In a follow-up to my commentary posted earlier today on Mish's post regarding the weight of credit on money supply—and building on the concept of "lost money" from before (or why the recent doubling of base money has had little upward pressure on prices)—this post will develop the parallel concept of "lost credit."
Lost money refers to base money that should not be counted toward total money supply because it is not being spent and not participating in the economy. If the Fed printed a trillion dollars and stuffed it in coffee cans, and bury it, then those newly printed dollars have no effect on the economy and shouldn't be counted until the point they are found and spent. Similarly if the Fed generates nearly $1 trillion in base money and distributes it to banks where it just sits in bank reserves, it is "lost" to the economic system.
Now, Mish's article estimates $40 trillion of credit in the private market. That this came about in a fractional reserve system allegedly set at 10%. With less than $1 trillion in base money before last September, there shouldn't really be any more than $9 trillion in outstanding credit.
I have no doubt there is more than that, and I have no reason to doubt the $40 trillion figure. So here I will present an argument that much of it shouldn't be factored in to the active money supply, regardless of its market value.
Say I take out a $1M loan to buy a big yacht. Not knowing how to sail, I sink it a week later. Say I didn't buy insurance, and I declare bankruptcy. $1M has been moved from the bank to the seller; the seller still has the money, but the bank has no chance of getting it back. Luckily, for the bank, they packaged the loan and sold it as a security before the boat sank. They recouped their $1M + fees before the security became worthless. The fiat fractional reserve money supply is completely unchanged: the seller of the yacht is spending away and the bank can still lend freely. I'm just out a yacht but I didn't pay much for it either (assuming no down payment). The person screwed is a buyer of that security whose wealth is now irrevocably gone with the boat sitting at the bottom of the ocean. The person who bought the "security" faced the full burden of the loss of wealth.
So, that toxic security would still be added to the amount of outstanding credit until the bankruptcy hearings are finalized. In this case, it's market value would be $0. But that credit no longer plays a role in the money supply. The person who bought the security became the true owner of the boat and I sank it. Even if I didn't sink it, that credit is no more a part of the money supply than is an unpaid Superbowl bet between friends. It is a loan between private parties disconnected from fractional reserves.
It's "Lost Credit." Regardless of its value, toxic or not, securitized debt should not be added in to the money supply.