An Economic Expansion That Wasn’t

In recent days my friends have been asking me the same questions that we hear on TV many times a day… What is happening to the financial markets, and is it the beginning of the end for America? Below is just my personal view on the situation.

America as a nation has enjoyed vigorous economic growth for a very long period of time, going back to the 18^th century. As the economy grew, Americans got wealthier, and now we enjoy one of the highest standards of living, as compared to the rest of the world. But what drives the underlying economic growth that makes us all richer in the end? It is the process of innovation and progress that drives economic growth. It is people coming up with new discoveries and technologies that provide more “bang for the buck”, and ultimately make our lives easier and more productive. America historically has been an innovator, with inventors like Edison, Westinghouse, and Ford revolutionizing technologies that made our lives better. It is the process of innovation that lies at the core of any economic expansion. That was then…

What great innovation spurred our last economic expansion that started in 2001? Was it a great new discovery, or a technological breakthrough? The main innovation was in the area of financial services, with proliferation of complex financial instruments like adjustable-rate mortgages, mortgage-backed securities, credit-default swaps, etc. In theory, these securities may work well for you, if you can understand them. The problem was, very few of us could… And, of course, the brilliant financial “innovation” of subprime mortgages! The underlying idea was that people who could not be trusted to make conventional mortgage payments (say, 6%), could somehow be trusted to make higher subprime payments (say, 9%). Yeah, right…

The Fed, led by Alan Greenspan, was eager to encourage these financial innovations, and further fueled the flames of the real estate bubble by keeping interest rates too low for too long. The result was that it became too easy for everybody to obtain mortgages. And I mean everybody, i.e. those who could be trusted, and those who could not. Not surprisingly, real estate prices went through the roof, as everybody thought that it was a cool thing to buy a house, or two, or three. If you were not buying, then refinancing was the thing to do. It seemed like a win-win offer – pay a new lower mortgage rate, and get some cash from your new higher hypothetical home price. Of course, the bottom line of all these financial innovations was just to facilitate borrowing more and more money. And when the payment was due, everybody could borrow even more to pay the previous debt. If it sounds like a pyramid scheme, it was. And you know what happens in the end of any pyramid scheme. This is now…

So, the great “innovation” that spurred the latest expansion was just a fancy way to disguise borrowing money that we could not repay. Some innovation indeed… It did not produce any technological breakthroughs, and we did not become more productive as a society. The bottom line is that the latest economic expansion was nothing but a sham, with home and stock prices being inflated through a pyramid scheme.

Now what? We have to realize that our newfound wealth of the past few years was completely undeserved, and it was not backed by the real economy. We now have to adjust our spending to the levels that are justified by our true economy, and realize that individual 401k retirement plans reflect the bitter reality. And better yet, we have to find ways to come up with real innovations that will create true wealth for everybody in the economy.

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