Vincent Cable: This recession is very far from over

The mother of all economic crises seems mysteriously to have vanished in the face of a determined counter-offensive by the forces of optimism. There are daily accounts of returning confidence in financial and property markets and bodies like the National Institute of Economic and Social Research are forecasting an early return to growth. Perhaps those government ministers who spotted the "green shoots of recovery" in the frozen winter earth were not so deluded after all?

The truth is that there is enormous uncertainty. None of us know whether the recession will be mild and short, or deep and prolonged. What we do know is that there has been a massive policy response: near zero interest rates; credit expansion through quantitative easing; large government fiscal deficits; bank rescues; and a big devaluation.

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The ideas represented by Milton Friedman and Keynes have been pooled and a combination of highly expansionary monetary and fiscal policy has been deployed. There has been an impact. The rate of economic decline has been slowed; the errors of the 1930s have been avoided; and the fears of Armageddon have lifted.

But this is an economists' and financiers' recovery rather than a real one: forward indicators and market expectations rather than facts on the ground. Unemployment is still rising steeply, especially among young people. The late summer will see a large cohort of unemployed graduates. Banks are continuing to restrict credit to solvent borrowers. Local small businesses with an exemplary credit history still come to my weekly advice surgery angry that banks are forcing them to the wall through unrealistic demands for higher security and fees. There is little sign too that heavily indebted consumers want to embark on a spending spree; or that business is contemplating investment beyond the rebuilding of stocks.

In framing the policy and political response to recovery – if that is what this is – we need to reflect on what we are recovering from. The optimists are treating the crisis like a bad dose of flu. It was frightening while temperatures raged at dangerous levels, but the fever is passing. As with the recessions of the 1980s and 1990s, we can expect to return to "normal".

This diagnosis is profoundly wrong. The patient has suffered a massive heart attack. Thanks to the wonders of modern economic medicine, the patient is improving remarkably rapidly in the Intensive Care Unit. But any suggestion of a return to "normality" is an invitation to another heart attack. There is now a long term legacy of weakness which we have to learn to live with.

One early challenge is phasing out the monetary steroids that kept the patient alive. There is now less fear of deflation – the world of falling prices, wages, output and employment. But deflation risk has not disappeared and there is the prospect of rising unemployment even when the recession is said to be "over". A greater risk is that overshooting from relaxed monetary policy will spill over into inflation. Rising oil prices are a reminder that any global recovery could translate quickly into commodity price inflation. There is a plausible scenario of prolonged stagflation in which recovery is aborted by anti-inflationary interest rate rises. If the Bank of England is to retain its independence, as it should, there is no easy resolution of this dilemma.

Politicians don't control interest rates. But they do have responsibility for the public finances. Here, the legacy issues are acute and likely to be long lasting. Already a debate has erupted around the "cuts" agenda: unusually puerile even by the standards of Westminster Punch and Judy. Mr 5 per cent vs. Mr 10 per cent. We have a government committed to real cuts in government consumption and savage cuts – a halving – of public investment posing as champions of public expenditure while the Conservatives, with the sketchiest of detail, want to cut more, sooner. A proper debate in the form of a Spending Review has just been shelved.

There is, in fact, much uncertainty concerning the size of a sustainable budget deficit: the "tipping point" at which government borrowing triggers a collapse of confidence in money markets. We know that somewhere ahead in the fog there is a steep cliff but not where it is. Even though the 40 per cent debt to GDP target has lapsed, government debt levels in relation to GDP, while increasing, are not exceptional by historic or comparative standards. But there is a nagging doubt in the markets about the sustainability of UK government borrowing (and therefore debt). Unlike the US government the UK cannot borrow abroad in its own currency and unlike the Japanese we do not have an army of small savers who want to lend patriotically to the government.

How then do governments respond rationally to a possible but unquantifiable event – a collapse of confidence? One objective basis for policy is the size of the "structural budget" deficit which will not correct itself as the economy recovers. Current estimates (they vary) are around 3 to 4 per cent of GDP. The public sector was allowed to expand on a revenue base – buoyant financial services and ever rising house prices – which was illusory. There will have to be realistic tax and spending plans to eliminate it. This requires a willingness to identify and cut substantial areas of long term government spending.

Making explicit choices is surely preferable to an approach that cuts services indiscriminately. That is why it is necessary to take on some sacred cows: public-sector pensions (ending defined benefit schemes for new entrants and raising contribution rates); tax credits (embracing 2m recipients with well over average incomes); defence (involving vast long-term commitments to maintaining a worldwide role); and higher education for half the population.

But a bigger question concerns the vast sums the Government pumped into the banking system (and even bigger guarantees). There is a danger now of a dash for cash: a quick sell off of public shares at give-away prices, leaving the taxpayer with a vast toxic pile of bank liabilities and with the banks and the City unreformed. In the Square Mile and the Treasury the dangerous idea is beginning to gather momentum that the crisis is over and that "normality" can soon be restored. Bonuses are back in fashion. Dangerous stuff. If a fresh heart attack is to be avoided in the financial sector, damaging the wider economy, a long period of regulated convalescence is required. The crisis is not over.

Vince Cable is the Liberal Democrat Shadow Chancellor and Deputy Leader