The people pay the price

Combine the foolishness of American banks with the hesitancy of British ministers, and you produce a

The credit crunch, after festering for months, has finally become very real for ordinary citizens, investors and businesses. Until now the talk of banking woes in the City and on Wall Street looked to be a remote event, confined to the exclusive parlours of the financial world.

But the earth tremor that sent share markets from Hong Kong to London and from Tokyo to New York crashing, in the biggest one-day fall since the events of 11 September 2001, was a hugely meaningful event for millions of people around the world. It was the moment when the markets finally recognised that the $100bn-plus losses incurred so far by the banks through sub-prime lending, the collapse of the US housing market and the squeeze on consumer credit could lead not just America, but the whole world, into recession.

The notion that the US's financial and economic problems could somehow be isolated from the rest of the world - because of the resilience of the Asian economic miracle - has been rudely shattered. Nothing symbolised the threat that the credit crisis poses to global stability better than the dramatic decision by the Federal Reserve, the US central bank, to slash interest rates by three-quarters of a point, to 3.5 per cent, in the biggest one-day cut since 1984.

This underscores the gravity of the crisis we all now face. The sharp fall in Britain's main FTSE-100 index, a barometer of business confidence, affects every person in the country. It has an immediate impact on people with pensions, who have seen the value of their hard-earned retirement savings devalued overnight. It might take years for the pension pots to recover. The BT pension fund, one of the largest in the nation, has fallen back into deficit after building a fragile surplus in recent years. The same applies to mutual savings ranging from endowment insurance policies, intended to pay off mortgages, to unit trust holdings and money put into Gordon Brown's Child Trust Fund, for the benefit of the next generation. All will be damaged.

The stock market is telling us that, with the banks crippled by bad debt, the UK economy is heading for a sharp downturn. The signs are mounting daily. Mortgage lending collapsed by 25 per cent in the final months of 2007; experts believe that the pressure from the housing market will push consumers to stop spending and could lead to a severe slowdown.

Public companies across Britain are confessing to the stock market that it is highly unlikely they will achieve the profits they had forecast. Funds that invest in commercial property, such as the one operated by Scottish Widows (part of the Lloyds TSB Group), have been forced to close the escape route to ordinary investors, because the value of offices, shopping centres and industrial parks is tumbling.

Yet the government's room for manoeuvre is extremely limited. Even before the credit crunch, revenues were falling, opening up a large gap in the public accounts. Tax receipts, buoyant in the good times, are creating a huge hole in the public finances, which were £44bn in the red in the first nine months of 2007/2008.

Echoes of Leyland

This provides a grim picture for a Labour government whose hard-won reputation for economic competence has already been badly damaged by the drawn-out saga of Northern Rock. Ministers' handling of the affair is proving to be a triumph of indecision and ineptitude. Finally, after five months of vacillation, the Chancellor, Alistair Darling, has hatched a "private sector" solution, which the City sees as having a much better chance of reopening the auction for the failed Newcastle mortgage lender. However, the plan requires it to backtrack on previous assurances that Bank of England loans and guarantees, amounting to £55bn in all, will be for the short term only.

In what is the biggest-ever rescue for a private enterprise, outstripping even the bailouts of British Leyland, Rolls-Royce and other industrial enterprises in the 1960s and 1970s, the government could still be supporting the Rock in five years' time, perhaps long after the current Brown government has left Downing Street.

Britain's highly politicised handling of the crisis at Northern Rock contrasts sharply with the practical financial solutions adopted elsewhere.

In the period that the Rock was on the injury list, the German authorities moved to help bail out two banks seriously hurt by America's sub-prime lending problems. In the US itself, the authorities moved to ensure a crisis at two of their biggest trailer-park mortgage lenders was contained.

The uncertainty that has infected stock markets can be blamed only in part on Britain's cack-handed handling of Northern Rock. Responsibility rests with the so-called T3 - the tripartite regulatory structure created by Gordon Brown as chancellor in 1997. Brown and his then top adviser, Ed Balls, thought that by moving banking supervision away from the Bank of England to the Financial Services Authority, they would prevent the Old Lady of Threadneedle Street from being tainted by future banking collapses.

Instead, they created a power vacuum in which none of the parties to the new structure - not the Bank of England, not the FSA, not the Treasury - was able to act quickly and decisively. Clarity is critical to the rescue of any financial institution at moments when the need to maintain confidence is vital. It was the lack of purposeful leadership which allowed the conditions to occur that led to Britain's first mass bank run since the 1860s on 17 September 2007 - a new "Black Monday" for the City.

Authority should have stayed with the Bank of England. The reality is that central banks, like the Fed and bank regulators in Germany, are best placed to sort out emergencies behind closed doors and announce their decisions afterwards. This was not an option available to the current governor, Mer vyn King, when the markets froze over in August 2007.

Brown's claim that there was "no offer" from Lloyds TSB to rescue the Rock last year was a piece of dissembling. At the behest of Northern Rock's investment bankers, Merrill Lynch, senior executives at Lloyds TSB had been given access to the Rock's loan book. They then made a tentative offer of £2 a share for the company, a result that the shareholders can now only dream of.

Lloyds TSB needed assurance that if it could not fund the market loans to Northern Rock as they fell due, it could call on a fallback guarantee of up to £30bn. That now looks like a cheap solution, given the current £55bn in loans and guarantees outstanding, and the months of uncertainty. But the Bank of England was unable and unwilling to go along with the Lloyds offer, and Darling, barely two months in the post, was not bold enough to see this as a quick exit route.

Proper bailouts

While Britain was hesitating, the German banking super visor swung into action. Germany's IKB bank, caught up in the US crisis with an amazing £5bn of sub-prime loans on its books, was bailed out by one of its rivals, KfW Group, which injected ?4.8bn (£3.6bn) into the enterprise in exchange for a share stake. Another German bank, Sachsen, the bank for the region of Saxony, was saved from failure by an injection of £12bn from a consortium of German banks and quietly absorbed by a bigger rival, LBBW.

In the US, a similar rescue, under the watchful eye of the Fed, was organised for the sub-prime mortgage lender Countrywide Financial, a company of not dissimilar size to Northern Rock. Initially, last summer, Bank of America propped up Countrywide by injecting £1bn of new capital. Early this year, Bank of America completed the job by taking the company's obligations directly on to its books when it bought it for £2bn. Both in Germany and the US, in contrast to Britain, pressure was applied on healthy banks to bail out problem lenders in the interest of financial stability.

Brown and his government could have saved themselves a huge measure of political grief and great financial cost had they acted earlier. But it should not be forgotten that Northern Rock is part of a far wider malaise, with total losses from the sub-prime fallout estimated as high as £250bn worldwide.

We are all paying a heavy price for the foolishness of the American banks and Britain's hesitancy in bringing the Northern Rock catastrophe to an early close.

Alex Brummer is City editor of the Daily Mail

The crunch: a timeline

3 August 2007 US stock markets fall heavily, signalling the start of a credit crunch

31 August Bush announces measures to tackle lending crisis in the US

13 September UK government agrees to act as lender of last resort to Northern Rock

14 September Northern Rock customers rush to withdraw money; share price plummets

5 October Merrill Lynch announces £2.7bn in losses linked to sub-prime mortgages

16 November Northern Rock's chief executive resigns

25 November Northern Rock confirms Virgin as preferred bidder

6 December Bank of England cuts interest rates for the first time since 2005

13 December Four central banks inject £50bn into the global economy

19 January 2008 Brown discloses talks are taking place to find private buyer for Northern Rock

22 January US Federal Reserve slashes interest rates by 0.75%, the largest cut in nearly 25 years

Research by Craig Burnett