By Michael Mandel 

Is the market and economic turmoil nothing more than a crisis of confidence? To listen to Ben Bernanke and Hank Paulson, you might think so. "At the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets," Bernanke told the Economic Club of New York on Oct. 15.

On Oct. 20, Paulson went further, explaining the bank recapitalization program this way: "Our purpose is to increase confidence in our banks and increase the confidence of our banks so that they will deploy, not hoard, their capital. And we expect them to do so, as increased confidence will lead to increased lending."

The implication of the Bernanke-Paulson view is that the underlying economic system is fundamentally sound, so that restoring trust in the financial system will put us back on a growth course. From that perspective, the infusion of massive amounts of capital into banks, which replaces the money lost in bad mortgages, will enable lending to begin again. Once investors see that all is well, then they will cease their irrational behavior, and start putting money back into stock markets and companies around the world.

Treating the Wrong Problem?

But what if the Bernanke-Paulson view is wrong? What if financial stress is a symptom, not a cause?

What if we face a wrenching readjustment of the global real economy rather than a crisis of confidence rooted in the financial system? What if Bernanke and Paulson are treating the wrong problem? What if investors, realizing that their long held assumptions about the global economy are wrong, are rationally bailing out of stock markets in almost every country, at least for now?

In fact, there's good reason to believe that the current crisis reflects a growing realization: Long accepted patterns of cross-border technological transfer, foreign trade, and global finance are simply not sustainable.

Three Big Flows

For the past 10 years, global growth has been driven by three big flows. The first flow was the transmission of knowledge, technology, and business know-how from the U.S. and other industrialized countries to low-wage emerging economies such as China and India. Under the neutral name of "supply chain management," multinationals taught local suppliers to make shirts, laptop computers, and airplane rudders that could be sold around the world. Moreover, U.S. and European companies gave suppliers access to enough information that they could develop their own cell phones, software, and other tech products. The result: a massive improvement in productivity and living standards in emerging economies.

The second flow was the movement of goods and services from China and other emerging economies to the U.S. Massive amounts of production capacity was built around the world, assuming that the U.S. was always going to be the consumer of last resort. Indeed, the value of U.S. imports—over $2.3 trillion in 2007—was larger than the entire output of Britain, the sixth-largest economy in the world. The result: Rising living standards in the U.S., rising employment, and production around the world.

The final flow, of course, was financial. The rest of the world lent U.S. consumers trillions of dollars to finance the trade deficit. The money flowed into the country in all sorts of ways, including cheap mortgages and cheap credit for cars and televisions that were made overseas. At the same time, companies in emerging markets were borrowing heavily to build the factories that were going to supply the developed world.

Something Had to Give

This tri-flow worked as long as everyone believed that American consumers could finance their debt. But here's the problem: At the same time Americans were borrowing, their real wages were falling—and not just for the least educated. By BusinessWeek's calculations, real weekly earnings for college grads without an advanced degree have dropped every year since 2002.

You can't pay back rising debt with falling wages; something had to give.

The first thing that broke were subprime mortgages, given to less creditworthy borrowers. But once investors started to look, they realized that the entire global edifice was built on an impossibility. The tri-flow that had built global prosperity could not be sustained.

Good News and Bad News

That's why the financial crisis has spread across the globe. Investors are peering at every country, from Kuwait to Korea, asking the question: Is it sound enough to survive if American demand for imports falls? The problem is in the structure of the global real economy, not the financial system.

This is both bad news and good news. The bad news is that government injections of capital into banks around the world can slow the damage, but they cannot fix the basic problem. The global economy has to go through a readjustment process that will be difficult even if policymakers can restore confidence in the financial system.

The good news is twofold. First, the productivity gains in the emerging economies are real. Sooner rather than later, their growth will resume. Second, we do have a tool for easing the adjustment, and that's fiscal stimulus. With private demand for credit weak, governments can judiciously borrow and spend to help pump up growth and employment.

The final implication: Policymakers should stop talking about investor confidence as if it exists in a vacuum. Instead, they should focus on the real goal of stimulating the creation of innovative new goods and services that the U.S. can produce and sell on global markets. That would reduce the amount of borrowing the country has to do, and help create a sustainable global economy. This crisis is not any fun. But if it shakes up companies and government, and forces them to focus on innovation, the end result will be stronger, more solid economic growth.