A year ago the Federal Reserve and the European Central Bank rode to the aid of the inter-bank markets, ending the first dramatic week of the credit crunch. That was the week the wholesale markets froze, paralysing the banking system. The suddenness of this seizure was without precedent. It was just like the emergency stop in the driving test — only without a rehearsal. Unfortunately, few drivers were wearing seat belts and it took just over a month for the crunch to claim its first victim, Northern Rock. The markets remain frozen despite the best efforts of the central banks.

It is hard to see any resolution of this crisis. As we saw again last week, the huge sums of capital the banks are raising through rights issues and the like are being swallowed by provisions for bad debts, leaving them desperately short of capital. The banks are unwilling to lend to each other and increasingly reluctant to lend to anyone else. What effect is this having on the economy and how can this be mitigated?

Although the effects of the credit crunch are now most obvious in the mortgage and housing markets, these are just one reflection of a more fundamental problem — Britain’s economic imbalances and its dependence on variable-rate bank borrowing.

Since the millennium, the economy has been moving ahead rapidly on the back of strong consumer and government spending and borrowing. Initially, that helped to stave off the effects of the world recession, which hit exports and investment hard. However, the boom continued long after the recovery in the world economy, supported by the plentiful supply of cheap finance in international markets. Despite all the warnings, the government used the booming tax revenues to finance current spending rather than saving them for a rainy day.

The banks made up for the shortage of savings deposits by using securitisation vehicles to help finance their lending. These hold mortgages, financing them through short-term commercial paper. (Last year in July, for example, Northern Rock had lent £106 billion in mortgages but hived off £49 billion into its vehicle, Granite, leaving it vulnerable to the seizure of the commercial paper market.) The current account of the balance of payments went from bad to worse but the pound stayed strong, supported by the inflows of capital from overseas. Exports remained in the doldrums.

Now of course it’s a very different story. The crisis has suddenly pitched the British economy into the long-overdue rebalancing from consumption to investment and exports. It has reduced the capital inflows that were supporting the pound and cut off the wholesale funds that were financing the banks.

As Sir James Crosby’s report on the mortgage market made clear two weeks ago, securitisation provided about two-thirds of the mortgage finance available in 2006 before the crisis began. Now that this market has closed, the mortgage lenders are dependent on savings deposits. That is why you see advertisements for cash Isas rather than two-year fixed-rate mortgage deals in their windows. But these deposits also have to fund repayments of outstanding securitisation issues so there will be little left over for new mortgage finance. New mortgage approvals are down to a third of last year’s level and set to fall further.

As I say, the mortgage funding problem is just a reflection of the fundamental macroeconomic problem. Basically, if we cannot find some way of replacing those international banking inflows and financing the current-account deficit, domestic investment must fall and savings must increase to make up the shortfall. That may sound like a good thing and we certainly should start to save more. However, the problem is that this kind of adjustment is hard to make quickly and normally comes with all sorts of recessionary side-effects. For example, investment in housing is falling in response to the mortgage famine, and this is decimating jobs in the construction, mortgage and related industries. It now looks like we will see a recession rather than a rebalancing of the economy.

Market interest rates have risen and exchange rates fallen as part of this adjustment. The current account has begun to improve, but that is largely because the crisis has hit the profits that overseas banks make in Britain. The slowdown in the economy has also reduced imports. Exporters have taken advantage of the lower exchange rate — but by increasing prices rather than production. Export volumes grew 1.5% in the year to the first quarter, while sterling export prices increased nearly 8.5%. It seems that a decade of high living and high exchange rates has taken its toll on export capacity.

The adjustment to the economy has been complicated by the surge in world food and energy prices. This has squeezed household budgets, making it much more difficult for us to increase savings. Next Tuesday is likely to see inflation topping 4% on the consumer price index, taking another big bite out of disposable incomes. It has also squeezed company profit margins, with similar effects. The exchequer was a big beneficiary of the expansion in the financial sector and it will be a big victim of the downturn. All in all, it is hard to see where a sharp increase in savings could come from.

Nevertheless, the public sector does offer a safety net, which will help to cushion the economy from recession. The fiscal rules are being rewritten to allow for much higher government borrowing.

The government has the ability to use the gilt-edged market to tap into sovereign wealth and other international investment funds that are still in plentiful supply. Indeed, it is one of the few UK borrowers that can access these markets. This will help take the place of bank finance in funding the current account and (indirectly) the UK money and mortgage markets. Indeed it already has. The £27 billion used to rescue Northern Rock last autumn was financed by selling gilts and many of these will have been bought by overseas investors. The Bank of England’s £50 billion special liquidity scheme was meant to kick-start the inter-bank markets but will at least have provided some support for sterling and the housing market.

The Treasury now faces the challenge of finding ways of easing this difficult adjustment. House prices must fall back to a more affordable level, but it would be a mistake to allow them to fall too far. That would plunge the high street and the rest of the economy into recession, hitting the exchequer hard. It would seriously impair housebuilding capacity, reducing supply and making housing less affordable in years to come. The chancellor is looking at stamp duty, but it may prove necessary to extend the special liquidity scheme to help the market find a proper footing. Government support for the banks will be hard to stomach, especially as they led us into this mess. Yet one way or another, I am afraid that the taxpayer will end up with the bill.

- Peter Spencer is professor of economics and finance at the University of York and economic adviser to the Ernst & Young Item Club

David Smith is away

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