70% of bank funds were diverted to real estate mortgage. The income of families and household was diverted from buying goods and services to buying properties- houses and buildings. A large chunk of money was used in payment of debt service to banks and financial companies. The payment of debt service by the economy's non-financial sectors interrupts the circular flow of income supposed to exist between produces and consumers.
The problem of financing network became more complex. Britain faced acute credit crisis in the recent periods caused by slack lending practice by banks, financial turmoil caused by dearth of liquidity, extending risky loans to unpredictable parties and passing on to other institutions, excessive dependency on credit rating companies, over dependence on in financial markets or inadequate liquidity risk management. This has put many sectors of the economy at risk such as UK commercial property sector, Stock markets, First-time buyers, Buy-to-let investors, UK's sub-prime borrowers and many others.
There was exponential growth of savings and debt in UK market. They were used mainly for financing the purchase of real estate, stocks and bonds. Net savings don't increase in the economy because it is used in re lending for or refinancing assets. This process does not necessarily promote new investment in tangible assets or new factories that add to new employment. No more output is added, no more factors of production is paid.
Thus there is a blockade in the circular flow of income. UK faced this very type of economic scenario recently.
Consumption from household, which accounts for about 70% of GDP, is the basis of production. Exports add to the consumption share because it takes off consumption of other country's consumption also. Consumption of UK in recent years had been 90% that was financed out of the real income of the country and not debt. Consumption by household should flow directly from income received from producing goods and services in the country and not financed by debts.
In 2007 Gross consumption in UK has been increasing as per the data furnished by bank of England in its report from the Expenditure components of Demand Table 2A
2006 2007 Q1 Q2 Q3
Percentage of Household consumption: 0.7 0.7 0.7 1.1
Govt. Consumption 0.4 0.6 0.5 0.3
Investment 2.4 1.0 -0.8 2.4
Final Domestic Demand 0.9 0.8 0.5 1.1
Higher mortgage rate however will have the biggest impact on consumption. Banks who are themselves borrowing from inter-bank markets at higher rates of 6.5 % or more will charge more to the clients to be profitable. According to Lombard Street Research, household debt is 165% of disposable income in the UK but only 130% in the US. With UK interest rates 20%-25% higher than in the US, UK borrowers are at least 50% more vulnerable. In the first half of 2007, the household sector had a financial deficit of 27.8bn, greater than the 27.4bn for the whole of last year. Richard Jeffrey, economist at Ingenious Securities, estimates a total of 50bn for the year, equivalent to 3.6% of GDP.
Household expenditure rose by 0.1% down from 0.8% in the previous quarter. Final consumption expenditure of