of new
goods and services will be reflected in the deflator. With both GDP and the deflator, the market
tends to focus on the quarter/quarter change. Year/year changes are also cited frequently, though
they do not provide the timeliest indications of economic activity or inflation. The bond market
often reacts to GDP, though the price moves are typically small, as much of the GDP data is easily
predicted using monthly economic releases such as personal consumption, durable goods shipments,
construction spending, international trade, and inventories.
Chart: 1.2

Chart indicates positive influence on the economy.

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The Consumer Price Index (CPI)
The Consumer Price Index (CPI) is a measure of the average change in price over time in a fixed
market basket of goods and services bought by consumers for day-to-day living. The All Items CPI
for the U.S. is the broadest, most comprehensive index, and is often quoted as the source for the
"rate of inflation". The CPI for All Items less Food and Energy (also sometimes referred to as the
"core" or " underlying" CPI) excludes volatile food and energy prices. Some analysts use this index
to track long-term trends in prices. Changes are usually calculated from indexes before seasonal
adjustment. Unadjusted indexes are more commonly used for annual percent change. While the CPI
report is a welcome change from previous months in which inflation topped expectations, there
remain significant core and noncore cost pressures in the pipeline. The report will not affect the Fed
current deliberations on monetary policy. The core CPI inflation rate is currently running at a 2.7%
year-over-year pace compared to 2.0% one year ago. Import prices decreased in March by 1.6%,
after falling by a revised 0.6% in February.
Tab: 0.7

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Import and Export Prices (United States)
The overall import price index measures the price change of products purchased from other
countries by U.S. residents. The overall export price index measures the change in the prices of
domestically produced U.S. goods shipped to other countries. These indices are calculated using a
method similar to that used to calculate the consumer price index (CPI). Every month, the Bureau
of Labor Statistics collects net transaction prices for more than 20,000 products from over 6,000
companies and secondary sources. These prices are then weighted according to the relative
importance (i.e. the share of expenditures) of the product in 1995. The terms of trade for the U.S.
improved in March despite a drop in export prices as import prices, driven lower by falling oil prices,
declined by an even larger amount. Import prices are now lower than their year-ago level as world oil
prices have displayed considerable weakness.

Tab: 0.8

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Since imports make up roughly 15% of the goods purchased in the U.S., the change in import prices
have an impact on U.S. inflation. In addition, prices of imports affect the profitability of U.S. firms.
For instance, when import prices are low, U.S. firms must lower prices to compete with the cheaper
imports, and thus profits are reduced. Conversely, when import prices rise, U.S. firms are able to
raise prices more easily, and hence increase profits. Export prices are an indicator of the demand for
U.S. goods abroad, and thus provide information about economic conditions abroad. For instance, a
recession in Japan will lead to reduced demand for U.S. products, thus leading to lower prices for
U.S. exports.
Tab: 0.9

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Tab: 1.0
Import and Export Prices

Import Prices Mar-01 Feb-01 % Change Mo. Ago % Change Yr. Ago

All commodities 97.8 99.4 -1.6 -1.5

Capital goods 79.7 79.8 -0.1 -2.0

Consumer goods excl.
96.6 96.6 0.0 -0.5
Export Prices

All commodities 96.2 96.3 -0.1 -0.1

Capital goods 96.6 96.5 0.1 0.6

Consumer goods excl.
101.9 102.0 -0.1 -0.4
Agricultural commodities 85.1 84.9 0.2 0.8

Import prices decreased in March by 1.6%, after falling by a revised 0.6% in February. Petroleum
prices, which fell 5.9%, accounted for most of the fall in import prices for the month; they are now
down by 11.0% over the last 12 months. Agricultural prices and the prices of food, feed and drink
showed the most robust price gains among export commodities, gaining 0.2% and 0.7%,
respectively. Since imports make up roughly 15% of the goods purchased in the U.S., the change in
import prices have an impact on U.S. inflation. In addition, prices of imports affect the profitability
of U.S. firms. For instance, when import prices are low, U.S. firms must lower prices to compete
with the cheaper imports, and thus profits are reduced. Conversely, when import prices rise, U.S.
firms are able to raise prices more easily, and hence increase profits. Export prices are an indicator of
the demand for U.S. goods abroad, and thus provide information about economic conditions
abroad. Import and Export prices are directly influenced by exchange rate fluctuations with a lag
created by advance orders contracts.

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Employment Cost Index (ECI)
The ECI is useful in analyzing changes in wages and fringe benefits in relation to productivity and
inflation, as a guide for collective bargaining negotiations, and for cost escalators in union and other
business contracts. Look for an acceleration or deceleration in growth. The employment cost index
(ECI) data are based on a survey of employer payrolls in the 3rd month of the quarter for the pay
period including the 12th day of the month. The survey is a probability sample of approximately
3,600 private industry employers and 700 state and local governments, public schools and public
hospitals. The ECI measures changes in labor costs of money wages and salaries and non-cash fringe
benefits in non-farm private industry and state and local government for workers at all levels of
Tab: 1.1

Benefit cost growth has accelerated from 3.3% in December of 1999 to 4.9% in December of 2000.
In the fourth quarter, the growth in benefits costs moderated to its lowest increase of the year, in line
with a deceleration in the growth in all types of health-care costs. Another reason for the deceleration
in benefits costs is the decline in overtime hours. Manufacturing overtime fell to its since 1993
during the fourth quarter. Accordingly, benefits costs actually fell in the manufacturing industry
during the fourth quarter. The moderate fourth quarter increase in compensation costs should give
the Fed the confidence to lower rates further at the next FOMC meeting in order to steady the

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course of the economy and to keep the economy a recession at bay. However, any rate decrease
would take sometime to work its way through the economy.
Chart: 1.2

The employment cost index increased a moderate 0.8% in the fourth quarter, which translates into
year-over-year growth of 4.1%. Both the wage and benefit components decelerated relative to the
third quarter. The moderate growth suggests that inflation originating in the labor market is not a
threat, particularly as productivity growth remains strong. Benefit cost growth has accelerated from
3.3% in December of 1999 to 4.9% in December of 2000. In the fourth quarter, the growth in
benefits costs moderated to its lowest increase of the year, in line with a deceleration in the growth in
all types of health-care costs. Another reason for the deceleration in benefits costs is the decline in
overtime hours. Manufacturing overtime fell to its since 1993 during the fourth quarter.
Accordingly, benefits costs actually fell in the manufacturing industry during the fourth quarter. The
moderate fourth quarter increase in compensation costs should give the Fed the confidence to lower
rates further at the next FOMC meeting in order to steady the course of the economy and to keep
the economy a recession at bay.

Producer Price Indexes

The term Producer Price Index (PPI) refers to a family of indexes that measure the average changes
in selling prices received by domestic producers for their output measuring price change from the
perspective of the seller. The PPI tracks changes in prices for nearly every goods producing industry
in the domestic economy, including agriculture, electricity and natural gas, forestry, fisheries,

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manufacturing, and mining. Sellers' and purchasers' prices may differ due to government subsidies,
sales and excise taxes, and distribution costs. There are three primary publication structures for the
PPI: industry, commodity and stage-of-processing. The industry structure organizes products
according to the Standard Industrial Classification (SIC) system. Thus, prices of products from the
same industry are computed together. The commodity structure organizes products by material
composition or similarity of end uses. This structure organizes products by the degree of fabrication.
Goods are classified into three broad groups. Examples include coal, crude petroleum, grains, logs
and timber, and iron ore. The second group consists of Intermediate Materials, Supplies, and
Components. Examples include flour, lumber, fabric, and leather. The last grouping, Finished
Goods, is the most closely watched as an indicator of inflationary pressures. Finished goods are
products that will not undergo further processing, and are ready for sale to the final user. Examples
include bakery products, apparel, gasoline, and books. The financial markets follow the PPI for
finished goods closely because it is an important indicator of commodity price pressure, and because
it usually presages changes in the Consumer Price Index.

Tab: 1.2

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The producer price index for finished goods fell 0.1% in March. A sharp fall in the price of energy-
related goods offset increases in other broad categories. Excluding the more volatile items, food and
energy, producer prices increased by 0.1%. Finished goods are defined as commodities that are ready
for sale to the final-demand user, either an individual consumer or a business firm. In national
income accounting terminology, the Finished Goods Price Index roughly measures changes in prices
received by producers for two portions of the gross national product:
(1) Personal consumption expenditures on goods, and
(2) capital investment expenditures on equipment.

The Economic Cycle Research Institute (ECRI) Future Inflation Gauge

The FIG is a weighted average of eight key economic data series designed to predict cyclical swings
in the inflation rate. The index generally turns up before acceleration in inflation and vice versa. The
components used to construct the index are: Industrial materials prices, Real estate loans, insured
unemployment rate, yield spread, Civilian employment, Federal and nonfederal debt, Import prices,
The percentage of purchasing managers reporting slower deliveries. Although, the financial markets
are not very sensitive to this report since its data components have all been previously released and
the fact that this data is not a commonly reported statistic, the report could still be quite
instrumental. An upward trend in the Future Inflation Gauge (FIG) raises the possibility of an
increase in Consumer Price Index inflation within the proceeding few months. The sharper and
longer the trend, the greater is the risk of inflation.
Chart: 1.3

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Effects of US Government Policies on the Financial Market Economy

The ECRI Future Inflation Gauge (FIG) declined in March. This is the eleventh consecutive
monthly decline for the index, which is designed to anticipate cyclical swings in inflation. This is
supported by the recent NAPM report, which shows that price pressures have quickly abated in
manufacturing, with both the price index and the supplier delivery index falling below 50%. This
marks a departure from nearly two years of rising input prices. This will provide some relief to the
Fed that its rapid reduction of interest rates has not sparked inflation. The recent downward trend in
oil prices has also been very beneficial in reducing price pressures. Among other indicators,
production of consumer products declined across the board in February, following the broad
slowdown in consumer spending. Almost daily layoff announcements and plunging stock market
values have spooked consumers and tightened their purse strings, and as a result, retailers?
inventories are growing. Moreover, further risk arises as firms pull back on their investment plans as
concerns about the economy ability to stave off recession mount. Additionally, the labor markets
remain weak, as employment declined by 87,000 in March in stark contrast to the expected increase
of 50,000 jobs. The manufacturing sector dropped another 81,000 jobs during the month. The
unemployment rate increased to 4.3%. The release indicates that the economy weakened
significantly in March. The behavior of the FIG, along with corroborating evidence of
contemporaneous releases, indicates that the risk of real sector weakness outweighs inflationary
pressures. As such, the Fed is likely to continue to ease monetary policy in the near future.

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Effects of US Government Policies on the Financial Market Economy

The Yield Curve

The Yield curve is used to describe the term structure of interest rates displayed by plotting the
interest rate yields on bonds with differing terms to maturity, but with the same risk, liquidity, and
tax considerations. The yield curve, specifically the spread between the interest rates on the ten-year
note and the three-month Treasury bill is a valuable forecasting tool. It is simple to use Treasury and
significantly outperforms other financial and macroeconomic indicators in predicting recessions two
to six quarters ahead. Typically, yield curves slope upwards, i.e., long-term interest rates are higher
than short-term ones. The reverse of that situation produces an inverted yield curve. However, the
changes in the yield curve originate entirely from the Fed rate cuts. Actually, long-term rates have
been generally stable over the first three months of 2001, implying those investors' inflation
expectations have not changed significantly.

Chart: 1.3

A variety of factors outside of inflation expectations are now having an impact on long-term bond
prices, which are in turn preventing an increase in yields at the long end of the yield curve. One
major factor is the flight to quality impact of foreign investors seeking U.S. dollar securities during
times of economic uncertainty. In addition, the weak returns of the domestic stock market have also
caused some investors to move money from stocks to fixed income securities, while at the same time,
the ongoing retirement of some long-term bonds by the Treasury has reduced the available supply.

The Yield Curve as a Predictor of Recession

In July 2000, the spread between the 10-year T-Bond and 3-month T-Bill rates turned negative
(inverted) for the first time since 1989. The yield curve remained inverted for seven months, but in

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Effects of US Government Policies on the Financial Market Economy

recent weeks has begun to revert to a normal upward sloping shape. In the past, there has been an
observable relationship between the slope of the yield curve and subsequent economic growth, but
the relationship is fading
Chart: 1.4

The theory behind this relationship is based on the inflation expectations of bondholders. If
investors believe that inflation will accelerate, as it generally would in an environment of improving
economic growth, bondholders will sell long-term bonds for short-term securities. The result is that
long-term yields rise and short-term yields fall, or the yield curve's slope becomes increasingly
positive. In the case of an inverted yield curve, the exact opposite happens. Investor expectations are
for decelerating inflation, which is generally coincident with slowing economic growth. In this case,
demand for long-term bond increases relative to short-term securities, causing long-term yields to fall
relative to short-term yields. This will cause the yield curve to flatten, and if the change in
expectations is sufficient, to become negatively sloped.

The Federal Reserve Bank of New York published an article (Current Issues in Economics and
Finance, 1996) on the effectiveness of the yield curve and the spread between the 10-year T-Bond
and 3-month T-Bill rates, as a predictor of recessions: (see The Yield Curve as a Predictor of U.S.
Recessions by Arturo Estrella and Frederic S. Mishkin). Factors outside of investors' inflation
expectations are becoming increasingly more important to bond yields. Investors' inflation
expectations have become less important in today's low inflation environment. A probability this
high is very unusual and indicative of a significant risk of recession.

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Effects of US Government Policies on the Financial Market Economy

A Probability of Future Recession

Recession in economics is a period of two or more successive quarters of decreasing production
business cycle characterized by a decline in employment, which in turn causes the incomes and
spending of households to decline. A recession can develops into a severe and prolonged depression
if the extent and quality of credit extended during the previous period of prosperity was poor and
excessive, there is an excess amount of productive capacity in existence, and also the ability of
government monetary, fiscal, and foreign policies to reverse the downward trend. The Great
Depression was a period of about 10 years, 1929-1940, dominated by two recessions.

Nonetheless, the U.S. recession risks are rising. The global crisis also threatens to unravel further due
to weakening commodity-dependent economies. A prolonged plunging global demand is
undermining prices for everything from oil to food. Soft commodity prices in turn are thwarting the
financial position of nations from Canada to South Africa. The Brazilian economy appears
particularly vulnerable due to its large short-term debt obligations. Oil prices near their current $15
Bbl will likely be high enough to allow these economies to make it through, particularly with the aid
of the IMF, World Bank and U.S. banks.

The steepness of the yield curve can be an excellent indicator of a possible future recession for several
reasons. Current monetary policy has a significant influence on the yield curve spread and on real
activity over the next several quarters. A decrease in the short rate tends to boost the yield curve as
well as to accelerate real growth in the near term. Expectations of future inflation and real interest
rates contained in the yield curve spread also seem to play an important role in the prediction of
economic activity. The yield curve spread variable examined here corresponds to a forward interest
rate applicable from three months to ten years into the future. The expected real rate may be
associated with expectations of future monetary policy and hence of future real growth. Moreover,
because inflation tends to be positively related to activity, the expected inflation component may also
be informative about future growth.

Although the yield curve has clear advantages as a predictor of future economic events, several other
variables have been widely used to forecast the path of the economy. Among financial variables,
stock prices have gained much attention. Finance theory suggests that stock prices are determined by
expectations about future dividend streams, which in turn are related to the future state of the

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economy. Among macroeconomic variables, the Commerce Departments (now the Conference
Boards) index of leading economic indicators appears to have an established performance record in
predicting real economic activity. An alternative index of leading indicators, developed in Stock and
Watson (1989), appears to perform better than the Commerce Departments index of leading
economic indicators.

Chart: 1.5

Estimating the Probability of Recession

The so-called "Probit Model" can be employed to assess how well each indicator variable predicts
recessions. This application directly relates the probability of being in a recession to a specific
explanatory variable such as the yield curve spread. The yield spread is the difference between two
prices or interest rates. A yield spread represents the differential between the yields on two
comparable bonds in different markets. It can also be used to describe the differential between the

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yields on a euro bond and a comparable government bond of the same currency. If the spread
tightens, this means the differential has narrowed, and if it widens, it has got bigger. If the spread on
a bond tightens, this could mean that the bond is in demand, and if it widens this could mean the
bond is not doing so well. When the price of a bond rises, the yield falls and vice versa. For instance,
one of the most successful models estimates the probability of recession four quarters in the future as
a function of the current value of the yield curve spread between the ten-year Treasury note and the
three-month Treasury bill.

The following leading index is composed of three local (state or metro level) indicators, two broad
regional indicators, and two national-level indicators. Because no single variable explains shifts in the
business cycle, the variables are combined into a composite index. Each of the component variables
is weighted and aggregated into a composite leading index using the same methodology as the
national leading index as derived by the Bureau of Economic Analysis and currently implemented by
the Conference Board. One outcome of this method is that the component weights are specific to
the location for which the index is constructed. For example, the weight on the housing permit
component in Connecticut is slightly different than in Nevada. Since regional recessions may have
more than one cause, no single variable can reliably predict all types of recessions. Because the
volatility in a component series varies by location (employment growth in Las Vegas versus
employment growth in Gary, Indiana), no single set of weights is appropriate for all indexes.
Combining the indicators in a weighted composite thus increases the predictive power of the leading

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Tab: 1.4

State Leading Indicators

Current Business Cycle Probability of Recession

Oct-99 Feb-00 Apr-00

Alabama 80m2 82m2 12% 12% 13%

Alaska 85m8 87m8 13% 13% 14%

Arizona 81m7 82m8 14% 13% 14%

Arkansas 79m11 83m2 15% 15% 16%

California 90m7 93m10 12% 12% 13%

Colorado 86m3 87m3 13% 13% 14%

Connecticut 89m2 92m6 12% 13% 14%

Delaware 90m2 91m8 11% 12% 11%

Florida 90m6 91m12 13% 12% 13%

Georgia 90m6 91m10 13% 12% 14%

Hawaii 92m4 94m5 13% 14% 15%

Idaho 85m6 86m8 14% 14% 15%

Illinois 90m8 92m3 12% 11% 12%

Indiana 90m8 91m3 11% 11% 12%

Iowa 85m5 85m12 14% 13% 13%

Kansas 81m8 83m3 13% 12% 13%

Kentucky 79m7 83m7 11% 13% 13%

Louisiana 84m8 87m3 13% 13% 14%

Maine 90m1 92m3 12% 12% 14%

Maryland 90m3 92m9 12% 12% 11%

Massachusetts 89m1 92m6 13% 13% 14%

Michigan 90m7 91m4 12% 13% 11%

Minnesota 80m2 82m11 14% 14% 13%

Mississippi 90m7 91m5 12% 13% 14%

Missouri 90m6 91m4 12% 13% 12%

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Montana 84m8 87m8 12% 12% 13%

Nebraska 80m2 83m2 14% 12% 10%

Nevada 81m8 83m2 12% 13% 12%

New Hampshire 89m6 91m12 13% 12% 13%

New Jersey 89m3 92m5 12% 12% 13%

New Mexico 81m12 83m1 12% 13% 11%

New York 89m3 92m12 13% 14% 13%

North Carolina 90m5 91m4 13% 13% 15%

North Dakota 85m8 86m11 13% 13% 15%

Ohio 90m6 91m6 10% 12% 11%

Oklahoma 84m10 87m7 13% 13% 14%

Oregon 90m8 91m4 14% 13% 15%

Pennsylvania 90m3 92m2 12% 12% 10%

Rhode Island 89m1 91m7 11% 12% 12%

South Carolina 90m9 91m9 14% 13% 15%

South Dakota 81m1 82m8 12% 12% 11%

Tennessee 90m6 91m4 11% 12% 13%

Texas 86m1 86m12 16% 17% 19%

Utah 82m5 83m2 13% 13% 12%

Vermont 89m12 91m6 11% 12% 12%

Virginia 90m3 91m4 14% 13% 16%

Washington 81m6 82m8 15% 14% 16%

West Virginia 90m3 91m7 12% 11% 12%

Wisconsin 79m12 83m1 10% 12% 11%

Wyoming 86m1 87m6 15% 15% 18%

United States 90m7 91m3 12% 12% 13%

Changes in the level of the composite leading index (LEI) for regions are comparable over time.
Thus, the composite index is more likely to signal a recession if more than one individual
component indicates a downturn. Moreover, index levels are not comparable across locations. For

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example, it would be incorrect to conclude that an increase in the LEI for Las Vegas reflects the same
amount of improvement as a similar increase in the LEI for Hartford. To facilitate the interpretation
of index level changes, both in terms of magnitude and across locations, the LEI is translated into a
probability of recession. This is a particular advantage for an index based on regional data, which are
more volatile than national data.

The recession probabilities are estimated by means of a logistic regression in panel form. The right-
hand variables are the level of the LEI and the year-over-year change in the LEI. The coefficients on
both variables are negative. A negative sign on the level variable indicates that the probability of a
recession is lower for regions with larger index values. For example, Nevada's employment grew by
8.0% and Connecticut's grew at just 0.9% on a year-over-year basis in June. A 50% decrease applied
to the index for both locations brings Connecticut much closer to recession than it does Nevada, the
state with the higher index value. By contrast, the negative sign on the change variable indicates that
a decrease in the value of the leading index implies a greater likelihood of recession, other factors
held constant. Thus, for two states with equal values of the leading index, the state with the larger
decrease will also see the greater increase in its recession probability. In order to maintain
comparability between states and the metro areas within the states, the state coefficients are applied
to the metro areas. While the state coefficients do vary some from those derived from a metropolitan
panel regression, the loss in precision is compensated by the greater ease of metro-state comparison.

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Effects of US Government Policies on the Financial Market Economy

The U.S. Financial Market System

A financial system represents the process of lending and borrowing of funds by both private and
government established franchises relatively to capital formation and transfer within a defined
horizon. A good financial infrastructure should be reliable in providing the inter-mediation of funds
transfer, large capital allocation requirements, markets debt instruments at some efficiently
determined prices, and of course, adequate and precise information about its market and operations.
The US Financial Market System is currently the most organized institutional structure or
mechanism for creating wealth and exchanging financial assets in the whole world. There are four
essential elements of a financial system:

I. The lenders and borrowers, i.e. the non-financial economic units.

II. The financial institutions, which intermediate the lending and borrowing process
III. The financial instruments to satisfy the various needs of the participants.
IV. The financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading
(dealing) of the financial instruments.

Given the existence of surplus and deficit economic units, or a supply of and a demand for loanable
funds, some financial conduit are necessary to coordinate the excess surplus units with the deficit
units. The needs of these units may be reconciled through direct security exchanges or through
financial intermediaries. This probability of security product and services is progressive, but the
amplitude makes the world of investing quite complex. Generally, inevitable conflict arises when
lenders sometimes require security investments that differ from those borrowers prefer to issue, and
borrowers generally require accommodation on terms differing from those which lenders are willing
or able to grant. Therefore, the government has provided a Regulatory authority for securities
industry in the US.

U.S. Securities and Exchange Commission (SEC)

The U.S. Securities and Exchange Commissions duties include protecting investors and maintaining
the integrity of the securities markets. The laws and rules that govern the securities industry in the
United States derive from a simple and straightforward concept: all investors, whether large
institutions or private individuals, should have access to certain basic facts about an investment prior

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to buying it. The public companies must disclose or facilitate access to their financial information.
Because the concept of fair market value requires that only with steady flow of timely,
comprehensive and accurate information can people make sound investment decisions. The SEC
supervises other key participants in the securities world, including stock exchanges, broker-dealers,
investment advisors, mutual funds, and public utility holding companies by enforcing the securities
laws, and protecting investors.

However, it is the primary overseer and regulator of the U.S. securities markets, the SEC works
closely with many other institutions, including Congress, other federal departments and agencies,
the self-regulatory organizations (e.g. the stock exchanges), state securities regulators, and various
private sector organizations. The SEC Division of Corporation Finance provides administrative
interpretations of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust
Indenture Act of 1939, and recommends regulations to implement these statutes. They must also
review documents that publicly held companies are required to file with the Commission. The
documents include: registration statements for newly offered securities; annual and quarterly filings
(Forms 10-K and 10-Q); documents concerning tender offers (offer to buy a large number of shares
of a corporation, usually at a premium above the current market price); and related filings for
mergers and acquisitions.

These documents disclose information about the companies' financial condition and business
practices that might be relevant to an investor's decision to buy, sell, or hold the security whether it
is positive or negative. Another division, Market Regulation, establishes and maintains standards for
fair, orderly, and efficient markets. The division of Market regulation regulates the major securities
market participants such as: broker-dealer firms; self-regulatory organizations (SROs), which include
the stock exchanges and the National Association of Securities Dealers (NASD), Municipal
Securities Rulemaking Board (MSRB), and clearing agencies (SROs that help facilitate trade
settlement); transfer agents (parties that maintain records of stock and bond owners); and securities
information processors.

A self-regulatory organization is a member organization that creates and enforces rules for its
members based on the federal securities laws. The Division of Market Regulation also oversees the
Securities Investor Protection Corporation (SIPC), which is a private, non-profit corporation that

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Effects of US Government Policies on the Financial Market Economy

insures the securities and cash in the customer accounts of member brokerage firms against the
failure of those firms. SIPC insurance does not cover investor losses arising from market declines or
fraud. Market Regulation's responsibilities include: reviewing and approving proposed new rules and
proposed changes to existing rules filed by the SROs; monitoring the market activities and carrying
out the Commission's financial integrity program for broker-dealers.

The Division of Investment Management oversees and regulates the $15 trillion investment
management industry and administers the securities laws affecting investment companies (including
mutual funds) and investment advisers. In applying the federal securities laws to this industry, the
Division works to improve disclosure and minimize risk for investors without imposing undue costs
on regulated entities by developing new rules and amendments to adapt regulatory structures to new
circumstances. They also review enforcement matters involving laws and regulations for the public
advisers, investment companies, and SEC inspection. As the utility industry evolves from a regulated
monopoly to a competitive, market-driven industry, the Division also exercises oversight of
registered and exempt utility holding companies under the Public Utility Holding Company Act of

With the SEC scrutinizing the Security market and the Fed monitoring the Banks, the activity of the
insurance industry remains free of federal regulation due to an exemption written into federal law in
1945. Many in the insurance industry are convinced the National Association of Insurance
Commissioners (NAIC), an unofficial group that helps regulators from different states devise
common approaches, wants the federal government to become involved in insurance regulation.
Some Corporate leaders have argued that U.S. insurance companies face greater competition
domestically from foreign insurance companies, which have a broader financial service bases in their
home countries. Routing in favor, that passage of financial modernization legislation would allow
United States banks, securities firms, and insurance companies to be in a position to consolidate a
global leadership in finance.

Regulation Integrity
The SEC routinely receives complaints from investors about the investment products they have
purchased. Nonetheless, not all investments are securities under the securities laws. For example, the
banking authorities regulate some products, such as notes issued by banks. The Federal Reserve and

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Justice Department take this issue very seriously, and they conduct anti-trust reviews on several
activities including manipulation and banks mergers. Manipulation is intentional conduct designed
to deceive investors by controlling or artificially affecting the market for a security. The government
proved at trial that Microsoft had engaged in a broad pattern of anticompetitive conduct to eradicate
a developing threat to its monopoly power in its core business - personal computer operating systems
- and that Microsoft's conduct had harmed consumers.

Under the 1994 law, which repealed the restrictions on interstate banking and branching, federal
regulators are prohibited from allowing banks to merge if the resulting organization has more than
10 percent of the nations bank deposits or 30 percent of a states deposit base. The 1994 interstate
banking law also prohibits interstate banks from establishing deposit production offices, whereby a
large bank simply siphons off the deposits of a community or state without providing loans.
However, when community banks merge with regional or national banks, the market share for
locally controlled competitors, including newly chartered institutions, generally increases.

The noteworthy mergers of recent times include Citicorp-Travelers, which brought about the
integration of a money center commercial bank with a major insurance and securities firm. The
unity of Bank of America and NationsBank created a national coast-to-coast retail bank based upon
a union of two dominant regional banks. Washington Mutual merger with Great Western and
Home Savings involved the creation of the largest S&L in the country, with a West Coast emphasis,
the deposits of which account for over 11 percent of the taxpayer-backed savings association deposit
insurance fund. The Household-Beneficial merger involves a consolidation of two of the largest
consumer finance companies in the country. There has been an increasing public concern about
concentration of resources attendant in these recently accomplished mergers.

International Relations
When the U.S. provides resources to the IMF, it receives a liquid, interest-bearing claim on the IMF
backed by the Funds substantial reserves, which include almost $40 billion in gold. By bolstering
the financial resources of the IMF, Congress will put in place an insurance policy ensuring that a
quick response to the crisis is possible if it deepens or widens further. Conversely, failure to support
the IMF would leave the U.S. and world economy vulnerable to additional financial shocks in Asia
or elsewhere. It would be seen abroad as repudiation of current American leadership and of the long-

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standing American commitment to expanding global trade. Indeed, failure to support the IMF
would send destabilizing shock waves through the international financial system, with dangerous
knock-on effects for broader U.S. security and political interests.

International Regulation
The Economists review of regional economies indicated that countries with prudential and
transparent financial regulations have done well and those without have found public treasuries
jeopardized. Ironically, U.S. banks overseas compete at a severe disadvantage. They are in head to
head competition with European and Asian banks, which can offer a larger range of financial
products to international corporations and customers. Other international control authority comes
from Basle, where the central bankers' bank is based in Switzerland. The Basle Committee set up by
the Bank for International Settlements, which drew up international capital adequacy standards for
banks (once known as the Cooke Committee, after a former chairman). The Bretton Wood, New
Hampshire in the US remarks the international conference in 1944, which resulted in the
establishment of the World Bank and the International Monetary Fund.

The Bottom line

Technological developments, overcapacity in the industry, and other market forces are reshaping
Americas financial services industry. These developments have unique implications within the
context of the general trends occurring in the financial service marketplace. Unlike its European and
Asian counterparts, the American public has been skeptical about allowing the financial service
marketplace to be monopolized by a handful of large institutions, but rationale infers inevitability of
some degree of involvement. Americas financial services industry is the most competitive,
transparent, vibrant, and efficient one in the world because of its pro-market diversification and its
pro-competition business philosophy.

Amplitude of the US Financial Services

Financial institutions primarily issue financial liabilities that are acceptable as assets to the lenders
and use the funds so obtained to acquire claims that reflect the requirements of the borrowers. The
difference remains with the nature of claims and services offered to lenders and in the nature of the
claims on and services offered to the borrowers. Financial institutions may be classified in two broad
categories, i.e. deposit and non-deposit intermediaries. The deposit intermediaries represent the

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United States Federal Reserve Banks and the private sector banks. The non-deposit intermediaries
represents those operations which are based on certain contractual agreements: Insurance,
Investment funds, Public Investment, Portfolio institutions, Unit trusts, Brokerages, Participation
mortgage bond schemes, Housing Trust, Independent Trust Small Business Development
Corporation, National Housing Finance Corporation and the Industrial Development Corporation.

Banking plays two roles in a modern capitalist economy: It provides a means of payment and
channels resources into capital development. The private banks and banks intermediate mainly
between the ultimate lenders (in the form of deposits) and ultimate borrowers (in the form of loans,
hire-purchase and leasing contracts, mortgage advances and the purchase of securities). There is also
an element of intermediation between financial intermediaries. For example, banks issue liabilities to
insurance companies and pension funds and make loans to or hold the securities of other financial
institutions. The United States financial sector has undergone marked changes in conducting its
financial services over the past decades. New developments have forged their ways to liberalize both
the government and the private financial deposit and non-deposit sector by the emergence of high
capacity technologies. Parts of this revolution, pioneered by NASDAQ followed by other exchanges
such as the American Stock Exchange and the London Stock and exchanges in continental Europe,
such as Euronext and the Frankfurt Exchange (owned by Deutsche Borse. Electronic
communications networks (ECNs), including Brut, Instinet, The Island, and Archipelago, are
speeding change, literally, by connecting buyers and sellers of stock (thereby bypassing brokers and
stock exchanges) and executing trades automatically. Around-the-clock global trading of securities is
just around the corner. Mutual fund managers such as Janus Capital, The Vanguard Group, FMR
and brokerages such as Merrill Lynch, Morgan Stanley Dean Witter, and Goldman Sachs give
average folks ingress to financial markets. Venture capital companies and investment firms have
changed the way fledgling firms get their footing. More people invest in stocks and mutual funds
than ever. The role of the insurance industry is also significant in the nation's financial affairs.
Insurance companies hold great sums of money as reserves against future claims and in related
policyholder accounts. Their investment activities with these funds have significant impacts on the
nation's financial markets.

Financial Instruments and Products

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Because of the processes of borrowing and financial intermediation, there are a wide range of
financial instruments and products provided by the United States financial industry. Primary
Securities are issued by ultimate borrowers; they represent the obligations of the private sector,
examples are Hire-purchase contracts; Leasing contracts, Mortgage advances, Overdrafts and
Personal IOUs. Financial intermediaries issue indirect Securities as obligations of deposit examples
are Bank notes, Savings accounts, and Fixed deposits. Other kinds of such indirect securities include
those that represent the obligations of contractual intermediaries like Insurance policies, Members'
interest in pension funds and Retirement annuities; and some presenting the obligations of portfolio
institutions, such as Participation mortgage bonds and the Mutual fund units (only marketable to

The securities that can be traded in the secondary market are Primary Securities issued by ultimate
borrowers, representing the obligations of the private sector; examples are Bankers' acceptances,
Coupons, Trade bills, Promissory notes and Commercial paper. Other securities representing the
obligations of the public sector includes Equities, Bonds, Treasury bills and Government bonds;
those representing obligations of the semi-public sector, Municipal Capital project bills, Bridging
bonds, Municipal bonds, Public corporation bonds, Call bonds, the derivatives, and the swaps.
Indirect Securities (issued by financial intermediaries) representing the liabilities of private banks
include Negotiable certificates of deposit. Others representing the liabilities of public or semi-public
banks are Federal Reserve bills, Bank bills, corporate debentures, Development bonds.

Analysis of the US Financial Market Fundamentals

The economic function of the financial market is to provide channels for transferring the excess
funds of surplus units to deficit units. Put slightly differently, financial markets constitute the
mechanism that link surplus and deficit units, providing the means for surplus units to finance
deficit units either directly or indirectly through financial intermediaries. However, financial markets
provide surplus and deficit units with additional options. Surplus units may purchase primary or
indirect securities or reduce their debt by purchasing their own outstanding securities. It will be
evident that the participants in the financial markets are the borrowers (issuers of securities), the
lenders (buyers of securities), the financial intermediaries (buyers and issuers of securities and other
debt obligations), and the brokers.

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The terminology and concepts used in the financial markets can be confusing. For example,
reference is often made to the primary market, the secondary market, the spot market, the options
and futures markets, financial exchanges, the money and capital markets, the swap market, etc. The
Primary market is the market level where issues of new securities to borrow money for consumption
or investment purposes are conducted. This market could include the issue of both primary and
indirect securities. It will be evident that the markets in non-negotiable instruments, such as
mortgage loans, savings deposits and life policies, are entirely primary markets.

Secondary market is the term used for the markets in which previously issued financial claims are
traded. These active markets exist in many securities but they differ in terms of so-called breadth and
depth or liquidity. For the purpose of this analysis, the secondary market, it is important to
distinguish between brokers and market makers. Market-makers, on the other hand, are some of the
financial institutions, mainly the banks who have assumed this function, i.e. they are prepared to
quote buying and selling prices simultaneously for certain securities and are prepared to deal in
reasonable volumes. Firstly, it assists the primary market to increase the ease with which issuers
places securities, by providing investors with the assurance on their arbitrary interest. Secondly, a
secondary market provides the basis for the determination of rates to be offered on new issues. In the
third place, it registers changing market conditions rapidly, indicating the receptiveness of the
market to new primary issues. Fourthly, an active secondary market enables investors to rapidly
adjust their portfolios in terms of size, risk, return, liquidity, and maturity. Finally, it enables the
central bank to buy and sell securities in order to influence liquidity in the financial markets (open-
market operations).

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The Financial Markets

The financial markets is the platform for the exchange of capital and credit, including the money
markets and the capital markets, which embrace the primary or new issues market and the secondary
market. The line demarcating the money and Capital markets is usually drawn based on term to
maturity of the securities traded, and is arbitrarily determined to be one year. The Capital market is
considered as the market for the issue and trading of long-term securities, while the money market is
the market for the issue and trading of short-term securities. In respect of the money and Capital
markets two other terms need to be clarified, i.e. repurchase agreements and Interest rate swaps. A
repurchase agreement is the sale of a previously issued security at an agreed rate of interest for a
specified period. An interest rate swap entails the swapping of interest obligations between two
parties via a facilitator, i.e. it is an agreement between two parties to exchange a fixed rate of interest
for a floating rate of interest in the same currency. These amounts are calculated with reference to a
mutually agreed notional amount. This amount is not exchanged between the parties. The term of
the agreement determines whether it is a money market or capital market transaction.

The Money Market

Generally, corporations raise money by issuing long term debt and equity instruments. The money
market is where buying and selling short-term loanable funds in the form of securities and loans
takes place. Short term loans are traded which can be converted into cash rather quickly. The buyer
of a money market instrument is the lender. The seller of the money market instrument is the
borrower. Money market instruments have maturity of one year or less. Most have maturity of six
months or less. The majority of money market instruments are issued at a discount. This means that
the lender of the money does not receive interest payments. Rather, they might lend $96,000 and
receive $100,000 at maturity. For the most part, $100,000 is the minimum amount that is traded in
the money market. Money market instruments are regarded as quite safe. Of course, there are some
instruments, which are considered safer than others are. T-Bills are considered safer than commercial
paper. Nevertheless, they are all considered low risk.

The money market trades both corporate and government debt securities. T-Bills are the majority of
what is traded in the money market. However, Treasury Notes are also traded. Treasury Notes have
maturities from one year to ten years. T-Bonds are also traded. However, the only T-Bonds traded

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have one year or less to maturity. One of the greatest advantages to the Money Market is the great
liquidity. It is such a huge market that the spreads are kept relatively low. In addition, interest earned
from the Money Market is free of state tax. One last feature of the Money Market is the absence of
business risk.

Types of Money Market Instruments

US Treasury and Money market instruments

Chart: 1.5

The U.S. Government issues the U.S. Treasury Bills. They represent U.S. government obligations. The
Treasury Department has weekly 3 month and 6 month T-Bill auctions. The Treasury Department
offers Tax Anticipation Bills through special auctions. T-Bills are issued in denominations of
$10,000 through $1,000,000. There is an excellent secondary market because they are liquid and
discounted in actual days based on a year.

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Prime Sales Finance Paper is promissory notes from finance companies placed directly with the
investor. There is no secondary market for these. Under certain conditions, the company will buy
back the securities before maturity. They will usually adjust the interest rate in this event. These can
be either discounted or interest bearing.
Dealer Paper (Finance) is promissory notes of finance companies sold through commercial paper
dealers. Their denominations range from $100,000 to $5,000,000. There is a limited secondary

Dealer Paper (Industrial) is promissory notes of the leading and largest industrial firms. It is sold
through commercial paper dealers. They are sold in denominations of $500,000 to $5,000,000.
They mature on certain dates form 30 days to 180 days. There is a limited secondary market.

Prime Bankers' Acceptance are time drafts drawn on and accepted by a banking institution that
substitutes its credit for that have the importer or holder of the merchandise. They range in
denominations from $25,000 to $1,000,000. They mature in up to 270 days. There is a good
secondary market in these.

Negotiable Time Certificates of Deposit are certificates of time deposit at a commercial bank. They
range in denominations from $100,000 to $1,000,000. The maturities are unlimited. There is a
good secondary market. The rate is based on a yield basis for actual days for a 360-day year, and
Interest is paid at maturity.

Project Notes of Local Public Housing Agencies are notes of local agencies secured by a contract with
federal agencies and by the pledge of the full faith and credit of the U.S. Government. They are sold
in denominations of $1,000 to $1,000,000. They mature in periods of up to one year. There is a
good secondary market for these. The rate is based on a yield basis. Interest is paid at maturity. In

Tax and Bond Anticipation Notes are notes of states, municipalities, or political subdivisions. They
are issued in denominations of $1,000 to $1,000,000. They usually mature in periods of 3 months
to 1 year from the date of issue. The rate is determined on a yield basis. Interest is paid at maturity
based on usually 30 days and a 360-day year.

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Spot, forward financial instrument is traded and settled on the same or on the following day. If,
however, the instrument is traded today for settlement in two weeks, it is a forward transaction. The
price of the forward transaction will be the spot price plus the price of money for a two-week term.

Derivatives Markets

The derivatives market is a term for the options and futures markets and the former can be split into
options on spot instruments and options on futures. Both are linked to the forward market in that
their prices are largely determined by the forward price. An option bestows on the holder the right,
but not the obligation, to buy or sell the underlying asset at a predetermined price during a specified
period. From this it will be evident that the holders will exercise their options only if it is profitable
to do so. Their potential profit is not fixed, while their potential loss is limited to the amount of the
premium paid. A futures contract, on the other hand, is an agreement to buy from, or sell to, a
standard quantity and quality of asset, such as the financial asset, commodity or notional asset) on a
specific date, at a price to be determined at the time of negotiation of the contract. Options and
futures are termed derivatives because they are derived from specified underlying assets or notional

Financial Exchanges
A distinction as required, separates the over-the-counter (OTC) market and the exchanges. OTC
refers to the meeting of buyers and sellers over the counter. This is a broad term encompassing a
meeting at a counter in, for example, a retail outlet or in a market such as a flower market, over the
telephone or via a communications system. OTC markets may be subject to regulation or may be
free of supervision by the authorities. Most markets start in this way, progressing to become formal
markets. Formal markets (or exchanges), on the other hand, are usually governed by statute and the
rules and regulations of such an exchange. In United States, the money market is an OTC market,
whereas the bond and futures markets are formalized.

The Capital Market

The capital market is a place where securities such as shares, bonds, and stocks are traded and where
new securities are issued on medium and long-term basis. There are three major schools of thought

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concerning the capital market. Although prices for bonds and other fixed-income investments
fluctuate as interest rates change, these fluctuations are usually small. While it is less volatile than the
options market, stock market returns do vary widely. As a result, investors in the stock market
should have a longer period and a greater risk tolerance than is advised for some other, less volatile
forms of investment. Although historical returns on long-term stock investments have been relatively
high, stock prices tend to move more rapidly and to greater extremes than prices of most other kinds
of financial assets. Potential stock market investors should reflect on how much their financial and
emotional comfort could be tested in periods of declining prices. During the 1980s, in particular,
the return from bonds was unusually high, largely due to declines in interest rates. All prospective
investments are mostly evaluated in terms of the trade-offs between risk and reward.

Chart: 1.6 Chart: 1.7

Treasury Bonds are long-term securities with maturities greater than 10 years. Treasury bonds are
coupon-bearing securities that pay interest on a semiannual basis. Treasury bonds are backed by the
full faith and credit of the U.S. Government. However, there is one notable measure of risk and
return is the range of possible outcome with a U.S. Treasury bond. Investors are assured of getting a
series of modest interest payments and your principal (the amount of your initial investment) will be
preserved if you hold the bond to maturity. With the riskiest of investments, such as the speculative
purchase of a stock option, investors may quadruple their asset or lose it all. In addition to the

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matter of liquidity, at least three other kinds of risk are considered: credit risk, interest rate risk, and
price volatility.

The Basic Principles of Intermarket Analysis

The premise of intermarket analysis relies on the theory that all markets are related. The principle of
intermarket analysis helps identify the entailed relationship. The major markets such as commodity,
currency, bond, and stock markets are closely interrelated on a large-scale. Rising commodity prices
are usually associated with rising inflation, which puts upward pressure on interest rates. The
direction of commodity prices is affected by the direction of a country's currency. A falling currency,
usually gives a boost to commodities priced in that currency. That boost ignites inflation fears and
puts pressure on central bankers to raise interest rates, which has a negative impact on the stock
market especially those in certain rate-sensitive market sectors. However, not all stocks, are equally
interest rate driven, some stock groups get hurt in a climate of rising interest rates, while others
actually benefit in a climate of rising rates. In an increasingly interrelated financial world, the
intermarket technical analysts seem to be claiming the huge advantage. It starts with the basic belief
that as money flows from one area to another, it does so based on the rational decisions of the entire
market place. Interest rates are thus driven by the direction of money flow, especially commodity
prices. The price of oil can have an impact on the price of corn. If energy prices were to rise, pushing
inflationary expectations and interest rates higher, it could lead to an economic slowdown in those
Asian countries that are net importers of oil. A drop in the demand for pork could result, leading to
a contraction in this one market and an inevitable decline in demand for feed. The same is true for
gold, which not only moves in relation to oil and bond prices, but also within the entire commodity
complex. The pursuit of intermarket analysis through the relationships and movements of the
markets themselves represents the sum total of the economic decisions of most, if not all, of the

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Global Effect
Global markets play an important role in intermarket analysis. Major changes in commodity prices
affect the bond markets of different countries in different ways, depending upon their economic
structure. The fate of copper tends to lead demand for semiconductors, while bond prices move
inversely to the energy complex, while leading major directional changes in commodity prices. While
central banks use the financial system as a conduit to transmit small changes in the availability of
bank reserves into the final demand for housing and automobiles, they acknowledge that the process
works with a significant lag. Despite the fact that globalization of the financial markets is primarily
subjective to find repetitive patterns in single-market data thought to be useful for market
forecasting, and objective trend-following indicators such as moving averages, which due to their
mathematical construction tend to lag behind market action. The efficacy of structural strategies
relies solely upon single-market technical analysis methods and indicators to examine the price
movements of individual markets that quantify the simultaneous linkages between international
markets and their effects on the general trend. This evolution is necessary, given the complexity of
the global financial arena.
Chart: 1.8 Chart: 1.9

Short term: Buy UKX, Sell

Long term: buy INDU

An interesting comparison of the UK FTSE broad equity and the US Dow Industrial index shows a
disparity between long (Chart: 1.8) and short term (1.9) -- interests recommendation. This is
particularly interesting by the fact that the ECB had just eased its benchmark for interest rate by a
quarter point, which is quite forthcoming for both the European and the American investors. These

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two markets tend to move up and down together. The farther the two markets diverged, the more
violent the eventual correction would have to be.

Japans Effect on U.S. Market

Global market trends affect those in the United States. The following illustration helps demonstrate
this principle, by comparing the Japanese stock market to the yield on the U.S. 10-year Treasury
note market over a four-year span. The two markets have a striking correlation.
Chart: 2.0

The chart makes perfect sense. Japan has the second largest economy in the world. For most of the
past decade, the Japanese economy has been in a deflationary recession, which in turn has
contributed in no small way to the global downtrend in long-term rates. That helps explain the
simultaneous drop in Japanese stocks and U.S. The bottom in Japanese stocks in the fourth quarter
of 1998 and 2001 coincided exactly with the bottom in U.S. interest rates, while both markets rose
together through 1999. The upturn in Japanese stocks at the start of 1999 anticipated recovery in
the Japanese economy later that year. New strength in Japan (and Asia in general) also improved
global demand for industrial commodities like copper and oil, and both rose. Rising commodity

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prices contributed to higher global interest rates. US economists spent most of 1999 questioning the
rise in the U.S. interest rates in the face of relatively low U.S. inflation. Technically, it is increasingly
difficult to separate market trends from economic trends. Economists have known for years that
bond and stock markets anticipate economic trends. If those market trends have some application to
economic forecasting, so be it. Intermarket analysis can easily help detect the course of the dollar, oil,
bonds, and the stock market. They can also track the relative performance of market groups, and
best performing world indices.

Focal Points
In a systematic approach to the study of financial markets, the elements of economy and crowd
psychology influence market behavior. External factors tend to perturb the markets dynamic
equilibrium and cause deviations from its habitual patterns for a short time, but after awhile the
market will resume its natural order and rhythm. External factors that are strong enough to influence
market movement and direction are the Focal Points. A Focal Point helps full advantage of
intermarket analysis, and to avoid pitfalls. Understanding and implementing intermarket analysis
under the guidance and influence of Focal Points, requires meaningful insights on the different
markets' movements and their influence on each other.

Focal Points represent the fundamental changes and economic news events that a market will focus
on at any given period. In order to identify the primary cause of price movement, market
participants gather their focus on specific economic news (foreign or domestic). For instance, the
Focal Point of today might be the Japanese Yen, tomorrow the European bank interest rates, or
economic leading indicators announcement, perhaps analyst or credit ratings or, the immediately
after Alan Greenspans comment, maybe an earthquake damage in Gujarat, or devaluation in
Argentina and so on. The Focal Point of today might not have any importance for tomorrow. The
focal point factor relies on facts and its effect, thus depends largely on the market mood and the
most popular interpretation. This phenomenon is a direct result of the dynamics of Focal Points. Of
course, a Focal Point may also play a more significant role in the presence of increased uncertainty
and a lack of clear direction. Under these conditions, any small or benign factor would be a Focal
Point. One major characteristic of Focal Points is that they are dynamic and do not tend to remain
or project the same intensity with the passage of time. Sometimes, intermarket relationships may fail
to act as forecasted or expected because of the change of a Focal Point. Being aware of the temporary

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influence of Focal Points allows investors to execute better entries and exits with our trades. Focal
Points are the principal causes of optimism and pessimism in the market, causing the participants to
swing from one emotional extreme to the other.

Global Waves
The collapse of Asian currencies in 1997 caused a corresponding collapse in Asian stock markets,
and sent a wave of effects around the globe. Worries of global deflation pushed commodity prices
into a downturn and contributed to a worldwide pull out of stocks into bonds, triggered a downturn
in the U.S. stock market several months later. Over this period, economic activity in several
countries in that region either slowed or declined, and this reduced their demand for U.S. products.
By themselves, these factors would reduce the demand for U.S. products and therefore lower output
and employment. In 1999, a reverse effect occurred, sending a sharp rise in the price of oil at the
start of that year pushed interest rates higher around the globe as inflation fears resurfaced. A
recovery in Asian stock markets also contributed to global demand for industrial commodities like
copper and aluminum. The following rise in commodity prices reawakened inflation fears and
prompted the Federal Reserve to embark on a series of rate hikes in the middle of the year.
Tab: 1.6

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The Euro Zone

The appearance of foot-and-mouth disease in continental Europe added to the compounding
inflationary pressures sparked by the "mad cow" health scare, according to economists. There was an
overall impact on economic growth in the euro-zone's 12 countries. Even so, some countries are
more vulnerable than others are. In Ireland, which exports about 90 per cent of its food production,
had a to 2.5 percentage GDP points shortage due to a reduction in export revenues and knock-on
effects. France's national statistical office also reported a 0.3-point month-on-month increase in
French inflation in February partly on rising meat prices. Healthy domestic demand, boosted by
lower oil prices and tax cuts in Germany, France and other countries, will largely offset the impact of
falling US demand for European exports, they assert. "It used to be the case that when the US
caught a cold, Europe got pneumonia. But those times are over," a remark Jean-Claude Trichet, the
Bank of France governor who is in line to be the European Central Bank's next president in his
defense that that the ECB need not reduce rate amidst the concurrent global turmoil. The UK
authorities, supervising an economy outside the euro-zone seem to agree but it remains to be seen
how soon the wave of economic slowdown will prompt the European Central Bank to change their
opinion. The US economy has expanded so powerfully since the mid-1990s that it is uncertain
exactly how a US downturn in the age of the technology-driven "new economy" may affect the rest
of the world.

Europe's economic growth shows no sign of being slowed down by the faltering US economy,
claimed Wim Duisenberg, president of the European Central Bank. "At present there are no
convincing signs that the slowdown in the US economy is having significant and lasting spillover
effects on the euro area economy as a whole". In his assessment of the outlook for 12-nation euro-
zone economy before the European Parliament's economic and monetary affairs committee,
Duisenberg forecasted three successive years of "robust growth", a rapid fall in inflation to within the
ECB's target level this year and further falls in unemployment. Acknowledging, "the more moderate
prospects for world growth" might slow euro-zone exports; "Europe is overwhelmingly dependent
on domestic demand, so to a large extent it is isolated but not entirely." Duisenberg's good news
message contrasts with Alan Greenspan's recent comments that the US economic outlook remained
troubled, despite interest rate cuts by the Federal Reserve in January. Germany seems to have
suffered more than other euro-zone members have from the ECB's tight monetary stance because its

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low inflation rate last year kept real interest rates higher than the area's average.3 Optimistic private
sector economists calculate that, for every one-percentage point fall in annual US economic growth,
the euro-zone would experience a drop of only 0.2 to 0.25 percentage points. This estimate is
reached mainly by considering the impact on euro-zone exports. Although the US absorbed 16.3
percent of the area's total exports in 1999, sales to the US accounted for only about 3 per cent of the
euro-zone's gross domestic product. Additionally, the euro area corporate sector has invested
substantial amounts of capital in the US economy in recent years, which implies that aggregate
confidence levels of big European companies could be more affected by a US slowdown this time
around than before.

However, there are already signs that some euro-zone politicians do not want the euros recovery to
go too far and are apprehensive that President-elect George Bush's administration in the US will not
be as committed as the outgoing Clinton administration to a "strong dollar" policy. Karl-Heinz
Grasser, the Austrian finance minister, mentioned interest in euro growth but was uncertain, "Of
course, against the background of exports, we have to see how high we want it to go. One point on
which euro-zone policymakers and economists concur is that the region will certainly benefit from
income tax cuts coming into effect this year in many European countries. The tax cuts, amounting
to perhaps 0.7 percentage points of GDP for the whole euro area, will give a significant boost to
household disposable incomes at the same time as inflation starts to come down as a result of falling
oil prices. Taken together, all these factors suggest that the euro-zone should comfortably achieve a
growth rate year within what the ECB considers the region's historical trend rate of 2 to 2.5 percent.

Intermarket Relationship
Being in the right sector at the right time (and out of the wrong sectors) has become one of the key
factors to trading success. While intermarket principles are invaluable in understanding how bonds,
stocks, commodities, and currencies work off each other, it can also be extremely helpful in
understanding why certain sectors of the market do well at certain times and badly at others. The
intermarket principles bring new light on the application of sector rotation, which has become so
important in recent years. Being in the right sector at the right time (and out of the wrong sectors)
has become one of the keys to stock market success. The basic key relationship factors are based on
the following principles:

World Financial News section, April/2001 Financial Times

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! Commodity prices and bond prices usually trend in the opposite direction. (Commodity
prices and bond yields usually trend in the same direction.)
! Bond prices usually trend in the same direction as the stock market
! Rising bond prices are good for stocks; falling bond prices are bad for stocks. (Falling bond
yields are good for stocks; rising bond yields are bad for stocks.)
! The bond market usually changes direction long before stocks do; therefore, the bond
market is a leading indicator of potential trend changes in stocks.
! Commodity prices usually trend in the opposite direction of the dollar.
! A rising dollar is bad for commodities; a falling dollar is good for commodities.
! A rising dollar is normally good for U.S. stocks and bonds because it is noninflationary.
! A strong currency attracts foreign money into a country's stock market.

Commodities versus Bonds

An important intermarket relationship for stock investors and traders to monitor is the one between
interest rates and the stock market. As a general guideline, a rising rate environment is negative for
stocks; likewise, falling rates are bullish for stocks. The direction of commodity prices plays a key
role in the direction of U.S. interest rates. It was no coincidence that 1999 saw the biggest upturn in
commodity prices in years, and one of the biggest downturns in bond prices (and biggest upturns in
bond yields). The proxy for interest rates is the Treasury bond futures market. As T-bond prices
move inversely to yield, an uptrend in T-bond prices indicates a falling interest rate. The T-bond
market has been in an uptrend for more than a year (falling rates), and the stock market has followed
suit. This had a negative effect on the U.S. stock market particularly on "old economy" stocks that
have traditionally been more affected by interest rate direction. ("New economy" technology stocks
proved relatively immune to rising rates during 1999.) It is significant that the fed fund is used as a
benchmark for short-term rates in general, and it affects longer-term rates because bond traders use
short term borrowing to finance their purchases. The discount rate, charged to banks for loans
directly from the Federal Reserve, is less significant than the fed funds rate because banks less
frequently use it. The Fed timing generally accentuates the power of the Fed moves.

! The CRB turned up about a month before T-bonds turned down (1987).
! Gold turned up about three months before Eurodollars turned down (1987).
! The dollar turned down as crude oil began to bottom (1993)

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! DJ Utilities peaked a few weeks before T-bonds (1993).

! Electric Utilities turned up about two months before T-bonds (1994).
! Copper bottomed as T-bonds topped (1993).
! The (German) D-Mark and Comex Gold turned up together ((1989)

Although intermarket forces say a lot about the direction of inflation and interest rates (and can have
an important influence on asset allocation strategies), their most practical day-to-day impact can be
seen in the area of sector and industry group rotation, that is, how money tends to flow from one
sector or industry into another.
Chart: 2.1

The chart (Chart: 2.1) indicates index value, dividend in index points, price appreciation, change in
price appreciation, total returns, and change in total returns for interest rates, which impact
commodity prices. The total return of an index is calculated by adding the simple price appreciation
of the index to the compounded return gained from reinvesting the total dividends paid by the index
members. The total dividends realized by the index each day are determined by adding the weighted
dividends paid of all stocks going ex-dividend on that day. These total weighted dividends are
divided by the index's base value to arrive at the dividends index point equivalent.

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Chart: 2.2

CRB Index versus Rates

The commodities that make up the CRB Index can be individually correlated. On a micro level,
individual stocks are compared to their own industries. To tie it all together in a real world example,
the analysis of a stock, such as chocolate maker Hershey Foods, should include the overall market, its
major raw material cocoa, interest rates used to finance operations and debt, and foreign exchange
rates used when calculating profits overseas. Any one of these markets affects the shareholders'
bottom line. A comparison of the CRB Index (a basket of seventeen commodity markets) and the
yield on the 10-year Treasury note (which has become the new benchmark for long-term U.S.
interest rates) shows that a decline in long-term interest rates coincided with a falling commodity
index. As global deflation fears pushed money out of commodities and into Treasury bonds and
notes, both markets started changing direction near the end of 1998 and the start of 1999.

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Chart: 2.3

Relative strength analysis can determine which commodities are leading, and which are lagging
Supply pressures and the January raise in the stock indexes pressured Treasuries until the day
preceding the conclusion of the Fed's regular meeting on January 31st. On the 30th, the Conference
Board's Consumer Confidence Index for January posted its biggest drop in over ten years. Treasuries
rallied on the news. In addition, boosted by further economic news released that day. The first
official estimate of the gross domestic product for the fourth quarter was lower than analysts had
forecast. The gross domestic product is a measure of the total market value of final goods and
services produced within the country and are the broadest gauge of economic activity. Also released
that day was the Chicago Purchasing Managers Index, which was also lower than expected. The
news suggested that the Fed would need to continue stimulating the economy in order to avoid a

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Chart: 2.4

The National Association of Purchasing Management Index further supported this conclusion the
next day for January. The index fell for the sixth straight month and indicated that the
manufacturing sector was contracting at an accelerating rate.

10-Year Treasury Note Yield swing matched that of the CRB Bond index as both were bolstered by
the assurance that the Fed meeting would conclude with another aggressive rate cut. Here (Chart:
2.5), estimates the historical relationship between the CRB Index and the TNX and calculates their
optimal hedge. The chart helps to precisely determine the statistical relationship between the values
of the two securities, while the line of regression is calculated for their historical values. Where BETA
is the slope of the line and ALPHA is the y-intercept. The slope of the line of regression is a
statistical estimate of the historical relationship between the changes in the values of two securities
(change Y/change X). The correlation factor (R2), which is the square of the correlation coefficient,
measures the accuracy of the straight-line fit determined by the historical regression analysis. The
higher the correlation factor, the better the data fit and the more likely the regression analysis is

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appropriate. Therefore, the higher the correlation factor, the more constant the relationship is
between the changes in the values of the two securities, and the lower the correlation factor the more
variable the relationship. The correlation factor can range from 0 to 1, where 1 indicates a perfect fit.
Chart: 2.5

Bond and Equity Factors

The Money market serves as a leading indicator for the futures market. Bond traders tend to watch
the S&P for their lead during the day, as the Cash and Bond markets were the primary factors in
their S&P trading plans. Each individual market moves according to its own internal dynamics. For
instance, the S&P 500 as a financial market, shares a set of common characteristics with other
financial markets. Because of this commonality, it will react to economic news and related financial
numbers upon public release. As an illustration, changes in the interest rate will have a significant
impact on Bond, S&P, currency, and other related financial markets. Even though other markets
such as the physical commodities might also have a reaction to economic change, their impact would
be to a much lesser extent and lower significance, relative to the core financial markets. A good
example is observable when the equity market reacts to a sell-off in the Bond market, which would
in turn effect, the commodity and U.S. Dollar markets. "Studies in equity and bond markets
confirm that broad-based indexes of returns within each market are highly correlated, even though

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the included securities and index weights are different." (Streetwise, the Best of the Journal of
Portfolio Management, p.15, 1998, Princeton University Press)

The Bond and S&P futures markets usually trend in the same direction, as the equity market enjoys
a high level of growth, under a low interest rate environment the Bond futures becomes bearish
outlook. Normally, rising rates would be expected to have a negative impact on the stock market.
Although new economy" technology stocks rose sharply during the second half of 1999, "old
economy" stocks stopped rising right around the time the Fed started tightening in the middle of
that year. New York Stock Exchange (NYSE) Composite Index, for example, peaked in July 1999.
The Dow Jones Industrial Average lost 8 percent during that nine-month period. The most dramatic
impact of rising rates on the stock market was reflected in its impact on the broader market. A
comparison between Treasury bond prices with the NYSE Advance-Decline line and shows a
dramatic fall in market breadth since 1999. The broader stock market was more adversely affected by
rising interest rates than most people realized, which also contradicted the view put forward by some
market observers that the stock market are more affected by rising rates than rising oil prices. The
following illustration of the impact on the stock market of rising oil prices and rates fluctuation since
2000 unveils sector and industry group rotation in a more dramatic sense than expected.
Chart: 2.6

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Treasuries came under pressure after 150 basis point ease, the 10-Year Treasury Note Yield was
lower, and The Bond benchmark index surged to an unprecedented range bolstering the bond
market. The decline in stocks helped the bond market absorb the Treasury's quarterly refunding
supply. On the hand, news weighed on stocks as it foreshadowed less spending and lower corporate
earnings. All of this information, combined with a continuing string warnings regarding corporate
earnings, sent stocks sharply lower, also helping bonds as investors took money out of equities and
into the safety of the Treasury market. However, on February 6, $11 billion in 5-Year Notes were
issued and on the seventh, $11 billion.
Chart: 2.7

CMR moving
Upside the Dow
as Fed eases

Figure 3.8 is a ratio of the Morgan Stanley Consumer Index (CMR) to the Dow. It shows poor
performance by consumer stocks during 1999 (as rates were rising). However, the first quarter of
2000 showed new signs of strength in this defensive sector. The chart shows the ratio line breaking a
yearlong down trend line and hitting the highest level in six months. To intermarket analysts,
consumer stocks were returning that signal to favor. It was also a signal that the marketing the first

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half of 2000 was also caused by a sudden downturn in technology stocks and a more cautious mood
in the stock market. It was also a signal that the market forces from a sector rotation standpoint. The
preceding arguments may seem logical, but more subtle intermarket influences exist between various
market groups. During a period of rising industrial commodity prices, for example, basic material
stocks (like aluminum and copper) usually do relatively well. At the same time, consumer staples
(drugs) and retail stocks usually do worse. As rising interest, rates begin to slow the economy (which
the stock market usually spots six to nine months early), economically sensitive cyclical stocks start
to weaken relatively, while consumer-oriented stocks start to take up the slack.
Chart: 2.8

NASD precipitates,
while the REIT
surges. Both LIBOR
and the FED fund
rates move

By the spring of 2001, the NASDAQ Composite Index had lost over 50 percent from its ultimate
range. Although the decline hurt those investors heavily concentrated in technology stocks, it gave a
boost to more defensive shares like real estate stocks (REITs). Chart: 2.8 shows that the sharp
downturn in the technology-dominated NASDAQ Composite Index coincided almost perfectly with
a sharp upturn in the Morgan Stanley REIT Index (RMS). The chart shows that some of the money
fleeing the technology sector found its way into the REIT market. RE1Ts have traditionally acted as

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a defensive haven during times of market weakness because of their low correlation to the rest of the

The Healthcare Sector

The plunge in the NASDAQ market in the spring of 2000 caused another more subtle rotation in
the market. This rotation occurred within the health care sector. Biotech Index (BTK) RE1Ts have
traditionally acted as a defensive haven during times of market weakness because of their low
correlation to the rest of the market.
Chart: 2.9

Chart: 2.9 compares the Biotech Index (BTK) with the Pharmaceutical Index (DRG) during the
first half of 2000. During the first three months of 2001, a strong biotech group helped to hold the
NASDAQ market above water. At the same time, traditional drug stocks were out of favor.
However, a pull back in Biotech Index later in 2000 dragged the NASDAQ down with it. Figure 4.0
shows a dramatic upturn in drug stocks just as the biotech peaked. As money tends to stay within a
broad market sector, the chart seems to reflect a group rotation within the health care sector-out of
riskier biotech stocks into safer and more defensive drug stocks.

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Commodities as Economic indicators

Copper is a good barometer of global economic trends. A strong copper market implies economic
strength. A weak copper market implies economic weakness.
Chart: 3.0

Copper Lumber
g trend


10-Yr Treasury
Notes Yield

Chart: 3.0 shows why it is a good idea for traders in Treasury notes (and bonds) to keep an eye on
copper as well. The chart shows the remarkably close correlation between copper futures prices and
the yield on the 10-year Treasury note. A downside correction in copper coincided perfectly with a
pullback in Treasury note yields. Lumber is directly tied to the housing market, which itself is
considered a leading indicator of economic trends. Chart: 3.0 also show lumber prices peaking, just
as the Federal Reserve Board started lower interest rates.

Awareness of the financial markets' intermarket condition sheds light on why certain market sectors
do better or worse at certain times. That insight, combined with relative strength (or ratio) charts, is
invaluable in the implementation of sector rotation strategies, which also help identify their current
state of economy. Because financial markets act as leading indicators for economic trends,
intermarket analysis elevates the usefulness of technical analysis into the realm of economic

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forecasting. Technical analysis of any one-market class, such as the stock market, is incomplete
without some understanding of what is happening in the other three classes (commodities,
currencies, and bonds). Location is also crucial to stock market success. As noted previously~ being
in the right sectors and industry groups at the right time is more important than being in the market
as a whole. During 1999, rising oil prices proved to be bullish for energy stocks, but bearish for
financials and transports. Rising interest rates also kept downward pressure on consumer staples and
retail stocks for most of that year: That started to change in 2000 because of continued Federal
Reserve tightening and a resulting inverted yield curve during the first quarter.

The Oil Factor

Much until March 2001, oil service stocks have risen dramatically. The pricing power for oil service
companies is much stronger than for virtually any segment of the global economy due to the
continued consolidation trend, tight equipment and people availability, and rising demand. From
Prof Andrew Oswalds view, the world economic slowdown has been caused by a classic oil price rise,
and not classic credit squeeze. The Professor argued that the timing of the current slowdown fits the
oil-price explanation. The price of oil trebled between 1998 and 2000. Throughout the period when
interest rates were raised, US inflation remained quite subdued. Had oil prices not risen, US
inflation would have likely been close to zero. The oil price rises turned out to have a temporary and
relatively minor effect on inflation but, alas, the impact of the Federal Reserve's interest rate increases
have caused severe and unnecessary damage to technology companies, the one sector that is
responsible for the US's outstanding productivity increases. With stock price declines of 80 per cent
or more even in solid technology companies, it will be very difficult for those companies to come up
with the next generation of productivity-enhancing innovations. Andrew Oswald, Warwick

The following chart, (Chart: 3.1) 5year comparison between the Fed fund, the 10 yr Treasury Note
yields, and the crude oil commodity futures helps support the argument. Prof Andrew Oswalds view
is largely persuasive. The oil price did played a significant role in the recent global economic
slowdown. OPECs procrastination to increase oil production since mid 1999 had caused demand to
override supply. In addition, the rising cost of energy was devastating to production, which in turn
slowed inventory sales. The retained inventory caused major profit declines and credit default.

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Chart: 3.1

Thus, the oil price hike is inseparable from the credit squeeze. The following chart (Chart: 3.2)
illustrates a comparison of crude oil futures prices and the yield on the U.S. 10-year Treasury note.
In this case, the correlation between the two markets is much more dramatic and striking. For most
of 1999, it is hard to tell the two markets apart. There seems little doubt that the dramatic ascent in
oil prices (and its inflationary impact) was one of the principal forces driving long-term rates higher
during the entire year. To the far right, the chart shows that a correction in oil prices during the first
quarter of 2000 coincided with a pullback in long-term rates. However, not for long because the Oil
future continued an upward trend after the OPEC president, Chakib Khelil announced an
unlikelihood for production increase from member countries.

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Chart: 3.2

Transports Hurt by Rising Oil

The American Gas Association Financial held a Forum on May 8, 2001 in Florida. This conference
featured speakers from various companies in the energy sector meeting to discuss relevant industry
wide issues impacting the future of the energy business, the economics of the industry, and ways in
which investors view the energy sector. The foregoing discussion, focus on certain trends and general
market and economic conditions and outlook on production levels or rates, prices, margins and
currency exchange rates. The development was attributed in part to 2000 record-high gasoline
prices. Preliminary statistics from the Department of Transportation show that a total of 2.688
trillion miles were traveled in 2000, down from 2.691 trillion miles the year before. That 0.1-
percent drop was recorded even as the number of registered vehicles climbed by an estimated 2.2
percent from 1999 to 2000. Total U.S. miles driven in December even registered a 3-percent drop
from the 1998 level. Previous year-to-year declines in total miles traveled by vehicles occurred in
1974, 1979, and 1980 and signaled economic recessions. This time around, despite all the signs of a
slowing economy, economists and transportation experts contemplated that high fuel prices were the
primary cause of the transportation decline.

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The Vice president, Dick Cheney acknowledged that the U.S. economy's slowdown could turn into
a recession, but refused to offer incentives to boost oil Production. The Bush administration's energy
policy seems to rely on easing government regulations rather than tax breaks or other financial
incentives to spur companies to produce more energy. Vice President Dick Cheney said, ``Most of
the financial incentives'' will go for conservation and renewable energy, such as solar and wind
power. While President Bush vowed recently to fight against any price gouging that might occur at
gasoline pumps. Indiana Gov. Frank O'Bannon suspended a state sales tax from July through part of
October, and the Illinois legislature reduced a gasoline sales tax from 6.25 percent to 1.25 percent
for the entire second half of 2000. Despite the popular slowdown in other sectors, the economy
continues to grow by rising gasoline demand nationwide, and prices are already at peak levels of last
summer. This growing demand continues to weigh on refineries, already operating at full capacity
making from 16 to 17, grades of gasoline to meet different clean air standards around the country.
Chart 3.3 shows the negative impact rising oil prices had on transportation stocks (airlines in
particular). Within a couple of months of the upturn in oil prices at the start of 1999, transportation
stocks started a major decline. During that period, transportation stocks lost 40 percent of their
value. (On the right side of the chart, you can see how the pullback in oil during the first quarter of
2000 had the opposite effect of giving a boost to transportation stocks.) Transportation stocks were
not the only group hurt by rising the oil prices.
Chart: 3.3

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As rising oil prices led to rising interest rates, those market groups that are most sensitive to rates
began to suffer, especially financial stocks. During a period of rising industrial commodity prices, for
example, basic material stocks (like aluminum and copper) usually do relatively well. At the same
time, consumer staples and retail stocks usually do worse. As rising interest, rates begin to slow the
economy (which the stock market usually spots six to nine months early), economically sensitive
cyclical stocks start to weaken while consumer-oriented stocks start to take up the slack. They also
show that in a climate of rising oil prices and rising interest rates (as in 1999), oil stocks are a good
place to be while financial and transportation stocks are not.

The Repercussion of Oil Dependence

There has been a growing debate concerning the direction of future global oil production. Several
prominent international petroleum geologists have written numerous papers expressing the view that
world oil production will peak in the not too distant future, possibly before 2010. They base their
assessment on a 1956 model developed by the petroleum geoscientist M. King Hubbert. The
Hubbert model assumes that if oil production is unrestrained in a very large producing region, it will
follow a bell-shaped curve with peak production occurring when approximately 1/2 of the ultimately
recoverable amount of oil is extracted. Like most potent energy factors, oil is liable to exhaustion and
draught. Matthew Simmons wrote an article in February 1999 on World Oil, discussing the
problem of declining oil fields in many producing basins around the world and the impact of these
declining fields on global oil production. He wondered what the average depletion rate may be for
declining oil fields and how that will influence long-term supply. Organizations such as the U.S.
Department of Energy/Energy Information Administration (U.S. DOE/EIA) and the American
Petroleum Institute (API) express the opposing view that oil production will increase far into the
future. There was the panic that refiners' capacities were already stretched to meet demand of the
winter, according to the International Energy Agency (IEA). In September 2000, the US released oil
from its strategic petroleum reserve for only the second time in 23 years in a further attempt to cool
the market.

How the World Has Became Utterly Dependent On Oil

Naturally, Crude oil is a substance classed as a hydrocarbon found trapped in certain rocks below the
earth's crust. It highly flammable potential makes it viable to generate energy. Burning crude oil
itself, however, is of limited use. When refined along with other hydrocarbon as natural gas, crude

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oil makes an excellent fuel and other useful petroleum chemical products. There are more than
4,000 different petrochemical products, but those that are considered as basic products include
ethylene, propylene, butadiene, benzene, ammonia, and methanol. The petrochemicals include a
number of products such as plastics, synthetic fibers, synthetic rubbers, detergents, and chemical
fertilizers; while liquefied petroleum gas (LPG), naphtha, kerosene, gas oil and fuel oil comes directly
from the refinery. Other useful products, which are not fuels, can also be manufactured by refining
crude oil, such as lubricants and asphalt (used in paving roads). A range of sub-items like perfumes
and insecticides are also ultimately derived from crude oil.

The first modern oilfield was discovered in Pennsylvania, during the early 1860s, and indeed, a new
dawning of global prosperity had begun as the oil flowed. One of the pioneer of the gasoline engine
was the German engineer Karl Benz, who produced a mechanically propelled tricycle in 1885 with
Daimler. The 19th century fuels for automobiles were coal tar distillates and the lighter fractions
from the distillation of crude oil. The early 20th century oil companies were producing gasoline as a
simple distillate from petroleum, until a General Motors' scientist, Thomas Midgley, Jr (1889
1944) invented leaded (ethyl) gasoline during the World War 1. He also devised the octane number
method of rating petrol quality. The evolution of gasoline underwent a series of refinement
processes. The preceding decades introduced catalytic cracking and further increased the
compression ratio and higher-octane fuels.

A fuel crisis emerged in 1973, leading to the Arab oil embargo, fuel scarcities and price increases
prompted automobile designers to scale down the largest models and to develop new lines of small
cars and trucks. The fuel crisis led to the requirements of clean-air technologies, and helped initiate
long-lasting changes in the auto industry. Rising gasoline prices led to an increased demand for small
cars, and U.S. manufacturers turned out their own models to compete with foreign ones. As the
crisis abated around 1974, a national speed limit, set at 55 mph was introduced in an attempt to
conserve fuel, but was raised to 65 mph on rural interstate highways in 1987 and repealed in 1995,
returning to the states the power to set their own speed limits. The Clean Air Act created major
changes on gasoline rightfully intended to eliminate pollution and triggered new standard models to
reduce weight and increase economy. High-strength plastics and aluminum replaced steel in many
components, and smaller, more efficient engines were designed to meet the growing imagination of
consumers. By the early 1990s, nearly all engines boasted electronic controls, such as fuel-injection

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systems, to manage all vital functions and to provide the most efficient fuel economy and emission
control. The world has utterly become dependent on oil.

The Organization of Petroleum Exporting Countries (OPEC)

After the oil crisis in 1975, OPEC was part of the calls for the creation of a new international
economic order. OPEC called on the industrialized and developing countries to get together in order
to solve the problems facing the poor countries and to look for a way to establish a better economic
system by allowing more trade and more exchange of knowledge between developing and OECD
countries. OPECs history began in 1960, when five major exporters, Iran, Iraq, Kuwait, Saudi
Arabia, and Venezuela, founded it after a long tussle with the international oil companies over the
issues of price, revenues and control of the rate at which oil reserves were depleted. The motive
behind this unity largely attributes the increasing realism of the role of oils powerful trade
dynamism, and the western civilizations growing dependence upon it for investment and healthy
life. Naturally, oil-producing countries, from the OECD countries, including Britain and the US,
have always being skeptic about the legitimacy of the OPEC. Often portrayed by the OECD as a
greedy and untrustworthy cartel, cynically manipulating the price of oil (BBC News), however,
OPEC membership grew as more oil-well got discovered in different places around the world.

World Crude Oil Reserves

World crude oil reserves are estimated at more than one trillion barrels, of which the 11 OPEC
Member Countries hold more than 75 per cent. OPEC's Members currently produce around 27
million to 28 million barrels per day of oil, or some 40 per cent of the world total output, which
stands at about 75 million barrels per day. The OPEC crude basket is the arithmetic average of these
crude qualities: Algerian Saharan Blend, Indonesian Minas, Saudi Arabian Light, Dubai Fateh,
Venezuelan Tia Juana Light, Nigerian Bonny Light and Mexican Isthmus.

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Chart: 1.7

Demographic Profile of the OPEC Members

Budget GDP: Purchasing Unemployment
International Population
External Debt (Revenues/Expe power parity (Per rate (Below
Reserves (Education)
nditures) Capita) poverty line)
Middle East

Saudi Arabia $ 14,000,000,000.00 0 ($47.9Bln/$45.4Bln)$206Bln ($10,300) 21Mln (63%) 0% (NA)

Iraq NA $130,000,000,000.00 NA $60Bln ($2,700) 23Mln (58%) Severe
United Arab Emira NA $ 10,000,000,000.00 $5.1Bln ($5.4) $54Bln ($24,000) 2.4Mln(80%) 0% (N.A)
Kuwait $ 6,610,000,000.00 $ 8,000,000,000.00 $10.3Bln ($14.5 Bln $46Bln ($22300) 1.9Mln (78.9) 1.8% (N.A)
Iran NA $21,900,000,000 $34.6Bln ($34.9) $371.2Bln ($5,500) 68.9 Mln (72.1) 20% (50%)
Qatar $ 529,280,000.00 $ 11,000,000,000.00 $3.7Bln ($4.5) $11.2Bln ($16700) 697 Tsd (79.9%) N.A


Nigeria $ 3,342,986,160.00 $ 34,000,000,000.00 $13.9Bln/13.9Bln 132.7Bln ($1300) 112.5Mln (58%) 28% (34.1%)
Libya $ 10,132,800,000.00 $ 26,000,000,000.00 $10.4 Bln ($10.3 Bln $38Bln ($7000) 5.6Mln (76.2%) 25%
Algeria $ 11,094,900,000.00 $ 33,000,000,000.00 13.7 Bln ($13.10 Bln$20.4 Bln ($4000) 30Mln (61.6%) 28% (23%)


Indonesia $17,548,300,000.00 $136,000,000,000 $42.8/$42.8 $960 Bln ($4,600) 213 Mln (83.8%) 15%

South America

Venezuela $ 10,000,000,000.00 $ 26,500,000,000.00 $12Bln/$11.5Bln $185 Bln ($8,300) 22.8Mln. (91%) 11.5% (60%)

Countries with relatively small oil reserves, or those such as Algeria and Libya with premium-quality
crude, or yet others like Iran and Nigeria with large populations and few other resources, are often
seen as "hawks" pushing for higher prices. Meanwhile, producers like Saudi Arabia and Kuwait, with
massive reserves and small populations fear that high prices will accelerate technological change and
the development of new deposits, reducing the value of their oil in the ground. Anger at Kuwait's
alleged over-production and weakening of the oil price was, for example, one of the main reasons for
Iraq's invasion of Kuwait in 1990. Currently, American consumers paying higher fuel bills are angry
with Gulf producers for failing to show gratitude for that earlier rescue by raising output now.
Politics are never entirely absent from price considerations. Nevertheless, it may not be the market
force it was, OPEC had once again succeeded in reining in production and boosting prices. Over the

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long term, OPEC has been unable to resist these pressures and it can be acknowledged that the cartel
have come to achieve its main objectives.

Highlights of Oil Crisis

! 1973 - High oil prices cause world economic crisis
! 1990 - Iraq anger at Kuwait over-production sparks Gulf War
! 1998 - World oil price drops to $10 a barrel
! 2000 - OPEC puts squeeze on production to boost prices

Tab: 1.8

World Crude Oil Supply & Demand Balance

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Chart: 3.4

Saudi on the
upside while high
prices is driven
the rest of the
cartel down

The Real and Nominal Crises

Oil remains a very desirable commodity and its increasing demand is making producer more aware
of their powerful positions. The growing interdependence of global market relationships and
globalization of the private sectors could as well become a determinant factor for another race in the
quest of Middle East oil (mainly Gulf oil). One faction may emerge from the United States' growing
dependence on Gulf Oil and, another from China's growing thirst for oil and its increasing
dependence on the region. So a new US-versus-China scenario begins to merge, which links global
oil security to oil geopolitics in the Gulf and the Asia-Pacific regions. Not only does the region
contain 65% of the world's proven crude oil reserves, but there is also a growing global and US
dependence on Gulf oil.

In 1996, more than 36% of the industrialized world's oil received their supply from the Gulf, and if
the current trends hold, the world's dependence on Gulf oil will increase with Gulf producers
accounting for a projected 48 percent in 2010. One new development will be China's projected
growing dependence on oil from the region with economic and geopolitical consequences. Victories
in both the Cold War and the Gulf War have helped the United States and its allies gain a

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substantial degree of oil security. Without revolutionary changes inside the Gulf Cooperation
Council (GCC) states especially Saudi Arabia, there is very little prospect that Gulf oil will be
withheld from international markets in the near future. Oil and security head the list of US national
interests in the Gulf and the two are interconnected. On this aspect, concerning the national
interest, security means the maintenance of a political order conducive to US access to the region's
energy markets and communication routes and protection of related US investments and assets. The
United States is the biggest consumer of oil in the world accounting for 26 percent of current world
production or nearly 18 million barrels a day (mbd), while itself producing only about 12 percent or
8.36 mb. In 1995, the US imported 55 percent of its oil needs, or 10 mbd, more than half of which
came from the Gulf. It will not be conducive to the United States' national interest for the Gulf
region to be dominated by either Iran or Iraq.

The center of gravity of oil consumption is really shifting to the Asia-Pacific region. In 1990, the
region overtook Western Europe in oil consumption and if the oil demand trend discernible in the
region continues into the future, the Asia-Pacific region is projected to overtake North America
(including Mexico) by 1998 to become the world's biggest consumer of crude oil. The Asia-Pacific
countries are growing increasingly concerned about their ability to supply enough oil to fuel future
economic growth. In 1993, China became a net crude oil importer or the first time. It must now
make new oil discoveries if it is to maintain the momentum of its economic growth and avoid
becoming heavily dependent on oil imports. In 1995, the Asia-Pacific region imported 10.9 mbd of
crude oil and refined products, or 61 percent of its oil needs. By 2000, the region could be
importing about 17 mbd or 72 percent of its needs, most of which will come from the Gulf. Thus,
the Asia-Pacific countries will become more dependent on Gulf oil soon if they maintain their
current rate of economic development. China's spectacular economic growth has led to a
corresponding leap in oil consumption and a growing dependence on oil imports which now
account for 12 percent of its oil needs. Moreover, if China's economic growth continues as its
current pace, it will become the world's third largest importer of crude oil after the United States
and Japan. By 2000, China will need to import more than 2 mbd, or 45 percent of its oil needs, if
no substantial new oil reserves are found in its territory.

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Chart: 3.5

Chinas leading equity indices have toped the ranking chart for more than two year consecutively
(Chart: 3.5). Analysts project that by the year 2005, China's economy will have overtaken Japan's to
become the second biggest economy in the world after the United States. There is, however, a
consensus among experts that China can sustain growth rates of 7 percent-10 percent per annum,
implying a doubling of its Gross National Product (GNP) every 7-10 years.

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Chart: 3.6

US trade chart
shows a declining
import from China
and export slows as

One thing, however, is certain China will be as robust as the United States in defending its access to
oil supplies. Furthermore, China may not shy away from the use of force to defend its rights to
access. However, to satisfy its needs, China may look to the Middle East, Southeast Asia, or Siberia.
It could trade arms for oil with the Middle East or could use arms to secure oil from Southeast Asia,
especially from the South China Sea. It is this growing thirst for oil, which is behind China's
assertion of its sovereignty over the Spratly islands and other specks in the South China Sea. The
Spratly Islands are group of low islands and coral reefs in the central South China Sea that are
claimed by China, Taiwan, and Vietnam, and in part by Malaysia, the Philippines, and Brunei.
Fighting has occurred, most notably between Chinese and Vietnamese vessels in 1988, and the
Spratly remain a source of international tension. However, oil wealth beneath the South China Sea is
fuelling an explosive arms race in Southeast Asia. This raises the question as to whether China will
risk upsetting its Southeast Asian neighbors over the South China Sea when it is trying to attract
investment and secure markets. The answer to that question will be determined by the power
structure in post-Deng China and by China's need for foreign investment and technology.

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This leaves the Gulf region as the other major source of oil supplies for China. China has for years
been supplying arms to the Gulf countries especially Iran and Iraq not only as a source of hard
currency but in exchange for oil. Soon the United States will no longer be in a position to guarantee
the stability of the Asia-Pacific region by its unilateral actions and forward military presence. This
depends primarily on the growing economic and military power of key Asian nations, particularly

Moreover, Asian leaders have been talking about creating an Asian Monetary Fund to counter the
Washington consensus and ultimately creating a regional equivalent of the euro. A symbolic move
towards promoting greater regional integration was marked when 13 Asian countries decided to
operate a currency swap arrangement between their central banks. Noteworthy is the role that China
is playing in encouraging these regional initiatives. Nonetheless, the agreement will help foster closer
institutional ties in a region driven by historic animosities.

The Wealth Effect

Wealth Effect is an economic conception that infers spending as propelled by the size of assets and
profit. Thus, the rate of spending is consistent relatively to growth or decline of personal income. In
this case, an increase in size of asset and profit will ensure a relative increase in the spending rather
than saving. This cyclical effect plays a key role, in the American economy and remains a major
determinant in policy decision processes. The New York Fed study's results showed some variation
in the wealth effect over time, and the importance of differentiating between temporary and
permanent movements in both income and wealth. It is estimated that every dollar of increased
stock market wealth generates one to three cents of additional consumer spending. A wealth effect,
measured as the marginal propensity to consume out of wealth, is admittedly much lower than the
marginal propensity to consume out of income.

Using marginal propensity as a reasonable estimate, the $12.4 trillion dollar exposure of the
households to stock price fluctuations produces a decline in consumer spending that amounts to $50

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billion for every 10% decline in stock values. Therefore, a 20% decline in stock prices, which is on
the low end of a crash scenario, would amount to a hit on consumer spending that is worth about
1% of GDP (in 1999 dollar terms). Even if the wealth effect is currently only half as large, the
impact would be economically significant by any measure, and this would only be the direct effect,
as multiplier forces could easily reduce GDP by 1.5 to 2 times the first round decline in consumer
spending, especially if general consumer and business sentiment decline simultaneously.

Tab: 1.9

The Conference Board reports provide current analyst surveys and displays a brief overview of
Consumer Confidence, which detail consumer attitudes and its significance on the market as
observed. If, on the other hand, the economy weakens before a sudden stock crash, or if a long bear
market combines with other negative forces, the likelihood of a recession will increase substantially.
In his most recent testimony before Congress, Fed Chairman Greenspan said he saw moderation in

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stock market prices as one reason that consumers are slowing their pace of spending. If the stock
market rallies again, however, this could induce the Fed to raise rates to preempt inflationary
pressures from the wealth effect. The premise is that when the value of equities rises, the generated
profit makes people feel confident about spending. An absence of spending could be related to a
more dramatic reverse in wealth effect causing the result of a lag between spending and changes in
wealth. This type of correlation can be observed when a relationship analysis between the S&P 500
and retail sales is conducted.

Chart: 3.7A

The similarity between the trending patterns is remarkable, and it is even more vivid on recent
analysis, comparing the both securities.

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Chart: 3.7B

Economists and financial analysts argue that the effects of stock market on the economy can be
observed directly through the rate of consumption and the wealth effect. This argument was boosted
when Federal Reserve Chairman Alan Greenspan testified that the wealth effect has added a full
percentage point to the growth in gross domestic product over the past three years. The wealth effect
in part refers to the observation that significant increase in the market values of financial and real-
estate assets as they affect the growth of GDP. This is so because increases in asset values tend to
influence how consumers and businesses spend their money, and increases in consumer spending
and corporate investments contribute directly to the growth of GDP.

The Premise of Wealth Creation

It is also true that real wealth creation is ultimately based upon the returns to investments (current
consumption foregone) made today, and that consumption cannot outpace a nation's productive
capacity in the end. A sustained reduction in the saving rate would eventually result in decreased

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investment and stock values, unless productivity growth strengthens. If the current increase in
productivity growth remains for the long-term, investment relative to the overall economy can
remain constant even as saving declines.

Chart: 3.8

A comparative analysis between the US growth rates, National economy and personal finance
indicators show a decline in growth and leveling in others. May is turning out to be a favorable
month in the US economy cycle.

In a system where investment funds are only based on internally generated income creation, funds
flowing to financial markets cause those prices to rise, assuming constant trade volumes, but in turn
reduce the amount of money households have to spend. However, this totally neglects the fact that
there are other sources of liquidity to financial markets. That is, there are external sources as
monetary authorities regularly inject new money into the economy. Generally, money growth in
excess of real GDP growth, unless completely tucked under a pillow, eventually finds its way into
prices. Rising prices can be manifested in higher product prices, asset prices, or some combination.
With a combination of average growth in M2 and M3 that has neared double digits since mid-
decade, much of this extra liquidity is indeed finding its way into financial assets. That is, monetary

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injections allow both consumption and asset prices to rise. In addition to monetary actions, the
argument totally ignores the impact of foreign flows. Foreign inflows are a large and increasing share
of the U.S. financial market. According to the Federal Reserve, the share of U.S. financial assets held
by foreigners has risen from under 10% to 13.4% just since 1992 and has since been increasing.
Foreigners now hold more than one-third of all Treasury debt. Tab: 2.0

These inflows also allow nominal wealth creation without affecting the amount consumers can
spend. Thus, injections from monetary authorities or foreign sources are examples of mechanisms
that can buoy financial prices, while allowing domestic households to increase their consumption.
Thus, there is another source of savings, another way for at least nominal wealth to increase, could
rely on the magnitude of American role in global finance. That is to encourage more investments
abroad, by mergers, acquisition, or direct investment access to foreign exchanges.

Consequences of the Wealth Effect

Economists argue that in order for households to spend their wealth, however generated, it must be
liquidated. It is true that if everyone who wanted to spend their wealth had to cash it in at the same
time, they'd find their actual wealth far less than what their paper wealth was. Nevertheless, people
who get wealthier need not actually spend out of capital gains. As people feel wealthier, particularly
in an unexpected way, they can save less to achieve their wealth goals and so consume more. Indeed,
falling saving behavior as wealth rises is generally accepted as validation of the wealth effect. The

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dramatic fall in the saving rate corresponding with the stock market boom and attendant surge in
net worth seems to casually support this proposition. That is, many people leave their wealth
untouched, but simply save less currently. Certainly, the fact that a large portion of wealth, at least of
the middle class, is housed in illiquid assets such as retirement accounts and housing argues that they
will not spend out of capital gains, but out of future savings.

The national economy chart made a recent scary dive, but its now leveling out.
Chart: 3.9

Some of this extra spending may indeed be based on illusion, as wealth is typically measured by
multiplying a current market price by assets held. A baby boomer household that spends more and
saves less based on their appreciating house value or stock portfolio will not likely look as rich upon
retirement when sizable other members of their generation are also liquidating.

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The Logic of Investment Failure

Dietrich Doerner's book, The Logic of Failure, illustrates the many mistakes most people make
when trying to solve complex problems. One important clause to this approach is the theory of
inventory amplitude and the magnitude of consumer support. Often, investors suffered recently
because they failed to recognize the markets complex systems. They assumed that high returns were
the norm of the new economy. Without a good description of the universe of investing, prediction is
haphazard, and control almost impossible. Since the market system is complex, investors would need
to define the purpose of their portfolios to avoid the "logic of failure". Should they stay in the
market waiting for a recovery, how much profit is enough and how to avoid compounding negative
return years? Unfortunately, the market is akin to a dark driven by heavy losses as Tycoons have
become humbled as personal fortunes collapsed in recent times. The implosion of the Internet
bubble left many of the recently attained high new worth individual at less than one-fifth of their
previous highs and several companies loaded with debt. The following table the losses of financial
assets from recent corporate leaders.

Tab: 2.1
Company Individual Value of asset-1999 Downturn-2000 % of Change
WorldCom Bernie Ebbers $1.7 Billion 388 Million -77%
Softbank Masayoshi Son $69 Billion 4 Billion -94%
Yahoo Jerry Yang $11.3 Billion 1.26 Billion -89%
Apple Computer Steve Jobs $1 Billion $212 Million -80%
Microsoft Bill Gates $ 87 Billion $32 Billion -64%
Bookham Tech. Andrew Rickman $2 Billion $388 Million -83%
Priceline Jay Walker -99%
Amazon Jeff Bezo -88%
PCCW Richard Li -99%

The NASDAQ market, which comprises many of the biggest US tech companies, lost more than
Dollars 3,000bln in value since its peak in March - more than three times the gross domestic
product of China. Stock markets around the world have felt the tremors from NASDAQs stumble.
Germany's Neuer Markt, Europe's fledgling market for technology companies, hardly had a chance

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to establish itself before trouble struck. It was the end of a classic stock market bubble. Like other
technology-driven investment booms of the past - such as the early days of the railroads - the mania
for information technology was founded on a wonderful vision. This technological revolution would
have profound social and economic consequences, changing everyday life in ways that were not yet
imaginable - and creating wealth that could only be dreamed of. Personal fortunes are not the only
things tarnished: glittering reputations have lost their shine as the bull market in tech and telecom
stocks has faded. The former visionaries of the dotcom world are the ones to have lost most

The Lack of Wealth Effect

Spending, in late 20th century America is not fueled merely by wealth. It is also fueled by easy
credit. People who are not wealthy still have access to credit and can spend. A person who has credit
card balances equal to 2 1/2 years worth of his income may still obtain credit. The US economy
thrives on borrowed money, which is not a bad thing if the money were recycled in some productive
manner. However, the implosion of valueless commercial productivity continues to take its toll on
the economy and the lack of sufficient exogenous privatization opportunity exacerbates loss.
Although, the wealth effect proves peoples propensity to spend, even a sharp reduction in wealth
from an equities contraction can be met with easy credit which will keep anything other than a mild
recession from occurring. What would be required is outspread of liquidity such global stake finance.
Hence, if equities contraction will occur in the near future, there is still a strong argument as to why
it could be averted.

Consumer Confidence
Consumer confidence is measured by two widely followed confidence reports: University of
Michigan and the Conference Board. Consumers are more inclined to spend when they feel
confident about their financial and employment prospects. At times, the consumer may worry more
about inflation than unemployment, and vise versa. Nevertheless, in either case, consumer
confidence reflects the paramount economic concern facing the nation or individual. The level of
consumer confidence from the conference board and the index from the university of Michigan are
good leading indicators of consumer spending.

Tab: 2.2

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U. O F M I C H I G A N

Consumer Attitude

3)Sentiment CONSSENT 88.40 04/30/01 91.50 03/31 -3.39 Monthly

4)Expectations CONSEXP 82.20 04/30/01 83.90 03/31 -2.03 Monthly
5)Current CONSCURR 98.00 04/30/01 103.40 03/31 -5.22 Monthly
Consumer Comfort
3)Comfort Index ACNFCOMF 3.0 05/14/01 1.0 05/07 200.0 WEEKLY o
4)National Economy ACNFECON 6.0 05/14/01 6.0 05/07 .0 WEEKLY o
5)Personal Finance ACNFFINA 22.0 05/14/01 20.0 05/07 10.0 WEEKLY o
6)Buying Climate ACNFBUY -18.0 05/14/01 -22.0 05/07 18.2 WEEKLY o

The consumer confidence index is made up of two components, expectations, and current
conditions. Expectations about future economic conditions have been the reason behind the
dramatic decline in confidence in recent months. Economic report showed that orders placed with
U.S. factories fell 3.8 percent in January and the National Association of Purchasing Management's

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(NAPM) factory index declined as well as the non-manufacturing businesses. Most large businesses
have stopped hiring, shrink costs or worse, cut their workforce. Changes in the global market and IT
expansion literacy may have brought about new development and shifts in market shares. With
declining household net worth and cash flow, retail sales have gone from expanding at over a double-
digit pace one year ago to low single-digit growth most recently. With more than 50 percent of
American households owning stocks directly or in mutual funds, this concern is no longer a matter
of concern to the usual few.

Chart: 4.0

The link between stocks and consumer spending is observable through its impact on permanent
income, which increases expected lifetime income, causing consumers to spend more. All the same,
the relationship between the stock market and the economy can also be measured through the
consumer wealth effect. When stock prices were rising, consumers were willing and able to spend
more aggressively. Thus, consumer confidence hit an all-time high about the same time the stock
market was peaking during the period of exuberance. This was the period when realizations rose
from $135 billion in 1994 to an estimated $550 billion between 1999 and 2000.

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Chart: 4.1

Confidence is the key difference between a soft economy and a recessionary one. If confidence is
lost, then investors and lenders stop providing credit, businesses stop investing, and consumers stop
spending. If confidence is maintained, then investing, lending, and spending growth, at worst, only
slows. Further, consumer confidence (the composite index) is still 20% from its peak of last spring.
Various economic data shows weak factory orders to retail sales predict slow growth in coming
quarters. With the economic environment as uncertain as it has been in recent months, the
expectation component of the consumer confidence index could be in for some large swings. Indeed,
between 1990 and 1994, the last time the U.S. economy was in a downturn, the expectation
component of the index plunged dramatically (between 25 and 45 points) and subsequently
rebounded four times before eventually stabilizing.

Chart: 4.2

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The notion that recovery from the US stock market fall can be reversed soon by restoring consumer
confidence depends on how much increase is observable in the moving average of US personal
savings as a percentage of disposable income. The US private-sector net savings (households' and
companies' savings minus investment) has declined precipitously. In the purpose of an Investment
Retirement Account, either to maximize returns, or have enough money to retire leads to the
questions of what sort of annual returns to expect, and what risks should taken to get them. If, at the
end of 1987, an investor had started with Dollars 1m in a tax-deferred portfolio indexed to the S&P
500 stock index would have compounded to about Dollars 6.1m by the end of 1999. The Fed
further lowered its target for the fed funds rate by 150 basis points since the beginning of the year,
which should ultimately lighten the financial load on highly leveraged households and businesses,
maintain demand for housing and other consumer durables, and could convince investors to at least
calm down and hold on to their stocks.

Saving the US Economy

The Europeans claim that issue at hand is not whether emergency cuts in interest rates can repel a
recession, but that the US requires a recession to rebalance its economy. The US government seems
to be allowing its favorable popularity gradually slip in terms of international cooperation and
mutual respect. In foreign policy, deep conservative characteristic seems to be defining the USs
commitment towards a unilateralist foreign policy. The popular opinion about the Unites States
constitutional dynamic balances on the assurance that nothing so crude could ever really shape US
life and direction. Many foreign opinions are building up momentum and, even critics at home are
murmuring that America is beginning to fulfill every stereotype of the wild frontier.

The USs decision to reject the Kyoto Protocol to the United Nations framework convention on
climate Change, apropos global warming was an alarming manifestation of the administration's
priorities of profit at any cost and the unfettered market over sensible regulation. In the attempt to
resolve the oil issue, the government intends to open the National Wildlife Refuge to oil and natural
gas drilling up to the 1.5m-acre coastal plain, which extends across the border between Alaska and
the Yukon. The idea is intensely disfavored by environmentalists. The Canadian environment

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minister, David Anderson, has vowed to oppose the exploration. In the height of this sub crisis, the
US suffered a serious diplomatic defeat with the loss of its seat on the United Nations Human
Rights Commission. The most logical excuse for voting off the US would be a discontentment over
Washington's opposition to the Kyoto Protocol on climate change, the International Criminal Court
and the Ottawa treaty on landmines mobilized. Others point to disagreement with the Bush
administration's plans to build a missile defense shield and in effect scrap the 1972 Anti-Ballistic
Missile treaty. Nonetheless, the Bush team insists its pursuit of national interest base on the premise
that 10 pounds of care do not pay one ounce of debt.

The Duties and Responsibilities of the United States

Today's liberal trading system is the fulfillment of plans first hatched almost seven decades ago. His
efforts and those of his colleagues and successors have borne spectacular fruit: between 1950 and
1999, the volume of world merchandise trade increased 19 times, while world output rose six-fold.
Thanks to the establishment of United Nations, there has not been a world war, trade has been able
to flourish properly, and international grievance or needs have been easily resolved in spite of its
existence. Behind that success were new institutions: first, the General Agreement on Tariffs and
Trade and then, since 1995, the World Trade Organization which has tremendously helped in
achieving certain institutionalized global economic co-operation. These impetus-centralized edifices
are great work of universal benevolence, and not for granted.

"I have never faltered, and I will never falter, in my belief that enduring peace and the welfare of
nations are indissolubly connected with friendliness, fairness, equality and the maximum practicable
degree of freedom in international trade." Hull, Cordell 18711955. Cordell Hull was the longest
serving Secretary of State of the United States, and Nobel Prize winner, was best known as the
"Father of the United Nations." It is a title extended to Sec. Hull by President Franklin Roosevelt.
Hull played a major role in drafting the income tax sections of the 1913 Underwood-Simmons
Tariff Act and the 1916 inheritance law during Woodrow Wilson's first term as president.

Hull strongly shared President Wilson's idealistic concept of the League of Nations. With economic
ideas rooted in nineteenth-century liberalism, he believed that economic nationalism was a major
cause of war, as opposed to Herbert Hoover's high tariff policy. President Franklin D. Roosevelt
chose Hull as his Secretary of State, rather than resorting to a bureaucratic technician. Utterly driven

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by the Wilsonian principles, Hull figured that certain standard principles of mutual regard would be
vital to world cooperation and peace. Hull was right. He became tremendously successful, improving
diplomatic ties with Latin America committing the United States to a policy of nonintervention in
the domestic affairs of the region.

After the World War II, Hull proposed the formation of an organization of world representatives.
He formed an Advisory Committee on Postwar Foreign Policy composed of both Republicans and
Democrats, and came up with the Charter of the United Nations, which became the basis for
proposals submitted by the United States at the 1944 Dumbarton Oaks Conference. Following
nomination by Roosevelt, the Norwegian Nobel Committee presented the 1945 Nobel Prize for
Peace to Cordell Hull in recognition of his works. In the acceptance, Hull wrote: Under the
ominous shadow which the Second World War and its attendant circumstances have cast on the
world, peace has become as essential to civilized existence as the air we breathe is to life itself. There
is no greater responsibility resting upon peoples and governments everywhere, than to see that
enduring peace will be established and maintained. The United States is committed by legacy to the
goal of freer trade with the most sensible strategy. The immediate challenge is to bring the
promotion of hemispheric free trade into line with nations global role.

US Foreign Exchange and Trade Controls - 1st Quarter 2001

The United States generally does not impose exchange controls or restrictions on the flow of capital
funds abroad and generally does not impose exchange controls or restrictions on the flow of currency
into or out of the country. The federal government generally does not require foreign investors to
obtain government approval before engaging in business in the United States. Depending on the
investment, foreign-owned US businesses may be subject to annual information reporting
requirements imposed by the Department of Agriculture, Department of Commerce, SEC,
Department of the Treasury and IRS. With Asian import growth rebounding rapidly in 2000, Japan
out of recession and Europe slowly recovering, US export growth should be strong for the 2001 year.
Certain restrictions are placed for former Eastern bloc countries on certain high-tech electronics,
carbon and polymer fibers, telecommunications equipment, military equipment, civil air navigation
and communications equipment, marine technology, computers and propulsion systems, but have
been eased in many other areas. General export embargoes remain in place on Cuba, Iraq, Iran,

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Libya, and North Korea. Most World Trade Organization member governments favor broader and
more comprehensive trade negotiation conference to be held in November in Qatar.

Chairman Dr. Alan Greenspan made several comments during his Trade policy testimony before the
Committee on Finance on April 4 2001. He maintained (showing regrets) that despite the
remarkable success over a near half-century of GATT, the General Agreement on Trade and Tariffs,
and its successor, the World Trade Organization, in reducing trade barriers, our trade laws and
negotiating practices are essentially adversarial. The best of all possible worlds for competition is for
both parties to lower trade barriers. Moreover, even should our trading partners not retaliate in the
face of increased American trade barriers--an unlikely event--we would do ourselves great harm by
lessening the vigor of American competitiveness. The United States has been a world leader in terms
of free trade and open markets for capital as well as goods and services. The combination of an
economic downturn with protectionist pressures could threaten the stability of the trading system.

The US Economy Need Not Recede

The question, if the US is already in a recession or not, remains semantic. If a recession is defined as
a serious fall of growth below trend, the US has been in recession since the last quarter of 2000.
Conventional definition of two quarters of falling output falls a little short of required affirmation
thus it will require a longer period, perhaps two years to confirm. By then, however, the economy
would have drowned in it, and this would become a terrible defeat for political and financial leaders.
Historical observation of the last three international recessions, in 1973-75, 1979-82 and 1989-93,
shows two cases out of three forecasting performance of the Organization for Economic Co-
operation and Development was either poor or "a failure". The International Monetary Fund and
the World Bank both highlighted the need for a common approach to combating the global
economic slowdown and ensuring financial stability during their spring 2001 meetings in
Washington DC. The comment from the IMF representative was rather unimaginative. The trouble
is, nobody wants to forecast a serious slowdown, let alone a recession. World leaders and central
bankers admitted they expect difficulty, but not as severe as recession for they would be to blame,
held accountable and expected to fix it.

If the US can trigger another wave of control over some newer economy feasibility, the recession
would not be required. If the trend growth of US output were maintained at 3 per cent, a few years

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of 2 per cent output growth would be sufficient to bring employment and activity back to a rate
consistent with low and stable inflation. The question remains if such ability currently exists or not.
The concept is quite analytical, especially when extrapolated as a battlefield combat. A recession is
like a retreat on the battlefield with the back against the wall. There is no room for retreat, or panic
for that matter. Over the years, the financial markets have come to adopt the tradition of allowing
the dead to bury themselves, quiescently. Ruins occur daily in the financial market place. The
financial system has sufficient monetary power to fuel the conduit to deficit with credit, enabling the
fallen hero to live to fight another day. The US retail sales rose amidst this chaos in April. This
indicates that American consumers maintains the world's largest domestic economy, and can sustain
a recovery partly single-handedly over some given period. The Commerce Department, said that the
gains easily exceeded most economists' forecasts and were accompanied by figures from the
University of Michigan's monthly survey of consumers. If the consumer confidence index continues
to trend higher, as it did in April from 88.4 to 92.6 in May 2001, the Fed may not cut interest rates
even when the market is slightly down.

If productivity and sales are increased or maintained at a considerable pace, this allows wages to
increase without triggering higher inflation. However, if productivity and sales falter, pressures for
higher wages could force companies to raise prices, triggering inflation. Nonetheless, the process of
floating and consistency requires a great deal of leadership. What can be contained in the economy
process remains within some normal degrees of resource utilization or employment level. The US
cannot afford a recession amidst clearly great global opportunity.

The Riddles of the US Financial Crisis

The answers to the following questions can be lumped, if certain catalysts are understood in regards
to the characters of profiles of the American society.
How can the United States have high growth, high employment and low prices without
productivity gains, and if companies can't pass on costs to consumers, who ends up paying
the rising debt?
How will the Fed achieve the goal of "growth in the economy" if investment is falling as
interest rates go lower?
Why does investment fall when interest rates are also falling? Why would savings rates
suddenly improve?

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If growth rates continue to be positive, where is the labor and skills mixing going to come
from to sustain the growth?
Are US workers being paid enough?

The recession underway is largely due to too much investment capacity and poor resource
redeployment (Excess capacity, inadequate profitable utilization, costly supply chasing profitless
demand, rising debt, falling margins, inability to pass on costs). The argument that higher inflation
and interest rates in the past account for the discrepancy of the present overvaluation is not
convincing. Recently, new claims for unemployment benefits number are important because they
measure jobless claims. It is bad for the economy if this number continues to increase. According to
the office of New York City Mayor Rudy Giulliani (competent), report said that the Wall Street
earnings could plunge as much as 74 percent this year, as a slowing economy and a bear market in
stocks crimps underwriting, trading and advisory fees. New York-based brokerages will earn about
$5.5 billion in 2001, down from $21 billion in 2000, as reported by Giuliani's budget director,
Adam Barsky, the forecast New York City's estimate of Wall Street's drop in annual profitability is
the bleakest yet. So far, analysts are only predicting an average decline of 9.7 percent for Merrill
Lynch & Co., Goldman Sachs Group Inc., Morgan Stanley Dean Witter & Co., Lehman Brothers
Holdings Inc., and Bear Stearns Cos., according to First Call/Thomson Financial.

Comparison between Job Cuts and the Executive Pay trends

The fact is that during this period of skyrocketing costs in the executive suites, company's leaders
have been aggressively eliminating jobs in the name of cost cutting and efficiency. The effect of this
trend has raised a broad range of philosophical and practical concerns. Profits are under pressure, job
cuts are soaring, but the executive big payouts are still at record high. One of those occasional spasms
of controversy about executive pay has erupted in the UK, as Sir Ronald Hampel, Chairman of
United Business Media, stoutly defended a $934,600 special bonus paid to Lord Hollick, the
company's chief executive, in the face of significant opposition from institutional investors. A big
question looms there regarding top management pay. Even with a softening economy, CEO pay
continues to skyrocket. Inequality between CEO pay and worker pay is at its worst point ever.

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Tab: 2.3

Business Week report indicated that high levels of CEO pay foreshadow poor stock performance.
The companies examined in the study performed even worse when compared to their industry peers.
Between January 1, 1993, and February 28, 2001, Disney stock returned just 128.3%. Other major
companies covered in the report were Intel, Citigroup, Lucent, Cisco Systems, Tyco International,
HJ Heinz, General Electric, Sears, Goodyear, Coca-Cola, Greentree Financial, Cendant, Conseco,
Health South, IBM, Computer Associates, and Andrew Corporation. Mitigating the CEO pay trend
may improve performance in customer satisfaction, employee satisfaction, or performance on social
issues such as predatory payroll and Fair value Economy.

A new study reveals that high-priced executive compensation plans reward past performance more
than sustained business success. While top-paid CEOs are expected to guide their corporations to
superior performance relative to industry peers, their performance has been mediocre, according to
the report released today by United for a Fair Economy. This means, by implication, that top
increases in CEO compensation continue to dwarf the compensation increases enjoyed by
employees. Between 1990 and 1997, CEO cash compensation rose 82% and average total
compensation (including stock options) rose 298% to $7,800,000, vastly exceeding the 22%
increase in factory wages and S&P earnings growth of 110% (Business Week Survey of Executive
Compensation; Bureau of Labor Statistics). Whereas, executive pay in the global context, U.S. CEOs
make on average 1,871 times the average wage of Mexican Maquiladora workers ($4,168 a year) and
15,600 times the minimum wage of workers in Vietnam ($500 a year), two of the many countries in
which the US companies conduct business. The fact that money is the acclaimed measure of value

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becomes totally beclouded when the amount paid to executives are compared to the following
potentials: Nobel prize winners ($58,000), ($174,000) Average University Presidents, ($291,000)
U.S. Presidents, ($259,000) AFL-CIO presidents, ($539,000) Chairmen of the Joint Chiefs of Staff,
($21,840) Average workers, ($5,441) Minimum-wage earners.
Tab: 2.4

Executive Pay Rises at Three Times Rate of Inflation

The overall effect of an incentives pay system is to drain talent from the more traditional sectors of
the economy into the fast-growing areas. Growth enthusiasts may argue that this is a good idea, but
booms tend to come to an unexpected end, and the core of the economy also requires good
management. An annual pay review pack providing detailed up-to-date analysis of each executive's
remuneration compared to the market, and issued to coincide with the company's pay review

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Chart: 4.3

The executive
branch (white collar)
continues to trend
higher and was not
perturbed by the
market or service
employee drop

The most popular months for executive salary reviews are January and April. Executive share options
are an important part of the executive package, with 58% of respondents intending to grant options
in the near future and, for the majority, the grant will be because of a multiple of basic salary. The
median value of shares optioned last year to an executive participating in an executive share option
scheme was 81% of basic salary. By way of comparison, the Standard & Poor 500 Index fell 10
percent in 2000 and the NASDAQ Composite Index fell 39 percent. The typical hourly worker
received a 3 percent raise last year, and salaried employees got about 4 percent more during the same
time. Inequality between the shop floor and the executive suite is at an all-time high. According to
Business Week, the average CEO made 42 times the average blue-collar worker's pay in 1980, 84
times in 1990 and a staggering 531 times in 2000. Academic studies, including those published by
the University of California, Berkeley, and Stanford University, have shown this inequality hurts
employee morale and productivity and boosts turnover.

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Tab: 2.5

CEO pay packages like to point out other highly compensated individuals such as sports stars.
However, unlike many under-performing CEOs, star athletes pay are based on their performance on
the field. Moreover, a study published by the Academy of Management Journal in 1999 found that
the smaller the gap between highest- and lowest-paid players, the higher the level of team
performance. Runaway CEO pay leaves shareholders footing the bill for excessive executive
compensation packages. Almost two-thirds of CEO pay is in the form of stock options. A report by
the executive compensation consultant Watson Wyatt Worldwide found that promising executives
too many stock options actually hurts stock valuations. The whole concept of poverty level and
traditional preferential enfranchisement needs appropriation. Recently, student activists at Harvard
University completed a 21-day sit-in designated to boosting the wages of low-income workers at
their prestigious university. The living wage committee will include low-wage workers for the first
time in Harvard history.

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The Culture of Transformation

Whatever is in a perfect state must remain thus, needs not change. In spite of the indisputable
dynamic attributes and the extremely useful potential of the US financial market system, our
economy has yet to reach a perfect state or even some degree of plausible respite. This is a remarkable
observation considering so many years of mercantile experiences and tremendous output of
productivity. For more than a 6 centuries, the American world had religiously focused on
mercantilism and the pursuit of happiness. What kind of mercantile system of governance has the
best potential to produce the highest yield may depend on the ingenuity of management and
propagandists on both sides of the ideological divide during the battle for ascendance within
communism, social democracy, and capitalism that spanned the 20th century. Each system had its
claim to success of being capable to produce resilient workers and prodigious displays of zenith
achievements as standard bearers of respective ideals.

The Efficiency of Value

The American capitalism is designated to the pursuit of happiness, and peace -- which infers security
(as some sort of insurance for happiness). If happiness means a condition of supreme well-being and
good spirits, then it cannot be motivated by greed or lack of value. Americans have contributed a
great deal towards the progress of the contemporary world, almost in every aspect of civilization has
frontiers being pushed. It is apprehensible to acknowledge then, that United States is happy about its
position in the world, but also bears the right to be discontented about direction which global
mercantilism is being distorted by dogmatic ordinances from within and without its circumference.
Happiness itself is value, thus wherever value is realized, and contained happiness is meant to ensue
no matter how temporarily it occurs. The comprehension of value may be determinant in the
pursuit of happiness. Thus, when looking to conclude the wherewithal benefit measures in the
diverse systems of mercantilism that are polarizing world community developments, it must,
essentially be based on value. Value is a general rule, not just in emerging economies or developing
nations; whether or not civilized or developed, production and produce, services and acts, resources
and ordinances, including wealth itself. Thus, if by wealth, yields that are not manifested or based by
value must default essentially over time. This has been true through the cause of history where

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tremendously high investment yields become eroded, due to the lack of market sustenance, or
products enjoyable or utilitarian performance.

The concept of modern economics evolved from the free trade system is based on the evident ideals
of Adam Smith in the Wealth of Nations. The immediate consequence of trade, based on the
exchange of reciprocal requirements, buying and selling, like every activity, must yield a direct source
of gain for the trader, the tradition is to buy cheaper sell higher. The growth in global economy has
provided mercantilism with arbitrary amplitude of market horizon, provided the individual national
interest covers the opportunity scope. The concept of coherent value says, all controversies about
profits aside, that better sales, must have bigger yields. The same logic infers that better values
determine quantity of demands in a fair market access scenario. Such points stem from the modern
economists (product incentives).

The English and the French have quarreled over the ages on the issue of value, and their agreement
based on simplistic profit has derailed the reasons on the aspect of fair market trade. The English
defined the costs of production as the expression of real value, while the French objected to the fact
that utility of an object measures it value by deducing the abstract value. According to modern logic
price is determined by cost, under normal circumstances. However, price does not reflect an actual
exchange-value, and neither does the costs of production the measure of value. The English
economists asserted that the abstract value of a thing is determined by the costs of production. Nota
bene, the abstract value, not the exchange-value, the exchangeable value, value in exchange that,
which is something quite peculiar, because no ordinary conditions aside the circumstance of
competition would sell an object for less than it costs him to produce it. A trade of such commodity
in a general open market where different technical, geographic and other factors accessible can bring
about different cost, and thus demand id filtered by different prices, which the cardinal factor, the
circumstance of competition, is then improbable. Abstract value and its determination by the costs
of production are, after all, only abstractions, nonentities, and if at all temporal. This means that the
utility of a product is essentially a constituent of value. Value lies within the realms of severe
obscurantism because it can be easily manipulated, and channeled independently to observe certain
necessities of life especially in a society with multi-layered social profiles. Within such criterion, value
ought to include certain enjoyable luxurious elements in order to meet the appetite of the upper
class, or a mixture of both luxury and utilitarianism to inspire the middle class, or pure utilitarian

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object without seam of luxury may fulfill the need of the lower class. This categorical psychology lays
the secondary law that relates markets, products, and prices. The transition from modern civilization
to the complex contemporary Age of Computer Technology, the premise of required utilitarian
values has learned to include certain enjoyable elements, such as ease, mode, size, and efficiency and
equal access as essential consistencies.

The Ideals of Nationalism

The fundamental level costs includes the rent, lease, resources, materials, conveyance, energy, and
most importantly, labor to complete production and manufacturing at the industrial level. The
managerial sectors represent the second constituents; they sum the costs of capital credits at the
financial markets, insurance facilities, and executive services. The third constituents are the costs of
market accessibility as determined by private and government trade negotiations and product
marketability. Since the goal of national interests focuses on favorable strengths and opportunity
factors that supports its efficiency and productions to fulfill the needs and wants of its sovereignty.
These legacies represent the macrocosms of many features that characterized the ideological
differences existing between corporations, organizations, communities, nations, and continents since
the Industrial Revolution. A nation must have certain defined goals for both long term and short-
term horizon relative to the aspect of global mercantilism and self-sustenance.

Hegemonic nations focus mostly on territorial strategies and defense, thus prioritizing a substantial
amount of their budget on weaponry and military power above all. Hegemonic interests are pattern
shown by highly productive intellectual states, where the society bounds often infer cultural
supremacy. These kinds of societies pattern of subsistence are thwarted by either religious or certain
social intolerance, or judicial rigidity. The austere sovereignties are motivated by ideals of
Expansionism, Ostracism, and Classicism.

Economic Nations
Economic nations direct most of their strengths and distinct capacities towards certain sustenance
standards and objectives. They are countries with well-established financial market economy and
political systems. Principal goals are gains and profits, which is readily understood by trade partners.
Economic nations, in spite of their active market engagement and involvement with each other, are
most instance members of a trade group with common interests and various conscientious standards.

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Group of Five (G-5) are the five leading countries (France, Germany, Japan, the U.K., and the U.S.)
that meet periodically to achieve some cooperative effort on international economic issues. When
currency issues are discussed, the monetary authorities of these nations hold the meeting. The Group
of Seven (G-7) represents G-5 countries including Canada and Italy. The Group of Ten (G-10)
represent the ten major industrialized countries whose mission is to create a more stable world
economic trading environment through monetary and fiscal policies. The ten are Belgium, Canada,
France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, and the United
States. The European Union is also an economic and political union established by members of the
Western European Countries. The European Union spans the communities with common interests
measured by scope of the European standard, especially in the area of foreign and security policy, a
central European bank and common currency. The most popular economic organization is the
OECD (The Organization for Economic Cooperation and Development).
Tab: 2.6
OECD Countries
Australia Luxembourg Austria Mexico Belgium Netherlands
Canada New Zealand Czech Rep. Norway Denmark Poland
Finland Portugal France Slovak Republic
Germany South Korea Greece Spain
Hungary Sweden Iceland Switzerland

Developing Nations
Developing nations can now be separated from the term underdeveloped nations, which had
previously been used to infer the 3rd World nations collectively. Developing countries have a
pattern of certain degree of feasibility in regards to emerging economy developments, some degree of
legislative ordinance, and political stability over a convincing period. It is also required that
developing countries show so aptitude of proper documentation, standard accounting methods,
certain degree of inclination towards technology information services and development. Most
importantly, increasing number of the middle class due to progress in education standards,
progressive health system, progressive commutation system, defined transportation and energy
control stability. Developing nations denotes where significant efforts of the society reflect probable
indication of progress, especially in Privatization programs. There are several private investments

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between developing nations and the economic nations; a popular market maker in this sector is JP
Tab: 2.7

The United States also uses sovereign debt and complex credit-enhanced bonds issued under the
Brady Plan Agreements to invest in the Developing countries emerging markets. Objective
Emerging Market-Equity Ivy Developing Markets Fund is an open-end fund registered in the USA.
The Fund's objective seeks long-term growth. Developing nations with emerging markets include:
Singapore, which has been tremendously impressive, Israel, Malaysia, China, Brazil, South Africa,
Turkey, Greece, Saudi Arabia, Bahrain, Kuwait, Taiwan, India, Argentina, Chile, Venezuela.

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Tab: 2.8

These economies, which have some capacity to finance current account deficits from reserves, may
also be able to borrow abroad.

The Nominal Nations

The next category would be the inferred Nominal nations. They are so called because these
countries remain under observation to meet the regulatory standards of common law. Nominal
countries are mostly deep in incongruous entities (ethnic cleansing or severe anarchy); usually there
is no significant pattern of civilization, or social ordinance, quite rare if at all. Death rates are high
and low birth rate due to local incorrigibility of disease causal factors. No exhibition of market
economy system management capability, or public safety or any substantial amount of traces of
functional management system of natural resources, civic standards by measure of communication,
energy and productivity. Nonetheless, the shortcomings of nominal and developing nations can be
understood through the deduction of their past histories and current social status. There many
constrains that seem to bind the underdeveloped societies to their plights. Many social analysts tend
to blame the historical aspect on the immediate circumstances by inferring slave trade and
colonization, or base their discourse on exploitation. Nonetheless, record performance showed grave

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deterioration has started and continued beneath the breakeven point since after the period of
independence, with the exception of few. This characteristic is severe, and particularly observable in
nominal entities. The apparent problem is not historically analytic, reminiscent of Socrates cave
theory; simply based on lack of precise decisiveness. Decisiveness in this case is properly inferred.
This is Nominal nations are sparsely dispatched around the globe, but there are certain
concentrations in North Africa and Sahara, Sub-Saharan Africa. There are also many in Asia, Pacific
and Middle East, Middle East, Asia/Pacific. Surprisingly there are also few in the Western
Hemisphere, especially the Central and Eastern Europe. The Central America South America and
the Caribbean also have a substantial share.

Nominal societies suffer a great deal from their sovereignties, which oppresses them and sway them
in severe disarray. Most existence is bounded to severe poverty, exacerbated by deceases. Poor
educational system compensates the cycle of inherent political instability. It is natural that nominal
societies would try to flee their plight at any given opportunity. This pattern is natural to the nature
of man, just as the European did in the dark ages. However, nominal nations are truly matchless to
their worldly counterparts, who tend to worsen their conditions by tightening quotas and restrictions
on trade relations and denying them access of passage. Often economic nations impose these
restrictions to nominal countries because of image perceived of their self-installed leaders. Most
nominal states are under military rules, which mean that the people are governed by dictatorship.
Such leaders drain national treasury and pockets gain from natural resources, which remains to be
the only form of resources. People are scared, the markets are off, and trade performances are severe,
citizen refuses to pay taxes due to the level of income, which leaves average more than the 50% of
the society below poverty level. The reluctant government would be content with embezzlements
and proceeds from resource sales would sustain military support, until one coup survives the other.
Fifteen The Financial Services Authority for inadequate money-laundering investigation found 42
accounts in 15 UK banks through which flowed $1.3bln over four years linked to General Sani
Abacha, the late Nigerian dictator. Over more than 25 years, Nigeria's thriving oil sector generated
more than Dollars 250bln - rich pickings for its political and military elite and its international
trading partners. More than Dollars 4bln (Pounds 2.7bln) may have disappeared during the general's
four years in office. The scale of such corruption helped argue the relief appeal for country's foreign
debt, estimated at between $28bln and $35bln. Bankers, however, argue that better management of
resources by one of the world's largest oil producers would have prevented the debt issue from

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reaching critical proportions. Swiss banks were used to shelter the fortunes of wealthy dictators such
as the late President Marcos of the Philippines. Greece had to counter money laundering amid
concern about funds for former Yugoslav president Slobodan Milosevic. Diplomats argue
continually that in a political system where patronage is the key not only to success but also to
survival, a serious effort to deal with corruption.

The prevailing analysis discourses the probable reasons for marginalization of African countries in
the world economy. There is a tendency for declining shares in nearly all sub-sectors of trade, plus a
tendency for shares decline. Currently war and civil unrest is occurring in less than 55% of Nominal
nations. Africa's plight is desperate. Having miss out on industrial expansion, Africa now risks being
excluded from the global information revolution. Former South African leader, President Nelson
Mandela once, told the FT that there are greater needs for a stable economic environment, well-
regulated markets, flourishing private sector sand drastic action to curb corruption in Africa than
anywhere else. African societies will find it utterly difficult, perhaps impossible to break the cycle of
cave theory, except there is some strategic compensatory rescue intervention-policy agreement in
place. Such is an idea whose time has come.

Market access to African benefit can only be stimulated by efficient mainland transportation system.
Thus, in order to trigger an on set of production, demand, and supply efficiency -- the most basic
fundamental transportation industry must be in place. An era of the railroad industry would roll the
continent out of its shame. There are few railroads in Africa, but most are no longer functioning
right. One other major problem with nominal nations is the inadequacy of management or
maintenance, which is driving the continent to ruin. African leaders, at the forefront backed by the
US, Japan, and the European Union, are drawing up a plan for the continent's recovery. Farm
subsidies, debt cancellation, the doubling of aid, liberalization of agricultural trade, textiles and
clothing, and investment in disease prevention products may seem to all have roles to play in
recovery. Nonetheless, Africa can no longer survive on crumbs alone. Being decisive about its goals,
estimates, and certain feasibility its economy should help strengthen the continent's voice in world
trade negotiations. A railroad project would be properly inferred as an economic valued added
development project, where there is plenty of profit to be made by bilateral or private lenders. This
reflects great opportunities to world investors and reciprocally beneficent to both the Africa states
and the public world. More importantly, such commencement will bring about the breaking of the

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cave theory cycle. It is up to African governments to demonstrate commitment by looking deeper

into such ideologies and be decisive as to how to best implement it, but it will also not be surprising
if no action is taken.

Nonetheless, African leaders need to recognize that such significance would be a revolutionary move
towards market-driven economic developments and strong social institutional infrastructures and
active measures to alleviate poverty. More importantly, the railroad ideology would, essentially need
to span the whole continent, possibly conjoining it to Europe and Asia. This would create a mixed
economic system in which both the government and private enterprise will play important roles in
regards to production, consumption, investment, and transaction. The technological revolution of
the 1980s and 1990s brought a new entrepreneurial culture that increased the wealth of most
countries across the globe, except those nominal nations, and especially the African countries. This
was simply because the essential infrastructure upon which technology developed was not anywhere.

Railroad was of course an American ideal that brought about the crucial change on industrial growth
and emergence of the corporation, which appeared first in the railroad industry and then elsewhere.
High-salaried managers who became the heads of corporations replaced business barons. The rise of
the corporation triggered, in turn, the rise of an organized labor movement that served as a
countervailing force to the power and influence of business. This economic culture, and lessons
learned from it would lay a vital foundation to serve as part of the strategy. In this case, the Africans
would need a great deal of American help, not essentially because of its surpassed experience in
railroad land scope challenges, but also because of some certain strategic adherence which is favorable
to both parties. Many Americans, especially those of African heritage may find appealing or even
more so fulfilling career developing opportunities on this account. However, like most things, it
sounds too good to be true because most African countries have entered into contractual preference
arrangements with the EU. The EU has accounted for more than two-thirds of total African trade in
2000. The ratios for U.S. and Japan have declined respectively. However, there is enough room to
accommodate the super economic powers business of such a magnitude. The OAU (Organization
of African Unity) is one of the most comprehensive political organization is in Africa, and would
perhaps play a determinant role. For their part, the organization will have to become more flexible in
working together with other core group organizations that have contributed vitally to in helping
nominal countries help themselves better. Core group organizations are working together with the

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least Developed Countries to coordinate their trade assistance agenda through Integrated Framework
for Trade-Related Technical Assistance to these countries. These organizations include the
International Monetary Fund (IMF), International Trade Center (ITC), and United Nations,
Conference on Trade and Development (UNCTAD), United Nations Development Programs
(UNDP), World Bank, World Trade Organization (WTO).

Least Developed Countries

Tab: 2.9
Afghanistan Angola Bangladesh Benin
Bhutan Burkina Faso Burundi
Cambodia Cape Verde Central African Chad
Comoros Democratic Republic of Djibouti
Equatorial Eritrea Ethiopia Gambia
Guinea Guinea - Bissau Haiti
Kiribati Lao People's Lesotho Liberia
Madagascar Malawi Maldives

Many nominal nations and some developing countries are subjective to making the mistake of not
having well defined goals, or not clarifying their development agenda, at least not properly enough
to ensure concomitant understanding of their directions and desires. This does not only make global
trade a more severely obscured complexity, crudeness also adds to grave atrophies of both financial
and intellectual resources. Certain degree of feasibility and disclosure and aptitudes are essentially to
basic global fair market economic fundamentals, because only then can a party venture application of
value to exchange. The lack thereof may explain why many nominal nations economy easily falters
in ruins, poverty dwelling and often default on their debts. Not only culture (determination,
persistence, visions, feasibility and general care interests), but also bold leaderships that set the tide
that turned the favorable production yields to the advantage of western civilizations.

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The Progress of Efficiency

Frederick Winslow Taylor, the American management theorist, commenced the worldwide
orchestration of efficiency in the process of production and manufacturing, which have had most
important influences in corporate organizations since the 20th century. Taylors approach to broker
the process of production into different labor divisions enabled semi-skilled workers to close just as
good a job, breaking the cabal of artisans. Its full potential became apparent two years later when
Ford Motor engineers achieved efficiencies big, enough to yield more than double the rates it paid its
production workers. His archetype of the perfect worker ("Schmidt) any such human being
machine: responsive to programmed commands and incentives. Taylors concept was widely
practiced. The Bolshevik revolution leader, Vladimir Illych Lenin, before the outbreak of the First
World War, first rejected scientific management describing Taylorism as the "enslavement of
humankind to the machine". Joseph Stalin, Lenin's successor, was equally enthusiastic. He
understood the propaganda implications externally and, more importantly, internally, of celebrating
the achievements of manual workers. One of Stalin greatest manipulation moves to inspire the ranks
of Soviet labor to ever greater effort was to make Stakhanovism the Soviet icon of worker perfection,
a representation exceptional output, and efficiency by individual workers. Stakhanovism work is a
combination of manual and mental work. It enables the Stakhanovites to show their mettle, to
display their faculties, to give free reign to their creative ideas; it signifies the victory of man over
machine." However, Communism lacked efficiency on both the production and sustenance levels,
and about thirteen years ago, Mikhail Gorbachev caught the world off guard by dismantling the
largest military and political dictatorship this world has ever seen. American media was abuzz with
the new Soviet concepts of reform: Glasnost (openness) and perestroika (reform). Nonetheless,
communism emerged stronger in China, where the ancient culture, pay rates and population size
favors mass qualitative factory productivity by enabling it to keep craftsmanship as an essential part
of its production processes, defying Taylorism. This meant cheap labor exacerbated by solemn
abhorrence of the bloody terror, lack of tolerance, and procrastinating blames distort its credulous
mercantile system.

Social democracy has been in tune with history, transformation from the warfare into the welfare
state. Members of the Party of European Socialists head ten of the 15 governments in power in the
European Union. The same is also true of Italy, if Silvio Burleson triumphs over the moribund
center-right parties of old. The Scandinavians have shown social democracy as a viable economic

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system. The social democratic position accepts the present context and structures of capitalism,
which separates it from traditional Marxist thinking.

The Publics Private Economy

Political economy came into being as a natural result of the expansion of trade. The cardinal point in
the mercantile system is the theory of the balance of trade. Thus, to constitute wealth, only such
transactions that would bring consistent cash flow into the country are valuable enough to be
generally considered profitable accounts. To ascertain these profitable accounts, imports are required
from specific order of brand specialization, based on either forward, or future exchanges whereby
production order is consistent. Exports, compensatory to the prevailing analysis of import, would be
designated by appropriation believed to serve some major viable interest where the quantities or
perhaps the qualities of products determine prices according to country standards. In order to
balance trade, there must be some degree of designated specialties, strategically sparsely distributed to
essentially boost competition, where mergers and acquisitions are essentially mitigated to avoid,
monopoly, oligopoly and in extreme cases, plutocracy. This opportunity would favor the world at
large, especially where there is greater opportunity to access distanced information, feasibility and
investments, to some magnitude orchestrate certain productivity and inspire efficiency by same
methods or some innovations.

Global Finance
The global finance operations combine various areas of faculties in order to provide comprehensive
solutions to the complex globalization issues thwarting modern international trades. Global finance
focuses mainly on the privatization aspect of globalization and provides feasibility on the global
economy. Globalization is the tendency toward a worldwide investment environment, and the
integration of national capital markets. Globalization differs from other forms of intensified
interdependence between national economies: true economic globalization involves a qualitative shift
toward a system based on a consolidated global market place for industrialization, production,
distribution and consumption rather than on autonomous national economies. In conducting the
global transactional operations, financial firms continue to customize several financial instruments
specifically to stimulate the global economy according to the appraised pros and cons, terms and
conditions surrounding the business circumstances.

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Country Risk Assessment

Amount of intelligence, time and effort required for gathering and data analysis lead to regular
country assessment reports on a number of emerging countries at the periphery of the market
economy. Emphasis is put on macroeconomic adjustment, external financing requirements, risk
ranking, openness to foreign direct investment, and governance. External debt analysis and debt-
equity conversion opportunities lays emphasis on liquidity and solvency imbalances, predictability of
external debt crises, debt restructuring. The corporate sector are continually developing their
(blacklist) database to include statistical and analytical work on international finance data stemming
from emerging markets' balance of payments and banks' liabilities compared with non-bank private
depositors. The existence of a global finance compels national governments to reappraise their
assumptions of economic governance and adopt a more systematic approach to the implementation
of socio-economic policies.

Customized Global Security instruments

Global Depository Receipt is a receipt denoting ownership of foreign-based corporation stock shares,
which can be traded in numerous capital markets around the world.

Global bonds are designed to qualify for immediate trading in any domestic capital market and in the
Euro market. Brady Bonds are issued by emerging countries under a debt reduction plan.
Commodity-Linked Bonds value depends on the foreign price of a specified export commodity of
the debtor country. In the debt workout process, these bonds usually link debt service payments to
the price of the exported commodity.

Bilateral loans are loans from governments and their agencies (including central banks), loans from
autonomous bodies, and direct loans from official export credit agencies. Loans from multilateral
organizations are loans and credits from the World Bank, regional development banks, and other
multilateral and intergovernmental agencies. Excluded are loans from funds administered by an
international organization on behalf of a single donor government; these are classified as loans from

Bridge Loans are used in the context of managing a country's debt profile, it is short-term financing
provided to a debtor country--usually by the monetary authorities of industrial countries in

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conjunction with other central banks, governments, multilateral institutions and commercial banks--
to supplement the country's foreign reserves prior to finalizing adjustment programs and determined
lending packages.

Global fund is a mutual fund that can invest anywhere in the world, including the U.S.

Co-financing is a mechanism by which creditors provide project loans in parallel with loans granted
by multilateral agencies such as the World Bank. In principle, cross-default clauses prevent debtors
from defaulting on amounts owed to co-financiers without defaulting on the official institutions.

IMF purchases are total drawings on the general resources account of the IMF during the year
specified, excluding drawings in the reserve tranche. IMF repurchases are total repayments of
outstanding drawings from the general resources account during the year specified, excluding
repayments due in the reserve tranche.

Interbank Lines are short-term working capital extended between banks to cover short-term claims
on a revolving basis. Letter of credit is a form of guarantee of payment issued by a bank on behalf of a
borrower that assures the payment of interest and repayment of principal on bond issues. Guarantee
is a written promise by one party to be liable for a specific obligation of a second party in the event
that the second party does not fulfill its financial obligation.

The Role of Technology Development in Globalization

At the initial stage of integration, firms that operates their products globally, needed to spend so
much money entails developing understandings of how globally dispersed parts of the organization
should be harnessed to create value in locations around the world. However, many new high
capacity technologies have been developed to enable financial transactions and access resources
between international banks, international exchanges, and official institutions worldwide.
International Banking and Investment Services system -- computer network based in Valley Forge,
Pennsylvania, enables traders to buy global securities for their own accounts. The network provides
traders with confirmations, currency positions, credit information, and settlements. In this way,
financial technologies have done more good to the economy than harm. The recognition of this
prosperity-enhancing sea-change in world markets and, in that context, of the counterproductive

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consequences of pervasive intervention has led many governments to reduce tariffs and trade barriers
and, where necessary, to deregulate markets.

However, there is also no doubt that this transition to the new high-tech economy has spurred
exuberance and cynicisms that characterizes the western economic pattern of failure. The measure of
technology value should be how much it enhances standards of living through the effects of
competition on productivity, especially on the market scope. It is difficult to find credible evidence
that technology trade has affected the level of total employment on the magnitude of globalization.
The increasing "digital divide" - the gap between countries rich and poor in information technology
as showed no lasting benefits to the affluent countries themselves. Financial firms continue to suffer
recent financing excesses in technology markets due to the lack of inventory adjustments, company
rationalization, market-confidence and key psychology variability. Blind acceptance of every
tantalizing twist of the IT product cycle quickly became the norm in business circles. There was no
rhyme or reason to budgeting. The Technology sector demise began due to its intense concentration
on short-term profit, which required immediate upgrade to surpass competitive product without
significant enhancement in real value. Transitional upgrades spurred from unnecessary new series of
e-mail platforms, flat-screen panels, wireless bells and whistles, voice commands, new operating
systems or a third-generation personal digital assistant, electronic games and play stations and the
latest installment of the popular Final Fantasy series.

Affluent countries overdo on information technology outstripped any conceivable productivity

payback. Dotcom mania was the froth on an exponential surge of IT appliances driven by largely
unprofitable businesses. The overhang has now reached the peaks of New Economy gone to excess,
just like Old Economies of the past. History also warns that for every excess in the real economy -
there is usually a counterpart in the financial system. However, at the same time, companies that
were reorganized around "e-business" strategies tend to survive without a big corporate commitment
to the IT culture was deemed inconceivable. If just a quarter of total investment that was lost to the
IT exuberance were channeled to developing communication facilities, the world would have
become a better place by now and the return from such venture would certainly be a better bet than
extreme IT upgrades. Not to be mistaken, some IT upgrades are useful and some of the IT sectors
are extremely useful especially those that tends to provide significant economic value to connection
between corporations and households, either by synchronization of corporate internet to remote

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locations (LAN, WAN), or virtual storage as well IT security systems. The remarkable growth in
distance education shows the importance of such remote access facility would become, without
shadow of a doubt, the sustainable propensity factor of the more productive technology innovation
possible over the longer run. On a the overall feasibility, the serious improvement in risk control
system and intranet or extranet security ideals could encourage corporations to increase the volume
of employees working via remote locations. Saving time, money and preserving energy and thereby
much room to improve performance.

The Worlds Wealth

Companies operating in more than one country at a time have become some of the most powerful
economic and political entities in the world today. Some of these corporations have more power
than the nation-states across whose borders they operate. For instance: the combined revenues of just
General Motors and Ford--the two largest automobile corporations in the world--exceed the
combined Gross Domestic Product (GDP) for all of sub-Saharan African corporations and
governments. The combined sales of Mitsubishi, Mitsui, ITOCHU, Sumitomo, Marubeni, and
Nissho Iwai, Japan's top six Sogo Sosha or trading companies, are nearly equivalent to the combined
GDP of all of South America. Itochu Corporation's sales, for instance, exceed the gross domestic
product of Austria, while those of Royal Dutch/Shell equal Iran's GDP. Together, the sales of
Mitsui and General Motors are greater than the GDPs of Denmark, Portugal, Turkey combined,
and US$50 billion more than all the GDPs of the countries in sub-Saharan Africa. Top Global
companies are:

Tab: 3.0
1. General Electric 482 US
2. Microsoft 363 US
3. Exxon Mobil 306 US
4. Pfizer 273 US
5. Citigroup 250 US
6. Wal-Mart 231 US
7. AOL Time Warner 214 US
8. Royal Dutch/Shell 210 UK/HO
9. Intel 207 US

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10. NTT Do Como 206 Japan

11. IBM 202 US
12. BP 201 BP
13. Vodafone 197 UK

General Electric is the world's most admired company, yet in a deeply unfashionable sector. The US
company's success was underlined with publication of the FTs annual survey of the world's largest
companies, ranked by market capitalization. GE regained the number one spot it lost to Microsoft
two years ago, and its $477bln market value was more than 50 per cent bigger than that of its nearest
rival. Investors decided companies that focused on a limited portfolio were more likely to produce
superior returns. That task, as well as keeping aloft GE's heady price/ earnings ratio, will depend
largely to Jack Welch's successor, Jeffrey Immelt as the new CEO. What matters is genuine and
consistent management ability.

Tab: 3.1
All Time largest Mergers and Acquisition -US

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World Wealth Ranked by Individuals

The 14th Annual List of the World's Billionaires from the Forbes magazines shows a new surge of
wealth creation around the globe. Three of the four wealthiest men have lost billions on paper over
the past 12 months--and the richest of them all, Bill Gates, is poorer by tens of billions. The good
news is that riches are spreading, albeit slowly, to more parts of the world. An additional 180,000
people became high net worth individuals last year. More than a third of these individuals live in
North America with a combined wealth of $8.8 trillion. The percentage of Millionaires across the
world according to the regional population show the following: Latin America 0.09%, Eastern Bloc
0.20%, Middle East 0.22%, Asia 1.70%, Africa 0.04%, North America 2.54%, Europe 2.31%.
Tab: 3.2
Gates, William H. III 60 United States

Ellison, Lawrence Joseph 47 United States

Allen, Paul Gardner 28 United States

Buffet, Warren Edward 25.6 United States

Albrecht, Theo & Karl and family 20 Germany

Alsaud, Prince Alwaleed Bin Talal 20 Saudi Arabia

Walton, S. Robson 20 United States

Son, Masayoshi 19.4 Japan

Dell, Michael 19.1 United States

Thomson, Kenneth 16.1 Canada

Anschutz, Philip F. 15.5 United States

Ballmer, Steven Anthony 15.5 United States

Bettencourt, Liliane 15.2 France

Berlusconi, Silvio 12.8 Italy

Quandt, Johanna and family 12.8 Germany

Arnault, Bernard 12.6 France

Redstone, Sumner M. 12.1 United States

Kluge, John Werner 11.9 United States

Kirch, Leo 11.5 Germany

Li Ka-shing 11.3 Hong Kong

Ergen, Charles 11.2 United States

Pritzker, Thomas J. 10.7 United States

Murdoch, Keith Rupert 9.4 United States

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Takei, Yasuo 9.3 Japan

Bertarelli, Ernesto 9.1 Switzerland

The Philosopher Kings of Global Finance

Many influential people may influence the direction of the United States economy for the better.
Among the few names that would be mentioned, apart from government intellectuals and elected
officials would be such names like, Warren Buffet, Sanford Weill, George Soros, Rupert Murdoch,
William C. Steere Jr., Mike Bloomberg, Steve Case, and others. The people have shown tremendous
quality in their specific strengths and have undoubted potential to lead the country in the favorable
direction of privatization and globalization. George Soros now realizes social values with its fund for
Eastern Europe; many religiously and non-religiously inspired volunteer groups realize "goods"
ranging from helping the old, to saving dolphins and fighting human-right abuses. Next to politics
and actors from civil society, private businesses can also perform governance: by caring for their
employees, sponsoring social activities, by charity and by more structural "socially responsible
business. He says that total global inequality has, in fact, risen, and goes on to argue that openness to
trade exacerbates inequality within developing countries by placing the poor at the mercy of
movements in international commodity prices

Citigroups Sandy Weill

Sandy Weill, being the favorite, is the Chief executive office at Citigroup, which hires about 240,000
employees worldwide. The New York Times profile of Sandy Weill portrayed a atypical CEO rising
through the ranks. I would set goals, I would set realistic goals and as I approached that goal, I
would keep on letting out more rope all the time. Sanford Weill April 2001 CNBC.

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Tab: 3.3

When the merger of Citicorp and Travelers was announced in 1998, much of it was built on the
foundation of cross-selling opportunities. The cross- selling as it relates to the corporate side of the
business has been fantastic. There are many initiatives working in this company and the merger,
which was just 2 1/2 years ago, both travelers and Citicorp at that point in time were earning about
3 1/2 billion dollars each. Moreover, last year both companies together earned 14 billion dollars, so
much more than double what they were earning putting them together at two years before and four
times what either of them were doing initially. The following index represents the Wall Street
companies with best performances, with asset management, stock and bond underwriting,
investment banking and brokerage. Citigroup emerged clearly the leader.

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Tab: 3.4

Tab: 3.5

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Recognizing that America is going to be in a difficult economy due to the changing tides of
recessionary expectation ad corporate layoff campaign that global finance offers better have for
corporate businesses. Citigroup has made many acquisition, last year in a Asia, Africa, Australia,
Central America and South America. As a mater of fact, the new acquisition of the Mexican Grupo
Financiero Banamex-Accival shows how poised the company is to play the global role in finance,
especially under the leadership of Sandy Weill. This latest move was biggest Latin American
acquisition by a United States company, Citigroup would buy Mexico's second- largest bank for
$12.5 billion in cash and stock. The purchase demonstrates Citigroup's faith in the recovery of
Mexico's economy and banking system since the financial crisis of 1994. Citigroup officials said they
saw tremendous lending potential in Mexico and hoped to use the company's Banamex brand name
to serve the fast-growing Hispanic population in the United States as well.
Tab: 3.6

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Chart: 4.4

Citigroup earns $15 billion after tax each year, which is bigger than any financial services company.
It was at 39 low during the March 2001 trough but has been moving up aggressively. Citigroup
operates in more than 100 countries and has about 140 - 146 million customers. This a true global
story, thus globalization has its competitive edge. For most investors, this a great long-term company
to buy and tuck away. Citigroup has shares in all over the world, and its really leveraging its
footprint to take market share both on the investment banking side as well on the consumer side and
it's a franchise which might endure for at least While Sandy is there.

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Conclusion summary
American capitalisms economic success validates the view that the economy operates best in open
and competitive markets. However, business in America does not completely run without a complex
web of government regulations that shapes many aspects of it financial operations. The United States
has a GDP purchasing power of about $8 - $9 trillion with a growth rate of GDP Growth rate
fluctuating between 3.8 and 3.0%. Its Budget revenue and Budget expenditures fluctuates around $2
trillion per fiscal year. Thus, the US Government actions and decisions influence the financial
market a great deal. Although the American government approach to regulation of its market
economy is far from perfect, truth is that American businesses cannot sustain ultimately by laissez-
faire. Without governments support -- whether by means of monetary/fiscal/foreign, policy
amendment, or spontaneous regulative decision about concurrent matters, the American market
economy would be ultimately chaotic.

Recession hysteria has become the focal point. The blame of bad economic performance also points

at the weakness perceived in the poor technology sector, which had been largely responsible for the

recent boom. The problem, however, according to analysis had not spurred from technology

innovation financing alone, rather it rest on the total deterioration in production value at the cost of

the consumer as witness in the Ford and Firestone case. Other findings show that the growing

pattern of exorbitant employee compensation irregularities taking its toll on shareholder value and its

further discouraging efficiency and excellence, which had been responsible for US economic

leadership position on the global stage. In spite of the innovative intelligent devices and intensity of

American people, the implosion of endogenous exuberance products, lacking substantial utilitarian

value, especially in the telecom sector that proliferates the retail domain so pervasively has

significantly diminished consumer confidence.

However, there are many ways the federal government can the spur growth in the economy. One is

through the federal reserves monetary policy reform, another is through the fiscal or tax poll system.

In addition, less restrictive conditions in financial markets should help lay the groundwork for a

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rebound in economic growth. Argument that revenue projections will decline as the economy

weakens actually boosts the desirability for tax cuts. As expected in the 2001 spring, the rate

reduction could jump-start the sluggish economy and the tax cut should perpetuate further growth

of investments. Lower interest rates means less cost prices for everything from adjustable mortgages

to automobile loans, while lower taxes will give the active public more cash. Some economists might

be in favor of a tax cut for other reasons - for example, a marginal rate reduction will lessen any

work-disincentives in the labor market - but the question remains if fiscal policy is a good way to

fight recessions. A stimulative monetary policy lowers interest rates and hence encourages

investment. This is in contrast to an expansionary fiscal policy - either a decrease in income taxes or

an increase in spending, which will lead to higher interest rates and less investment. If the economy

reacts quickly to one policy and slowly to the other, then the fast-acting policy would be desirable.

Theoretically, the currency markets might expect large US tax cuts to push up real interest rates as

they did in the early Reagan years. However, the wealth effect can only continue its prolific cycle if

savings accelerates over spending. While spending is required, however, it can only reflect the rate of

income stability, which seems to be becoming increasingly dependent on the degree at which

America participates in global economy. Naturally, America still has the upper hand, in reaping the

emerging opportunities of globalization. The quicker this transition occurs, the sooner the U.S.

economy as well rational long-term benefits start to manifest. There is much opportunity in global

finance. US Government's position is best to trigger privatization towards global finance to the

advantage of US investment, which at this era of globalization would be imperative in saving the US


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Investments by Zvi Bodie, et al
Solutions Manual for Use with Investments by Zvi Bodie, et al
Wall Street A History by Charles R. Geisst
New Thinking in Technical Analysis: Trading Models from the Masters by Rick Bensignor
Taxes, Loans, and Inflation: (Studies of Government Finance, Second Series) by C. Eugene
Steuerle, Bruce K. MacLaury
Wealth of Nations (Great Minds Series) by Adam Smith
The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by D. S. Landes
An Analysis Of The Power Of Government To Create And Set A Value On Money By Edwin
Vieira, Jr. - National Alliance for Constitutional Money, Inc.
The Federal Budget: Politics, Policy, Process by Allen Schick with Felix LoStracco
Intermarket technical analysis According to John Murphy
Demographics Profile of a Changing Society: A series of Report on the Economic and
Investment Implication of Demographic Change by R.F. Hokenson Chief Economist DLJ.
A Manual for Writers of Term Papers, Theses, and Dissertations (Chicago Guides to Writing,
Editing, and Publishing) by Kate L. Turabian


Investment Ideas: Dissecting The Bear by William L. Valentine, CFA March 2001
The Importance of an Intermarket Perspective By Louis B. Mendelsohn (Streetwise, the Best of
the Journal of Portfolio Management, 1998, Princeton University Press)
Historical Lessons For Tax Reform by Daniel Mitchell
Productivity and Costs Importance (A-F): Bureau of Labor Statistics March 2000
Country Finance United States Tax incentives The Tax Reform Act
Financial Instability and the Decline of Banking: Public Policy Implications by Hyman P.
Minsky The Jerome Levy Economics Institute

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Brookings Estimates of Long-Term Fiscal Gaps by Bar Rosenburg, (Journal of Portfolio

Brookings Wharton Papers on Urban Affairs by William G. Gale and Janet Rothenberg William
G. Gale, John B. Shoven, and Mark J. Warshawsky (2000)
Setting National Priorities: The 2000 Election and Beyond Robert D. Reischauer and Henry J.
Economist Intelligence Unit (EIU) Journal on Economic Activities and Country Analysis
Economic Policy Institute Annual Report

Comments and Analysis on Current Affairs

Financial Times (FT)

Treasuries Start Off Strong, but Falter as Stocks Strengthen By Anwar A. Husain: FT
Asia-Pacific: Investors shift to mutual funds By John Willman, Mar 22, 2001: FT
Prominent Gauge of future US economic growth by Peronet Despeignes: FT
Tech Stocks In Turmoil: By Joe Leahy And Richard Waters Dec 23, 2000: FT
Greatest workers of all time by Richard Donkin Published: May 11 2001: FT
Is The House Tax Bill Needed To Avert A Recession? By Peter R. Orszag: FT
Financial Services Industry By Ryan Caione: FT
The Yield Curve Lies By Michael Burt Financial Times, Apr 16, 2001: FT
A different kind of wealth effect By John Plender: FT
Shrinking Wealth By Celia Chen: FT
The Yield Curve as a Predictor of U.S. Recessions by Arturo Estrella and Frederic S. Mishkin

The New York Times

Tax (Credit) & Spend: Liberalism's latest social engineering. (Comparison of Bush and Gore tax
plans) by Lawrence A. Kudlow: NY Times
Joseph Kahn, "Treasury Choice Varies from Bush on Tax Outlook, NY Times, Jan 18, 2001

Consumer Reality Check by Sophia Koropeckyj: Briefing

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Organizational Resources

Government Resources
Federal Reserve Statistical Release
National Economic Council economic policy-making process: with respect to domestic and
international economic issues
Costs: The Bureau of Labor Statistics of the Department of Labor.
Council of Economic Advisers: national economic policy
Office of Management and Budget: Surplus and Deficit Data
Office of Science and Technology Policy (OSTP): plays a critical investment role in maintaining
American leadership in science and technology.
Census Bureau

Corporate Analyst Opinion

Wayne Angell chief US economist at Bear Stearns and a former Federal Reserve governor: Fed's
policy-making open market committee.
ROBERT Rubin Chief economist Citigroup and a former Secretary of the Treasury: Fed's
policy-making open market committee.
David Lereah Chief Economist National Association of Realtors (NAR) consumer confidence
and the deteriorating economy sector comparison.
"Perspectives on the Budget Surplus, Alan J. Auerbach and William G. Gale: University of
California, Berkeley

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Financial Analytics
Bloomberg Professional Analytics
Thomson Global Markets
Dismal Scientist
Research Magazine

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