Does America really need an economy that depends on creating new bubbles to get us out of the mess caused by the bursting of old ones? Is it possible to replace this with an economic system that generates growth without bubbles? I think the answers to these questions are No and Yes.

The most recent example of this bubble economy is the way the dot-com frenzy's aftermath was replaced by a debt bubble, which was focused heavily on a now-imploding mortgage-backed securities (MBS) industry. The dot-com bubble expanded thanks to the public's insatiable appetite for dot-com IPOs, regardless of whether the issuer was or could become profitable. The MBS bubble grew thanks to rock-bottom interest rates, rising housing prices and institutional investor demand for higher "risk-free" yields, all of which ignored the cost of a market reversal.

But the MBS part of the current bubble may not be the last to burst. There are also the leveraged loans that fueled a boom in private equity -- a market which has lost 70% of its business in the last year. Thankfully, massive defaults in such loans have yet to occur. The New York Times reports that capital-starved banks are starting to limit commercial and industrial loans that fuel normal business expansion. It reports that such loans have dropped 3% since 2007, from $3.36 trillion to $3.27 trillion.

The most interesting part of this article is the quotes. For instance, John W. Kiefer, chief executive of First Capital, a private commercial lender, said, "Before, they wouldn't verify income and they were loose on the valuations of collateral. Now they're tightening down on the ability to repay. They go off the reservation, and now they come back to basics. It's preservation for many of them at this point. It's survival."

What causes these bubbles to expand and contract? Here are five sources:

• Securitization - If a bank sells a loan rather than keeping it on its books, it does not care whether the borrower pays back the loan. Now that the securitization market is dead, banks can't sell the loans they originate so they pay more attention to whether the borrower can repay.
• Leverage - During the boom, the typical investment bank and hedge fund had $1 of capital for every $32 in assets, meaning that it borrowed the other $31. This level of borrowing expands profits when the bubble is expanding and magnifies the losses during a contraction. If these financial institutions had more of a cushion of capital, they would not need to look to taxpayers to bail them out of their business mistakes.
• Fear of getting left behind - During an expansion, financial institutions look at their peers and they wonder why they are not doing as well. Their CEOs latch onto one type of activity and force their people to copy that one area. This is how Merrill Lynch & Co. (NYSE: MER) got to be such big player in trading MBSs -- its former CEO thought Goldman Sachs Group (NYSE: GS) was ahead due to its exposure there and he wanted to manage his Goldman envy.
• Young staff - When the bubble pops, financial institutions fire the people who made the loans and originated the deals. Many of the people they fire have the experience to understand what went right and what went wrong. And when the banks fire these people, they lose the wisdom that could keep the banks from making the same mistakes again. When bubbles begin to expand again, the financial institutions hire a new crop of young bankers to bring in business. And this new crop lacks the wisdom of the ones that got fired.
• Heads-I-win, tails-you-lose pay - As I have pointed out here and here, financial institutions pay people for the volume of business they bring in. This encourages them to close as many big deals as they can and to ignore the quality of those deals. When the deals go bad, nobody asks them to fork over their multi-million dollar bonuses to cover the losses of the deals they originated.

If we replace each of these things, we can end the bubbles. Here's how that would work:

• End securitization - As I pointed out here, securitization's costs are enormous and its benefits are hard to quantify. But if financial institutions are required to hold on to the loans they originate, they will be far more careful about extending credit. This will keep their losses at a manageable level.
• Independent monitoring of adherence to credit standards - In the wake of popping bubbles, chastened bankers always spend time updating their procedure manuals with very conservative guidelines about how much they will lend to borrowers based on their ability to repay and how much capital they need as a cushion against problems. To prevent bubbles, we need well-financed, independent, and rigorous monitoring of how well financial institutions actually apply these standards. And if they don't follow those standards, we should give the independent monitors the power to make sure they do.
• Experienced staff - Financial institutions need to keep a sufficient number of managers with the experience of having lived through previous bubbles who will guide those who lack that wisdom. Ultimately it is up to the financial institutions themselves to make the right decisions. And those decisions are likely to be made by people with the experience to know when to say no.
• Equitable pay - As I've posted, I think we should put bankers' pay in an escrow account. If the loans and deals they originate perform well -- after, say, five years -- then they get their bonuses. If not, the funds in the escrow account go to compensate bank shareholders for the losses of the bad loans and deals they originated. This, more than anything else, would align the interests of those who bring in business with those of the entire financial system.

These changes will cause the people who issue credit to care about the long-term profitability of the financial system because their careers will depend on it.

Now all we need is for a big enough crisis in the U.S. to get Washington to examine the root causes of bubbles and to take these changes seriously so we can end these costly cycles of bubble expansion and collapse.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.