The verdict is in: greed and ineffective risk controls by financial institutions, ineffectual governmental regulation, and incompetence by Fannie Mae and Freddie Mac caused the financial crisis we are all experiencing. We are busy acting on this verdict by enacting tough financial reform measures and perhaps repairing or eliminating the GSE's. Unfortunately, the verdict and punishment go to the symptoms, not the cause of the crisis - like a jury incarcerating the gun for the commission of a murder. The cause of this crisis will be difficult and painful to fix, and there is no one in the public sector who has an interest in addressing it.
For the last fifteen years, Americans have used two asset bubbles -Internet and housing- to create an unsustainable standard of living. The United States has relied on this illusory wealth to mask the impact of global competition - specifically, the stagnation of real wages caused by the transition of the U.S. economy from a manufacturing based economy to a service based economy. The personal and political imperative is to refuse to recognize this economic reality. The result is that U.S. GDP became dependent on one overriding factor: consumer spending, which in the last decade has come to exceed 70% of GDP. We also know that monetary policy, enabled by China's surplus, kept interest rates at a very low level, enabling U.S. consumers to borrow and fuel growth. Earlier in the decade, our current Fed. Chairman concluded that the transition to a service based economy led by consumer spending would create a "Great Moderation". The cycle of continuing recessions and economic growth would be broken by steady growth with muted inflation. Indeed, the investment community called the economic conditions of the mid-years of this decade the "Goldilocks economy" - not too hot and not too cold. The "China two-step" allowed this to happen. We bought China's goods; China used the surplus dollars they received to buy our debt, and because demand for our debt was strong, the Fed. could keep interest rates low.
The problem is that this interrelationship is based on an unsustainable imbalance: the U.S. consumer does not save, period, and the Chinese consumer (such as it is) does not spend. China's economy is export based, and the U.S. economy is based on leverage. This dance stopped when the collateral (assets we were using to borrow against) lost its value. The use of governmental leverage (stimulus) does not address these long term imbalances and prolongs the sad fact we all must face - this country's life style cannot be supported by this country's current economic base.
The real verdict is that as a society we have created an unsustainable myth of economic prosperity over the last decade. We must face the reality that we are left with a legacy of unfulfillable promises (e.g. defined benefit plans and Medicare) created in an era when the U.S. enjoyed economic hegemony. To address this verdict we must rely on our great strengths, still unmatched in the world: (1) to be entrepreneurial and innovate; (2) to attract the best and brightest from other countries to our shores (Does it make sense that almost 90% of the Math PHD students in this country are foreign born and immigration policy requires many of them to leave after they graduate?); and (3) to use these resources to satisfy the growing demands of consumers in third world countries. Focusing on cannibalizing the financial sector may make the country feel good, but will not result in the increased real prosperity we all seek.
