Keynes once described the work of Friedrich Hayek as "an extraordinary example of how, starting with a mistake, a remorseless logician can end up in Bedlam". Since September 2008 the world economy has been closer to Bedlam than at any time since the end of the Second World War. Turmoil in stock exchanges and commodity markets has been accompanied by almost constant public wrangling between politicians, financial regulators and bankers. Even worse output and employment have been on a drastic downward slide, causing many comparisons to be drawn with the Great Depression of the early 1930s. 

Is there an intellectual mistake that, by the remorseless logic of events, has ended up in the international financial Bedlam of late 2008 and early 2009? Of course, the current crisis is complex and multi-faceted, and has many causes. However, the argument here is that one particular line of thought has to carry a large share of the blame for what went wrong. Only now is a rather different set of ideas being heard, perhaps foreshadowing a radical move to better policies and a sharp improvement in the economic situation. 

Our starting point is a recondite article in the May 1988 issue of the American Economic Review, on "Credit, money and aggregate demand" by Ben Bernanke and Alan Blinder. Both authors later became prominent in the Federal Reserve, with Bernanke receiving the ultimate accolade when he was appointed chairman of the board of governors in February 2006. The article's emphasis was on "the special nature of bank loans". Following the lead of the Harvard economist, Professor Benjamin Friedman (not to be confused with the redoubtable Milton Friedman of Chicago), Bernanke and Blinder referred to "new interest in the credit-GNP relationship". By "credit" they meant bank lending to the private sector.

The 1988 article received numerous citations in other economists' journal articles, the key metric of academic stardom. In 1995, Bernanke was encouraged by this success to write a further article, with New York University Professor Mark Gertler, on "the credit channel of monetary policy transmission". The heart of their argument was that "informational frictions in credit markets worsen during tight-money periods", with the difference in cost between internal and external funds to companies enhancing "the effects of monetary policy on the real economy". The remarks on "informational frictions" were a dutiful allusion to Joseph Stiglitz, awarded the Nobel Prize for economics in 2001, who had written on "asymmetric information" as a cause of imperfections in financial markets. Bernanke and Gertler further differentiated between so-called "balance sheet" and "bank lending" channels "to explain the facts", although — curiously — they added a warning that comparisons of actual credit aggregates with other macroeconomic variables were not "valid tests" of the theory. (We shall return to this later.)