This is the great cyclical cleansing

By Terry McCrann

January 23, 2008 12:00pm

THIS is the great cleansing. Every 20 years or so we need one, to hose away all the crud that's built up in the market. The excess. The over-ripe values built on sand and fantasy.

To de-spiv - albeit inevitably and, sadly, only temporarily - the financial system. To teach another generation of young 'masters of the universe' that greed and slickness do not add to substance and sustainability.

We had the 'de-crudding' in one day back in 1987. After the tsunami rolled in overnight from across the Pacific.

This time, we've pre-empted Wall St. In these days of globalised real-time trading, our market's 7 per cent drop yesterday was in anticipation of the Dow opening 500 points down on its Friday close.

And then going who knows where. Or feared.

More pointedly, this big one-day point loss yesterday came after the market had already gone down 18 per cent in barely two months.

This has given us two chilling figures. A $100 billion single-day loss in share values, double the dollars lost in the, albeit much bigger percentage, drop in October 1987.

Making total losses since the market peaked, so bullishly and so wildly inaccurately in November, approaching $400 billion.

Again, never before have we lost that sum from share values, as we've never previously 'had it to lose'.

Back in 1987 I noted two positives. The loss had been so dramatic, it was almost clinically surgical. Plus it only 'gave back' the last exaggerated run-up in over-inflated share prices.

So for most people they'd hardly had the extra value long enough to notice its loss.

Although it hasn't happened all in one day this time, there is a similar thread of rapid rise and loss.

The market is now back to where it was in October 2006.

So yes, you might have lost all the increase since then, but you still have - we all have - all the huge rise in share values from 2001 through 2006.

Speaking very broadly, that much of the rise is built on firmer foundations. Of the real strength in the economy; most obviously the benefits bestowed by China.

And which are sustainable into the longer term. If not necessarily quite to the extent of the more starry-eyed projections of China (and India) boundless.

Now there are key fundamental similarities between now and 1987. Adding up to a bubble that had to burst at some point.

Then the paper-shuffling entrepreneurs. Now the private equity and other financial whiz kids. And one time-dishonored constant - debt.

Back then it was banks shovelling billions to Bond and mates. Today, it was (US) banks shovelling much smaller sums, but to many more, NINJAs.

No-income, no-job or assets home-loan borrowers.

And then spreading the infection across not just the US financial system, but the world's, through the securitisation of those mortgages. The sub-prime syndrome and its subsequent meltdown.

Now that is obviously the proximate cause of the slump on Wall St, which has then spread directly and indirectly across the globe.

Direct share market drops. Huge Citigroup and Merrill Lynch writedowns. Centro and RAMs. They are all part of the disease. All feeding off and fanning the infection.

But there's a much bigger issue behind all this. And both it and its ultimate playing out will really determine where all this goes. And how quickly.

Simply, that much of the growth in the US economy, its share market and incomes and wealth has pivoted on China.

But not just on China as a new source of global growth, but an elaborate global re-channelling of money.

At its simplest China making and selling to US consumers; and lending them the money to buy, by investing the trade surpluses in US investments.

The whole sub-prime edifice would never have been able to be erected but for this.

It was always at best merely unsustainable; but more likely at risk of the sort of implosion we are seeing now.

This is really the most troubling difference with 1987. But at the same time, the most encouraging.

China's economic development is real enough. So surely once we've 'de-crudded' we can get back to real basics.

The sort of real basics that 20 years ago, took to the early 1990s to re-emerge, after the bank disasters and the recession we had to have.

So both the nervous uncertainty and the encouraging upside turn on the US.

Not on what happened overnight. If it finished bad, we'll have to take more pain today. Not even where Wall St goes over the next weeks or even months.

But what happens in the real, basic US economy. Does it go into recession? How deep and for how long?

Now it is very much, it is entirely, a matter of the US recession they (and the rest of us) have to have.

A stronger, more competitive, more fundamentally healthy US economy is needed to put the US-China-Australia virtuous circle back on track.

There's a great chance of that happening. But it's going to happen after and through an awful lot of volatility right through 2008.

Don't rush back into the water too quickly. But keep your bathers on.