When the financial crisis hit, banks panicked and severely limited how many new loans they made. As a result there was less new money entering the economy, and consequently there was less spending. But because all that earlier borrowing still has to be repaid, money continued to disappear from the economy. In this situation, if the government does nothing then the amount of money in the economy would start to fall. This is exactly what happened in the US in the Great Depression, when the amount of money in the US economy shrank by a third. The money wasn’t “going somewhere else” – it was actually disappearing out of existence. Fast-forward to 2008 and the same thing happened again. A decreasing/contracting money supply can lead to a fall in spending, a shrinking economy and rising unemployment. Even though people might be paying off debts, this leaves them with less money and the economy as a whole ends up with less money flowing around.
Chapter 4 of Modernising Money covers the ‘debt-deflation’ problems that occur in a recession due to the fact that money is created by banks.