What if this is not a financial crisis?

Three and a half years after the failure of Lehman's, Western governments are still running huge deficits. Interest rates remain at rock-bottom levels and central banks are printing more and more money. Yet unemployment is rising and wages fail to keep pace with inflation. What's going on? Professor Bruce Greenwald, of Columbia University, believes the treatment isn't working because the illness has been misdiagnosed - this is not a financial crisis.

If that's hard to believe, think back to 2003-2007. People spent so much of their incomes that savings rates went to zero. America had a construction boom. Britain had banking and public-sector booms. None were repeatable or sustainable. Yet we did not reach full employment and real average wages stagnated. Some boom.

Greenwald suggests this is no coincidence. To understand the financial crisis, you have to explain what went before. His explanation is the terminal decline of manufacturing employment. Rampant consumer, government and investment spending failed to deliver a boom because manufacturing shed jobs. We didn't notice because low interest rates enabled us to borrow to maintain our standard of living.

This problem has two causes. First, manufacturing productivity has been growing faster than output. So the value of manufactured goods has held up well. But employment has been decimated. Manufacturing jobs pay good wages for relatively uneducated people.

They've been replaced by jobs in consumer services retailing, fast food, call-centres which are poorly paid. Something similar happened in America in the 1930s, when the dying industry was agriculture. Mechanisation and fertilisers improved productivity. The same volume of food could be grown by fewer workers. Redundant farm workers, trapped by falling house prices, could not move for the few jobs available.

Austrian economists say other countries managed the transition better than the US. They claim government intervention turned a difficult situation into the Great Depression. President Roosevelt legislated to maintain agricultural wages. If he had let them fall, fewer jobs would have been lost. The Austrians may be right. But the decline of agriculture prompted the politicians to intervene as they always do to get elected and stay there.

The second part of the problem is globalisation. Manufacturing jobs have been moving offshore since the 1980s. That's why you can trace the origins of stagnant wages back to that time. At first, Japan was the main beneficiary. Latterly, it's been China, India and the rest of Asia.

Between 2003 and 2007, the US ran a trade deficit of up to 7% of GDP. That meant the rest of the economy had to grow by 7% per year just to stand still. Reversing globalisation is unlikely to work. Visit a Japanese car plant and you'll find it's all done by robots. There are jobs in support functions. But it now requires large amounts of capital investment to create relatively few manufacturing jobs.

This hasn't stopped British politicians making the case for manufacturing. But Greenwald's analysis suggests special treatment for the industry will just waste money. If the market won't create jobs, government-made jobs will be expensive.

So what industries could possibly replace manufacturing? Picking winners is ill-advised. The most likely candidates are education and health. They already employ many people and, arguably, Britain is competitive in these industries. But these jobs require qualifications. How are we to export health and education services while they're mainly in the public sector? America is more likely to gain.

We need a sea-change in government policy to encourage job creation, and especially job creators entrepreneurs and start-up firms. I'd start by eliminating employers' national insurance surcharge. It's extraordinary to tax jobs when we're so short of them.

We must sweep away job-destroying regulations. How about lower income and capital-gains taxes for entrepreneurs? Of course, politicians are unlikely to do this. Our leaders will persist with existing policies, which won't work. Consumer and government spending can't grow while there's still so much debt. Firms won't invest while consumers aren't spending. That leaves increasing exports or reducing imports.

You see why US politicians might favour import restrictions. Greenwald's analysis provides a kind of justification. Bashing China would be popular especially in an election year. Plus America is still capable of making stuff that is imported from Asia. Carefully targeted import restrictions might raise employment a little without starting a full-blown trade war.

But that's not true for a small open economy like Britain's. So we're left with weakening the pound to boost exports. Quantitative easing (QE) isn't helping much because nearly every other central bank is doing the same. Their governments have the same plan to boost exports. So expect the Bank of England to ratchet up the stakes in each round of QE until either it works or inflation soars.

James Grant, publisher of Grant Interest Rate Observer, likens inflation to tomato ketchup. You can shake the bottle for ages and nothing happens. Then suddenly, your dinner is drowning in the stuff. My advice? Own investments that gain from a weaker pound and rising inflation and buy Asian currencies and gold.

Simon writes the True Value newsletter . Contact 020-7633 3780.