How to fix the Economy. An article by John Stepek.

Last week I talked about what the likely outcome of the housing crash was going to be. And let's make no mistake about it - there will be a housing crash. There's not much that can be done to prevent that now. But what can we do to make a better, more functional economy when we actually start to recover?

Well, let's look at how we ended up here in the first place. Globalisation in the form of ever-cheaper consumer goods from the east has allowed interest rates around the world to stay low, apparently without stoking inflation.

But although inflation didn't show up in consumer prices, it did in the price of assets, such as shares and property.

Asset bubbles
Low interest rates inspired over-confidence and huge risk-taking in the financial sector. Hedge fund managers, investment banks and other financial players borrowed piles of money to bet on markets, and it seemed they could never lose. On the occasions when they did - such as when the dot com bubble burst - the world's central banks stepped in to save them from their own folly.

But now the credit bubble itself has popped. This affects everything in the financial sector, not just house prices. So this is a global problem - it's not limited to the UK or the US. Carelessly invested money has created distortions across the world. But unfortunately for Britain, we are arguably one of the single most vulnerable countries to the credit bubble popping.

The City of London has been our flagship wealth generator. But now the party's over for the City, and all the hedge funds and non-doms are getting itchy feet.

The government is worried that they'll leave and take their taxes and "trickle-down" wealth with them, but the truth is, it doesn't matter as much as you might think. Their earning power has peaked with the credit bubble, so whatever happens, we won't be able to rely on them as a prop for the rest of the economy.

The wider economy
So outside of finance, what have we been doing for the past 10 years?

Well, the Centre for Economics and Business Research compiled some interesting data recently. It showed that between June 1996 and June 2006, 2.9 million extra jobs had been created.

Of these, 1.5 million were in the public sector, while around 300,000 came from hotels and restaurants, 350,000 from construction and nearly 500,000 in retail and distribution.

In other words, more than half of the extra employees in the workforce in the past 10 years are directly employed by the government. The lion's share of the new jobs in the private sector involve building houses and selling things to one another, all of which is directly dependent on the property boom.

So we have a vast swathe of state employees, all being paid for by a private sector dependent mainly on creative financing, and the resale of cheap goods from China - not to mention a great deal of government borrowing.

That equals an extremely unbalanced economy. The only way to get the UK as it stands back on its feet would be to re-inflate the credit bubble. But for one thing, that seems almost impossible - the banks are now licking their wounds and won't be ready to lend as manically for many years. And for another, it would only postpone the final reckoning, and make it even worse.

How to fix it
What we need to do is get our economy back into some sort of balance.

Roger Bootle of Capital Economics argues that manufacturing needs to come back to the fore. "We needed the borrowing binge because we were not earning enough from abroad to pay our way. Exports have been well below imports."

And there's a good reason for that - over the same 10 years, we've lost roughly one million jobs in manufacturing.

So how do we sort this out? Bootle argues for lower interest rates, as a way to devalue sterling, and thus make our exports more attractive.

It's not a bad argument, but it risks stoking inflation. There's also the problem that with demand for goods likely to slow across the world, we're also trying to sell into a weakening market, at a time when we're not exactly known for our manufacturing prowess.

As James Dyson, inventor of the eponymous vacuum cleaner, has pointed out: "If Britain wants to be more than a mere trading partner, we need to create exciting and useful products and technology." But unfortunately, the country is "facing a chronic shortage of engineers."

This is something we could address over time, but our education system has been hamstrung by a government so desperate to rig attainment statistics that subjects like media studies are regarded as important as fundamental, difficult subjects like maths and science.

So to my mind, if we really want to rebalance our economy, there's one crucial thing we really need to do. We need to put the government back in its box.

What needs to change in Westminster?
Typically, the more input a government has into an economy, the less productive it becomes. And that makes the economy less adaptable and responsive to change. Which is a problem when you come to a massive turning point, as is happening now.

Over the past 10 years, government spending as a proportion of gross domestic product has risen from below 40% to 44%, at a time when it has been falling in most European countries.

Effectively, the government has said that it knows how to spend our money better than we do.

Meanwhile, our tax system changes every five minutes, creating loopholes, which lead to more laws to close them down, which in turn create even more loopholes, to the point where Tolley's Yellow Tax Handbook has almost doubled in size in the past seven years. And the latest U-turn on the 10p tax band will make the arcane system of tax credits even more complicated and prone to fraud.

But as long as house prices have been rising, and jobs have been abundant, we've been happy to ignore the government's increasing role in our lives, and the amount of money that it's spent in the past decade.

Change coming
The good news is that with recession looming and public sector workers across the UK on strike or planning strikes, we'll relearn the folly of trusting the government with our money.

What needs to happen is a retreat from central planning in favour of locally-made decisions - letting head teachers run their own schools and set their own agendas and giving parents a genuine choice as to which school they send their kids, for example.

There should also be a mass cull of all the pointless bureaucratic middle-management jobs, and unskilled pseudo-jobs (like community support officers, instead of proper police) that have sprung up throughout the public sector.

Is tax the answer?
If the banks won't lend, then there is another way to get money into hard-pressed consumers' pockets - tax cuts. Remember them?

Now that people are getting poorer and paying more attention to their wage slips, they might just realise how much money the government is getting from them every month. When times are hard, the idea of paying high taxes for low-quality public services will become a lot less acceptable.

The bad news is that finding a group of politicians ready and willing to genuinely reduce the role of government - effectively relinquishing some of their power - won't be as easy.

But as voters we still have some power left. If enough of us demand smaller government, they'll listen. I'd suggest that a good start is to write to your local MP, and to his or her opponents. There's no silver bullet for the mess we're in - but it's a start.

Read more from John Stepek here.