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The Real Story Behind the Great Recession

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I've become increasingly dismayed at the mainstream media's failure to explain the root cause of the Great Recession. While the crisis spawned entertaining films like Inside Job and captivating books such as Too Big to Fail and The Big Short, all of the sources zeroed in on pieces of the crisis at the expense of the whole.

To give you a different perspective, I've chosen to do the opposite. In the paragraphs that follow, we'll exam the Great Recession from a million miles up. And as you'll see, the true story is less about greedy bankers and sleazy politicians and more about the global balance of power.

The origin of bubbles
If you look closely, you'll find a speculative asset bubble at the heart of every financial crisis. The first on record occurred in the Netherlands in the mid-1600s, and while it's hard to imagine, the assets at issue were tulips. You heard that right -- tulips. For a variety of reasons, tulips became status symbols and highly coveted luxury items among the Dutch. They were so coveted, in fact, that at the height of the bubble, a single bulb sold for more than 10 times the annual income of a skilled craftsman. And while the tulip trade produced many a millionaire, its concomitant downfall did just the opposite, obliterating fortunes and throwing the Dutch economy into shock.

Since then, the world has witnessed tens if not hundreds of similar financial crises. The 1700s saw the South Sea bubble in France. The 1800s saw the Railway mania in England. The 1900s saw the Great Depression and the real estate bubble in Japan. Indeed, as you can see, our housing bubble of the last decade was only the most recent of such occurrences throughout history. And while these bubbles involved a variety of asset types, all of them began and ended in the exact same way: Euphoria followed by dismay.

The centrality of credit
Despite the fact that every bubble seems to catch people by surprise -- myself included -- they actually proceed in a relatively predictable manner. There's a shock to the economy, such as the proliferation of the Internet or the creation of financial derivatives that purportedly eliminate the risk of mortgage default. Then comes an infusion of credit, often in the form of loans from abroad and leverage at existing financial institutions. The proceeds of the credit are then invested in a specific asset or asset class such as tulips, technology stocks, or real estate. The price of said assets correspondingly increase, which attracts more speculators, and more credit. And on and on, until there's no credit left to drive the prices higher.

It's at this point that everything begins to unwind. Speculators flood the market with the overpriced assets. This drives asset prices down. Banks then demand more collateral for loans guaranteed by the assets. The need to post more collateral induces borrowers to sell even more assets, which drives asset prices further downward. This continues until asset prices can't decrease any further, speculators are broke, and banks are left with loans secured by now-worthless collateral. Credit correspondingly ceases, the economy suffers, and the blame game begins.

While financial crises wreak havoc on an underlying economy, what's important here is the role that credit plays. It's the fuel to a bubble's fire, the yin to its yang. Think of the scene from Brokeback Mountain when Jake Gyllenhaal tells Heath Ledger, "I wish I knew how to quit you." Now insert a bubble and credit, and you get the point. To put it simply, bubbles can't exist without credit.

The current and capital accounts
The year 1982 probably doesn't mean much to you. It was the year Michael Jackson released Thriller, TIME magazine named the computer its "Man of the Year," and both Mike "The Situation" Sorrentino and Lil' Wayne were born.

Ring a bell? If not, then certainly you'll remember that it was the last year the United States ever recorded a current account surplus. And while nobody can deny The Situation's unparalleled contribution to American society, the latter event was the most significant thing to happen to the United States since its ascent to geopolitical prominence following World War II. Indeed, it's not an exaggeration to say it represented a tectonic shift in the global economic balance of power and set into motion a series of events which culminated in the Great Recession.

A country's balance of payments consists of two accounts: the current account and the capital account. The current account is the difference between a country's imports and exports. If a country exports more than it imports, its current account is positive. And if it imports more than it exports, its current account is negative. The capital account, on the other hand, represents the flow of capital. If more capital flows into a country in the form of loans and asset purchases than out of the country in a similar form, then the current account is positive. And vice versa.

The important thing to remember here is that the balance of payments must… wait for it… balance. Therefore, a country like the United States that's running a current account deficit must by definition be running a capital account surplus.

Bernanke and the chicken and the egg
The issue at the heart of the matter is causality; namely, does a country access cheap international credit (and therefore run a capital account surplus) because it wants to live beyond its means, or does a country live beyond its means (and therefore run a current account deficit) because of access to cheap credit? According to Ben Bernanke, the Chairman of the Federal Reserve, it's the latter.

Bernanke's narrative of the crisis goes something like this: For a variety of reasons, including high savings rates in Asia and inflated oil prices in the Middle East, the world accumulated an excess supply of capital over the past 30 years. This capital flooded into the United States because of our rule of law and the size and stability of our economy. This influx of capital (i.e., credit) drove interest rates down to historically low levels, and created a demand for new financial instruments to invest in -- think mortgage-backed securities. As more and more Americans accessed these historically cheap forms of credit, we imported more than we exported and the price of assets (namely, houses) increased. You fill in the rest.

When the bubble popped, as they always do, the United States government felt obliged to nationalize the world's largest insurance company, American International Group (NYSE: AIG  ) , and bail out banks like Bank of America (NYSE: BAC  ) , JPMorgan (NYSE: JPM  ) , and Citigroup (NYSE: C  ) . And as my colleague Brian Stoffel recently pointed out, the residual effects of the crisis (in the form of debt assumed by European governments) now threaten the foundation of Greek companies like DryShips (Nasdaq: DRYS  ) , OceanFreight (Nasdaq: OCNF  ) , and Aegean Marine Petroleum Network (NYSE: ANW  ) .

So where does it end?
At this point, it's hard to see an endgame that doesn't include multiple sovereign defaults and an increased concentration of economic power in Asia. I'd love to hear if any of you think differently -- leave a comment below.

In light of this doom and gloom, if you want a safe place to stash your money until these issues are resolved, I suggest you check out The Motley Fool's special report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." Click here to access the report while it's still free and available.

Foolish contributor John Maxfield, J.D., owns shares of Bank of America. The Motley Fool owns shares of JPMorgan Chase, Bank of America, and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (13) | Recommend This Article (27)

Comments from our Foolish Readers

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 November 08, 2011, at 2:30 PM, Duke5343 wrote:

    First this artical skips over 1999 Fair housing and Bank De-regulation, forgets to mention Barney Franks role a patient Zero in this meltdown & history of pressuring banks to give loans to poor, forgot to mention Fannie & Freddie & how they put AAA rating on junk put together by the bands, forgot to mention the Greed of Real Estate agents and brokers who Bragged about selling homes to those they KNEW could not afford to buy - McMansions of middle class

    Also fogot to mention the 02 pull back recession and after people pulled Billions from market and pumped in Real Estate - TOO Much was left out of this article

  • Report this Comment On November 08, 2011, at 2:38 PM, Zankudo wrote:

    Oh I don't think Barney Frank caused the problem single-handedly or Fan or Fred. The problem was greed and deregulation. The greed came from the big boys on the Street and it trickled down to the masses when the bubble caught hold. The de-regulation came from the big boys on the street working the mouths of the pols. Slicing and dicing mortgages then paying off the rating agencies to peddle the CDOs to Dusseldorf was a self-inflicted wound. It was a bubble like all the others but it needn't have been but for 30 years of de-regulation, presidents who pandered to Goldman Sachs all of whom were running the show in D.C. and of course easy money from Greenspan. Greenspan was wrong, along with Clinton, Ruben, Geitner, Bush Jr., Paulsen, etc ad infinitum, ad nauseum.

  • Report this Comment On November 08, 2011, at 2:53 PM, Ikarruss wrote:

    That’s the nice point of view, here’s another:

    The American (if you are from Latin America) or European (if you live in Africa) economy looks so good and is paying so much that it is irresistible to sell to it (if you live in Asia) or go to work in it if you can get there. The economy is so good they start paying you for ¿services? and offer ¿derivatives? to pay you if you give them goods. They are taken because (but not by all), of course credit is good. The solution of course is just to have inflation in the ‘good’ economies. But that is a drag and we can now control it. Then the credit runs out before inflation sets in and somebody realizes you can’t have inflation everywere at once!

    Same facts just veiwed from another angle.

  • Report this Comment On November 08, 2011, at 4:56 PM, ballengerm wrote:

    Duke, I think there are a lot of interesting truths in what you are saying.

    I don't think enough attention has been paid to the fact that, throughout the whole building of this bubble, all the role models for the middle class were encouraging home ownership and bolstering the now-exposed myth that real estate is always a sound investment.

    The federal government cooperated with tax and policy incentives as well as constant rhetoric advocating greater home ownership for lower income folks.

    After these forces had collaborated over decades to ingrain the glory of home ownership into the culture of the middle class, weren't the predatory lenders just giving the people what they wanted? I can't imagine that, if Countrywide had told a person seeking a mortgage that they couldn't afford it, that person would not have just gone down the street to WaMu or whoever would have lended to them, no matter the terms. How much of the blame is due to the lender agreeing to give someone too big of a loan, and how much to the mortgage seeker demanding this loan at all costs?

    I'm young, and grateful that I am entering the game after home ownership and mortgages were exposed for the terrible investment most of them truly are. There is no way I will ever consider buying a home with less than 20% down and longer than a 15 year term. I wish the federal government would give up the myth and end the mortgage interest tax deduction.

  • Report this Comment On November 08, 2011, at 8:09 PM, DividendsBoom wrote:

    Who you blame for a bubble does not change the fact that it was indeed a bubble at it's core. Tough to blame politicians, even the ones that might have a clue are outnumbered and silenced if they dare stand against popular opinion. I get putting it on FED policy as they should have a longer-term focus, but they more or less followed national policy handed down to them, and don't have much of a track record for intelligent long-run action. A rise in personal responsibility for your own well-being is badly needed. Our country preaches individualism in everything but responsibility. As disliked as Dave Ramsay is around here, I would guess that most of his listeners fared better than a comparable non-listener

  • Report this Comment On November 08, 2011, at 8:11 PM, DividendsBoom wrote:

    I agree wholeheartedly with your interest rate statement truth, can't default on a mortgage if you never can artificially afford it.

  • Report this Comment On November 08, 2011, at 8:22 PM, Clint35 wrote:

    Concomitant? Did you really use that word? Concomitant? Sorry I didn't go to Harvard. Excuse me while I search for my dictionary. But, pretty good article. Keep up the good work.

  • Report this Comment On November 08, 2011, at 10:04 PM, DDHv wrote:

    Given the present situation, the best ROI investment I have found is: wait for it - to grow some of your own food. Even an apartment dweller can do this; read "How to grow food in small spaces." You don't get a cash income, but with modern intensive gardening methods quite a bit of savings is possible. Of course there is a danger - the squash tried to take over the garden this year, and we can't eat all of them ourselves. BJ is being creative with recipes tho.;-))

    The basic definition of investing would be to spend in a way that improves the probable future. We can invest, with this definition, in physical things also. We've modified our house enough to cut the heat bill by about a third, and in North Dakota, that helps. There are other possibilities.

    Thinking out of the box should include some physical reality investments.

    PS, Also, I don't need to pay for a gym membership to get enough work for my muscles.

  • Report this Comment On November 08, 2011, at 10:47 PM, dcfoolz wrote:

    For any of you who wish to get more "big picture" views of this and other financial crises, I recommend the book:

    This Time Is Different: Eight Centuries of Financial Folly. by Professors Carmen Reinhart & Kenneth Rogoff

    It is not beyond the grasp of someone with good logical and critical thinking skills. It includes some math and lots of table/charts/graphs. However, the authors are good a simplifying & summarizing the issues for regular folks like me. This book is for the intellectually honest among us!

  • Report this Comment On November 08, 2011, at 11:04 PM, whereaminow wrote:

    Fairly nice job, in that you idenify a relationship between an asset bubble and an expansion of credit (beyond natural limits.). I often get pressed about the Tulip Bubble in relation to business cycle theory because so few people know the amazing amount of credit out of "thin air" that accompanied that bubble. Economist Doug French has actually tracked the credit expansion of every bubble in recorded history. The root is always the same: credit expansion, i.e. monetary inflation.

    Bernanke is obviously dishonest or a fool. One only has to look at how long interest rates were artificially low in relation to when asset prices rose to see what causes what. Eve without such evidence the logical chain of reasoning leads you to understand that centrally planned interest rates will disrupt an economy, usually through inflation and credit expansion.

    So rather than smoothing out the business cycle, something mainstream economists do not even understand, the central bank makes the disruptions worse with their constant mingling with the natural rate of interest.

    Study the Austrian Theory of the Business Cycle. The Austrian School is the only ecoomic school that had dozens of scholars correctly predict the housing bubble. It was Austrian School scholar F.A. Hayek who won the Nobel Prize for showing how central banks exacerbate the boom and the bust.


  • Report this Comment On November 08, 2011, at 11:29 PM, Frankydontfailme wrote:

    Excellent article. I hope to hear more about how you plan to invest in this continuing deleveraging cycle.

  • Report this Comment On November 14, 2011, at 10:01 AM, FUSION10 wrote:

    It's not only macro economics - it's also about

    competition. You have a healthy and a ruinous competition.

    Fist we are made slaves,then, if we are not happy, the robots will come.

    The moment, ex- boss of world bank stated:

    that their won't be and never will be enough jobs in future for all, due to the fact that we produce more with less people, - he was quickly outed from his post.

    Just for the reason to stay in the market, companies must act toward the competition.

    This shows what the real threat is - that companies reduce the value of an individual person more and more to a status of plain consumer (if they have the money!), they don't depend on his/hers working power anymore.

    What to do with the 99% rest?

  • Report this Comment On November 15, 2011, at 4:05 PM, rfaramir wrote:

    Excellent article, but you stopped before you found out where artificially cheap credit comes from: the Federal Reserve (in our country).

    Bernanke: "This influx of capital (i.e., credit) drove interest rates down"

    No. Bernanke drove interest rates down. He's in charge of them, after all.

    "high savings rates in Asia"

    Caused by Asians producing stuff and the US printing money to buy it. Therefore, Asians have excess dollars looking for somewhere to invest it. Trouble waiting to happen, caused by the Fed. It's certainly not the Asians' fault for working hard, is it?

    "inflated oil prices in the Middle East"

    Caused by the printing of US dollars. Again, the Fed.

    At every step, Bernanke tries to deflect the blame that is rightfully his (or his predecessors'). End the Fed!

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