The ancient Roman playwright Plautus once remarked: "I am a rich man as long as I do not repay my creditors." Across two millennia his observation captures a lot of the mechanism behind the surging good times in the several years before 2008, and the subsequent crash.

In the good times, American, British and other consumers bought more than their incomes could allow, financing the balance out of money borrowed against rising house prices.

Once the creditors became fearful of not being repaid they stopped lending, tried to claim the collateral, and the process went into savage reverse.

Now the bankers are enjoying their own Plautus moment. "We are rich men as long as we get almost free money and guarantees from the government."

The International Monetary Fund estimates that developed country governments have provided an average of about 30 per cent of gross domestic product in support for the financial sector in the past year. Never before has one sector received such massive support - and even more remarkably, support in return for almost no conditions on what the bankers do with it.

Meanwhile, the outlook for output and employment is gloomy in much of the West. Even economies that seem to be in recovery, like Japan, Germany and France, are having a jobless recovery.

To understand why, think of a household as a car. When the household borrows it is stepping on the accelerator. But borrowing also loads up the car with debt. When the household stops borrowing it takes its foot off the accelerator and the car not only slows, but slows much faster than otherwise because of the accumulated weight of debt. When the household starts to repay the debt it is stepping on the brake. Replicated across an entire economy, braking the car causes a multiplier process of lower spending, job losses, business failures, and bank failures.

What should be done? Wisdom begins by recognising that the financial sector is a service sector, akin to transport, electricity and sewerage, and should be judged by how well it performs this function.

There is no plausible justification for the US financial sector's share of total corporate profits rising from 16 per cent or less in 1973-1985 to 41 per cent through the 2000s. Nor for remuneration in finance to be so much higher than in comparable professions (almost 200 per cent higher according to a recent study which compared earnings of Harvard graduates who went into finance with those who went into law, medicine, and non-financial business).

Banks should be required to maintain higher levels of capital than in the past, the level graduated so as to rise in good times and fall in bad times. This is also a good way indirectly to limit super-profits and bonuses less controversially than through an incomes policy.

Banks should be prohibited from owning and trading risky securities on their own behalf using borrowed money. This is the key practice that got big US banks into deep trouble in 2008. They became addicted to it because it provided most of their profits - and most of their bonuses.

The key step is to reinstate a clear separation between commercial (or "utility") banking and investment ("casino") banking. Commercial banks should take deposits, manage the payments system, make standard loans, and even trade securities on behalf of clients (but not on behalf of themselves). They should be rescued by governments when they fail, but their managers should face the same penalties as managers in other industries.

Investment banks should not be rescued, they should be liquidated when they fail, and the government should use competition rules to ensure that none are too big to fail; too big to fail means too big to exist.

Governments of small economies with their own currencies, and those of "emerging markets", should manage flows of capital across the national border. The dangers of unrestricted flows are only too apparent right now, as overflowing money in the US and Britain rushes in to these economies at record levels - overvaluing the exchange rate and blowing up asset bubbles.

The IMF should reverse its prescription for all countries to liberalise inflows and outflows of capital. It should recognise the wisdom of Hans Morganthau, the US Treasury Secretary at the time of the Bretton Woods negotiations in 1944. He said that the aim of the negotiations was to put in place a set of international economic rules which would ensure that the system never again fell prey to international speculators, as in the 1920s.

The Bretton Woods system, with limited private capital flows as one of its pillars, served the world well for several decades after World War II. In particular, it helped to ensure stable growth of trade, without the disruptions to exchange rates caused by volatile capital flows.

Western nations may well be in for a period of sustained turbulence over the next decade, fuelled by income inequality, fiscal austerity, energy uncertainty, the rise of large, super-competitive non-Western states, climate change, and the need for far-reaching respecialisation of Western economies.

Elites who have made money hand over fist during the good times (the share of US income accruing to the top 1 per cent of the population rose from 9 per cent to more than 22 per cent between 1980 and 2006) may try to impose authoritarian, even fascistic rule to defend their privileges.

The question is how more generous social movements can counter them.

* Robert Wade, a New Zealander, is professor of political economy at the London School of Economics and Political Science. He will give the Bruce Jesson Memorial Lecture at the Maidment Theatre, Auckland University, today at 6.30pm.