Why Credit Suisse believes austerity could drag us down

The shadow banking system is the part of the finance sector that isn’t backed by the government (the way traditional banks are) and includes everything from private equity to hedge funds to other investment funds. Shadow banks got a bad rap for fueling the financial crisis. But this system has also continued to play a significant role in providing liquidity — in the form of debt and credit — to keep the global economy running.

But there’s a dilemma: Shadow banking is unlikely to ever come back to its pre-recession highs, and it’s unclear what, if anything, will take its place. Even as the global economy has shown signs of recovery, the supply of very safe collateral to back new loans has dwindled (collateral can include things like houses and European sovereign debt). And that means the shadow banking sector will continue to pull back.

In the immediate aftermath of the recession, the government’s fiscal stimulus and monetary easing stepped in to fill the gap when the shadow banking dropped off, as Credit Suisse explains in a new report that Kevin Drum and FT’s Alphaville both flag. But more recently there’s been push for fiscal austerity, even though the private sector “is still not creating money,” Credit Suisse points out.

In fact, Credit Suisse expects the shadow banking sector to contract even further in 2012. In the U.S., this will be happening just as new regulations on derivatives, a mainstay of the shadow banking sector, come into effect. At the same time, fiscal deficits will be shrinking, which could crunch the money supply just as the demand for credit starts to recover.

In other words, as Drum explains, it’s essentially the argument against now being the time for aggressive fiscal austerity, given how much already depending on the government. “The public sector is still doing King Collateral’s work,” Credit Suisse concludes. “How long it acts as Regent may be the central question for financial markets in the next decade.”