Government must be tougher on the banks

After just over a year of dramatic but remote events in the banking system, the financial crisis is hitting the real economy.

The Governor of the Bank of England thinks that, after a nasty recession next year, the economy will turn upwards in 2010. I hope he is right. For there are two other equally plausible outcomes.

One is that the vicious downward spiral will take the economy far below the two per cent decline in GDP that he envisages. The other is that the decline bottoms out but the economy doesn't recover quickly.

The underlying assumption is that the banking system has now been fixed. I doubt it. The reason why companies are shedding jobs is partly because consumer demand has contracted dramatically - but it's also because banks will not lend on reasonable terms even to sound business customers.

It is truly shocking that, having committed £37 billion of taxpayers' money to recapitalise the banks, the Government has now decided to wash its hands of any further responsibility. It declines even to appoint directors. The undertaking by the banks to maintain a flow of lending and to discipline bonuses has been quietly buried. Yet the banks are at the centre of the downward vortex.

It is not the role of government to decide to whom banks lend. But the Government must ensure that credit is available on reasonable terms for solvent businesses. The banks argue that they have to give over-riding priority to rebuild their capital, repay government loans and restore dividends. But if the contraction of their balance sheets further deepens recession, it will lead to mounting bad debts, requiring yet more capital. The Government, as a shareholder, must be less supine.

To be sure, it is difficult for banks to raise money at present. But the Government should, for a start, insist that they get rid of their investment banking casino operations in order to concentrate resources on mainstream lending.

And while cuts in the interest rates are necessary, they are not sufficient. My Lib-Dem colleagues and I have been arguing for some time that there should be income tax cuts for those on low and middle incomes, raising tax thresholds and/or cutting the basic rate. There is also a strong case for pressing ahead with easily mobilised public investment projects that are intrinsically sound.

Our ratio of public debt to GDP is healthy. It is sensible to treat the public sector as a safe haven in an economic storm. But, after the recession, there will have to be tightening up on public finances to prevent us lurching back to high taxation, high inflation - or both.