MPC members have argued that Bank rate cuts and fiscal policy must bear more of the burden of supporting the economy because the “bank credit channel” of monetary policy is impaired. The logic is indisputable but the optimal solution is surely to take direct action to revive credit supply.

In the US, mortgage giants Fannie Mae and Freddie Mac, now under government control, are maintaining lending while the Fed has started to buy commercial paper and mortgage-backed securities on a large scale. The Fed’s recent actions have contributed to the three-month LIBOR / OIS spread falling to 1.8% – well below the UK level of 2.2% – while there are tentative signs of a pick-up in monetary growth.

In the UK, by contrast, state-run Northern Rock is on course to cut outstanding loans by £25-30 billion in 2009 while the Bank of England remains resolutely opposed to Fed-style direct lending to firms and households. Government plans to expand support for small firm credit and offer guarantees on mortgage securities backed by new loans are promising but cannot fully substitute for use of the central bank’s balance sheet.

The Bank’s intransigence is an extension of its refusal to offer lender-of-last-resort support to the banking system on other than penal terms – the special liquidity scheme is much more expensive to access than equivalent Fed or ECB facilities. The penal approach was also in evidence in Mervyn King’s recent suggestion that banks will be forced to raise still more capital if they refuse to expand their lending. The Bank’s October Financial Stability Report contained a detailed discussion of why the government’s £50 billion recapitalisation plan would be sufficient to cushion banks against losses over the next five years even in a severe macroeconomic scenario and assuming a low level of underlying future profits. Mr. King’s apparent U-turn is puzzling and threatens to undermine the confidence-building effects of the rescue package.

Cuts in interest rates reduce the opportunity cost of holding money in more liquid forms. Narrow money M1 – currency and checkable deposits – usually picks up relative to broader measures like M2 and M3. This is a sign that the change in interest rates is affecting behaviour and often precedes a recovery in economic activity.

US real M1 typically leads turning points in the economic cycle by 6-12 months – see first chart. Its annual rate of change bottomed in May and moved up sharply in September and October. Recent figures may have been artificially boosted by a flight of cash from money market funds. However, a further recovery in November and December would suggest an approaching trough in economic activity.

Eurozone figures released today also show M1 picking up, with a particularly large rise in October – see second chart. UK data will be available on Monday.

Note that M1 – unlike the monetary base – does not include bank reserves held at the central bank, so is not directly affected by “quantitative easing”.

Revised third-quarter GDP figures released today confirm a 0.5% quarterly decline. From the expenditure side, a 2.4% fall in capital spending contributed 0.4pp to the GDP drop, with consumer spending, inventories and trade each adding a further 0.1pp. The only positive was a rise in government consumption, contributing 0.2pp.

The extent of the weakness in capital spending was surprising given business investment figures released yesterday, showing a decline of only 0.2%. This suggests a large fall in housing investment, consistent with starts data and anecdotal evidence.

National Statistics also released September figures on services output. This series can be combined with industrial production to create a monthly GDP proxy – the two sectors account for 93% of gross value added. The chart below shows quarterly GDP with this monthly indicator.

The July reading of the monthly series was equal to the second-quarter average. The quarterly GDP decline reflected marked weakness in August and September, partly due to the escalating financial crisis. Monthly output fell by 0.8% in August and September combined.

The late-quarter deterioration implies a negative carry-over into the fourth quarter – September output was 0.3% below the third-quarter average. Together with recent very weak business surveys, this suggests a GDP decline of more than 0.5% in the current quarter.

The strategy is to finance a short-term giveaway with a long-term rise in income taxes. It is doubtful that this will amount to much of a “stimulus” to spending and activity.

The changes to national insurance were a major surprise, raising £3.8 billion in 2011-12. Other measures targeting top earners will garner a further £2.2 billion in that year.

The economic forecasts underlying the fiscal projections are optimistic – GDP falls by just 0.25% in 2008-09 and 0.5% in 2009-10 before climbing 2% in 2010-11 and 3% in 2011-12. This implies a mild recession by historical standards, against emerging evidence.

A key risk is that the economy has not regained sufficient momentum by 2010 to withstand programmed large tax rises. Government debt will embark on an explosive path if these increases are postponed.

The VAT cut contributes to the annual RPI change moving deep into negative territory – minus 2.25% by September 2009. However, a rapid rebound is then forecast, to 2.5% in September 2010, with the VAT reversal and higher excise duties contributing.

Servicing the growing debt eats significantly into resources – debt interest is forecast to rise from 1.3% of GDP in 2009-10 to 2.5% in 2012-13. The risk is of a larger increase as huge near-term borrowing needs put upward pressure on real yields.

Total debt issuance by the Debt Management Office is now projected at £161 billion, more than double the Budget forecast of £79 billion. The authorities have rejected advice to “underfund” the deficit in order to boost dangerously low broad money growth.

Most economists support the government’s plans to expand borrowing over and above the rise entailed by operation of the “automatic stabilisers”. However, a larger deficit does not necessarily imply a “fiscal stimulus”.

A standard economic principle is that most consumers base their level of spending on their income expectations over the long term rather than current earnings. Current income is a key factor only for those households with no savings or unable to obtain credit.

It follows that a temporary tax cut applied across all households and to be paid for by higher future taxes is unlikely to have a significant impact on consumption. Measures targeted at savings-short, credit-constrained households would have a greater chance of success but even in this case the rise in spending of those benefiting would be partly offset by cut-backs by other consumers anticipating lower future post-tax income.

This is not to say fiscal actions financed by higher borrowing can never deliver a short-term stimulus. However, policies must be designed to enhance the economy’s supply potential over the longer term, thereby warranting higher long-term income expectations. Examples include cuts in marginal tax rates, which stimulate entrepreneurship and effort, and public investment in projects promising a high long-term return (e.g. transport infrastructure).

A temporary cut in VAT fails the test of being targeted at households more likely to spend any windfall gain and has no positive impact on the economy’s long-term supply potential. Consumption of higher-value items will rise in the months before the lower rate is withdrawn but fall by exactly the same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.

The longer-term “multiplier effect” of this VAT jiggling is likely to be close to zero.

Of course, higher borrowing may also have monetary effects – a rise in the deficit financed by bank borrowing would boost the money supply, thereby representing a “net injection of cash to the economy”. However, the same positive monetary impact could be achieved simply by underfunding the existing deficit, without a need for yet further fiscal “largesse”.