Leading article: Interest rate cuts alone will not save our economy

At the heart of the problem is the continued weakness of the banks

The Bank of England's half percentage point cut in its base rate yesterday was smaller than some forecasts. But it still counts as a hefty reduction. And the cut, of course, takes the official borrowing rate down to a historic low. The question is: what will this action achieve?

The cut will make it cheaper for banks to borrow cash from the Bank of England. This will increase the profitability of the banks' day-to-day activities. In normal times, this would encourage them to lend more to the wider economy. But these are not normal times. And rate cuts alone are clearly not going to be enough to stimulate our ailing economy.

Despite the four successive cuts in recent months the liquidity crisis is showing no signs of abating. Perfectly viable businesses are not getting the credit they need to operate. This lack of funding in conjunction with collapsing consumer demand is putting us on course for a perilously hard economic landing.

On the liquidity front, the signs are that the greatest problem is not so much the price of credit but rather its availability. It is simply harder to get a loan at any price. The number of lenders has shrunk drastically since the financial carnage of last October. Some of the aggressive lenders of the boom years such as Bradford and Bingley and Northern Rock have crashed out of the market. And the remaining domestic players such as Barclays, the Royal Bank of Scotland and Lloyds are contracting their lending to shore up their individual balance sheets, despite the fact they all stand to suffer more in the event of a prolonged slump.

At the heart of the problem is not the Bank rate, but the continued weakness of the banks themselves. The cost of their funding from the Bank of England has been slashed, but the rate at which they borrow from the money markets (although it has come down from last year's punishing levels) remains stubbornly high. While they cannot borrow freely from the financial markets they are unlikely to engage in any expansionary lending. The name of the game is still survival, rather than business opportunities.

What all this tells us is that the markets still do not think that banks are adequately capitalised. They cannot be relied upon to lubricate the economy with the necessary credit it needs. There are several possible ways around this, ranging from the Conservative proposal for government guarantees for new bank lending, to the creation of a "bad bank" which will take on the sector's remaining toxic debt, to a further round of recapitalisation and, finally, the Bank of England engaging in "quantitative easing".

The last option, which effectively amounts to pumping cash into the economy, would have to be handled with extreme care. It could easily result in a nasty dose of rising prices down the line. Britain risks lurching from the bad dream of deflation into an inflationary nightmare.

Resolute and sensible action is required from our fiscal and monetary authorities. Yet at the moment, the Government seems to be unsure about its next move. The Chancellor, Alistair Darling, having floated the prospect of quantitative easing earlier this week, yesterday seemed to be rowing back from it. At the weekend Gordon Brown rejected calls for a further round of enforced recapitalisation of the banks. The Government urgently needs to make up its mind because time is not on our side. The longer the economy is starved of the credit it needs to function, the longer and more painful this recession will be.