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Osborne King
Chancellor George Osborne and Bank of England Governor Mervyn King want banks to lend more in the UK economy (Reuters)

Despite the worsening outlook for Britain's economy, and a looming threat to the City of London from an unresolved Eurozone crisis, banks are being encouraged by government and monetary policymakers to increase their lending to smaller firms and consumers - potentially creating a new credit bubble that would destroy a recovery if it burst.

While it is hoped that the increased credit in the economy will cure the demand malaise blighting Britain, if recent government and Bank of England efforts to encourage growth prove impotent, the resulting increased debt load for Britons and small business owners will add another heavy burden on the shoulders of recovery.

Under the Bank of England's two credit easing schemes, banks are being offered cheap loans as a way of stimulating lending, which is currently being squeezed.

Financial firms are conscious of the Eurozone's sovereign debt crisis, which many are exposed to, and the catastrophic losses that would flow from any sudden negative shift in the single currency area's situation.

As a result they are not keen to take on additional lending risk.

The first Bank of England scheme is called the Extended Term Collateral Repo (ECTR). It allows banks to offer up bad assets as collateral in secured borrowing at a discounted rate from the Bank, cash they would not be able to access in the inter-bank lending market.

Funding for Lending (FLS) is the second scheme and sees banks offered cheap loans in direct correlation to the amount they lend to the real economy of small-and-medium sized enterprises (SMEs) and consumers.

As lending to these sections of the economy increases, so does the total value of discount-rate loans financiers can access from the Bank.

Already FLS has led to some of the biggest High Street banks in Britain, such as RBS and Lloyds, pulling down their mortgage rates.

Aldermore, one of the new smaller "challenger" financial institutions that are said to be the future model of banking in the UK, has said it will be signing up to FLS. It also expects to increase its lending by £1bn over the next year.

Mortgage approvals are on the rise, too, and look set to grow further when the credit easing schemes fully take hold on the financial sector.

British Bankers Association data shows that in August the number of home loans given the rubber stamp grew to 30,533, up from the previous month's 28,750.

More consumers are taking on a serious amount of debt and this trend will continue as mortgages become more accessible because of the Bank's credit easing.

Yet as we build up more debt, there are concerning signs that there is another economic storm further down the road.

UK growth forecasts slashed

Bank of England economists have slashed their forecasts for the UK economy, predicting near flat growth for 2012, followed by a much slower recovery than previously thought.

Likewise the International Monetary Fund (IMF) cut its predictions for the UK to just 1.3 percent growth in 2013, 0.6 percent lower than before.

In all forecasts on the UK economy there is a caveat that the wider economic environment is so uncertain and unstable that anything could happen - good or bad.

Global forecasts do not paint a rosier picture. Demand is likely to be dampened by the slowing growth in key emerging economies such as India and China, while the Eurozone - Britain's biggest trading partner - still has no end in sight for its deep sovereign debt crisis.

It is also likely to take longer for inflation reach the government's 2 percent target than had been hoped, with wage growth continuing to be outpaced by the ever-growing cost of living.

Inflation is beholden to the volatile commodity prices that leap and fall month by month, having a knock on effect to the food and fuel prices paid by consumers for essential items in their lives.

Robust labour market data has confused economists, because despite the sharpening recession employment has reached its highest level since 2009.

However many expect this situation not to last and anticipate unemployment to rise across the next year. There is also an increasing number of self-employed and part-time workers, which is a far cry from the security and stability of full-time permanent work.

As those in secure employment at the moment take on significant financial responsibility, such as a mortgage, they open themselves up to the potential for a personal catastrophe if - as many are suggesting - there is still worse to come from some of the darkest economic days in modern history.

Business surveys, such as the purchasing managers indexes, indicate that firms are already cutting staff as well as slashing future investment.

Research by business group the British Chambers of Commerce (BCC) both business confidence and investment levels have fallen to those seen around the start of the double-dip recession at the end of 2011.

Figures from independent fiscal watchdog Office for Budget Responsibility (OBR) show how drastically business investment has been scaled back in 2012.

In November 2011 the OBR said that it was likely to grow by 7 percent in the coming year. Most recent analysis has investment expanding by a mere 0.7 percent.

Official figures point to a profitability black hole.

Company bottom lines remain sturdy despite the downturn, with the Office for National Statistics (ONS) reporting barely any change in the return on capital employed for private business over the past few quarters.

However this is not due to any increase in output or business levels, but rather cost cutting and scrapped investments, which cannot indefinitely underpin profitability.

Cuts now also threaten the future capacity of a business to expand and limit its growth potential, which on a large scale could hold back the economy.

As business retreat on future expansion in the face of a worsening economic outlook, and consumers feel the pinch of above-wages inflation growth as well as the likelihood of a weakening labour market, fuelling both of these parts of the economy now with cheap credit may be providing the foundations to another credit crisis.

Government action to lift demand

The government is desperately trying to grow the economy with as little fiscal intervention as it can.

Since being elected in May 2010, the Conservative and Liberal Democrat coalition has insisted that public austerity is the only way to bring down the budget deficit left behind by 13 years of a Labour administration.

Despite Britain lapsing into a double-dip recession, the government insists it must stick rigidly to its spending cuts programme, even though demand has dried up in the domestic economy and many are calling for a significant fiscal boost to restore consumer confidence, create more jobs, and give the private sector a lift with the knock on effect.

Chancellor George Osborne has largely rejected these calls, but is pursuing several thrifty policies in the hope that they alone will stimulate activity in the economy and, as a result, boost confidence among moribund Britons.

A £9.4bn investment to upgrade the creaking rail network was announced, as well as a scheme that sees the taxpayer act as guarantor to major infrastructure projects struggling to find finance from lenders. Around £40bn worth of projects are said be eligible, though the scheme is subject to parliamentary approval in the coming months.

Business Secretary Vince Cable has pledged £1bn of public money to a state-backed investment bank that will support small business lending.

There is also a review of planning red tape underway to see if any of the excess bureaucracy holding up construction firms can be cut away.

Uncertain future

No guarantees can be given about how successful this collection of policies will be at turning the UK economy around and, as with everything else, the results are in the hands of the global financial gods who may bestow a fresh crisis on the world, or intensify one that already exists.

In some ways the government is trapped between a rock and a hard place. Do nothing and it may take a long time for demand to recover in the economy and so a return to economic normality would take more time than they would like.

It would be particularly inconvenient for the coalition if there are no strong signs of a turnaround before the 2015 election, with voters inclined to cast the ballots by the fullness of their wallets.

On the other side, the action they are taking may help stimulate demand and part of this must include increasing the availability of credit - which, if the world takes a turn for the worse in the next year, could spark a fresh debt disaster.

If there is no meaningful growth in the economy tomorrow, today's growing debts cannot be repaid and the domino effect could bring Britain crashing back down again.

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