Almost nine months later, the questions have to be asked, "Was the government right in its views on the economic outlook?" and "Has the case for large-scale and rapid capital raising in the banking industry been validated?" On the face of it, the shocking deterioration in economic conditions and the recent announcement of large losses in banks' loan portfolios vindicate the stance taken by the government and its regulatory agencies. But that conclusion is too hasty. Banks are unique and rather odd institutions, which occupy such a central position in a modern market economy that their behaviour can interact with the business cycle in unexpected ways.

In a 1933 academic article in Econometrica one of the USA's most influential economists, Irving Fisher, proposed "the debt-deflation theory of great depressions". Starting from a boom in which people had borrowed heavily, he suggested that an unforeseen deterioration in business conditions might cause large repayment of bank debt. The repayment of bank debt would reduce the amount of money in the economy (which he called "deposit currency"), which in turn would cause a fall in prices, with a disproportionate effect on profits, the value of businesses and asset prices, leading to further repayments of debt, another round of reductions in bank deposits, a further fall in prices and so on. The disaster was rather like the capsizing of a ship. In Fisher's words, under "normal conditions" a ship is always near "a stable equilibrium", but "after being tipped beyond a certain angle" it "no longer has this tendency to return to equilibrium, but, instead, a tendency to depart further from it". 

The problem with last October's bank recapitalisation exercise was that it capsized the British economy. (The same comment is true of similar exercises in other economies, but there is no space here to go into details.) The warnings of a big recession were particularly foolish and counter-productive, since they caused an abrupt step downwards in business expectations. The shock to the banks was so sudden and severe that they reacted not by increasing the availability of credit, as officialdom had intended, but by restricting it further. (The Bank of England publishes a monthly series for "sterling unused credit facilities". It had started falling in mid-2007, but the pace of decline accelerated in the immediate aftermath of the bank recapitalisation exercise.) 

Just as Irving Fisher warned over 60 years ago, a restriction of bank credit stops the growth of households' and companies' deposits. The lack of money in the economy hits spending, profits and asset prices, and asset price falls lead to an unexpectedly high level of losses on bank's loan assets. The result is a self-feeding and unstable downward spiral of retrenchment. In the 1933 article Fisher emphasised the sometimes paradoxical nature of this downward spiral. People repay bank debt in order to improve their financial circumstances, but — if everyone does so at the same time — the resulting fall in bank deposits (ie, in the quantity of money) causes a drop in prices and possibly an increase in the real value of the remaining debts. To quote from him again, "the mass effort to get out of debt sinks us more deeply into debt".