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Credit vs Capital

The FED Reserve itself agrees that it can only provide short-term lending vs collateral or short-term liquidity, but they can not provide capital.  If this distinction is not disputed then what exactly is the difference between credit and capital, and how are they misunderstood today?

First, capital can only be created by the private sector or by individuals who live within their means and actually save!  Who would have thought that even in America we may need to save money to create capital which would in turn allow our economy to truly grow.  Recent economic growth in the face of a negative savings rate can be directly correlated to the increase in capital being "pumped" into our system from Asia.

Asia (namely China and Japan) have been running a trade surplus with the US for many years.  This imbalance has resulted in some countries owning very large dollar surpluses.  As these countries build large supplies of US dollars, they have a very few options for what to do with the reserves.  Option One: they can sell the dollars; buy their own currency and invest the capital back into their own countries.  This sounds like a great idea, but if they do this it will cause the dollar to weaken and their own currency to strengthen... simple supply and demand at work.  As a countries currency raises versus the currencies of their trade partners, their ability to effectively export becomes strained.  Since Asia needs to export to the US, the option of selling their dollars and buying their own currency is clearly not beneficial to their countries.  That leaves Option Two:  invest in assets that are priced in the currency of which the Asian country holds a surplus.  In this case, it seems that most countries have chosen this option and have invested huge sums of dollars back into US treasuries.  This wave of capital investments from other countries pushed the price of treasuries up, which in turn brings yields down.  Since this occurred with capital that was not owned or created inside the US, it lead to artificially low interest rates in the US, and a large credit bubble....which takes us back to the difference between credit and capital.

With interest rates artificially low and capital shrinking in the US (negative savings rate), we began spending on credit with the misunderstanding of to whom this borrowed capital belongs.  Throughout most of US history when we as a country borrow money, we are borrowing from ourselves.  During the last depression and recovery, debt percentages went to ratios that we are nearing once again.  The big difference was the fact the 100% of the debt was held by people in the US.  We were effectively using our own capital to grow, while using credit for added liquidity.  This time around, we have not used our own capital, so the resulting credit bubble was much more damaging than expected.  Currently almost 50% of all US debt is owned by foreign investors. The main reason for this cycle being more damaging, is the fact that the capital growth which occurs through the extension of credit, was leaving the country even as GPD was rising.

The banking system is a perfect example of the both credit and capital, they use capital to extend credit to grow more capital.  Regardless of how you feel about the current fractional banking system this is the way it works right now.  Credit and capital often go hand-in-hand, but should never be treated or thought of as similar because they are not remotely similar! 

For us to dig out of this credit hole we have dug, we must first find a way to grow our capital.  If we start wisely investing and prudently saving and the future of America is still bright.  If we stay addicted to borrowing foreign captial, the future quality of life in America will undoubtly continue to decline.