accomodatory actions of monetary policymakers. and the rise in house prices has led to a natural increase in debt as people need to borrow more money to finance the purchase of a house. chart 4 : aggregate income gearing per cent 18 interest and mortgage principal repayments interest only source : ons and bank of england as far as debt levels are concerned, for me the key issue for monetary policy is that the more capital gearing or leverage increases the greater the vulnerability to shocks and the consequent adjustment to consumption behaviour. i think this is true for individuals and for the economy at large. let me explain why it might matter if capital gearing rises. imagine two states of the world. in the first an individual has assets of £1 million, and debt of £900, 000. in the second an individual has assets of £100, 000, and debt of zero. in each case the individual ’ s net worth or equity is the same. then imagine a shock that causes the average level of asset prices to fall by 10 %. in the former case the wealth is wiped out, whereas in the latter the wealth has fallen but only to £90, 000 [ chart 5 ]. this is of a course a stylised example, but it makes the point that the more leveraged you are, the more your wealth will be impacted by a given shock. chart 5 : an illustration of the effects of leverage no leverage high leverage £, 000 £, 000 assets debt label : net wealth assets debt net wealth original situation ` after 10 % fall in asset prices in my experience as leverage increases, so the level of debt ceases to be a mere residual and becomes more of a determinant of behaviour in its own right, and hence becomes of real consequence for monetary policy. until recently domestic debt in the uk has been increasing at rates of around 12 % per annum, or approximately 8 % per annum above the increases in post tax nominal income implying significant increases both in leverage and income gearing [ chart 6 ]. chart 6 : annual growth rate of total debt and post tax income percent total debt income chart 10 : www. statistics. gov. uk it is interesting to reflect on whether this increase has been a factor in the recent turndown in consumption. we cannot prove it, but i have been struck by two things. firstly, has the stabilisation in house prices led homeowners to become more conservative or precautionary in their borrowing habits, realising

the world economy that we find ways of allowing competitiveness to adjust so that trade imbalances, and hence the present scale of indebtedness, can be reduced. neither liquidity nor austerity are answers to the question of how to restore a loss of competitiveness. dealing with these structural issues will take time. meanwhile, how do we resolve the immediate crisis of confidence in some banks and sovereigns? since the summer, there have been renewed concerns about the adequacy of the capital of banks in the euro area to absorb likely future losses, thus jeopardising their ability to raise funds. wholesale funding dried up for many banks over the summer, and share prices of european banks are around 35 % lower today than at the start of july. a transparent recognition of losses and a substantial injection of additional capital are necessary to restore market confidence. on its bis central bankers ’ speeches own, however, such a policy will raise difficult political questions about the capacity of the weaker sovereigns to pay for any recapitalisation of their banks. bank and sovereign solvency concerns are inextricably intertwined. in the end, the underlying solvency concerns require countries to adopt compatible policies so that they can credibly service their internal and external debts. what does this mean for our own economy? our objective must be to steer the uk economy slowly back to a position of more normal interest rates and lower budget deficits. with a lower level of sterling and a credible plan to reduce the fiscal deficit over the medium term, we were on track. but the problems in the euro area and the marked slowing in the world economy have lengthened the period over which a return to normality is likely. 2011 has been the year of the reluctant recovery. growth has disappointed, both here and abroad. business and consumer confidence have fallen sharply, not only at home but also elsewhere in europe and the united states. and the level of world trade in goods has stagnated. a slowing of the world economy, especially in the euro area, is a threat to our strategy of rebalancing and recovery of the uk economy. despite the more competitive level of sterling, the recovery in our trade position is at risk of stalling. it is not surprising, therefore, that although unemployment has been broadly stable over the past two years at around 2½ million, a rate of about 8 %, it has risen in recent months, especially among young people. and total output remains around