As Mervyn King suggested last night, the prospects for living standards in the near future are grim. Higher economic growth will help and the government should therefore pursue policies that liberate the supply side of the economy. However, the growth in living standards might well lag far behind the growth in output.

In the first place, there is the public sector debt overhang. In the next four years alone, public sector debt interest will increase by £20bn. Of course, the holders of that debt will receive that money from taxpayers but the build up of public sector debt has crowded out productive private sector investment so the holders of UK government debt are receiving transfers from taxpayers and not profits from investment. Had the government not embarked on debt reduction the cost of debt servicing would have been a further £10bn higher.

Spending by increasing government borrowing involves a straightforward inter-generational transfer in favour of the borrowing generation. An indication of the extent of this transfer from 2015 is that the additional interest alone (without paying back the capital) is not much less than the total Council Tax take. If the government were not borrowing so much at the current time, Council Tax could be more or less abolished after 2015 – alternatively, the tax increase proposed by the government would have been entirely unnecessary.

This explicit government borrowing is in addition to the implicit government borrowing arising from older generations voting themselves pensions and healthcare provision that have not been funded by the sacrifice of consumption during their working lifetime. The consumption of the next generation will have to be sacrificed instead! This, together with explicit debt, totals, perhaps, 500% of national income and will, again, be serviced by transfers from the young to the old.

In addition to government borrowing there is private borrowing. Some of the increase in private sector credit might have been encouraged by loose monetary policy or inflated expectations of economic growth caused by Ed Balls and Gordon Brown suggesting that they had increased the sustainable growth rate. However, by and large, it has been brought about by private decisions – but private decisions that will have to be reversed.

Furthermore, over many years we have had an increase in the tax burden and in government spending which, to only a limited extent, will be reversed. Insofar as government uses money less wisely than individuals, this will again cut living standards.

Mervyn King suggested that the collapse of the financial system will also cause a necessary reduction in living standards. This is true, though this should be a “one-off” effect. The second factor he identified was the rise in commodity prices. Again, Mervyn King is right to suggest that a rise in oil prices and so on will require a cut in living standards. The economic arguments are a little complicated but, basically, the relative price of goods we are exporting has reduced compared with the relative price of the goods we are importing. We are therefore a little less well off than we would otherwise have been.

Some of these factors may reverse and the growth of living standards may resume, but whether or not that is the case, we must not make the wrong policy choices. The correct policy choice, if we are worried about growth and living standards, is liberalisation of the real economy. This will enable the greatest degree of adaptation to (for example) the relative scarcity of commodities and also enable faster levels of general economic growth. The government is certainly going in the wrong direction here with the extension of and increase in the minimum wage; the significant extension of anti-discrimination and employment protection laws; tighter regulation of bank capital; and the likely tightening of mortgage lending regulation. There is an urgent need to move in precisely the opposite direction thus liberalising employment law and removing “double” taxes such as capital gains tax and penal taxes such as the 50p rate.

We should also identify and avoid the wrong policy choices. In the 1970s, we reacted to falling growth, falling living standards and rising commodity prices by loosening monetary policy. Mervyn King suggested yesterday that tighter monetary policy would not have led to higher living standards. It is also true that loosening monetary policy in reaction to problems in the real economy will not raise living standards either. The two great threats to inflation are, firstly, that the Bank of England will do precisely that and, secondly, that the money created by QE will find its way into the broader money supply as the banks start to lend again (pushed to do so by a government that also applauds regulatory restrictions that prevent them from doing so!).

It is not that the government needs a vision for growth as suggested by the CBI President. The government needs a strategy for liberalisation. Problems in the real economy demand liberalisation of the real economy, not more government borrowing or more money printing. Liberalisation might not prevent a decline in living standards but it gives us our best shot.