These are gratifying times to be an economist - it's rather like being a doctor during the bubonic plague. But what do the experts think lies ahead for Britain - and its broken economy?

As it is with doctors, so it is with economists. Their diagnoses may vary, their prognoses differ and their remedies seem worse than the actual ailment.

Roger Bootle is one of the City's best-known economists. A former chief economist at HSBC, he runs consultancy Capital Economics and is a specialist adviser to the House of Commons Treasury Committee. His recent book, The Trouble with Markets, analyses the causes of the current financial crisis and discusses the threats to capitalism arising from it.

Roger Bootle believes the UK economy came closer to disaster than at any other period in recent history - and warns it will be several years before there is a return to what most people would regard as normality.

"I think we are in for a long period of slog, during which time the growth rate will be pretty low and the economy will struggle to use up the spare capacity released from the contraction of 2008," he says. "The fiscal numbers are simply dreadful."

In fact, Bootle's fears for 2010 are "worse than I - or anyone else, I think - could have imagined six months or a year ago.  

"That has turned me from being a straightforward Keynesian, believing in more fiscal expansion, into being a fiscal conservative and thinking that the numbers should be consolidated," he adds.

However, Bootle sees a risk that an incoming government will feel compelled to act drastically and quickly to cut the deficit, with damaging effects. "I expect the first Budget in 2010 to be a complete blockbuster - I think it is going to be ghastly," he explains.

"I think we are going to see big rises in taxes. I expect to see a 20% VAT rate and they may extend the coverage of VAT. We have been told about the top rate of income tax going up and I think the basic rate will go up as well by two, three or four pence. It will be a ghastly blow for consumers."

On top of that, he expects expenditure cuts and a very tough programme of expenditure control.

The effect, Bootle says, will be to damp down the prospects of recovery, although much will depend on other policies that a new government might put in place. "Will it, for instance, carry on with quantitative easing? Will it extend it? Might it take a more active role in running the banks? One possibility is that the government does more to boost bank lending."

On the subject of quantitative easing, Bootle subscribes to the consensus view that 'printing' money in these circumstances is not inevitably inflationary and that there is a real danger of the opposite - deflation - occuring.

"What needs to be done at the moment is to ward off debt deflation where prices fall, intensifying the burden of debt," he explains. "People pay down debt, which intensifies the downward pressure on the price level - the sort of spiral that happened in the US in the 1930s and in Japan in the 1990s."

Quantitative easing so far has not boosted the overall money supply because the banks have been so busy trying to shrink their balance sheets, he adds.

On this question of generating inflation, Bootle says it depends where the starting point is: "If the starting point is one where there is significant excess capacity then the extra 'printing' of money may well boost aggregate demand; that is the intention of it. It is only when you use up the spare capacity that it turns into inflation."

So, there is a medium-term inflationary danger. However, the real danger lies in the authorities not being able to reverse quantitative easing in a timely enough fashion.

Bootle says: "This would leave all this stimulus in the economy and then the economy recovers, and with all this money sloshing around the banks start lending more and the whole thing goes whoosh and you get this inflationary explosion."

At the moment, Bootle says there is hardly any risk of that at all, although the headline inflation numbers are going to move significantly higher: "A lot of people are then going to say 'aha, I told you so, it's the quantitative easing'. It won't be."

Turning to the underlying cause of the crisis, Bootle says it comes down to the mistaken idea that markets work and should be left alone.

"It seems to me that to blame the bankers for what has happened is a bit like blaming kids let loose in a sweet shop for eating too much candy," he says. "What do you expect banks to do?

"We've had this notion of let it all hang out, let a thousand flowers bloom, allow free markets to operate without restraint; it all works for the best of all possible worlds. I think we are learning now that actually it doesn't. There are conditions and circumstances and bits of the economy where that's just too dangerous, and banking is one of them."

He adds: "It's very easy for individuals to take on too much risk and to be too optimistic - and face the consequences. But because it is too dangerous for banks to be allowed to fail they have had a free option. It's heads I win, tails you lose because if the thing goes badly wrong they get bailed out."

It may be that to have a stable financial system you have to have a less innovative and perhaps more expensive one but, for Bootle, that's a price worth paying.

"I think, though, that we are in danger of significant regulatory overdrive, and not for the first time. The regulator made a mess of it in the first place so what is happening now? Well, more regulation.

It's ironic, really. It's regulation of the worst kind. We have the Financial Services Authority jumping in here, there and everywhere and we haven't got a clear idea of how we are going to run this part of the economy in what is supposed to be a free-market capitalist system.

"We are in a fluid time and again it is in the world of ideas that the issues will be thrashed out. We have got to evolve a new consensus about the role of the state in relation to finance.

"And I think it is too early to expect there to be a solution, not least because finance is global and it's not going to be good enough for one country in isolation to evolve an answer to all this."

A different view

Liam Halligan is chief economist at Prosperity Capital Management, an asset management firm with investments worth more than $3.5 billion (£2.11 billion) in emerging markets; mainly Russia and the former Soviet Union.

He is a member of the Society of Business Economists and a fellow of the Royal Society of Arts, Manufactures & Commerce. He also writes a regular column for the Sunday Telegraph.

Liam Halligan is extremely critical of the authorities' response to the economic crisis and shares Bootle's view that tough times lie ahead. "I fear we are at the beginning of a very difficult period in our history, when living standards plunge, public finances deteriorate further and enterprise stagnates."

Unlike Bootle, however, he attributes blame more to individuals than to the system and scorns the notion that deflation is a threat.

"My view is that what the British government, and to a lesser extent the US government, has been doing in the past year and a half will make future historians wince. What it has done is attack the problem of too much leverage with more leverage," he explains.

"It has debased our currency as a way of tackling our long-term sovereign debt. It has printed money to try and stimulate the economy, but all that will do is generate medium and long-term inflation.

This isn't rocket science; it seems to me completely clear - and increasingly the world's investors know it - which is why, once quantitative easing ends, the UK is going to have a lot of problems selling its sovereign debt."

Asked what he would have done differently, his response is blunt: "If we are looking for lessons we can't start from the question of what would I have done. We have to spool back and think how we got into this absurd position in the first place.

"For the past 10 years, some of us have been warning about the ridiculousness of Gordon Brown's policy. We have warned about massive off-balance sheet liabilities on the UK's national accounts such as public sector pensions, private finance initiatives and contingencies such as Network Rail. These are multibillion pound liabilities that have not been acknowledged.

"For many years, some of us warned about rigging the work of the Monetary Policy Committee (MPC), introducing an inflation target that lacks credibility by switching preference from the Retail Price Index to the Consumer Price Index, and so on."

Of course the government had to support the banking system, Halligan says, but not in the way that it did.

"The government doesn't have to stand behind each and every bank; there's a big difference. You stand behind the banking system, but at the same time you make sure any bail-out money you give to individual banks is contingent on the results of a root-and-branch, no-holds-barred external audit, which we have not even begun to do.
 
"We have shovelled money that the government has got, and money that it hasn't, into the banks so that it can attempt to recapitalise themselves from the absurd position that they got themselves into through bonus-fuelled binges and betting with taxpayers' money.

"None of the bail-out money we spent, money that taxpayers had already paid and money that taxpayers are going to have to pay in the future, was contingent on these external audits in order to determine the state of the balance sheets of the UK's banks. We still don't know the extent of the losses. This is an insane situation. That is why future historians will wince."

The whole of the political policy-making elite, he says, seems to have been captured by the banking sector and banks are now charging usurious rates of interest while using taxpayers' money - and printed money - to try and float themselves off the rocks and solve the problems in their off-balance-sheet vehicles.

As for talk of deflation, that's hooey. "These guys have been going on about deflation for about two years, and we have spent most of that time with inflation above the MPC's target. The inflation spike from 1.1% to 1.5% in October marked the start of a trend where inflation is going to go above 3% in the next six months.

"Within six months, Mervyn King will be writing a letter to the chancellor describing why inflation is so high, not why it is so low."

As for the distinction between headline inflation and core inflation, Halligan sees this as sophistry: "Core inflation is good in a world where no one eats or heats their home, no one needs to move around, turbines drive themselves and industry has no energy requirements.

"Core inflation? What total, total nonsense. It's almost as nonsensical as this 'output gapology'. Apparently, because there is an output gap we can print money and don't have to worry about inflation. And yet the reality is that the credit crunch, as all bank-led slumps have done in history, destroys supply.

"It doesn't preserve supply, it destroys the economy's productive capacity. It leads to companies closing down, workforces being dispersed, skills being eroded, and investment that should be happening to maintain productive capacity not happening.

"It is complete nonsense that there is lots of productive capacity on the sidelines that will act as some kind of huge sponge to mop up the fact that we have doubled our monetary base - almost tripled it - in less than a year. It is an intellectual conceit; even bigger than the intellectual conceit that is deflation.

"Both these concepts - deflation and the output gap - are sops to carry on this mad money printing; this mad expansionary policy to stop powerful people in the banking sector and their absurd friends in politics from facing up to these realities."

Conclusion

So, as market economists are wont to say, "you pays your money and you takes your choice". Either you accept that quantitative easing is necessary to stimulate demand and aid economic recovery, and without it there is a risk of deflation, or you go along with Liam Halligan and agree it is foolish and inevitably inflationary.

On other matters there is greater accord - the road to recovery will be long and hard. There is agreement on more regulation; particularly of banking activity. Both economists see merit in separating the so-called casino activities of investment banking from conventional commercial banking, although the government seems reluctant to accept it.

And there is agreement that the greatest threat to the economy is a fiscal crisis. The level of government indebtedness is horrific and unless convincing measures are taken to reduce it, lack of confidence in UK sovereign debt may prove catastrophic.

Not for nothing is economics called the dismal science.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010.

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