“I can see another financial bomb going off”

Once a self-styled free radical, Vince Cable is now grappling with the compromises of power. Here he

Consensus is growing that interest rates have been kept too low for too long and that inflation, which stands at 4.5 per cent, is accelerating dangerously, just as inequality deepens, growth flatlines and incomes decline. Worse still, as we enter the age of austerity, is that near-zero interest rates are artificially supporting an already unstable housing market.

Spencer Dale, chief economist at the Bank of England and a member of the Monetary Policy Committee (MPC), has spoken of the immediate need to raise the Bank's base rate and then to keep nudging it upwards. "I don't take lightly the impact this could have on some families," he said in an interview with the Financial Times on 21 May. "But I think the cost to our economy as a whole – were inflation to persist for longer and our credibility [to] start to be eroded – would be even worse."

The coalition government's "emergency" deficit reduction programme is based on one fundamental principle: when fiscal policy is so tight, monetary policy needs to remain as loose as possible. It's often said that, because of the rapidity and harshness of the cuts in public spending as well as the absence of growth in the UK economy, the government needs greater flexibility. It needs to be less rigid and more pragmatic. It needs a plan B, dare I use the cliché.

In one sense, it already has a plan B (abnormally low interest rates and the option of more quantitative easing). What it might soon need, especially if the MPC votes to raise interest rates, is a plan C (which would mean slower cuts and the kind of humiliating policy reversal that the Chancellor, George Osborne, would never sanction).

I put this to the Business Secretary, Vince Cable, when we meet on a bright, breezy afternoon at his office, with its high windows and fine views of Westminster Abbey. Reclining in a large, soft chair and sipping from a mug of tea, Cable, who has shrewd eyes and a rumpled charm, is quick to point out that the greater danger is not inflation, but deflation.

He cites the long deflationary slump that followed the financial crisis in Japan at the beginning of the 1990s as a warning of what might lie ahead for Britain.

“Japan has never recovered since 1990," he says. "And that's the thing that some economic writers never engage with: what happens when a financial system collapses? The progressives have never engaged with this issue; [John Maynard] Keynes never wrote about it. Nobody engaged with the problem of what, as a social democrat, you do when your financial system goes down . . . The Japanese thing is a very serious warning for us."

Systemic neglect

On the question of inflation, Cable says the governor of the Bank of England, Mervyn King, is "making the point that, first of all, inflation is imported, not domestically generated". It is, in essence, transitory.

What about the VAT rise and its effect on prices and consumer confidence? "But that was exogenous," he counters. "There's no indication that that has been translated to the labour market [in terms of wage demands]. There's no evidence of shortage of capacity yet . . . We don't have an underlying inflation problem. The Bank's job, as the governor keeps pointing out, is not to look at today's numbers, but to look 18 months ahead."

So deflation is the fear, then?

“He [King] would certainly argue that . . . If politicians were setting interest rates, people would be panicking. Letting people be independent and making their own technical judgements is right. So far, they've been very supportive."

Was he relieved to see the hawkish Andrew Sentance, who continually voted to raise interest rates, leave the MPC?

“I don't see it in crudely personal terms," Cable says, "but it still seems that the centre of gravity at the MPC is very much at the governor . . . I find that reassuring."

A few weeks ago, over lunch at the New Statesman, Cable and I discussed some of those economists who robustly oppose his position on deficit reduction. In a considered and impressive essay in the NS in January, he had argued, against the professor of political economy Robert Skidelsky and our economics editor, David Blanchflower, that Keynes would have supported the coalition government's macroeconomic policies.

Yet the banks are not lending, especially to small and medium-sized businesses, and the government, though it is spending, is not spending enough to power growth.

As James K Galbraith, son of the more famous J K, has written: "Governments and banks are the two entities with the power to create something from nothing. If total spending power is to grow, one or the other of these two great financial motors – public deficits or private loans – has to be in action."

“The point I stressed when I was having lunch with you," Cable says now, "is that it's not just a Keynesian lack of demand, it's not just a Budget deficit problem. You have a model of economic growth that has broken down, comprehensively broken down. We had personal debt, which was unbelievably high, and this means you have an overhang debt on houses.

"You've got a property bubble, where property prices went out of control, and so now you have households worrying about falling house prices. Businesses that can't use their property as security. We've got this long-term, systemic neglect of key productive sectors, including manufacturing, because the exchange rate was overvalued. We've got the hollowing out of industry: we now don't have the skills. And then we have the deficit, which was the consequence of the bank collapse.

"We had a broken model. Growing out of that isn't just about pressing a few buttons and reducing government spending . . .

“It is worrying that we are lagging behind Germany and France but I think there are very deep structural reasons for that. They haven't had a banking collapse; we have."

Discipline and punish

How anxious is he about the reluctance of the banks to lend? "On the specific issue of banks lending to SMEs, figures are bad," he says. "The banks claim that it's a problem of demand – and it is, in part. But I think it's a deeper problem: banks aren't going out for business. They've run down their branch networks and relationships with SMEs. They aren't being aggressive enough in going out and supporting good companies that want to grow and recover. It would be an absolute disaster if the banks, having fuelled an uncontrolled boom, are now strangling small-scale enterprise."

Cable is prepared to be tougher. "We can say: you guys haven't met your side of the agreement; we can punish you by slamming on more taxes. That is a sanction they know that's there. We've already put taxes on the banks; the balance sheet tax. There are other things happening in parallel, which are extremely important, which are the structural reforms from Vickers [the report that is likely to result in the separation of high street from investment, or 'casino', banking]. Sanctions are the final resort. The problem is that the tax mechanisms are not as straightforward as Ed Balls implies, just slapping on another bonus tax. Well, the bonuses have gone; they've transferred it into normal salaries."

During the coalition talks after the general election last year, Cable addressed a hastily convened meeting of Lib Dem MPs and told them: "My heart beats on the left." What he meant was that he felt emotionally and ideologically more aligned to Labour than to the Conservatives. He still does. He describes himself to me as a social democrat, in that "I have a belief in egalitarian policies on tax, wealth and income. I believe in good, accessible public services; but I also believe in a market economy, openness and free trade. That's my definition of social democracy. The first big political book that influenced me was by [Tony] Crosland. That's the tradition I came out of."

In a speech to the Lib Dem annual conference last September in Liverpool, Cable argued for a new approach to taxation, switching the burden from earned to unearned income, from taxing income, or jobs, to assets, principally property and land. I agree with him that the old high-tax-and-spend model of social democracy is bankrupt in a globalised age, when capital is so mobile and the rich are so adept at avoiding taxation. We talk about this.

“If you're trying to design a system from scratch," he says, "what you probably want is a Danish-type model, which relates tax to property values. Council tax doesn't work anymore [in Britain]. The link is broken. There are all kinds of technical problems about valuations; how you concentrate it at the top end with the bottom end. Those are the things we should be looking at. People are more mobile than property, although one has to be careful about rich people saying, 'I'll live somewhere else.' They would say that, they always say that."

Last spring, he was still just about the nation's favourite Vince, a self-styled free radical and ubiquitous pontificant and sage. All the same, he urged his fellow MPs to follow him into coalition with the Tories because, as he once told me, he was "an enthusiastic deficit hawk". Now, all these months later, he talks of how "embattled" Lib Dems feel, of the mistakes made in government, but also of the successes and personal satisfactions.

The debate over the rise in tuition fees was, he says, a "failure of presentation". What the coalition has introduced is a "progressive graduate tax in all but name", even if that is misunderstood. He repeats: "We have got a progressive graduate tax: it isn't about fees, and there's no fixed debt, because you don't have to pay it . . ." Unless, I interject, you earn a fixed amount after graduation, and then you pay retrospectively. "But if you don't, you don't pay it."

It was a "bad mistake", he says, for the party leadership, before the election, to have signed the National Union of Students pledge not to raise tuition fees. "We all take responsibility for being involved in that. I wasn't very keen on that [at the time]. But it's collective responsibility" – he pauses, sips his tea – "we all did it.

"We had a meeting of our key people yesterday. One of my colleagues, who you would think of as quite critical of radical policy, said: 'We should get eight or nine out of ten for our policy, but one or two for our politics.' I think that's a fair assessment of how things are."

He does not pity or feel sorry for his party leader, Nick Clegg, who has become the most widely ridiculed national politician. What he feels for him is empathy. "I don't think he needs pity. Absolutely not, because he's quite a strong guy. But he has put up with an enormous amount of very, very vicious stuff, and what's worse about it, it's come from both sides . . . And it isn't so much feeling sorry for him, just sort of feeling a sense of kinship, because I've been subject to – not as much abuse as him – but a certain amount, as have all our colleagues in government, and systematically. I mean, the right-wing press is relentless. And I just look through the press cuttings, from the Express and the Mail and the Sun, and it's relentlessly hostile. And it also comes from, you know, our friends on the left." He smiles.

Nuclear options

What has sustained the Lib Dems through all the abuse and the collapse of their support, through the accusations of betrayal and of lies and policy flip-flops, is the belief that as a party the "correct call" was made by going into government. "We realise it's a long game, not a short game and this is, in a sense, where I think the Labour Party is making a bad mistake. What they're doing at the moment is tactically very clever but strategically very stupid. Ed Miliband comes across as sort of very clever but tactically smart, rather than strategic, and all this endless point-scoring, I find, isn't helping him or anybody else. It's short-term.

“Our view is more strategic. It's that, in the short run, you take a big hit but, in the long run, you get respect. I think the word 'respect' is rather important. You get respect because you've been there, you've been in government, you're taking difficult decisions, difficult and popular, but you have to do it, you've done it, and people in several years' time will look back and say, 'Woah. OK, well, they're serious players.' " But yes, "We would work with Labour in coalition."

One of the unintended consequences of the decision to enter into coalition is the possible break-up of the British Union. The Liberal Democrats were never strong in Scotland, but they had clusters of support, in the Highlands and islands and some rural areas. Much of that support has been transferred to the Scottish National Party – more out of protest, one suspects, than through conviction.

Cable is a dedicated unionist. "We are not going to lose Scotland," he says. "I'm sure of that. The SNP did extremely well in the election, and it was brilliant campaigning. There clearly is a wish in Scotland to be able to make their own decisions, but there is no evidence, not a shred, that suggests the majority of people in Scotland want full independence, with all that means – you know, with armies and border posts and separate currencies and all the rest of it." However, as Business Secretary, he boldly says that he supports fiscal autonomy for Scotland.

Should the Scots be free to set their own corporation tax, even if the rate turns out to be as low as it is in Ireland?

“I think the logic of that is irresistible, if you have a devolved system. I think it's obviously got to be . . . If you want power, then you have to have the responsibility, and the responsibility goes with making fiscal choices, and fiscal choices involve not just spending a block grant, which is what happens at the moment, but making decisions on how to raise revenue."

From the beginning of the coalition, Cable and George Osborne metaphorically signed what friends have described as a non-aggression pact. Is it true, I ask him. Did you make a pact? "Sort of, yeah," he says. "[But] there's no peace treaty thing. I meet him every week, have a good discussion about the current agenda. There is clearly an implicit understanding that there's no rule to having an opposition chancellor in the government offering a legal commentary on all the things the government's doing . . . [Our pact] was not explicit, but there is an understanding. I respect that we have to have a common view on the basic economic management and he gives me a major role to play in the growth agenda, which is extremely important for government."

It's sometimes said that the ghost in the machine at the Treasury is Rupert Harrison, Osborne's chief of staff, who happens to be a former student of Stewart Wood, the Oxford don who is now Ed Miliband's trusted consigliere. Is Cable concerned about the power of Harrison and how he operates as one of Osborne's most potent proxies?

“Well, you know, what are we comparing? Gordon [Brown] had Ed Balls . . . I find him [Harrison] an extraordinarily bright guy, really great and easy to talk to. So, I mean, having someone like that around is not a problem."

He has spoken of the ruthlessness of his fellow Conservative cabinet ministers. Does he trust them? "We have a businesslike relationship," is all he will say.

When, before Christmas, Cable was covertly recorded at his constituency office by two giggly female reporters posing as wide-eyed constituents, he spoke of his "nuclear" option: the power he felt he had to use the threat of resignation to destabilise the coalition. It's often been remarked by those looking in from outside that the compromises of power, as opposed to the liberties of opposition, have made Cable unhappy and fretful. I've never believed this. At the age of 68, he understands that he has been given the opportunity late in life to do "something I've wanted to do, to have a proper job in government".

Signs of a serious problem

In conversation, his tone is nearly always calm and moderate. His voice quickens noticeably only when he talks about Brown and what he considers to be his failures in government. The "big, interesting question", he says, is why Brown allowed the boom to get out of control; why he allowed the economy to be built on a foundation of debt. "He's bright enough and now realises and signals – he doesn't have a very humble style – an acknowledgement that something went very badly wrong there. He and Ed Balls were persuaded that the City of London should always be deferred to as a great source of wealth creation."

As for the notion of Brown replacing the disgraced Dominique Strauss-Kahn as head of the IMF, he says: "That is now a dead issue. I don't approach it that way round: how do we find a job for Gordon Brown?" He would prefer a successor to be appointed from an emerging nation – from India or Singapore, for instance.

Above all, Cable wants to continue in government and confirms that he wants to stand at the next election, in 2015. "I'd like to go on. Deng Xiaoping is a real model . . . who knows?" He chuckles. Working outside politics "for most of my adult life", he says, "I was a perfectly well adjusted human being, and I managed to live without it. I suppose at some point I shall get on and do other things. As you know, I have other interests – I like writing, I love literature, I love music [and] dancing."

But translating ideas into action and the possibilities of power excite him. "I think," he says, conflating tenses, "when I look back on it there were really big things that we've done here, whether it's [reforming] higher education, sorting out the Royal Mail, a lot of things. The banking system. Which will be major legacies. So, although it's been quite difficult, I'm glad I've been in that position. There's no short-term fix. The politics will be tricky to manage, but that's what we're committed to – the durability of the coalition."

His greatest concern at present is that we could be heading for another financial crash. I mention Warren Buffett and his remark about the damage that asset-backed securities have done to the world economy and could do again: truly they are instruments of mass destruction.

“I'm concerned that there is a lack of popular understanding about how serious the problems are . . . the sheer magnitude of the crisis we've got, and particularly the long term impact of the collapse of the banking system."

The Indian billionaire Ratan Tata has spoken of how, compared to workers in developing countries such as India, British managers do not work hard enough. Perhaps we have become too affluent, too complacent; too protected by near-zero interest rates.

“Ratan Tata also spoke," says Cable, "about India having a wartime feel about it in industry and we don't have that. There isn't the recognition, to my mind, of the seriousness of the problem.

“Yes, I think this is the thing that worries me more than anything else . . . We really haven't engaged with the real depths and seriousness of the financial crash. You've got bits and pieces of regulation being put in place, but it's very piecemeal. The structure of banks are being addressed in the UK but nowhere else. There is a bit happening in terms of complex derivatives, in terms of clearing house arrangements, though it's a bit limited. I was very impressed with that Warren Buffett metaphor that asset-backed mortgage lending was the atomic bomb, and that there are hydrogen bombs out there. I just don't think that collectively governments have got to grips with this at all."

So another huge bomb could go off, sooner rather than later?

“It's not imminent. But you can see this happening."