THE BLOG
08/25/2011 05:19 pm ET Updated Oct 25, 2011

Compensating for "Disappeared" Money


Republican presidential candidates are confused when they attack the Fed for "printing money." So are many others. The Fed was created in 1913 precisely to "print money" when it was needed because leaders 100 years ago understood that when goods and labor are plentiful and money is scarce it penalizes industrious Americans.

In 1913 it was southerners who especially wanted a money supply that could grow as needed. Southern farmers were often cash-strapped and indebted and needed easier credit and a more flexible money supply. Southern congressional leaders also understood that money is something that governments and banking systems can create and that there is no good reason for it to be scarce when plenty of products and labor are available.

In 1913 southerners had a large role in shaping the Fed. They wanted money and credit to be more easily available but they strongly preferred a semi-private largely independent money-creating Fed to the alternative, a federally controlled money-creating Treasury. When President Woodrow Wilson and Congress compromised to create the Fed the deal struck with southerners gave the Fed an important role in creating money and limited the role of the Federal Treasury.

The Fed as it was designed can create money in two ways. It can buy bonds or other assets from private banks or others as it did recently in QE 1 and QE 2, giving the banks money to lend in the process. Banks, it was assumed, would always want to lend the money they got from the Fed, a process that creates additional money and eventually jobs.

More rarely, the Fed has created money by buying U.S. government bonds directly from the Treasury as it did during World Wars I and II. This provides the government with money and creates employment for tens of millions of Americans as the experience of the two wars clearly shows.

An essential point that confuses the Republican candidates and others is that banks have to lend the funds the Fed provides and borrowers have to spend them before jobs are created. If money just sits in bank vaults as "excess reserves" or is used by banks to buy other "paper," little money gets into the real economy to create jobs no matter how many bonds and assets the Fed buys to pump up money supply.

The money situation today is the opposite of what it was during the housing boom that ended in 2007. Then mortgage lenders, credit card companies and banks were lending all the money the Fed was providing them. Banks kept as little as possible in their vaults and mortgage and credit card companies lent money to anyone who could draw a breath. Governor Perry would surely recognize that this was "printing money." Today, banks are not lending the money the Fed is making available to them and as a result there is the opposite of a boom.

The cause of the near Depression the U.S. is still experiencing in 2011 is certainly not that the Fed is creating too much money. It is that the collapse of home values and the drop in the value of retirement plans between 2007 and 2009 wiped out 25 percent of the net worth of Americans or $15 trillion. This "disappeared" money, as the Republicans should know, was the nest egg for hundreds of millions of Americans and collateral for a huge amount of job-creating spending.

The Republican candidates, if they were serious people, also would recognize that the disappearance of so much money can not be remedied if the Fed and the government are prevented from trying to compensate for this "disappearance." 300 million Americans in 2011 are poorer than they were in 2007. The government's stimulus program and the Fed's efforts in QE 1 and QE 2 were aimed at filling the enormous hole created by the disappearance of $15 trillion. They have had only modest success for two reasons. Most important, the efforts are dwarfed by the size of the money wealth that disappeared. The other impediment has been that banks have become cautious now as they were incautious during the boom about making loans. It would be good if presidential candidates would focus on these obvious facts.

What the Fed needs to do, if it is able, is buy the bonds of entities that will spend the money the way the government did in World War II. My favorite such entity would be an Infrastructure Bank that could issue bonds to finance roads, airports, communications and other facilities that everyone knows the country needs. The U.S. desperately needs a vast modernization program to remain the World's leading nation and such a program also would be a huge boon for American business and American workers. This final step, one that will provide money to entities that will surely spend it on things the country needs is the step that creates jobs and growth as all the candidates should know.