The Western World’s economic health and vitality depends primarily on its inhabitants continuing to consume.

As a parent of teenage girls I have become increasingly aware of the barrage of advertising and marketing designed to create the perception of new needs.  The belief that things obtained will lead to inner happiness (sadly no truer now than it ever was).

I digress; the concern for Western Governments is that consumers have funded consumption in the 2000’s not from excess income but from increasing debt.

The interconnectedness of economic actions and reactions which worked to make this possible are now working in opposite directions.

These include:

House prices

Rising house prices enables additional borrowing, coupled with loose lending criteria; this was a major source of fresh capital to fund consumption.

Now house prices outside London are static (falling in real terms because inflation is 5%) and lending has become far more restrictive.

Government Spending

The UK Government employs 23% of the total UK workforce.

Government spending rose under Labour creating jobs and higher incomes.

We now have public sector pay freezes, cuts to capital expenditure and an overall reduction in total spending.


The metrics for Government debt and its’ rise or fall are compounding in either direction.

If an economy slows then this can lead to less consumption, less corporate profits made, less corporate tax paid, less income tax paid, higher unemployment benefits claimed, less consumption, less VAT raised – the Government cuts its expenditure again, more jobs lost, less income tax is collected, leading to an increased budget deficit, the cost of borrowing rises for Government debt as ratings agencies cut ratings, Governments deficit increases…..and so on!

Availability of credit / banks and the credit crunch

The amount of money in the economy varies, over an economic cycle. Banks can effectively gear up their balance sheets to create money or de-leverage and remove it from the economy and this will depend upon prevailing confidence and profitability.

What is happening now is that Banks are busily destroying money, not physically but in terms of the amount of leverage they have.

So this is roughly how it works.

Example 1

A bank makes loans of £1million in total (it has £1 million of its own capital).

Gearing is 1 times its capital.

All loans go bad, total default = bank loses its capital.

Example 2

Bank has £10 Billion of assets (Tier one capital)

Bank has loans of £150 Billion (it is leveraged 15 times to its own capital)

10% of loans go bad i.e. £15 Billion.

Bank not only goes bust but leaves an unfunded liability of £5 Billion which will then trigger another Bank to default etc etc

This in essence was the highly leveraged state of Banks in 2008.

So, post 2008, the Banks concluded that leveraging was too high and that it needed to be reduced.

So from 2008 having:

£150 Billion of loans

£10 Billion of Tier 1 Capital

A bank in 2012 may have:

£100 Billion of loans

£20 Billion of Tier 1 capital

Now this looks like a good thing, in many ways it is a good thing but whilst banks are now safer the unintended consequence of the deleveraging is that Bank A has sucked out and destroyed £50 Billion of money formerly in the economy. It has taken in loan repayments and not created new loans.

This is what the politicians are jumping up and down about because what is happening is causing economies to contract which causes tax to fall (see unemployment).

Now the politicians have a valid point but so do the banks and it is difficult on the one hand to blame the banks for causing the problems by injudicious lending, and then castigate them for having far stricter lending criteria which reduces the current lending.

As a side issue this illustrates the point being hotly debated by academics, namely ‘is market capitalism more or less effective than centrally controlled capitalism?’

The question relates to the alternate approaches of China and the West and challenges the free market hypothesis as the most efficient.


The Quantitative Easing of the US and UK Central banks (and the stealthier version now underway in Europe) is designed in part to counteract the destruction of capital by Banks, and to help stimulate consumption and support asset prices so that a recession does not morph into a depression (and the Japanese experience of extended deflation).

This is why consumption matters and is a key to economic health.

NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.