What the Financial Crisis Is Really About

Contrary to popular belief, the financial crisis isn't rooted in the housing bubble, nor in the "bad banks" of financial institutions such as Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , or Wachovia (now owned by Wells Fargo (NYSE: WFC  ) ). Instead, Tyler Cowen says the blame belongs elsewhere -- in an entirely different decade.

Cowen is a George Mason University professor of economics, co-creator of the popular economics blog marginalrevolution.com, and author of the new book Create Your Own Economy. In a recent talk at Motley Fool headquarters, he suggested that the financial crisis may have started 10 years ago, when the "real economy" started stagnating in ways that didn't show up in productivity statistics.

"The crisis is fundamentally about the real economy," said Cowen:

[Critics] blame monetary policy too much. I agree, monetary policy is just as bad in some ways. They're not incorrect; but they're not seeing the deeper roots. We've had housing bubbles before. If it were just about a housing bubble, it would be over by now. It would be a smaller thing like in the late '80s, and then later in the early '90s, but it's not. So my intuition is, it has to be more than that.

Cowen blamed innovation; it had its merits, but didn't necessarily create a lot of jobs. As he put it, "I think we overlooked the fact that a lot of the new forms of productivity -- like the Web -- are great for your life, but are not in any way revenue-enhancing."

Starting 10 years ago, Cowen said, the real economy began to stagnate as revenue models crashed. That's when banks like Bear Stearns (now owned by JPMorgan Chase (NYSE: JPM  ) ) and Barclays (NYSE: BCS  ) took to new products like subprime-mortgage securities -- "the proverbial canary in the coal mine," as Cowen calls it. We're still deleveraging from the burden of those bad decisions.

Cowen said that many of the business models applied to Internet innovations, such as Twitter, simply can't be monetized. But he did think they'll get cheap enough to survive as philanthropic endeavors. "It will be like Wikipedia," he said. "It will be a service. People who care about social change in Iran and other places will be willing to support Twitter."

And unlike those who think that a lost decade is in front of us, Cowen said he thinks we've just emerged from one. "We assumed we were having 10 wonderful years, when we were actually having 10 years of stagnation," Cowen said. The economist argued that median wage growth has been fairly stagnant, while equities -- depending on your starting point -- haven't done very well. Cowen believes we're in a regrouping period in which productivity is low.

Where we go from here
Economic drivers for recovery will be very diffuse, according to Cowen. He argued that no particular sector will pull us out, or will exports. "If we knew what the source was we'd be out." Instead, Cowen believes that recovery will be a very slow adjustment -- wiggling back and forth for five to 10 years, with a lot of failures along the way. "I think we'll have something that looks like a recovery," he said. "It will be jobless and we'll slump back."

And while inflation isn't a threat to the economy right now, Cowen believes it could really heat up with recovery, causing problems down the road.

Telltale signs of economic recovery
The economy contracted at a mild 1% in the second quarter, in contrast to the sharp declines seen the last two quarters. This definitely demonstrates that the recession is easing, and some take it as confirmation that our economic woes are over. But Cowen is more skeptical than most.

He doesn't believe in the talk of "green shoots," or the newly coined notion of a "jobless recovery." Instead, he's looking for sustained job growth that isn't artificially propped up by government stimulus. "If you look at underemployment and people leaving the work force, the real unemployment rate in this country is quite higher than the measured number," Cowen said. "It's been that way for a while, and is going to stay high for a while. I look for that to change."

Aside from jobs, Cowen said he's also looking for signs that China won't collapse. Though some doubt that China's potential brewing bubble will burst, Cowen said the scenario is still on the table: "If they collapse we're in a lot of trouble."

He also worries about Eastern Europe, and the overreach of German and Austrian banks. While any impending fallout may not be severe, if Eastern Europe's financial system implodes, the economist believes we could catch some of that fallout. "So we need to clear up Eastern Europe, we need to see China is for real, and then we need job growth," Cowen said. "None of those things are really on the horizon right now."

Further somewhat less apocalyptic Foolishness:

Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (14)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 13, 2009, at 7:09 PM, mjblazin wrote:

    Weren't the movement by banks into non-standard securities driven by the voracious need for pension funds to get above market income streams to fit their models? My hypothesis is that the huge amount of boomer money flowing into defined benefits plans (and corresponding huge commitments upon retirement) combined with extremely low interest rates mandated by the Fed drove the funds to seek alternative investments that "looked" as safe as standard bond/equity mixes, but paid much better. Otherwise the contributors would have had to ante up significantly more money to support same benefits. The sub-prime securities only existed to fill the pension funds' needs. Later the banks learned they could make piles of cash at both ends, selling the securities and creating the mortgages. Then the third group like AIG traders joined the party making money insuring the whole mess. IBut i was the pension funds' insatiable demands for more that provided the river of cash that found a use supporting increasingly risky home investments. I would make the case that a world of 100% defined contribution plans would not have caused the same problems.

  • Report this Comment On August 14, 2009, at 2:16 AM, mlaursen wrote:

    re: "As he put it, 'I think we overlooked the fact that a lot of the new forms of productivity -- like the Web -- are great for your life, but are not in any way revenue-enhancing.'"

    I don't get it. Is revenue the only thing that helps an economy. Doesn't figuring out how to do things in a less costly way help an economy, too?

  • Report this Comment On August 14, 2009, at 11:09 PM, carefulinvestor wrote:

    Cowen must be driving blind. The Internet has not enhanced productivity? Well, I communicate more effectively, hold fewer meetings, shop online (increasing competitiveness and driving prices down), and reach my destination using less gas because I have a map and traffic updates on my cell phone. The US is also selling Internet-related technology overseas. High tech and materials technology are highly sought degrees. Where do the world's students come to study? I have one word for the premise of this article - balderdash.

  • Report this Comment On August 22, 2009, at 12:45 PM, WasSleeping wrote:

    Read this:

    http://www.freelists.org/post/harbor/Ron-Paul-No-Go

    He reckons the USA is Germany II

    The guy is a free thinker, and I love the way he sees the world.

    http://www.freelists.org/archive/harbor

    It will leave you thinking about everything!

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