Bernanke's Choices

The famous Austrian economist, Ludwig von Mises, said

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

What this means is that the Fed has a choice: pain now or much more pain later. Currently, Bernanke is trying to keep the credit expansion going. The Fed can keep extending credit at cheaper and cheaper prices by lowering interest rates. Eventually, though, the debt level will become so high that banks will become reluctant to extend credit at any price or debtors will refuse to take on more debt. At that point, the Fed's efforts to increase the credit expansion will be like "pushing on a string." The money supply will start contracting and the Fed will be left with a choice. It can print money and drop it from helicopters. This will lead to the total destruction of the dollar. Or it can let interest rates rise to the free market level as Paul Volker did in 1979.

The problem is that in the late 70's, the United States was a creditor nation and today we are a massive debtor nation. Will the Fed have the stomach to let interest rates to double digits to save the dollar? Many doubt it. The dollar and gold are telling a story. Gold is hitting new highs and is close to an all time high of $930/oz. The dollar index is at 75.58, close to its all-time low set in November. Even if the Fed is successful in the near term at keeping the credit supply expanding without destroying the dollar, it will only result in more future pain as Mises pointed out. And as somebody pointed out, inflation makes rich people richer and poor people poorer. Deflation makes everybody poorer. The market is currently telling us that the Fed wants inflation and will get it. But markets are often wrong. These are interesting times.