On Monday, Blackrock's global head of fixed income Peter Fisher told CNBC that a slow recovery is part and parcel of deleveraging after a 30-year bull run in credit expansion. While this should be self evident to anyone with even a rudimentary knowledge of how the system works, no one seems to want to concede the point and let it happen.
The latest Fed minutes (released Wednesday) are proof that there is an overwhelming, tendency -- indeed, an irresistible urge -- to attempt to fight fire with fire by printing more money to inject into banks, providing them with even more capital to deploy into the system so everyone can attempt to leverage themselves out of a downturn created by excessive leverage. According to the minutes, FOMC members "judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery." It would seem that if after trillions of dollars in asset purchases the U.S. economy is still not recovering at an acceptable rate, it might occur to the Fed (and to everyone waiting breathlessly for QE3) that this strategy is not working.
Perhaps it is time for the world's deeply indebted countries to realize that there simply is no easy way out of these crises. After years of borrowing from the future, it is time to cut back on credit, not expand it anew. How quickly we have forgotten that it was the runaway expansion of credit that led us here in the first place. Now policymakers are doing everything they can to reinflate the credit bubble.
Ironically, the "credit" we live and die by, and the "credit" the Fed is so desperately trying to convince banks to extend, isn't even real credit in the first place. It is but counterfeit credit, to borrow Kieth Weiner's terminology from his article "Inflation: An Expansion of Counterfeit Credit." As Weiner notes, real credit can only be extended when someone has produced excess capital (i.e., more than he or she needs or consumes). In such an instance, the producer may seek to allow others to use that excess for a set time period in exchange for a fixed rate of interest and, of course, the return of the principal at maturity. If someone does not create a surplus, there can be no real credit -- this is common sense as all that is being said is that credit cannot be created from thin air.
But when surpluses are no longer being produced, there can be no real credit extended and the pace of economic activity naturally grinds to a halt. In order to get the ball rolling again (i.e., to allow people to continue to live beyond their means), the Fed extends credit -- it is the so-called "lender of last resort." But as Weiner rightly points out, the Fed doesn't extend real credit (the Fed hasn't worked hard to produce a surplus of capital) -- it extends counterfeit credit. It is credit created from thin air.
The banking system exacerbates the problem by extending its own form of counterfeit credit. This is done by consistently borrowing short and lending long. This is duration mismatch. The depositor has no intention of loaning his or her money out to someone for an extended period of time -- they are "demand deposits" after all. The bank, however, doesn't have to worry about what the individual depositor intends because there are always other individual depositors coming in the door with money so that when one depositor comes in demanding his money (which has, in all likelihood, been lent out without his consent), the bank simply pays that depositor with another depositor's money and so on and so forth.
Keep in mind that fractional reserve banking doesn't have to work like this. If a depositor knows the terms (duration and rate) under which his money is to be loaned out and the bank sticks to the terms, real credit can be extended, no dishonesty exists, and all depositors know at all times that when they come back to get their money, it will be there (not someone else's money, but in principle, the very same money that was deposited in the first place). Not so with duration mismatch. Our banks rely
on the fact that on most days, they will not face too many withdrawal demands. However, it is a mathematical certainty that eventually the bank will default in the face a large crowd all trying to withdraw their money at once. (emphasis mine)
Note that this does not have to be the case with fractional reserve banking. Again, it is a result of borrowing short to lend long, not a result of loaning out deposits.
In such a system as this, it is a small miracle that things have only come close to collapsing on a few occasions. As I have said before, the whole enterprise is based on confidence and trust. There is no inherent logic in it at all. A system devoid of counterfeit credit and duration mismatch is elegant and logical and cannot, by its very nature, fail. It is almost tautological in its functioning. The complexity of our system is created by the need to extend credit where credit (surpluses) do not exist and by the Fed's need to perpetuate the system. The longer the system is allowed to operate this way, the harder will be the fall if ever it is allowed to return to a natural equilibrium where people live within their means and all credit is real credit and not counterfeit.
In my view, the lack of economic growth (i.e., the slow pace of the recovery) results from a system that depends on the extension of counterfeit credit. Each dollar of QE that finds its way into the system via the extension of credit by banks is another dollar loaned that was not created by someone producing a surplus. In other words, these are dollars created from thin air and they are inflationary. These dollars will eventually end up being used as demand deposits, which will then invariably be loaned out, meaning that counterfeit credit (money printed by the Fed to buy assets) is used to extend more counterfeit credit (banks borrowing short to lend long).
The economy cannot be expected to recover while policymakers continue to feed this system. Eventually, Americans must begin to produce more than they consume again -- they must be encouraged and allowed to deleverage. QE is not encouraging this and as such will ultimately fail when failure is defined as the inability to create sustainable economic growth. As long as this is the case, it makes sense to bet on inflation hedges like gold (GLD), commodities, and hard assets.