The last 15 years in global markets have been marked by one consistent factor: the ready availability, even overabundance of capital. Returns to investors have been driven down to dangerously low levels, both in debt and equity, by over-expansionary monetary policy, while asset values even after crashes have been far higher than their historical norms. Yet this insouciance about capital, this preparedness to waste it in one feckless bubble after another must have an inevitable result: at some point in the near future we will face a world of capital scarcity, like the late 1930s in the United States, the early1950s in Europe or the 1980s in Latin America.

The explosion in global liquidity is apparent in domestic money supply statistics, but becomes even clearer when international central bank reserves are tallied. In 1995, global central bank foreign exchange and gold reserves totaled $1.39 trillion, approximately 4 percent of a $33 trillion world economy. In the first quarter of 2010, reserves totaled $8.3 trillion, approximately 14 percent of a world economy that had grown to $60 trillion. The rate of increase in global reserves was 6.8% per annum in 1995-2000, when the global economy was expanding at a rapid rate and the Asian crisis had increased Asian’ countries desire for liquidity. However reserves increased by 16.4 percent per annum in the ten years from the first quarter of 2000 to 2010 – a period in which the world suffered through two debilitating recessions. Liquidity in central banks alone has increased by 3½ times as a proportion of the economy.

This isn’t a “savings glut” as the foolish Fed chairman Ben Bernanke would have us believe. It is almost unrelated to private savings, because few private individuals hold balances in their central banks. It is instead a liquidity glut, caused by the manic monetary expansion of the Fed and its sister central banks. The world’s central banks are holding far higher cash balances than they have traditionally needed to provide liquidity for their country’s cross-border transactions.

This global liquidity glut has led to bubble after bubble, first in tech stocks, then in housing, more recently in commodities and most recently and gigantically in US Treasuries. The last-mentioned is perhaps the most perplexing bubble of all. With inflation substantially positive and threatening to be accelerated by rising commodity prices and the import of Chinese and Indian inflation, and the U.S. Treasury running record deficits and threatening to increase them further, it is irrational for 10-year U.S. Treasuries to trade on a yield little above 2.5%. Only the global liquidity glut has made such pathetic real returns, with substantial risk to principal from both interest rate moves and potential default, appear attractive.

The traditional safety valve against excessive creations of liquidity, the emergence of galloping consumer price inflation, has not taken effect because of the upsurge since 1995 or so in international outsourcing enabled by the Internet and modern telecommunications. That holiday from inflationary history may now be coming to an end. Galloping inflation in India and wage increases in China are increasing the prices of outsourced goods and services in their two most important countries of origin. Thus consumer price inflation will shortly return with a vengeance.

More interesting however is what the end of this period of monetary madness will mean for capital availability. It will inevitably involve a massive destruction of the capital that has been so abundant. We are already seeing the beginnings of this in the housing market, where additional liquidity was expected to prevent the tsunami of mortgage foreclosures, but appears to have done little to achieve this. Now house prices in both Britain and the United States are resuming their descent to a ‘true’ bottom and further waves of foreclosures will surely follow.

Each foreclosure represents a loss of capital in two directions. First, the homeowner loses whatever equity he originally put into the house. In the early part of the downturn, this was very often zero, but as we get deeper into the home mortgage pool and the price declines get bigger, foreclosures will often be affecting homeowners who put in at least 5%-10% of the purchase price (plus very substantial closing costs) as down-payment, if not the full traditional 20%. Second, the lender, whether a traditional bank or a group of investors in a mortgage pool, loses not only the home’s decline in value during the downturn, but also the additional cost of a forced sale, together with the substantial legal and other costs of foreclosure. In other words, the capital lost through foreclosure is much greater than the simple decline in price of the asset.

Now imagine a situation in which inflation has reappeared, and the Fed and other monetary authorities have been forced to tighten interest rates to fight inflation. The prices of government bonds will decline, to take account of new higher yields. Some countries and highly leveraged companies will get into difficulties, forcing a further write-down of their debt obligations. Commodities prices will decline, as the cost of holding inventory will have substantially increased and there will no longer be the chance to speculate at very low financing cost. And finally, global stock markets will decline sharply, both because corporate earnings will be adversely affected by the new higher financing costs (the rise in US corporate earnings in the past decade has itself been a bubble) and because rising bond yields will deflate mechanical valuation models, thereby reducing price-earnings ratios.

With all these price declines, the level of distress in debt markets will be substantial. The enormous hedge fund industry, which relies so heavily on leverage, will discover that its assets have become worth less than its liabilities, and so many hedge funds will be forced into default. Private equity, which has benefited so enormously from the excess of capital availability and the consequent ease of leverage, will find its leverage going into reverse, as earning power declines, leverage costs increase and leverage availability declines – there will thus be a wave of costly bankruptcies here too.

The costs imposed by bankruptcy will quickly demonstrate there to be substantial hysteresis in the leverage cycle. Leveraging up to the eyeballs and then going bankrupt is not a cost-free process, so the economy has less capital at the end of it than it had when it started. That is to be expected; capital has been hugely misallocated in the 15 years of cheap money, and the cost of that misallocation will itself reduce the capital stock once proper valuation metrics reassert themselves.

If the destruction of capital in the downturn will be greater than the creation of capital in the upturn, then by the time the downturn bottoms out we will be in a capital-short world. This generation has very little experience of such an environment. The Great Depression destroyed immense amounts of capital, as did World War II, but their effects were uneven. The Great Depression’s destruction was focused on the United States, Germany and some emerging markets such as Argentina, where capital destruction had been greatest – Britain had little capital destruction and enjoyed excellent economic performance during the decade. Conversely World War II’s capital destroying effects were concentrated in Britain, Germany and Japan, but not in the Soviet Union, which benefited from immense Allied shipments and from looting East Germany and eastern Europe. Most spectacularly, capital was not destroyed in the United States, where war profits were combined with profits from asset stripping British companies at knock-down prices (the looting of American Viscose will not quickly be forgiven!)

Nevertheless, even in the United States, the price-earnings ratio on the New York Stock Exchange was a mere 7 in 1949, implying an investment hurdle rate of more than 10% after tax, while in Britain, Germany and Japan remained capital-short for a decade after the war. Indeed in Britain, where high taxes prevented capital bases from being rebuilt, the economy suffered from chronic underinvestment until the late 1980s.

The era of capital shortage that remains within living memory is Latin America in the 1980s. The Latin American effective default of 1982 both cut off outside sources of capital and imposed immense losses on Latin American domestic investors. Consequently, as pointed out by the Center for Economic and Policy Research’s Mark Weisbrot in 2001, Latin America suffered economic growth well below par in the 1980s and 1990s, even though economic policy was vastly improved in most countries during those years.

The correct conclusion is not Weisbrot’s: that protectionism, import substitution and nationalization represented a superior policy mix to the free market; it is that capital shortages have a very severe effect on economic growth, in some cases such as Mexico and Venezuela preventing productivity growth altogether. The Conference Board’s Total Economy Database demonstrates that between 1981, the year before the default, and 2000, a period of generally rising prosperity, labor productivity declined by 1.5% annually in Venezuela and 0.6% annually in Mexico, while even in Brazil it rose by only 0.6% annually. More free-market oriented policies and lower inflation in all three countries was unable to overcome the effects of capital shortages.

In a world of capital shortage, the countries where the shortage is least acute will do best. France, Germany and Italy, with double-digit savings rates, will outperform Britain, the United States, Canada and Australia, whose savings rates have consistently lagged. Japan, traditionally the home of high savings, will not benefit much because its savings have been dumped in the money pit of government debt. China, with a very high savings rate, will outperform India, where the savings rate is lower and much private sector saving is sucked into the government’s excessive deficits. Chile, with privatized pensions and a high savings rate, will outperform the rest of Latin America, where savings rates are lower. Switzerland, with high savings and an immense capital base, will get richer still. Taiwan, South Korea and Singapore will thrive, Africa, including South Africa, will suffer.

The debacle of loss to come as asset prices deflate will be very unpleasant indeed, but the new world to emerge thereafter won’t be a great deal pleasanter except for the thrifty, who will find truly attractive returns available on their funds. Philosophically if not financially, we should welcome the change.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)