John Redwood: Admit we're in trouble, Gordon, and get cutting

It's dangerous to ignore the collapse of the stock markets: they are trying to tell us something. In the latter part of the 1990s, the international economy was kept going by an amazing asset inflation and a US consumer boom. People made vast paper fortunes in hi-tech shares. Wall Street analysts hoped that when the bubble burst, life would carry on as if nothing had happened; other shares, they thought, would take up the running. They were unwilling to look across at Japan, where a huge asset blow-off at the end of the 1980s has left the economy wallowing in the recessionary volcanic dust ever since.

Here in the UK some commentators came to believe that boom and bust had been abolished – that an independent Bank of England had found the magic formula for perpetual growth and prosperity. Unfortunately for us, it hasn't. The news is deteriorating rapidly.

The City was wildly over-optimistic about the economic outlook before the murderous attack on the World Trade Centre. That event has forced a rethink of the prospects. It has accelerated the drop in air travel and tourism that had already begun. It has highlighted the downwards twist for many manufacturers that were already struggling.

We have seen the agony of several big companies, illustrating just how quickly even the greatest can spin out of control. BT moved from cash-generating giant to overstretched borrower thanks to the telecoms licence auctions. Marconi showed how exposed a highly geared telecoms firm is once the music stops. Now it is the turn of BA to admit the damage done by spending too much in the good times instead of saving some cash for the bad times. Its pain becomes Boeing's grief.

It is most important to learn the lessons of Japan. At the peak of that country's success, it boasted that the development value of the land on which the emperor's palace stood was worth more than the state of California. If that was the case it was time to sell the palace and buy California.

When Japan went into decline, its rulers tried most of the remedies on offer. They tried huge public deficits, only to discover they led Japan deep into debt but not into growth. They tried low interest rates, and they tried keeping the banks afloat. It made no difference. Scared people kept on saving, not spending.

The more the Dow and the FTSE fall, the bigger will be the effect on confidence, consumption and the banking sys- tem. We are seeing a sharp deterioration in cash flow for many companies. Good companies will need the help of their banks to see them through. The Bank of England needs to dust down the files of the old Lifeboat, which handled the secondary banking and property crash of the 1970s.

The Government is right to refuse to ride to the rescue of airlines with direct subsidies. It must tell the Bank of England it has a duty to supply enough cash to the system, but it must also tell the banks to start making decisions about who can survive. Some boards will need changing; some companies will need to raise new equity; there will be plenty of activity renewing borrowings and offering emergency facilities. Japan shows you should not just cut interest rates and hope all will be well. Hard decisions have to be made about who to save.

Above all, the Government needs to reassert its trustworthiness on the economy before the markets make a mockery of it. Gordon Brown has to produce some forecasts soon. He would be well advised to accept that we are in for hard times. He needs to show how government spending increases and revenues disappoint as soon as growth slows. He needs to take action now to stop borrowing getting out of control by the end of this Parliament. He needs to admit there will be many redundancies, as we are now seeing, and make provision for them. He will have to cut his planned increases in spending, while protecting schools, hospitals and the police

He will have to tell the markets that he is taking early action. Past chancellors have believed their own hype, assumed the economy would carry on growing and ended up making far bigger cuts under the cosh of the markets. A little honest pessimism and prudence now will save much worse medicine later.

The Right Honourable John Redwood MP is a former trade minister.