Only charlatans can predict, with any confidence, what will happen as the financial crisis evolves into recession – or worse. Although I am often credited with having anticipated some of the consequences of a housing and credit bubble, I was also schooled in the Shell scenario discipline, whose starting point is that those who claim they can predict the future are liars even if, by chance, they are later proved right.

What we can say on the strength of historical experience and basic theory is that we are entering into a recessionary period – of unknown length and depth – as a consequence of contraction of the money supply in the “credit crunch”, the shock to business and household confidence and the effect of falling house prices.

Highly indebted households – and UK households have the highest level of debt relative to income in the developed world – are trying to improve their domestic balance sheets by reducing borrowing (and spending) and increasing savings. Such an adjustment would have had to occur when the asset bubble burst, but it is being made much more severe by the simultaneous impact of the banking crisis, with its profound uncertainties and associated credit squeeze.

I do not think there are any cheerful souls left who think the damage is superficial and that the government measures to recapitalise banks and guarantee inter-bank lending mean a quick return to “normality”. The debate is now between those who believe the real horrors have not yet been confronted and who see no prospect of recovery until the banking system has been purged of bad debt and those – like me – who hope and believe that the financial crisis has essentially passed, with the policy focus shifting to the real economy and long-term regulatory reform.

The political debate is dominated by demands for more regulation to replace the laissez-faire approach, which is blamed for the collapse of banks. Now, I am happier than most to lay into greedy bankers, the wickedness of short-selling and the amorality of hedge funds. But I worry about what more regulation means.

Even in “light touch” London there is no shortage of Financial Services Authority forms to fill in and the firms at the centre of this deregulated anarchy spend a lot of their time on compliance issues. Regulated banks have been more vulnerable than unregulated hedge funds. More regulation did not stop New York becoming the centre of the global meltdown. There must be something in the complaint of Alan Greenspan, former chairman of the US Federal Reserve, that more regulation leads, among other things, to more avoidance. But to do nothing is to counsel despair. Evidently we need “more intelligent regulation”. The question is: how do regulatory bodies suddenly become “more intelligent”?

One answer is for regulators to concentrate on a few key essentials, such as obligatory capital requirements – in order to limit the scope for dangerous levels of debt in institutions crucial to systemic stability.

A related principle is obligatory transparency. The most emotive issue is executive pay and bonuses. In general, government should not be involved in setting individuals’ pay, and inequalities of income and wealth should be dealt with through the tax system. But there is clear evidence that bonus systems linked to maximising returns on equity have led to excessive risk-taking.

There is a growing body of opinion that while individual pay contracts cannot seriously be regulated, regulation can and should ensure that payments should in future be in stock that is not redeemable for five years or more – when performance has been demonstrated.

One of the biggest regulatory issues is what is to happen to the banks themselves. They cannot return to their previous method of operation – any more than a victim of a massive heart attack can return to his previous lifestyle.

The contradiction between competitive profit-seeking to enrich shareholders and executives and a responsibility for careful, prudent behaviour in the interests of systemic stability has proved impossible to reconcile.

For the immediate future there will be a large state banking sector that will, in time, face growing problems in reconciling its commitment to maximise returns to the taxpayer with social objectives and fair competition with other banking institutions.

It may be that the present mishmash of institutional arrangements will have to give way to a system of narrow banking, in which banks are confined to a range of low-risk activities. Then, in a few years, we are likely to see a sell-off of nationalised banks – and it is vital that they do not simply return to the unsustainable, unstable structure that we had before.

Vince Cable MP is the Liberal Democrat Treasury spokesman.

From the Demos report After the Apocalypse: Lessons from the Global Financial Crisis

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