“It can’t happen here.” Those are famous last words uttered by people who build on tropical coasts just before a hurricane, tidal wave, earthquake or volcano ravages their happy homes.

Economics is no exception. Back in 1929, just before Wall Street stocks took their long-time dive, President Herbert Hoover’s blue ribbon commission declared, in effect: The future is serene. Business cycles are only the historic growing pains of capitalism. But now we are in a New Era.

There followed, however, a whole decade of global miseries: unemployment on a massive scale; bank failures in the thousands; home mortgage foreclosures and bankruptcies in the millions.

Ancient history? And therefore irrelevant history? Not quite.

Most of my readers were alive during Japan’s so-called Lost Decade. That qualifies as a long, long slump. (Actually, Japan’s economic malaise has extended well beyond the 1990s. Up to the present day, she has not regained the positive interest-rate levels that prevail globally; and where her peers need to fight to fend off undue inflation, Japan still struggles to end her post-1990 deflation.)

But only history specialists know that in the 1920s, following the post-World War I global recession, Japan alone had already suffered an earlier lost decade. This stress period not only challenged its western-style democracy, in a subtle sense it can be argued that it was the seed that generated the 1941 Pearl Harbor escapade. Moral: Lost decades breed political unrest and create dangerous geopolitical neighbors.

The reason I am revisiting the above banalities is to help us understand and resolve the upcoming fundamental debates both in America and abroad. Willy-nilly governments everywhere — and that includes central banks, fiscal treasuries and SEC-type regulators of financial markets — will inescapably have to move in to help heal the grave new wounds in our financial systems.

Important query: Should the state’s role be confined to (1) the central banks’ setting of official short-term interest rates on the shortest and (safest) government bonds; and (2) limited short-time programmes of budget deficit spending?

In ordinary, moderate ups and downs of economic cycles, those conventional weapons do their job pretty well. But they were not enough in turn-of-the-century Japan. Nor were they enough when they were reluctantly tried in the 1929-1939 Great Depression.

The world currently is living through hybrid stagflation — weak jobs and profits coinciding with accelerating price-level inflation. Because of the earlier 1970s supply shocks from oil and harvests, stagflation is today pretty well understood.

There are no perfect rules for the needed government interventions to follow. Like an imperfect dictionary that is better than no dictionary at all, I dare to nominate some prudent considerations:

1. The foolish home buyers who signed up for homes they could never afford must not be compensated for their foolishness.

2. The rashest lenders — whether they are sleazy mortgage brokers or Bear Stearns Investment Bank or Merrill Lynch — should not and cannot be made whole. Only their best collaterals, which may be temporarily (!) illiquid because of the financial panic, should be taken over by governments. Warren Buffett, canny multi-multibillionaire, provided one stratagem when he offered to take over the good assets of rash insurers of bonds and loans. They refused such an offer because they had hoped to use their good stuff to be a skeleton key to open the door to a government bailout.

3. Most of the proposals so far suggested in America and in Europe only provide short-term relief for borrowers and lenders. That only puts off the evil day, because it could be a long-term help only under the dubious hope that housing prices will soon be rising once again.

This ignores fundamental truth. Because housing and commercial building are themselves so long-lived, one must accept that for a considerable number of years real-estate markets may well still be falling markets.

Luckily, by November 2008 the elections will replace the Bush-time legislators and cabinet heads with a less incompetent new set. Realism prevents one from being confident that a change of the party in power will easily and quickly do what will be needed to restore some stability for financial markets here and abroad. But better, though less than the best, still beats recent bungling.

(C) 2007 Tribune Media Services

(Businessworld Issue 1-7 April 2008)