Banks had therefore to increase capital/asset ratios in an already sluggish economic environment. As capital was hard to raise in the traumatised conditions of late 2008, they reacted by tightening credit terms and trying to shrink their assets. President Barack Obama was later to endorse this process as part of an allegedly beneficial "shrinking" of the financial system. But one consequence ought to have been obvious to all: that the drastic increase in banks' regulatory capital/asset ratios would reinforce the destruction of money. Paradoxically, official attempts to make bankers safer aggravated the recession.
By early 2009, macroeconomic conditions were so dire in the UK that a radical policy reappraisal had become essential. Some counterweight was needed to the destruction of money. The answer was for the state itself to create money on a massive scale. That was the thinking behind the Bank of England's announcement in early March of a programme of so-called "quantitative easing" (QE). Until the end of October, it purchased £175 billion of government securities from the private sector, paying for them by crediting sums to the sellers' bank deposits. This added to the quantity of money.
The good news is that this was a highly expansionary open-market operation, of the kind that Friedman would have blessed, and the positive effect on the quantity of money of these transactions has indeed been huge. If the official gilt purchases had not occurred, the quantity of money would today be more than £150 billion (almost 10 per cent) less than is the case. Most importantly, the economy is in much better shape now than it was at the start of the year.
The bad news is that the Bank's creation of money has been offset by the continuing operation of the forces that were destroying money in late 2008. Indeed, in the QE period, the UK banks' claims on private sector agents (both here and abroad) have fallen so much that the quantity of money has grown only slightly, if at all.
The critics will say that the failure of the quantity of money to grow demonstrates that QE has been futile. The truth is very different, that the Bank's programme of money creation was bold, necessary and beneficial. It came too late to stop the recession, but it has rescued Britain from a recession much more catastrophic than the one which we have in fact suffered.
