What is to be done? As a result of the global banking meltdown that began in the second week of September, the world economy has plunged into recession. Whether or not this mishap could have been avoided if the US Government had taken timely action to stabilise Lehman Brothers instead of deliberately driving it into bankruptcy is a moot point. All that matters today is preventing an outright collapse of the non-financial economy that would match the scale of the financial disaster.

Such a catastrophic collapse is a real threat. Only a handful of economic statistics relating to the post-Lehman period have been published so far, but they show record-breaking falls in consumer spending, industrial output and housing — and anecdotal evidence suggests that much worse is to come. One typical comment: “The real collapse has not even started because banks were waiting to be recapitalised before they put their overleveraged borrowers into liquidation. There will be a tsunami of commercial properties foreclosures and private equity bankruptcies in the first quarter of next year.”

So is it now too late to prevent the chaos that suddenly engulfed the financial system this month spreading to rest of the economy? Probably not, but radical action is extremely urgent. The main mechanism to protect non-financial jobs, investment and consumption must, as always, be macroeconomic demand management. But before focusing on macro policies, let us not forget that this disaster started in the banking system and that much of the damage was done by ill-considered accounting and regulatory changes driven by the fundamentalist ideology that “the market is always right”. Specifically, policymakers around the world should suspend the mark-to-market accounting and “risk-based” capital regulation that has vastly exaggerated the boom and the bust of the present credit cycle and has magnified a normal, if severe, downturn in global property markets into the greatest financial crisis of our lifetimes. The British Government should also be ready to renegotiate some of the details of its broadly sensible bank rescue package — for example, by tightening the requirement to maintain credit lines and also by eliminating the five-year minimum term of the preference shares - in order to increase the chances that private shareholders will help to recapitalise the banks.

Turning to the core macro issues, the top priority in Britain and the rest of Europe, particularly, must be sharply lower interest rates, rather than the fiscal stimulus suggested by Alistair Darling over the weekend. This is for four reasons. First, there is huge scope for lower interest rates in Britain and the eurozone. This is not true of the United States and Japan, where interest rates are already near rock-bottom levels and fiscal stimulus is likely to be the main defence against recession. Secondly, fiscal packages take months to implement and are liable to be politically captured by special interests. Thirdly, public borrowing has to be repaid, meaning that large fiscal packages should be complemented with credible long-term plans to reduce spending or increase taxes. While a newly elected US president might be able to propose a radical restructuring of the tax system that would stimulate the economy in the short term while reducing deficits in the long term, it will be impossible to strike such a balance in Britain a year before the general election.

Finally, and most importantly, experience suggests that monetary policy is generally more effective than fiscal policy in managing demand. This is likely to be true even though the credit system is paralysed, partly because lower official rates are needed to compensate for drastically wider credit spreads and partly because ultra-low official rates will help to strengthen the banks and encourage them to resume lending.

How far, then, should interest rates be reduced? In the past two British recessions — 1979-82 and 1991-92 — interest rates were cut by a whopping ten percentage points before growth was restored . Looking back to the 1960s and 1970s, interest rates reductions in recessions were never less than three percentage points. Thus the minimum action required from the Bank of England is a three-point cut from the peak of 5.75 per cent to 2.75 per cent. But, given the magnitude of this crisis, the Bank should be much bolder.

A full-point cut at the next MPC meeting followed by another half-point in December would get rates down to 3 per cent by Christmas. Beyond that, the Bank and the Government should make clear to the public and business community that Britain is moving towards rates much lower than anything experienced since the Second World War. Policymakers must focus on a simple and undeniable fact: Britain is more exposed than any other major economy to a housing slump and a contraction in financial services. Britain should, therefore, have the lowest interest rates — not the highest — in the world. This implies that the Bank's objective should be to get interest rates down to 2 per cent by the spring and to around the US level — 1.5 per cent at present but almost certain to be reduced to 1per cent before the end of this year.

An interest rate of 1 per cent may be far outside the experience of anyone living in Britain today, but then the same is true of the banking crisis. Gordon Brown was the first to recognise that these unprecedented events demanded unprecedented responses and this is as true of monetary policy as it is of government support for banks. It follows, therefore, that Britain should adopt the ultra-low interest rate regime that is taken for granted in the US and Japan. And the Japanese experience of the 1990s shows that central bankers must be prepared to “think the unthinkable” about interest rates sooner rather than later, if they want to avert disaster.

The British Government, having unexpectedly emerged as global leader in the institutional response to the banking crisis, should take the lead in a monetary policy gestalt-shift - and right away. A consequence of Britain reducing interest rates to well below the European level may well be a sharp fall in sterling. The possibility of a large temporary currency movement, far from deterring such a radical shift in monetary policy, should be seen as desirable. In a flexible market economy, exports act as a natural offset to the slump in financial services and housing — this is what is happening in the US. The ability to use radically lower interest and exchange rates to stabilise the British economy is the main advantage of keeping sterling out of the euro.

Now is the time for the Bank of England to take maximum advantage of this freedom of action. If the Bank fails to do this, then critical mutterings about its erratic performance in this crisis will turn into a full-blown challenge to central bank independence from politicians of all parties. And if the Bank refuses to act urgently to mitigate the recession, a challenge to its independence will be amply justified.

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