The obvious next question is, "Why did the annual rate of money growth tumble from a double-digit rate in 2006 and 2007 to almost nothing from the start of 2008?" The answer is, "Partly because some banks had got it wrong, but mostly because of officialdom's misguided reaction to the crisis." To understand why officialdom's reaction was misguided, a few words are needed on how banks operate and, in particular, how they balance risk and return in the management of their capital. Banks are unusual businesses, in that their obligation to repay depositors with cash forces them to hold very safe assets. But safe assets deliver a low interest rate. In order to make a healthy return on capital, banks need to offset the low interest rates by high leverage. By the standards of the corporate sector as a whole, their assets and liabilities are an exceptionally high multiple, often 20 or more times, of their capital. But leverage must not go too far, otherwise the risk of insolvency would be unacceptable. Regulators and customers would be unhappy if the capital/asset ratio were only 1 or 2 per cent. 

It has to be admitted that some banks' mistakes were one element in the collapse in money growth seen at the start of the Great Recession. RBS's and HBOS's heavy losses eroded their capital. In the best of all possible worlds, that erosion of capital implied that they would have had to sell off some assets and reduce their balance sheets. And that reduction in balance-sheet size would have meant a decline in their deposit liabilities, which constitute most of the quantity of money. 

But officialdom made matters much worse. Old-fashioned central bankers, such as the top brass at the Bank of England 50 or 100 years ago, had frequently themselves been bankers in the private sector. Their     response to the threat of a major business downturn was to cut interest rates and, if necessary, extend loans to banks short of cash. They did not demand large increases in banks' capital at the most difficult moment in the cycle. To be frank, there was a lot of chumminess between old-fashioned central bankers and the commercial banking industry, particularly in a society like Britain riddled with networks of privilege and mutual back-scratching. Nevertheless, the traditional tendency of old-fashioned central bankers to be soft on banks during the crisis had benign effects. It maintained credit availability, and so prevented collapses in banks' assets and hence in the quantity of money. To that extent the chumminess and mutual back-scratching served a social function, as well as the often tacky purposes of the private individuals involved.

In the Great Recession the key people in central banks were no longer ex-bankers. Instead they were typically economists with little or no hands-on experience of business and finance in the private sector. They reacted to the events of late 2008 by being hard on the banks. They demanded not only that banks increase their capital relative to their assets, but also that the move to higher capital/asset ratios had to take place quickly. Whereas the old-fashioned central banker would help commercial banks with loans (probably very expensive loans, by the way) to give them time to sort out their affairs, the economist-as-central-banker of late 2008 and 2009 insisted on rapid and large-scale bank recapitalisation. (In the UK Mervyn King, the Governor of the Bank of England, was the most prominent of these economists-as-central-banker. He had a major political ally in the recapitalisation exercise, in the shape of the then Prime Minister, Gordon Brown, as I discussed in my review of Brown's book, Beyond the Crash, in the March 2011 issue of Standpoint.)

It was the combination of the increase in capital/asset ratios and the bank recapitalisation that caused the severe collapse in money growth. This statement is so important in understanding the Great Recession that it cannot be emphasised too strongly. The decisions to raise the capital/asset ratios and to enforce the large-scale recapitalisations were of course taken by officialdom, particularly by Brown and King. Senior bankers — people who had spent their entire working lives in the profit-seeking private sector — could see what the results would be, and were aghast. The blame for the disaster falls mostly on officialdom, not the bankers.