BOSTON

THE ELECTION for president next month is too late; the Treasury Department and the Federal Reserve decided the course of the United States the other week. Understanding why means understanding how banks create money and how everyone suffers when that money doesn’t get created.

Yes, banks create money. Or, at least they did until recently. The way it’s done is called fractional reserve banking and it’s the central premise of most modern banking systems.

Here is how it’s supposed to work: Most money put in a bank doesn’t sit still. The bank only keeps a fraction. The rest is loaned out. Say that banks have a fractional reserve requirement of 10 percent. That means that for every $10 deposit, the bank must keep $1. The remaining $9 it can lend, which it does. That borrowed $9 is likely to end up in a bank and if it does the bank will only keep 90 cents. The rest it will lend.

Repeat the process until the bank can’t lend anymore and that initial $10 deposit will add up to $100 circulating in the economy. Not $100 in cash, but $100 that shows up in bankbooks, meaning $100 that can be used by producers and consumers as a medium of exchange. In fact, most exchanges that take place in the economy don’t use cash. Credit cards, checks and margin purchases all take place by moving around the debits and credits on bankbooks. Those debits and credits add up to much more liquid money in the system than banks actually have on deposit, than there is cash in the system.

The government, which prints cash, wants the system to work this way. The fractional reserve banking system turns banks into distributors of cash for the government printing presses. As distributors, banks play the important role of deciding where cash goes by assessing the risk posed by borrowers and charging interest accordingly. The business of banking is the business of risk assessment — the business of determining the chances of things going right and things going wrong.

What we pay all those guys on Wall Street to do is to assess risk and price it accordingly. That is what all those analysts are supposed to do. If the banking system is working, interest rates set by banks should ensure that money flows where risk is low because interest rates are cheap. Theoretically, that should be where the economy needs money to go.

But, the system isn’t working. Banks didn’t price risk properly and money ended up pooling in places it shouldn’t have — namely into mortgages that borrowers could not afford to repay. And when borrowers don’t repay loans the fractional banking system runs into trouble. All that money banks created by lending disappears. But the debits in the bankbooks don’t, which means that there is no more money to lend and bank money creation and distribution stops.

This doesn’t happen often, but when it does the consequences are disastrous. Commerce in a complex economy like the United States doesn’t work without money. The food on shelves in grocery stores, the fuel in airplanes and the cash that gets forked over by a teller in return for a paycheck all depend on there being adequate money in the system to reflect the state of economic activity. If there isn’t enough, economic activity will contract. That means empty offices, boarded-up windows and soup for dinner.

The Treasury Department and the Federal Reserve are acting in tandem to fix the banking system. The Fed has announced that it would begin buying commercial paper, or the debt issued by businesses to keep cash flowing on a day-to-day basis. Banks normally do this, lending out money for a short period so businesses have the cash to use their assets profitably. But this is only a short-term fix. The Fed does not have the capability — all those analysts — to be the nation’s risk assessor. That infrastructure exists in the banks and if money is to be distributed properly, if risk assessment going forward is to get done, the government must infuse the banks with cash.

The Treasury Department’s execution of the Emergency Economic Stabilization Act of 2008 — the bailout bill — is designed to get money into banks so they can distribute it and keep the economy running.

Don’t believe the hype coming from Congress. The only way this plan will work is if the government overpays for the bad bank assets that created this mess. The point of the plan is to basically deposit vast sums in the banks, so they can start assessing risk and distributing money. This doesn’t mean that all the government’s money gets thrown away. Those assets have some kind of value and will perhaps be worth more later.

But this exercise is not about investing taxpayer money. It’s about breathing life into the banking system so that the Fed can stop lending money to businesses, an activity it really is not prepared to do. This will cost taxpayers something no matter what. In return, we get a chance to avoid rebuilding the banking system from scratch, and the economic stagnation, unemployment, breadlines and lost years that such a project entails.

This whole exercise assumes that the banking system can still assess risk properly and distribute money accordingly. The last year is evidence that this is a big assumption. More than anything else, lawmakers need to devise ways to get banks to stop thinking like casino managers and to start thinking like banks again. That means getting bankers to stop analyzing whether the price of an asset will rise and to start analyzing how much income that asset will produce. The concepts are linked, but not the same. One deals with speculating on what the market — the combined sentiments, will, delusions and wishes of everyone — will do. The other deals with understanding how business — the provision of value-added goods and services — works.

The Emergency Economic Stabilization Act is far from perfect. Most economists think that it would have been more prudent to temporarily nationalize banks by having the government infuse the banks with cash in exchange for bank stock as opposed to troubled assets. This would give the government more control over how the banks go forward and arguably a better chance of making a profit. This might happen yet. But if it does it will be because the banking system is in such bad shape that government ownership of some banks is the only thing that will give consumers faith in the system’s viability.

If the Treasury and the Fed get it right, the new president will have a lot of work to do putting financial regulation back on track. If they don’t, there won’t be anything to regulate, nothing to put on track and that means America’s complex economy won’t work. There should be a new president-elect four weeks from now. It shouldn’t take much longer to find out what kind of country he’ll find himself running.

So, hate bankers all you want; just don’t hate the bailout bill. It might be an early Christmas present to Wall Street. But if it works, it will let us use cash to put our own Christmas presents under the tree, as opposed to melting down the silverware.

Arthur Kimball-Stanley, an occasional contributor, is a former writer for The Providence Journal and Dow Jones and now a student at Boston College Law School.