Excessive liquidity is removed by the collapse of banks.
So what is this big hoohah about bankrupt financial institutions and the attempt by the government to save them?
When there is too much money in the economy, this money got pushed into assets which do not have any conceivable return. This is fine if the assets are bought with cash or past savings. But, if the assets are bought with borrowed money, then it creates a potential problem for loan repayment. It is just a matter of time that the loan repayment problem will appear in the form of non-performing loans in the books of banks.
The only way that banks can hide the problem of NPL is to keep the ratio of NPL to total loans down. As NPL rises, total loans must rise faster. That is banks are forced to gear up and escalate their lending. Banks keep lending until there are no more borrowers to lend to. Then, the NPL ratio surges.
If the gearing of banks has been increased by the reselling of mortages, then the other financial institutions buying the mortgage papers are at risk, no matter how big the potential rate of return may be. One fine day, the mortgage papers will be worth nothing when borrowers cannot repay their mortgages.
The rise in NPL means that banks must use more of their capital to cover their NPL. This cannot happen because the banks are fully geared. Since they have to throw all their capital into the NPL hole, there is no more extra cash for them to lend to new customers. If this happens to one bank, the other banks can help. If this happens to most of the banks, then there is a shortage of liquidity in the system. There is a seizure in the credit line in the whole financial system.
The natural thing to happen is for the banks to go bankrupt - which could mean 10 cents to each dollar of deposit can be repaid. Ordinary depositors pay for the sins of the banks and the borrowers.
So the central banks have to come in to rescue the banks. The mortgages are fine, because they are real estate; if the price of real estate has collapse because of the credit crunch, it is just a matter of time (18 years in Japan and still counting) for the real estate to recover. The central banks can come in to buy these mortgages and keep them. With those mortgages, the central banks can inject more capital into the banks.
But financial institutions which have bought the mortgage papers (not the mortgages) have only useless pieces of paper left. These mortgage papers are sometimes called mortgage-backed bonds, and bonds generally have a limited life, say, one year, three years, five years. These bonds become worthless because the banks issuing these mortgage bonds have gone bust. These are financial institutions that are caught with their pants down. They simply collapse, having exhausted all the reserves they have built up over the years, some, over 100 years. For these financial institutions, they will still have other assets which they can sell to other financial institutions.
It is therefore important in a monetary economy to control the money supply tightly to ensure that there is sufficient liquidity to finance businessess and other real economic activities. It is highly irresponsible for the central bank to keep printing money and maintaining a high pace of expansion of the money supply in the hope of keeping a dying economy alive. This is like pushing a string - the real economy will continue to die while tycoons are created in the financial and real estate sectors. When the uneducated rich begins to laugh at the educated poor, you know the world is upside down and ready for punishment for the greedy.
It is the responsibility of the central bank to keep a disciplined growth in the money supply so that ordinary people do not suffer - by putting their hard-earned savings as bank deposits at risk, by making them poor by engineering the escalation of property prices which put house ownership out of their reach, and generally allowing an insidous creeping up of prices in general. Inflation means ordinary people must tighten their belts so that the rich can consume more.