THE BLOG
11/23/2008 05:12 am ET Updated May 25, 2011

Credit Crunch and the Money Supply

Our money supply has recently slowed to a screeching halt. That is exacerbating our problems and heightening the credit crunch. The faster we spend, the more money there is available in the economy. Money we put under the proverbial mattress is non existent capital as far as the economy is concerned.

Which brings me to a fundamental problem we have had with our money supply for a very long time.

Imagine a world in which Uncle Sam is the monopoly supplier of bananas, in the same way that he is now the monopoly supplier of money. A board of independent experts meets periodically to determine the banana supply in the country. When they get things right, the resulting price of bananas make growers and consumers use bananas wisely. But when they guess wrong, which inevitably they will from time to time, things get out of whack. If for example they increase the banana supply too much, people will start using more bananas. They will eat banana bread instead of regular bread, and make banana jam when previously they used strawberry. Bananas will get so cheap that there will be new banana-based candy. And banana growers will make plans anticipating more of the easy bananas policy, plans which will be foiled if the board changes course.

It would be very important for this board to always get things right with bananas, because otherwise the economy will become distorted. And people will become anxious about future decisions of the banana board.

Luckily, bananas are supplied by markets, with competitive growers and consumers adjusting daily to new information about changing costs, replacement products etc. No one worries about getting the banana supply right, because markets do that job well.

Unfortunately, this is not how we deal with money. Money supply used to be determined by the amount of gold the Fed had in its coffers. If the economy did well, gold bars poured in, and the central bank was able to increase lending. If confidence waned, the gold left the country, and lending activity would tighten (if that was the case now, Fort Knox would be empty).

But we have been off the gold standard for a long time, and now the supply of money is determined by the board of the Federal Reserve. These guys don't know and cannot adjust to changes in people's demand for money. They are also susceptible to political pressures, because politicians regularly demand they boost the economy with easy money. So the Federal Reserve distorts the economy with its decisions on the supply of money, decisions that are inevitably mistaken. And that is how we get asset bubbles. And bubbles are bound to pop, the dire consequences of which we are now experiencing.

This is a lousy way to handle something as crucial as the supply of money. I would argue money is at least as important as bananas (albeit not to monkeys). Markets should supply money the way they supply bananas and most every other product we use.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment partnership.