The current financial system uses credit as currency. This is created out of thin air through a process called fractional reserve banking. What we think of as money circulating in the economy is in fact credit notes, conjured into existence through the issuing of loans. When someone takes up a loan in a bank, currency is created. When people pay down on their loans, currency is destroyed.
This means that there must be a steady demand for credit for the system to operate correctly. There must also be a steady supply of credit. The supply and demand for credit must balance. However, this has not been the case lately. The Federal Reserve has lowered its interest rate while at the same time reducing the currency supply, which is equivalent to a storehouse simultaneously lowering prices and supply.
What the Fed has done goes contrary to the law of supply and demand. It has increased demand for credit by lowering interest rates, while at the same time reducing the supply by retiring credit. The rather predictable outcome of this is that there is suddenly a shortage of credit notes. Since dollars are credit notes in circulation, there is a shortage of dollars. People go to banks expecting to get cheap credit. But the banks are stretched to their limits. They cannot extend more credit. Desperate for credit, people start offering higher rates. What ensues is a spike in interest rates.
Making this all the worse is the fact that people are so used to cheap credit that the economy cannot function without it. A large segment of the economy relies entirely on cheap credit to function. Some of the largest companies in the economy make no money themselves. They pay their expenses by taking up loans. People investing in these companies are similarly leveraged.
All of these people depend on cheap credit. Without a steady supply of cheap dollars, the whole system implodes. However, people's appetite for credit is waning. Not only has the Fed been retiring debt over the past year or so, so has a lot of individuals. People are deleveraging, meaning that they are returning currency to banks. Instead of issuing currency through credit expansion, banks are now retiring currency through credit reduction.
With interest rates spiking, it is now suddenly clear to a lot of people that they may be too deep in debt. The impulse to deleverage is becoming stronger. Unless the Fed regains control of the situation rather soon, there will be a rush to pay back debt. This will dry up the supply of dollars even more, sending interest rates higher still. A lot of people will find themselves trapped, unable to service their debt. Prices of real-estate, stocks and bonds will come crashing down as these people are forced to sell into a market void of cash.
The only way to avoid this is for the Fed to soak the market with cheap credit. For every penny returned through deleverage, the Fed must conjure up a penny of its own. The Fed must start buying what everyone else is selling, meaning that just about everything will be owned by the Fed, and the handful of people controlling it. The ultimate outcome of this will be a massive wealth divide, where the bankers own just about everything, and the average guy in the street owns nothing.
By U.S. Government - Extracted from PDF version of the Federal Reserve's Purposes & Functions document (direct PDF URL [1])., Public Domain, Link
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