Yesterday, the Bank of England surprised just about everyone by doing what just about everyone felt it should do.

The interest rate was slashed by 1.5 per cent to 3 per cent. It was the biggest rate cut since 1981; interest rates are now at their lowest level since 1954 and now all eyes turn to the banks.

“Shame on them,” cry the media – for the banks are not toeing the line. They are not doing as they are told. Banks’ stock with the UK public is at an all-time low, and now their intransigence is just making things a whole lot worse. Nationalize the lot of them, then they will comply.

It is just that it isn’t like that at all. It is time to lift the veil of secrecy on how the Bank of England determines the rate of interest. And then we can understand what is really going on a whole lot better.

The first thing you need to understand is that there is no magic switch. If the Bank of England decides it wants interest rates to change, there is more to it than for the MPC committee to gather together in a dark room sprayed with incense, holding hands, chanting, followed by the performance of some ritual, and then screaming in unison: “Cut rates to 3 per cent.”

A comment on one blog this morning asked: why doesn’t the Bank of England change the LIBOR rate? Well, the answer is quite simple, because it can’t.

Pick up any book on economic theory and you will read that the rate of interest is that rate which ensures the supply of savings equals the demand for credit. All banks were ever supposed to do was use the money deposited in their vaults, and lend it elsewhere. If there are an awful lot of people out there who want to borrow, and very few who want to save, then there isn’t enough money to lend, and so interest rates go up.

The last few years have seen the savings ratio in the UK and US plummet, while demand for debt reached unprecedented levels. Economic theory would say interest rates should go up. Instead, rates were incredibly low. How could this be? – well money flowed in from abroad. From Japan, via the carry trade; from China, where consumer demand was not keeping up with economic growth; from the oil exporting countries, where the high price of oil had boosted local coffers. Such was the availability of credit that, on occasions, the rate of interest set by the market was actually lower than the rate set by the Fed. Alan Greenspan called this a conundrum, although in truth he knew full well what was going on.

Now it’s all in reverse.

You will recall, Alistair Darling has called for a return to traditional banking. That’s when banks operate by lending out the money that’s on deposit to other customers – and usually controlled by a Captain Mainwaring-type of bank manager.

Well, if we really do return to traditional banking, how can we possibly see banks lend more without seeing a corresponding rise in the savings rate? Yet, if savings do rise, aggregate demand across the economy will plummet, and the recession will get a lot worse.

In practice, when the Bank of England chooses to change the rate of interest, it plays around with government securities. When it wants to up rates, it sells securities to the banks, leavings the banks with less spare money. When it wants to lower rates, it buys securities, meaning the banks have lots of spare spondulicks.

But you see, if the rate of interest offered by banks were to fall to 3 per cent, consider the impact this will have on the demand for money. It will go though the roof. People will seek to borrow their way out of difficulty. Then consider how few people will want to save.

The truth is, it is high consumer borrowing that lies behind this crisis. It is inconceivable that borrowing levels could return to anything like the levels seen in 2007, yet if rates did indeed fall to 3 per cent for mainstream loans, demand would shoot up.

They say it is the interbank lending level that matters, but in truth that is just part of the picture.

For the last few months there have been growing calls for banks to reduce risk, and if they want to do that, they need to increase their margins. Bizarrely, they are now being criticised for doing the very thing that last year they were being criticised for not doing.

When a cut in interest rates will really help, however, will be if repayments for those in debt can be reduced. That will boost the economy, without creating more unsustainable debt.

Then again, there is another side to the argument. There are occasions when what is right for the individual is not right for the whole. A bank attempts to reduce risk by cutting the supply of credit, and making higher margins. But if all banks do this, the economy will weaken, more customers will default on their loans and banks will lose out. Banks may actually reduce risk if they all, acting in tandem, choose to be more generous.

And finally, before we leave this issue, we just can’t ignore one comment made yesterday by Ray Boulger in the Telegraph: “When property prices are falling high loan-to-value mortgages are riskier than when prices are rising,” he said.

That is an interesting comment, and in a way Mr Boulger put his finger on one of the most crucial points, but for the opposite reason he gave.

Surely, if prices are rising, that means in the long-term current prices are more likely to be too high. Lenders who supply loans secured against property when it is rising, are taking more of a long-term risk. When prices are falling, it seems safe to assume price is closer to a sustainable level. Do you see the logic?

Surely it was the willingness to lend because house prices were going up, which provides the single biggest explanation for the whole d**n mess.