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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.
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