The Federal Reserve (Fed) has gone beyond playing with fire, and may have indeed set the house on fire. It's one thing to push interest rates to near zero to stimulate the economy; it's another to "monetize the debt" by printing money to buy government debt. In recent weeks, the Fed has broken outside even those boundaries and become actively engaged in managing the private sector beyond the core banking system. Worse still, the steps taken may be difficult to reverse and as such may shape the U.S. economy for a long time. These steps are taken with the best of intentions, to "save" the economy. The only trouble is that we may be on a slippery slope to destroying capitalism on the way. In "doing whatever it takes" to get the economy back on its feet, the Fed risks destroying the foundation of why the U.S. has been able to establish itself as the world's leading economic force. Actively participating in credit allocation within the private sector, the Federal Reserve (Fed) jeopardizes the capitalist foundation the U.S. economy is built on. As a result of these actions, the U.S. may be on its way to becoming a modern incarnation of a planned economy.

Why these harsh words? To understand what is so frightening with recent Fed activity, consider that most central banks focus on interest rates, inflation and money supply to promote price stability (and maximum employment in the Fed's case). Generally, they all influence credit creation by managing the cost of borrowing. Central banks may employ slightly different levers and targets; and while some central banks are better than others at achieving their goals, what they have in common is that they traditionally focus on government debt, mostly short-term Treasuries, to achieve their goals. This is very much by design as good central bank policy leads to an environment of price stability fostering long-term economic prosperity. On the other hand, bad central bank policy may lead to inflation, wide swings in economic activity or unnecessarily high unemployment. However, free market forces will push the private sector to make the best of it. It's when policy makers start subsidizing ailing sectors of the economy that distortions are created that will come back to haunt us. Traditionally, for better or worse, elected officials decide on the socio-economic fabric of society. Now, the Fed decides which areas of the economy need to be propped up.

Creating Hysteria To Pursue Policies

The hysteria that has been created by policy makers and the media has allowed the Fed to pursue its recent unorthodox policies. In late September, the world financial system looked rather dire; the government was able to play a role to avoid a disorderly collapse; but the government's role should have been limited to allowing an orderly adjustment of the excesses of the credit bubble. Instead, the latest salvo to promote the bailouts is that payrolls have dropped by the largest amount since World War II. This may be the case in absolute numbers as the population has grown, but more jobs were lost as a percentage of the workforce in a twelve month period in each of 1982, 1961, 1958, 1954, 1948/49; in many of the cases more than twice as many. Recessions are no fun, neither are personal or corporate bankruptcies; but they may be the cure needed to weed out the excesses of the boom. In contrast, today, hedge fund managers that ran their funds into the ground are raising hundreds of millions of dollars to start anew. Some of the folks that ran Long Term Capital Management into the ground in 1998 started fresh only to have another massive failure in the current credit crisis. We don't expect the new breed of second chances to be any better. And while the blame lies with the managers, excessively low interest rates contribute to irrational risk taking: all of the bailouts focus on those who have been over-leveraged. What about the group of responsible savers that rely on income? With interest rates near zero, many are tempted to engage in highly leveraged strategies to meet their required income objectives. Pension funds "must" return 6% per year, leaving them little leeway but to give money to hedge fund managers to magically turn 1% yields into 20% returns; the way to achieve this is with leverage. Actually, there is another way: the Swiss public pension fund system just announced that it will scale down its long-term return objective to 4% from its current 6% per annum.

Giving Credit Where No Credit is Due

In late December, the Fed Board of Governors approved GMAC's application to become a bank. The vote was 4-1, and the one board member with experience as a bank regulator, Elizabeth Duke, dissented. There was another hurdle: GMAC, General Motors' finance arm, did not have sufficient capital to be a bank. That problem was solved, too, in early January, as the Treasury injected $5 billion into GMAC; the Treasury also GM $1 billion, so that GM could inject that money into GMAC. Equipped now with a minimum capital base, GMAC is able to operate as a bank, go to the Fed to access the TARP program, as well as other regular and emergency Fed windows.

In December, car sales fell off the cliff. But it wasn't only GM that had problems; even Toyota that had access to credit and introduced zero percent financing, recorded a 37% plunge in sales (unlike other car makers, Toyota has traditionally not offered zero percent financing). Shell-shocked consumers are worried about their jobs and have lost a substantial amount of their net worth in 2008; further, incentive programs prior to the bursting of the credit bubble lured consumers into 6-year loans with zero percent financing. Consumers simply don't want or need a car right now. Policy makers take this as a reason to provide money to GMAC that pursues a business model proven to be ruinous: it simply doesn't make sense to offer cars at 0% if interest rates are above that, even if they are "close to zero" as they are now. GMAC takes money from the Treasury to be able to request more from the Fed. And the first course of business for GMAC is to extend zero percent financing to consumers with lower credit ratings than had traditionally qualified.

Difficult to Unwind: Long Term Inflation Likely

The Fed is only ramping up its mission to allocate credit where the Fed - rather than the free market - deems it appropriate. A major program announced in the fourth quarter, but rolled out in early January consists of a $500 billion program to buy mortgage-backed securities (MBS). The perceived positive is the plummeting of mortgage rates. Consumers with superb credit now qualify for 30-year mortgages at less than 5%. One problem with such programs is that the Fed intentionally inflates prices (lowers the yields) on these securities; in turn, rational market participants may abstain from buying them. As a result the Fed risks replacing private sector activity, rather than encouraging it. Furthermore, the Fed jeopardizes the dollar as foreigners may be discouraged from buying U.S. government and agency security debt; given that the U.S. has become dependent on foreigners to finance its spending needs as well as the unprecedented debt that will be financed in 2009. This is a very dangerous road to be on.

The Fed may be able to phase out its commercial paper subsidy program or drain liquidity from the TARP program over time; however, the $500 billion MBS program may be difficult, if not impossible to unwind. Indeed, the design of the MBS program calls for holding of the securities until maturity. For practical purposes, this means that the Fed's balance sheet is not just "temporarily" inflated, but that the Fed will permanently keep more money in the economy. Traditionally, the Fed's balance sheet is $900 billion. Therefore, even if one gives the Fed the benefit of the doubt that the current escalation to over $2 trillion is temporary, there will be a significant hangover as not all additions can easily be removed. This doesn't even consider that, quite likely, the MBS purchase program may need to be extended beyond the 6-month period it was put in place for. Watch for bond manager Bill Gross this June, calling for the Fed to continue buying MBS, preferably the ones he has on the books, to save the economy from collapse. Incidentally, his firm, PIMCO, is one of the firms managing the Fed program.

To counter the effects of this added money in the economy, the Fed would need to keep interest rates permanently higher. One realistic alternative, however, is that the additional money will stay in the economy as draining it would cause too much economic hardship. This may well embed inflation into the U.S. economy for years to come. Importantly, note that there is little, if any, accountability at the Fed monitoring its actions; no one is there to ensure that the Fed will, at some point, phase out its programs or added powers.

Live Free Or Die

By engaging in credit allocation to specific sectors of the economy, the U.S. is stepping into a territory traditionally left to governments with a socialist or communist brand. Communism has shown us that planned economies don't work. New Hampshire in 1945 added the slogan "Live Free or Die" to its state emblem, a quote stemming from a general in the Revolutionary war. Translated to the economic crisis, this should mean that a severe recession ought to be the lesser evil than a planned economy. And to continue the parallel, when communism swept Eastern Europe, the standard of living for everyone dropped. In today's world, we already see that the "re-failure" rate of those who defaulted, then renegotiated their teaser rate loans, is above 50%. Yet all taxpayers have to pay the price for the bailouts.

To be sure, we are a far cry from communism. But we must keep our eyes open and not be blinded by the perceived "help" of money printed by the Fed. Debt is the origin, not the solution to the problems we face. The Declaration of Independence's "life, liberty and the pursuit of happiness" may be difficult to achieve when drowned in debt; building sustainable wealth without the shackles of debt may be the more appropriate path. It's not by mistake that the Founding Fathers be backed by a precious metal that cannot be inflated to give in to the temptation of the day.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.