When Premier and Finance Minister Paula Cox delivers her Budget for the 2011/12 fiscal year, she will be doing so against the backdrop of a troubled and fragile local economy.The last two years have been pretty grim, with jobs disappearing and businesses fighting for dear life. And the start of this year does not bode well for 2011, with consumers continuing to spend ever less money at the Island’s retailers and service providers.The tourism industry has continued its long-term decline and even international business is wobbling.The question that many people are asking is: How did we get to this point? For most of the past decade the Island’s economy was booming, unemployment was a rarely uttered word and prosperity flourished. Here are some of the factors that help to explain how we got here.Overheating EconomyAfter the 9/11 terrorist attacks on New York and Washington, a wave of new insurance companies set up on the Island to accommodate a spike in insurance demand. Billions of dollars of new capital flooded in and companies including Axis Capital, Allied World and Endurance Specialty now well established global players were born.The result for the economy was a shot in the arm, as more guest workers came in, business services flourished, demand for real estate soared and Bermudian property owners were able to rake in high rents. The beneficial effects rippled through the whole economy.In 2005, it happened again, as another wave of new companies set up on the Island. Flagstone, Validus and Ariel Re were among the newcomers this time, as about 80 percent of the new capital to flow into the property and casualty reinsurance industry in the wake of Hurricane Katrina arrived in Bermuda.The influx of business created huge demands on the infrastructure. New homes and office buildings were going up at an accelerating rate, as thousands of jobs were created in construction and dozens of small construction companies were set up.The result is apparent in the gross domestic product (GDP) numbers, published every year by the Department of Statistics. In 1999, the GDP was a little more than $3.2 billion. In 2008, GDP peaked at $6.1 billion. Over the same period, construction’s share of GDP rose from $210 million to $370 million; real estate and renting activities shot up from $560.1 million to $856.4 million and the business activities sector grew from $278.8 million to $589.2 million.It was the international business sector that had the biggest impact, more than tripling from $456.9 million in 1999 to $1.55 billion in 2008. The economy was booming.Some, during this period of feel-good prosperity for many, warned of the economy “overheating”. Two who used the phrase consistently were United Bermuda Party MP and Finance spokesman Bob Richards and economist Craig Simmons. Back in 2006, Mr Richards, was warning that the construction sector, in particular, was overheating dangerously, and that the less well-off were getting left behind by the rapid rise in the cost of living.Mr Simmons warned of Government’s role in blowing up the bubble back in August 2008, when he told The Royal Gazette: “Despite clear evidence of an overheated economy, successive Government Budgets do nothing to slow the flow of spending.” At that time inflation was climbing close to five percent.The crisisThe problems emanating from borrowers with poor credit ratings struggling to pay back sub-prime mortgages in the US became very apparent in 2007. An orgy of loose lending and property “flipping” in the US had made property investment success seem easy until then.Many, including the investment banks who ploughed billions of dollars into exotic financial instruments like collateralised debt obligations (CDOs), which fuelled the property boom, and the rating agencies that gave these risky investments a cast-iron AAA rating, appeared to be believe that house prices could only move in one direction.When property values started to tumble, so did the hundreds of billions of dollars worth of CDOs and the house of cards collapsed.On September 15, 2008, the 158-year-old Wall Street investment bank Lehman Brothers filed for bankruptcy, sparking a market meltdown that sent shock waves the world over. The Dow Jones Industrial Average fell 504 points in a single day. Things went full circle, from easy money to a full-blown credit crisis, as lending ground to a halt.Bermuda would be impacted heavily, but it was some time before the effects became apparent in the everyday life of the average resident. One obvious impact came from the struggles of Butterfield Bank, which had invested hundreds of millions of dollars in securities backed by US mortgages.Although Butterfield has since stabilised, thanks to a Government-guaranteed preference share issue and more than $500 million ploughed in by new investors last year, the effects of its problems have stripped a huge amount of wealth directly out of the Bermuda economy.Many Bermudians had invested heavily in the bank, as the most liquid stock they could buy on the Bermuda Stock Exchange. The shares lost about 95 percent of their value in the space of three years.Also lost were Butterfield’s handsome dividends. In 2007, the bank paid out more than $55 million to shareholders, a lot of it going straight into the pockets of seniors, who relied on them as a key source of retirement income. Those dividends have dried up completely for the time being.Americans, who make up the majority of visitors to the Island, started to cut their travel budgets, for leisure and business, and Bermuda, whose tourism industry was already in chronic decline, suffered badly.The 78,806 visitors who came to Bermuda by air during the July through September period last year was the lowest number recorded for the peak period of the year since the modern recording system started in the 1980s.At the same time, the Island’s international companies started to trim some of the fat. Work permits were allowed to expire and departing employees were not replaced. Some jobs were moved to less expensive locations. There were few big announcements, but much steady attrition.The plunge in asset values and the rush of investors pulling out their money hit Bermuda’s funds industry hard. The net asset value of Bermuda investment funds was nearly $250 billion in the first quarter of 2008, but plummeted to $147.3 billion by the end of 2009.Leaders of world economic powers, including US President Barack Obama, pointed a finger of blame at offshore financial centres for playing a part in the crisis. The threat of punitive action against international companies based in places like Bermuda grew perceptibly.At the same time came a regulatory challenge from Europe in the shape of the new Solvency II rules which will require insurers to hold more capital and achieve higher standards of corporate governance. The Bermuda Monetary Authority has moved to enhance its regulation to match the Solvency II standard to ensure Island companies doing business in Europe are not competitively disadvantaged, but the consequent additional regulatory burden may detract from Bermuda’s appeal as a domicile.In 2009, the Island lost seven percent of its international business jobs and last year it is likely more posts disappeared.The influx of companies slowed to a trickle and some companies moved their holding companies, capital or back office operations off the Island. The owners of the plethora of new office buildings that had sprung up all over Hamilton over the past five years are not finding tenants easy to come by.When apartments emptied, replacement tenants became more difficult to find, and Bermudians who banked on international business tenants to pay second mortgages found themselves with an expensive problem.The downward spiral was apparent in the slowing flow of dollars into the tills of local businesses. Every month for the past two years, retails sales volume, which takes inflation into account, has fallen. Businesses closed and jobs were lost.Construction’s woes show up well in the sales figures. In October last year, the sales index for building materials stores slumped to a record low of 56.9, against the standard of 100 representing 2006 sales levels, the Department of Statistics reported.The decline in imports of goods to the Island illustrate the diminishing appetite for spending. The value of goods brought in in 2008 was $1.16 billion and declined to $1.07 billion in 2009, according to Government’s balance of payments figures, indicating a decline of about 8.6 percent.Full-year figures are not yet available for 2010, but using second-quarter figures for comparison, imported goods slumped from $301 million in 2008 to $253 million in 2010 a two-year fall of 15.9 percent.In 2009, Bermuda’s GDP fell by 5.8 percent or 8.1 percent after taking inflation into account to $5.7 billion; in 2010 it most likely fell further.Fiscal woesWhile the private sector is in such decline, there is little hope that the Government will be able to prop up the economy during the downturn with an increase in public sector spending.The upcoming Budget will likely feature more cost cutting than major public investments, given Government’s heavy debt burden.The Consolidated Funds statement released recently showed the extent of a growing problem. Government expenditure outstripped revenue by $311 million in the fiscal year through March 2010, as the net public debt soared to almost $970 million.Even after subtracting the $200 million guarantee for Butterfield Bank preference shares, the public debt more than quadrupled in the four years since March 2006. The cost of servicing the debt alone is now at around $100,000 per day.During the boom years of the past decade, Government could bank on revenues exceeding projections, as it did for six successive fiscal years from 2002/03 through 2007/08. The 2009/10 $53 million shortfall against projections was a wake-up call.Even though the two percentage point payroll tax rise that took effect in April last year should have boosted revenues somewhat during the past ten months, that will have been offset by job cuts and hours reductions that businesses have made in response to the tax increase and the tough economy.Premier Paula Cox’s promise to make spending cuts of $150 million will be a start, but the actions she will take to achieve it have yet to be unveiled and may inflict further pain on the economy.More restraint in public spending during the windfall years and most notably during the tenure of Ms Cox’s predecessor, Dr Ewart Brown would undoubtedly have made some of the tough decisions she faces today a little easier.The light at the end of the tunnel for the Island is that the US economy, on which Bermuda is so reliant, is showing signs of steady recovery. It emerged from recession in the third quarter of 2009, GDP has grown in every quarter since and was 3.2 percent in the fourth quarter of 2010.US stock markets have returned to pre-crisis levels, although the high official unemployment rate, now about nine percent, is a fly in the ointment that is likely to keep that recovery slow.