Above all, official measures to deal with the banking problem had to be structured so as not to cause a recession and damage innocent bystanders. In the critical weeks in September and October 2008 the key movers and shakers often gave the impression of not knowing where events would take them or what they should do next. Most fundamentally, they knew from the mess around them that banks mattered enormously to macroeconomic outcomes, but they lacked a coherent theory of how banking fitted into the economy, and why it affected spending and output. Both Mervyn King and Ben Bernanke, then chairman of the Federal Reserve, endorsed bank recapitalisation because they saw it as a way of restoring confidence to the banking system, and so unfreezing the inter-bank market and stimulating new bank lending to the private sector.

But was it not obvious that the demands for banks to have higher capital/asset ratios would slow the growth of assets or even cause bank assets to contract? In late 2008, in Britain, the USA and most of Europe, banks’ assets were dominated by loans to the private sector. A contraction of banks’ assets therefore meant a contraction in their loan portfolios. Since banks like to be gentle to existing customers and not to pull credit lines when loan conditions are being met, a contraction in loan portfolios implied a drastic restriction of the availability of new credit. Far from stimulating extra bank lending to the private sector, the recapitalisation programme of October 2008 was followed in the UK by an intensification of the credit crunch. (Similar programmes elsewhere had similar consequences.)

When a customer repays a bank loan, he or she uses a bank deposit. A sum in the deposit is paid to the bank, and both the deposit and the loan are cancelled. Nowadays bank deposits are the principal form of money. More generally, if officialdom instructs banks to sell their riskiest assets and “to tidy up their balance sheets”, loan repayment causes the destruction of money balances. Whereas in early 2007 the quantity of money had been growing in the UK at a double-digit annual rate, by early 2009 the rate of money growth had collapsed and was liable soon to go negative.

Bank recapitalisation was a vicious deflationary shock to the British economy, at just the wrong moment in the cycle. The Great Recession of late 2008 and early 2009 was the UK’s most severe setback in private sector demand since the inter-war period. (Government spending carried on growing.) Officialdom punished the bankers, but in the process it punished everyone else too. The squeeze on money balances, due to banks’ shrinkage of their businesses, exacerbated the weakness of demand. Job losses occurred throughout the economy, affecting millions of people unconnected with finance, and remote from the squabbling in Whitehall and Threadneedle Street.

The downward spiral could have been checked, easily and quickly, if the Bank of England and the Treasury had taken the right decisions in autumn 2008. First, the Bank should have extended LTROs, on Draghi’s December 2011 model, to British banks. Second, policy-makers were and remain too obsessed with banks’ capital. They need to be told that no recognised economic theory proposes that national income is a function of banking system capital. The standard and traditional view, that national income and wealth are determined by the quantity of money, is correct. Large-scale money creation by the state, as in “quantitative easing” programmes, can always stop a demand downturn. If QE had been announced on the morning of October 8, 2008, instead of the misjudged and mistimed bank recapitalisation, the Great Recession would not have happened.