LONDON How naive many of us were last autumn to have thought that the collapse of the British bank Northern Rock and the onset of the credit crunch would wash through the system in nine to 12 months and then it would be back to business as usual, with the banks having put their houses in order after a stern dressing-down from politicians and regulators.

Last week`s tumultuous events on the financial markets tell us something quite different that the world is a hugely changed place and that the legacy of the near meltdown of the global financial system will be with us for a long time to come.

In a just a few days, we witnessed the biggest economic crisis since the Great Depression although, thankfully, confidence has been temporarily restored by the swift and decisive action of politicians and central bankers, who have learnt a thing or two from the 1930s when the authorities displayed extraordinary ineptitude.

The changes afoot are both geopolitical and financial. Confirmation that one of Wall Street`s most pre-eminent investment banks, Morgan Stanley, headed by John Mack, is in talks about selling a 49 per cent stake to the China Investment Corporation is a development that is rich in symbolism.

Communist China, the new superpower of the East, is coming to the rescue of capitalist America, which must pick up the tab for years of reckless lending by the banks, consumer excess and light-touch regulation that allowed the explosion of derivatives to go unchallenged and which brought the world economy to the brink of disaster.

China has accumulated billions in foreign reserves while America has effectively bankrupted itself; it cannot be long before the Chinese are welcomed into the US to buy stricken assets that were previously considered national icons General Motors and Ford look particularly vulnerable.

In a nutshell, the crisis has underlined the fact that US power is ebbing away and that free market fundamentalism has become an ideology that is beginning to look as outdated as the Leninist doctrine of democratic centralism. The financial repercussions will be no less far-reaching. Just consider what has happened over the last seven days HBOS, the biggest mortgage bank in Britain looked as if it could go down, while Wall Street was shaken to its foundations by the demise or rescue of leading investment banks Lehman Brothers, Merrill Lynch and Morgan Stanley. Bear Stearns, led by Jimmy Cayne, you may remember, disappeared after the Federal Reserve engineered a rescue by JP Morgan back in March.

With luck, American Treasury Secretary Hank Paulson`s plan for Washington to remove bad debt from US bank balance sheets will restore calm - and some semblance of stability.

But banks will still be reluctant to lend, as they must rebuild their balance sheets and meet new, tougher capital requirements that are being drawn up to prevent a repeat of the credit crunch in future. That means the cost of debt will remain high for businesses and mortgage borrowers. Credit will be sucked out of the economy, stifling economic growth. Without a strong and vibrant financial sector, a modern economy cannot function properly and the wheels of commerce are bound to turn more slowly; a contraction of credit will dent consumer spending, prevent businesses from expanding and lead to a rising tide of bankruptcies.

When the cycle turns, however, banks are going to behave very differently. They will be more risk-averse, which is a good thing if it means an end to irresponsible lending; and they will be regulated more heavily than at any time since the Second World War. Again, that will be a plus, as what the crisis has demonstrated is that banks cannot be left to their own devices.

In particular, financial products such as derivatives will need to be vetted and approved. Why should we not require the same level of safety from our banks as from the makers of home appliances such as kettles, to ensure that they don`t blow up in our faces?

Although short-sellers aggravated an already fragile trading environment, HBOS and the American insurance group AIG, rescued by the US authorities last week, ran into trouble because they strayed into the uncharted territory of credit default swaps, collateralised debt obligations, mortgage-backed securities and other exotic products. That allowed them to expand their business by creating a huge new industry that gorged on itself, but it was one that was built around `funny money` because in the end many of these weird and wonderful instruments weren`t worth the paper they were written on.

Heavily regulated, the reformed banks possibly shorn of a bonus culture that has encouraged greed and short-termism and which played a major role in bringing about both a credit boom and housing bust will inevitably make less profit, but this will be a boon for financial stability and restore prosperity. Sadly, we are not there yet Paulson`s $1 trillion bail-out of the banks looks like a masterstroke, but it carries considerable risk as it undermines the US balance sheet and could lead to another precipitous fall in the value of the dollar and, with it, a further decline in US prestige.

Finally, there is the sickly housing market on both sides of the Atlantic. It lies at the heart of the current global financial firestorm, and there are few signs that we have reached the bottom. This is a crisis where there simply aren`t any quick fixes. Don`t let anyone tell you otherwise. — Dawn/ The Guardian News Service