Economic crises go through four distinct stages. First, there is the bubble-induced mania when markets rocket skywards and the word on the street is that the good times will last for ever.After bubble comes denial. This is the period when it is obvious to any independent-minded observer that the party is over but policymakers and the financial markets can’t bring themselves to admit it. We hit this phase in spring 2007. There were no wider implications for the rest of the US economy, let alone the stability of the financial markets or the global economy as a whole.

Denial is followed by panic when it becomes clear that nothing has really changed since Dutch tulips in the 17th century and that the latest period of speculative excess will end in tears, just like all the others. At this point there is a fork in the road. Policymakers act to allay the panic by cutting interest rates and throwing money at the financial system. If the measures work, it is back pretty much to business as usual within a few months.

All the experience of the past 25 years mirrors this sort of pattern. The US recessions of the early 1990s and 2001 lasted for only eight months; there was barely a pause for breath when the Federal Reserve took pre-emptive action to prevent recession in 1987 and 1998.Sometimes, and only rarely, markets discover that what they had believed to be a miracle cure was, in fact, a placebo. The crisis is so serious that there is little or no response to the easing of policy; in these circumstances panic is followed by capitulation. Seven months into the credit crunch, we have now arrived at the fork in the road.

It is a sign of how serious the current situation is that those who argue that there is a risk of a 1930s-style slump are no longer treated as stark, staring mad. Indeed, the argument in the US is not over whether there is going to be a recession, but how long and deep the recession will be.

Nouriel Roubini, professor of economics at Columbia University in New York, is one of those sceptical about the idea that the US will suffer only a short, shallow downturn. For one thing, America is enduring the biggest housing market bust in its history, and prices are likely to carry on falling sharply. Then there is the credit crunch, which is far more severe than in the early 1990s or early 2000s.Monetary policy, in other words, has lost its traction. This may well be one of them, since the third big difference between now and the downturns of the early 90s and the early part of this decade is that consumers are far more indebted. Falling house prices, credit that is harder to come by and more expensive, years of living on the never-never - all in all, it’s a potentially explosive cocktail.Roubini says that the Fed is, belatedly, alive to the danger. “To understand the Fed actions one has to realise that there is now a rising probability of a ‘catastrophic’ financial and economic outcome, ie, a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

“That is the reason the Fed had thrown all caution to the wind. Bernanke clearly feels that the clock has turned back 78 years to the early months of 1930. He is slashing interest rates because he fears that the Great Depression is just around the corner.

Consider. Until the early 1970s, the linchpin of the global economy was the Bretton Woods system of fixed exchange rates. Gold was fixed at $35 an ounce and other currencies were pegged against the greenback. Rising US inflationary pressure in the late 1960s led to the break-up of the Bretton Woods

system, and that was followed by a plunging dollar, leading to sharply higher import prices. To make matters worse, oil producers raised the price of crude, with the result that inflation went through the roof.

What we are now seeing is the break-up of Bretton Woods mark 2. The linchpin of this looser and less comprehensive system was the fixed exchange rate between the dollar and the Chinese yuan. By keeping its currency low, Beijing flooded the world with cheap goods and kept US inflation muted. That pushed down interest rates, but led to a massive US trade deficit with China and pushed up asset prices.

Politicians in Washington demanded that Beijing allow its currency to rise. And over the past two and a half years this is what the Chinese have done, in small and gradual steps. It’s not really surprising that they have done so, since the flipside of lower inflationary pressure in the west has been a build-up of inflationary pressure in China.

As a result, the writing is on the wall for Bretton Woods 2. Bernanke has sent out the signal that he cares far more about boosting growth than he does about fighting inflation, which is why the dollar has fallen and gold has gone up. So a return to soup kitchens and dustbowl economics should not be ruled out. — The Guardian