The British economy is going to shrink and many small and medium-sized businesses could go bust as it does so, Lord Mandelson, the newly appointed Business Secretary, admitted yesterday.

However, he refused to use the word “recession” as the Government continued its efforts to mitigate the effects of the global economic downturn.

Until now ministers had talked only of an economic slowdown but had stuck to the Treasury script, which envisages growth slowing but at no point going backwards.

“Of course the economy is going to contract, that is unavoidable,” Lord Mandelson told the BBC's Andrew Marr Show. However, he added: “I'm not going to use that word [recession] because I can't foretell the size of the contraction that is going to occur.”

His admission came as the mood among business leaders darkened dramatically again, according to the latest confidence survey from Lloyds TSB. Fewer than one in three businesses expect their business activity to increase over the next year, while 23 per cent expect their trade to deteriorate, according to the bank's latest business barometer. The resulting balance of 8 is down sharply from 24 in August and is the lowest recorded since the survey began in 2002.

Trevor Williams, chief economist at Lloyds TSB Corporate Markets, said that business confidence was “at rock bottom”.

Confidence about the outlook for the economy also fell back to near-record lows in September. A balance of 48 per cent of companies said that they were more pessimistic rather than optimistic about the economy over the next 12 months than they had been in June, down from 33 per cent in August.

Buoyant business confidence is important because without it production is cut, capital spending is shelved and stocks are run down, all leading to shrinking demand and job cuts.

Official figures due on Friday are expected to confirm that the economy shrank between July and September, after grinding to a halt in the second quarter of the year.

The National Institute of Economic and Social Research, the respected think-tank, has calculated that output fell by 0.2 per cent in the third quarter. If output also contracts in the final quarter of the year, as many economists expect, the country will officially be in recession. Yet there are growing fears that a recession could be more prolonged than previously thought. Ernst & Young's ITEM club has forecast that Britain's economy will contract by 1 per cent next year. This would be the first full year of shrinking output since the last recession in 1991, when output fell by 1.4 per cent over the year.

The deteriorating economic conditions are expected to cause a fresh surge in unemployment, which rose at the fastest rate in 17 years last month, as businesses are forced to cut their workforces in the face of declining consumer demand. Some economists forecast that the number of people out of work in Britain will rise to three million in 2010.

Yet there are hopes that inflation, which soared to 16-year high of 5.2 per cent last month, may have peaked, according to the latest Lloyds findings.

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