As a follow-up to this week’s previous post about the stock market and automakers, here is Rachel with more on how the economy works.

I think one of the most common misconceptions is that the government is in charge of creating money. Yes, they produce physical cash and they attempt to manage the money supply via interest rates, discount rates, and reserve requirements. But if you look at these ways that the Treasury and the Federal Reserve can manipulate the money supply, it’s largely through controlling the bank’s actions. And while the government usually plays a strong role in determining the amount of money in circulation, lately it’s found that it’s ability to affect change has been limited.

Banks utilize fractional reserve requirements to leverage the amount of money they are able to loan. Essentially a reserve ratio is a limit set by the government that ties the amount of loans made to the amount of deposits held by the bank. Conservatively, banks today have a required reserve ratio of 10% (and in some cases 3% or 0%). This means that for every $100 of legal tender that is deposited with the bank, the bank is allowed to loan out $90. Should this $90 be spent in such a way that it is eventually re-deposited with a bank, that bank is able to issue a new loan of $81 based on their fractional reserve requirements. If this process continues uninterrupted, the bank can issue up to $1,000 in newly created fiat money from that original $100 deposit. Because bank credit has been legally decreed by the government to be a medium of exchange, the banks just created $900.

For a bank to remain operational, reserve requirements must be met every day, meaning that a bank must have the correct ratio of deposits to outstanding loans. Previously, banks could borrow from each other if they had a shortfall of deposits or, for a small interest rate, lend any excess deposits overnight to banks in need. So what does the current landscape look like? As more and more institutions become crippled and sometimes bankrupted by their bad loans and “toxic assets”, the inter-bank lending market has seen increased stagnation. Banks are scared of what yet undisclosed disaster may lie in wait on each others’ balance sheets, and thus are unwilling to lend to any entity that they deem to be a risk in returning their capital. Banks who previously relied on the operational flexibility allowed by the market’s liquidity (read: all of the them) are now severely limiting credit issued to consumers, as the existence of their business depends on them keeping what remains of their balance sheet in check.

What does all that mean? No lending. And what happens when the banks refuse to lend money, not to individuals, not to corporations, not even to each other? The end result is that you have an economy used to the periodic injection of $900 waiting in fear, unable to find financing for basic individual and business needs. As the perception that the money supply has dried up continues, consumers stop spending and businesses are then hit with decreased revenue in addition to loss of credit. This has lead to business cost-cutinng efforts, including work force reduction, which in turn contributes to the growing consumer panic. Growth has slowed to the point of retraction, spending has ground to a halt, and you have a society that is firmly in the midst of both economic and financial crises.

Say what you will about the bailouts, but the government’s interest is intrinsically tied to the bank’s operations. The banking system’s ability and willingness to lend are going to play a large role in the economy because the whole process is a cyclical relationship. So far we have spent $158.6 billion in “recapitalizing the banks.” Though the execution of this plan has been somewhat dubious, the overall goal is to provide the banks with more money in deposits, meaning that they can now lend without fear of violating their reserve requirement. Theoretically, injecting the money into the economy through the banks should bolster their balance sheets, allow lending, increase consumer confidence, help businesses, and slow the downward spiral. Admittedly this theory depends entirely on your economic perspective and has already displayed several significant flaws.

The politics behind the bailouts are sticky and the plan’s effectiveness is questioned by many. However, it is useful to try to try to think through the banking system and the interwoven structure of cause and effect without the cloud of sensational news. I would love to hear your thoughts on the situation.

Also, those who are further interested may want to follow NPR’s Planet Money podcast for a more in-depth look at many of the underlying issues.