BRITAIN seems to have decided to spend its way out of the tight economic corner that the country seems to have landed itself into because of the credit crunch, slowdown of the real economy and the looming recession.

Prime Minister Gordon Brown has already pumped billions into the banking sector for recapitalisation purposes so as to help capital scarce banks to re-open their loaning windows at least for the small businesses. He is also planning to cut taxes.

Meanwhile, the Bank of England’s November Inflation Report gives the strongest possible signal that the Monetary Policy Committee would cut interest rates significantly further over the coming months with the possibility of the rates going down to one per cent or even below.

The British Prime Minister wants the rich world and the emerging markets particularly the Bric (Brazil, Russia, India and China) to follow him on this course. Simply put, he wants the world to use the forgotten Keynesian theory to break down the Reagan-Thatcher illusions of capitalism.

An emergency package of tax cuts and public spending is being considered by ministers and Treasury officials as the government looks at ways to jolt the flagging economy back to life.

The measures, which have yet to be finalised, would be included in the pre-budget report this month and need to be worth about £15bn to have much effect, say experts.

While it is possible to boost the economy with higher public spending, cuts in taxes and increases in tax credits aimed at poorer households are said to be easier to implement quickly.

In a sign of the new thinking in the government, Gordon Brown began preparing the ground publicly last Friday for tax cuts, saying there was an “emerging consensus” across the world that fiscal policy should be used in addition to monetary policy “to support growth”.

Meanwhile, in its quarterly inflation report released on Wednesday, the Bank of England warned that the economic landscape had changed dramatically since August.

It said the UK economy could shrink by two per cent over the next year, compared to its estimate of “broadly flat” growth made in August.

Bank governor Mervyn King said the Bank would be prepared to cut interest rates further if needed.

The bank now expects inflation to decline to one per cent by 2010, below its two per cent target, in a dramatic change to its last forecast.

This would mean that the bank had scope for further rate cuts in order to maintain inflation at its target rate in two years’ time.

The forecast for CPI inflation based on markets’ interest rate expectations (of a fall in rates to just below three per cent) predicted an inflation rate of around one per cent - that is, a full one per cent below the two per cent target — at the two year policy horizon.

Even in the third year of the forecast, inflation is expected to remain well below two per cent. The clear implication is that the MPC needs to bring interest rates down much further to avoid a prolonged undershoot of its inflation target.

What’s more, the central forecast shows a significant probability (around 15 per cent) of outright deflation. Some economists believe that deflation is now more likely than not in this cycle, either next year in response to falling food and energy prices or further ahead as core inflation falls sharply in response to the creation of huge amounts of spare capacity.

Meanwhile, the MPC’s forecasts for the real economy have also been revised down sharply. The economy is expected to contract by around 1.5 per cent next year, in line with the general forecast.

However, growth is then expected to re-accelerate strongly to around 1.7 per cent in 2010 and to 3.0 per cent in 2011, implying a much shorter downturn than seen in the early 1990s. The general view is that the continued effects of the credit crunch and the likelihood of a prolonged period of adjustment in the household sector point to a longer downturn. Still, some economists expect the economy to contract by another one per cent in 2010.

All of which points to the need for interest rates to come down to very low levels and to stay there for a long time. Admittedly, the Inflation Report forecasts do not take account of any fiscal loosening in the forthcoming Pre-Budget Report. But to some it seems very unlikely that even major tax cuts will relieve the need for much looser monetary policy too.

Another cut in interest rates of at least 0.5 per cent at the MPC’s next meeting in December now looks very likely, with further moves in the following months perhaps bringing interest rates down to one per cent by the middle of next year. But like Mr King, many do not rule out the possibility that interest rates have to fall all the way to zero.

Forcing Mr Brown’s hand and leaving the BoE no other option but to remove the leash on both the fiscal and monetary policies at the same time are a number of factors but primary among them is the politically explosive state of employment report released recently.

The UK unemployment rate is continuing to soar, with the claimant count still almost certain to reach one million next month.

October’s monthly rise of 36,500 was slightly smaller than the consensus forecast of 40,000, but with September’s increase revised up, the level still reached 980,000. The other activity figures aren’t any better.

The ILO measure of unemployment rose by 140,000 in the three months to September to over 1.8 million, while employment fell by almost 100,000. Much worse is to come as some research studies expect the ILO measure to peak in 2010 at around 3.3 million.

At least rising unemployment is ensuring that the recent rise in inflation doesn’t feed through into wages growth, with headline average earnings growth in September easing from 3.4 per cent to three per cent.

Overall, the rapid deterioration in the labour market highlights the need for interest rates to fall much further – with the BoE Inflation Report confirming that more rate cuts are on their way, said Vicky Redwood of Capital Economics Ltd, a London based research firm.