You can't solve problems you don't understand

The policy response to the credit crunch cannot succeed unless policymakers understand the problem they are dealing with. The system is suffering from classic duration mis-match but the response so far merely prolongs the misguided short-term thinking.

Policy and regulation in recent years have favoured borrowing and lending over saving and investing. This was supposed to deliver sustainable growth, but it was an illusion. It merely transfers growth from the future to today. FSA rules made it very cumbersome to put money into a pension or long-term savings, but amazingly simple to borrow money regardless of ability to repay the loans. This is the opposite of prudent policy. In a young population, debt has time to be repaid, but with a rapidly ageing population this cannot work. The Government too has borrowed irresponsibly from future taxpayers. Public spending has financed public sector consumption, not investment and the public sector pension liabilities are not even budgeted for at all! Yet these costs are inescapable.

We need to redress the balance of thinking between short-term and long-term. Duration mis-matches are responsible for much of the failed financial models that led to the crisis and my assessment is that a far more subtle and finessed approach is needed. Policymakers should consider the following:

100% guarantees should apply only to longer term deposits The authorities should only offer any 100% guarantees to deposits that people are willing to leave for a period of time not just overnight.

100% guarantees only apply to existing deposits? Taxpayer guarantees should only have applied to existing deposits, not to everyone else who transfers in after the fact. The authorities need concerted action to stop money whizzing round from bank to bank on rumour and fear. Whether it is too late to address this or not is a difficult question.

Not all banks can survive We need to encourage deposits to stay for a time while authorities examine bank assets to see which banks are solvent and which are not. Some banks will clearly have to be taken over, but even those that are relatively healthy are being undermined by the lack of proper information and the sheer scale of panic.

Cutting interest rates is not that important now. The problem is not the cost of credit but the availability of credit. Official rate cuts may just allow lenders to rebuild their margins rather than passing on the cuts.

Reform bonus systems in future Short-term profit maximisation undermines long-term stability. For example, bank bonuses should only be drawn down over a period of, say, 10 years and should be forfeited if profits are not sustained.

Unfortunately, the politicians are also being advised by many of the very bankers that got us into this mess in the first place. This is like allowing the addicts to control the drug counter. Everyone is addicted to debt and has been living beyond their means. We must find out who can afford to repay and who can't.

A recession is inevitable and long overdue. A period of retrenchment and removal of the excesses is essential but painful. It's not the end of the world.

Politicians should not pretend that they can prevent the downturn. Capitalism can only survive if there are some losers. This applies to the financial sector as well as everyone else. Banks and policymakers have operated in recent years as if everyone can be a winner, but this is impossible. Taking banks into public ownership just transfers the problems from private to public sectors but does not make it disappear. By all means take stakes in healthy banks if they need capital and the market won't provide it, but don't give blanket guarantees to failed business models.