Macroeconomic Environment 23

4.1 U.S. Economic Activity

The economic recovery that began in the second 

half of 2009 continued in 2011 and early 2012. 

Nonetheless, the pace of activity and employment 

growth remained quite modest compared with previous 

economic expansions, as a number of factors have 

continued to weigh on growth in spending and 

production. These factors include a depressed housing 

market, the spillover effects of the fiscal and financial 

difficulties in Europe, continued fiscal retrenchment 

of state and local governments within the United 

States, uncertainty about the federal budget and 

related policies, and less credit availability for many 

households and small businesses compared to precrisis norms. 

4 Macroeconomic Environment

Chart 4.1.1 Change in Real Gross Domestic Product

4.1.1 Real Gross Domestic Product

Economic growth continued at a modest to 

moderate pace in 2011 and early 2012. Real 

GDP increased less than 1 percent at an annual 

rate in the first half of 2011, as economic 

activity was held down by temporary factors, 

particularly supply chain disruptions stemming 

from a major earthquake and tsunami in Japan 

and the damping effect of a sharp run-up in 

energy and commodity prices on consumer 

spending (Chart 4.1.1). Growth picked up in 

the second half of the year to an annual rate 

of nearly 2.5 percent, as the effects of these 

temporary factors waned. Real GDP expanded 

at an annual rate of 1.9 percent in the first 

quarter of 2012, and available indicators suggest 

a continued moderate pace of growth in the 

second quarter. Among the factors that are 

hampering growth are a depressed housing 

market, the spillover effects of the fiscal and 

financial difficulties in Europe, continued fiscal 

retrenchment of state and local governments 

within the United States, uncertainty about 

U.S. federal budget and policy, and credit 

availability that is significantly tighter relative 

to pre-crisis norms for many households and 

small businesses. 
24 2012 FSOC / / Annual Report

Consumption and Residential Investment

Real personal consumption expenditures (PCE) 

increased 1.6 percent in 2011 (Q4/Q4) and 2.5 

percent (annualized rate) in the first quarter 

of this year (Chart 4.1.2). Real disposable 

income rose more modestly, held down by the 

weak labor market. The weak pace of income 

growth over 2011 and early 2012, combined 

with increases in consumer outlays, brought the 

personal saving rate down from 5.2 percent in 

late 2010 to 3.7 percent in the first quarter of 

2012 (Chart 4.1.3).

In addition to the weak gains in income, a 

number of other factors also restrained the pace 

of improvement in consumer expenditures. 

Household wealth (relative to income) remains 

well below the elevated levels that prevailed 

in the mid-2000s, when it was supported by 

house prices and household equity holdings. 

Similarly, underwriting standards remain tight 

for many potential borrowers—particularly 

for mortgage credit, which continues to weigh 

down housing demand and refinancing activity 

despite historically low interest rates. In part, 

these factors have been reflected in readings on 

consumer sentiment, which remain low relative 

to levels before the financial crisis, despite 

having retraced much of the decline that 

occurred in the summer of 2011 as difficulties 

in Europe flared and the debate over the U.S. 

debt ceiling became heated. 

The housing market remains strained. In 2011, 

both new and existing home sales remained 

near the low levels that have prevailed, on 

average, since 2008. Residential construction 

activity and housing starts remained tepid, 

especially for single-family homes, given weak 

demand, the abundant stock of vacant homes, 

and low housing prices (Chart 4.1.4). However, 

recent indicators have been somewhat more 

encouraging. Home prices have begun to 

stabilize, with some measures showing an uptick 

in early 2012. In addition, multifamily housing 

starts have been trending upward since early 

2010, albeit from low levels.

Chart 4.1.2 Change in Real Personal Consumption Expenditures

Chart 4.1.3 Personal Saving Rate

Chart 4.1.4 Private Housing Starts
Macroeconomic Environment 25

Business Fixed Investment

Real business fixed investment (BFI) posted 

a solid increase in 2011, rising 8.1 percent on 

a Q4/Q4 basis. However, growth has been 

slower so far in 2012, and BFI as a share of GDP 

remains considerably below its pre-recession 

level. Much of the deceleration in BFI this year 

has been in expenditures on equipment and 

software (E&S), which rose at an annual rate of 

just 3.5 percent in the first quarter after rising 

9.6 percent (Q4/Q4) in 2011; this step-down 

in E&S investment may be related in part to 

renewed concerns among businesses about 

the global economic and financial situation. 

Meanwhile, investment in nonresidential 

structures has increased somewhat, on net, 

in recent quarters after a period of very steep 

declines, but conditions in the sector remain 

difficult: vacancy rates for commercial space are 

still high, prices of existing structures are low, 

and financing conditions for builders are still 

tight despite some signs of recent easing.

Government Purchases

Real government expenditures at the federal, 

state, and local level continue to contract. Real 

state and local government purchases fell by 

2.5 percent on a Q4/Q4 basis in 2011 due to 

ongoing budgetary pressures, continuing the 

pattern seen since the onset of the recession 

and financial crisis. Real federal government 

purchases fell throughout 2011 and early 2012 

following the withdrawal of the fiscal stimulus 

provided during the crisis and large declines 

in federal defense spending in 2011:Q4 and 

2012:Q1.

Imports and Exports

Real exports of goods and services rose 4.7 

percent over 2011, boosted by continued growth 

in overall foreign economic activity. The 

increase in export demand was concentrated 

in the emerging market economies (EMEs), 

while exports to the euro area declined toward 

the end of the year. As U.S. economic activity 

grew modestly in 2011, real imports of goods 

and services rose by 3.6 percent. Altogether, the 

contribution of net exports to growth in real 
26 2012 FSOC / / Annual Report

GDP was essentially zero last year and in the 

first quarter of this year.

4.1.2 The Labor Market

The labor market strengthened over the course 

of 2011 and the first several months of 2012. 

Nonetheless, the improvement in employment 

and other labor market indicators since the end 

of the recession has been modest, and the labor 

market has a considerable distance to go before 

returning to the conditions that prevailed prior 

to the recession and financial crisis.

Nonfarm payroll employment increased at an 

average monthly rate of 153,000 jobs in 2011 

(Chart 4.1.5). The private sector added an 

average of 175,000 jobs monthly last year, while 

government payrolls dropped at an average 

rate of 22,000 per month (mostly at state and 

local governments). During the first half of 

2012, private payrolls advanced about 159,000 

per month, just below the average pace in 2011, 

and the pace of job loss at governments has 

moderated somewhat. Overall through June 

2012, the level of payroll employment remains 

about five million below its peak in January 2008.

The unemployment rate has declined 

significantly, from its peak of 10 percent in 

October 2009 to 8.2 percent in June 2012, 

although it remains far above levels that 

prevailed prior to the recession (Chart 4.1.6). 

Some of this decline in the unemployment 

rate is attributable to reduced labor force 

participation (Chart 4.1.7). While part of the 

reduction in participation reflects demographic 

shifts associated with an aging baby boomer 

population, the weak economy has played an 

important role by discouraging many workers 

from continuing to search for positions. In 

addition, long-duration joblessness continues to 

account for an especially large share of the total. 

In June 2012, 5.2 million persons among those 

counted as unemployed—about 42 percent of 

the total—had been out of work for more than 

six months (Chart 4.1.8). The number of workers 

employed part-time for economic reasons has 

fallen somewhat over the past year, though it 

remains high by historical norms. 

Chart 4.1.5 Net Change in Payroll Employment

Chart 4.1.6 Civilian Unemployment Rate

Chart 4.1.7 Labor Force Participation Rate
Macroeconomic Environment 27

4.2 Private Nonfinancial Balance Sheets 

and Credit Flows 

4.2.1 Nonfinancial Corporate Sector

The ratio of debt to net worth in the nonfinancial 

corporate sector, which had spiked during the 

downturn, continued to decline in 2011. Credit 

flows to this sector have remained relatively strong, 

with robust bond issuance and an increased pace of 

lending from bank and nonbank companies. Credit 

quality indicators remain solid, with low delinquency 

and default rates. 

Nonfinancial corporate balance sheets 

deteriorated significantly during the recession, 

with measures of balance sheet leverage reaching 

historical highs. Corporate balance sheets 

improved markedly in 2010 and a bit more in 

2011. The ratio of debt to net worth in this sector 

is now in line with its average level over the past 

20 years (Chart 4.2.1). Profits at nonfinancial 

corporations increased sharply in 2010 and 

remained high in 2011, driving equity market 

values for nonfinancial corporations back to 

near pre-crisis levels and allowing nonfinancial 

corporations to boost capital through 

retained earnings. In particular, nonfinancial 

corporations have accumulated a substantial 

buffer stock of liquid assets (Chart 4.2.2).

This improvement in corporate profits 

and credit quality supported high levels of 

borrowing by nonfinancial corporate firms. 

In bond markets, which comprise the largest 

source of credit to the corporate sector, gross 

issuance by investment grade nonfinancial firms 

has been very strong (Chart 4.2.3), although 

issuing firms appear to have mainly used these 

bonds to refinance existing debt. Issuance of 

high-yield bonds dropped in the second half 

of 2011, but the pace of issuance through May 

2012 remained above the 2001-2012 average 

annual pace. Corporate bond spreads widened 

during fall of 2011 as investors became more 

cautious in the wake of the U.S. debt ceiling 

talks in August 2011 and developments 

in European markets (Chart 4.2.4). As of 

July 6, 2012 corporate spreads still remained 

elevated relative to early 2011. The amount of 

Chart 4.1.8 Long-Term Unemployment*

Chart 4.2.1 Nonfinancial Corporate Credit Market Debt to 

Net Worth

Chart 4.2.2 Financial Ratios for Nonfinancial Corporations
28 2012 FSOC / / Annual Report

commercial paper issued by businesses edged 

up only slightly over the past year despite 

relatively stable cost of issuance.

The net amount of loans to the nonfinancial 

corporate sector, which includes loans from 

bank and nonbank sources, rose at an annual 

rate of $132 billion in 2011, with the same 

pace of growth continuing in the first quarter 

of 2012. Bank lending to commercial and 

industrial (C&I) borrowers continued to rise 

between June 2011 and April 2012, reaching 

$1.4 trillion. While the bulk of this increase has 

been organic, charter conversions by thrifts 

boosted C&I loans in the banking sector by 

about $16 billion over this period. Over the 

same period, respondents to the Senior Loan 

Officer Opinion Survey (SLOOS) generally 

continued to report less stringent underwriting 

standards and lower spreads on C&I loans to 

large and medium-sized firms (Chart 4.2.5). 

Available indicators of credit quality remain 

solid: the default rate on nonfinancial 

corporate bonds is at a low level by historical 

standards (Chart 4.2.6); C&I loan delinquency 

rates continued to decline through the first 

quarter of 2012 (Chart 4.2.7); and expected 

year-ahead default rates for nonfinancial 

firms as measured by Moody’s KMV model 

remain steady. 

4.2.2 Commercial Real Estate Sector

Financing conditions in the commercial real estate 

sector remain strained following a long period of 

banks reporting tighter underwriting standards 

and subdued commercial mortgage-backed security 

(CMBS) issuance.

In contrast to the relatively sanguine credit 

conditions for corporate borrowers, financial 

conditions in the commercial real estate 

(CRE) sector remain strained amid weak 

underlying economic fundamentals and tight 

underwriting standards by banks. Prices for 

some segments of commercial properties 

have remained at low levels, and vacancy and 

delinquency rates continue to be elevated. 

After a sustained period of tightening, recent 

Chart 4.2.3 Bond Issuance by Nonfinancial Firms

Chart 4.2.4 Corporate Bond Spreads

Chart 4.2.5 Bank Business Lending Standards and Demand
Macroeconomic Environment 29

SLOOS data show that lenders have generally 

refrained from further tightening standards 

on CRE loans. At the same time, moderate 

fractions of respondents indicated stronger 

demand for CRE loans in recent quarters. 

Consistent with these results, the decline 

in CRE loans on banks’ balance sheets has 

slowed over the past year. Nonetheless, credit 

conditions for CRE remain tight by historical 

standards. In particular, respondents to a 

special question in the July 2011 SLOOS 

reported that CRE standards were at or near 

their strictest levels since 2005, and the survey 

results have shown little change in standards, 

on net, since July 2011. 

After relatively strong post-crisis issuance of 

CMBS in the first half of 2011, the amount of 

new CMBS issuance has been more subdued 

recently, and issuance in early 2012 was slightly 

below the pace set in the first half of 2011 

(Chart 4.2.8). CMBS delinquency rates and 

spreads remained high as borrowers struggled 

to refinance much of the approximately $33 

billion in maturing five-year loans that were 

originated at the peak of CRE prices in 2007. 

4.2.3 Noncorporate Business Sector

Small business lending remains subdued, in part 

because of the ongoing low real estate prices that 

have reduced the value of potential collateral for 

small business loans. There are some signs, however, 

that credit conditions for small business are 

gradually improving.

Net worth in the noncorporate sector, which 

is composed primarily of small businesses, fell 

sharply during the downturn but turned up in 

2010 and grew a bit more in 2011. Real estate 

comprises a large share of the assets held by the 

noncorporate sector (Chart 4.2.9), so changes 

in real estate values tend to have a very large 

impact on small business balance sheets. The 

value of real estate assets fell 12 percent in the 

noncorporate sector from 2007 to 2009, leading 

to a significant increase in the ratio of debt to 

net worth (Chart 4.2.10). This ratio recovered 

some in 2010 and 2011, as net worth improved 

Chart 4.2.6 Nonfinancial Corporate Bond Default Rate

Chart 4.2.7 Noncurrent Commercial & Industrial (C&I) Loans

Chart 4.2.8 CMBS New Issuance
30 2012 FSOC / / Annual Report

and debt contracted slightly, but it remains well 

above pre-recession levels.

Small businesses generally have access to a 

narrower range of financing options than 

corporations and thus depend more on bank 

loans, frequently secured by real estate. Since 

the beginning of the financial crisis, lower 

real estate collateral values and strains in 

the banking sector have constrained credit 

availability for many small businesses. However, 

there are signs that credit conditions for 

small businesses are gradually improving. 

Net borrowing by nonfinancial noncorporate 

businesses turned positive in the second half 

of 2011, after declining substantially during 

the crisis (Chart 4.2.11). Furthermore, after a 

sustained period of tightening of standards and 

terms on loans to small businesses, respondents 

to the SLOOS noted some easing on loan 

standards and spreads in recent quarters (Chart 

4.2.12). In addition, since the beginning of 

2012, the fraction of banks reporting stronger 

demand for C&I loans from small businesses 

has edged up. While the stock of small loans to 

businesses on bank balance sheets at the end 

of last year was more than 15 percent below its 

peak before the crisis, these loans ticked up in 

the fourth quarter of 2011, registering their first 

increase since 2008, and continued to increase 

in the first quarter of 2012. 

Business lending by credit unions, which 

predominantly lend to small businesses, 

increased by 6 percent in 2011 to reach nearly 

$16.5 billion. Similar improvements in credit 

conditions are evident in the small business 

surveys conducted by the National Federation 

of Independent Business. The fraction of firms 

reporting that credit had become more difficult 

to obtain declined through the first quarter of 

2012 (Chart 4.2.13). 

Notwithstanding these improvements, the 

fraction of firms reporting difficulty obtaining 

credit remains elevated relative to the pre-crisis 

period. Owners of new businesses, who might 

have tapped into the equity in their homes 

or used their homes as collateral for small 

Chart 4.2.9 Noncorporate Assets

Chart 4.2.10 Noncorporate Credit Market Debt to Net Worth

Chart 4.2.11 Net Borrowing by Nonfinancial Noncorporate 

Businesses
Macroeconomic Environment 31

business loans, have found conditions especially 

challenging in recent years. In addition, 

business receivables at finance companies, an 

important source of small business financing, 

continued to decline through February 2012 

and were down nearly 30 percent from their 

peak in July 2008. 

4.2.4 Household Sector

Household net worth improved slightly, on net, from 

the end of 2010 to the first quarter of 2012. The 

fraction of household income needed to cover debt 

service payments decreased further, though mortgagerelated debt remains high relative to home values. 

Consumer credit has grown steadily, mostly owing to 

an expansion in non-revolving credit, including a 

significant increase in the amount of student loans to 

finance higher education. 

Aggregate household net worth rose almost 

$1 trillion in 2011 to $60.0 trillion (nominal) 

in 2011:Q4, then jumped an additional $2.8 

trillion in 2012:Q1. This large increase in 

household net worth in the first quarter 

primarily reflected gains on corporate equity 

(directly and indirectly held), although gains on 

real estate assets and net saving also contributed 

to this increase in net worth (Chart 4.2.14). 

As discussed earlier, home prices continued to 

decline in 2011 but appear to have stabilized, 

and some measures of home prices have shown 

upticks recently. Owners’ equity in housing has 

remained near a record low of approximately 

40 percent since mid-2008 through March 

2012, roughly 20 percentage points lower than 

its average over 1990 to 2005 (Chart 4.2.15). 

All told, the ratio of household net worth to 

disposable personal income is now around 

its post-WWII average level, although it is far 

below the level reached in 2007. However, not 

all households have experienced a significant 

improvement in their balance sheet positions. 

For example, lower-income households with 

smaller exposures to the stock market have not 

benefitted much from the recovery in equity 

prices over the past several years. 

Household debt outstanding, about threequarters of which is accounted for by home 

Chart 4.2.12 Bank Business Lending Standards and Demand

Chart 4.2.13 Small Businesses’ Difficulty Obtaining Credit

Chart 4.2.14 Household and Nonprofit Balance Sheets
32 2012 FSOC / / Annual Report

Chart 4.2.17 Household Financial Obligations Ratio

mortgages, declined further in 2011. This 

decline represented, to some degree, efforts 

by households to pay down their existing 

debt, as well as a low volume of new mortgage 

originations. It also reflects the effects of 

foreclosures and “short sales,” which have, 

in the aggregate, reduced mortgage debt on 

household balance sheets. Moreover, access 

to residential mortgages remains constrained 

by tight underwriting standards, discussed 

further in Section 5.1.4. Deleveraging by 

households, along with low interest rates, 

various government tax and transfer programs, 

and rising employment and income, have 

helped households manage their monthly 

debt burdens. The household debt service 

ratio—the fraction of disposable income 

needed to cover household debt payments—

continued to fall last year (Chart 4.2.16). The 

financial obligations ratio, which measures a 

household’s burden from a broader measure 

of commitments, including rent payments and 

homeowners’ insurance, also moved down last 

year for homeowners (Chart 4.2.17). 

As of the first quarter of 2012, non-mortgage 

consumer credit outstanding increased nearly 

5 percent from a year earlier to $2.5 trillion. 

Most of this increase in consumer borrowing 

is in non-revolving credit (Chart 4.2.18), which 

accounts for nearly two-thirds of total consumer 

credit as of the first quarter in 2012. Among 

non-revolving credit, student and auto loans 

have been the fastest-growing categories, with 

new student loans primarily originated by the 

federal government. 

Growth in revolving credit, on the other hand, 

has continued to be weak, even contracting 

recently after posting gains in the fourth 

quarter of 2011. The reduction in revolving 

credit is in part driven by the fact that all but 

“super prime” borrowers continue to face 

tight underwriting standards for credit cards 

as lenders pursue higher-quality borrowers. 

While the credit card limits for super prime 

borrowers with credit scores greater than 750 

have been increasing since 2011, limits for 

“prime” borrowers with credit scores between 

Chart 4.2.15 Share of Owners’ Equity in Household Real Estate

Chart 4.2.16 Household Debt Service Ratio
Macroeconomic Environment 33

650 and 749 picked up only slightly. In contrast, 

credit card limits for “subprime” borrowers 

with credit scores less than 650 continued 

to edge down until the end of 2011 (Chart 

4.2.19). Data on credit card solicitations show 

a similar preference by banks toward higher 

quality borrowers.

Delinquency rates for consumer credit remain 

low. Student loan delinquencies and defaults 

are above pre-crisis level, but are below the 

peaks seen during the recession. Relatively low 

delinquency rates for revolving credit and auto 

loans likely reflect, in part, the composition 

shift toward higher-quality borrowers. In 

particular, the increases in delinquency rates 

on credit card and auto loans during the 

crisis were largely driven by a sharp rise in the 

delinquency rate of subprime borrowers, which 

remains significantly above historical levels 

(Chart 4.2.20). In contrast, the delinquency 

rates on credit card and auto loans to super 

prime and prime consumers were more stable 

through the crisis and are currently at their 

historical averages.

At the same time, demand for credit by most 

consumers continues to be modest relative to 

the pre-crisis period as households continue 

to recalibrate their balance sheets in the wake 

of large wealth losses during the crisis, tepid 

gains in labor markets, moderate economic 

growth, and economic uncertainties. Only a 

small fraction of respondents to the SLOOS, 

on net, report stronger demand for credit 

by consumers. Looking across the credit 

spectrum, credit applications increased 

slightly over the past year but, through the first 

quarter of 2012, remained largely subdued 

relative to the pre-crisis period (Chart 4.2.21). 

4.3 Government Sectors 

Government finances in the United States 

deteriorated sharply during the recession, as 

public sector borrowing largely replaced private 

borrowing in credit markets (Chart 4.3.1). So far, 

global financial markets have been able to absorb 

the substantial increase in U.S. federal debt, but 

Chart 4.2.18 Nonmortgage Consumer Credit Flows

Chart 4.2.19 Average Amount of Revolving Credit Available

Chart 4.2.20 Credit Card Delinquency Rates by Credit Score
34 2012 FSOC / / Annual Report

Chart 4.3.2 Federal Unified Budget Surplus

concerns about the prospects for meaningful deficit 

reduction in coming years persist.

4.3.1 Federal Government

The deficit in the federal unified budget 

widened significantly during the recession 

and gradually narrowed thereafter. The 

Congressional Budget Office (CBO) projects 

the deficit in the current fiscal year to be 7.6 

percent of nominal GDP—1.1 percentage points 

lower than in 2011 but substantially above the 

average value of 1.3 percent of GDP for precrisis fiscal years 2000 to 2007 (Chart 4.3.2). 

This appreciable increase in the deficit mostly 

reflects the usual cyclical response of revenues 

and spending to a weak economy, as well as the 

fiscal actions taken to ease the effects of the 

recession and aid the recovery.

The outlook for the budget over the medium 

term is subject to considerable uncertainty 

with respect to both the performance of the 

economy and the policy path that will be 

followed. The CBO presents two scenarios 

based on different assumptions about 

expenditure and tax configurations. In the 

CBO baseline projection for the period 

through 2022, which assumes that current laws 

generally remain unchanged, the deficit shrinks 

appreciably over the next couple of years and 

remains small thereafter. However, in the CBO 

“Alternative Fiscal Scenario,” which is arguably 

more plausible because it generally maintains 

the tax and spending policies that have recently 

been in effect, the deficit narrows much less 

in the near term and turns back up after 2018, 

mainly because of the budgetary pressures 

stemming from the aging of the population and 

rapidly rising costs for health care. Consistent 

with this projection for the deficit, federal debt 

held by the public is expected to rise from 68 

percent of GDP at the end of fiscal year 2011 to 

93 percent of GDP in 2022 (Chart 4.3.3).

Concerns about the budget outlook weighed 

on the rating agencies’ assessments of U.S. 

sovereign debt. In August 2011, Standard and 

Poor’s downgraded the long-term sovereign 

credit rating of the United States, citing that 

Chart 4.2.21 Applications for Credit

Chart 4.3.1 Net Debt Outstanding as a Percent of GDP
Macroeconomic Environment 35

the effectiveness, stability, and predictability 

of American policymaking and political 

institutions had weakened at a time of fiscal 

and economic challenges. (See Box A: Impacts 

of Downgrade of U.S. Treasury Securities.)

Moody’s and Fitch have U.S. sovereign debt 

on negative outlook. These rating actions do 

not appear to have affected the demand for 

Treasury securities, as market participants 

continue to purchase U.S. debt for its relative 

safety and liquidity. Bid-to-cover ratios at 

Treasury security auctions remain at the top 

end of historical ranges, and indicators of 

foreign participation have remained on trend 

with recent years. 

Despite the sizable increase in public debt 

outstanding, net interest costs amounted to 

only about 1.5 percent of GDP in recent years, 

consistent with trends of the past decade but 

lower than average values during the 1990s 

of about 3 percent of GDP (Chart 4.3.4). This 

decline reflects the fact the interest rates 

have fallen to historically low levels even as 

debt outstanding has increased. The average 

maturity of public debt outstanding has 

risen sharply since late 2008 and is above its 

30-year average. 

4.3.2 State and Local Governments

State and local budgets were strained during 

the recession, and municipalities continue 

to struggle to repair their fiscal positions. 

From the middle of 2008 to April 2012, these 

governments cut roughly 650,000 jobs (more 

than 3 percent of their workforces) and 

trimmed other operating expenditures to satisfy 

balanced budget requirements. They have also 

reduced capital expenditures, which, in real 

terms, have fallen to their lowest levels since the 

late 1990s. In part because of the weakness in 

capital spending, state and local borrowing has 

decelerated noticeably since the onset of the 

recession, and posted a small decline in 2011 

and in the first quarter of 2012 (Chart 4.3.5).

State and local government tax revenues, in 

aggregate, began to register mild growth in 

2010 after declining in the aftermath of the 

Chart 4.3.3 Federal Debt Held by the Public

Chart 4.3.4 Interest Outlays and Average Maturity of U.S. 

Public Debt

Chart 4.3.5 Change in State and Local Government Debt
36 2012 FSOC / / Annual Report

Chart 4.3.7 Change in Local Tax Revenue

Chart 4.3.8 Municipal Bond Issuance by Type

financial crisis (Chart 4.3.6). Much of the 

improvement has been at the state level, where 

personal income tax receipts in particular 

have picked up as the economic recovery has 

proceeded. In contrast, tax collections at 

the local level have exhibited essentially no 

growth over the past two years, mainly because 

property tax collections, which account for 

roughly three-fourths of local tax revenues, 

have been depressed by the downturn in home 

prices and a reluctance to raise tax rates at a 

time when real incomes of constituents are 

under pressure (Chart 4.3.7).

Overall, the resources available to state and 

local governments to finance their spending 

remain tight. The sector’s tax revenues are 

only slightly higher than they were in 2008. 

The federal stimulus grants provided under 

the American Recovery and Reinvestment Act 

of 2009 have largely wound down, and other 

initiatives (e.g., the Build America Bonds 

program) have expired. Many states have cut 

back on assistance to their localities in order to 

shore up their own budgets. Finally, balances 

in reserve funds, which provide an important 

safety valve in times of budgetary stress, have 

been depleted in many cases.

As a result of these budgetary issues, net credit 

flows to state and local governments have been 

mixed over the past year. While the amount 

of revenue bonds issued continues to exceed 

the amount of general obligation bonds, the 

share of general obligation bonds among the 

total issuance increased substantially in 2012 

(Chart 4.3.8). Net issuance of municipal bonds 

has been slow as of late, in part reflecting the 

weakness in infrastructure investment and 

ratings downgrades by Moody’s over the past 

12 months, which have substantially outpaced 

upgrades. At the same time, the cost of 

municipal bonds—as measured by the yield 

ratio to similar maturity Treasury securities—

has risen, with investors demanding higher 

returns from issuers facing fiscal challenges 

(Chart 4.3.9). The issuance of Variable Rate 

Demand Obligations (VRDOs), an important 

source of funding for municipalities, has 

Chart 4.3.6 Change in State Tax Revenue
Macroeconomic Environment 37

also been declining since the financial crisis 

(Chart 4.3.10). A primary reason is the gradual 

retraction of European banks from providing 

liquidity to this market. 

Budget trajectories will remain challenged 

in coming years, as many state and local 

governments will need to increase their 

contributions to their employee pension funds, 

both to rebuild assets after experiencing 

significant financial losses and to address 

chronic underfunding during the past 

decade. In addition, many governments are 

not setting aside money to fund their ongoing 

obligations to provide health care to their 

retired employees. Unfunded liabilities remain 

substantial. Estimates of aggregate unfunded 

pension liabilities span a wide range, in part 

because of differences in how liabilities are 

valued, but may be in the range of $2 trillion 

to $3 trillion. (For an additional discussion 

of accounting issues related to state and local 

pension funds, see Section 5.3.5.) Estimates 

for the cost of providing retiree health benefits 

are subject to even greater uncertainty, in part 

because of the difficulty of projecting health 

care costs decades into the future, but one 

estimate put the states’ collective unfunded 

liability as of 2010 at over $625 billion.

4.4 External Environment

Outside of the United States, both realized and 

prospective growth rates have been mixed over the past 

year. The primary financial stability focus has been on 

the developments in Europe. Despite ongoing efforts 

by European authorities to contain the crisis, debt 

sustainability concerns, fiscal consolidation efforts, 

bank deleveraging, and funding market stresses on 

banks and sovereigns continue to weigh on European 

growth prospects. Outside of the euro area, foreign 

growth picked up in 2012:Q1, with lower growth 

in the euro area and China partly offset by more 

positive developments in other regions. The tone of the 

incoming data in 2012:Q2 is decidedly weaker. 

4.4.1 Advanced Foreign Economies

In the aggregate, the advanced economies 

maintained positive growth through 2011 and 

Chart 4.3.9 Municipal Tax-Exempt Bond Yield Ratios

Chart 4.3.10 ARS and VRDO Funding of Long-Term Muni Bonds
38 2012 FSOC / / Annual Report

Chart 4.4.3 Euro Area GDP Growth

early 2012 (Chart 4.4.1). The growth rates 

across advanced economies reflect a mix of 

more positive outcomes in the United States 

and Japan, among others, and the challenges 

within European countries in managing fiscal 

problems, bank funding stress and deleveraging, 

and structural change (Chart 4.4.2). 

Euro Area Economic Conditions and 

Policy Initiatives

Over the last 12 months, the euro area 

sovereign debt crisis intensified as concerns 

about the sustainability of public finances and 

the robustness of banks in some countries 

soared. Some European financial institutions 

faced reduced access to funds, reflecting in 

part their large exposures to stressed sovereigns 

as well as their reliance on wholesale funding 

markets, including short-term dollar funding 

provided by money market funds. European 

leaders recognize the need to deepen their 

economic and monetary union, as exemplified 

by the new fiscal compact treaty signed by most 

European Union (EU) members in March 

2012 and by the proposal to establish a single 

European banking supervisor put forth in June 

2012. Work continues on elaborating a systemwide solution capable of commanding both 

political and market support.

The euro area economies experienced a 

widespread slowing of economic activity due 

to the intensification of the crisis, the effects 

of banking problems and the related bank 

deleveraging on lending to the real economy, 

and the impact of fiscal consolidation efforts. 

Despite various measures implemented by the 

European authorities to combat the crisis, 

discussed below, the euro area GDP contracted 

by 1.2 percent (annual rate) in the fourth 

quarter of 2011, and the GDP growth rate 

for the first quarter of 2012 was near zero. 

Similarly, labor market conditions deteriorated 

further, as the unemployment rate reached 

11.1 percent in May 2012, the highest level 

since 1995. 

Growth prospects in the euro area differ across 

countries (Chart 4.4.3). Germany, France, and 

Chart 4.4.1 Real GDP Growth

Chart 4.4.2 Developed Market Economies GDP Growth
Macroeconomic Environment 39

Ireland continue to grow, although at a more 

subdued pace, while Italy, Spain, Portugal, 

and Greece are projected to contract, with 

unemployment rates rising substantially. 

Vulnerable European countries continue to 

face important challenges as they strive to 

improve fiscal positions, strengthen vulnerable 

banks, and carry out structural reforms to 

improve their long-term growth outlook, even 

as short-term growth is weak or negative. The 

stresses in the sovereign debt markets of euro 

area countries are discussed in greater detail 

in Section 5.1.

European authorities responded to these 

developments with a number of policy 

measures. In response to Greece’s plunging 

output and challenges meeting fiscal targets, 

EU and IMF officials, the Greek government, 

and private creditors finalized an enhanced 

rescue package in February 2012. This package 

included a more ambitious private-sector debt 

exchange involving a significant principal 

write-down, together with additional official 

financing through early 2016. (See Box B: 

Greek Sovereign Debt Restructuring.)

Additionally, European authorities took actions 

to improve the fiscal governance in the region 

and to enhance their ability to provide financial 

support to euro area countries under stress. 

EU members, excluding the United Kingdom 

and the Czech Republic, signed a new fiscal 

compact treaty designed to strengthen fiscal 

rules, enhance surveillance, and improve 

enforcement. This treaty, if ratified, would 

require countries to legislate national fiscal 

rules and should generally limit structural 

fiscal deficits to 0.5 percent of GDP. Authorities 

moved up the introduction of the European 

Stability Mechanism (ESM), a permanent €500 

billion lending facility, to July 2012—about 

a year earlier than originally planned. In 

addition, they agreed to increase the combined 

lending capacity of their rescue facilities from 

€500 billion to €700 billion, of which €500 

billion remains uncommitted. Moreover, 

European authorities augmented the scope and 

flexibility of the existing facilities, empowering 
40 2012 FSOC / / Annual Report

Chart 4.4.4 ECB Liquidity Providing Operations them to purchase sovereign debt in primary and 

secondary markets and offer debt guarantees.

European policymakers also took steps to 

strengthen the capital positions of euro area 

financial institutions. In October of 2011, the 

European Banking Authority (EBA) announced 

that large banks would be required to build 

up “exceptional and temporary” capital 

buffers to meet a core tier one capital ratio 

of 9 percent and cover the cost of marking to 

market their sovereign debt exposures by the 

end of June 2012. According to a December 

2011 EBA report, 62 banks intended to create 

capital buffers equivalent to €98 billion, 

about 25 percent larger than required. (This 

does not include the Greek banks and three 

other institutions that would be recapitalized 

separately by national authorities.) More 

recently, in June 2012, Spain requested EU 

assistance to recapitalize its banking sector. 

(See Box C: Recent Fiscal and Banking 

Developments in Spain.) Finally, in an effort to 

address the link between banks and sovereigns, 

euro area leaders agreed in late June 2012 to 

establish a single supervisory mechanism for 

banks in the euro area and to grant the ESM 

the possibility of recapitalizing banks directly.

Meanwhile, the European Central Bank (ECB) 

adopted various policy measures to support 

liquidity conditions in financial markets. First, 

in August 2011, the ECB resumed purchases 

of euro area marketable debt, including the 

debt of Italy and Spain, in order to improve 

the functioning of sovereign debt markets 

and facilitate the transmission of monetary 

policy in the region. Then, in December 2011, 

the ECB eased rules on collateral for ECB 

refinancing operations and scheduled two 

longer-term refinancing operations (LTROs) 

to improve banks’ funding conditions. With 

the LTROs, the value of outstanding ECB 

liquidity providing operations has increased to 

over €1.25 trillion (Chart 4.4.4). Moreover, in 

November 2011, the Bank of Canada, the Bank 

of England, the Bank of Japan, the ECB, the 

Federal Reserve, and the Swiss National Bank 

engaged in coordinated actions to enhance 
Macroeconomic Environment 41

their capacity to provide liquidity support 

to the global financial system. In particular, 

the reduced fees applied to draws on dollar 

liquidity swap lines provided by the Federal 

Reserve, as well as the extended expiration of 

these facilities, were intended to ease strains 

in financial markets and thereby mitigate the 

effects of such strains on the supply of credit to 

households and businesses.

These measures contributed to improvements 

in euro area financial conditions during 

the first few months of this year, with dollar 

funding pressures substantially diminished. 

The net result was a considerable narrowing of 

euro-dollar foreign exchange (FX) swap basis 

spreads, reflecting reduced short-term dollar 

funding pressure for euro area institutions 

(Chart 4.4.5). Recent utilization of the dollar 

liquidity swap lines peaked at over $100 billion 

in February 2012, with the outstanding amount 

for the Federal Reserve’s dollar liquidity swap 

lines at $28 billion as of July 4 (Chart 4.4.6). 

Growth and financial stability conditions in 

the euro area remain under pressure. Market 

participants are attentive to the limited capacity 

of the euro area financial backstop in the 

context of its multiple possible uses. Although 

the Greek debt restructuring and subsequent 

triggering of credit default swap (CDS) 

contracts, discussed further in Box B: Greek 

Sovereign Debt Restructuring, passed without 

broad market disruption, much uncertainty 

remains in the region. Uncertainty about fiscal 

consolidation and structural reform highlight 

the challenges of adjustment within a monetary 

union. Meanwhile, concerns about other 

European peripherals (including Portugal, 

Ireland, Italy, and Spain), especially around 

fiscal sustainability, health of their banking 

sectors, and general competitiveness of their 

economies, continue to weigh on real growth 

and financial activity in these countries.

4.4.2 Emerging Market Economies

In the second half of last year, economic growth 

in many EMEs slowed slightly, as earlier policy 

tightening, a weakening of external demand 

Chart 4.4.5 Euro-Dollar Implied FX Swap Basis

Chart 4.4.6 Total Swap Line Amount Outstanding
42 2012 FSOC / / Annual Report

Chart 4.4.8 Net International Financial Flows to EMEs

owing to the fiscal crisis in Europe, and supply 

chain disruptions stemming from floods in 

Thailand weighed on growth (Chart 4.4.7). 

At the beginning of this year, growth in EMEs 

rebounded, reflecting a restoration of the 

normal supply chain and some improvement in 

demand from advanced economies. However, 

the indicators for the second quarter of 2012 

suggest significantly weaker activity in EMEs.

On balance, EMEs have received substantial 

volumes of net inflows of capital since late 2009, 

which also contributed to currency appreciation 

pressures. These inflows decelerated in the 

second half of last year, reflecting both a 

general flight to safety and concerns about 

growth spillovers from the deteriorating 

situation in Europe (Chart 4.4.8). Declining 

commodity prices are also a concern for 

some emerging economies, particularly in 

Latin America. Overall, while growth across 

major EMEs, including Brazil, Mexico, India, 

Russia, and China, stayed firmly in positive 

territory, these global headwinds weighed on 

local prospects.

Chinese growth prospects remain relatively 

solid by international standards. Year-overyear growth slowed in 2012:Q1 to just above 8 

percent, reflecting weaker investment spending, 

with macro-prudential restrictions weighing 

on the property sector, and slower export 

growth, especially to Europe. A possible hard 

landing of the Chinese economy is a risk that 

could spill over to other EMEs and the global 

economy, which has created some anxiety in 

financial markets. There are growing concerns 

that weaker external demand in the advanced 

economies, combined with a deceleration in 

domestic investment, could lead to a more 

prolonged economic slowdown in China than 

was previously expected. Another source of 

concern is the movement of savings into lesswell-regulated nonbank financing channels 

in an effort to obtain higher yields. Finally, 

additional risks could emerge from stresses in 

the banking sector, stemming from the massive 

increase in credit to the domestic economy 

(“social financing” in the official Chinese 

Chart 4.4.7 Emerging Market Economies GDP Growth
Macroeconomic Environment 43

terminology), deployed as part of China’s policy 

response to the global financial crisis in 2008-

2009 (Chart 4.4.9). To contain a potential 

run-up in inflation, property prices, and debt 

levels resulting from this credit expansion, 

Chinese authorities began taking a tighter 

monetary stance in late 2010, with some success. 

But with the latest data pointing to weakerthan-expected economic activity in China in 

the first five months of 2012, authorities began 

implementing a number of fiscal and monetary 

measures to support growth. 

Chart 4.4.9 Change in Total Chinese Social Financing