When economist Milton Friedman celebrated his 90th birthday, Ben Bernanke, the current Federal Reserve Chairman, said the following:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

We did it!  Quite an admission isn’t it?  Well, they did it again!  Anatomy of a Crisis highlighted the policies and practices that lead to the housing bubble, and in this column I’ll discuss how it was the Federal Reserve (the FED) that made the bubble possible in the first place. The FED doesn’t manipulate the money supply directly,at least not very often, they do it by setting interest rates, altering reserve requirements (the amount of money banks must keep on deposit with the FED), and serving as a safety net for the fractional reserve banking system that I briefly discussed in “Big Trouble in Little Washington”. A fractional reserve system that couldn’t expand deposits to the extent that they do without the FED.

Economies have something known as the Price System, whereby market forces determine the price for the goods and services you buy everyday.  Liquidity (credit) is no different.  The FED however, doesn’t allow the price system to work. They artificially set the price, and when that price is lower than the price system would set it, the economy receives an infusion of capital. Credit expansion is an increase in the money supply (inflation) and in 2001 the FED slashed rates from 4.0%, which was close to the historical average, to below 2.0%, and then continued to hold them there for the next 3 years.

This gives banks an incentive to lend, and cheap credit gives people an incentive to borrow. Capital (money) poured into the economy! This created an inflation fueled boom that eventually had to go bust. That money always goes somewhere, and in this case, with the help of Freddie Mac and Fannie Mae it was Mortgage Backed Securities that wouldn’t have existed without this massive infusion of capital.

Unfortunately, the FED wasn’t finished. In 2004 they began raising interest rates to stem the tide of money flowing into the economy, and rates eventually reached 5.25%, which was above the historical average.  Anytime money pours into the economy, the market must adjust, but when the FED set the price of liquidity above what the market would dictate, it creates a credit crunch and the economy over-adjusts, just as it did at the beginning of the Great Depression.  Credit dries up and assets tumble. They did it again!

Now they are trying to pour money back into the economy to shore up these assets. What do you think will happen this time?