Rana Foroohar

For the last few years, markets were from Mars, and the real economy was from Venus. The two literally occupied different worlds, as stock prices kept rising, even as wages were stagnant and growth was slow. As of yesterday, that divide has been bridged. Stock prices finally plunged into a real correction of the kind we haven’t seen since the apex of the European debt crisis three years ago.

The question is, why now? The answer comes in two parts. First, with Europe in danger of tipping into recession, and China’s growth much lower than the official statistics would indicate (that’s one of the big reasons oil prices are down since China is now the world’s major consumer of energy), investors have realized that a wimpy recovery in the U.S. isn’t enough to buoy global growth. Sure, growth numbers were a bit better this year than last, but we’re still in a 3 percent economy that doesn’t look or feel much different than the 2 percent economy (see my Curious Capitalist column on that topic). If you think of the global economy as three legs on a stool, the legs being the U.S., Europe, and the emerging markets led by China, what’s becoming very clear to markets is that a 3 percent economy in the U.S. isn’t enough to sustain global momentum. Indeed, the U.S. may grow faster than the world as a whole this year, which is an odd thing for a developed market. It speaks to how weak the global economy as a whole still is.

Second, markets have realized that this recovery has been a genetically engineered recovery. It’s been engineered by the monetary scientists at the Fed, who’ve pumped $4 trillion into the economy since 2009 in an attempt to strengthen an economy that is fundamentally not as strong as it looks. Despite the Fed’s best efforts (and I agree that they needed to do something, especially in the beginning), the real economy simply hasn’t caught up to the markets. Unemployment has ticked down, but wages still haven’t ticked up. It’s no accident that weak retail sales in the U.S. were one of the economic indicators that triggered the sell-off. As I’ve said many times before, you can’t have a sustainable recovery, one markets can really believe in, until you have the majority of the population with more money in their pockets.

The reality is that this hasn’t happened in the last few years, and for many people, decades (the average male worker today makes less in real terms than he did in the early 1970s).

So does this mean we are in for a long, slow slide? Not exactly. I’d bet more on increased volatility (if you are a subscriber, you can read this piece I wrote on the coming Age of Volatility, back in 2011). Markets will go up and down, but as long as the U.S. is the prettiest house on the ugly block that is the global economy, money may stay parked in the largest American multinationals longer than you’d think. Whether or not our economy deserves the vote of confidence is another question.

Traditional lenders aren't doing their job. Enter a raft of startups to do it for them

You know credit is tight when the former chair of the Federal Reserve can’t get a mortgage. Ben Bernanke, who isn’t exactly hard up (he reportedly makes at least $200,000 a speech), recently lamented that he wasn’t able to refinance his home because of tight credit conditions. This is an inglorious reminder that the housing recovery is being driven not by first-time home buyers or people who want to trade up but by wealthy people who don’t need a loan. Since most middle-class Americans still hold most of their wealth as equity in their homes, we won’t achieve a sustainable recovery until we fix the housing market.

Banks would say the difficult credit conditions reflect the higher costs of complying with new regulations like Dodd-Frank. There’s some truth to that but not enough to justify turning down nearly any borrower who can’t put down 30% cash on a house. A more accurate explanation is that home-mortgage lending isn’t nearly as profitable as securities trading, which is where big banks still make much of their money these days. And so, hidden in the sluggish housing recovery is another revolution: American banks continue to morph into investment houses in ways that could ultimately put our financial system at risk.

Rather than Bemoan this, I am encouraged by some of the innovative companies trying take advantage of these shifts. A whole new category of nontraditional lenders is springing up to take traditional banking’s place. Nonbank financial firms, a category that includes everything from companies like Detroit-based Quicken Loans to peer-to-peer lenders like the Lending Club, are growing exponentially. (Peer-to-peer lending is the relatively new practice of lending money to unrelated individuals without going through a traditional intermediary like a bank.) This category of nonbank banks is taking up a lot of the slack left by traditional banks in the aftermath of the financial crisis. During the first half of this year, almost a quarter of mortgages made by the top 30 lenders came from nonbank firms, the highest level since the financial crisis began.

Many of these lenders use unconventional metrics to judge how creditworthy borrowers really are. They’re focusing not just on borrowers’ salary and tax returns, which are the basis of most traditional mortgage-lending calculations, but also on their field of work, what kind of degree program they are in or what their potential income trajectory might be.

Such metrics enable these lenders to take on risks that traditional banks now shun. “There’s a misperception out there that millennials don’t want to buy a home,” explains Mike Cagney, CEO of Social Finance, a company that has already done over $1 billion in crowdsourced student-loan refinancing and is now pushing into the online mortgage market. “But the reality is that they don’t have the credit to do it.” Cagney says many of his initial mortgage borrowers mirror the profile of the customers to whom he gives reduced-rate student loans–upwardly mobile young professionals, many with degrees from top schools, who have bright futures in high-income professions but little cash in the bank. Particularly on the coasts, where real estate prices are high, it is nearly impossible for a young person to buy a home with a traditional credit profile.

Of course, it’s not only upwardly mobile future members of the 1% who deserve a break on credit. Research shows that many low-income borrowers with steady jobs are much better credit risks than they look like on paper. One University of North Carolina study found that even poor buyers could be better-than-average credit risks if judged on metrics other than how much cash they have on hand. That’s not to say we should have runaway borrowing as we did in the run-up to 2008, but credit standards are still very tight relative to historical averages.

Nontraditional lending has already shown there is an alternative to the not-very-public-minded banking system we have in place now. That raises the question, Why should big banks whose primary business model is no longer consumer lending be government-insured in the first place? (Many would argue that the bailout guarantee implicit in such insurance was the reason the too-big-to-fail institutions were able to leverage up and cause the subprime crisis in the first place.) Perhaps the safest thing would be for banking as a whole to go back to a model in which institutions simply keep a lot more cash on hand, or have unlimited liability as a hedge against risk taking? Who knows? That might make mortgage lending look good again.

Tapes of what really happens between bankers and regulators show how far we have to go

In some ways, the most shocking thing about the 46 hours of secret audiotapes made by former Federal Reserve bank examiner Carmen Segarra in 2012 is that they are no shock at all. Did anyone ever doubt that the New York Fed was in hock to Wall Street? Or that Fed bank examiners–the regulators tasked with monitoring the risks banks take–might fear alienating the powerful financiers on whom they depend for information or future jobs?

It’s one thing to know and another to hear in painful, crackling detail how the Fed’s financial cops slip on their velvet gloves to deal with Goldman Sachs. Or how Segarra, one of a group of examiners brought in after the financial crisis to keep a closer watch on the till, was fired, perhaps for doing her job a little too well. One can only hope that this latest example of regulatory capture by Wall Street will focus minds on the fact that six years on from the crisis, we still have a dysfunctional financial system.

Consider one of the shady deals highlighted on the secret tapes of New York Fed meetings, which Segarra made with a spy recorder before she was let go and which were made public on Sept. 26 in a joint report by ProPublica and This American Life. The 2012 transaction with Banco Santander, initiated in the midst of the European debt crisis, ensured that the Spanish bank would look better on paper than it really was at the time. Santander paid Goldman a $40 million fee to hold shares in a Brazilian subsidiary so that it could meet European Banking Authority rules. The Fed employees, who work inside the banks they examine (yes, it’s literally an inside job), knew the deal was dodgy. One even compared it to Goldman’s “getting paid to watch a briefcase.” But it was technically legal, and nobody wanted to make a fuss, so the transaction went through.

It’s hard to know where to begin with what’s problematic here. I’ll focus on the least sexy but perhaps most important point: existing capital requirements–the cash that banks are obligated to hold to offset risk–are pathetic. Despite all the postcrisis backslapping in Washington about how banks have become safer, our system as a whole has not. No too-big-to-fail institution currently is required to keep more than 3% of its holdings in cash (a figure that will rise to 5% and 6% in 2018), which means banks can fund 97% of their own investments with debt. No company outside the financial sector would dream of conducting daily business with that much risk. As Stanford professor Anat Admati, whose book The Bankers’ New Clothes makes a powerful case for reining in such leverage levels, told me, “We’ve got to get rid of this idea that banking is special and that it should be treated differently than every other industry.”

Of course, if you start telling financiers they should use more than a few percentage points of their own money when they gamble, they’ll throw a fit. They will tell you that would make it impossible for them to lend to real businesses. They will also uncork lots of complex financial terms–”Tier 1 capital,” “liquidity ratios,” “risk-weighted off-balance-sheet exposures”–that tend to suffocate useful (a.k.a. comprehensible) debate. Financiers use insider jargon to intimidate and obfuscate. This is something we need to fight. In banking, as in so many things, complexity is the enemy. The right questions are the simplest ones: Are financial institutions doing things that provide a clear, measurable benefit to the real economy? Sadly, the answer is often no.

One thing we’ve learned since the crisis is that bailing out Wall Street didn’t help Main Street. Credit to individuals and many businesses plummeted during and after the bailouts and remains below precrisis levels today. Numerous experts believe that the size of the financial sector is slowing growth in the real economy by sucking the monetary oxygen out of the room. Banks don’t want to lend; they want to trade, often via esoteric deals that do almost nothing for anyone outside Wall Street.

This disconnect between the real economy and finance is now being closely studied by policymakers and academics. Adair Turner, a former British banking regulator, thinks that only about 15% of U.K. financial flows go to the real economy; the rest stay within the financial system, propping up existing corporate assets, supporting trading and enabling $40 million briefcase-watching fees. If the New York Fed really wants to redeem itself, it might consider commissioning a similar study to look at Wall Street’s contribution to the U.S. economy. After all, if finance can’t justify itself by showing it’s actually doing what it was set up to do–take in deposits and lend them back to all of us–what can justify it?

Yes, 3% growth is better than 2%. But, for most Americans, it’s actually more worrisome

A little over three years ago, I wrote a column titled “The 2% Economy,” explaining how a recovery with only 2% GDP growth, no new middle-class jobs and stagnant wages wasn’t really a recovery after all. Like everyone, I hoped that once growth kicked up to about 3%, middle-class jobs and wages would finally revive.

But we’re now in a 3% economy, and I’m writing the same column. Only this time, the message is more disturbing. Growth is back. Unemployment is down. But only a fraction of the jobs lost during the Great Recession that pay more than $15 per hour have been found. And wage growth is still hovering near zero, where it’s been for the past decade. Something is very, very broken in our economy.

It’s a change that’s been coming for 20 years. From World War II to the 1980s, according to data from the McKinsey Global Institute, it took roughly six months after GDP rebounded from a recession for employment to recovery fully. But in the 1990–91 recession and recovery, it took 15 months, and in 2001 it took 39 months. This time around, it’s taken 41 months–more than three years–to replace the jobs lost in the Great Recession. And while the quantity has come back, the quality hasn’t. The job market, as everyone knows, is extremely bifurcated: there are jobs for Ph.D.s and burger flippers but not enough in between. That’s a problem in an economy that’s made up chiefly of consumer spending. When the majority of people don’t have more money, they can’t spend more, and companies can’t create more jobs higher up the food chain. This backstory is laid out in an interim Organisation for Economic Co-operation and Development report cautioning that poor job creation and flat wages are “holding back a stronger recovery in consumer spending.” If this trend is left unchecked, we are looking at a generation that will be permanently less well off than their parents.

There are so many signs of this around us already. The decline in August home sales–a result of wealthy cash buyers and investors stepping back from the market–shows how what little recovery in housing we’ve seen so far has been driven by the rich; anyone who actually needs a mortgage has been slower to jump in. The real estate recovery too is very bifurcated, with much of the gains concentrated in a few more affluent, fast-growing cities. (Plenty of places in the Rust and Sun Belts are still underwater.) While overall consumer debt is down, it is still high by international standards, and student debt is off the charts. When I asked one smart investor where he expected the next financial crisis to come from, he said, “Student debt.” Interest rates on tuition loans are high and fixed, and the loans can’t be refinanced, meaning they’re a trap that’s hard to escape. And student debt continues to grow fast. History shows that the speed of increase in debt, more than the sheer amount, is a predictor of bubbles. By that measure, student debt is blinking red: it has tripled over the past decade and now outstrips credit-card debt and auto loans.

It’s easy to understand why. Much of the population is desperately trying to educate its way out of a terrifying cycle of downward mobility. But students are fighting strong structural shifts in the economy. While technology-driven productivity used to be what economists said would save us from jobless recoveries, technology these days removes jobs from the economy. Just think of companies like Facebook and Twitter, which create a fraction of the jobs the last generation of big tech firms like Apple or Microsoft did, not to mention the multitude of middle-class positions created by the industrial giants of old.

And we’re just getting started: consider the outcry in certain cities over companies like Zillow, Uber and Airbnb, which are fostering “creative destruction” in new sectors like real estate, transportation and hotels. McKinsey estimates that new technologies will put up to 140 million service jobs at risk in the next decade. Critics of this estimate say we’re underestimating the opportunities that will come with everyone having a smartphone. All I can say is, I hope so. What’s clear is that development isn’t yet reflected in stronger consumption or official economic statistics.

What I do see is growing discontent with the economic status quo. In my 2011 column I wrote, “It’s clear that the 2% economy heralds an era of even more divisive, populist politics–at home and abroad.” Ditto the 3% economy. Witness outrage over displaced lower-income workers in the Bay Area, or the fact that the Fed is keeping interest rates low in part because gridlock has prevented Washington from doing more to stimulate the real economy, or the Treasury Department’s new rules limiting American companies’ ability to move outside U.S. tax jurisdiction. Whatever number you put on growth, a recovery that doesn’t feel like a recovery is, yet again, no recovery at all.