The collapse of Lehman Brothers on 15 September 2008 unleashed the worst global downturn since the Great Depression of 1929. And it was almost entirely unanticipated. Ten years on is a good time to ask what governments, policymakers, and economists might learn from this catastrophe – how to prevent future ones, and how to overcome them if they happen. Of these two, prevention is far better than cure. Once a downturn gathers momentum, the scale of intervention needed to reverse it becomes frighteningly large. Budget deficits balloon, public debts soar, governments take over banks – all conjuring up visions of looming state bankruptcy, or worse, state control over the economy. So the most important question is: how can these catastrophes be prevented?

By prevention, I do not chiefly mean trying to stop the semi-regular fluctuations of the business cycle. Capitalist market economies exhibit rhythms of economic activity. The political economist Joseph Schumpeter called them waves of creation and destruction, or perhaps they simply arise from temporary mistakes of optimism and pessimism. The authorities already possess the tools to dampen, if not altogether prevent, these fluctuations – if they want to. Central banks can use interest rates to restrict or expand credit; government budgets have built-in stabilisers, with revenues falling when the economy turns down, and rising when it expands.

Beyond this, central banks could vary the reserve requirements of member banks counter-cyclically; local authorities could keep a buffer stock of public works – local improvements – which could be quickly expanded and contracted as unemployment rises and falls. Finally, there is a question of the “norm” around which the fluctuations might be allowed to occur. Should policy aim to maintain “high” full employment or be satisfied with “low’” full employment – the difference being between (say) an unemployment rate of 2-3% and 4-5%?

But the job of preventing economic collapses (of the order of 5% to 10% of national income, with unemployment doubling from “normal” times) requires far more ambitious thinking. Such collapses can happen at any time because, as John Maynard Keynes taught, the future is uncertain. It was the rapid spread of contagion through the banking system that brought it low in 2008. This was because big global banks held each other’s heavily insured risky assets. When the value of these assets collapsed, the banks and their insurers went bust. They then had to be rescued because they were “too big to fail”.

If the economy is allowed to fail, the “cure”, as the events of the past 10 years have shown, is very difficult. A severe recession is bound to increase the government’s deficit. This is because the government’s revenues automatically fall and its expenditures automatically rise, with extra payments to the casualties of the slump, whether households or banks. A continually rising deficit, financed by public bond issues, rapidly raises the national debt to seemingly astronomical heights. So a politically irresistible demand arises to “cut” the deficit. Cutting the deficit by cutting welfare becomes the litmus test of a government’s determination to “put its accounts in order”. This is what happened over most of the industrial world from 2010 onwards. Known as “austerity”, it was implemented in Britain by George Osborne, the Conservative chancellor of the exchequer.

‘The UK’s pre-crash finances were not much different from those of the other advanced economies.’ Photograph: Hannah Mckay/Reuters

In 2010, as the British economy was just beginning its long recovery, David Cameron came to power attacking the economic mismanagement and “reckless spending” of the Labour government. But in fact, the UK’s pre-crash finances were not much different from those of the other advanced economies. The response, then, was for the government to cut its spending, as any responsible household would do if threatened with mortgage foreclosure. Osborne announced a variety of spending cuts and tax rises which he claimed would reduce the budget deficit from 11% to 1% (and would liquidate the structural deficit completely) within the course of a single term of parliament, and significantly reduce the debt level. Yet the economy grew far less than Osborne had predicted for each year of parliament, and the deficit and debt did not reduce at anything like the rate he had predicted.

But he had overlooked the effect of austerity on the size of the economy. In the long run, potential output shrank significantly and persistently as a result of Osborne’s persistent austerity policy.

What is hardly realised, even today, is that the rhetoric supporting this policy of deficit-cutting in a slump gets almost no support from economic theory. The national debt is not a “burden on future generations”; it is a transfer between creditors and debtors. Such transfers may have undesirable distributional effects, but no net burden arises, either now or in the future.

Much more important was the false argument that cutting public spending promotes recovery by increasing the confidence of the business community. This doctrine of “expansionary fiscal consolidation” was much in vogue in 2010. It is false, because businesses invest when they see a market, and the market expands when consumers have more money to spend. If government, in an attempt to “balance the books”, reduces the community’s spending power, economic recovery stalls. And this is what happened. Osborne’s cuts chopped down the “green shoots of recovery” that had begun to appear at the end of 2009, and condemned Britain to at least two further years of stagnation. In fact, the effects of his “cure” linger still, in the form of lost output and earnings.

A final mistake was the belief that monetary policy could undo the effects of fiscal contraction. The idea was that if the central bank pumped enough money into the economy, people would start spending again. Certainly, what is called quantitative easing undid some of the bad effects of fiscal austerity. The error was to believe that printing money is the same as spending it. Much of the extra money “printed” by the central bank went to swell the cash reserves of banks and businesses, rather than being spent to revive activity. Because it went to the holders of existing assets, it increased inequality; and because the rich save more than the poor, it reduced the consumption base of the economy.

Three essential lessons should be, but have so far been only incompletely, learned. The most important is to prevent financial collapses in the first place. Banks have to be stopped from putting the economy in jeopardy by risky lending. This is a big reform agenda that has barely been scratched by telling banks to hold more capital or reserves. It requires breaking up banks into smaller units, and instituting controls over the type and destination of loans they make.

The second essential step is the revival of proper macroeconomic policy. Monetary policy on its own is too weak to prevent economic collapse, and too weak to bring about economic recovery. Fiscal policy needs to become again a powerful tool for economic management, not by “fine-tuning” the business cycle but by maintaining a steady stream of public investment amounting to at least 20% of total investment, to offset the inherent volatility of the private economy.

The third essential preventive step is to reverse the rise in inequality. If too much wealth and income is concentrated in too few hands, the consumption base of the economy becomes too weak to support full employment, high or low. The effects of failing to take precautions against a big collapse of economic activity and the botched and inegalitarian recovery measures implemented by most governments from 2010 onwards have left a damaging legacy of political resentment. The electoral support for populist movements, of which the vote for Brexit is an example, has deeper roots than mere economic distress. But the correlation between the collapse of 2008 and its consequences and the growth in support for populism is too striking to be ignored. Adequate policies of prevention would, by reducing the likelihood of large-scale economic collapses in the future, staunch the flight of voters toward political extremism.

• Robert Skidelsky is professor of political economy at Warwick University and the author of Money and Government: A Challenge to Mainstream Economics, published by Allen Lane