What happens when the money runs out?

Banks need the confidence of the public to survive and they have lost it for years to come. The dang

We are witnessing the collapse of the world financial system. To have said that even a month ago would have been to invite ridicule, but now it seems only a statement of the obvious as banks implode, governments panic and investors run. The initial liquidity crisis that broke in August 2007 and drove Northern Rock to the wall has evolved into a crisis of insolvency and finally into a crisis of confidence in the entire financial system.

The British government has been forced into an incremental nationalisation of the banking system, initially with Northern Rock, then Bradford and Bingley, and this week through the £50bn scheme to take equity stakes in leading British banks. But it is a race against time. Last week we started to see something that has never happened before in Britain, even in wartime: a generalised run on the banks. Mostly, this has been by computer - often within the banking system itself - rather than by orderly queues of depositors outside branches - but the result is much the same. The banks' capital reserves evaporate, leaving them insolvent. It is happening throughout Europe and has caused panic in governments. The very integrity of the European Union is under threat as member states resort to disordered and unco-ordinated acts of economic nationalism.

For most of us this chaos has appeared as if from nowhere. This is because financial institutions, regulators, analysts - with a few honourable exceptions like the New York economist Nouriel Roubini - have systematically underplayed the crisis over the past 12 months. When Alistair Darling warned of the severity of the crisis in an interview, he was castigated. We have been told that it is about a few sub-prime mortgages in the United States, that "the worst is over", that liquidity injections are working, when they clearly are not. This is as much a European crash as a Wall Street one and the stock markets of the world are now caught up in the financial psychodrama.

Public alarm is heightened by the incomprehensible language: "securitisation", "deleveraging", "structured investment vehicles" and "credit default swaps". Yet, behind the complexity and obfuscation, the essence of the crisis is simple: the banks have lent as if there were no tomorrow, and now tomorrow has arrived. Behind the fancy formulas lies the brutal truth: that financial institutions which loaned out 30, 40, 50 times their core capital now find themselves at the wrong end of their own leverage and are themselves being levered out of existence. They were not too big to fail after all.

Now they will have to be recapitalised - in other words real money will have to be injected into the banks to make them solvent so that they can lend again. This cannot now come from sovereign wealth funds, shareholders or loans from other financial institutions. It will have to come from the state - ultimately from the bank of you and me. It will require the government to buy large stakes in the banks or to nationalise them outright. This is an outcome governments desperately wished to avoid, but they are rapidly running out of alternatives.

Even though the United States has thrown $700bn at the Wall Street banks, stock markets have collapsed and bank lending remains frozen. Ireland has placed the entire collective wealth of its people at the disposal of its delinquent banks by guaranteeing all bank deposits. Germany righteously condemned beggar-my-neighbour Ireland, and then did the same, while insisting it had not. Denmark, Austria and Greece have followed suit. Bankrupt Iceland has called on trade unions to repatriate pension funds to throw into the black hole that used to be the economy.

As queues form outside London bullion dealers, we are seeing a breakdown of public trust in the banking system, and public trust is the one thing banks need to survive. Banking depends on a kind of benign confidence trick. They make their profits by lending out money they do not actually have - it is called fractional reserve banking. At any one time, a bank will have loans that far exceed its deposits. But the trick only works under certain conditions: if depositors can be persuaded not to withdraw their funds at the same time; if the banks are honest about their reserves; and if the assets they hold retain their value. At present, none of these conditions is being satisfied.

There is worse to come. The next stage will be corporate collapse as companies find they can't roll over loans from banks hoarding whatever cash they still have. Small companies are already having to pay penal interest rates. We may soon see global giants such as AT&T, Ford, General Motors go under. In Britain, companies that depended on the housing bubble are the first to feel the pressure - MFI, B&Q, estate agents. Then it will be high-end retailers, with chains such as John Lewis and Marks & Spencer under pressure, and then other high-street names financed by Icelandic banks. The shake-out in the financial sector will lead to further substantial job losses.

House prices, which have already plummeted, may now sink into the abyss as homes simply become unsaleable. In the worst case, if no one can get a mortgage, a house becomes worth only what people can afford to pay in cash. All those people who felt so secure in their bricks and mortar are about to find that their asset is in fact a liability swallowing money they don't have.

Globally, we are seeing increasing state involvement. Ireland has in effect merged the state with the banks, as has Iceland. In America, the Federal Reserve and Wall Street tried to stage a kind of financial coup, in the original Paulson plan, which would have allowed the treasury secretary to spend public money without political or judicial oversight. Public anger was intense. The danger is that governments, faced with popular resentment at such attempts to resolve the crisis, find themselves resorting to undemocratic means of managing dissent. Phlegmatic Britain doesn't do civil unrest. But we know from what happened in Europe in the 1930s that systemic financial crisis can lead rapidly to the growth of political extremism.

We may be about to discover just how dangerous it was to allow all those CCTV cameras to be put up on every street corner; to arm the police and turn them into a kind of civil army; to extend detention without trial. With luck, our democratic institutions will remain a bulwark against such authoritarianism, but this will require vigilance. This is a pivotal moment.

Governments have no alternative now but to take over and recapitalise the banks. This will mean huge losses to shareholders, but they are losing already. The state is now at the heart of the financial system. We are at the end of the delusion that an economy can be built on debt. It is payback time. Unfortunately we are all liable.