The credit binge is over – we’re going back to an older business world: Kohler

The short-term calls these days are not too hard: every time a central bank or government puts off a reckoning by printing or borrowing money, or by whacking taxpayers with the bill, the market rallies (phew). Any sign that the bozos in power are facing reality, down go the indices. For a while it was all about the US, the debt ceiling and QE, now it’s all about Greece, Slovakia, and the EFSF.

The pattern has been established for two years, although the trading range dropped by 15% three months ago to adjust for the greater risk of recession caused by declining business and consumer sentiment – caused, in turn, by consumers and business people watching TV and reading newspapers and websites and observing the total incompetence of the mob they had put in charge. As one headline put it: “If you’re not depressed, you haven’t been properly briefed.”

But the longer-term call is much more difficult because very few people have been around longer than 30 years, and these past three decades have been very unusual. In fact, it’s likely that the period since 1982 was an aberration in the history of the planet; what that means for the next 10 or 30 years is impossible to predict.

A lot of people refer to the “new normal” these days. But what’s if it’s actually the old normal revisited?

I started work as a finance journalist in 1970 when the All Ordinaries index was 400. I did a cadetship for a few years, travelled around, got married and returned to Australian 1979. The All Ordinaries was 400.

The seventies was a lost decade, largely because of the oil shock of 1973 and the stagflation that followed. But the most significant event was not the Yom Kippur War, but President Nixon’s decision in December 1971 to remove the US dollar from the gold standard so he could pay for the Vietnam War.

The Bretton Woods monetary system had been in place since the end of the Second World War, during which the US dollar was convertible into gold at $35 an ounce and other currencies were pegged to the dollar. In fact gold and silver had been the basis of money for the entire history of the world up to that point; Nixon’s action in 1971 began a whole new world of fiat (government determined) currency.

But even before then most governments had been abandoning monetary discipline.

The teachings of JM Keynes were already being perverted by politicians seeking to expand welfare programmes and maximise employment. Keynes did preach fiscal expansion to combat downturns, but he also warned of the need to balance the budget over the course of the cycle; only Australia still bothers with that.

After the end of Bretton Woods, governments and the private sector began a long orgy of borrowing, spending the wealth of future generations to bolster living standards.

During the 1970s the cash was scooped up by oil exporters of the Middle East, but after Paul Volcker caused the recession of 1981 to squeeze inflation out of the system, the oil price fell and the global bull market got underway.

Then in August 1987, President Reagan had appointed a weird acolyte of Ayn Rand as chairman of the Federal Reserve Board. In his book Griftopia, Matt Taibbi calls Alan Greenspan a “one in a billion asshole” and convincingly argues that he is “the key to understanding this generation’s financial disaster”.

Greenspan’s adherence to Randian free market extremism led to two decades of loose monetary policy that inflated a succession of bubbles, culminating in the US housing and credit bubble that collapsed in 2007.

And as I pointed out on Wednesday, he also colluded with the President of Citibank, Sandy Weill, to get the Glass-Steagall Act repealed in 1999, freeing the commercial banks to move into investment banking and trading in their own right.

Anyway, the 25 years from 1982 to 2007 saw a vast expansion of credit, including a blow-off in the final five years that saw credit expand at triple the normal rate, thanks largely to the innovation of ‘sub-prime loans’ packaged into fraudulent instruments with the connivance of ratings agencies and sold to investors rather than retained on bank balance sheets.

Looking back, it’s plain that this period was not ‘normal’. Among other things, credit expansion resulted in very high valuations for equities, so that when analysts point to long-term average price earnings ratios of 15 or so, they’re referring to an abnormal period. During the 1970s for example, the average PE was below 10.

There were, of course, credit expansions and asset bubbles under the gold standard before 1971, but they were always short-lived. The elastic band of gold convertibility and balanced budgets always snapped the system back.

This time it went for the longest time in history. What does that mean for the future? No one knows. Anyone who says they do know is making it up.

One thing is for sure: the debt will have to be dealt with – either repaid or written off. In the meantime there will be less economic activity and prosperity than there was while the debt was being built up.

That’s because the bubble lifestyle of that 25 years was all about borrowing prosperity from the future, and the future has now arrived.

This article first appeared on Business Spectator.