July 17 (Bloomberg) -- The worst crisis in modern financial history is set to culminate in an ideological clash, pitting the Federal Reserve against the European Central Bank in a debate that will shape the global economy for at least the next decade.

The catchphrase that will dominate central bank meetings for the rest of the year is “exit strategies;” now that the markets are showing some semblance of normality, how quickly should they be unhooked from the life-support systems that have transfused the banking system with government funds?

Act too quickly in raising official interest rates and reversing the flow of liquidity, and economies might slump back into recession, bringing Federal Reserve Chairman Ben Bernanke’s well-documented nightmare about deflation to life. Wait too long, though, and the seeds of the next crisis may be sown as policy remains lax and encourages yet more financial bubbles that will inevitably burst.

The outcome seems binary; our unelected guardians of stability will either awaken the ghost of inflation past, or condemn us to a deflationary spiral. Unfortunately, the most unlikely result seems to be a return to the Goldilocks economy of not too hot, not too cold that endured for a decade.

Maintaining Medication

Ideally, policy makers will act simultaneously around the world, with concurrent elimination of emergency measures. Moreover, ending the different kinds of local therapy being applied, via taxes, interest rates, distressed-debt purchases or whatever, should keep a balance, with some medications maintained while others are withdrawn. Finally, the cessation of crisis policies must not leave business short of credit; the liquidity can’t just end up in the hands of the banks, it must flow into the economy -- otherwise, what was the point?

None of this will be easy. Russell Jones, the head of fixed-income strategy at RBC Capital Markets in London, summed up the quandary in a research note this month. “History suggests that after severe financial traumas and the painful recessions that follow them, macroeconomic policy support should not be removed too soon and tightening monetary and fiscal policy simultaneously can be particularly hazardous,” he wrote.

The battle lines are being drawn. On the Keynesian side of the equation is the Fed (with an acknowledgment that these are strange days indeed when the U.S. seems more left-leaning than mainland Europe), under a new president who has no qualms about spending public money to either prop up or appropriate private companies, much as John Maynard Keynes might have advocated.

Keynes Versus Friedman

On the other is the ECB, sired as it was by a Bundesbank inculcated with memories of German hyperinflation in the 1920s, and much more in tune with Milton Friedman’s warnings that inflation is always and everywhere a monetary phenomenon.

“Preparations for exit are important,” ECB President Jean-Claude Trichet said in Munich earlier this week. “I would warn against a common and unfortunate view suggesting that it is currently too early, or even totally inopportune, to envisage appropriate exit strategies. Such a view is, in my opinion, plain wrong.”

Contrast that with comments from Federal Reserve Bank of San Francisco President Janet Yellen, who said at the beginning of this month the prospect that policy makers will leave the benchmark U.S. interest rate near zero for the next several years is “not outside the realm of possibility.”

Given the recession’s severity, “we should want to do more,” she said. “If we were not at zero, we would be lowering the funds rate.”

History Lessons

Deutsche Bank AG’s economics team, led by Peter Hooper in New York, wrote in a research report this week that the Fed must take care not to repeat past mistakes. In the 1930s, for example, the central bank talked itself into raising reserve requirements for lenders once it felt the economy was rebounding, stifling credit to companies and sabotaging growth.

At the beginning of this decade, by contrast, the Fed’s efforts to suppress borrowing costs helped inflate the credit boom, the Deutsche Bank economists wrote. “Getting the exit right from a massive dose of government support for and incursion into the private sector can be an exceedingly difficult task,” they said.

The Fed seems more concerned about the former than the latter. “We’re not going to repeat the classic mistake that the U.S. made in the 1930s and that governments around the world have made in financial crises, by at the first sign of hope putting the brakes on prematurely,” U.S. Treasury Secretary Timothy Geithner said this week.

Scary Words

Those are scary words for the growing crowd who expect money supply -- that economic relic we all used to scrutinize in the bygone years before central-bank minutes and inflation targeting -- to come back into fashion with a vengeance.

It may mean, though, that investors have a clear choice. Buy dollars, on the basis that preemptive ECB action will strangle the European economy and you don’t want to own the currency of a region in trouble. Or buy euros, on the grounds that higher ECB rates will deliver a higher return at a time when the U.S. is willing to debase its currency and risk blowing bubbles. Either way, sitting on the fence waiting for Goldilocks doesn’t seem like an option.

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net

Last Updated: July 16, 2009 19:00 EDT