'For every long there's a short.'

That is one of the comforting myths of the present credit bubble.

Yes, there are more derivatives than there are people...but no, they are not supposed to pose a threat to the world economy. Why not? Because there is always someone on the other side of the trade, say the experts.

Every dollar lost by one trader in London is recovered by a trader, say, in New York or Berlin. The total amount of 'money' or 'liquidity' remains constant. One man's loss is another man's gain.

But is it true? Is liquidity like water? Does every drop lost to evaporation come back as rain? Is it like energy and matter, of which the world supply is constant, unchanging and irreducible?

There's the problem, isn't it? We know very well that the world's supply of liquidity has recently grown at the fastest rate ever recorded. If it can increase, isn't it obvious that it can decrease too? And when it does go down, who gains?

One of the remarkable features of this entire remarkable period is the disappearance of what is called 'short' interest - interest in selling. We mentioned yesterday that the people who are supposed to have shorts - hedge funds and young, female celebrities - have been forgetting to put them on. Life is so pleasant...so safe...they don't think they need them anymore.

What was supposed to make hedge funds different from mutual funds or other collective investments was that they 'hedged.' They went short in order to protect themselves on the downside...thus trying to achieve decent returns even when the broad market went up. Time goes on and hedge fund managers - like hikers and husbands - lose track of where they are and how they got there.

Today, a 'hedge fund' is merely an unregulated pool of money in search of investors' cash. This desire is driven, not by a love of investors, but a love of investors' money. Warren Buffett describes hedge funds as a compensation plan disguised as an asset class. By that he means that hedge fund managers pay themselves so richly - typically, 2% of assets and 20% of profits - that is it unlikely there will be much left for investors. We have said so often ourselves.

But the burthen of today's comments is not to curse the darkness of the hedge fund industry but to light a small candle...hold it up...and burn their fat derrieres!

We are only joking, of course. Instead, we hold up our flickering lamp in order to try to see who is on the other side of these massive bets...and what will happen to all this 'liquidity' when the bets go bad. We have faith, dear reader...faith in the eternal verities...including this: Every dollar created out of thin air eventually goes back from whence it came.

But let us return to our first question: if there is a buyer for every seller, how come the world's supply of riches - cash, credit, liquidity - doesn't remain constant? First, it is worth pointing out that as a credit bubble expands, short interest does not expand with it; instead it shrinks. Look at the hedge funds themselves. They dropped their shorts because, as prices rose, short-selling became unnecessary...and chances to do it became harder to find.

"We're having a tremendous amount of trouble finding short ideas," says Paul Mampilly, managing director of investment group Kinetics Advisers LLC. "We prefer to be more long than short."

Who wants to short prices when they are going up? Only someone who is worried that they might go down. But the longer prices continue to go up, the less concerned about a reversal investors become. A hedge fund that actually hedges has a disadvantage in the marketplace; its short positions - though adding greatly to investors' security - depress the performance numbers. The fund managers may not be geniuses, but they can do simple math. 'Two and twenty' works a lot better on $50 million at 20% growth than on $25 million at 10%.

The other thing that happens in a big, long expansion of liquidity is that as the interest in hedging goes down so does the price of it. Thus, there are fewer and fewer actual dollars on the short side. Yes, if the market goes down, a few short sellers will make a lot of money, but nowhere near as much as the bulls will lose when their asset prices collapse.

And often, there really is no one on the other side at all. If the price of Google shares falls to $50...hundreds of billions of dollars simply disappear into a black hole. Except for the short interest, everyone is worse off. The money has gone away...up to 'money heaven,' never to be seen again.

You can see even more clearly how this works in the residential property market. A man who has a house worth $500,000 thinks he has a lot more wealth than the same man when his house falls to only $250,000. He is out a quarter of a million dollars. And who was on the other side of the trade? Who made the money he lost? Where is the short interest in the residential housing market? It didn't exist. When house prices fall almost everyone is worse off - except for new buyers. Owners feel poorer. Lenders make less money from new transactions...and old ones comes back to haunt them. Realtors make less. Builders make less. Appliance makers, toolmakers, furniture makers, Home Depot and other retailers - all make less; people are unwilling to put a lot of money into a house that is falling in price.

And imagine what happens if the dollar falls. The U.S. national debt is nearly $9 trillion and growing at $1.24 billion per day. Remember how Gerald Ford sounded the alarm back in '74 when the national debt was a grand total $30 billion. Now, it grows by more than that amount every month!

Well, imagine that the dollar is suddenly worth only 50 cents. People who thought they had nearly $9 trillion in assets suddenly realize they have lost $4.5 trillion. Where did the money go? Who was on the other side? The lenders are out trillions...while the borrower - the U.S. government - has achieved debt relief of the same amount. But it never actually had that amount of money; that is, it never had the money to pay back the loans...and never would have. In effect, the trillions would just be 'written off' like a bad debt. This doesn't mean people are necessarily worse off...but they definitely would have less cash and credit - less liquidity - than they had before. And other asset prices would collapse.

Of course, if the dollar were to fall in half...all of America's dollar-based assets would be marked down 50% too. Farms, factories, labor, stocks, bonds, tools, cars - everything would be reduced in price. The whole country would be about $35 trillion dollars poorer, at least on paper. And where is the short interest? A few speculators betting against the dollar...but what else? Again, the world would not necessarily be a worse place. U.S. industries would be more competitive...foreigners would stream in to buy U.S. assets at fire-sale prices...and even the working man might finally get a real pay increase. But, there would less cash around...fewer dollars...much less liquidity to flush up asset prices.

No, dear reader, when a credit bubble implodes, it swallows up what people once mistook for wealth. All of a sudden, they have less money to spend, less money to lend, and less money to invest. Asset prices go down...consumer spending goes down...and an economic recession comes up. What they once took for granted they now take to court - hoping to collect 10 cents on the dollar, if they are lucky.

Bill Bonner is the President of Agora Publishing.  For more on Bill Bonner, visit The Daily Reckoning.