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As Paul Volcker, former chairman of the Federal Reserve, recently reminded us: "financial crises are borne out of economic imbalances".

Economic imbalances are very present today in much of the western world, most notably in the US, the UK, Spain and Ireland all of which lie currently at the epicentre of this credit crisis.

Imbalances are also prevalent in Australia, New Zealand and many parts of Eastern Europe. Those economies are likely to be the source of future shocks as this credit crisis continues to unfold.

Indeed the roots of this current crisis lie in the series of emerging market crises starting with the Asian crisis in 1997 and then followed by the Russian crisis (1998), Brazilian crisis (1999), Turkish crisis (2001) and Argentine crisis (2002) as well as the stock market bubble and bust in 2000-2002. All of those crises, to varying degrees, were met with interest rate cuts and ever cheaper money in western economies. As Asia and other economies have spent the last decade sorting out their own houses, most especially reducing economic imbalances and paying down debt levels, those western economies, which are currently at the centre of this storm, have spent a decade building up imbalances and their debt levels.

Indeed the speed of debt accumulation in the last decade is unparalleled in recent history. The size of US householders' debt relative to the size of their economy, as measured by GDP, has risen from 68 per cent in 2000 to 98 per cent by the end of last year. That represents a 30 percentage point increase. This is a speed of credit accumulation which has not been experienced in the US since the 1920s during the last great US deflationary boom, which was also accompanied by a housing boom and a stock market bubble. Indeed as Table 1 shows the credit intensity of GDP growth in recent years has been at a multi-decade extreme. For every $ of GDP growth that the US economy has achieved in the last seven years, the economy, in its entirety, has borrowed almost $5.

Table 1: Credit intensity of GDP growth in the US

Source: Federal Reserve Flows of Funds, Longview Economics

Troublingly the credit intensity of growth in the UK is similar. Since the Labour Party came to power in 1997 - up until 2006, the most recent comprehensive data point - the UK's nominal GDP has grown by £457.4bn. Total economy debt, though, has more than doubled to £3,350.7bn, with over £4 of borrowing for every £1 of nominal GDP growth in the last decade.

Indeed unlike most western economies where the rapid growth of borrowing has been confined to just the household sector and the financial sector, in the UK it is not just those sectors which have taken on considerable leverage. The non-financial corporate sector has also rapidly grown its debt levels in the last decade, with non-financial corporate debt to GDP having risen from approximately 60 per cent of GDP in 1997 to over 110 per cent today.

Table 2: UK non-financial total economy debt to GDP (Q2 1997 & Q4 2006, plus differences)

Source: UK National Accounts, Longview Economics

While cheap money was the key driver of rapid increases in leverage levels, the banks played their part. As householders and companies demanded ever greater levels of leverage, banks competed aggressively to offer more and more attractive deals. Loan to value ratios were increased, net interest margins were squeezed while the value and amount of collateral required was reduced.

Pro-cyclical behaviour from the banks exacerbated the underlying trend. Reflecting that economy-wide debt build-up, banks rapidly increased their asset base relative to the size of their underlying equity. Barclays, for instance, in its last accounts reported £1.23 trillion of assets relative to an underlying shareholders' equity of £32.5bn. Indeed this level of leverage growth at the financials is readily demonstrated for the US financial sector, where the macro data is considerably superior and longer, see fig 1. US financial sector debt has increased from 60 per cent of GDP at the time of the Asian crisis to 110 per cent today. While the data may not be readily available, the trend in the UK financial sector is undoubtedly similar.

The cycle, though, has clearly turned. With that the banks are now competing to protect themselves against poor credits, that is credit standards, across the board, are being rapidly tightened.

After a decade of rapid house price gains, however, this will only serve to reinforce the slowdown in housing. The psychology of ever increasing prices, a psychology which is always present during the creation of financial bubbles, has clearly been pricked. House prices for the first time since 1995 have actually gone down, note that while the annual rate of growth slowed dramatically in 2004-05, the actual price of housing never fell. Given the high level of indebtedness, the curtailment of credit availability, high valuation levels and the size of the housing boom, this is unlikely to be a small bust. Indeed it is not difficult to make the argument that house price falls of 20 per cent to 30 per cent, in real terms, over two to three years is a conservative estimate.

This boom, in real terms, has been double the size of the last boom, in the 1980s, which in turn was over double the size of the 1970s' boom. Both those booms gave back most of their gains in the bust. The bulls will argue that the lack of supply will constrain the falls. Curiously that same argument was used by investors to justify the high US stock market valuation in 1929. While supply is clearly a factor this has, however, been a global house price boom, fuelled by cheap money and willing banks, in areas of the world where land is limited as well as parts of the world where it is plentiful, for example Nevada, Spain, Australia, Wales and Scotland. While clearly a lack of supply is an important structural point, it is arguably already in the price, this UK housing boom was +175 per cent from trough to peak in real terms; the US boom was only +58 per cent and Spain was only +100 per cent, all in real terms. Where supply is limited, prices appear to have risen the most.

It is this potential for significant housing - as well as commercial real estate - losses, coupled with other credit crunch related hits that has caused such a high level of anxiety amongst the banking community.

In the last UK housing downturn, for example, Barclays had a loan loss provision of 1.5 per cent of its loan book in 1990, 1.5 per cent in 1991, 2.5 per cent in 1992 and 2.0 per cent in 1993.

If UK banks' provisioning is again at a level similar to that of Barclays during the early 1990s, almost all major UK banks will make little or no profit for three or four years. This, of course, is an environment in which dividends will be cut either partially or completely. Over and above those concerns about UK residential property many of the banks have earned considerable profit in recent years from lending to the UK commercial property sector as well as lending to overseas residential and commercial property sectors in those economies which have had the biggest booms and are also therefore some of the most vulnerable parts of the world most notably Australia, Ireland and Spain.

It is into this backdrop that the Bank of England recently launched its special liquidity scheme on 21 April, whereby it has agreed to provide liquidity to the banks in return for AAA rated paper, primarily mortgage backed. While the scheme should serve its purpose acting as a liquidity backstop for banks, thereby avoiding a run on UK banks created purely by liquidity fears, a la Bear Stearns, it will not halt or indeed reverse the current tightening of credit standards. All risk of losses from the collateral remains with the commercial banks. It will not therefore change the current very real possibility of significant bank losses in the event of a 20 per cent to 30 per cent fall in UK house prices over the next two to three years, as well as the risk of losses from other parts of UK banks' asset portfolios. That is why banks are currently rushing to shore up their equity capital base through rights issues, RBS and Halifax being the two most recent examples. That is also why that trend of banks increasingly seeking to boost their capital bases through rights issues is unlikely to go away anytime in the near future.

Chris Watling is chief executive officer of Longview Economics