Much type has been wasted on the credit and liquidity crises of the past few years.
Call it what you will — "extend and pretend" or "delay and pray." The result is the same.
After many decades of credit expansion and malinvestment, the debt came due in 2008.
Lehman Brothers was sacrificed on the altar of Charon and the Federal Reserve ginned up somewhere between $6 and $8 trillion to restore faith in the markets and get credit moving again.
This Did Not Work
In previous years when the central bank extended credit, it formed a bubble.
Money goes where it is most loved...
We had dot-com bubbles, subprime bubbles, and commodity bubbles. I remember the uranium bubble with particular fondness.
But for some reason, after the biggest printing scheme known to history, there was no bubble.
What happened to all the money?
Why after every country in the world puked out a stimulus plan has no asset class gone up?
Not only has the G20 taken on vast amounts of new debt — but we have nothing to show for it.
In fact, the global economy is worse off.
Instead of a liquidity crisis on the level of a large bank like Lehman or Bear Stearns, we have a credit crisis on the sovereign level of Spain and Italy.
Instead of credit default swaps that might take down AIG were nothing done, we're looking at CDS that will take down Europe because there is nothing left to do.
The Dark Banks
The answer to the missing money question lies in an unregulated banking system that is estimated to represent over 30% of the banking industry.
It's called the shadow banking system (SBS).
A regular bank takes deposits and loans out money. It is heavily regulated by government entities.
The shadow banking system, on the other hand, is simply a collection of financial entities, systems, and rituals that moves outside the regulated world of governments.
It is made up of hedge funds, money market funds, and structured investment vehicles.
I won't bore you with the nitty-gritty...
Just know that these groups act as a middleman between those who have money and those who want money. And because they are unregulated, they can leverage up as high as they want.
This, of course, leads to failure.
The list of failed highfliers is long.
One SBS you might remember is Long-Term Capital Management. It failed in 1998 and was bailed out by the large banks at the request of the government. Another is Amaranth Advisors, which failed in 2006 on a $9 billion natural gas bet.
MF Global is perhaps the most recent failure of this magnitude. Its mistake was in thinking Germany would bail out Greece.
Dark Pools of Liquidity
Regular banks are regulated and take deposits. Shadow banks are unregulated and take risks. These institutions can bet the house on the riskiest of assets.
In 1995, due to Alan Greenspan gutting regulation, this shadow banking system grew larger than the regular banking system. In 2004 it grew bigger than the U.S. GDP. Then it went up some more...
Here's a chart from the New York Fed (with a thanks to Mish's Global Economic Trend Analysis for covering this topic in detail):
However, after the crash in 2008, hedge funds were crushed with record redemptions.
Hundreds if not thousands went whitefish belly-up. Their creditors and trading partners were left gasping for air.
The house of cards was sitting on a shaky table in a clown circus rodeo.
So, the Bernanke cash — over $6 trillion of it since 2008 — went first to the regulated banks and then found its way to the SBS (note the green line on that chart above is ever higher).
This Is Deflationary
These charts show a massive reduction in credit.
That's money off the table and reduction of velocity.
This goes a long way toward explaining the current state of the economy and the theme “first deflation, then inflation.”
Markets tend to overshoot on the upside as well as the downside. This begs the question of how much farther the SBS will deleverage — and what you can expect to see as we look into the black void of a deflationary spiral.
More on that next week.
Since 1995, Christian DeHaemer has specialized in frontier market opportunities. He has traveled extensively and invested in places as varied as Cuba, Mongolia, and Kenya. Chris believes the best way to make money is to get there first with the most. Christian is the founder of Crisis & Opportunity and Managing Director of Wealth Daily. He is also a contributor for Energy & Capital. For more on Christian, see his editor's page.