We couldn't have a better Federal Reserve Chairman than Ben Bernanke right now - he's an academic expert on how the Federal Reserve System failed to back the banking system in 1929 and the 1930s (while trying to prop up the dollar to keep it constant with the price of gold).  When people want to flee to gold, the demand for gold rises - hence, the price of gold would naturally rise.  The only way to make dollars match that rise in the price of gold is to reduce the supply of dollars available - i.e. - make them scarce.  Thus - if we were currently on the gold standard, the Federal Reserve would have had to shut down credit and take dollars out of the system to keep the dollar value equal to gold.

 

We know what that did in the Great Depression - the dollar rose in value dramatically, deflation was double digit, and unemployment shot to 25% since businesses shut down due to lack of credit and currency flows.

 

Bernanke understands this - so what is the Federal Reserve doing right now?  It is creating massive amounts of dollars by lowering interest rates and issuing a record amount of cash at its discount windows ... Fed Loans to Banks Almost Double to $98 Billion

 

This money creation would normally be inflationary - at this rate, possibly hyperinflationary - but the earliest signal on whether the value of the dollar is falling due to Federal Reserve actions would be the world currency markets.  Yet - the value of the dollar is rising against the Euro:

 

 

Oil prices are falling dramatically (i.e. - the dollar is becoming more valuable) - house prices are falling, other prices are falling.  Yet - gold is still rising, so if the Fed was defending the dollar only against gold it would not be loaning money and all of the banks and other institutions would be rapidly failing as the money supply contracted.

 

Economics is my hobby - particularly monetary economics.  What we are seeing on the part of the Federal Reserve System is superb action, being taken in precisely the right direction.  The amount of dollars being created daily by the Federal Reserve System under Bernanke's guidance is unprecedented.  The trick for Bernanke is to know when he needs to reverse these actions - and he's going to have to reverse it quick when consumers and investors are ready to dive back in, because all of the money he's creating will have to be rapidly withdrawn from the system when the velocity of money accelerates in the system again.

 

If Bernanke isn't quick enough on the contraction of the money supply, you will see an inflationary surge - signaled first by a drop in the value of the dollar on the currency exchange markets.

 

He wouldn't have been able to do any of this without the ability to inject money into the economy, and withdraw it at the discretion of Federal Reserve operations.

 

This is a beautiful example of a monetary feedback control system in operation, with actions being taken at an unprecedented level.  If the mathematics of monetary theory (developed with the aid of statistics from the massive disturbance in 1929 through 1933 - in my profession, process control, we call that a "bump test") holds through this massive disturbance the Federal Reserve System ought to prevent these financial issues from hitting the real economy hard enough to cause a long depression.

 

Any senior level economics majors in college right now ought to consider going to graduate school - the data being generated from this crisis will be a tremendous source of academic advancement in monetary theory for years.  There are going to be tons of doctorates earned as a result of this.