Of the extra £175bn the Bank has created through its QE policy since March, around £173bn has been used to buy UK gilts. That's no great surprise. But it is far from ideal.

When the policy started, the chancellor authorised the Bank to buy £150bn worth of assets, of which "up to £50bn" could be private sector debt.

It's fair to say that limit has not been reached: as of now, the Bank's Asset Purchase Facility (APF) has spent just £2bn on commercial paper and corporate bonds.

Why buy mainly gilts? The justification was three-fold. First, by boosting demand for government bonds, you lower the interest rate on that debt, and since that (risk-free) rate sets the floor for rates across the board, you should lower the cost of borrowing for firms and households as well.

Second, by buying only risk-free public debt you prevented the Bank from taking a lot of private sector risk onto its balance sheet (a particular concern earlier in the year when there was so much uncertainty about what all that securitized private debt was worth).

But the final, and most telling, reason was that there simply wasn't enough British corporate debt out there to buy. The Bank would have swallowed up the entire market in a matter of weeks.

I've mentioned before that a number of observers have called for the Bank to extend the range of the APF: notably the IMF, Martin Weale, and Danny Gabay of Fathom Consulting.

The emphasis on gilts has put the Bank rather out on a limb relative to other central banks - notably the US Federal Reserve, which has been able to purchase a much broader range of assets under it's "credit easing" policy.

But, as Adam Posen, the newest MPC member, pointed out in his speech of 26 October, it's a function of British companies' disturbing dependence on the banking system for its funds. In his words:

"[T]he financial system in the UK doesn't seem to have a spare tyre for the provision of capital to non-financial businesses when the banking system has popped a leak".

That lack of a corporate bond market, he said:

"[R]eveals a major long term structural problem in UK financial markets which could be of potential harm as the UK economy begins to recover".

In its statement today, the MPC pointed to evidence that its policy was working. And the evidence is there: gilt yields are undoubtedly lower than they would have been without QE, and bigger companies are using that opportunity to issue debt on a larger scale than in the past.

But, as the MPC themselves note, the key question for the recovery is about the banks: whether they will ultimately provide the credit to finance a healthy recovery.

This has been a recurring theme here - I won't belabour the point. Just to note that, if the economy is recovering, now is the moment of truth.

Until now, the commercial banks have been able to say, with some justice, that the lack of lending is due as much to low demand from firms themselves as to insufficient supply by banks.

As a rule, companies don't want to take on a lot of new debt in a recession. But once things are looking up, they will be going to their banks for more working capital, or loans for new investment.

If the banks are demanding much tougher terms and/or limiting the amount they will lend at any price, now is when that constraint on the recovery will kick in.

We will wait and see - and so will the MPC. But in the meantime, many economists who supported the QE policy are left feeling a bit queasy that so much is being rested on an asset with such an uncertain relationship to the broader economy.

Thanks to QE we do not really know what the "risk-free" rate of interest is over any length of time into the future. All the city knows is that money is (almost) free and there's an (almost) unlimited supply of it.

We talk about it being hard to spot the impact of the Bank's policy (and that of other central banks). But in a sense, that's crackers. You can see the impact of easy monetary policy everywhere.

Across the global economy, cheap and plentiful money is doing wonders for asset prices. It's also making it easier for governments - especially the British government - to borrow an enormous amount. It's even causing headaches for emerging market governments, as they struggle to cope with shedloads of incoming investor cash.

But I'm sure the MPC would like to be able to point to more visible effects of its policy closer to home - for households and businesses in the real economy.

By voting to inject a further £25bn into the economy, the Bank's policy makers have signalled that they don't think the economy's out of the woods yet.

But they have halved the rate at which that money is being spent. In the first five months of the QE, the bank was spending £25bn a month. Since August, the monthly purchases have fallen to around £17bn. Now the MPC plans to spend three months purchasing assets of £25bn - a monthly average of around £8bn.

If the economy behaves more or less as the MPC expects, you could say they have put themselves on a path to end QE at their February meeting - or at least put the policy on hold.

Like many City forecasters, the Bank was fairly sure that the economy had come out of recession in the third quarter. That official estimate of a 0.4% decline in GDP, announced on 23 October 23, was a surprise to the MPC as well. We will find out in next week's Quarterly Inflation Report whether the Bank is revising its view - or rather waiting for the ONS statisticians to revise theirs. And of course, the Bank's policy-makers will have those new forecasts in front of them at their meeting.

You'll remember there was a lively debate about the reliability of the figures on the day they came out - much of it stirred by Ben Broadbent and Kevin Daly at Goldman Sachs (see my earlier post, First draft of UK economic history). If anything, the discussion has heated up since then, with the release of fresh data also seemingly at odds with the ONS view.

The CIPS/Markit UK manufacturing survey of purchasing managers showed UK manufacturing activity at its highest level in two years. Today we saw the fourth consecutive monthly rise in the service sector PMI as well.

As the CEBR pointed out, this is also the sixth month in which the index has been above the neutral mark of 50.

Folks at the ONS point out, rightly, that they are basing their estimates on hard data, whereas the critics tend to highlight mainly surveys. Graham Turner of GFC Economics added his voice to that debate today, stating his view that the PMI surveys have been systematically overstating the strength of the recovery, not just in the UK but "across the industrialised bloc".

For example, the various ISM indices suggest that the US manufacturing output has turned up rapidly, but in reality, "production has risen only 3.5% from its low point in May, and remains 13.8% below its peak."

Turner thinks the problem might be even more pronounced in the service sector surveys, because they have much lower coverage than the ONS among smaller companies, and there is evidence that it is the smaller firms that have been most affected by a decline in the availability of credit.

All of which might be true. But I guess if you think (as the critics do) that the PMI surveys often turn out to be closer to the final official version of economic reality than the ONS's own official estimates, simply to point out that the surveys are at odds with early estimates of (say) manufacturing output rather begs the question. And, as Turner admits, it's not just the PMI survey data that seems out of line. The CBI, BCC and other surveys are also at odds with the ONS.

(Apologies for giving so much space to Goldman Sachs on this debate, but they seem to me to have mounted the most robust critique of the figures to date. I'd be happy to hear from others who feel they have something to add).

There's also the fact that employment, extraordinarily for this stage in a recession, is flattening out, or even going up. As Charles Goodhart pointed out at Fathom Consulting's Monetary Policy Forum on Monday, this suggests that firms are taking on workers, at a time when output is falling - just the opposite of what you would expect.

The ONS's own official estimates for expenditure have also been weaker than the output numbers. Unlike many other official statistical agencies, it doesn't fully incorporate this data into its final GDP estimates for a year or two. That's when all the big revisions tend to be made.

Unhappily for us - because it means this tremendously important debate about whether or not the UK is already out of recession may not be resolved until 2010 - or even 2011.

As this chart shows, those final revisions made a big difference in the case of the early 1980s recession. And others too. Goldman Sachs calculates that of the 29 occasions between 1975 and 2007 on which the initial estimate of GDP was negative, the average revision has been a stunning +1.0% quarter-on quarter. In other words, if that average held true of the past two quarters, Britain might turn out to have gone out of recession six months ago.

Now, no-one (I know of) is suggesting the revisions will be that large. Indeed, the ONS might even revise that 0.4% decline downwards a little next month, because of slightly weaker than expected construction data. But the eventual version of history - one or two years down the road - could well be quite a bit brighter.

As for the folks at the ONS - well, they appear unperturbed. In their view, the surveys are often at odds with the official picture, and there is no unusual discrepancy with other data to be explained.

They are certainly not going to be swayed by the opinions of city economists, though privately they are puzzled as to why respected forecasters such as the Bank of England and the NIESR were also expecting something better.

But even if the Bank does think the ONS figures might be over-gloomy, it will not change their basic view that the recovery - regardless of when it turns out to have started - will be slow and uneven.

In the end, it is that longer-term prognosis that will matter most for the future of UK monetary policy.

Update 17:50: I've said that much of the debate, in effect, comes down to whether you trust the official output data or the surveys. Obviously the ONS data has the advantage that it's based on solid numbers, reported to them by a much larger number of companies across the country.

The surveys are often more "qualitative"; they ask firms more general questions about what's been happening to orders etc and what they expect in the future. On the other hand, they have the advantage of being more timely than the official data, which is why some see them as a better guide to where the economy is right now.

The director of the NIESR, Martin Weale has alerted me to a paper he and three colleagues have just written, available on the NIESR website [375KB PDF]. It looks at whether there is a predictable relationship between the answers that firms give in the CBI's Industrial Trends Survey, and what they tell the ONS. The paper's technical, but the main conclusion is that, where you can line up the two sets of answers against each other, the CBI survey doesn't give a more timely indication of what's happening to output than the ONS survey.

Specifically: "firm-level qualitative data do not provide a good coincident indicator of growth." And the CBI survey "has little role to play in enhancing our knowledge of what has happened to manufacturing output. However, where the CBI is asking questions not covered by the ONS - about future export orders, for example, the authors do find that the CBI survey provides some useful information.

Unfortunately they were not able to get the data to analyse the PMI surveys in the same way. But economists who think that people are making too much of the PMI surveys do point out that today's PMI surveys weren't around in the early 90s. We can't be sure that their predictive powers still hold when you're talking about an economy coming out of a recession (or not).

Clearly we've not heard of the last of this debate.

You may remember that I wrote about the dismal state of the dismal science back in the summer. There's been a lot of talk about economists' role in causing the financial crisis, and it's an interesting debate. But not nearly as interesting, to me, as the question of where economics goes from here.

Somehow, somewhere, large parts of the profession seem to have lost their way - or at least lost their connection to the world as it is.

I've been talking to some heavy hitters inside and outside the profession to find out what economics needs to find its way back. You can hear the results of those conversations in a Radio 4 Analysis programme that first airs on 2 November.

I spoke to Professor Myron Scholes. He was pretty unrepentant, even though he won his Nobel Prize for helping to make modern financial derivatives possible. He also started a hedge fund, Long-Term Capital Management which created a mini credit crunch of its own, running up losses of more than $4.5bn in just four months in the summer of 1998.

But Charlie Bean has had to experience the gaps in modern economic thinking first-hand over the past few years, first as chief economist, now deputy governor of the Bank of England. He says you don't need to devise a lot of fancy new economic theories to explain what went wrong. But he does think that economists need a greater understanding of history - and their own limitations.

For Lord Robert Skidelsky, Keynes' biographer, it's all been further proof that economists lost their way when they departed from the master. Keynes understood uncertainty. If economists want to catch up with the way the world works, he thinks they're going to need to find a way to incorporate it too.

Large chunks of economic life could not be reduced to a set of probabilities. That, in turn, means they can only imperfectly translate into mathematical models.

"...in order to get determinate results, you can't have unknowns. And therefore to make the maths possible ...you have to theorise on the basis of perfect information and prices always being correct and so on. Now just... reduce the amount of maths in the subject and you get closer to real life."

In other words, the stuff you can count isn't necessarily the stuff that counts.

But for me, the most interesting contributions came from Richard Thaler, the leading behavioural economist, and Michael Sandel, a distinguished political philosopher at Harvard who taught me many years ago.

Thaler and his fellow travellers have had a good crisis. Ever since he co-wrote Nudge, politicians and policy wonks have been rushing to incorporate Thaler's ideas into policy - for example, we've had more discussion today of forcing people to decide whether or not to be organ donors. That's the fruit of experiments showing that we make different decisions when we are forced to choose, than if we can simply follow the path of least resistance.

Thaler had a good take on the failings of mainstream economics going into the crisis, particularly financial market economics. He said it partly grew out of a failure to distinguish between easy problems and difficult problems:

"We have the idea that people optimise, and they optimise regardless of how hard the problem is. So let's contrast two problems. One is figuring out how much milk to buy when you go to the grocery store. Now you know that's an inventory problem, we could write down the mathematics of it, but most families pretty much know how to do it and they do it through trial and error. So that's an easy problem in part because there's lots of opportunities for learning. Now compare that with, say, playing chess. No-one plays chess perfectly, even Gary Kasparov - otherwise the game wouldn't be interesting, it would be solved - and most of us play horribly. Now a theory that says we buy milk and play chess equally well is just preposterous. We need to accommodate degree of difficulty.
 
Now the way this relates to the banking crisis is that being a banker has just gotten a lot harder. If you go back to the world of the banker in that Christmas movie... It's A Wonderful Life, you know that guy was making loans to people he knew in his town. And you know that's a pretty easy problem. Now if, if you're buying and selling mortgage-backed securities, that's pretty hard. And if you're running a bank that has a hundred divisions, each of which are engaged in highly complicated transactions, the job of being a CEO has become immensely difficult..."

On this view, it's not just that the financial deals themselves were getting more complex - it's also that the economic models were assuming they had gotten easier.

"The models kept assuming people were smarter and smarter, but the world was getting harder and harder and so the models were getting further away from reality. So if banking was like in It's A Wonderful Life, then the old models might be fine. But when you have Citibank selling liquidity puts and the vice chairman of Citibank admitting later that he had never heard the term 'liquidity put', then you know you're dealing in a completely new world."

It's a great critique - but, as Thaler would be the first to admit, it is more a critique than a competing theory.

Useful though it is, you're not going to be able to base the future of economics on behavioural economics alone. Why? Well, for one thing, it doesn't lend itself very readily to concrete advice. Politicians like their economists to tell them what to do, even if they ignore them afterwards.

Behavioural economics isn't like that: it shows you that it matters how, exactly, a policy is designed - what the default options are, or how medical evidence is presented. We'll opt for an operation if it has a 90% success rate, for example, but not if the chance of dying on the table is 1 in 10. But it doesn't tell you which to choose. Economists who like to draw a sharp line between objective economic analysis and subjective value judgments think that's a big problem.

Funnily enough, outsiders like Professor Sandel thinks that's the great strength of that kind of economics (he's not a big fan of the other types). It brings the value judgements to the surface, rather than burying them deep in the assumptions of the models.

For similar reasons, Sandel has clearly enjoyed the recent popular uproar over bank bailouts and bankers' bonuses:

"I was interested in the economists [in the Obama Administration] who were making this critique. They said it's terribly greedy. What I wish the journalists had asked them was is there a distinction between greed and self-interest, do you think?
 
Strictly speaking, no mainstream economist would recognise any such distinction, and yet for political purposes they attack greed as if it's a thing independent of self-interest... Citizens generally who looked at this - at the bailouts and the bonuses and been outraged - they believe there is a difference between greed and self-interest. But there's no way of capturing that intuition in economic analysis because, according to economic analysis, in any case one is deploying self-interest or greed, which is simply self-interest squared, to serve a social purpose. That's what the economic model says. And you have to introduce some normative assumption about what is excessive pursuit of gain in order to make sense of greed as a vice independent of the self-interest that all of the economic models presuppose. So I think there are intuitions in everyday life that people have that the economic models simply don't capture, and greed is one of them."

I suspect that it will take more than a financial crisis to make Wall Street economists want to think about the quest for justice as well. But the economics being taught at universities around the world this autumn has already been changed by the events of the past few years.

It will change even more in the years to come, though don't expect it to happen quickly.

Professor Thaler reminded me of an old line: that "science marches on funeral by funeral". Most economists don't like admitting they've changed their mind about anything.

Analysis is on Radio 4 at 2030 on 2 November (repeated 2130 8 November) and will be available online to listen again for a week.

But that's not the way human nature works. As Gore Vidal once said: "it's not enough to succeed. Others must fail." And right now it's the UK that seems to be failing.

As commentators were quick to note this morning when the latest GDP figures came out, a sixth consecutive quarter of economic decline means that the UK is still in recession, while Germany, France and Japan are all now recovering.

Their economies all grew between April and June. They will probably have grown in the third quarter as well, and we're expecting the US to come out of recovery when we get their third quarter figures next week.

So, what's the problem? Chancellor Alistair Darling suggested in an interview for the BBC today that the likes of Germany and Japan had much sharper losses in output at the start, which would lead you to expect a sharper rebound.

It is true that the comparison between Britain and other countries looks a bit better when you compare the total decline in national income from peak to trough (or from the start of the recession until the end).

On that basis, Germany lost 6.7% of national income over the course of its recession. And many German economists don't think their country is out of the woods: they think another quarter or two of negative growth is quite possible.

Assuming the UK comes out of recession in the last three months of the year - and we're learning not to assume anything - then the overall loss of output for the UK would be somewhat lower, at 5.9%. The total decline for Japan has been a whopping 8.4%.

It is France and the US that come out best. The peak-to-trough decline for France will have been 3.5%. Assuming the US has now come out of recovery, its loss in income will have been 3.7%. (Thanks to Chris Apostolou at Fathom Consulting for pulling the numbers together for me).

The latest consensus forecasts are for growth of 1.3% in 2010 in the UK, similar to the government's own forecast. The prediction for Germany is 1.4%, and for France it's 1.2%. The US is expected to grow by 2.6% - but that, too, is a good deal lower than you would usually expect coming out of a steep recession.

Looking ahead, the similarities are greater than the differences. The road to recovery is expected to be fairly slow in all the major advanced economies, the UK included.

When you ask economists to explain why Britain is lagging behind, they can provide any number of reasons - particularly our greater reliance on the financial sector compared to our neighbours.

That prior dependence on the City, along with the poor state of the public finances and our long-term need to increase saving, could well lead us to enjoy slower growth than other economies in the next few years. But right now, we shouldn't fret too much about "falling behind".

It may not be comfortable for the government, but the truth is it's better for our economy to have other markets recover than for all of us to remain in recession.

After all, the cheap pound can't help British exports - or a long-term re-balancing of our economy - if there's no-one out there who wants to buy.

Growth in the rest of the world may rankle. But our own recovery won't get far without it.

PS Sorry a data mix-up resulted in earlier figures being different.

Many economists have said they expect this recovery to be slower than usual. But, if right, these data suggest it has not yet even arrived.

The very weak state of bank lending - and low state of household and business confidence in the UK and many other economies - are still taking their toll.

News of further falls in manufacturing and industrial output earlier this month had suggested that the figures might be weaker than initially hoped. But most expected the service sector to show modest growth.

However, the Office for National Statistics (ONS) estimates that output in this sector - which accounts for by far the largest share of the economy - showed another slight fall in the past three months, of 0.2%.

I suspect that the further decline in the service industries in the past quarter is a large part of the reason why so many forecasters have been caught short.

But it is worth remembering that the ONS does not have complete data for that part of the economy at this early stage - far from it. It is quite possible that the number will be revised.

Historically, official output numbers have tended to be revised upwards, over time. But this has been less true in recent times. The estimate for the first quarter of this year was eventually revised - downwards - by 0.7%.

The bottom line is that we should take this as very much a first draft of UK economic history - but clearly a disappointing one.

Update, 11:34: There's been a rapid response to today's figures from Ben Broadbent, of Goldman Sachs, who has long argued that the ONS was understating the strength of the economy.

To say he thinks the figures should be treated with a grain of salt would be an understatement:

"Do today's data tell us anything about what is really going on in the economy? Probably not. In the past, the ONS's early GDP estimates have contained no statistically useful information about growth. In the 10 years to 2007Q4 (the latest quarter for which we have fully reconciled UK GDP data), the correlation between quarterly GDP growth according to the first release and quarterly GDP growth based on the most recent data is only 0.10. In a regression of the latest quarterly growth on the first quarterly estimate, the coefficient on the early official estimate is not significant. The correlation between the UK's latest data and the Euro-zone's first release is much higher, with a correlation coefficient of 0.34. Amazingly, if one wants to know in real time what is happening in the UK economy, it has been better to follow the Euro-zone's early GDP estimates than the UK's GDP estimates.
 
"The data also run contrary to pretty much every other indicator of UK growth. The Composite PMI - which has historically been a more reliable indicator of UK growth than the ONS's preliminary estimate - is consistent with growth of +0.7%qoq." "

Broadbent notes that it's not just the PMI data - car sales, retail sales, net exports, housing starts are all growing at a pretty good clip. And it's curious, to say the least, that employment seems to be stabilising even as output (officially) continues to fall.

For the non-statisticians amongst you, the shorthand way to express those correlation numbers would be that you'd not be much worse off tossing a coin to find out where the economy was headed. I look forward to hearing the ONS response.

Update, 17:30: I promised you a response: this just in from ONS.

"ONS produces the earliest estimate of GDP of any of the major economies, around 25 days after the reference quarter - on 23 October for July-September 2009. This provides policy makers with an early estimate of the real growth in economic activity, but this is inevitably revised as the underlying data sources mature. However, we are open about how much our preliminary estimate later gets revised - over the last five years, the average absolute revision (that is, without regard to the plus or minus sign) has been only 0.03 percentage points between the first estimate and the one a month later, and 0.08 percentage points between that estimate and the third estimate a month thereafter. We are confident that today's figure is our best, central, estimate at this point in time."

I suspect the Goldman boys would say the big revisions happen after the first three estimates referred to here, perhaps a year or two after the event, when the ONS reconciles the output data with more complete information on the amount of spending in the economy, and people's incomes. But I'll let you know what they say.

It's not just this government that is being too timid. King thinks the entire G20 approach to reforming financial regulation may eventually have to be re-thought. Why? Because it's partly based on the assumption that once you have told banks that they are too important to fail, you can somehow prevent them from taking crazy risks on the taxpayers' dime.

"It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place. The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the 'too important to fail' question."

This cri de coeur does not come out of nowhere. For some time now, policy makers and regulators around the world have recognised that rescuing the financial system had left them with what we economists might call the mother of all moral hazard problems.

In the past, bankers might have suspected that the taxpayers would bail them out if they got into trouble. But thanks to last autumn, they now know for sure.

This is what has been keeping a lot of central bankers awake at night the past few months: if they took all those risks before, when they couldn't be sure they had a safety net, what on Earth are they going to get up to, now that the insurance is there for all to see?

Mervyn King has voiced many of these concerns in the past. But never this bluntly, at least in public. Here's another killer paragraph:

"To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform. It is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector. Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don't, distorts the allocation of resources and management of risk. That is what economists mean by 'moral hazard'. The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The 'too important to fail' problem is too important to ignore."

Logically, there are two solutions to the "too important to fail" problem. One is to accept that such institutions exist, but to impose tough regulations to reduce the chance that they will actually fail. That is broadly the approach being taken by the G20, with a belt, braces and chewing gum approach that will require banks to hold more capital, including more liquid capital, and put caps on total leverage (debt).

The governor says this approach "has attractions but also problems". We never hear about the attractions. But there are two pages of problems, the most important being that you never really know how much capital a bank is going to need - and we've been chronically bad at guessing it in the past. He says that requiring banks to issue "contingent capital" is an important way to beef up this approach. That is debt which turns into equity once certain emergency trigger points are reached. But you still have the basic incentive problem created by the belief inside the banks that they are too important to fail.

We knew that King favoured the more radical alternative - which is to "find a way that institutions can fail without imposing unacceptable costs on the rest of society". In essence, this comes down to separating out the essential, humdrum utility side of banking from the speculative, more casino side that has got us all into so much trouble. We taxpayers only underwrite the bit that's crucial to the broader economy, and by its nature doesn't involve so much risk.

Respectable voices such as the economist John Kay and Paul Volcker, the former Fed Chairman, have put forward suggestions along these lines. But it's fair to say that it has been dismissed as unworkable by the most mainstream opinion, including that of the chancellor.

The Conservatives have rushed to applaud the speech, and to remind everyone who will listen that George Osborne has said he thinks there is a case for separating some of the riskiest investment bank activities from plain old vanilla banking. But he only wants to pursue the idea at an international level. As a unilateral UK policy, the Tories have also dismissed it out of hand.

In his speech King says "it is hard to see why" it would be impossible to distinguish between different types of banking. After all, regulators do so all the time. "What does seem impractical, however, are the current arrangements".

In his blog, Robert Peston has often pointed out how un-radical the post-crisis reform agenda for banking has turned out to be.

For his part, Martin Wolf recently wrote a remarkably radical column in the FT, arguing that the financial sector has emerged rather less secure than the one we had before, and urging greater boldness. "The financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant."

Now Mervyn King has used his bully pulpit as Bank governor to turn up the volume on this debate. I doubt he did so lightly. But quite simply, he thinks that with the current approach, we will only have tackled the symptoms of the problem. The ultimate cause will come back to bite us - perhaps rather sooner than we might have thought.

The governor may not get his way. But in a week when policy makers and ordinary taxpayers are reading in disbelief of a forecast 50% rise in city bonuses, just 12 months after the biggest financial bailout in world history, his speech will add fuel to the fire.

PS: An earlier version of this post mentioned a line which was in the text of the governor's speech, but not in the speech as delivered (an extract of which is now embedded above).

That is the basic message of today's thoughtful paper on mortgage regulation from the FSA on regulating the mortgage industry better in the future [2.58MB PDF].

In a world where all major financial institutions (and a lot of minor ones too) are essentially being underwritten by taxpayers, it's not clear where "their" corporate self interest ends, and the broader public interest begins. But we have known since at least the start of the year that Lord Turner's FSA was going to stop assuming that bankers knew best.

We've been hearing some of the implications for how much "core" capital banks need to hold, their stock of liquid assets, and their overall amount of debt - or leverage. One message of this report is that we should expect those reforms profoundly to affect the mortgage market as well.

If banks can't borrow as much as before, and have to hold higher capital reserves against riskier forms of borrowing, that can, and surely will, affect the quantity and quality of mortgages they offer. Of course, the decline in the housing market has done a lot of that already.

You might think that those broader regulations ought to be enough to fix the mortgage market too. And the FSA partly agrees. If you think the problem before was that banks and building societies weren't putting enough capital or liquidity aside to protect against bad mortgage debt - the regulators think that problem will largely be solved by those broader reforms.

But they don't think that's the whole solution - because it does nothing to protect individuals from getting into serious difficulties. In fact, as the FSA points out, they may be so desperate to borrow that they are willing to pay high charges which make the loan profitable for the bank, even though the charges themselves give the individual an even greater risk of becoming unstuck.

That broader reform of capital standards also does nothing to address the problem that there were a lot of non-banks providing the riskier kind of loans.

These lenders had far fewer controls in place to protect either lender or borrower than the mainstream banks and building societies, and were responsible for much more than their fair share of overextended borrowers - and mortgage defaults. Since they only came into the market in the boom years, and got out when prices fell, they also made the boom and bust cycle that much worse.

Thus the FSA's decision to single out self-certified mortgages for abolition - and all other products which do not require proof of income. These accounted for a shocking 49% of mortgages in 2007, a large number from specialist lenders.

As the authors of the paper note, tartly:

"No other country that we assessed for comparative purposes featured a similarly significant NIV (non-income verified) market segment, with the exception of the USA and Ireland, both of which have experienced a boom in mortgage credit and house prices followed by a severe reduction in both."

In other words, we were not in good company.

It is quite true that this step could end up making it harder for some self-employed people and others with irregular incomes to get a mortgage. But it's difficult to see how you could address the problems that the FSA has set out to solve without imposing slightly higher logistical hurdles on these borrowers.

It all comes back to the same basic logic. If we think it was too easy to get a loan in the boom years, then the 'solution' has to involve making it harder. At least for some people. The challenge is to make sure it's the right people.

Precisely for that reason, I suspect the FSA is right to shy away from simple limits on loan-to-value ratios or loan-to-income ratios.

The surprising facts are that loan-to-value ratios actually fell from 1995 onwards. It was loan-to-income ratios that rose as house prices took off in the boom. But, it turns out, a high loan-to-income ratio is not necessarily a good sign of the risk that a borrower will default. Much better indicators are the type of loan (ie whether it's self-certified), the borrower's credit rating and, crucially, their other expenses.

That is why, among other things, lenders are going to be asked to assess affordability - not just relative to income or to the value of the house but also relative to the individual's lending capacity, and their other spending.

This could be an Achilles heel in the FSA's proposals. Because, with the best will in the world, it's hard to assess how individuals really spend their money. And people do tend to underestimate their regular expenditure. The paper doesn't expect lenders do go through the receipts in your wallet - merely that they "check that the level of expenditure declared by a consumer is plausible." That leaves plenty to argue about after the fact, if the loan goes wrong.

The bigger point is that there will still be bad mortgage loans under any plausible regulatory regime - and borrowers will still get into arrears. And giving lenders responsibility for checking affordability cannot mean that they are judged responsible for all and every default.

But if the FSA has its way, lenders will not be able to actually profit from borrowers going into arrears. That will remove one major incentive to lend people slightly more than they should borrow. They will also be required to do their own due diligence rather than simply leaving it up to us. Those seem like two sensible steps in the right direction.

That's the question that many outraged citizens in Britain and America have been asking the past few days.

But for economists, there's a much bigger question: how will banks meet the cost of writing off all the bad debts they still have sitting on their books - and help fund an economic recovery as well?

The IMF recently reduced its estimate of the total bank losses for banks in the major markets as a result of the crisis - from around $3.8 trillion to $2.8 trillion. That's the good news.

The bad news is that, collectively, they are less than half way through the job of recognizing those losses and writing them off.

The Fund reckons that US banks are about 60% of the way there. But in the UK and the euro area, the figure is more like 40%.

Put it another way, the Fund thinks that around 60% of the £400bn in British bank losses as a result of the crisis has yet to be written off.

That has gloomsters such as Danny Gabay, of Fathom Consulting, predicting a second wave of the banking crisis here in the UK. He says we've had the first, foreign, wave. That took out a large chunk of lending capacity in the UK.

But the domestic wave of the crisis could still be ahead. And if the banks are still mired in debt, they will surely be reluctant to fund a full-blooded recovery.

As I said, that's one of the darker views out there. I might add that Gabay thinks the good news on the labour market is a false dawn as well. Most see the smaller than expected rise in unemployment as reason to hope that the labour market has become more flexible.

He thinks it shows the market has been even slower to adjust than it has been in the past, and a much larger rise in joblessness is still to come.

More upbeat analysts point to the sharp fall in the cost of bank funding since the start of the year. With so much liquidity sloshing round the system, they think it's only a matter of time before bank lending starts to pick up as well.

In other words, they say the recovery scenario is still on track.

And, of course, the IMF could be wrong about the total bank losses as a result of the crunch. It is something of a moving target.

That is all quite possible. We will get further clues on the state of the real economy when we get next week's preliminary estimate for third quarter GDP in the UK (though not that many more, given how much these preliminary figures are usually revised).

But for Carl Weinberg, Chief Economist for High Frequency Economics, it is simply impossible to generate a healthy recovery out of the kind of credit contraction we're still seeing around the developed world. "The next leg of this credit crunch will be the effect of a prolonged period of credit retraction among small and medium-sized enterprises."

Indeed, he see the contraction in bank lending to companies in the UK as a sign of more to come in the US and Europe (see chart below from one of Weinberg's recent reports). In his view, all the major economies could well be shrinking again by the turn of the year.

I'm not sure I'm that gloomy. But for anyone caught up in the euphoria on Wall Street and in the City in recent weeks, the still enfeebled state of lending to ordinary businesses around the world ought to be pause for thought.

The latest chapter of the MPs' expenses saga revolves around the issue that I wrote about when the scandal first broke - which was then only lurking in the sidelines.

Put bluntly, an economist would say it doesn't matter what MPs say they spent their expenses on. What matters is how much they got.

Why? Because as I explained in that earlier post - economists (and lawyers, and accountants...) tend to think money is fungible. If you give me a pound to buy a newspaper, you don't expect me to buy it with that same physical coin.

You can't even guarantee that it's the newspaper purchase you are making possible. I might already have a pound in my pocket for the paper - and use your pound to buy chocolate. You can't say for sure, even if I give you a receipt.

The parallel with MPs' expenses - for any who missed it - is that all you can say about an MP who receives £20,000 towards their mortgage payments is that they have £20,0000 more to play with, and that they have mortgage costs of £20,000 to pay.

They might have had enough money to pay the mortgage already - and the money from the taxpayer is actually funding an exorbitant cigar habit. We will never know.

The MPs who received much less than £20,000, but are being forced to pay back money, grasp this concept implicitly. That's why they think it's unfair that mortgage payments are not being limited retrospectively - though it looks like they will be in future.

"Fungibility" is an ugly word (someone commented at my previous post that it wasn't a proper word at all). But you can't understand the true madness of the expenses story without it.

Asset sales could raise £16bn by 2013-14. Last week, George Osborne proposed savings that would also come to about £16bn by 2013-14. But the following year, 2014-15, Mr Osborne's proposals are supposed to be still saving the Treasury £7bn. Whereas in that year we can expect these asset sales to be saving approximately zero.

Why? Because, in theory at least, if you limit benefits or cut the public sector wage bill, you cut spending in all years, not just this one. The same cannot be said for asset sales. You can only sell an asset once. It can help a government cut borrowing in the year of the sale, but the following year it has to sell something else to get the same effect.

In practice, the distinction between the two is a little fuzzier. You could see some of the impact of the public sector pay freeze reversed if there are "catch-up" wage settlements later on. More importantly, any saving from raising the state retirement age will only last until 2026, when the government was already planning to make all of us retire later.

But the difference in kind between the Conservative proposals and these asset sales is still fairly stark.

That was my second reaction to the prime minister's comments when we journalists were told about them on Sunday night. My first was: "haven't we heard this somewhere before?".

We had. Back in April, on Budget day, the Chancellor said he was planning to sell £16bn-worth of assets over the next few years. Ever since then, the stock answer to criticism about the government's plans to halve public sector net investment by 2014 has been that there were all these asset sales in the pipeline - the proceeds of which would be used to top up investment.

The prime minister said again today that the asset sales would be used for investment as well as for paying down debt. But, to state the obvious, they can't do both at the same time.

Number 10 said today that asset sales were just one part of the government's programme to get public borrowing under control. Many economists would say that's just as well.

In fact, the rest of the speech focussed on other differences between Labour and the Conservatives on the economy - with Gordon Brown saying how difficult it would be for any government to cut borrowing if the economy doesn't return to health. I discussed this issue at length in my last post.

But, as I said then, the difference of timing - if there is one - must apply mainly to 2010. As Evan Davis said to Lord Mandelson this morning, the government is forecasting more than 3% growth in the economy from 2011 onwards. If that's not a time to cut public borrowing, when is?

"[T]he longer we wait for a credible plan, the bigger the bill for our children to pay. The longer we wait, the greater the risk to the recovery. The longer we wait, the higher the chance we return to recession."

You can make a case for all three of those claims. The average person can also understand them. You can't always say that of a political leader's rhetoric on the economy.

What is more, the bulk of City opinion would sign up to the Cameron view. The financial markets almost always want governments to spend and borrow less.

Certainly, with a £175bn deficit, you'd be hard-pressed to find an economist who thinks the government is borrowing too little.

But it is important to note what Cameron did not say. He did not say that the longer we wait to cut the deficit, the bigger the bill for our children. He merely gave that impression.

He did not say that, because if he had, there would have been plenty of economists who disagreed, including Martin Wolf, the senior economic commentator of the FT and not a man who is known for his love of the state.

Of course, it's true in a tautological sense that borrowing will be larger tomorrow, if whoever is in power fails to make it smaller today.

The more interesting question is whether attempts to cut the deficit much more quickly than planned can succeed in a weak economy.

Why? Because, as I've said before, you're unlikely to be able to reduce borrowing as a share of national income (you may not even be able to reduce it in absolute terms) if national income declines at the same time.

Not only do you have a falling denominator (GDP), but you end up spending more on things like unemployment benefit, just as you are cutting elsewhere. Overall spending may not even fall.

If the next government withdraws too much demand from the economy, too quickly, that is what will happen.

I'm not suggesting that this is what the Conservatives will do. For all the rhetoric, I suspect that the shadow chancellor and his team know they can only take it so far.

That's why David Cameron spoke today only about the urgent need to have a "credible plan", not an urgent need to implement it.

Everything the shadow chancellor has said so far suggests that an incoming Tory government would pre-announce dramatic cuts for 2011 onwards, and some extra cuts - or tax rises - up-front.

But I'm not sure there would be dramatically more tightening in 2010-11 than Labour already plans. If the Tories won, they, too, would be looking at the strength of the recovery in making that call.

As I've said many times now, there might well be some economic benefit to announcing tough deficit cuts. We can expect the City to applaud, for all the reasons mentioned above.

And when you're borrowing this much, applause from the City is a very useful thing to have. That's why an early announcement of future cuts would make a lot of sense.

But we should remember that interest rates - short and long-term rates - are already extraordinarily low. In fact, one of the great surprises of recent months has been how easy it has been for the UK to fund this enormous deficit.

International comparison suggests that quantitative easing - the fact that the Bank of England is buying so many gilts on its own account - means that the interest rate on the British government's debt is perhaps 70 basis points lower than it would otherwise be.

But government bond yields have been low everywhere, despite record public borrowing.

In the Conservatives' view, interest rates will stay low for longer if there is decisive action on the deficit, which will help the economy. That's quite plausible. But it's hard to see how they could actually go much lower than they are today.

To believe that deficit cuts will bring lower interest rates - long-term ones, anyway - and boost the economy, you have also to believe that there will be a dramatic change to city sentiment - and a panicked rise in gilt yields - between now and the election.

In other words, you have to believe that the markets will start to doubt that a tough Conservative chancellor is about to take control. It's an interesting view for the opposition leader to take.

Enough already. If all of these permutations prove anything, it is that we now have an extraordinarily complex economic calculation at the heart of Britain's political economy.

David Cameron says "the longer we wait, the greater the risk to the economy". If we're talking about rhetoric, that is almost certainly true.

When you have a deficit as large as Britain has, politicians - whether they are in power now or have a good chance of winning it in future - all need to talk seriously about getting the nation's public finances under control.

If the government - any government - delays that conversation for too long, then they are indeed taking risks with the recovery. But when the prospects for private sector demand are uncertain at best, there are risks to translating that tough talk into action.

If any government does too much, too soon, then that could endanger the recovery as well. David Cameron talked of a plan today - not a timetable - because I think he knows that as well.

On the question of scale - Robert Chote of the Institute for Fiscal Studies and I have come up with a clearer way to think about the big picture. Though it's not for the faint-hearted.

You'll remember that the government has said it will cut borrowing by £45bn a year, in today's money, by 2014 (or 3.2% of GDP). To do that, they've said they will raise taxes by about £9bn.

The Tories today said they would accept those increases, at least for now.

As an aside, it's true that Osborne's speech leaves a question mark over the new 50p rate for the highest earners, because he would only say he would keep it in place until the end of the public sector pay freeze in 2012. But there's no firm commitment to get rid of it in the next Parliament, either. Of course, if the IFS is right that it won't raise very much money, keeping it becomes rather a moot point.

So, roughly speaking, both the government and the Tories have signed up to £9bn in tax rises between now and 2014. But even on the government's own plans, that still leaves a roughly £36bn cut in public spending between now and 2014 relative to what you might have forecast before the crunch.

Today Osborne set out his stall. But even if all of George Osborne's plans were adopted tomorrow - and achieved that £7bn a year cost saving by 2014 - you'd only be one fifth of the way to the total squeeze in spending that the government has pencilled in for the next parliament.

And - just to really do your head in - even if the next government meets that target, the Chancellor's Budget forecasts suggest that the deficit in 2014 would still be nearly £100bn. The Conservatives have said many times that they would want to move faster.

As Labour has been quick to stress, this analysis leaves out various Conservative spending pledges which do not appear to have been costed. For example, the Treasury claims that reversing what Osborne called Gordon Brown's "raid on pensions" would cost the exchequer £3-5bn a year. He committed the party to do that in today's speech. And the new allowance for married couples doesn't seem to have been factored into the shadow chancellor's numbers either.

It all goes to underline the point I made earlier - that you ain't seen nothing yet. The Conservatives have a lot further to go if they're going to match their plans to their tough rhetoric. (And, of course, so does the government. The pressure will now be on the chancellor to show how he plans to fill that £36bn hole next month, in his Pre-Budget Report.)

All in good time, the Tories might say. And there was a great deal that the shadow chancellor didn't announce in his speech. Whisper it softly, but if they're committed to tightening more than the government in the first year - it's tax rises, rather than spending increases, that can raise money fastest. For example, each additional 1p on the basic rate of VAT would raise about £4.5bn a year.

There are also still plenty of "middle class" benefits which Osborne left untouched today - presumably because he didn't want to scare every non-public-sector worker as well.

As I mentioned on Monday, getting rid of child benefit and child tax credits for families earning more than £31,000 a year would save a whopping £6bn a year. By limiting himself to just the child tax credit piece of that - and abolishing it only for families on incomes over £50,000 - Osborne will save a mere £400m a year. Whoever wins the next election, I'd be surprised if the next government leaves the other "middle class benefits" intact.

The first macro point is on the scale of the package. Assume, for a moment, that Tory officials are right and it would raise about £7bn a year - half a per cent of GDP - by the end of the next parliament, or £23bn in total over that period.

The government's budget plans would cut borrowing by about 1% of GDP - roughly £14bn - a year over the next eight years. So, assuming that the Conservatives spend no more than Labour in other areas, you could say they are taking the government's squeeze and raising it by another half a percent of GDP a year.

If nothing else changed (which of course it will, but bear with me) that would mean the deficit was still high by historical standards by the end of the next Parliament.

Let's be clear: this is not the limit of the Conservatives' ambition with respect to budget cuts. We may or may not get details of the rest of the squeeze this side of the general election - but you can bet there will be more to come.

Point two relates to the timing. As I've been saying for some time, the big dividing line between the Conservatives and Labour over the budget is over when you start to cut borrowing. Labour says it's too risky to cut while the economy is still weak - the Tories say that borrowing is too high to risk delay.

I've been surprised how willing the Conservatives have been to confront this argument head-on. As I have argued in the past, there is a respectable economic case for saying that tighter policy will help the economy more than hurt it - by building confidence in the markets and delaying higher interest rates (I'm not saying it's right, but it's perfectly respectable).

The trouble, for the Tories, is that Labour have intuition on their side on this one. Most people assume, understandably, that lower public demand in the economy must mean slower growth overall.

But what's even more interesting is that, on the basis of the plans announced so far, this enormous chasm in rhetoric belies a very small difference in what they would do.

As the IFS has pointed out, Labour's plans are front-loaded - they're actually planning to withdraw 2% of GDP - around £25bn - from the economy in 2010-11 by withdrawing the stimulus. Whereas today's plan from Osborne is highly back-loaded.

That £7bn a year saving is by the end of the next parliament. So is the £3bn a year to be saved on cutting bureaucracy. And the public sector pay freeze - the biggest single saving, doesn't take effect until 2011.

By my reckoning, these measures taken alone would only cut borrowing by maybe £2bn, if that, in 2010-11. Or at most 0.2% of GDP.

As I've said, I firmly expect that the Conservatives would squeeze more than this if they won the next general election. But on the basis of what we know now, the big picture difference between them and Labour in 2010-11 is pretty small. It's a good point to bear in mind - as they now go to war over the fine print.

Whomever wins the next election, it has long been obvious that the next government would go for tighter public sector pay control - and a faster timetable for raising the state retirement age. In the most challenging fiscal environment that anyone can remember, each offered potentially large savings, at relatively little cost compared to the alternatives. They were too unterrible to pass up.

It's a solid rule of political economy that if it becomes clear that something will have to happen - it won't be long before politicians try to make it their own. And so it has proved.

On the substance of the two proposals - let me just make a few brief observations.

The first is that the Conservative proposal would save far more money over the long-term - though clearly it would not save much money between now and 2016 (or whenever they decide the new retirement age would kick in).

Tory sources say the change would save £13bn a year from the deficit, or a little under 1% of GDP. There's room to quibble with that number - for example, we don't yet know whether the change will apply to women, and if so, when. On current plans, the shift to 65 for women won't be finished until 2020.

The Conservatives say that the impact on women is "up for review" - in which case it's hard to see how they came up with the £13bn number. But getting people to work longer could clearly deliver this order of saving, albeit over a number of years.

In a paper I discussed back in May, the National Institute for Economic Social Research said that adding one year to our effective working lives would reduce public borrowing by 1% of GDP after 10 years, and reduce the national debt by 20% of GDP over 30 years.

For many in their late 50s, retirement is now firmly in their sights. It's not nothing to be asked to work another six years rather than five - especially if you've been a manual labourer all your life. But the pain will be concentrated among relatively few - and even many 58 or 59-year-olds will have been planning to work beyond 65 of their own accord.

This is a very tight timetable for a change that would normally be decades in the preparing. But it raises tax revenues and cuts pension spending in one stroke. It's not hard to see why the Conservatives decided to go first - before Labour claimed the policy as their own.

You could say the same of Labour's prospective pay "freeze" in the public sector, but that would suggest the two proposals were comparable - which I'm not sure they are.

One could eventually save at least £10bn a year. We don't know what the chancellor's latest pay proposals would save the government, but you can bet it will be in the low hundreds of millions a year. And that's if there is no "catch-up" growth in the pay bill later on.

Why so little? Because the vast majority of public sector workers won't be affected. The Treasury says that 40,000 senior workers will be affected by the pay freeze - and another 700,000 will see their pay rise next year limited to zero to 1%.

That sounds like a lot of people, until you remember that there are more than six million public sector workers in Britain - more than 2.5 million of them working directly for central government (including the NHS). And remember those 700,000 are being limited to a 0-1% pay rise, in a year when the government's own forecast is for inflation of just 1%.

Something tells me that George Osborne isn't going to let things rest there.