As the markets fall, Gordon Brown's luck is finally beginning to run out

If you are wondering why shares in Britain have fallen even further than shares in America, consider this. The US is cutting taxes, whereas we are putting them up. As a result, America's shaky recovery looks like being sustained, whereas ours may well be aborted.

The State of the Union Address gave President Bush the chance to sell his tax cuts, cuts that have met with quite a lot of criticism. But whatever view you take of the structure of the tax cuts, the fact remains that it will give a direct boost of about $100bn (£60bn) a year for several years. That is about 1 per cent of America's gross domestic product. According to the US bank JP Morgan Chase, if the package goes through Congress in more or less its present form, it would add between one and two percentage points to growth for the next two years. And the economy could feel the impact of this as early as this summer.

Now contrast that with what is happening here. So far we have come through the downturn in rather better shape than any other large developed country, better indeed than the US for we have not had a single quarter when the economy has shrunk. Add to that the fact that, on conventional measures such as price/earnings ratios, shares in London are much cheaper than those in New York. Given this economic performance and these better values it is odd that the performance of our markets should be so dismal. Even the troubling prospect of war should not hit us harder than the US, if only because, unlike the States, Britain remains a net exporter of petroleum.

So what's up? There can be no precise explanation of this profound malaise. Markets are too incoherent for that. In addition, shares in the US have to some extent been supported by the fall in the dollar – if you allow for that, the fall there has been larger than it would first appear. Still, the divergence is troubling, and the best explanation seems to be in the different performance of our governments, and in particular two mistakes by our Chancellor.

We increased taxation during the upswing of the economic cycle, which, with one important reservation, was fine. That reservation is over pension fund taxation, which has turned out to be the Chancellor's first historic mistake. In his first budget he added a tax on dividends paid to pension funds or, more precisely he ended the concession whereby they could reclaim part of the tax paid by companies. This looked like a clever wheeze. It had no immediate impact on demand. All it meant was that pension funds would grow a little more slowly in the future, and at that time, when shares were rising, that did not seem to matter too much.

What few people had appreciated was that this would encourage a long-term shift that was about to take place, away from shares and into fixed-interest securities. One pension fund, that of Boots the Chemist, sold all its shares and put the money into bonds. Others to some extent followed. And of course the more funds that made the switch, the weaker share prices became. A tax that seemed appropriate in a bull market made the bear market that followed much worse.

Now Gordon Brown is about to make another mistake. For the past eight years there has been a steady increase in the number of people in work, the result of both falling unemployment and more people being encouraged into the job market. Come April, there is to be a sharp increase in taxation, specifically targeted on job creation, in the form of higher National Insurance contributions for both employers and employees. While jobs are rising it might seem reasonable to tax them..

The danger is that this increase in taxation will hit the economy just at a time when it is most vulnerable, when it is about to turn down. For the moment, it has to be admitted, there is no evidence in the data either that employers will curb their hiring or that consumers will notice their smaller pay-packets and cut back their spending. But by the time a trend appears in the figures it may be too late. Economics is about confidence, and it really is not very bright to hit people's confidence with extra taxation just when they are already feeling a bit jittery. Increasing taxes in a downturn is just the sort of pro-cyclical policy that the Germans have been doing and the Chancellor rightly thinks is nuts.

Wait a minute, you may think. Surely this additional taxation is being spent – indeed more money is being spent than the rise in taxes will provide. That is why the Government's deficit is soaring so fast. It may be increasing taxes but it is increasing spending even faster.

That is true. The fiscal maths indeed suggest that the Government is promoting more growth. But it is not promoting confidence. There is mounting evidence that much of the additional spending is being wasted. The productivity of the NHS has been falling for several years, so more money is needed just to achieve the same output. Huge sums are being spent on the railways with no evident improvement in performance. There is evidence of a collapse of morale among public-sector employees – witness the sharp rise in time off for sickness. Something quite serious seems to be going wrong.

I am not at all clear what that is. People in the public sector blame the Treasury, which they claim is trying to micro-manage the way they spend their allocations without knowing enough to do so sensibly. It may be, too, that spending is simply rising too fast – something like 10 per cent year on year, according to recent figures – for the money to be used wisely. It may be that there are too many outside consultants stumbling around not knowing what they are doing.

The most coherent explanation I have heard from within the Treasury is that it has to learn the new skill of contract management, which is different from its old skill of departmental control. It is finding this transition very tough.

Still, whatever is going wrong, it ain't doing anything for confidence, both in the public sector and in the wider community. Remember that public spending alone does not generate self-sustaining growth, as we know from the failure of successive Japanese spending packages. What is needed is confidence and competence.

It is now becoming clear that Gordon Brown had an amazing run of luck. He had the longest period of economic growth (and the longest bull market) since the war. He had the windfall from the sale of 3G mobile-phone licences. He had an economy benefiting from nearly two decades of labour market reforms, and therefore able to grow more rapidly than most continental countries. He made one great decision, allowing the Bank of England to set interest rates, and then basked in his good fortune.

That run of luck is now coming to an end. The markets everywhere are having their worst fright for a generation. The response in the United States is to cut taxes and boost confidence. Our response is to increase taxes and boost public spending. And our markets are more frightened even than theirs.