At bottom, the so-called “New Economy” was an attempt to escape the laws of financial gravity. This was its true meaning, not the “revolution” in information technology (which, instead, acted at its handmaiden). The recent market volatility isn’t really just about the defaults on some subprime loans or the resulting collapse of some overleveraged hedge funds. The market could be about to collapse because we are talking about the pending and painful deconstruction of the New Economy itself.

Let’s look at how we got into this mess. J.P. Morgan once said that the three most important attributes of a borrower were character, capacity (to pay), and collateral—in descending order. New economy lenders have reversed this order. They look primarily to collateral (such as real estate values) for security when making loans, and sometimes give a passing glance to capacity (income). As for character, they don’t even bother to meet borrowers, like lenders used to, never mind do background checks; a friend of mine once received credit card solicitations in the space of six months for his dog, his newly-born son, and his computer (which had a cybermoniker). And the use of “liar loans” based on false income statements underscores lenders’ lack of concern for both character and capacity. Do they know more than old JP? I doubt it.

Instead, losses under such a regime are all but inevitable. That’s because the mortgage brokers, the originators (read, “used car sellers”) of these loans, had no “skin in the game,” and therefore no incentive to exercise even a modicum of caution. Nor did the “bankers,” who initially funded them, bear the risk for long. No, they quickly offloaded these “time bombs” to hedge funds who didn’t know better, yet bought these already leveraged instruments with further leverage—sometimes ten to one or more. The only surprise was that there have been few major blowups until recently. But like a game of musical chairs or hot potato, the system was set up to fail.

Even the rating agencies got caught up in this mentality. Unlike some other people, I don’t believe that the rating agencies colluded with issuers to put out deceptive ratings of e.g., “AAA” structured product. What probably happened was a bit more insidious: the rating agencies deceived themselves about the New Economy and made honest errors of conclusion stemming from seriously flawed premises. They therefore could say with “legal accuracy” that their ratings were bona fide “to the best of their knowledge and belief.” In so doing, they committed an error called the fallacy of composition.

Risks come in two varieties. The first is experience risk. On any given day, a statistical number of subprime loans can be expected to default. But only a small percentage of them probably will. By monitoring the historical default rates of such loans over a period of time, rating agencies can compile data on the experience of different classes of loans. Therefore, the process of structuring backing a package of such loans and adding a cushion of cash sufficient to cover the losses experienced historically, will ensure that investors will come out whole most of the time. Hence “AAA” ratings for such “insured” packages, which works a bit like private mortgage insurance.

The second risk can be euphemistically called business cycle risk; the possibility that today will not be most like other days. Because of the business cycle, there will be bad days when a large number of loans—subprime and otherwise--will default because of systemic risk. Because subprime loans are more vulnerable than others to such risk, their high ratings will be invalid under these circumstances even after the above-mentioned “enhancement.” The problem is that recent experience is seldom a good guide to business cycle risk. The only way to guard against risks relating to a downturn in the business cycle is to presume that one will occur, even though it has not done so in the recent past. But by relying on experience, the rating agencies essentially suspended that presumption, and so let themselves be blindsided. Although doing so was imprudent, such actions might just meet the “prudent man” standard of conduct because many others were on the same page. (“Look ma, all the other kids are doing it.”) But to paraphrase Mark Twain, “Reports of the demise of the business cycle were greatly exaggerated.”

Meanwhile, in the real economy, investors deluded themselves. One such false belief was that earnings could forever grow faster than volume gains could support, because of rising margins. But look where it took us: margins were boosted by “offshoring” production to low cost workers in the in the Third World. Most people thought this could go on for a long time (at least until gross margins reached 100%). But these chickens are now coming home to roost. Forget about merely cheap and shoddy goods. As Mattel’s nine million toy recall showed, “Buying Chinese goods could be hazardous to your health.” Now trade barriers are going up that could make Smoot-Hawley of the 1930s look like “free trade” by comparison. Meanwhile, the cheap finance that supported low interest rates and earlier growth is about to disappear, as China (and other countries) flees a falling dollar occasioned by our large trade deficits. When all this happens, U.S. corporate earnings and GDP growth will head toward zero.

Going into the year 2000, it seemed like stock prices of the technology stocks in the NASDAQ were reflecting 2010 earnings, not those of 2000. Bernie Ebbers’ Big Lie was that Internet use was doubling every 100 days in the year 2000 (or tenfold, annualized). When it “only” doubled during the whole year, companies like Global Crossing went bankrupt because it had ramped up for a sixfold increase in capacity. Meanwhile, the average CEO was making an average of about 400 times as much as the average worker, up from around 40 times in 1980. Was this an accident? Maybe not. Basically, a bunch of turn of the century CEOs promised to produce ten years of earnings growth in one, citing the “New Economy” as their excuse. When the market responded positively, they then collected ten times as much pay as their predecessors (400 times that of the average worker instead of 40 times), through stock options. They justified such “pay for performance” by pointing to the fact that “The market says so.”

But this turned out to be illusory. A stock can be analyzed as a combination of a bond plus a call option. Why did NASAQ go to 5000 in the year 2000 and then collapse to 1000? My guess is that 1000 represented a fair “bond value” for the index at the time. The remaining 4000 points then represented a humongous “call option” on the New Economy. But when hoped-for events don’t occur by the expiration date, the time premiums on the “options” fall to zero (as was the case cited above), leaving only the 1000 bond value.

When Bill Gross of Pimco shocked the investment world by estimating the value of the Dow at 5000 in 2002, he was probably referring to its bond value. My own estimate of this metric, updated to 2007, is something like 6700. In a 1930s scenario, blue chip stocks won’t go to zero, but they will fall to the point where they (collectively) yield more on dividends than Treasury bonds will yield in interest. Then stocks will be trading like bonds, having lost all of the option premiums that characterized their valuations during the period of general belief in the new economy. And in worst case situations like 1932 and 1974, the Dow went to about half of its bond value, a valuation that would put it between 3000 and 3500.

The world will survive the coming market crash and resulting crisis. But our recent view of it will not. It will be a painful lesson, but we are about to find out that the Emperor called the New Economy has no clothes.