I know this might sound stereotypic, but since we are facing the heat in one way or the other, I thought of starting here. Everyone today, is talking about the Credit Crisis. The best part is that each conversation has given this crisis either a new definition or a new dimension. I am following suit by compiling this one. Let’s add a more detailed dimension to it. The “Illusion of Wealth”.

Before the so-called Credit Crisis, the world was awash with wealth. And now central banks are pumping in more money than ever and yet everyone is short!!!

Gold Reserves

Ever since the central banks stopped pegging their currencies to the price of gold, money has been a nebulous concept; a Promise to pay the Bearer or a “Cheque” from the central bank, rather than a permanent store of wealth. Nevertheless, most central banks do still hold substantial reserves of gold foreign currencies as a buffer against financial turbulence.

However, the size of these gold reserves (US$ 845 bn of gold in central bank vaults) is a sobering reminder of how much the value of money is an expression of confidence, or perhaps even a confidence trick. Centrals banks do not need to hold these gold reserves on a larger scale since their ultimate response to a severe crisis, like this one, is to print more money. This process is underway, primarily in the US and UK, through an intervention called "Quantitative Easing”. Critics have gone to extent to saying that this crisis has exposed the inherent weakness of paper or “fiat” money.

Cash in Circulation

The narrowest measure of money is known by economists as M0 and counts all the notes and coins in circulation plus the reserve which commercial banks are required to hold with the central banks. Because of the process of loan creation, this way of counting money can produce a much lower number than the amount of theoretical cash flying around the world in electronic form. The global M0 in October 2009 was roughly US$ 3.9 tn. This too has been growing though, especially led the increases in money supply in China and US.

Attempts to avoid the economic recession after the investment bubble burst at the turn of the century also led central banks to reduce interest rates to historically lower levels. Since interest rates effectively measure the “price” of money, this corrective action led to explosion of cheap debt which has caused the current meltdown.

Traditional Banking System

Ever since the queues formed outside the Northern Rock, it has been slowly dawning on the people that all the banks are inherently unstable. Under a system called “Fractional Reserve Banking”, the banks are allowed to lend many times the amount they take in as deposits – on the assumption that not all depositors will ever want their money back at once (Remember – loan creation). Instead, the banks are required to hold small core reserves with the central bank.

For example, $1 for every $4 they lend out. You put $100 in; they can lend out $80 to someone wanting a car. The car company puts that $80 back into the banking system, and its bank gets to lend out another $64 and so on; creating up to $360 of new money if taken to extreme, which in this case of crisis has happened.

As commercial banks found more and more sophisticated ways of luring customers in to taking loans and with historically low interest rates, as an icing on the cake for the borrowers, this process saw the assets of the world big commercial banks balloon to $39tn according to the Bank for International Settlements.

Shadow Banking System

Banking regulations have been heavily criticized during this crash, but the rules governing commercial bank lending were very stringent compared to the so-called “Shadow Banking System”.

Led by the Investment Banks and Hedge Funds, traders found even more exotic ways to escape limits on how much they can borrow to increase their returns. One financial instrument in particular, the credit derivative, grew to dwarf the value of the underlying debt on which it was based – peaking at US$ 62 tn according to the International Swaps and Derivatives Association.

Ostensibly, Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) allowed lenders to insure themselves against the risk of any one borrower going bust and therefore lend greater amounts more safely. Instead, traders lost touch of who owed what and products like CDO squared took financial engineering into fantasy land.

The notional value of all derivatives reached US$ 863 tn – many times the value of all economic activity on the planet Earth.

The Great Asset Bubble

Easy money fuelled a series of gigantic bubbles in the price of key assets such as property. These bubbles are now bursting with violent consequences. Working out how much the world is worth is tricky, but the Economist made a stab at US 115 tn for developed economies in 2002 – including property, shares and bonds. In the subsequent boom, shares alone soared to a peak of US$ 51 tn.

Applying the same multiple to other asset bubbles suggests the total asset value of developed economies peaked at US$ 290 tn compared to with the Global GDP of around US$ 55 tn.

Asset prices matter more than usual because loose credit conditions previously meant that customers were able to borrow against the value of their homes or share portfolios to spend yet more money. We all felt wealthier, so we spent more.

An Unstable Pyramid

Viewed from the bottom up, the explosion in debt and asset prices that occurred during the boom years looks unstable and top-heavy. It even bears similarity to the pyramid or “Ponzi” schemes carried out by the fund managers like Bernie Madoff; all the time all the participants believed in the inexorable growth of the economy, rising debt levels sustainable. When the music stopped, the whole edifice began to wobble.

Why the BAIL OUTS are ineffectual?

Attempts to restore stability by pumping in public money have had some effect but the sums of money are tiny relative to the problem. The total value of state assistance to the banking system – either through direct spending or guarantees is estimated US$ 1.9 tn.

The next stage is seeing central banks’ attempt to re-inflate the bubble by injecting new money into the system through a process called “Quantitative Easing”.

Velocity of Money : mv = pq

As they dust down their economics textbooks, one equation is enjoying a revival among bankers trying to understand why the credit crunch is so powerful.

The quantitative theory of money can be expressed in just four letters that serve to explain much of what is happening to the world today: m, v, p and q. Put crudely; m = amount of money in circulation, v = velocity with which it zips around the financial system, p = price of goods and q = quantity of economic output.

During the economic boom, financial innovations sped up the flow of money through the system. Now the banks stop lending to each other and nervous customers stop spending, velocity is tumbling. Even though the money supply is being increased by the central banks, it is not enough to prevent steep falls in the prices and the output, or GDP, of the world economy.

Source: GFMS

- Gaurav Shah, DeFinancial Times