I read a very interesting article today which I think sums up one of the underlying reasons behind the recession we are currently facing. It concerns the difference between ‘broad’ money and ‘base’ money which I will describe in a moment.

Many people blame the problems the banks are facing on their own irresponsible lending (which may also have led to so many people seeking debt help and advice as they can no longer afford to keep up the monthly payments required on their credit cards, personal loans etc.) and the fact that banks were lending out far more than the deposits they held.

To say that banks lend out more money than they hold is true and it is known as capital leverage, in fact shareholders’ funds are generally only one tenth of the bank’s loans and other assets giving a capital leverage factor of 10. This has been talked about a lot recently by politicians and regulators as the major factor behind the collapse of institutions such as Northern Rock. There is, however, another factor which is just as, if not more, important.

Let’s widen the horizon from a bank to the Economy. Just as we have capital leverage at the heart of the banking system we have a similar mechanism, liquidity leverage, at the heart of the national economy and this is measured by the money multiplier. The money multiplier in the UK is 19 – the ‘broad’ money (the private money supply created by the financial system) is £1900billion as opposed to the ‘base’ money (the money printed or made available by the Bank of England) which is £100billion. The ‘virtual’ money is 19 times the ‘real’ money.

A money multiplier of 19 doesn’t really mean much until you compare it to other economies. In Japan the figure is 11, in the Eurozone it is 7.5 and in the United States it is down from 10 to just 5.3 after the Federal Reserve almost doubled the amount of ‘base’ money in an attempt to boost confidence in their financial system.

What we end up with is a double edged sword – capital leverage multiplies the losses of the shareholders and liquidity leverage multiplies the panic and lack of confidence which, in turn, leads to runs on banks such as Northern Rock and Lehmans.

So there you have it – when an already punch drunk economy receives a capital leverage blow to the solar plexus followed by a liquidity leverage uppercut to the chin, the rest, as they say, is history……..or, in our case, the present!