THROUGHOUT the start of this recession and in the run-up to this year’s pre-budget report, we have had a lot of talk about fiscal stimulus. As it turned out, the report was all fiscal but not very stimulating.

The government claims that there is a global consensus on the need for such a stimulus, no matter the state of a nation’s finances. Not only is this not true — Angela Merkel poured cold water on the idea a few days ago, for one — but this talk has been a distraction from what we really need.

As I have consistently argued, along with others such as Richard Lambert and Mervyn King, it is in monetary policy, not fiscal policy, where politicians and economists must aim their firepower.

Monetary activism means, first and foremost, lower interest rates. But it is not just the price of money, the interest rate, that is the problem. Cutting rates and appealing to banks to pass on the cuts is not enough. We have to take action on the quantity of credit.

The Bank of England says that the growth of the supply of credit in the economy has fallen close to zero, the lowest level in nearly 30 years.

The CBI says the number of firms reporting reduced and withdrawn lines of credit has risen from one-third to over 40% in the past month alone.

What’s more, the market for credit insurance is drying up. At least 12,000 British businesses have had vital insurance cover withdrawn in the past week.

Despite the bank recapitalisation, the fundamental problem has not changed. Markets are worried that banks don’t have enough capital to cover their losses, so instead of lending to businesses, the banks are cutting down their balance sheets. If everyone does that at the same time, more businesses go under and the recession gets deeper. That’s not in the banks’ interests or the country’s interests.

This is a credit crunch and it needs credit solutions. Our guiding principle should be to use radical government action to get lending moving, but as far as possible for lending decisions to be made according to market incentives. That combines the best of both worlds, and means we would maximise the chances of having a viable banking system to help lift us out of recession.

As Mervyn King has said, it wouldn’t be wise to rule anything out at this stage.

But while there is no single panacea, there is radical action we can take now.

On Friday I proposed establishing a temporary new government body — the National Loan Guarantee Scheme — to underwrite lending from the banks to British businesses. It would do so for a commercial insurance fee, passed on by the banks, that would properly protect the taxpayer. Banks would be able to use the scheme’s guarantees to underwrite a significant proportion of any new loans to business.

Crucially that proportion must be less than 100%. This means they will have the right incentives to avoid making reckless loans, and it will be the banks, not politicians or bureaucrats, making the decisions about who to lend to.

The end result of this partnership will be more lending at lower rates of interest, because the banks won’t have to put aside so much precious capital in order to make new loans.

A similar approach should be taken with trade credit insurance, which has dried up over the past few weeks with worrying consequences for the day-to-day workings of our economy. The French government has just announced a scheme to tackle the trade credit problem, and our government must surely follow.

This is the kind of action the real economy needs — not doubling the national debt to £1 trillion.

Thousands of healthy businesses and millions of people who work for them are desperately relying on the government to get the credit markets moving again. For their sake, it must act now before it is too late.

- David Cameron is leader of the Conservative party

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