Potholes in the Road – Lessons from the End of Cheap Money

Potholes in the Road – Lessons from the End of Cheap Money

Potholes in the Road

Lessons from the End of Cheap Money

Wes Chapman

June 22, 2013


Road Trip!

Two weeks ago my wife and I took an old-school road trip – driving a U-Haul truck full of furniture on a two day romp from New Hampshire to Nashville. The truck was new, the weather mostly good, and she read aloud for most of the trip from Nadeau & Barlow’s delightful new book, The Story of Spanish, a magnificent work that ties the origins of modern Spanish to the very idiosyncratic history of the Iberian Peninsula. As I feasted on this virtuoso audio-book performance, I watched America on the march on the Great Craton – mile after mile of new highways being built, old ones repaired and bumper-to-bumper trucks loaded with steel in all states of fabrication. The motels and restaurants along the way were packed, new construction sprouting like mushrooms after the rain, and new factory parking lots full – juxtaposed with the rotting hulks of old brownfield sites. On balance it was a great trip for a linguistically-oriented, economic optimist.

 American Roads with Trucks

America on the move

In the weeks before we hit the road, the bond market had already started to show signs of sobering up, after a five year monetary bender. As we drove along, taking it all in, I mentioned that my meager supply of rolling puts on the 20 year Treasury might be insufficient for what was coming. I was right.

We have witnessed a 30 year epic decline in interest rates, culminating in short term interest rates driven to near zero levels by the US Federal Reserve (and all other major central banks), and the concurrent (and much more controversial program) of so-called quantitative easing – QE (open market bond purchases). This string of QEn+1  programs started to provide liquidity to a desperately illiquid bond market in 2008, and ended (last week?) in an $85 billion a month program of mortgage bond purchases to prop up the financial markets in general, and the housing market in particular. Vastly different problems, but treated with the same tincture of cheap money.

Last week, the hint of the end of cheap money by Mr. Bernanke brought the stock market to its knees – losing over $750 billion in a single day. And this is at the hint that the gravy train will have to end – what happens when the Fed actually stops buying bonds. Even worse, the market quakes at the thought of the Fed actually turning into a seller of its recently acquired $3+ trillion in bonds.

Let’s take a step back and consider – just for a minute – if the orgy of bond acquisitions over the last 3 years, and the last 30 years of ever cheaper money, has actually done anything to propel economic growth and reduce unemployment.

If Excess Liquidity Propels Growth and Jobs,

Fed Balance sheet growth

Federal Reserve Balance Sheet – 95 years to hit $600 billion,

5 years to hit $3 trillion

Then Doing it Consistently for Long Periods,

Declining Bond Rates

20 years of ever cheaper money

And Lots More of it

Money Supply Growth Long Term

Money Supply Nearly Triples


Ought to Produce Record Employment – But Didn’t

Civilian Employment

The trend of employment continues down

As Consumer Sentiment Weakens over the Long Term

Consumer Sentiment

Cheap and Plentiful Money does not Equal Happiness

Money Turnover Slows as Reserves and Fear Rise

Declining Multiplier

When we have more of any asset, we use it less efficiently

Beginning with the dual mandate (http://www.mwestonchapman.com/chaos-theory-in-financial-markets-the-feds-dual-mandate/) we sent the Federal Reserve into battle to slay the monsters of economic cyclicality in general and unemployment in particular. The Fed is a well-run and closely monitored institution – much like the US military. Both are staffed by professionals, largely insulated from short-term political vacillation, and generally recognized as “best-in-class” in the world. But like the military, have we asked too much of it? Have we pushed it into a battle that it can’t possibly win? Consider the following:


Basic Mission


“Extended   Mission”


Federal   Reserve

Maintain market liquidity, control   inflation, lender of last resort

Long-term record of great success

Fight unemployment, reduce economic   cyclicality

Extended, debilitating fight over   decades, using the tools available – and resulting in nearly total failure

US Military

Defend US and its allies against   assault by foreign powers

Brilliant record since British   invasion , War of 1812

Impose elected democracy on peasant   cultures and religious fundamentalists stuck in the 12th century

Extended, debilitating fight, decades   long, using the tools available – and resulting in nearly total failure


For a variety of reasons, tincture of time probably has had more to do with the current recovery than the impact of cheap money – particularly in the last couple of years. Furthermore, the extreme reliance on cheap money has promoted a series of asset bubbles (e.g. oil, Chinese apartments, gold) during the recovery, which have distorted the recovery and reduced demand growth. It is important to remember that the ribbons of moving steel across the highways of America are the real expression of economic wellbeing – not the “sturm und drang” of hedge funds rebalancing their portfolios.

I predict that after the whining stops, the end of ultra-cheap money will do nothing to hurt the economy. As recently stated by Robert Arnott, Chairman of Research Associates,  “It creates massive misallocation of resources, and it has never been correlated with improved future growth prospects anywhere”. We’re almost 5 years into this recovery, and they very rarely last more than 7 years – so the real question regarding the US economy is – what are the probable causes of the next downturn?

My Top 5 Candidates for the Next Crisis     

1)      Popping the Chinese Asset Bubble. The Baron’s piece this week on this subject was priceless. The fundamental problem gets back to the uncomfortable fit between centrally planned economies and active participation in the global marketplace – both financial and trade. The Chinese economy has grown into an industrial behemoth – the second largest in the world – providing the largest source of demand growth and industrial production growth. In the last decade, the Chinese economy has been an archetype of the worst of both capitalism and centrally planned economies – producing vast amounts of excess assets (central planning), financed by vast amounts of unaccountable credit (capitalism). The Chinese built the South China Mall, twice the size of the Mall of America in 2005 to accommodate an anticipated flood of shoppers, and it remains 99% unoccupied to this day. There is a ghost city in Inner Mongolia – Ordos – reputedly capable of providing all municipal needs for 1 million people – except it is totally vacant. All of the major cities are surrounded by rings of totally empty apartment buildings. None of this riotous excess is reflected properly on any balance sheets used to finance it, and therein lies the rub. Last week saw a spike in Chinese borrowing rates into the mid-teens – always a precursor of bad news to come.

 Empty roads of A-town ordos housing complex

Plenty of Vacancy Signs in Ordos

2)      The Rotten Euro. I called the Euro a dead duck back in September of 2011, and stand by the prediction, http://www.mwestonchapman.com/the-end-of-the-euro/. In the best of Wall St. traditions, if you make a controversial call, never give a date – which fortunately I didn’t, because the Euro has held on a lot longer than I had expected. The bad news which had been papered over in Ireland and other economies is just starting to come to light, and the sort of economic Verdun seen in Greece for the last 5 years will eventually produce a violent counter-reaction, either in the ballot box or on the street. No confederation has ever issued a successful fiat currency – and I have no reason to believe that the Euro will be the first.

3)      Rotten Banks. The G20 operates its banking system with a series of poorly designed regulatory regimes – mixed between regional, national and multinational regulators. The funding sources are all over the place, and there is no lender of last resort on a systemic basis. While this sounds like a derivative of point 2, the rot in the banking system is opaque and political in ways that make the fundamentals of the Euro look good. The long decline in interest rates has allowed banks to hide their non-performing loans behind roll-overs, hidden by very low rates. Accounting gimmicks are the order of the day to hide losses and inflate capital.

4)      Rebelion de las Masas (with apologies to Jose Ortega y Gasset). Since the great summer of rebellion in the Western World in 1968, we have seen crime rates fall, roughly as the median age of the population increased. This has produced a localized myopia towards the risks of youthful uprisings like those that have recently swept the Arab world, and are currently sweeping through Turkey and Brazil. The economic impact of these is both supply and demand side based. We really have no idea how the world will sort out the persistent and dramatic imbalances in population and economic growth rates, and it’s been a long time since we actually saw any non-religious political turmoil. Of the G20 members, China is uniquely vulnerable to potential political upheaval, and any supply side disruption out of China could produce an immediate spike in inflation for all manufactured products.

El Pueblo Unido

Unhappy Young People in a Public Timeout

5)      The unforeseen consequences of cheap money. The July 2013 Scientific American has a superb article, Walls of Water by Dana Mackenzie which examines why the pollution from the BP Deepwater Horizon oil spill seemingly vanished, and when it may reappear. As with money in economics, pollutants in the ocean do not disperse evenly. The oceans have invisible walls called transport barriers which block uniform dispersion. When these transport barriers coalesce into a coherent system they are called Lagrangian coherent structures, which bring predictability to seemingly chaotic systems; like a disastrous oil spill, or wildly speculative abuse of monetary policy. In truth, the Fed has no idea whether its cheap money efforts are helpful or not, and if not when and where the trouble will emerge. A maritime analogy is the case of the SS Jacob Luckenbach, which sunk off the coast of San Francisco in 1953, and began polluting the coast annually beginning in 1991, and was not discovered as the cause until 2002. The Fed has been dumping ever more monetary pollutants into a system with pretty well defined transport barriers for several decades, in the vain hope that economic prosperity would result. Like the oil from the Luckenbach, this has been building up somewhere out of sight, waiting to show up as the monetary equivalent of an oil spill somewhere in the future.

Wes Chapman
Written by Wes Chapman

2 Comment responses

  1. Avatar
    June 23, 2013

    The TBT has been an outstanding investment lately.


  2. Avatar
    June 24, 2013

    Wise words Master. 2 reactions: Top Candidate for the Next Crisis — #5, simply because it drives the other 4 to varying degrees, so the oil slicks are are visibly bubbling up;

    More broadly, the dual mandate is a failure. Time to rescind it. You lefties, take the lead if you really care about the middle class. While disrupting the real economy, the financial engineers ride it to the moon — those same folks you want to banish to the 9th rung.