In this current case, the new money went into the housing sector. The new money available meant a rise in demand, which meant a rise in prices – the housing bubble.

It is this manipulation of the money supply causing the wild upswings and then the crashing downturns, which did not exist before government’s backing of fractional reserve in the 19th century, and especially not before central banking in the 20th century.

There is a multiplier effect of up to ten times in the sector receiving the new money. This is not just Austrian theory, the others also agree. So we have a major price bubble, and a major debt bubble, in multiples of the original increase in the money supply. If the funny-money tap is turned off, the debt will be proved to be unserviceable.

That is the underlying situation that the derivatives market is trying to deal with.

A derivative derives from the underlying contract. The derivative functions to transfer the risk of the underlying contract to the buyer or seller. Derivatives can greatly multiply the risk or return.

In short:
• The risk that the derivatives bubble was trying to manage was the risk from the massive unserviceable debt bubble, created by government’s chronic policies of easy money, without which, the derivatives bubble wouldn’t exist.
• The risk of any given contract, underlying or derivative, should be on the person who knowingly undertakes it, which is the situation that would prevail without market regulation.
• The problem is that the risk is, by government, imposed on people who never undertook it, eg when Freddie and Fannie misused derivatives contracts and Joe Public ends up paying for the risk of contracts of which he was not a beneficiary.
• Just as bad underlying loans were made in the knowledge that the government would ultimately bail them out, so bad derivatives contracts were also made with the same tacit backing.

Further upstream from the derivatives problem, is the prime cause of the entire financial crisis: government fiat money.

Ultimately, which do you trust more: gold or politicians’ promises