It is Osborne’s plan that failed, but Miliband who must move on

What Labour lacks is a story to tell about how it would govern in a time of austerity.

It could have been the Chancellor's Black Tuesday. On 29 November, George Osborne stood before parliament and admitted that all of his economic calculations have been wrong. Growth will be much lower than anticipated, unemployment and debt higher. The promise to have the budget deficit defeated in time for a 2015 general election was withdrawn.

Since Osborne's timetable was designed to coincide with the electoral cycle, missing the vital deadline upsets the calculations that underpinned the coalition between Liberal Democrats and Conservatives. It was meant to be a fixed-term, joint enterprise to deal with the public finances. With austerity now due to linger on well into the next parliament, the two parties are finding it harder to imagine how they might peacefully part company before polling day. Coalition management has already become "messier", according to one senior Whitehall official, with fiercer competition to leave a yellow or blue stamp on potentially popular measures.

Question of trust

In negotiations ahead of the autumn statement, the Lib Dems pushed through plans for a £1bn fund to tackle youth unemployment with subsidised work placements. Televised images of Nick Clegg looking earnest surrounded by apprentice craftsmen were cheered in the Deputy Prime Minister's office as a triumph of political positioning. The mood was dampened when news leaked out that the plan would be financed with a freeze on tax credits for middle- income households. Camp Clegg believes this "supremely unhelpful" additional piece of information was briefed by disgruntled Tories in the Department for Work and Pensions (DWP), jealous of Lib Dem incursions on their employment policy turf.

A similar squabble erupted over plans to increase the number of free nursery places for two-year-olds. Although technically this also falls under the DWP's remit, it was the Deputy PM who forced the issue of affordable childcare on to the agenda of the "quad" - the coalition steering committee that comprises David Cameron, Osborne, Clegg and the Chief Secretary to the Treasury, Danny Alexander. Clegg wanted credit for the idea. The Tories felt he had fronted enough good news for a while. The policy was announced on the morning of the Chancellor's statement as a Treasury decision.

The atmosphere in the quad is still civil but there is less cosy consensus and more forthright bartering over policy. "It is more transactional," says a source familiar with the discussions. Tory MPs complain that the Lib Dems are the more mischievous party when it comes to leaking quad victories, while Downing Street claims to operate a policy of non-retaliation. "We try to rise above all that," says one No 10 aide.

Cameron and Osborne know there is a natural limit to Lib Dem glory-seeking. The junior party needs coalition to look like a functional model of government at least as much as it needs to get the credit for individual policies. The one fixed point of total unanimity is the need never to question the budget cuts contained in last year's spending review. It is the sacred text, enshrining the commitment to fiscal rigour that is supposed to have fended off those predatory bond traders who are now feasting on the carcasses of indebted governments elsewhere in Europe.

The coalition parties are confident that the discipline they are showing in keeping to tight spending rules puts them ahead of Ed Miliband and Ed Balls in the competition to look like reliably parsimonious custodians of the nation's depleted wealth. Downing Street still believes Labour can be defeated in a campaign dominated by credibility on the deficit. "The next election will now be fought on the question, 'Who do you trust to finish the job?'," says a senior government adviser. The gamble is that enough voters have now decided that the whole financial mess was made by Labour that they can't envisage putting the party back in charge, even if they detect truth in the opposition claim that premature austerity has suffocated growth.

Balls is admired across the Labour front bench for his formidable economic brain, but some shadow cabinet ministers worry that his determination to prevail in an argument that should have been won last summer (when Labour was distracted by its leadership contest) is blinding him to a political reality: the public cares less about what caused the deficit than about how politicians will deal with it. Balls knows what he thinks the Chancellor should be doing differently. He has a "five-point plan" to create jobs and stimulate growth. What Labour lacks, however, is a story to tell about how it would protect public services when budgets are shrinking.

Grey austerity

For that reason, public-sector strikes over government pension reforms on 30 November represented exquisitely bad timing for Labour. "A source of frustration," is how one shadow cabinet minister described it. Miliband would gladly have let the news of Osborne's economic woes reverberate through the week. Instead, the focus shifted to an issue that risks discomfort for the Labour leader, given his party's financial reliance on trade unions.

Labour's position is a queasy combination of sympathising with the strikers' grievances and wishing they were not on strike. That ambivalence probably captures the public mood fairly well, but if Miliband wants to form a government he will have to start expressing clearer views on what he thinks the state can afford, whether in public-sector pensions or any other benefit to which the coalition is taking an axe.

Labour has been craving the day when Osborne's strategy would finally be seen to have failed. Then the Chancellor's Black Tuesday came and merely blended into the calendar of grey austerity stretching ahead for years.

No politician of the current generation has ever had to imagine being in power with the state coffers so empty for so long. It is a prospect that will certainly put a strain on the coalition. The Tories and Lib Dems are struggling to agree on what government should be doing when there is no more money to spend. What unites them is the need to tell voters that Labour has nothing to offer in that debate. Miliband's urgent task is to prove them wrong.