The credit crisis is almost a year old. To begin with it was seen as nemesis for financial sector hubris. Many thought that, with the exception of the construction sector, the “real” economy would be unaffected. That dream is fading. But the economic impact took a long time to unfold. The explanation lies in the complicated nature of what constitutes “liquidity”. Traditionally, liquidity has been measured as broad money or credit – more or less matching the flipsides of banks’ balance sheets.

The amount of credit banks create is a function of several variables. But let’s focus on two: leverage and the credit multiplier. Usually about $8-$10 of credit is created for every $1 of banks’ risk-free capital. “Power money” is money central banks inject into the banking system. It also limits bank credit. Banks can lend out power money only a finite number of times. The exact number, or “credit multiplier”, is set by the amount of precautionary reserves banks make for each loan.