The Board of Governors of the Federal Reserve System (“The Fed”) has a dual mandate – full employment and price stability. To put it another way, The Fed’s job is to promote economic growth without causing inflation.

How is this best accomplished? To listen to The Fed is to believe it’s through properly functioning financial markets. Ben & Company provides a very simple explanation on their website: “The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.”

That’s it – straight and to the point. It’s all about the free flow of capital. It’s not about the housing market, consumer demand, the Dollar, corporate profits, the stock market or any other explanation (even though these things may be the logical ends of monetary policy).

In essence, The Fed strives to ensure a match between lenders and borrowers – between those with capital and those seeking it. Unfortunately, their current strategy of lowering borrowing costs is a loser’s game.

Today’s economic problems aren’t the result of a traditional cyclical slowdown – they’re caused by a credit bubble fueled by cheap money and indiscriminate use of leverage.

The problem isn’t the price of money. There’s plenty of it out there and it’s plenty cheap.

The problem is banks won’t lend it. They’re tightening lending standards regardless of the creditworthiness of borrowers.

Why? Let’s look to the balance sheet…

Banks are sitting on a mountain of toxic debt since their customers stopped buying pools of credit known as SIVs (Structured Investment Vehicles). Some of the underlying credits are in default and there’s fear of increasing problems with payback.

Traditionally this wouldn’t be a problem as banks can hold securities until maturity. In today’s world of modern finance, banks are intertwined with brokerages (e.g. JPMorgan Chase). Brokers don’t hold securities until maturity – they trade them. For traders, accounting rules require ongoing estimation of the value of securities owned.

The good news is that these securities will always have some value – the PV of future expected cash flows. But in a world of fear where investors expect defaults there is no market to speak of. There aren’t any customers. No one will buy.

The intrinsic value (PV of future expected cash flows) becomes meaningless. If there’s no demand for securities then they have no marketable value. The SIVs are worthless.

The result has been massive asset write downs wiping out hundreds of billions in value.

In sum, The Fed can make money as cheap as it wants but the solution simply won’t ‘cut’ it (delicious pun intended!) unless the banks stop hoarding capital to shore up their balance sheets.