Life After ZIRP
Roughly three years ago, after traversing between Los Angeles and San Francisco via the expansive San Joaquin Valley, we penned the article, Salting the Economy to Death. At the time, the monetary order was approach peak ZIRP.
Our boy ZIRP has passed away. Mr. 2.2% effective has taken his place in the meantime. [PT]
We found the absurdity of zero bound interest rates to have parallels to the absurdity of hundreds upon hundreds of miles of blooming crop fields within the setting of an arid desert wasteland.
Given today’s changing financial conditions, namely the prospect of a sustained period of rising interest rates, we have taken the opportunity to refine our analysis. What follows is an attempt to bring clarity to disorder.
The natural starting point for the topic at hand is from a place of delusion. That is, the popular delusion that central planners can stimulate robust economic growth by setting interest rates artificially low. The general theory is that cheap credit compels individuals and businesses to borrow loads of cash – and consume.
Over a sample size of five to ten years, say the growth half of the business cycle, central bankers can falsely take credit for engineering a productive economy. Profits increase. Jobs are created. Wages rise. A cycle of expansion takes root. These are the theoretical benefits to an economy that central bankers claim they impart with just a little extra liquidity. In practice, however, this policy antidote is a disaster.
Without question, cheap credit can have a stimulative influence on an economy with moderate debt levels. But once an economy has reached total debt saturation, where new debt fails to produce new growth, the cheap credit trick no longer works to stimulate the economy. In fact, the additional credit, and its flip-side debt, distorts prices and strangles future growth.
Monetary policy over the last three decades and over the last decade in particular, has placed the economy in the unfavorable position where more and more digital monetary credits are needed each month just to stand still.
After nearly a decade of ZIRP, from December 2008 to December 2015, the structure of the economy was distorted to the point where a zero bound federal funds rate actually became restrictive. The Fed’s incremental increases to the federal funds rate since then, are now draining liquidity from the financial system at an accelerating rate. A dangerous situation is unfolding.
“Get up – keep in line, It’s gettin’ tighter all the time
You say you’re feelin’ fine, It’s gettin’ tighter all the time”
Moreover, applications of additional government debt, through fiscal stimulus, also serve to promote the economy’s ultimate demise. President Trump’s tax cuts may have temporarily increased GDP growth. But they have also spiked the deficit, resulting in a permanent increase to the national debt. The fleeting burst of growth has been borrowed from the future at the expense of tomorrow’s tax payers.
The fundamental fact is that the current financial and economic paradigm, characterized by heavy handed fiscal and monetary intervention, is an epic problem. Debt based stimulus is both sustaining and killing the economy at the same time. No doubt, this is a ridiculous situation. Here we will look to California’s San Joaquin Valley for parallels…
The World’s Richest Agricultural Valley
Dropping down the backside of the grapevine from the Tejon Pass, along Interstate 5 between Los Angeles and San Francisco, one is greeted by an endless sea of agricultural fields. These farms of the mega San Joaquin Valley are not the 160-acre family homestead farms rooted in the 19th century settlement of the Midwest. Nor are they in the yeoman farmer tradition envisioned by Thomas Jefferson. They are large-scale, highly productive, corporate farms.
Indeed, if you’ve never seen them, these massive agricultural operations are quite a sight. Yet what is even more incredible is that they exist at all. Given the dry conditions of the area, it is a miracle that anything – aside from cactus and scrub – grows here.
As University of California Berkeley Professor Emeritus, James Parsons wrote:
“The southern part of the valley was a barren desert waste with scattered saltbush when first viewed by Don Pedro Fages in 1772 coming from the south over Tejon Pass.”
“Less than five inches of rain annually falls in southwestern Kern County, maybe ten inches at Fresno. Pan evaporation in a summer month on the west side pushes 20 inches.”
Still, the barren desert wasteland and parched conditions observed by Fages nearly 250 years ago, including a negative water cycle, didn’t stand in the way of what was to come. With an outsized imagination, several mega water diversion projects, federal and state subsidized water, and cheap migrant field workers, mankind was able to create what has been called “the world’s richest agricultural valley, a technological miracle of productivity.”
Irrigation of fields in the San Joaquin Valley [PT]
Photo credit: Joe Mathews
Yet endlessly dumping chemical fertilizers, pesticides and herbicides, and imported water on sandy soil underlain by indurated hardpan is not without consequences. What has stimulated the productive miracle of the San Joaquin Valley over the last century is the same blend of factors that has propped up America’s financial markets and blown out government debt loads over this same period. Cheap credit and excess liquidity.
In his magnum opus, Cadillac Desert, which documents the insanity of water resource development in the west up through most of the 20th century, the late Marc Reisner offers the following characterization:
“Like so many great and extravagant achievements, from the fountains of Rome to the federal deficit, the immense national dam-construction program that allowed civilization to flourish in the deserts of the West contains the seeds of disintegration; it is the old saw about an empire’s rising higher and higher and having farther and farther to fall.
Without the federal government there would have been no Central Valley Project, and without that project California would never have amassed the wealth and creditworthiness to build its own State Water Project, which loosed a huge expansion of farming and urban development on the false promise of water that may never arrive.”
Pistachio orchard in a dry part of the valley. [PT]
Photo via researchgate.net
Choking On the Salt of Debt
In the San Joaquin Valley, vast irrigation networks convey water thousands of miles to make the desert bloom. But as surface water is conveyed along the open California aqueduct, it both evaporates and collects mineral deposits. The combination of these factors concentrates the water’s salt content. Then, as it is applied to irrigation, the residual salts collect in the soil.
After decades of this, along with the over-application of fertilizer through mechanized fertigation systems, the salt in the soil has built up so that it strangles the roots of the plants. To combat this, over-watering is required, because the irrigation water – while salty – is fresher than the salt encrusted soil. By applying excess irrigation water, the soils around the plants are temporarily freshened up so that crops can grow.
Yet, at the same time, this over-watering accelerates the mass quantity of salt being applied to the soil. There is no outlet for the salt to flush to; the valley is the basin’s terminus. Thus, in this grand paradox, the relative freshness of the excess water that is keeping the farmland alive is, at the same time, the source of the salt that is killing it. Reisner further explains:
“Nowhere is the salinity problem more serious than in the San Joaquin Valley of California, the most productive farming region in the entire world. There you have a shallow impermeable clay layer, the residual bottom of an ancient sea, underlying a million or so acres of fabulously profitable land. During the irrigation season, temperatures in the valley fluctuate between 90 and 110 degrees; the good water evaporates as if the sky were a sponge, the junk water goes down, and the problem gets worse and worse. Very little of the water seeps through the Corcoran Clay, so it rises back up to the root zones — in places, the clay is only a few feet down — water logs the land, and kills the crops.”
So, too, goes the U.S. economy. After nearly a decade of rapidly expanding its balance sheet, and pumping cheap credit and excess liquidity into financial markets, the Fed has produced a similar paradox. They must keep expanding the money base to keep the economy afloat… but in doing so they are ultimately killing it.
US monetary base vs. the S&P 500 Index. After the end of QE3, the monetary base began to stagnate – the 2016 dip and subsequent rebound was largely related to a reduction and rebound in bank reserves as Treasury deposits with the Fed first increased and then decreased again. True broad money supply growth actually accelerated at the time. This is no longer the case. QT is now beginning to affect money supply growth, as the pace of commercial bank lending continues to be anemic. The slowdown in money supply growth should begin to affect risk asset prices and economic activity with a lag. [PT]
Of course, the Fed knows it cannot expand its balance sheet without periodic, and abrupt, reductions. These are needed to whipsaw overextended debtors and attain some semblance of connection between the economy and financial markets. What’s even more absurd about our present circumstances is that the Fed is reducing its balance sheet and increasing the federal funds rate so that it can later increase its balance sheet and cut the federal funds rate to combat the forthcoming recession that will be exacerbated by its own actions.
To compound the matter, Trump’s tax cuts and trade war, during the waning days of a near decade long economic expansion, are pushing interest rates upward. Higher borrowing costs will choke the economy, which depends on cheap credit to function.
The root of the problem: total US credit market debt has climbed to almost $70 trillion as of Q1 2018. [PT]
This, in short, is why it doesn’t matter if the Fed raises the federal funds rate or cuts the federal funds rate, or if Uncle Sam borrows more or borrows less. At this point, there is no way out. The present financial order, like the salty crop fields in the San Joaquin Valley, is doomed to choke on the salt of debt.
Only several lifetimes – or more – of fallow conditions will restore economic growth and fertility to the country. The demise of the San Joaquin Valley as an agricultural region, however, will be indefinite.