As I write on Monday morning, prices for US Treasury securities are sharply higher again, and the yield curve is flattening. Meanwhile, commodity prices are falling, and the US stock markets will open lower. There’s no denying that we’ve seen a significant change in market psychology since mid-May. The first evidence of a shift came then, as it usually does, in the capital markets, with a huge upward spike in 10-year interest rates. You may remember my dispatches from that time. It was evident that the selling in notes and bonds was a response to technical factors (specifically, a change in how mortgage investors hedge their portfolios).

At the time, the media and many commentators focused on the idea that massive inflation was in the future, as the US government steps up its issuance of debt securities to fund the Obama Deficit Machine. As usual, when everyone agrees about something, that’s a cue to consider whether the opposite is true. Sure enough, the bond market break had run its course by mid-June, and we saw the beginning of the upswing in debt prices that continues today.

The accompanying change in sentiment has also been evident in the stock markets for the past several weeks. The 30% rally which began in early March has stalled out, with the S&P 500 now trading well below 900 (a couple of months ago, many expected to see that index at 1000 by year end). Broadly speaking, the sentiment last spring was that the end of the extreme financial disruptions would quickly clear the way for a robust recovery in the global economy.

This case never really made any sense. The extremely strong economic conditions that prevailed earlier in the decade were the result of a massive credit bubble, and you don’t recover from those easily. The widespread deleveraging that has taken place in global finance can’t help but be reflected in global economies. Relatively weak conditions are settling in for a long stay, and this realization is finally coming to market participants. The “green shoots” are weeds.

As I’ve said on numerous occasions in the past six months, the bond markets are still undecided whether the next large move will be inflationary or deflationary. This has been a singularly difficult question to answer because the tea leaves keep rearranging themselves. We’ve seen several multi-week cycles this year in which the prevailing view shifts from one side to the other.

In my opinion, the signs are now pointing more strongly toward deflation. Or in other words, to the next leg downward in the collapse of the housing bubble. The heroic efforts of government policymakers to deny reality and act as if they can forestall a necessary readjustment appear to be fizzling out. And the behavior of policymakers is an important clue to this situation. As usual, the focus falls on the mild personage of Fed Chairman Ben Bernanke.

I can’t call to mind a single historic episode when the collapse of an asset bubble was meaningfully mitigated by government authorities. It’s easy enough to say that they haven’t had the tools or the understanding to do so, but it’s more accurate to say that national politics works strongly against doing the right things. When trade and/or credit imbalances finally readjust, lots of people usually suffer a lot of disruption. The right response is to stanch the bleeding and treat the wounds, but let the disease run its course. That’s the kind of thing that no politician has an easy time doing.

In this case, we have Ben Bernanke, who it’s quite safe to say is the world’s thought-leader in the management of this crisis. And Bernanke, having studied for years the policy responses to the Great Depression and the Japanese Lost Decade, has been saying from the beginning that we must avoid the key mistakes of those episodes. In particular, policy responses must be massive and rapid. I promise you, people will be writing dissertations about the Bernankian Response for decades to come.

At this point, half of the verdict is clear. Extremely large interventions in capital markets, including near-blanket guarantees of private obligations, have prevented a global market meltdown that would have been a historic catastrophe. These responses were initiated at the outset of the financial crisis in 2007, and accelerated last September. (I suppose that means President Bush should get credit for them, no? [ed note -- No.])

But I had an interesting argument with a friend yesterday who is involved in politics. She asked me if the operations to save the banking system worked. I said yes, certainly. The world’s largest banks are no longer in danger of a cascade of collapses, as was threatened by the failures of Bear Stearns and Lehman Brothers. A moment later, she referred to this as a good thing, and there I stopped her. It worked, yes, but was it good? Only if you believe that it’s good to have a large raft of all-but-nationalized financial institutions kept fat and happy by exceptionally high reserve levels, and with no economic incentive to actually do their job, which is to intermediate credit, not to lobby Congress for higher salaries and bonuses. What Bernanke did was necessary to prevent a systemic collapse, but the aftermath isn’t pretty.

Still, that’s only half of the story. While the financial system has been rescued, the real-world economy is still in a deep funk. And it’s going to stay there for a while, because we all have to work off the effects of the credit bubble. Here, the policy responses of the Fed, the Administration and Congress are being less successful. But they won’t stop what they’re doing, because politically that would take a lot more courage than Barack Obama has.

As with so many things in this big-government renaissance, the basic assumptions at work were accepted without question and with barely any debate. Following Bernanke, policymakers simply assume that it’s possible to forestall widespread deflation with rapid, decisive action. Hence, the massive fiscal stimulus (soon to be stimuli, plural), the Fed’s quantitative easing program, the borderline-insane mortgage-support proposals coming from Congress and the FDIC, the largest peacetime budget deficits in history, and the continued pressure on bond markets to provide the cash. The basic idea is that we can stop the collapse of a credit bubble by blowing it back up again.

If this works, I’ll be the first to tip my hat to Ben Bernanke and the intellectual revolution he has founded. But it will be a repudiation of centuries of financial history. What’s far more likely to happen is that the massive reflation efforts will work for a time, possibly for years, possibly for a decade. In that time, some fundamental aspects of global finance and trade will need to be repaired. Two that spring to mind are the bad habit of Americans to spend beyond our means, and the worse habit of China and other developing countries to respond to our overspending by undervaluing their currencies and allowing their economies to overexpand.

The pathway to success for Bernankeism is all about buying time to reset the underlying imbalances. But it’s an extremely dangerous game because the tools of Bernankeism (and Obamian deficit spending) are all about giving us far more of what made us sick in the first place. If we can fix the basic problems before the painkillers wear off, we might be all right. If not, the game will end in a deflationary episode that could rival the Thirties.