A new conundrum: why would Bernanke destroy the dollar?

The breathtaking speed and force of the US dollar's ongoing disintegration amazes me, even though I saw it coming years ago. But there is one thing I got utterly wrong. I wrote a post in June, 2006, in which I postulated that the Fed, then led by newly appointed Ben Bernanke, would sacrifice the equity markets in an attempt to save the dollar. I thought they'd put up more of a fight, and that the dollar would crumble over the span of several years, not the nine months since the credit crisis started last summer. I concluded my analysis with this thought:

In the end the Fed will have to try defend the dollar to support the all important treasury bond market. This is what keeps the government solvent. And if things play out this way, I wonder how how much independance our Federal Reserve will really have anyway. I wonder if China's central bank Governor Zhou Xiaochuan, and Russian central bank chairman Sergei Ignatiev are now discrete and unofficial members of the Federal Reserve, and if they will be the ones who really set monetary policy.

Clearly, things have gone differently. In the first place, the Fed has no need to defend the treasury bond market right now. With all other kinds of fixed income paper looking like poison (i.e. toxic waste CDOs, etc), the only bond that has any attraction is the T-bill. That single bright spot in the Fed's universe will not last long. Next year, or this fall, when the T-bond market turns over, then the Fed will truly be out of options. Game over.

Most amazingly, the Fed has not made the slightest effort to save the dollar as it dropped like a stone. The dollar has fallen nearly 22% since December 2005, and is currently enduring an unprecedented and very possibly ruinous breakdown.

But instead of fighting to save the dollar, the Fed is fighting with all they've got to save wall street, and it's bond and stock markets.

The dollar's problem, denied against all reason by Bernanke, is inflation. We are clearly, indisputably, in double digit inflation right now. That is consumer price inflation. And cost inflation, felt by businesses, is rising very fast, with the price of oil. The United States of America is heading down the path of the Weimar Republic, if not Zimbabwe. Could we launch into hyper-inflation any faster? I don't think so. The Fed is desperately trying to prop up real estate prices, and monetizing the bond market. They are allowing the banks not to admit their insolvency. The Fed is spraying cash at the credit problem through high pressure hoses, but the money is going directly into commodities, not into the frozen bond markets.

Are the stock and bond markets really more important than the dollar? There has never been a worldwide currency collapse, so it is hard to predict the consequences. But there have been many stock market crashes and it seems that they are survivable. Ultimately, the dollar is far more important than the stock market. It is the uber-stock, the shares in the nation itself. A nation's currency represents citizens' belief in their country. It is significant that our bills have our founding fathers' portraits. And why would the Fed destroy the only thing that they have? Their only reason for existence is to regulate dollars. If the dollar is worthless and irrelevant, so is the Fed itself.

Jim Puplava has a theory that the Fed will succeed in re-inflating markets, at enormous cost, but that will only be a very short term solution. He calls it his oreo theory:

And the best way to describe what we see happening this year – and I was trying to think of an analogy, and here it is: An Oreo cookie. Dark on the outside and a creamy filling in the inside. And what I mean by that is the first quarter is we're going to see a lot of volatility, we're going to see a lot of roughness in the market, kind of what we're seeing right now with the major average is down anywhere from 3 to 5%. We may see a 10% to 15% correction in the markets. And then we're going to see monetary reflation kick in with a vengeance.

We're probably going to see fiscal stimulus. So by the second and third quarter I call that the filling. You're going to see the positive sides of monetary reflation and that's going to be higher asset prices. And then, however, by the time we get to the fourth quarter of the year, you're going to see inflation come back with a vengeance and you're going to see higher bond yields, higher inflation rates so that, John, when we get into the year 2009, central banks will be back into the rate-raising mode. And by 2010 – and hold onto your seat, get your Maalox, by 2010, if things unfold the way we think, the US will experience a depression.

Puplava knows a lot more about financial markets than I do. Maybe he is right, and the global economy won't collapse this year. Right, it will collapse in 2010. That's a relief. And maybe it explains what Bernanke is doing with his hyper-inflation game. He is doing what everyone does when they get into a financial tight spot: he is desperately trying to buy some time, and hoping for a miracle. It is not working so far. But when you are desperate, hope is always free. As is printing dollars.