Personalities matter in economics, as they do in history, politics and war. This is why economic forecasting can never be seriously scientific and why mathematical models in finance eventually lead to disaster. And why the world economy is now genuinely threatened by a once-in-a-lifetime depression. Why have the prophets of doom been proved right, while the relative optimists, myself included, been proved wrong? Is it because house prices have suddenly fallen faster than expected or banks have suddenly discovered more bad mortgages on their books? On the contrary, the US economy and housing markets have stabilised over the summer, consumer confidence improved as oil prices corrected and credit losses on US housing have remained about $550 billion, a modest amount in relation to total US mortgages worth more than $11,000 billion. What, then, has suddenly gone wrong?

The answer can be found in two children's stories: Mary Poppins and The Emperor's New Clothes. In Mary Poppins, the central incident when the children are refused repayment of a penny from their bank account and thereby trigger a bank run offers the clearest possible explanation of the inherent fragility of every capitalist financial system. What is happening today, with banks falling like ninepins not only in America and Britain but now also across Europe, has nothing to do with collapsing property prices, imprudent borrowing or greedy bankers. It is simply an old-fashioned bank run. When financial experts talk about “paralysis in wholesale funding” or a “frozen inter-bank market”, what they mean is that big depositors are all demanding their money back and the banks cannot pay them.

Normally big fund withdrawals cause no problems, because depositors who take money out of one bank put it into another. The second bank then lends it back to the first. But such recycling depends on the banks' willingness to lend to each other - and that willingness, in turn, depends on absolute confidence that banking continues without any disruptions. If this confidence is replaced by panic, no bank in the world can survive.

The only real guarantee against such panic is the knowledge that government will stand behind banks that are “too big to fail”. What triggered the bank run was that someone far grander than the children in Mary Poppins decided to make a withdrawal. And what Henry Paulson, the US Treasury Secretary, tried to withdraw was not just a penny - it was government support for the nation's banks.

In the four weeks since September 7, when Mr Paulson fired what he himself described as his financial “bazooka” - and vaporised the shareholders of Fannie Mae - I have been blaming the US Treasury Secretary for inadvertently sabotaging the global financial system. Some readers have ridiculed me for blaming Mr Paulson. By choosing him as a scapegoat, wasn't I just trying to distract attention from my failure to anticipate a global recession that would have happened anyway, with or without what I called the Paulson Doomsday Machine? Maybe. But Mr Paulson's personal responsibility for this recession is not just an ad hominem issue. The reason to focus on Paulson is not to personalise the disaster that started on September 7 but to understand what went wrong - and consider what might be done to put things right. Which is where we come to The Emperor's New Clothes.

Until early September, the credit crunch was certainly uncomfortable, but it did not seem like a life-threatening crisis. It was only after Mr Paulson fired his bazooka that a heart murmur exploded into a potentially fatal heart attack. The real explosion happened not on September 8, when Fannie was nationalised, nor September 15, when Lehman Brothers went bankrupt, but on September 23, when Mr Paulson appeared before the Senate Banking Committee to explain his request for a $700 billion Troubled Asset Relied Program (TARP). Suddenly the markets reached the conclusion I described a day later: that Mr Paulson was an emperor with no clothes.

Not only did he have no idea of how to use his $700 billion, but he offered none of the guarantees expected to either the shareholders or the depositors of US banks. Not surprisingly, the panic immediately spread, with two more enormous American bank failures and bank bailouts in Britain, Belgium, Germany and France.

Mr Paulson has now secured his $700 billion, but how he will spend it is still unclear. By the time he decides, it may well be too late. To avoid a deep recession, therefore, governments and central bankers in Europe must stop waiting for American leadership, at least until after the election on November 4.

At a minimum, the European Central Bank and the Bank of England must lend without limit to their banking systems and temporarily restrict all rules on the quality of collateral, as the US Federal Reserve has done. And the central banks should cut interest rates. But even more important now are the actions of governments, since they are the ultimate guarantors of private banks.

Governments all over the world should follow the lead of Ireland and offer temporary guarantees for all bank deposits, without limits. They must abolish the accounting rules that have encouraged the bank runs and back up these changes with guarantees that regulators will judge bank solvency by the long-term repayments expected on their loans and assets, not on volatile market values. And they must be willing to inject public capital into their banking systems on generous terms that support their existing bank shareholders, instead of wiping them out in the manner of Mr Paulson.

And what if governments do not act? Then comes the really bad news. By the middle of last week the shutdown in bank lending was almost complete - banks were refusing to lend not only to each other but also to businesses, homeowners and consumers outside the financial world. Until this happened, a recession in the non-financial economy might have been avoided, but once businesses are denied working capital, the game is up. From this point of view, the most important - and terrifying - business event this week had nothing to do with housing or even banking. It was the announcement by the government of California that it had been unable to raise $7 billion in “revenue-anticipation notes” to pay its contractors and employees. If the world's richest economy is unable to raise short-term working capital against anticipated Christmas sales tax receipts, imagine what is happening when small private businesses around the world approach their banks.

Does all this mean that banks that lent imprudently during the boom should now be supported with taxpayers' funds? The answer is emphatically: Yes! The time to worry about “greedy bankers” and tighten regulations will be in the next boom. Today, the risks of excessive caution are much higher than the hazards of rewarding greed. This may sound immoral; isn't far greater immorality to throw millions of workers, homeowners and businesses on to the scrapheap of recession?

It is easy to forget that the people who are now blamed for causing the Great Depression and Japan's “lost decade” - Andrew Mellon, the US Treasury Secretary in the 1930s, and Yasushi Mieno, the head of the Bank of Japan from 1989 to 1994 - were not stupid or wicked or even unpopular in their own time.

On the contrary, they were considered brilliant economists and financiers. They believed sincerely in what they were doing. And their puritanical views about “purging” credit excesses enjoyed widespread public support. It was only with hindsight that their incompetence and misjudgment became obvious. Future generations will probably say the same about Henry Paulson. Let us hope they don't say it of Mervyn King and Gordon Brown.

anatole.kaletsky@thetimes.co.uk

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