From last time, 97% of all money in the UK is debt-based, better known as "Bank Money" or "Balance".* In a system where no new debts are being taken, such where it is impossible to get a mortgage/credit care/corporate loan, one expects that the total money supply will also decrease with a decrease in debt, as they are largely equivalent. Though I said before** that in a 100% debt-based system debt can never be extinguished, it can clearly decrease in the short term; bankruptcies, en-debted people selling their goods to be people with capital and so on can all reduce the total outstanding debt, and thus the total supply of money.
So entering into this current "financial crisis", it at first appears that we will have a decreasing money supply, with more people either going bankrupt or paying off their debts, and simply not spending. This effect makes money "scarcer", it drives prices down by a lower demand for goods as money becomes more valuable. This is the classic deflation scenario that happened in the (first) great depression, and (I believe) has been happening in modern Japanese for the last 20 years. This necessarily requires reducing the number of units of money that is lent out on a given unit of cash, which, again, is about 30 in the UK today.
Such deflationary effects are more or less wiped out by the effect of central banks efforts to "provide liquidity" to the markets, to use the obsequious words of December newspaper headlines. "Provide liquidity", "Inject money supply" a menagerie of terms have been used to describe central banks efforts to "calm the waters of the market", such obfuscating terms should lead one to be immediately suspicious, especially when the total dollar value of such actions was around 1 Trillion dollars. A more accurate and less used phrase is "monetizing the debt".
In this system with 97% debt based money and 3% is cash, if people start to come in and ask for their cash (this can be private or corporate banking customers remember), and there are few new investors, the system is massively destabilized, as the bank needs to start calling in more or the loans they gave out.*** In this sort of a world, that is todays world, all banks are desperately crying for more cash. Central bankers, whose ears are ever by the modern bankers mouths, are simply giving them what they want, and giving lots of it. Sure, they are charging quite high interest rates for lending out this cash, but as you know now whatever cash the central banks lend out, private banks can lend 30 times the amount lent in the first place. While the effect of reducing the amount of money lent out on a single unit of cash will still happen, the money- multiplier as it were, if the change in number of units of cash increases faster than this multiplier is decreasing than the money supply will increase anyway.
This is called "monetizing the debt" as the central bank is exchanging cash for debt based money from the private banks. In other words it is changing what was at first money the bank lent out on cash it didn't have into real cash, rewarding their fraud. As I have mentioned several times, inflation occurs almost entirely because of an increase in the money supply, and you can see now that if enough of this debt is monetized the the inflation will be massive, perhaps even "hyperinflation", where inflation becomes best measured on scales shorter than a year.
Now, how can you tell which of these scenarios will happen? At the risk of becoming very boring, central banks lending to private banks is very different to private banks lending to private banks, as central banks lend cash, that is they lend money which can be re-lent on many times, and this lending is possibly the most important factor of the coming years. Can we tell how much they will lend? It may not have been decided yet (though I believe it would be naive to bet on that). Can we even tell how much is being lent now, let alone what will be lent? In the UK, apparently only when the BoE chooses to make a press release about it. I have checked the money supply data from the bank of England, and I can find no addition in December for the M0 lent out. If you have read the papers closely over the last few weeks, you'll see that the Bank Of England has been after, and will very likely be granted, powers to aid banks without informing the public or perhaps even anyone outside of Gordon Brown and Alistair Darling. They will be able to secretly print as much money as they deem fit, and they have already deemed fit to print a lot. These actions lead me to be that the BoE will choose hyperinflation, as they have specifically sought powers necessary for such a scenario to be hidden from the public. Hyperinflation trumps deflation in many ways, in that it makes old debts look smaller , somewhat "cushions" the fall in the value of housing,**** and decreases the value of the currency helping manufacturing and exports, though it completely destroys anyone's efforts to save (such as anyone holding a pension of pretty much any kind).
Ah now you want the solutions? The way to end this never ending spiral of debt? Well the current fall is utterly unstoppable, there are ways to make it never happen again, if you believe Milton Friedman, or me because I said I would tell you. It will have to wait anyway, as for now I have a date; perhaps I'll do a part IV of III sometime
*I'm told that this latter term is slightly less confusing
**Consider the man who takes 100 pounds in debt money, waits a year until he owes 1007 pounds, and then repays with the 100 pounds. Clearly the debt as decreased, but it can never be extinguished (without bankruptcy).
***From the last section of part i
****As I'm sure you've guessed, the HPC will still happen, it's just that the decrease in the value of money will make the fall less brilliant. If you measure house prices in gold, silver, oil, or sea water, they could well end roughly the same for either of the scenarios outlined above.