The economic collapse cannot be allowed to continue much longer. It is time for Plan B or, to be more precise, Plans C, D and E. A year ago, as it became apparent that the credit crunch was not going to be resolved by the self-regulating forces of private financial markets, I wrote repeatedly in this column about the need for a government-led Plan B. Such a plan was duly implemented in January and February, with sharp cuts in US interest rates, the nationalisation of Northern Rock, the forced merger of Bear Stearns and the strengthening of government guarantees for Fannie Mae and Freddie Mac. In September, however, the Bush Administration suddenly decided to expropriate Fannie Mae and liquidate Lehman Brothers, thereby sabotaging any chance of success for Plan B. At that point, Plan C had to swing into action. Hundreds of billions of dollars, pounds and euros of government money were injected into bank capital, with hundreds of billions more soon to be spent on tax cuts, public works and other forms of “fiscal stimulus”.

It is too early to say that Plan C has also failed, since most of the global fiscal stimulus has not even started while the banks have only recently been recapitalised. But early indications are not encouraging, especially as regards the behaviour of banks. Enormous sums of public money spent on buying bank shares seem to have had no effect on management attitudes in the banks. It therefore appears unlikely that financial conditions will return to normal in the near future. The question for policymakers around the world is what more needs to be done.

In Britain, the excessive hopes placed by the Government and the Bank of England on bank recapitalisation have been disappointed, as credit lines to businesses and personal borrowers have continued to be ruthlessly slashed by the banks. It is therefore time for a more radical and integrated approach, combining simultaneous radical action on the fiscal, monetary and credit fronts.

There has been widespread disquiet about the prospective increase in national debt from extra public borrowing (or from guarantees to bank loans and mortgages which are exactly equivalent to public borrowing). There have even been claims that the Government's fiscal policy has caused a collapse in sterling even though the pound's decline is not as unprecedented as widely suggested.

It is now time to ask a more fundamental question: Why shouldn't the Government borrow some of these extra funds at zero cost directly from the Bank of England? How much extra spending and borrowing could be financed in this Zimbabwean manner by a civilised and responsible G7 government? Actually, quite a lot. Britain's monetary base - which consists of banknotes issued by the Bank of England plus coins from the Royal Mint plus private bankers' deposits held at the Bank of England and therefore available at any time for conversion into banknotes with literally zero risk - is about £100 billion. The broadly defined M4 money supply, comprising all private sector bank and building society deposits, money market funds and so on, is £1,900 billion. In other words, the British financial system creates a private money supply roughly 19 times larger than the “base money” printed or otherwise made available by the Bank of England. This much larger private money supply is an adequate substitute for central bank money as long as people believe they can convert their deposits at private banks into Bank of England notes at any moment. But the moment there is an iota of doubt, bank deposits cease to be true money, as demonstrated by the queues outside Northern Rock last year.

The ratio of “broad money” created by private banks to “base money” issued by the central bank, is sometimes called the money multiplier and measures the liquidity leverage in the banking system. This is a separate issue from capital leverage - the fact that bank shareholders' funds are typically only about one tenth of their loans and other assets, which has been emphasised recently by politicians and regulators, especially in Britain, as the key problem facing the banks. While capital leverage is what multiplies the losses suffered by bank shareholders from dud loans, mortgages and other assets, liquidity leverage is what multiplies the panic in a bank run such as the one that very nearly hit the entire global economy after the Lehman collapse.

This liquidity leverage is much greater in Britain than in other advanced economies. In the eurozone, the broad money supply is €9.3 trillion, which is only 7.5 times the €1.15 trillion monetary base, while in Japan the ratio is about 11. In the US, where the broad money supply is about $8 trillion, the monetary base has recently been almost doubled to $1.5 trillion, reducing the money multiplier from 10 before the financial crisis to 5.3 today. Britain's liquidity leverage, at 19 times, is much higher mainly for reasons related to a relaxed approach to bank regulation and the Bank of England's operating methods.

Until recently, it was widely assumed that Britain's bank regulation and monetary management were among the best in the world and there seemed to be no reason to question the banking system's exceptionally high liquidity leverage. However, it now seems plausible that the 19-fold multiplication of base money by the British banking system has left the economy and the banks themselves dangerously exposed to liquidity crises. Let us suppose, therefore, that Britain adopted a more prudent system of liquidity management and regulation which reduced the money multiplier by half from 19 to 10. This could be done by requiring commercial banks to hold minimum deposits at the Bank of England worth at least 10 per cent of their total monetary liabilities. These deposits could receive interest at the Bank of England's bank rate, as they do at present. Alternatively, they could be interest-free - in which case they would be equivalent to a windfall tax on banks. If the Bank Rate falls to zero the difference between these two approaches would become irrelevant.

If such new liquidity regulations were introduced, the banking system's liquidity leverage could be reduced from 19 to about 10 by an increase in the present monetary base of £100 billion to about £200 billion. The Bank of England could increase the monetary base in this way by buying £100 billion worth of government bonds in the money markets. Alternatively, it could lend funds directly to the Government for new spending programmes or to the private sector for government-guaranteed mortgages and business loans. The additional £100 billion of new spending and borrowing would cost the Exchequer nothing if the private banks were required to hold interest-free deposits with the Bank of England. But suppose that a less punitive regime were adopted, with Bank of England reserves paying interest at bank rate, as they do at present. Even then, the cost of a £100billion expansion in public spending and borrowing would be negligible, for as long as the bank rate stayed very low. In effect, the Treasury could enjoy a windfall equivalent to 7 per cent of GDP at zero or very low cost to taxpayers.

The economic explanation for this windfall to the Government is simple: the Bank of England would in effect be taking for itself some of the profits that now accrue to the private banking system for financing industry, trade and home ownership. After the dismal performance of the banks in the past decade, such a transfer of profits to the public sector would surely be well deserved.

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