Forget VAT. Forget the Pre-Budget Report and the gaping hole in the public finances. Why has no one noticed that the financial system is clinically dead? Without bank loans, credit lines and overdrafts, good businesses will go bust and repossessions soar. The PBR was miserably irrelevant.

What to do? Peter Mandelson and Mervyn King seem to think that the banks are malingering. They are trying to jolt them into lending with threats. But could this kill the patient? They are right to want the banks to lend. But it is hard to urge simultaneously cheaper loans and more prudence. The banks need life support, not populist shock therapy.

Why aren't banks lending more? There seem to be four reasons, First, the near-death experience has made them cautious. There is no upside for a branch manager in Epsom agreeing to roll over a loan that might later go sour. Secondly, the bleak economic outlook makes many businesses and households riskier than a year ago. Banks have to keep capital to finance bad debts. Thirdly, they are desperate to remain independent, to keep their bonuses and dividends. Ministerial threats of nationalisation could make them even more reluctant to lend - if their balance sheets deteriorate, the Government may take them over. Fourthly, some have struggled to meet the demand by the Financial Services Authority (FSA) that they increase their capital cushion to almost twice what was required two years ago.

The FSA had to act, because it had been in a trance for so long. Between 2000 and 2008, under the noses of the FSA and Bank of England, UK banks went from having a small gap between loans and deposits, to sitting on a tottering pile of IOUs worth £722 billion more than their deposits.

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Without higher capital ratios, they were vulnerable. But to improve ratios they must raise new capital or reduce loans. Investors are wary of putting money in, and £37 billion from the Government does not bridge the gap. So it is bewildering for the Treasury to demand that the banks lend at 2007 levels again.

Alistair Darling seems to be saying that the Government recapitalised the banks to get them lending again. That is not true. It recapitalised them to save them from bankruptcy. Too much lending, and we risk going straight back to that scenario.

Ministers know that banks face higher costs of borrowing in Britain than in almost any other country. Both the US and UK governments are helping to recapitalise their banks, by making loans. But the repayment terms are very different. UK banks must pay a fixed interest rate of 12 per cent a year. US banks pay only 5 per cent, plus some warrants. The higher UK costs feed through to a higher cost of capital for businesses and consumers. The Government is penalising banks to give taxpayers a better “return”. But taxpayers suffer if banks cut off capital. The Government is outraged that loans are not cheap enough. But unless banks are profitable, they fail.

So how to protect businesses and householders? Not with populist rhetoric about first-time buyers. Mr Darling said on Monday that he would pursue the “Crosby” proposals for getting new mortgage lending going. But that would be to return to precisely the reckless securitisation that got us into this mess. The priority is getting banks to roll over existing loans, not to write new ones.

The Government is probably right to ask banks to extend repossession periods. It may make sense for one Epsom branch manager to repossess a house in Acacia Avenue, but if all branch managers did so, house prices in Acacia Avenue would fall so low that banks would make a loss selling them. But it may be too much to expect banks to act in their collective interest, when their individual balance sheets are under pressure.

One City analyst described the Treasury's demands as “like asking a patient in intensive care suddenly to get up and go jogging”.

The US authorities seem to agree. This week, the Federal Reserve effectively decided to act temporarily as a bank, while real banks are in trauma. It is lending $600 billion directly to businesses, funded by printing money. It seems the Fed would rather risk an almighty run on the dollar than Japanese-style deflation. The US Government knows that it could not afford to nationalise all its banks. It knows that private sector capital will be vital to the financial system's recovery. Its generous shoring up of Citigroup this week was designed to stoke investor confidence. What a contrast with the UK where the Government is talking as if it alone can solve the problems. But it is not big enough, without help from private investors.

There is a danger that the combination of punitive lending rates and negative rhetoric will create a self-fulfilling prophecy of UK banks with falling share prices that are frightened to lend. Mr King has hinted that a second recapitalisation may be necessary. A US-style lending facililty could get help to desperate businesses more quickly.

Further interest rate cuts would help. It is fashionable to argue that monetary policy is a blunt instrument, because banks are not passing the full cuts on to clients. But a third of householders have tracker mortgages that move with the base rate. Many businesses borrow at the interbank lending rate, which fell within 24 hours of the Bank's 1.5per cent cut. The Bank has indicated that it held back on further cuts in view of the Government's fiscal stimulus package.

But that package will not get banks jogging again. The Government was right to bail out the banks in October. It must realise that recession is a sideshow - the main event is still the credit crunch.

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