The new interest-rate orthodoxy is as flawed as the old one

Remember how it was in 1979-1981? Mrs Thatcher and Geoffrey Howe swallowed an untested theory whole and subjected Britain, brutally, to the monetarist experiment. All policy instruments were totally subordinated to "controlling the money supply" - the necessary and sufficient condition for stable growth with neither inflation nor involuntary unemployment.

The experiment failed catastrophically. The government could not control the money supply, but the frantic attempt to do so generated the worst recession, by far, of the post-war period. Far from being stable, output fluctuated wildly, while unemployment rose from about 1m to at least 3m. Inflation did not fall convincingly for at least 10 years. Not only did the experiment fail, causing untold hardship, the underlying theory was disproved.

Had you noticed that we are now being subjected to a second experiment which is based, once again, on an untried and questionable theory? According to this theory, there is a unique "equilibrium" level of output at which inflation will be stable. And there is a short-term interest rate (which, unlike the money supply, the central bank can control) which is the unique counterpart of this equilibrium, so setting the interest rate is properly left to technical experts. If they get it right, aggregate demand will eventually adjust automatically to the equilibrium level. The Budget must in general be balanced, and active fiscal policy is out of bounds.

I have many reasons for resisting this system of ideas, which I do not believe is securely based in economic theory or empirical research. But there is one objection, above all, that deserves to be brought strongly to readers' attention, because we may be getting to a point where adverse conditions put the whole apparatus under intolerable strain.

It is well known that house prices have been exploding and that the level of household debt relative to income has been rising. It is widely recognised that high debt/income levels are a potential source of weakness because highly geared households could get into trouble should there be a rise in interest rates or a fall in house prices. As against this, it has been pointed out that, with nominal interest rates so low, people can prudently take on more debt than used to be the case; also that the initial burden of a debt of a given size is much lower when inflation is low, even if real interest rates are the same in each case.

Yet these considerations do not touch the central issue. As the chart shows, the flow of net lending to the personal sector has been rising fairly steadily from about 3% of personal disposable income at the beginning of 1992 to 15% in the third quarter of 2002. This indicates the extent to which the growth of disposable income, consumption and so aggregate demand has depended on the growth in the credit flow.

It was not the rise in debt which generated the rise in demand so much as the rise in net lending - that is, the rise in the rise in debt. But this can obviously not be an abiding source of growth; it is an intrinsically unsustainable process.

A large fall in net lending is more likely than intuition might suppose, because it does not require that the debt itself should fall. Personal income has recently been rising at about 3% per annum. If the housing boom were now to taper off, as many people expect it will, it is plausible that the debt would rise no faster than this.

That would imply that net lending would stop rising altogether relative to income. The resulting decline in the lending/income ratio - from 15% to 3% - would be comparable in size to those which occurred after each of the last two splurges, at the beginning of the 1970s and the end of the 1980s, and large enough to generate another prolonged stagnation.

With the US in a similar plight, and euroland and Japan stuck in the mud as well, there is a real possibility that the whole world could find itself locked into an endemic stagnation which could become a recession.

The palpable weakness of the present policy regime is that it possesses no antidote for chronic demand deficiency. I think the potency of interest rate changes is, in general, being overestimated. But there is one feature of monetary policy which decisively limits its effectiveness in the long term; this is that interest rates (already very low) can never fall below zero.

Moreover, the so-called "golden rule", that the Budget be balanced over the cycle, excludes the use of fiscal policy to revive the economy if there comes to be a structural (as opposed to cyclical) deficiency in aggregate demand.

The active use of fiscal policy, both here and abroad, will eventually have to be rehabilitated. I just hope it will not take a worldwide recession to bring about the necessary changes in attitudes, theories, policies and institutions.

· Professor Wynne Godley works at the Cambridge Endowment for Research in Finance (Cerf) at the Judge Institute in Cambridge