It’s pretty simple really. The Federal Reserve Bank creates and destroys money. It has had that power since it was created in 1913. The trick is getting the supply of money right – not too much, not too little. But the Fed didn’t get it right. They printed too much money in 2003, and too little in 2006. Hence, the crisis.

If you found recent economic events confusing, it’s not your fault. Part of the confusion is due to the people whose job is to explain all this to you: the financial media. They got the story backwards, and having it confused in their own minds, were unable to make it clear in yours. I’ve known many, many financial journalists over the years and very few of them were involved in markets. Typically, they went to journalism school, not business school. They planned for a job in media covering politics or sports, not business. They don’t know much about how markets work, and (more importantly) they’re not inclined to give people who work in finance much benefit of the doubt. They believe that investors and brokers are, as a group, prone to large mistakes. When the value of investments such as homes or stocks move up quickly, and the journalists don’t know why, they label the phenomenon a ‘bubble’. They believe that these foolishly optimistic investors will soon become foolishly pessimistic and then the ‘bubble’ will ‘burst’.

That’s when the people in the media really go to work; they start searching for somebody to blame. Real estate speculators have to be held accountable, they say. Or perhaps it’s the mortgage brokers, who never should have agreed to give them mortgages in the first place, or the banks who approved the mortgages, or the state regulators who didn’t license the mortgage brokers properly. Perhaps it’s ‘predatory lenders’ who suckered people into paying too much interest, or the investment banks who bundled these mortgages together into a special kind of bond called a CDO. Maybe it’s the rating agencies who offer an opinion on how risky the investments are, or the hedge funds who bought them with (too much) borrowed money.

Maybe it’s the whole system, global ‘cowboy’ capitalism which has grown too big to be regulated by any one government, especially the mysterious and shadowy world of ‘derivatives’. If the journalists can’t understand them, then, of course, nobody can. It’s just too complicated!

And, they say, it’s too large! Sub-prime mortgage defaults are the ‘highest ever’. The sub-prime ‘toxic waste’ is global. There’s no telling how far it reaches, how far the ‘contagion’ will spread. There’s an estimated 400 trillion dollars in derivates out there! 400 trillion! It could all collapse in one global meltdown. The might have to intervene, but then again why should they ‘bail-out’ the bad guys?

So, the authorized version of events starts with bad real estate investors and ends with wise and benevolent central bankers. The problem is that this story is exactly backwards. It starts with foolish central bankers and moves on to investors. Sub-prime mortgage defaults aren’t the cause of tight credit – they’re the effect.

Here’s what really happened. In 2003 most reporters believed that the economy was lousy, and that the Bush tax cuts had not made things any better. They believed that the only hope was for the Fed to print large quantities of new money and send it out into the economy to make us all feel richer so we’d spend more and get things moving again. Alan Greenspan bought that line of reasoning and with it he bought very large quantities of federal bonds from banks. Money gushed into the bankers’ accounts, and the banks loaned it to customers who were good credit risks. When they ran out of borrowers who were good risks, they lent to borrowers with (as the commercials say) “not so perfect credit.” That’s what banks do when they have too much money. So the money which started with the Fed and went to the banks flowed into the hands of home-buyers and home-builders and renovators and realtors and eventually out into the hands of everybody. Prices began to rise.

The Fed realized in 2004 that it had gone too far and shrank the supply of money for two years. Where there had been too much money in 2003, there was, by 2006, too little. This pattern is, unfortunately, very common for central banks, they tend to go too far in one direction, then too far in the other direction.

When there’s a shortage of money, who feels it first? The people who are poor credit risks. In other words, the people who take out ‘sub-prime’ mortgages. Most vulnerable are people whose interest rates vary over time, rising and falling with the scarcity or abundance of money. If money were too tight, sub-prime borrowers with variable rates would feel it first. As the money shortage continued however, even good credit risk households with variable rates would have trouble getting or servicing loans. So would car purchasers and people who buy washing machines and refrigerators, so durable goods orders would unexpectedly plummet. Loan officers at banks would have already been tightening their standards. Student loan agencies would have to tighten their standards too. Companies whose value depends partly on abundant credit such as Home Depot or Sally Mae would become less attractive and any large investors such as hedge funds which were planning to purchase those companies would probably have second thoughts and push for a better deal.

In an environment like this banks would even hesitate to lend to each other. Foreign investors would wonder whether the US is a good place to invest anymore and perhaps pull some of their money out of the country. No longer needing dollars to buy US stocks and bonds, they would sell dollars, and their value would drop. Stock values would fall. Inflation measurements like CPI and PPI would begin to go down instead of up.

So far this chain of events describes perfectly what has occurred over the past year. The final test of the money shortage theory is what happens when the Fed reverses course and adds money back in, as they did this summer. The stock market would rally, the banks would loan to each other again, and the buy-out deals would get back on track. Large companies with huge piles of cash and no need to borrow would tend to do well. The decline in housing prices would slow down and eventually reverse. Particularly savvy investors would begin to buy up the mortgages that the panicking crowd has been fleeing from. This story should sound familiar. It describes exactly what the past two months have looked like.

Calls this week from Congress for a “Housing Czar” to oversee a new wave of regulation show how pervasive and how dangerous the backwards version of events is. It’s not a housing problem – it’s a credit problem. We don’t need a Housing Czar, we need a Credit Czar, and thankfully Alexander Hamilton (always thinking ahead) gave us one. He’s called the Secretary of the Treasury, and he’s doing exactly the right thing – finding out what government has done and is doing to make matters worse, and fixing it.