Jeremy Grantham, the chairman of US fund house GMO, believes craven central banks are setting the stage for prolonged troubles for western stock markets.

In a quarterly letter to clients, he writes, ôThe experiment in moral hazard is leading to a series of asset price bubbles, any of which might float out of control.ö

He believes each crisis over the past decade, from the Asian financial crisis to the tech bust, has produced or facilitated the next one, culminating in this summerÆs subprime debacle.

And yet each bailout (such as the Federal Reserve BankÆs slashing the federal funds rate to 1% in 2001) seems to only excite western stock markets. He notes that announcements of massive write-downs by banks such as Citibank, UBS and Credit Suisse have only led to rallies in stock markets, with investors apparently feeling this meant the worst was over.

Central banks in Europe and the United States have actively encouraged such activity by flooding markets with liquidity, and, most egregiously, the Bank of EnglandÆs decision on September 18 to bail out depositors at Northern Rock.

So equity markets in the US and Europe have closed the third quarter on a positive note, which Bentham finds amazing, given problems in the housing market, slowing corporate profits, a weakening dollar and the credit crisis.

Market participants justify this because the bad news has apparently been factored into stock prices. Bentham writes: ôLetÆs consider what [the market] is discounting: presumed continued dollar problems, almost certain housing weakness, slower economic growth in the US and Europe, weaker estimated profit growth in the US, higher commodity prices and more global pressures on inflation.ö

Acknowledging that were he in the shoes of central bankers, he might have made the same call, Bentham asks why central banks allowed the markets to get into this corner in the first place. His analysis of policy: ôTo let bubbles form unimpeded and yet to move to cushion the subsequent decline is a simple and workable definition of moral hazard.ö

For the first time in 20 years, he is worried about inflation, he says. One long-term factor is that aging societies in the west and in China will lead to shrinking workforces û and therefore to tighter labour markets and higher wages. This may be good for union workers but could spell trouble for equity and real-estate markets, he suggests, although he suspects that the bears wonÆt really bite for another 12-18 months, thanks to the short-term lift from loose monetary policy.

So what are investors to do? ôWe recommend continued extreme caution,ö Bentham writes. ôThe best hedge against the career risk of being too conservative remains emerging-market equity, overpriced but still attractive on a relative basis.ö