Damned if they do and damned if they don’t might be the popular verdict on the activities of the financial services sector in recent years. When interest rates were at historical lows, it supposedly encouraged a borrowing bonanza, fuelling a housing boom and spending surge, resulting in record levels of personal sector debt, equivalent today to 160% of earnings.

Now, however, it is payback time for lenders and borrowers. The credit crunch has meant financial institutions retrenching from many of their traditional activities as they try to shore up balance sheets, manage bad debts and rebuild margins. As a result, the housing market is slowing at rates not seen since the early 1990s, with prices falling and first-time buyers struggling to get a mortgage. And, with higher debt servicing charges squeezing disposable incomes and mortgage equity withdrawal tailing off, the next few months on the high street are expected to be bleak.

So, the sector that was at the forefront of Britain’s impressive growth of recent years is now thought to be adding to the downward pressure on the economy. The timing of interest rate cuts is now seen to be more a reflection of what is happening in financial markets than an indicator of the health of the real economy. This is a new problem, uncharted territory, and it emphasises the truth of the old maxim that ‘the past is not a good guide to the future’. Several interesting points are raised by the UK’s current predicament.

More than previously – with the possible exception of oil prices – the credit crunch highlights the increasingly global nature of economic events. There is at present a lack of confidence in wholesale financial markets in the UK, markets used by banks to raise funds over and above those they attract through their retail networks. But since last summer, bank A has not been willing to lend to bank B because of the uncertainty of what is in bank B’s portfolio. That uncertainty relates to sub-prime loans made in the US, but which have since found their way into the financial systems of most industrialised countries. It is not a uniquely British problem, either.

Second – if it is not too self-serving – it shows how important banks are to an economy. The UK can grow and prosper without car manufacturing capacity, with its textile industry relocated in Asia and its coal mines closed. But if the banking system stalls, the economy is in trouble.

Financial institutions in effect provide the plumbing that allows goods and services to move around a system, that takes risks on investments and that offers rewards for savings. Now, there is a need to unblock the pipes to get things moving again.

Third, the present impasse shows the limited influence policy-makers have on events. The key rate for bank-to-bank lending is three-month Libor, rather than Bank rate, the benchmark for retail customers. Generally, there is barely a cigarette paper between the two rates, but in the last three months of 2007, the differential jumped to 1.15%. Having almost disappeared in January – suggesting normal service was resuming – a gap has again emerged, of around 0.7% to 0.8%.

Confidence has again evaporated. Just because the MPC reduces Bank rate does not mean the gap with Libor will close or even stay the same. Uncertain financial institutions may not pass on Bank rate cuts to retail customers, because they are still uncomfortable with the risk, or they prefer to rebuild margins.

As the Bank of England Credit Conditions Survey for Q1 shows, there was a reduction in credit available to both personal and corporate customers in the three months to mid-March on the previous quarter, with further reductions expected in the next three months. At the same time, the increase in spreads on lending to both groups shows that what credit was available was getting more expensive. This was also expected to continue in the coming months. For an economy in which borrowing has underpinned growth, this will be a rude awakening. The BoE is probably as concerned with banking system liquidity as it is with interest rates, and this debate with the banks has been going on since last autumn.

If all this sounds terribly negative, consider the following points. Will the economy really be weaker if borrowers can no longer get 125% mortgages? Would it be such a bad thing if lending criteria are brought more into line with the borrowers’ ability to pay, and if the rates charged on lending reflect more realistically the risks involved?

If the UK economy is to be rebalanced as the policy-makers keep telling us it has to be, putting a tighter squeeze on consumption is an essential first step. Painful though it may be for many people and businesses in the short-term, this necessary correction may come to be regarded as a blessing in disguise.