WHEN we talk about bubbles, we tend to think of recent history but in fact this is an age-old phenomenon. (Note to patient readers; this is a long post because it is a condensed version of my BCA speech.)

Asset bubbles and rising debt levels go together. And it is not just government debt we have to worry about. US private sector debt has increased as a proportion of GDP from around 60% in the early 1950s to almost 300% at its peak.

Some increase in debt may have been inevitable as societies became more sophisticated. Many would say a certain degree of debt is beneficial since it allows individuals and companies to smooth their consumption over the cycle.

Others would say it doesn't matter. In aggregate, the world owes the money to itself; debt is just an accounting issue. A family is no poorer if a wife lends money to her husband, or vice versa. Another rationale is that asset prices have also been rising so that one needs to look at both sides of the balance sheet; it is net, not gross, debt that matters.

But that is wrong. Gross debt levels matter because, as is well known, the value of debt is fixed in nominal terms while the value of assets can fluctuate. High gross debt levels thus create a number of flash points when creditors start to doubt the value of their collateral, and when the debts have to be rolled over. These crisis points are now rippling through the system; first US homeowners, then investors in structured products, then banks, and now sovereigns.

It is no coincidence that this massive debt explosion has coincided with the end of the Bretton Woods system of the early 1970s. This destroyed the final link to gold and crucially, removed the balance of payments constraint from the concerns of economic policymakers, at least in the developed world.

The author Richard Duncan compiled this chart

from IMF data showing the growth in foreign exchange reserves since the end of Bretton Woods. From modest origins, they climbed above $1 trillion in the early 1970s before accelerating to almost $7 trillion in recent years. It is his contention that these reserves allowed surplus countries to expand their money supplies, while the deficit countries were not forced to cut back.

It was true that, in the main, developed countries found that they could run deficits without being punished by the markets. Indeed, eventually, they found that they could depreciate their exchange rates without being penalised by their creditors in the form of higher yields. This was an easy option in the short-term. But it was a bit like the 25-year old who boasts that smoking, drinking and overeating hasn't harmed him; the bad habits will catch up with him eventually.

Floating exchange rates gave countries an escape valve after the 1970s. And that was very important because attitudes were changing in another area of government policy. As one contemplates today's massive fiscal deficits, it seems incredible to remember that Keynesianism was virtually discredited in the mid-1970s. A Labour prime minister, Jim Callaghan, said

"We used to think that you could spend your way out of recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."

He was describing what used to be known as the stop-go cycle, in which governments entered office eager to expand the economy (think of the Barber boom in the early 1970s) only to slam on the brakes as inflation rose. One could describe it as the Keynesian ratchet in which each turn seemed to bring higher inflation.

After a chaotic 1970s, the world came up with a new system, based on the use of monetary policy. Inflation would be tamed by an independent central bank, and monetary policy would be used to limit the excesses of the cycle. The system appeared to work brilliantly. It delivered the great moderation, two decades of steady growth with generally declining inflation and very mild recessions. There was an enormous boom in the financial markets, as lower inflation allowed nominal yields on bonds and equities (and thus capital values) to rise substantially.

And so we turn to Hyman Minsky who argued that these periods of moderation lead eventually to speculation and crisis. Rising asset prices encourage people to borrow money and buy assets, most obviously in the housing market. Initially, people take out loans where they can meet both interest and capital repayments; then they take out loans where they can only meet the interest; in the final Ponzi stage (for which read subprime) they cannot even meet the interest payments but need rising prices to service the debt (essentially by flipping the asset).

It is my contention that we switched from a Keynesian ratchet to a monetary ratchet. Lower rates encouraged more borrowing and higher asset prices; when those prices faltered, central banks worried about a repeat of the debt deflation of the 1930s so they slashed rates to help markets recover. This became known as the Greenspan put after 1987, the first time it was clearly used but it was used many times, arguably most egregiously in 1998 after the collapse of LTCM.

The end game of this process seems clear in retrospect, even though it may not have been at the time. Valuations were driven to historically unprecedented levels, first in shares in 2000 and then in housing

in 2006. And interest rates have reached the event horizon of zero.

Let us think about that for a moment. The Bank of England was set up in 1694. For the next 300 years which included world wars, the Great Depression, a century or so of alternating deflation and inflation between 1815 and 1914, and the bank never previously felt the need to reduce rates below 2%. And this is combined with a fiscal deficit which, relative to GDP, is unknown outside world wars; one in four of the pounds spent by the British government is borrowed from the markets. Even with all that, the Bank of England has been obliged to add QE on top.

If zero rates and huge deficits were the answer to mankind's problems, we would have discovered this long ago. After all, governments would be delighted to borrow as much as they can for as little as possible.

What the authorities are clearly trying to do is to wind up one more round of the ratchet. If asset prices are higher, balance sheets will look healthy; if interest rates are low, borrowers can service their debts. Indeed, the Bank of England doesn't think British house prices are too high, even though they are well above historical averages relative to incomes; they are rational when compared to real interest rates. But who has been setting real interest rates? The bank, of course, at both the short (and via QE) at the long end.

This may be an early sign that central banks are falling into their old habits. Bubbles are very hard intellectually to deal with. Those who ride the bubble look smart; those who try to buck it, like the late Tony Dye, get fired. The bubble will often accompany a growing economy, rising corporate profits and rising tax revenues; governments, regulators and central banks tend to feel that all is well, and that the wisdom of their policies is being amply demonstrated.

But it is surely very hard to argue now that the right thing for central banks to do about bubbles is to ignore them, on the grounds that it is easy to clean up after they burst. The cost of the financial sector crisis has been enormous; never mind the actual bail-out, think of the lost tax revenues.

Surely it is clear that the monetary expansion of the last 30 years led to asset price, not consumer price, inflation perhaps because the rise of China and south-east Asia represented a massive deflationary shock for the manufactured goods sector.

The fundamental contradiction at the heart of the recovery is that the markets are dependent on the governments for support, but many governments are also dependent on the markets. The European debt crisis has shown there is a limit to the extent that markets will be willing to finance government deficits, and also a limit to the extent that politicians want to be dependent on markets. European countries, with Germany in the intellectual lead, are now acting to withdraw the stimulus. Eventually, one would expect the US to be forced, by political rather than financial pressures, to follow suit.

Given that economies may have to slam on the fiscal brakes, and that interest rates are already near zero, central banks may be forced into other means of boosting the economy, in particular quantitative easing or QE. I confess to being rather cynical about QE. We know of occasions in history when it didn't work (Japan) and we know when it resulted in hyperinflation (the Weimar republic). We don't know of any occasions when it definitely did work.

And we know it is a tactic that is ancient. The Emperor Nero was short of a few denarii to pay his soldiers so he created some more by debasing the currency. In effect he financed his deficit by printing money, just as the Bank of England has bought £200 billion of gilts from a country with a £157 billion deficit. Of course, Nero didn't have any economists to give his actions a sophisticated spin. But were his actions really that different?

I am not arguing that we are heading for hyperinflationary hell. But I think we have in the course of this long debt boom started to confuse claims on wealth with wealth itself. And I think that has been a further negative effect of the bubble mentality.

Indeed, just to provoke you, how about thinking of the last 40 years as one long bubble, in which fiat money has led to asset price inflation. Before you dismiss the idea, think about this; with gold at $1250 an ounce, the dollar has lost 97% of its purchasing power

in terms of what used to be though of as "real money" since 1971. The Romans took 200 years to achieve the same effect, cutting the amount of silver in their copins by 96%. Progress!

Go back to the early 18th century and there was another experiment with fiat money conducted by John Law on behalf of the French regent. Law was hired to improve the regent's finances and believed that a shortage of currency was holding back French growth. His clever scheme combined QE, subprime lending and an emerging markets fund.

A new bank was formed, Banque Generale, and the regent decreed that taxes could be paid in notes issued by the bank, effectively making them legal tended. Meanwhile, the Compagnie l'Occident was created to exploit the trading opportunities in the Mississippi basin, the emerging market of its day. Banque Generale lent investors the money to buy shares in this great opportunity and the money raised from the issue was used to repay the monarchy's debts. In short, money was created via a roundabout fashion to buy government bonds; an exact description of QE.

Investors bought shares because of the promise of a high dividend. But the Mississippi delta was a swamp with no prospect of generating any actual earnings. So the key was to keep pushing up prices; this was achieved by the offer of new shares which investors could buy with only a small deposit.

The scheme faltered when some chose to take profits. So Law resorted to guaranteeing to buy the shares at a set price (think of the TARP) involving the creation of more money. When people doubted the value of the bank notes, the company bought the bank (think Fannie Mae and Freddie Mac) to keep the system going. Eventually the whole thing collapsed some four years after it started.

Now I am not trying to suggest that, in the last forty years, the global economy has not become a lot wealthier. Clearly one can point to three great changes in productivity; the entry of the communist world into the capitalist system; the use of technology to spread information and reduce frictional costs; and the entry of women into the developed world workforce.

But I think it is possible to argue that the development of the bubble mentality has distorted monetary policy, led to the rise of an overpowerful rent-seeking financial sector, and in the Anglo-Saxon economies, led to the excessive focus of investment in housing. Some of this wealth may prove illusory and just like John Law, attempts to prop up asset prices that have lost relationship with the wealth of the underlying economy, may end up being a failure.