The public finances are shot to pieces. Inflation is rising and so is unemployment. Small businesses are being starved of credit by a malfunctioning system. Britain's economy is grotesquely unbalanced between the north and south, and between the City and manufacturing. This, in short, is the inheritance for George Osborne, and it is not a happy one. He must now have sympathy for Alistair Darling, dealt a similarly terrible hand by the departing Gordon Brown in the summer of 2007.

Osborne and his Liberal Democrat chief secretary David Laws will, no doubt, enjoy a honeymoon period, where the voters are happy to accept that Labour was responsible for the country's economic mess and the markets give the new team time to flesh out a strategy for putting Britain back on its feet. On paper, this is easy. The private sector enjoys a strong and spontaneous recovery to fill the gap left by the retrenchment of the state. A lower pound helps the UK to export while higher taxes and public spending cuts stifle domestic demand. It has to be said, though, that the UK's economic problems have been solved on paper many times in the last 100 years. Cracking them in reality has always proved a lot more difficult.

The upward trend in inflation is particularly unwelcome for the new Treasury team. As measured by the consumer prices index, the cost of living was 3.7% higher in April than a year earlier. This compares with an annual rate of 1.1% last September and a government target of 2%. Alternative measures of inflation show it at more than 5%. This creates problems for three reasons. First, it puts pressure on the Bank of England to raise the bank rate even though its monetary policy committee thinks the economy is still too weak to cope with higher borrowing costs. Second, it makes one of the government's deficit reduction options – an increase in VAT – much more of a risk since the impact would be to push inflation still higher. On some estimates, raising VAT to 20% could send CPI inflation above 6%.

Finally, a combination of rising inflation and negligible growth in earnings means real incomes are being squeezed. If workers respond by securing higher pay awards, the Bank of England will raise interest rates, thereby threatening recovery. If they tighten their belts, that too will threaten the recovery because consumer spending is responsible for around two thirds of gross domestic product. And if they borrow more to bridge the gap between income and spending, it will – as they say in the movies – be deja vu all over again.

Osborne is relying on the Bank keeping the bank rate low in order to offset the pain he is going to administer via tax and spending. A mix of loose monetary policy and tight fiscal policy is needed if the economy is to be rebalanced towards investment and exports, but the strategy would risk being strangled at birth if borrowing costs rose in response to higher inflation. Mervyn King sought to reassure the chancellor this week that inflation would soon be coming back down towards its target, but since the start of the crisis the Bank has tended to overestimate growth and underestimate inflation. This time last year, the central forecast for the not-so mystic Megs at the Bank was that inflation in the second quarter of 2010 would be 0.7%.

Both the Treasury and the Bank expect the economy to grow by about 3.5%, forecasts that look roaringly upbeat given the state of the UK's main export market, Europe, and the savage cuts that are in store for the public sector. Osborne will announce a three-year spending plan later in the year, and politically the pressure will be on him to front-load the pain into 2011, leaving less to do as the next election nears. These cuts will be the deepest since the late 1970s and, on some estimates, could slice two percentage points off growth next year. In other words, the private sector would have to grow by an implausible 5.5% to hit the Bank and Treasury growth forecasts.

So what does all that mean? It means that the economy is likely to grow more slowly while having higher inflation than policymakers assume. It means that those of middling incomes and below – many of them Liberal Democrats – are going to be hit by falling real incomes, rising taxes and cuts in public spending, with higher interest rates perhaps tossed in for good. And it means that there will be real pressure for the Lib Dems to call it quits. Not now, but as the pain from the cuts intensifies over the next 12 to 18 months. At that point, the coalition will be tested, perhaps to destruction.