If we bet one Euro on a coin toss, no money is created. We simply toss a coin and transfer an existing Euro between us in the appropriate direction.
If I am a bank and I loan you a Euro, 97 cents of that Euro are newly created money that didn't exist before. As you repay the loan, that loan-created money ceases to exist.
That the notional value of all derivatives is so huge just means that people have entered into too many bets. But that doesn't mean that money has been created in that notional amount. Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
Say, back in 2004 or 2005 I entered in a (say 5 year) CDS agreement with you. Not owning any of these debts myself I bet that in 2009 or 2010 - for example - GM, Chrysler (Cerberus), Fannie or Freddie Mac, AIG or Lehman Brothers etc. won´t pay its debts?
I´ll pay you $500,000 per year and in case anyone of them defaulted (according to the fine print) you´ll own me $10 million?
The fine print also involves going into government receivership. Certainly true for Fannie and Freddie Mac by now. I invested (2004-2008) maybe $2 million, you now own me $10 million!
The problem seems to be that these CDS contracts weren´t regulated at all. And nobody back in 2004 or 2005 expected a credit crunch just 1-2 years later. They were OTC (Over-The-Counter) contracts. Nobody regulated them, nobody oversaw them.
So I suspect that these CDS aren´t "neutral", we have to expect that they are heavily weighted against at least some companies? Wasn´t that the problem for AIG?
You pay me €100 now and I pay you €1M on some event of probability 1/10,000.
Would you take the bet?
And if you knew I couldn't pay it, would you take it?
And suppose you didn't know better and you still took it and I lost and I couldn't pay? What would happen? Would it be the end of the world?
And at which point in this game is money created? Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
I don't think money is ever created. Debts are created under certain conditions. But the debts can be enormous.
So you are right. The derivatives are not creating money or inflation but potential debts. Under black swan conditions, the debts could be so enormous that repayment is impossible. Which would then lead to potention cascading bankruptcies throughout the financial system....if all is so intertwined as some state. Buffetts financial WMD's.
Money which is hidden from balance sheets and audits can still exist as long as there's some way to convert it into real goods.
The awful toxic horror of money is that somehow these debts become illusory assets which exist for exactly as long as people believe in them.
When that confidence disappears, so does the value.
The only way to avoid a manic depressive economy is to ground value units in items with real physical value - not gold or silver, because their value is mostly still symbolic, but in the products of the ecosystem and in energy flows.
It's impossible to have a viable, stable economy when no one knows how much units of exchange are really worth, or when currency is subject to insane cycles of emotional and psychological excess.
And the real problem is that they may then be accepted as collateral for loans.
This is like what happened with subprime. A NINJA-mortgage salesman comes to an unemployed black man sitting in a porch in rural Alabama and asks him "would you like to own this house before it falls over?" and the man says "sure" so he gets a mortgage he will almost certainly end up defaulting on. But now he's a homeowner! So next time he goes to the bank they ask him "are you a homeowner?" and he ways "yes" and they offer him "how would you like to have a credit card?", so he gets a credit card. And so on. Most economists teach a theoretical framework that has been shown to be fundamentally useless. -- James K. Galbraith
