Much to commentators’ surprise, the United States Treasury bond market has been strong over the last few weeks, with the 10 year bond’s yield declining to 3.94 percent Thursday and mortgage originations for home purchase setting a new weekly record Wednesday. Happy Days, it is generally felt, are Here Again. High liquidity, like alcohol, generally has this effect — but leads to a nasty hangover afterwards.

Signs of high liquidity are apparent throughout the world, with the partial exception of Europe. Spreads on emerging market bank debt have narrowed continually, so that even debt of the near-bankrupt Turkey and the socialist-ruled Brazil now yield only a few percent above Treasury bonds, compared to yields of 15 to 18 percent above Treasury bonds in late 2002.

Margin debt on the New York Stock Exchange, announced Friday, at $173.2 billion was up almost 30 percent in the last year, a sure sign that small investors are once again in a frenetically speculative mood.

Emerging stock markets, with the notable exception of China, were up hugely during 2003, with India up more than 100 percent from its low, and such deadbeats as Argentina and Brazil doing even better in dollar terms. In China, the money has gone into bank lending, with bank loans to the Chinese corporate sector, mostly to prop up losses in state owned companies and invest in dubious real estate projects, up by over 30 percent of gross domestic product in 2003. My colleague Ed Lanfranco wrote Thursday about China’s automobile market, where automobile sales rose 34 percent in 2003, to 4.35 million vehicles, even though Chinese automobile prices remain above world levels, while China has become the world’s third largest automobile producer, behind the United States and Japan and ahead of Germany. This is of course wonderful news for the future prosperity of the human race (albeit less so for oil prices or global warming) — it does however suggest that in China too there may be an economic overheating problem.

The dollar has dropped by more than 30 percent against the euro since early 2002, the gold price has risen above $400 an ounce and crude oil is trading close to $35 — all of which suggests that there are too many dollars around for the amount of economic activity going on.

Only Europe and Japan are exempt from the tidal wave of easy money. In Japan, nominal interest rates remain low, but the economy is close to deflation, with consumer prices dropping as competition shakes out the dead wood in the Japanese distribution system.

In Europe, the European Central Bank under Wim Duisenberg pursued a cautious and sensible monetary policy, taking account of economic conditions in all the Euro member countries including inflationary Spain and Ireland. Since in the real world no good deed goes unpunished, he has now been replaced by a more inflation-prone Frenchman, Claude Trichet, and Europe has been plunged into a prolonged. albeit not particularly deep recession, made worse by the continual slide in the dollar, and the consequent difficulties for Euro zone exporters.

To add insult to injury, European policymakers are besieged by a Greek chorus from across the Atlantic, pointing out mysterious European “structural problems” that supposedly condemn Western Europe to an eternity of minimal productivity growth and economic stagnation. In reality, Europe’s “structural problems” of high taxes and heavy social costs are no worse and in some respects better than they have been for the last 25 years; there is a demographic problem approaching when the post-war baby boom retires, but we are half a decade away from that yet. It is little wonder that the modestly reforming French and German leaders, lumbered with an ever-appreciating currency that decimates their export markets and attracts a flood of under-priced Asian imports, find the moral lectures of the wholly un-reformist Bush administration hard to bear.

Britain shows what might be happening to the U.S. if it had pursued the fiscal but not the monetary side of the Bush/Greenspan U.S. policy. There the government deficit is widening rapidly, but the currency remains strong and the trade deficit, always a weak point of the British economy, is nowhere near crisis level. In Britain, unlike in the United States, the housing bubble appears to be beginning to deflate, but confidence in the economy is very much lower, with an economic optimism index currently registering minus 26, an excess of pessimists over optimists.

There’s no question that we are in a place without roadmaps — this particular combination of circumstances has not as far as I know been tried before. In 1929-33, the Federal Reserve pursued a tight monetary policy, with catastrophic results in terms of bank failures, making the Great Depression far deeper than would have been necessary as a result of the Wall Street crash. In Japan in the 1990s, the authorities pursued a loose fiscal policy similar to that being followed by the Bush administration, but the Bank of Japan, while allowing interest rates to decline, pursued a monetary policy considerably tighter than that followed by Greenspan since 2001.

Perhaps the closest to the current policy mix occurred in 1972-73, at a time when inflation was already a serious threat, but the overvaluation of the late 1960s had already been worked out of the stock market and housing markets. President Richard Nixon and Federal Reserve Chairman Arthur Burns pursued a combination, since rightly derided, of expansionary fiscal policy, loose monetary policy and price controls, which achieved Nixon’s 1972 re-election but resulted in a particularly nasty combination of inflation and recession for the reminder of the 1970s. The international situation in the 1970s was also not dissimilar; Japan was the extraordinary economic success story, similar to China or India today, while Germany, France and Britain undertook hopelessly over-expansionary fiscal and monetary policies, driven in Germany and Britain’s case by a surge in public spending.

One peculiar factor in the last six months, not much remarked on by commentators, is the cessation in growth of the U.S. money supply. M3 grew by steadily accelerating rates of nearly 10 percent in the 1990s, slowed to about 8 percent with the modest monetary tightening of 1999-2000, and then grew by 10 percent per annum between November 2000 and mid 2003, as the Fed pumped more money into the system — all of these rates being far faster than the growth in nominal gross domestic product. However, since July 2003 monetary growth has ceased; average M3 growth in the 13 weeks to January 12, 2004 was minus 4.5 percent at an annual rate from the 13 weeks earlier, and the very latest figures, released Thursday, show no sign of renewed monetary growth.

This is very puzzling; it didn’t happen in 1972-74, when M3 growth slowed from the 12 percent of 1972 and early 1973 (not in fact faster than in 2000-2003 when 1972-73 inflation is factored out) to about 6 percent per annum, but never went negative.

The halt in money supply growth does not have an immediate effect; how could it, when U.S. GDP grew at an 8.4 percent annual rate in the third quarter of 2003, and is estimated to have grown by close to 5 percent in the fourth quarter (preliminary figures are due out next Friday?) Notoriously, monetary policy influences the real economy only with a variable lag, of up to 2 years. However, the fall in money supply has now been taking place steadily for 6 months, so it is not simply a blip.

As I said, the current combination, of very loose monetary policy, very loose fiscal policy, an overvalued stock market, a housing boom and a huge U.S. payments deficit is new. 1973 is a reasonably close analogy, as are bizarre episodes deep in history such as the French Mississippi scheme of 1720 and the early years of the German Weimar republic in 1920-22. The sudden disappearance of U.S. money supply growth is telling us something, probably that there is a deep recession ahead. The sharp rise in gold, oil and commodity prices is telling us something, probably that we are about to experience a burst of inflation. The Chinese situation, and the huge disconnect between U.S. and European economic performance are telling us something,. probably that the U.S. dollar’s value is about to enter, not just a moderate decline, but a true collapse.

I can barely believe, even though I disapprove of the late 1990s stock market bubble and the Bush administration’s feckless economic polices, that we are about to enter a period of deep depression, high inflation and collapse of the U.S. dollar simultaneously — it would seem too bad to be true. Some other force must be acting, bringing huge disruptions to the world’s economic system, but not in itself leading to its collapse, even though imbalances are at record levels.

The most likely candidate for such a force, which to produce and sustain the current imbalances needs to be of a nature and degree never seen before, is the simultaneous emergence of both China and India, together representing 40 percent of the world’s population, as economic powerhouses. Both countries, mired in economically unproductive policies for centuries, are increasingly pursuing the free trade, free market, low tax policies that have been proven to lead to rapid economic growth. For China and India and, on a weighted average basis, the world’s population as a whole, this is unalloyed good news.

Unfortunately, it may not be good news for the U.S. and Western Europe. In previous decades, countries that have entered a period of rapid economic growth and moved towards advanced world living standards have been relatively small in population; the largest “economic miracle” country was Japan at just over 100 million. China and India, if their economies really get going, are an altogether different matter. Entry of 2.5 billion people fully into the world trading economy, however beneficial its long term effect on world prosperity as a whole, has the potential to be hugely disruptive to the advanced economies in the medium term — even now, the International Labor Office’s estimate Wednesday that world unemployment reached a record 186 million workers in 2003 demonstrates the size of the problem.

Studies have shown that the income differentials between countries, modest in 1800, increased enormously through industrialization and world economic growth in the next two centuries, and are now far higher than they have ever been before — more than 50 to 1 between the United States and most African countries.

This process may be about to go into reverse. As Western levels of technology and skill become available among fully half the world’s population, the returns for that technology and skill may be about to diminish very sharply indeed. In theory, we should all rejoice at the narrowing of the appalling differentials between the rich and the Third World. In practice, an uncomfortably large proportion of that narrowing may take the form of a relative impoverishment of the West.

As I said, it’s only a theory. The world doesn’t appear to have been precisely here before, so the economists’ usual technique of analogizing with past economic cycles doesn’t work. Maybe there’s some other way out of this unprecedented flood of world liquidity.

But I wouldn’t count on it.

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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.)

This article originally appeared on United Press International.