You read it here first: why quantitative easing won't work, and what should be done instead

On Thursday, as well as dropping the base rate to its lowest-ever level - half the previous lowest-ever figure, reached only a month earlier - the Bank of England announced it will put £75bn into the banks by way of quantitative easing.

It's my understanding that it will purchase Treasury bonds and AAA corporate bonds, most of them from the banks. The hope is that the banks will lend this cash and more to companies and individuals.

Hope? We're taking a step that could lead to rampant inflation in years to come in hope?

Worrying, the move seems to have wrong-footed George Osborne, who muttered something along the lines of 'they've messed up the economy so badly, they might as well give it a try'. Much better would have been to have explained why the move is almost certain to fail and, to avoid the 'do-nothing party' criticism levelled by Brown, instead reiterated the party's proposed alternative measures.

Politicians, especially those in opposition, are often accused of trying to appear wise with the benefit of hindsight. Though I'm not yet a politician, I aspire to be one. So I'll commit to my blog, now, the reasons why I believe the Bank of England, perhaps under the influence or direction of its political masters, is making a big mistake, and what I believe it should be doing instead. Let the future be my judge.

The root cause of our difficulties lies in the opacity of the balance sheets of our clearing banks. No-one knows how many of the loans, bonds and other assets they hold will turn out to be worthless, and how many will be redeemable for less than their balance sheet value. Some banks may be terminally insolvent, but no-one knows which. For this reason, they can't afford to take the risk of lending to one another, and they're under intense pressure to improve their own balance sheets, by retaining as much cash as possible.

Retaining as much cash as possible. Now there's a phrase. So if a nice man from Threadneedle Street turns up with a big pile of cash, offering to swap it for some bonds, what's your average bank likely to do with the cash? Retain as much of it as possible, obviously. Not just to improve its liquidity ratio, but also to boost its share price. Because shares in a potentially insolvent institution aren't worth much to anyone. And the one thing that's keeping the directors of the clearing banks motivated in this new, no-cash-bonus climate, is the prospect of share options granted at today's peppercorn stock prices. Which is fine in principle, except that the detail can result in those at the top being incentivised to boost the balance sheet (i.e. retaining cash) rather than profitability (i.e. lending the cash out), against a background of their institutions' shares being dragged down primarily by solvency fears and write-downs rather than a lack of profit on continuing activities.

Granted, cash is only slightly more secure than the top-grade bonds that it'll be swapped for, but it's more liquid, given the risk that Treasury bonds will soon become as commonplace as pizza home delivery leaflets, due to the country's need to borrow to buy its way out of the mess it's in. It also has the great benefit of being the asset that banks will need to accumulate over the next five years if they're to redeem the preference shares the Government was granted when it rescued them last year - something else the directors know they need to do to boost the share price.

I predict, therefore, that this first tranche of £75 billion will make no discernible impact on money supply in the real economy. The Bank of England has already said there'll be another £75 billion to follow if the first doesn't work. Which seems a strange approach to me: better, surely, to try something else, rather than repeat the exercise, if a plan doesn't succeed?

It seems to me that the banks are like wells. We'd like them to contain enough water that, when we pump the handle, a steady flow is delivered. Currently, the water level is below the point reached by the pump, so only air comes out of the standpipe. After we've chucked in our £75 billion barrel-full of liquid, it'll still be too low. So we'll do it again, Still no good. So next, in goes £100 billion worth. Only now, there's too much water in the well, and it's gushing out, over the sides, being wasted and flooding people's homes. 

The same could happen with the banks. In parallel with the quantitative easing process, they will continue the long, hard work of establishing just how bad the situation is, writing off and down assets and establishing the true state of their balance sheets. Until the second job is complete, none of the cash coming in from the Bank of England is going out to businesses and individuals. The downside to quantiative easing is that it's a nothing-or-everything measure: injecting £75 billion will either result in no new lending, if the banks' capital ratios and balance sheest are still found wanting, or up to £1 trillion if it's judged that the bank is now solvent enough to return to business as usual. And it's my prediction that the Bank of England will have to put as much as £200 billion into quantitative easing before the banks start lending again - which means they could eventually have the capacity to lend perhaps £2.5 trillion. And it'll find its way into the economy very quickly indeed. With that amount of cash in circulation, which the banks acquired so cheaply, they'll be fighting each other to place it. Hey presto - we'll be back in a debt-fuelled consumer boom and our companies will be over-leveraging themselves again.

So next time you hear Gordon Brown talking about prudence, remember it's not just the boom of the past 7-8 years and the current bust he didn't anticipate or head off; he's also, now, sowing the seeds of the next disastrous cycle.

Of course, I appreciate it's easy to criticise but harder to offer constructive alternatives. Actually, my party, and I, have proposed other solutions. Early on in the downturn, David Cameron proposed a £50 billion loan guarantee scheme aimed at keeping businesses solvent. I believe it's little short of criminal that the Government hasn't had the humility to follow this path; had it done so when David raised the idea, the number of business failures we're now seeing, and the resultant rise in unemployment, would have been less severe. A state-backed guarantee for ringfenced loans bypasses the problem of the state of the banks' balance sheets, enabling them to engage in profitable lending without having to concern themselves with its implications for their cash reserves. And it would make a lot of difference to the ability of businesses to survive the perfect storm of difficult trading and unsupportive banks, resulting in the preservation of many jobs.

The only drawback to a guarantee scheme is that it's a Pound for Pound measure, at least in the short term. £50 billion of taxpayers' money results in no more than £50 billion of lending, at least until the first tranche of loan repayments are received. I can see the attraction of quantitative easing: put £75 billion in, get up to £1 trillion out.

There's another idea, not yet adopted by my party, but I believe worthy of consideration, that potentially combines the best of both approaches. The Government should up three 'good banks' - meaning new institutions, with clean balance sheets from the get-go, and giving each of them say £50 billion to play with. This would give them the ability to lend around £700 million each- collectively, a couple of trillion Pounds - because, with clean balance sheets, they would be able to lend around 14 times their cash reserves, based on a liquidity ratio of seven percent. They would also be able to borrow from non-credit crunched banks abroad as well as institutions such as pension funds and local authorities, potentially boosting their ability to lend still further. To avoid overheating the economy, they would be directed to phase this lending over a number of years. Over time, they could even take over some of the enfeebled existing banks - once the true state of their balance sheets had become clear, of course, unlike Gordon Brown's ill-conceived 'shotgun wedding' between LloydsTSB and the car crash that was HBOS.

I appreciate that a bank capitalised to the tune of 'just' £50 billion is a minnow relative to the abovementioned whales - beached ones, admittedly. The kinds of new banks I have in mind would resemble Firstdirect rather than Barclays - no legacy branch network, just phone- and internet-based, with even its commercial lending personnel being mobile workers, visiting clients rather than esconsed in palatial offices. So why not just one 'good bank', working with £150 billion of capital?

It's simple: as a Conservative, I believe in competition and free trade. Even if we could fix the liquidity problem immediately, in the current environment consumers and businesses will be deterred from borrowing because rates and lending policies will remain both prohibitive and suspiciously uniform because of the alarming degree of consolidation that has taken place - and, in fact, encouraged. A minimum of two 'good banks' are required to bring about competition in lending to consumers and businesses by solvent institutions, while three are needed so each 'good bank' has a choice of two others with which to trade and from which to borrow.

Such an approach would also enable private equity firms to finance leveraged buyouts, which drive business efficiencies, help the public sector re-start new projects through PFI schemes - resulting in more employment in the construction sector - and also inject fresh capital into the mortgage market. Better still, as the providers of these institutions' shareholders' funds, we, the taxpayers, would own them, and could benefit from any future floation, and dividends in the meantime. And it would take away the pressure to keep pumping money into rescuing the existing banks, some of which (Lloyds and RBS in particular) are, through their own avarice and hubris, probably beyond long-term salvation.

During the current downturn, with banks calling overdrafts, many companies have been forced to try to raise equity investment. In almost all cases, investors have fought shy of buying into companies with deficits in their balance sheets due to historic losses or debts to creditors; the result is that managers and administrators collude to set up 'pre-packs' - new companies that acquire trading assets from troubled precursor businesses. Hitherto, taxpayers have been forced into acquiring equity in what are, in essence, lame duck companies - banks with toxic balance sheets. Much better, surely, to invest in shiny new businesses with no inherited problems.

As a Conservative, I feel deeply uncomfortable with the notion of state-owned banks. The risks are obvious: politicians and civil servants bring pressure to bear to have them pursue social objectives, at the expense of commercial prudence. So I stress that my preferred option for these 'good banks' is not direct Treasury funding but, rather, making shares available to the public, if necessary with sweeteners.

Take pensioners, for instance: many are asset-rich, but income-poor. And never more so than at a time when the base rate is a mere 0.5 percent. Maybe they could acquire interest-bearing shares in a newly-formed 'good bank'? And perhaps, to incentivise them to do this, the Government could agree that the income this brings them will be free from tax for, say, five years, after which the bank is likely to be into profit and its shares can be sold on for a capital gain (again, tax-free)? And wouldn't such an institution be a better home for local authorities' cash than a bank in a country such as Iceland or Ireland, with the risks that these places entail?

We live in interesting times. Even those who favour quantitative easing admit that the measure's track record is, at best, mixed. For the country's sake, I hope my pessimism is misplaced. But if it proves to be prescient, I very much hope the Government will not encourage the Bank of England to repeat the futile exercise but will, instead, pursue other, more original, but more rational, solutions.