Professor Edmund Phelps said rich states all need to bring ballooning debts under control, but at a calibrated pace Photo: Alamy"Britain has jumped on the band-wagon of fiscal tightening in a big way," said Professor Edmund Phelps from New York's Columbia University.
"I have some sympathy with that but I'm not sure it is being implemented as deftly as it should be. If you slam on the brakes too hard you risk throwing the infant through the windscreen," he told The Telegraph at a forum of Nobel laureates on Lake Constance.
Unlike many Left-leaning critics of the Government's policies, Professor Phelps is in the free-market camp and director of Columbia's Centre on Capitalism and Society. He made his name refuting the "Phillips Curve" assumptions of the 1960s that policy-makers could exploit an easy Keynesian trade-off between inflation and unemployment.
His warning echoes arguments made by Shadow Chancellor Ed Balls and may cause some discomfort in Downing Street, especially after CBI data for early August showed the sharpest drop in retail sales for a year.
Professor Phelps said the rich states all need to bring ballooning debts under control, but at a calibrated pace. The US has been too timid. "To do just $100bn of tightening this year is nothing. The US is in a complete mess and it must move to a budget surplus in absolute terms," he said.
He compared the US task with Britain's plight in the late 1940s. "The question is how to pay for the 'war', which is what Keynes worried about, except this time the war was our own housing market."
Like other Nobel laureates in Lindau, he warned against a third blast of quantitative easing (QE) by the Federal Reserve now that US core inflation is creeping back up to 2pc.
"I was a supporter of QE2 to prevent deflation but that potential justification is no longer there. The Fed should remain very watchful and keep its finger on the trigger. If we get a cyclical contraction on top of a slump, it could be serious."
Myron Scholes, who won the Nobel Prize for theories on derivatives, said QE is a misguided attempt to disguise both a bank bailout and dollar devaluation.
"Ben Bernanke knows his pistol is close to blanks. He is trying to weaken the dollar but it is only so long before Japan, Switzerland and others figure out how to retaliate, and if there is QE3 they will start arming themselves," he told the Telegraph.
"The question is how unconventional will Bernanke be. Will he buy equities, or real estate, until the Fed owns everything? The more illiquid assets they buy, the more difficult it will be to unwind.
"I wonder whether Bernanke might not say that 'the Europeans are our friends, and we know that the European Central Bank can't print money to buy bonds because the Germans won't let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them'. It is something to think about," he said.
Mr Bernanke hinted at this during a 2002 speech on deflation that is widely view as his policy "road map" for in extremis. Buying EMU bonds would allow the Fed to drive down the dollar and stabilise Europe's debt crisis at the same time.
Professor Scholes said the eurozone has squandered its chance of making the system work. "They had the opportunity from 1997 to 2010 to think about how to make the euro work and create a fiscal union. They did nothing," he said.
"For a common area to work it has to be 'socialised' with common taxation and fiscal transfers. People have to think that Italians are the same as Germans, and can work in each other's country. There has to be a homogeneity of beliefs."
He said the West risks repeating the errors of Japan the longer it refuses to confront the mountain of bad debts and fails to clears the way for a new cycle of growth. "I think it would have been better to get it over right away, even though it would have been a huge shock to the system. We had this heart attack and they keep treating every other part of the body, the hands, the feet, or the ankles," he said.
Mr Scholes, known to many as the guru behind the LTCM hedge fund that came to grief in 1998, said the apparent calm induced by global policy makers and central banks during the bubble created a massive risk free illusion and primed the system for disaster. "If things can be too calm, and volatility too low, people stop worrying. The tiger looked caged, but the cage door was open."
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