The ‘Sorcerer’s Apprentice’ is a poem written by the German writer Goethe in 1797. The sorcerer asks the apprentice to fetch water. Being lazy, the apprentice waits until the sorcerer leaves and then steals one of the magic spells to get a broom to fetch the water. This seems to work well and soon there is sufficient water. Unfortunately the apprentice does not know the magic spell to make the broom stop. More and more water is brought until the place is flooded. The apprentice breaks the broom in half, but this just means it brings twice as much. Eventually the sorcerer returns, stops the mayhem and tells the apprentice to leave the spells to wiser heads.

This is an apt analogy for the financial crisis of 2007–08, the subject of this chapter. The apprentice is the banking sector. The magic spell is the capacity of the banks to create money through debt. A major recipient was the financial sector, which used ‘leverage’ – that is, debt – to fuel its activities. The regulatory discipline that had been in place since the Great Depression had been breaking down since the 1970s. By 2007–08 banks and other financial agencies were on an orgy of debt-funded speculative activity that was more akin to gambling than traditional financial investment. Debt itself in the form of mortgages became a key focus for investment. Aggressive selling of mortgages to poor people eventually proved to be the weak point in the speculative dam. The chapter opens with one of the first signs of crisis, the failure of a small bank in the North-East of England (Box 5.1). I then go on to explain why the ‘leveraged’ activities of the financial sector were so precarious. Finally, I describe how the sorcerers, states and monetary authorities had to step back in to rescue the situation.

Box 5.1: Bank on the rocks

On 14 September 2007 a queue of people were lining up outside a small northern bank in the UK. They wanted their money back. The trigger for the run on the Northern Rock bank was a media report that it had needed to go to the Bank of England for a loan. It was the first bank run in Britain since 1866. The run began on a Friday.