The following discussion is about how the system could be run if adults were in charge. It is not necessarily about how it is being run now.
One of the things that the Federal Reserve Bank has tried to do to prevent the total collapse of the financial system and the economy is to pump liquidity into the economy. The popular press likes to call this printing money, and many of the readers of the press have taken to this metaphor.
This metaphor annoys me because it is not an accurate picture of how most of the liquidity is created. I have finally found one of the dangers of using this shorthand notation for what the Fed does. If you think of what they do as “printing money”, then it makes it hard to imagine the “unprinting of money” which they will do when the economy recovers. (Again, presuming that adults are in charge.)
The money that the Fed “prints” is mostly in computer transactions that credit the major financial institutions with money in their accounts with the Fed or in money that the Fed takes back. The Fed can buy government bonds and credit people with “money” in return. It can also sell the bonds it holds , and in return take back the “money” that people have.
The previously posted “documentary” Overdose: The Next Financial Crisis, with all its faults, does provide some useful fodder for this discussion.
When the “documentary” discusses the formation of the most recent housing/financial bubble, it does demonstrate how the shadow banking system “prints” money in the same way and to an even larger degree than the Fed does. Much liquidity is pumped into the economy, but no U.S. hard currency is actually created – no coins and no bills of various denominations.
In the subsequent discussion of the financial freeze when all the lending suddenly came to a halt, you can think of this as the “unprinting” of this money. Again, no coins nor dollar bills of various denominations were injured in this “unprinting”.
So what the Fed was trying to do when it started pumping liquidity into the system was to replace the liquidity that the shadow banking system withdrew too quickly and in excess of what was needed. Their trick is to put in just the right amount of liquidity, neither too much, nor too little. And they need to withdraw the liquidity when what they pumped in becomes more than the economy needs. This will happen when the shadow banking system starts putting back some of the liquidity it withdrew in excessive haste amidst the panic.
Their is a huge problem that the Fed has in trying to right the economy solely with the monetary policy at its disposal and without the aid of the fiscal policy that the Congress and the Executive branch have at their disposal. As the Fed pours liquidity in while there are no good investments to be made in the private sector with this liquidity, the liquidity gets sucked right back out of the economy by the huge figurative sponge of the people trying to save money until the economy improves.
The one way to get around this problem of soaking up the liquidity almost as fast as it can be pumped in, is for the Federal government to spend this liquidity in investing in capital equipment formation for the long haul. The Federal government is the only financial actor with the staying power and the foresight to be able to counter the short term trend. Well, it could have the foresight if their weren’t so many people who were only looking out for their own personal well being (which they should do) and who think the government should be run in the same way (which it should not do).
When I talk about capital equipment, I am thinking in an expansive way to include not only hard infrastructure assets, but also in soft goods like education, research, and health care.