Where the US goes, the UK follows - and this time it's back into the boom and bust cycles that defined previous decades, says Heather Stewart

Britain and America's special relationship may have frayed in recent years, but the credit crunch has provided a sharp reminder that where the economy is concerned, it remains rock solid. Wall Street and the City still march shoulder to shoulder - and the pain being felt by thousands of homeowners on Main Street, USA, will be echoed in the cul-de-sacs and housing estates of Britain before too long.

So when US Treasury Secretary Hank Paulson was forced to deny on Friday that he was drawing up panic plans to bail out Freddie Mac and Fannie Mae, the two giant government-backed mortgage lenders, investors on this side of the Atlantic took fright, and the FTSE100 plunged to its lowest level since late 2005.

Ever since Paulson brokered the bargain basement takeover of investment bank Bear Stearns earlier this year, investors have clung to a faint hope that the worst of the crisis was over. But this fresh drama showed the credit crunch entering a new and more damaging phase. It also provided a worrying omen about the consequences of a long-lasting housing downturn.

For thousands of workers in the UK - in financial services, housebuilding, estate agency - the credit crunch has already hit home in the harsh form of a P45. City banks have laid off one wave of staff after another since the new year; and as the mortgage shortage has sent house prices into a nosedive, mass layoffs have followed in sectors closely tied to the decade-long property boom.

The Home Builders Federation had warned repeatedly that without an urgent cut in interest rates or government-backed action to increase the supply of mortgages, its members would have to make thousands redundant; and it has been proved depressingly correct. Barratt Developments announced 1,200 job losses last week, taking the running total of job losses in the industry to more than 5,000; and boss Mark Clare warned that there could be more than 30,000 redundancies in the sector before the downturn is over.

Record fuel prices, combined with the threat of a severe economic slowdown, have led many commentators to compare the situation now with the 'stagflation' of the 1970s; but as the housing market becomes gloomier by the week, economists have begun to play down the parallels with that era, and mutter instead about echoes of the devastating recessions of the 1980s and early 1990s.

The latest quarterly survey by the British Chambers of Commerce, released last week, showed confidence among its members at its lowest since those years.

It used to be received wisdom among housing market bulls that there couldn't be a crash without the 'trigger' of high unemployment. But, according to the Halifax, house prices declined by 2 per cent in June alone, and are now down 8.6 per cent on a year ago - while the impact of the credit crunch on the labour market has only just begun. Mike Hume, chief European economist at Lehman Brothers, says we are already seeing the most rapid decline in property prices for at least 50 years - and raises fears of a major shake-out in the labour market.

Business leaders who remember the boom-bust economy of the 1970s say it is hard to imagine a return to that period. Martin Sorrell, chief executive of advertising firm WPP and an industry veteran, describes Britain back then as, 'like the Dark Ages'.

'It was tough. The country lurched from one crisis to another: miners' strikes, the four-day week, blackouts and secondary picketing. At times it was quite depressing: it was hard to see the chinks of light.'

There was barely any respite between this bleak period and the recession of the early 1980s - not through boom and bust but the Thatcher government's persistence with the monetarist experiment, despite its disastrous effect on employment in manufacturing, and a desire to crush the trade unions at any cost. In the recession of the early 1990s, social strife may have been less pronounced, but the job losses came thick and fast. Between the middle of 1990 and the end of 1992, unemployment increased by 1.4 million, with some 45,000 people joining the dole queue every month.

George Buckley, chief UK economist at Deutsche Bank, sees a number of parallels with the early 1990s, when John Major's government refused to slash interest rates to kick-start a recovery, because it was determined to stay within the European exchange rate mechanism (ERM), and had to prop up the pound. 'Both then and today, the Bank of England has its hands tied.' In the downturns suffered since 1997 - during the Asian financial crisis, the dotcom crash and the mini housing slowdown of 2005 - the Bank has been able to ride to the rescue by cutting rates, but this time it is trapped by rocketing oil prices.

'I think that if they came to the view that the economy is heading into a period of negative growth, rather than very weak growth, they would start cutting rates. The issue is, how quick they'll be to take that view - and I think they'll probably drag their feet a bit,' says Hume. He believes a recession is now all but inevitable, and forecasts that Bank governor Mervyn King and his colleagues will eventually be forced to slash rates to just 3.5 per cent.

Meanwhile, it is clear that high-profile job losses at financial services firms and housebuilders are just the beginning. Just as the Bear Stearns rescue marked a hiatus in America's financial crisis, rather than the end, analysts believe the nationalisation of Northern Rock, and a rash of write-offs and cash calls from Britain's beleagured banks could be just the first round.

Graham Turner, of GFC Economics, compares the questions over Fanny and Freddie to the plight of cash-strapped lender Bradford & Bingley. 'People are in the markets in both cases asking, what happens if the housing market keeps going down into 2009? They're getting the same answer,' he says. 'We're certain to see more insolvencies in the UK - it's just a question of when.'

And the longer the banking crisis persists, the more lending will be squeezed, the faster house prices will fall - and the greater becomes the risk to many thousands of jobs.

'This is the most calamitous fall in values that we have seen,' said one senior City source. 'We're doing another round of job cuts. It's so depressing.'

In construction, there is likely to be a huge knock-on effect among the many thousands of contractors who are already feeling the impact from the precipitous fall in the number of new homes being built, bought and sold. Alan Ritchie, general secretary of construction union Ucatt, says: 'We've seen thousands of job losses among housebuilders but that's just the tip of the iceberg because construction is the most casualised industry in the country. Most workers are forcibly self-employed. They don't get redundancy.'

The big question is how far the lay-offs will spread. Unemployment is what economists call a 'lagging indicator': employers lay off staff only when times have been hard for some months. 'Unemployment actually responds about six months later,' says Deutsche Bank's Buckley. 'Firms will keep their labour on: they'll want to see how serious the potential slowdown's going to be; how long it's going to last. But there comes a point at which they can't afford it.'

Consumer spending is under extreme pressure, with wages rising relatively slowly while basic costs are spiralling. With a sharp slowdown in consumer spending looking inevitable, and a number of retailers already reporting falling sales, a rash of job losses in that sector could be around the corner. Most economists are predicting a sharp increase in unemployment over the next two years. The OECD has forecast 100,000 job losses, pushing the unemployment rate to 5.7 per cent from 5.4 per cent now; Buckley thinks it will hit 6 per cent.

For the Labour party, the problem with the chilly climate is that it is not only sapping the feelgood factor, but also undermining the oft-repeated claim that Britain's economy rests on strong foundations, carefully laid down by what Gordon Brown likes to call 'long-term decisions' made during the government's early years in power.

Instead, many analysts argue that although the credit crunch was its proximate cause, today's downturn is in part the inevitable consequence of an extraordinary build-up of personal debt, and a rampant property bubble that was left unchecked - just as America's travails are partly the payback for the Greenspan boom years.

The Prime Minister has promised an 'economic plan' to help Britain through these torrid times, and Chancellor Alistair Darling has hinted heavily that he could cancel October's planned 2p rise in fuel duty, as a sop to businesses, and the Treasury is hurriedly examining measures to help homeowners. But there is little cash to spare for a radical tax-cutting package like that launched in the US earlier this year; and once a housing market downturn gathers pace there is little the government can do, particularly given the high levels of indebtedness among British households.

'Sadly, I think it's a case of watching the adjustment take place,' says Hume. 'There is far too much debt in the system, and that's going to have to unwind, and it's going to be very painful.'

A recession primer

· Politicians and number-crunchers are all saying that the housing market is overdue for a correction - in other words, however much you thought your home was worth, you were wrong.

· There's an awful lot of deleveraging going on - banks that have made risky loans trying to get their finances back in order by lending less and asking for more cash from shareholders.

· The Bank of England believes inflation will be brought under control only once a margin of spare capacity has opened up. In blunt terms, that means higher unemployment, mothballed factories and empty shops and offices.

· In the US, things are more fuzzy: a panel called the Business Cycle Dating Committee decides when a recession is under way - usually some months after the event. Its definition is 'a significant decline in economic activity spread across the economy... normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales'.