New monetarist theory tells us that monetary frictions can only be fully addressed by unsecured private sector debt — and thus can only be solved by designing incentive structures that make unsecured private sector debt enforceable, or in other words by a carefully designed banking system.
Prior to the 1930s, the central bank played two main roles: it supported the private sector money supply through panics and monitored the growth of credit, taking action to prevent credit-boom-driven inflation. (The latter was the real bills approach to bank regulation, which the Fed unfortunately was not well-equipped to address — explained here.)
Monetarism introduced a new era in which it was believed that government “control” of the money supply played an important role in economic activity. The financial system has evolved to match the theory. There has been a steady increase in the role of the central bank over the past few decades, and this evolution culminated in the vast expanse of the central bank role subsequent to the crisis of 2007-08.
With the collapse of interbank lending markets, the growth of central bank reserves, and the shift to secured lending backed by government debt, the role of unsecured private sector debt in the money supply has declined dramatically. In short, the better part of a century after it was first set forth the monetarist agenda of putting in place government control over the money supply and of minimizing the role of the private sector in the money supply is finally being achieved.
And just as new monetarist theory would predict, the decline in the use of unsecured, private sector instruments as money is associated with sluggish economic activity — because “M” is a poor substitute for the money that a well-structured banking system can provide.