I don't believe that it is a fundamentally incorrect approach. I believe, that human mind does something like that all the time, the difference is our minds have some additional processes that can, for example, filter hallucinations.
Kids at a specific age range are afraid of their imagination. Their imagination can place a monster into any dark place where nothing can be seen. Adult mind can do the same easily, but the difference is kids have difficulties distinguishing imagination and perception, while adult generally manage.
I believe, the ability of human mind to see difference between imagination/hallucinations from one hand and perception and memory from the other is not a fundamental thing stemming from the architecture of brains but a learned skill. Moreover people can be tricked to acquire false memory[1]. If LLM fell to tricks of Elizabet Loftus, we'd say LLM hallucinated.
What LLMs need is to learn some tricks to detect hallucinations. Probably they will not get 100% reliable detector, but to get to the level of humans they don't need 100% reliability.