For much of Britain, the City is another country, if not another world. On the average Briton’s consciousness, the Square Mile is mapped out as terra incognita. As the increasingly scary events of the credit crisis have unfolded, this lack of understanding has mingled with fear of the unknown to fuel suspicion of the mysterious, and seemingly now dangerous, black arts of the City’s money men.

It has become a commonplace observation, meanwhile, to point to a supposedly yawning reality gap between the Square Mile’s present, ever-deepening woes and purportedly more benign conditions in the “real economy” across the rest of the UK.

The dubious implication is that the City can be left to reap the financial whirlwind sown by its own greed and irresponsibility, while the rest of us sit out the storm in relative security.

The Bank of England Governor lent some credence to this view last week, pointing to the “remarkable resilience”, so far at least, of consumer spending and employment, and agreeing there is a sharp division of economic experience between the City and the real economy.

Mervyn King did not quite endorse the idea that the Square Mile can somehow be quarantined as a sort of financial plague island, while the rest of Britain remains immune from global financial pestilence. Yet the Governor sought to draw a line between the Bank’s policy moves to tackle the root causes of the credit squeeze blighting the markets, and action to address wider dangers to the economy as a whole. He argued that the first was largely a question of lack of liquidity that called for specific measures, while interest rate cuts to fend off any threat to the wider economy should be seen as separate. It was “absolutely vital to distinguish clearly”, these two sets of problems and responses, he said.

Mr King’s desire to draw this distinction is understandable while the Bank continues to be vexed by what he calls the “difficult balancing act” between conflicting pressures from persistent inflation and vulnerable growth.

With the Bank still deeply wary of aggressive interest rate cuts as soaring food and fuel costs continue to stoke price pressures, insistence that the credit crunch calls for separate and different remedies helps Mr King and his colleagues to hold the line against demands for sharply lower rates.

Unfortunately, the idea that the financial world and the real economy can exist in separate orbits, with little influence on each other, is a forlorn hope. Indeed, two events in the past week have made it all too clear that these two worlds now threaten to collide with potentially explosive results, and severe fallout for all of us.

The intensity of the influence of the financial and “real world” spheres on each other was underlined by Friday’s report from Nationwide Building Society of a fifth consecutive monthly fall in house prices.

News of this latest blow to homeowners, which cut annual growth in house prices to a 12-year low of just 1.1 per cent, came as the funding drought in money markets compelled three leading lending institutions to raise mortgage rates, despite the Bank’s cuts in base rates.

With outright year-on-year falls in house prices set to become grim reality as soon as next month, and the likelihood that the credit crunch will mean that home loans become scarcer and still more costly, these events raised the threat that Britain could be gripped by a vicious circle similar to that afflicting America.

Negative developments in financial markets and the real economy now threaten to feed on each other, with falling house prices battering property market sentiment, cutting demand and making lenders still more cautious, depressing house prices yet further. The downward spiral risks being intensified as a housing slump then saps consumer spending, weakening growth, imperilling jobs and adding to strains on institutions as more borrowers default.

The stark reality is that far from being somehow separate and distinct, the fates of Britain’s financial sector and the real economy have been, and remain, intimately bound up.

As Michael Saunders, of Citigroup, suggests, for the past decade both spheres have thrived as the financial sector provided the easy credit that fuelled a boom in domestic demand and asset prices. That, in turn, sustained City optimism over strong returns, made lenders feel secure to carry on lending with a casual attitude to risk, and made borrowers feel safe to keep on borrowing. “The financial excesses and real economy excesses of recent years are two sides of the same coin,” Mr Saunders says.

Now, the symbiotic relationship of the financial world and the real economy is turning toxic, as the virtuous cycle of credit-fuelled economic expansion goes into reverse.

Worse still, as Mr Saunders says, the excesses of recent times have left a legacy of record indebtedness for companies and households, steep interest and repayment costs, depleted savings and stretched asset prices. These leave Britain exposed to the credit squeeze’s imminent impact.

Citigroup’s calculations reveal how, after years of living beyond our means, the combined deficit of UK nonfinancial companies and households – the excess of what we spend over what we earn in income and profits - has leapt to 3.3 per cent of GDP, more than double the 2006 level, and the highest since 1989.

British households’ savings rate last year plunged to just 2.9 per cent of incomes, the lowest since 1959, while companies have now blown the big cash piles built early this decade. Repayment costs on borrowings for both households and companies are now the highest since the early 1990s.

Years of financial sector largesse have left the rest of us deep in the red, and both the financial world and the real economy are now deeply, and similarly, vulnerable as a result.

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