The past few days have seen the different parties competing to offer their own fiscal stimuli as ways of helping the economy from the recession that began last May. For the Conservatives and Liberal Democrats, the situation is quite straightforward. They propose policies that are not going to be implemented in the near term and they can then explain that the continuing recession is a consequence of a failure to implement these policies. But the Government, which will reveal its proposals in the Pre-Budget Report on Monday, is in a much harder position.

While a fiscal stimulus has much to commend it, it is important at the same time to understand that neither it, nor interest rate cuts of the type we saw at the start of the month, are going to bring an early end to the recession. Given the current state of credit markets, that is likely to continue for at least another year.

Neither a fiscal stimulus nor a monetary stimulus is a costless route to prosperity. Government borrowing raises levels of national debt. These debts have to be repaid in the future, or alternatively the interest on them has to be paid indefinitely. If borrowing stimulates the economy, debt service might be expected to have a depressing effect, which, over time, might be expected to balance out the stimulus.

However, in a recession there are likely to be people who would like to work and, as a result of the economic disruption, cannot. The argument for fiscal action is that by the time the debt is repaid the economy will be running smoothly again and people who want to work will be able to so that, over time, total output is increased. The same could be achieved by private borrowing, but, since people are not happy about borrowing at the moment and banks are not happy about lending, it is more effective for the Government to do the borrowing for them.

In normal times, active fiscal policy is unnecessary and possibly counter-productive. Cutting taxes today merely involves shifting consumption to the present from the inevitable time when taxes have to rise to pay debts. At the moment, with a sharp weakening of the economy, such a move is justified. Companies and individuals are constrained in what they can borrow, so they cannot rely on private credit to smooth out fluctuations in their incomes. Policy can help to reduce the effects of this market failure. At the same time, in the long term, saving needs to be much higher than it has been in the past few years.

If we are to have a fiscal boost, then it is important to know what might have the most traction in removing constraints. Of course, direct spending increases have a strong impact once they are implemented, but changing spending plans takes time and often the change takes place after the problem they are designed to deal with has gone away. An increase in government spending of £15billion would, if it could be delivered quickly, do a substantial amount to offset the fall in output expected for next year, adding just over half a per cent to output next year.

But we doubt that it could be delivered quickly. Tax cuts, on the other hand, can be implemented quickly. The Chancellor can choose between direct and indirect tax cuts. National Institute research suggests that, in normal times, a cut in indirect taxes worth 1 per cent of GDP for two years would raise output by around a quarter of a per cent. The gains from direct tax cuts of the same magnitude in normal times would be marginally less but, at a time of borrowing constraints, the balance of advantage has probably shifted in their favour. The effects of both are small because much of the impact spills over into imports and the increase in consumption may also crowd out other activity. With international co-ordination, these import leakages are reduced and the benefit is increased around two thirds.

A concern often expressed is that consumers will unwind fiscal policy. If they know that future taxes will rise, then they might well save up the benefits of current tax cuts. But in today's circumstances this is not very likely. More probably they would be grateful for the Government to facilitate the smoothing of spending, which, given current credit constraints, they cannot do for themselves.

Experience in America last summer showed that tax cuts generate an immediate increase in spending. The time appears ripe for a temporary cut in direct taxes on a significant scale to ameliorate the effects of the banking crisis on the economy. Fiscal policy cannot stop us going into recession now, but it can reduce the pain.

Ray Barrell is senior fellow and Martin Weale is director at the National Institute of Economic and Social Research. The next National Institute/European Forecasting Network forecast will be discuss internationally co-ordinated policy and will be published on November 24.

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