Last Monday I wrote on this page that the US Government's rescue of Fannie Mae and Freddie Mac probably marked the low-point of the global credit crisis and was “unqualified good news for the US economy”. Four days later, I wrote that this very same rescue “signalled the complete failure of the biggest, most dynamic, most innovative markets that have ever existed in the history of capitalism — the Wall Street stock market and the market for US bonds”.

Are these statements absurdly contradictory? Or did something change dramatically in those four days? Or was I just talking rubbish?

I believe the answer to all these questions is “no”. After the latest crisis at Lehman Brothers this weekend, I believe even more strongly that there is no contradiction between expecting a recovery, or at least stability, in the US economy and chaos in its financial system. Understanding why government actions that strengthen the “real” economy of non-financial jobs, investment and consumer spending can be disastrous for the financial sector is the key to any analysis of today's conditions in America, Britain and the eurozone.

Starting with the relatively good news, about the economic impact of this never-ending financial crisis, the key point is the wide gap that often exists between events in financial markets and conditions in the real economy. Economic statistics in America have shown no evidence of the catastrophic collapse that seemed to be implied by credit markets and bank shares. In fact, as the credit crisis has steadily worsened, US economic conditions have gradually stabilised and started to improve.

While there has, indeed, been an unprecedented collapse in finance and also in housing, leading to a moderate rise in unemployment, the US economy grew quite strongly in the latest quarter and the OECD has just raised its full-year growth forecast from 1.2 to 1.8 per cent. The US Government's seizure of Fannie and Freddie promises to give the non-financial economy a powerful shot in the arm. With Washington now using its own credit rating to increase the supply of new mortgages to US homeowners, the hints of stability that were already emerging in the US property market will probably turn into recovery sooner than expected.

The main explanation for the gap between financial and economic performance, here and in the United States, lies in the dominant role of expectations and regulation in financial markets. Because financial markets anticipate economic reality instead of simply responding to events, they are inherently prone to self-reinforcing cycles of euphoria and panic.

Since the early 1990s, regulatory changes, inspired by an over-zealous belief in free-market economics, have intensified boom-bust cycles. These regulatory distortions have rested on the naive belief that “the market is always right”. The greatest irony is that the last adherents of this free market dogma are the financial regulators whose raison d'être is to guard against situations when the markets are dangerously wrong, but who still insist, for example, that energy prices are never manipulated by speculation or that governments must draw black and white distinctions between shareholders and creditors of troubled banks.

The upshot of these regulatory failures, combined with 15 years of global macroeconomic conditions uniquely conducive to the growth of finance, has been the emergence of a wider gap between the financial and real economies. The disproportionate growth of finance is illustrated by the fact that debts owed by financial institutions to one another have mushroomed since the early 1990s - from 42 per cent to 112 per cent of US GDP. As a result, the growth of leverage within the financial sector has accounted for two thirds of the growth in US debt burdens over the past 15 years (see chart). Similar pictures emerge about Britain and most European economies.

The danger is that financial institutions are much more vulnerable to sudden withdrawals of liquidity or loss of confidence. This has become obvious with banks such as Northern Rock, Bear Stearns and Lehman Brothers suddenly being forced to pay back debts 30 or 40 times larger than their shareholders' funds and being unable to do so. There is, however, a silver lining. The de-leveraging process, whereby banks and hedge funds have to make huge cutbacks in borrowing and lending, is having much less effect on the availability of credit to non-financial businesses than might be imagined.

An extreme example of the disconnection between the real economy and the world of finance is the market for so-called credit default swaps, which essentially are bets between bank and hedge funds on whether particular companies or countries will default on their debts. The total value of contracts in this market is estimated at about $50 trillion - roughly equal to the entire world's GDP. But because these are contracts between one financial institution and another, payments on these bets would not, at least in principle, have much impact outside the financial world.

To understand the underlying reason why the enormous deleveraging triggered by the still-expanding financial crisis is doing much less damage than generally expected to the real economy, consider the following example: before the arrival of “hyper-finance”, if a family wanted a £100,000 mortgage they would go to the Halifax and simply borrow £100,000. Now consider what would have happened in the new financial world. The family would have borrowed £100,000 from Northern Rock, which would sell £100,000 of bonds to hedge funds, which would buy these bonds with £100,000 borrowed from Bear Stearns, their prime broker, which would raise this money by selling £100,000 of commercial paper to Citibank, which would then borrow £100,000 through the inter-bank market from Halifax. The original borrower is still the same household and the ultimate lender is still Haliax, but now a £100,000 mortgage has created £500,000 of new debt.

In theory, this entire chain of transactions could be squeezed, like a concertina, back to the original £100,000 loan between the homeowner and Halifax and the total credit in the banking system could be reduced by 80 per cent, with very little effect on the real economy. The reality would not, of course, be quite so simple. The huge reduction in credit would leave the final borrower and the ultimate lender exactly where they were before, but all those intermediate transactions would vanish, with the related jobs and profits. The unemployed bankers would have less money and their loss of spending power would, in turn, hit consumption and housing in a second-round deflation. Moreover, many imprudent financial products created in a world of unlimited leverage, for example 100 per cent mortgages, would disappear. And tougher lending conditions would, in turn, push down those asset prices most dependent on leverage, especially housing.

In short, the real economy would weaken, but not to the disastrous extent apparently implied by the scale of the financial crisis. This seems a reasonable description of conditions in the world economy since the credit crunch started — and they will probably continue at least until the end of this year.

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