In past banking crises, the rule for lenders of last resort, like the Federal Reserve, has always been to follow 19th-century businessman Walter Bagehot's principles:

  • Lend freely
  • At penalty rates
  • Against solid collateral.

In this crisis, Fed Chairman Ben "Helicopter" Bernanke seems to be doing the opposite, which may result in:

  • Making the banking crisis worse
  • Encouraging the recession he claims to want to avoid
  • Destroying the world's confidence in the U.S. dollar
  • Bringing on the next wave of stagflation.

Economics 101
To understand why Bernanke's panicked rate cuts are making things worse, remember the first law of economics: The Law of Supply and Demand. Everything has a market-clearing price. Force a price to be too high, and demand will slip, creating a surplus. Force a price to be too low, and demand will exceed supply, creating a shortage.

By aggressively cutting rates, Bernanke is lowering the price of money. That's supposed to stimulate demand and help the economy pull out of its nosedive. The problem is, that works in theory but not as it applies to our current crisis.

The fly in the ointment
Fed rate cuts (and promised future rate cuts) won't stave off this correction because the economy was never suffering from a lack of demand for borrowed money. On the contrary -- the problem is that the banks got spooked by rising defaults in mortgages and cut off the supply of cash. The evidence of that is how much mortgage rates have risen, even as Fed rates have plummeted.

The banks have been acting quite rationally for companies faced with the potential of significant losses. Although the Fed has been lowering rates, banks have been tightening standards and reducing their willingness to loan money.

When the supply of a thing decreases, the price for it should go up. Bernanke seems to think that the solution for the credit supply shock is in cutting the price. As a result, the rate cuts won't spur the economic growth many hope for. They will further weaken the U.S. dollar and bring on stagflation.

The merits of higher rates
After the excesses of the mortgage bubble, it became obvious that banks had to tighten their standards to stay solvent. But when banks stop loaning even to other banks, you have to wonder whether standards have become too tight. Citigroup had to sell a major equity stake in itself to stay afloat, largely because it couldn't borrow money from other banks.

Lower rates, however, do not encourage banks to lend to one another. A higher Federal Funds rate, on the other hand, would have increased the reward for more solvent banks to help Citigroup, so that it might not have needed that infusion of "desperation cash."

But back to stagflation
Tight credit standards also reduce competition elsewhere by making it more difficult for companies with fewer financial resources than AAA-debt-rated General Electric (NYSE: GE) to borrow. That also derails capital-intensive expansion plans and disables the engines of economic growth -- another path to economic stagnation.

At the same time, lowering interest rates makes the dollar itself less attractive a currency to hold. The reduced value of the dollar makes imported goods pricier. It's why oil is again surging, and oil producers such as Exxon Mobil (NYSE: XOM) and ConocoPhillips (NYSE: COP) are rising while the economy ostensibly slows. It's also why American manufacturers are cheering the weaker dollar. Their sales are helped by the artificial discounts on American-made goods that a weak currency brings.

Unfortunately, our economy thrives on imports, and high prices will lead to inflation. Put together slower growth with high inflation and we can say, Welcome back, stagflation!

Make the most of it
The old saying, "You can't fight the Fed," is still very true. As long as the Fed is determined to cut rates, the least we can do for ourselves is own the companies that will benefit:


Recent Benefit from Weak Currency


7.4 percentage points of its 10.1 percentage point
top-line growth

Caterpillar (NYSE: CAT)

$340 million in revenue gains

Coca-Cola (NYSE: KO)

8 percentage points boost in revenue

At Motley Fool Inside Value, we understand that investments are only as good as the economic environment in which they're made. That's why our investment selections take into account more than the companies we choose. It's the only way to stay on top of -- and to profit from -- the very missteps that serve up the value-priced opportunities we seek.

Interested in learning more about the companies that will thrive in this environment? Click to join Inside Value free for 30 days. There is no obligation to subscribe.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Coca-Cola and 3M are Inside Value selections. The Fool's disclosure policy did fairly well trying to take on the Fed, until the Fed turned on the printing presses and tried to inflate its way out of the ring.