I loved this analysis by Bill Gross of the current landscape for professional investors. You should read it, although it takes a technical point of view. It’s important because he studies how factors in the global economy will affect the investment landscape.

Now most ordinary people don’t really care about institutional investing, but they care quite a lot about the health of the global economy — sometimes even more than their representatives. And ultimately they care about investing, because the whole point of institutional investing is to create the funds that allow people to retire comfortably.

Mr. Gross (who runs PIMCO Funds and is probably the best bond trader in the world) is interested in how coming changes in the global economy will affect investors. I’m interested in how coming changes in finance will affect the global economy. From either point of view, the critical insight is this: the next several years will not see a reversion-to-mean, or a resumption of existing long-term trends. Rather the next few years will see fundamental change.

I’ve been saying since shortly before the financial crisis began in mid-2007 that we would see the end of highly-leveraged financing models. Gross adds the perspective that it’s specifically the growth in asset values, which has been funding increases in consumption and investment over the last several decades.

The old-fashioned way to finance business activity is to apply a lot of domain-specific knowledge and form an opinion about the potential returns of an investment opportunity. In other words, the value of a financial asset (and thus the interest rate at which the capital is to be lent) depends on the risk-adjusted returns one expects it to produce in the future.

But the modern way has been to value assets using mathematical models that compute risk statistically, on the basis of historical data. If the value of investments and of real assets (like houses) continues to increase, then the risk models suggest they will keep increasing. That enables people to borrow more and more money against those assets.

Stated that way, it’s hard to see how huge asset bubbles could fail to form! There are no built-in brakes to the process. Although this is far from the whole story of the current financial crisis, it’s a big part of it.

This leads us to the question I’ve been asking for the last two years: would the financial world return to mathematical risk modeling because it really doesn’t have better models? Or would theories like the “efficient markets hypothesis” start to recede in importance?

A much balder way to ask the question is: do free markets actually work? Or do they have fatal flaws built into them, which can’t be managed deterministically? If the latter is true, then we have no choice but to retreat to a world in which capital is much less plentiful and much more expensive. And in that world, economic growth across the world will necessarily be far, far smaller than it has been.

This in fact is the world which appears to be emerging. We’re now stuck in a global recession, which policy makers (including the G-20) insist on seeing as a cyclical phenomenon, treatable with standard policy tools. That’s why people like Barack Obama keep pushing massive fiscal stimulus as a way of “rescuing” the economy. But the global recession may not in fact be cyclical. The floods of money that various governments are creating may wind up creating nothing but stagflation, and starve the private sector of needed capital.

As I write, the world of finance is still frozen solid, with little or no net creation of new private credit. In fact, the US private sector continues to de-leverage, paying off debts, increasing personal savings, and not demanding any new credit.

Nearly every big-name economist and big-time policy maker is assuming that these effects are temporary, and will give way to a robust recovery. Meanwhile, extensive plans are being laid to re-regulate financial activities around the world, specifically in order to rein in the hyper-leveraged practices of the past.

That fact alone argues for an end to the practices of the last several decades, whether or not finance professionals choose to change those practices on their own. The long-term trends have gone into reverse. Where risk has been systematically overvalued (underpriced), the opposite promises to be true for the foreseeable future.

Much less capital will be available for risk-bearing asset classes like stocks, corporate debt, and real property. The stories everyone learns in basic investing classes (“over long periods of time, the stock market always gives superior returns, and your home always increases in value”) may prove wrong in the future. It will probably be the case that risk-free assets (such as government debt) will not return appreciably less than risk-bearing ones over time.

The result of all this is that considerably less capital will be available for risk-taking and thus for economic growth. This is a fundamental change that reverses the pattern of the past three decades. And since the developing world has been by far the greatest beneficiary of high global growth rates, they will be the ones to suffer the most.

The most appropriate policy which the government could follow would be to encourage higher returns on privately-invested capital. They can’t reverse the secular changes which are taking place, but they can attenuate some of the worse effects.

Unfortunately, our government is currently stuck in the view that the current crisis is like all the other recent ones, just a little bigger. The Keynesian response holds that government can effectively substitute public demand for private demand. And I’ll be the first to say it: that model can indeed possibly work. We can transform the US economy to a low-growth, government-directed model without creating massive hardship and unemployment. It’s far from ideal, but it’s not the end of the world. (A resurgence of trade unionism, however, would be extraordinarily destructive at this moment, by mispricing labor and destroying jobs.)

It would be far better to increase the risk-adjusted returns on private investments by cutting taxes on business and capital, and by pursuing a non-inflationary policy. And while I’m wishing, I’d also like a pony.

The policy choices we’re actually going to get, however, will give us a fragile, but more-or-less sustainable and government-directed economy. It’s very hard to imagine that the developing world can recover robustly in these circumstances. Expect to see a steady increase in international tensions over the next few years as hundreds of millions of people sink back toward poverty.