The Fed’s Game

I’ve been confused for a while about what the Fed is up to. Their usual cycle is to contract the money supply to cause economic downturns:

“The Federal Reserve definitely caused the Great Depression by contracting the amount of currency in circulation by one-third from 1929 to 1933.” – Milton Friedman

“However, this time around the Fed is lowering interest rates to stimulate borrowing, right?” This is the kind of muddy thinking that let me to confusion for the past couple months.

Of course not! Our economic problem today is the unwillingness of the banks to lend money, not that there is a lack of people who want to borrow it. The rationale is that due to the housing-bubble collapse the loans are riskier today than they’ve been in a long time. So, what convinces a lender to lend to risky borrowers? High interest rates. What is the Fed doing? Lowering interest rates.

The perfect cover for not lending money, and contracting the money supply.

At the same time, those banks are cashing out as many US Dollars are they can get their hands on from Washington, while the exchange rates still have some value. Once the ‘bailout’ is done, we can expect the government to start monetizing the debt (it can’t borrow that much) and the exchange rates will rationally go through the roof. This is the same game that was played in 1934 when the US was selling all its gold for ~$20/oz before confiscating all the citizens’ gold and raising the price to $35.

This time around, the instruments are slightly different but the game hasn’t really changed much. The last play ended at Bretton Woods, with the US Dollar as the world reserve currency. Who will win this time? The Euro? The Yuan? Something new? Picking the right horse in this race is likely to pay off well for the winner.