The course of deficit cutting has been set in stone and few expected that the Budget, announced on 23 March, would dislodge it. The purpose of this article is not to supply the facts and figures of the Chancellor's policy failings - though these are plentiful - but to explain why his policy of slashing public spending cannot be expected to produce a robust recovery. To put it simply, it is based on false premises. This gives Labour an opportunity to wrest the intellectual initiative, but only if it can develop an alternative policy, based on a better theory of the economy.

It is hard to get a debate of this kind going in England. At the end of The General Theory of Employment, Interest and Money, John Maynard Keynes observes: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." This fits the English (one should say English here, rather than British) view of themselves as people of practical genius, who leave theory to foreigners (forgetting the Scottish Enlightenment). Keynes would have come across many of this sort in public life, uttering common-sense banalities about the need to cut deficits and so forth, oblivious to the source of the banalities. He wanted to force his fellow economists - and, eventually, the wider educated public - to go back to the presuppositions on which their arguments depended, in order to show under what circumstances they might be true or false. He believed in the importance of theory for the making of good economic policy.

In this, he was only partly successful. Granted, there was a "Keynesian revolution" after the Second World War during which, for many years, economies - even the sickly British economy - prospered. We forget what a golden age the 1950s and 1960s were, especially for the manual working class, with full employment, steadily increasing wages and a growing margin for leisure and fun. When, in 1957, Harold Macmillan vulgarly claimed that Britons had "never had it so good", he was telling nothing less than the truth.

Then, the revolution got into trouble, as all revolutions do in the end, because the world moves on in unexpected ways. Older habits of mind reasserted themselves under Margaret Thatcher in this country and Ronald Reagan in the United States. Since then, it hasn't been as good in our part of the world, except for the shrinking minority of the rich and very rich. The great banking crisis of 2007-2009 brought about huge rescue packages - "stimulus policies", they were called - which Keynes would have approved of, but which were largely instinctive. Practical men knew how to act to save their system from total collapse. Now that the rescue has been done, it's back to business as usual.

The rescue packages left huge public deficits and we all know that deficits, whether public or private, are bad, don't we? You have to cut your coat according to your cloth; you must make ends meet. Anyone who says the contrary is a fool or a knave. So, we are being subjected to a huge programme of cuts: we complain about particular cuts when they hurt us, but we are unable to controvert the logic of the cuts as a whole.

Do the coalition politicians explain why they are behaving in this way? Hardly at all - the Business Secretary, Vince Cable, in his NS Essay of 17 January, was a rare exception. Mostly we just get the soundbites of common sense, which is supposedly bred in the bone. "We can't spend money we haven't got." "We must cut the burden on future generations." "We must keep the confidence of the markets." And, as Thatcher liked to say: "There is no alternative." In reality, there is - but we must dig a little to see what it is, and that requires some intellectual effort.

Two defunct economists compete for our allegiance today. One of them is Keynes. The other is the 19th-century thinker David Ricardo. Everything you read on the financial pages of our press relating to policy refers to one or the other of these gentlemen, though you will rarely hear their names mentioned.

The government's theory of budgetary policy is unconsciously inspired by Ricardo. Let me call it "Ricardian-Osbornism". It goes like this: the private sector creates wealth and the government squanders it. The smaller the government - the less it taxes and spends - the more the economy will thrive. This is the banality of the matter. But here is what the historian Niall Ferguson would call the "killer app": "Government borrowing is simply deferred taxation."

This "app" is known by the experts as Ricardian equivalence. Borrowing, it claims, is a tax: a deferred tax, which we have to pay in due course. The dreadful legacy of the last government was 10 per cent of deferred taxes. And this is a terrible obstacle to recovery because it means that forward-looking individuals and firms have to save an extra 10 per cent of their income to pay these expected taxes. That means they will spend 10 per cent less now than they would otherwise have done.

Therefore, the only way to restore private-sector spending is to cut the Budget deficit as quickly as possible by reducing public spending. This would remove the need to raise taxes, and thus release these extra savings to be spent now. That is why the government has embarked on a four-year programme of "consolidation" - mostly spending cuts - which will reduce the public deficit from 10 per cent of GDP to zero. The public, relieved of its fear of higher taxes, should then spend more, creating more productive private-sector jobs to replace the less productive public-sector jobs being shed. Cutting the Budget deficit is the royal road to recovery.

These are the basic outlines. There are many refinements that involve market reactions, "crowding out", interest rates and so on. But even those independent analysts who support Ricardian-Osbornism do not believe that it will bring us a very quick recovery. They are hedging their bets. They are right to do so - for there is an opposite theory of economic policy called "Keynesian".

The Keynesian theory goes like this. When the economy is fully employed and growing to capacity, Ricardian-Osbornism makes sense. In such circumstances, it is true - subject to certain qualifications - that public borrowing will "crowd out" private spending. But the theory is wrong, dead wrong, when the economy has suffered a huge injury. It's like telling a sick person not to call a doctor on the grounds that a healthy person would be better off without taking pills.

In other words, Ricardian-Osbornism would be an excellent cure for unemployment, if there was no unemployment to cure. A Keynesian would say that, in our present circumstances, Ricardian-Osbornism has got the story back to front. It's not the deficit that causes private spending to fall. It's the fall in private spending that causes the deficit to rise. And it's the deficit that is keeping the economy alive, if only modestly. The deficit is the price we are paying for the failure of the banking system. Any policy that gets the economy growing faster than it is doing now will automatically shrink the deficit as a share of national income.

What do we suppose happened between 2007 and 2009? We know that a great part of the world's banking system suffered a massive heart attack. The pumping of money into businesses and households, which is what banks do, stopped. That meant that all incomes fell and people had less to spend. In the language of Keynes, the seizure of the banking system led to a sharp fall in aggregate demand, or total spending. If everyone starts buying less, the economy starts producing less. The economy goes into a downward spiral. This is what happened in 1929 - and it started to happen in 2008.

If such a heart attack were to hit a society without a government, what would happen? The simple answer is that the patient would die or, what amounts to the same thing, indus­-trial society would come to an end and the population would shrink, through starvation or disease, to a level at which it could support itself by growing its own food.

One might think that this possibility is fantastical. But, for a few years in Russia following the collapse of communism in the early 1990s, the scenario seemed to be coming true. The state, in effect, ceased to function and people were growing their own food.

In the west, we have never experienced anything like this, not even during the Great Depression. The reason is that we have had governments that continued to spend money to fulfil their functions. What happens is that, as the private sector reduces its spending, the government deficit automatically rises, partly because its revenues fall off with the decline in taxable incomes and partly because its social expenditure rises to pay increased unemployment benefits.

However, Keynes would have said that these automatic circuit breakers were not enough. They help to bring the slump to an end, and that starts to bring about a natural recovery. As soon as prices stop falling, people start to expect them to rise. But the last thing we should do, according to Keynes, is to start cutting government spending before the recovery is firmly established.

Almost everyone who has studied the matter - except the Chancellor - is convinced that the huge, co-ordinated stimulus measures that were taken between the autumn of 2008 and the spring of 2009 had, by the end of 2009, cut off another great depression. Governments were acting on Keynesian theory, though they rarely used his name. As soon as the global economy stabilised, however, the engines were put into reverse.

In June 2010, the G20 governments agreed to embark on what they called "fiscal consolidation", or, in simple language, slashing their budget deficits even before their economies had recovered to anything like pre-recession conditions. Not all governments followed this: not the Chinese, and the Americans only partially. But in Europe we all became fiscal hawks.

Why? Analysts and historians will debate this question for years. There is nothing in economic theory that says that a country should aim to eliminate a deficit in four years rather than five or ten. European governments were no doubt spooked by the sovereign debt crises that erupted on the peripheries of the eurozone at the end of 2009, starting with Greece, then spreading by contagion to Ireland and Portugal. Suddenly, these governments were having to pay 7 per cent or 8 per cent on their debt. The bailouts, organised by the European Central Bank and the International Monetary Fund, came with stringent budgetary conditions.

In June 2010, George Osborne announced in parliament that if Britain did not produce a drastic fiscal consolidation package of its own, it would find itself in the same boat as Greece. Anything is possible, but this was extremely improbable. Not only was the British government able to borrow, even before the fiscal tightening was announced, at historically low real interest rates, but, unlike Greece, Britain had never defaulted on its sovereign debt.

In my view, the fear of becoming "another Greece" was used as an excuse for a programme of cuts that had been decided on other grounds. This is where the tug of unacknowledged Ricardian theory comes in. Among many, there was the instinctive feeling that we, as a society, had been living beyond our means and that the slump was in some senses the wages of sin.

The boom had been the illusion - a debt-fuelled illusion - and the slump was the reality: the occasion to purge our system of its rottenness. And the chief illusionist had been the gov­ernment, which had spent billions that it did not have. Beyond this was the feeling that government spending is wasteful and the slump was as good a moment as one will get to cut out the fat.

Once the immediate danger of a continued slide to a great depression was over, all these submerged feelings came to the surface and took control of policy. Even the Labour government was infected by them at the end.

Yet, on one point, I believe that the instincts were right. There was something of an illusion about the previous boom. One symptom was the excessive rewards that were being earned by the City of London - rewards which, as the chairman of the Financial Services Authority, Adair Turner, has pointed out, were out of proportion to the social usefulness of the City, but which swelled the coffers of the government and gave it the illusion that the public finances were under control.

In the period leading up to 2007, British incomes became much too dependent on the earnings of the City. A financial crisis was bound to make our recession particularly nasty. If we are to avoid this kind of disaster in future, we must find a way of rebalancing the British economy away from such reliance on the financial sector. As Winston Churchill said in 1925: "I would rather see finance less proud and industry more content."

And what about the prospects for recovery? If Ricardian-Osbornism is the correct theory, the confident expectation of £70bn worth of cuts over the next four years should already be having a stimulative effect on the economy. We should be starting to enjoy the benefits of what economists of a Ricardian persuasion call "expansionary fiscal contraction". People should be starting to spend the money they know they will no longer need to set aside to pay higher taxes. In short, the recovery should already have started to speed up.

But what has happened? Since the start of the austerity programme, every single forecasting agency - national and international - has revised its growth estimates downwards, giving as the most important reason for this the withdrawal of the stimulus. For the OECD area as a whole, GDP growth is expected to be lower this year than it was last year. The robust recovery is being pushed further and further into the future.

As for the UK, the economist David Blanchflower noted on 7 February on the New Statesman's website: "The problem is that consumer and business confidence has collapsed, net trade is still negative, unemployment is rising, youth unemployment is on course to hit the million mark along with falling house prices and growth was negative in the fourth quarter [of 2010]."

Numerical projections of the kind produced by official bodies should not be taken too seriously. No one knows whether Britain will grow more or less than 2 per cent this year. Their main use is to indicate trends. None of the trends points to a robust recovery.

People hope that China will act as the world's locomotive. What is happening in that country is important for our recovery but indirectly: less than 3 per cent of our exports go there. Rapid Chinese recovery does affect oil and commodity prices, however; the rise of these will have a negative impact on our growth prospects by squeezing real incomes. It will also alarm those who always see the microbe of inflation in the air and will put pressure on the Bank of England's Monetary Policy Committee to raise interest rates, adding a further turn to the deflationary screw.

A second point to emphasise is that, whatever the government does, there will be a recovery from the recession. Economies always recover from slumps, sooner or later. The depressed 1930s didn't consist entirely of Jarrow marches and depressed areas. Millions of people prospered. The Midlands and south-east boomed; there was a big rise in private housing construction; motor car ownership passed the million mark for the first time. Keynes made a fortune on the stock market between 1932 and 1937. The questions to ask are: how soon, how strong and whether the winners outnumber the losers. A healthy recovery should bring the economy back to full employment and normal growth within four or five years of the onset of the slump. There is no sign of this happening on the basis of present policy.

It's not surprising that some people are starting to talk about a plan B, but their thoughts on the matter have scarcely gone beyond another bout of printing money, or quantitative easing. If another policy initiative seems to be necessary in the next few months, this is probably what it will be. But there's a big, theoretical snag about quantitative easing. Printing money is not the same thing as spending money, and it is the spending, not the printing, of money that will have an impact on the economy.

Both the UK and US have had huge expansions in bank money but very mediocre growth in broad money, or bank deposits. The money that is being printed is going into the reserves of the banking system and not being lent out to those that need it most - businesses and households. The process we are seeing is what Keynes called liquidity preference - a strong preference for keeping one's money in cash or near cash, rather than committing it to illiquid investments that might yield a higher rate of return. This reflects the uncertainty about the course of recovery, as well as real problems in the balance sheets of financial institutions.

How would I try to square the circle? The main need is to deploy idle cash to finance long-term investment. The government can't do this directly because any further increase in borrowing is untenable, so we must find an alternative vehicle. What I suggest is a national investment bank.

Such a bank, initially seeded with capital by the government, could mobilise funds on the open market to support long-term private investment. The essence of banking is the ability to make loans several times the size of the initial capital. A national investment bank could attract money that is now languishing in idle balances by offering interest rates that are fractionally higher than the risk-free, long-term bond rate, using these loans to finance long-term investments in transport systems, green technology and social housing on better con­ditions than borrowers could obtain from the commercial banks. In short, we need a drastic upgrading and expansion of the putative green investment bank that was proposed by the Labour government. There are many successful examples to draw on, from the German KfW banking group and the Development Bank of Japan to Brazil's state-owned Banco do Brasil.

Take the European Investment Bank. The EU governments that control it have contributed €50bn in initial capital and the bank has raised a further €420bn on the capital market. It has used this to fund major infrastructure development projects throughout Europe, from the port of Barcelona and the Warsaw beltway to extension of France's TGV network and Britain's new, world-leading offshore wind energy industry. Over 50 years of operation, it has consistently turned a profit. Our infrastructure is rated one of the poorest in the developed world. The government talks big about the need for long-term investment. Here is a chance to do something practical about it.

Robert Skidelsky is a cross-bench peer. His book "Keynes: the Return of the Master" is published in paperback by Penguin (£9.99)