AFTER many years in which monetary policy — interest rates — was the only game in town, the focus has shifted. Suddenly, fiscal policy — tax and spending — is in the spotlight.

The focus on fiscal policy is understandable. Observing monetary policy this year has been like watching a slow-drying paint become safe to touch. The Bank of England, like the Federal Reserve and European Central Bank, has not changed interest rates this year. I grew up on rates changing a couple of times a month.

Sir Edward George, photographed last week steering a ferry across the Mersey, a skill that might become useful during his retirement, now has a distinctly “steady Eddie” view on interest rates, implying it will take a lot to shift them either way. The stock market’s cheerier tone in recent days will provide a further argument for holding rates steady. With only two more monetary policy committee meetings this year, we could see a full calendar year without a change in interest rates, which has not happened since 1959.

So fiscal policy is much more interesting. For the president of the European commission to describe Europe’s stability and growth pact as “stupid” is rather like the Queen saying the monarchy is a pretty silly idea. But Romano Prodi, in an interview with the French newspaper Le Monde, said just that.

The pact, to remind you, was introduced at Germany’s insistence to prevent euro members “free riding” by expanding their budget deficits without limit. In principle the idea was sound. Under the pact, countries should aim for a balanced budget and, except in the most extreme circumstances, not allow government borrowing to exceed 3% of gross domestic product.

Unfortunately, the pact is biting too soon, and in the wrong places. Germany, having pushed for it, will breach the 3% ceiling this year, finance minister Hans Eichel admitted last week.

France has already cocked a snook at the pact by saying, in effect, it will ignore it, and that defence spending should be excluded from the calculations. Portugal has also run up against its limits and other countries will do so as Europe’s slowdown bites.

The rules will doubtless be relaxed to remove some of the pact’s perverse features, which require countries to put up tax or cut spending at the bottom of the cycle. It is, however, a sorry episode. The pact’s practical flaws were obvious when it was first agreed six years ago. Everybody assumed it would be refined before being introduced. It wasn’t.

It seems odd, when talking about Europe’s fiscal mess, to mention our own chancellor in the same breath. Gordon Brown won plaudits for his tight control of the public finances during the last parliament and has continued to operate with low levels of public debt — 30% of GDP — and a surplus on his budget. Against predictions that a Labour chancellor would dive into the red, Brown became the new black.

Now, however, concern is growing. Figures on Friday showed public-sector net borrowing of more than £5 billion last month, the highest for nine years. A big full-year overshoot is now certain.

Last week I reported that the stock market falls this year had lopped £4 billion off the chancellor’s revenues. The Ernst & Young Item (independent Treasury modellers) Club, goes further in a report to be published tomorrow. It warns that the total shortfall will be £7 billion, taking into account other areas of revenue weakness, but most prominently a £5 billion undershoot in income-tax receipts. The hit that higher earners have taken in the City and elsewhere is being felt in the Treasury, it says.

“We are seeing a reversal of the shift towards the top end of the income distribution that marked Labour’s first term and boosted the chancellor’s war chest so spectacularly in the run-up to the general election,” says Professor Peter Spencer, Item’s economic adviser. “It is clear that the exceptionally low bonuses that hit average earnings earlier this year are the tip of the iceberg.”

This year’s revenue shortfall will, says Item, be followed by a similar result next year. The chancellor will breach his “golden rule” —- borrowing only to fund public investment — unless he raises taxes in the spring budget. Is Brown, like the members of euroland, falling foul of the fiscal rules, in this case his own, so that he will have to add to the already planned tax rises next year? The Treasury says no, because our rules are better than euroland’s. In particular, the golden rule only has to be achieved over the economic cycle, so a breach for one or two years would not matter, as long as it was made up.

There is less chance that if revenues undershoot significantly, as seems likely, so will public spending. Whitehall departments have become much better at spending their allocations. In the April-September period, central government spending rose by 9.4% on a year earlier, against a planned increase of 6.7%.

It seems unlikely that the loss of revenues will force Brown into emergency tax increases in the next budget. The National Insurance rises announced last April were deferred for a year precisely because no new tax increases were expected.

Longer term, though, there could be a problem. The Major government got into trouble in the early 1990s because unexpected weakness in tax revenues coincided with strong growth in public spending. The last thing Brown can afford is for the present sogginess of revenues to signal a new trend.

PS: I think it was first spotted here that public-sector pay and jobs were leaving the private sector behind, so it is only fair to offer a corrective update. The latest official figures show that, in spite of the private sector’s travails, pay is rising by 3.8%, against a mere 3% for the public sector. This is a far cry from last year, when public-sector pay growth hit a high of 5.9% while the private sector, hit by a savage drop in City bonuses, touched a low of 1.6%.

This may not be the last word on the subject. The figures were distorted by this summer’s delayed pay deal for 1m council workers. That settlement, between 7.7% and 10.9% over two years, will soon feature in the figures. Firemen want a 40% rise. Private-sector pay, meanwhile, looks set to take a battering as a result of another bad year for bonuses.

The bigger picture is that earnings are growing at 3.6%, well below the Bank of England’s 4.5% tolerance level. If unemployment edges up over the winter, the Bank has no reason not to cut interest rates.

Public-sector jobs continue to rule. They are up by 125,000 in the past year, while overall employment has been flat. Even our parsimonious chancellor has been recruiting, adding 77 to last year’s Treasury workforce of 1,457, perhaps to work on the chancellor’s five economic tests.

One can only hope that the tests are being conducted with more rigour than some of the analysis by outsiders. Last week Lord Layard, for Britain in Europe, blamed the drop in UK inward investment on non-participation in the euro.

It is true that UK inward investment fell last year, by 34% in terms of project numbers, and Britain’s share declined. But Ireland, snuggled inside the euro, suffered a bigger drop in inward investment, of 46%. And the drop in Britain’s share was due to a gain in share by countries in central and east Europe, some of which are not yet candidate countries for EU membership, let alone for joining the euro. There was, as you might expect, no evidence at all that the euro had any effect on these trends.