The US recession that began in December 2007 resulted in 403,000 lost jobs in September, 320,000 in October and 533,000 jobs in November. Projections for 2009 are ominous.

The global financial system is undergoing a meltdown that has not been seen since the 1930s and nobody seems to know what to do about it. How did we get to this point and how can we move forward?

Since world war two, economic policy in most western democracies has been based on Keynesian economics.

But although policy makers still rely on Keynes’ ideas, academics gave up on his theories 40 years ago and went back to classical economics: Keynesian theory could not explain how unemployment and inflation can coincide. The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual.

The US stock market has lost 40 per cent in the past three months and this is a good performance by the standards of many global markets.

In classical economics, the prices of stocks are determined by fundamentals and the fundamentals of the economy are sound. The US had the same stock of factories and machines in August that it had in July and the US workforce has not been afflicted by a sudden attack of contagious laziness. Although Keynes didn’t manage to work out all of the details of his theory he was right on one point: In the real world; psychology matters for the behaviour of markets!

When households believe that assets are not worth much, they spend less; unemployment increases and the belief becomes self-fulfilling. This is why households and firms are not spending today; they are forecasting further falls in asset prices and there is a real danger that these gloomy forecasts may turn out to be correct.

We have seen economies stagnate for a decade or more in the past – the UK in the 1920s, the US in the 1930s and Japan in the 1990s – and it would be presumptuous to think that this cannot happen again when the existing dominant paradigm says that it could not happen in the first place.

Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.

It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory.

For much of the post-war period, the US Federal Reserve has been relatively successful at combating recessions by lowering the interest rate to stimulate aggregate demand. The policy was unavailable in the 1930s because the interest rate on treasury securities was already near zero, just as it is today. It is this fact that makes the current crisis more like the Great Depression than any other of the post-war recessions.

So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.

It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.

Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.

Critics will argue that this policy is dangerous socialist meddling. But I am not arguing that the government should pick winners and losers: only that it should stabilise a broad basket of stocks.

This policy would still allow poorly run firms to fail but it would not allow all firms to fail at the same time. Although the free market is very good at deciding how many left and right shoes to produce, it cannot prevent systemic risk that arises from the psychology of herd behaviour. This is a job for Uncle Sam.

Prof Roger E. A. Farmer is vice chair for graduate studies in the department of economics at the University of California Los Angeles and the author of two forthcoming books on economics: Expectations, Employment and Prices and How the Economy Works and How to Fix it When it Doesn’t